**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 

(Mark One)

 

| x | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|--------------------------------------------------------------------------------------------------------|

 

**Forthe quarterly period ended December 31, 2007**

 

**OR**

 

| o | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|---------------------------------------------------------------------------------------------------------|

 

**Forthe transition period from          to**

 

**Commissionfile number: 333-133278**

 

**KIMBALLHILL, INC.**

*(Exactname of Registrant as specified in its charter)*

 

| **Illinois***(State or other jurisdiction*

* of incorporation or organization)*                         | ** ** | **36-2177380***(I.R.S. Employer*

*Identification  No.)* |
|---------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|
|                                                                                                          |       |                                                     |
| **5999  New Wilke Road, Suite 504  Rolling Meadows, Illinois***(Address of principal executive offices)* | ** ** | **60008***(Zip code)*                                    |

 

**(847) 364-7300***(Registrant’s telephone number, includingarea code)*

 

**NotApplicable***(Former name, former address and formerfiscal year, if changed since last report)*

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.

x Yes o No

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

o Large acceleratedfiler                          o Acceleratedfiler                         x Non-accelerated filer

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

o Yes xNo

 

As of February 1,2008, there were 4,385,898 shares of common stock outstanding.

 

 

 

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**KIMBALLHILL, INC. AND SUBSIDIARIES**

 

**FORM 10-Q**

 

**TABLE OFCONTENTS**

 
| ** **                              | **PAGE**                                                                                                               | ** ** |
|-----------------------------------------|------------------------------------------------------------------------------------------------------------------------|------------|
| PART I—FINANCIAL  INFORMATION |                                                                                                                   |       |
|                                    |                                                                                                                   |       |
| Item 1.                                 | Financial Statements.                                                                                                  |       |   |
|                                    |                                                                                                                   |       |
|                                    | Unaudited Condensed  Consolidated Balance Sheets as of December 31, 2007 and  September 30, 2007             | 3          |   |
|                                    |                                                                                                                   |       |
|                                    | Unaudited  Condensed Consolidated Statements of Operations for the Three Months Ended  December 31, 2007 and 2006 | 4          |   |
|                                    |                                                                                                                   |       |
|                                    | Unaudited Condensed  Consolidated Statements of Cash Flows for the Three Months Ended  December 31, 2007 and 2006 | 5          |   |
|                                    |                                                                                                                   |       |
|                                    | Notes to Unaudited  Condensed Consolidated Financial Statements                                                        | 6          |   |
|                                    |                                                                                                                   |       |
| Item 2.                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations.                           | 26         |   |
|                                    |                                                                                                                   |       |
| Item 3.                                 | Quantitative and  Qualitative Disclosures About Market Risk.                                                           | 44         |   |
|                                    |                                                                                                                   |       |
| Item 4.                                 | Controls and Procedures.                                                                                               | 45         |   |
|                                    |                                                                                                                   |       |
| PART II—OTHER  INFORMATION    |                                                                                                                   |       |
|                                    |                                                                                                                   |       |
| Item 1.                                 | Legal Proceedings.                                                                                                     | 46         |   |
|                                    |                                                                                                                   |       |
| Item 1A.                                | Risk Factors.                                                                                                          | 46         |   |
|                                    |                                                                                                                   |       |
| Item 5.                                 | Other Information.                                                                                                     | 48         |   |
|                                    |                                                                                                                   |       |
| Item 6.                                 | Exhibits.                                                                                                              | 49         |   |
|                                    |                                                                                                                   |       |
| SIGNATURES                              | 50                                                                                                                     |       |
|                                    |                                                                                                                   |       |
| EXHIBIT INDEX                           | 51                                                                                                                     |       |
|                                         |                                                                                                                        |            |  |  |  |

 

 

2

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** **

**PART I—FINANCIALINFORMATION**

**Item1.  Financial Statements.**

**Kimball Hill, Inc. andSubsidiaries**

**Unaudited Condensed ConsolidatedBalance Sheets**

 
| ** **                                                                                                                                               | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| **(in thousands, except shares)**                                                                                                                        | ** ** | **2007**              | ** ** | **2007**               | ** ** |
| **Assets**                                                                                                                                               | ** ** | ** **            | ** ** | ** **             | ** ** |
| HOMEBUILDING:                                                                                                                                            |       |                  |       |                   |       |
| Cash and cash  equivalents                                                                                                                               |       | $                     | 22,811     |                   | $          | 27,996 |   |
| Receivables                                                                                                                                              |       | 16,793                |       | 33,985                 |       |
| Income taxes  receivable                                                                                                                                 |       | 55,472                |       | 22,834                 |       |
| Inventory                                                                                                                                                |       | 604,699               |       | 662,266                |       |
| Inventory not  owned                                                                                                                                     |       | 33,441                |       | 30,100                 |       |
| Deferred  expenses and other assets                                                                                                                      |       | 17,662                |       | 19,311                 |       |
| Investments in and  advances to unconsolidated entities                                                                                                  |       | 13,684                |       | 24,936                 |       |
| Deferred income  taxes                                                                                                                                   |       | 14,031                |       | 42,148                 |       |
| Property and  equipment, net of accumulated depreciation                                                                                                 |       | 11,693                |       | 11,303                 |       |
|                                                                                                                                                     |       | 790,286               |       | 874,879                |       |
| MORTGAGE BANKING:                                                                                                                                        |       |                  |       |                   |       |
| Cash and cash  equivalents                                                                                                                               |       | 2,900                 |       | 3,059                  |       |
| Restricted cash                                                                                                                                          |       | 538                   |       |                   |       |
| Trade accounts  receivable                                                                                                                               |       | 549                   |       | 1,680                  |       |
| Mortgage loans  held for sale                                                                                                                            |       | 900                   |       | 1,577                  |       |
| Investments in  and advances to unconsolidated entities                                                                                                  |       | 300                   |       |                   |       |
| Property and  equipment, net of accumulated depreciation                                                                                                 |       |                  |       | 213                    |       |
|                                                                                                                                                     |       | 5,187                 |       | 6,529                  |       |
| TOTAL ASSETS                                                                                                                                             |       | $                     | 795,473    |                   | $          | 881,408 |   |
| **Liabilities and equity**                                                                                                                               | ** ** | ** **            | ** ** | ** **             | ** ** |
| HOMEBUILDING:                                                                                                                                            |       |                  |       |                   |       |
| Accounts payable  and accrued expenses                                                                                                                   |       | $                     | 78,174     |                   | $          | 96,905 |   |
| Deposits on  sales of residential units                                                                                                                  |       | 4,360                 |       | 4,701                  |       |
| Liabilities  related to inventory not owned                                                                                                              |       | 5,850                 |       | 2,675                  |       |
| Notes payable                                                                                                                                            |       | 541,842               |       | 563,723                |       |
|                                                                                                                                                     |       | 630,226               |       | 668,004                |       |
| MORTGAGE BANKING:                                                                                                                                        |       |                  |       |                   |       |
| Accounts payable  and accrued expenses                                                                                                                   |       | 319                   |       | 450                    |       |
| Other  liabilities                                                                                                                                       |       | 1,322                 |       | 423                    |       |
|                                                                                                                                                     |       | 1,641                 |       | 873                    |       |
| Total  liabilities                                                                                                                                       |       | 631,867               |       | 668,877                |       |
| MINORITY INTEREST IN CONSOLIDATED PARTNERSHIPS                                                                                                           |       | 12,242                |       | 12,252                 |       |
| MINORITY INTEREST IN INVENTORY NOT OWNED                                                                                                                 |       | 37,166                |       | 37,166                 |       |
| REDEEMABLE EQUITY:                                                                                                                                       |       |                  |       |                   |       |
| Redeemable  common stock, no par value; shares outstanding: 164,704 and 210,704 at December 31,  2007 and September 30, 2007                   |       | 1,079                 |       | 10,367                 |       |
| SHAREHOLDERS’ EQUITY:                                                                                                                               |       |                  |       |                   |       |
| Common stock, no  par value; 10,000,000 shares authorized; shares outstanding: 4,221,194 and  4,221,941 at December 31, 2007 and September 30, 2007 |       | 108,270               |       | 108,183                |       |
| Retained  earnings                                                                                                                                       |       | 4,849                 |       | 44,563                 |       |
| Total  shareholders’ equity                                                                                                                         |       | 113,119               |       | 152,746                |       |
| TOTAL LIABILITIES AND EQUITY                                                                                                                             |       | $                     | 795,473    |                   | $          | 881,408 |   |
| * *                                                                                                                                                 | * *   | * *              | * *   | * *               | * *   |

* *

*See notes to unaudited condensed consolidatedfinancial statements.*

 

 

3

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**KimballHill, Inc. and Subsidiaries**

**UnauditedCondensed Consolidated Statements of Operations**

 
| **For the three months ended  December 31, 2007 and 2006**           | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **(in thousands)**                                                        | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| HOMEBUILDING:                                                             |       |       |       |       |       |
| Revenues:                                                                 |       |       |       |       |       |
| Sales of  residential units and land                                      |       | $          | 150,380    |       | $          | 238,412 |   |
| Rental and other  income                                                  |       | 2,007      |       | 417        |       |
| Total  homebuilding revenues                                              |       | 152,387    |       | 238,829    |       |
| Expenses:                                                                 |       |       |       |       |       |
| Cost of sales of  residential units and land                              |       | 161,679    |       | 243,151    |       |
| General and  administrative                                               |       | 16,846     |       | 16,626     |       |
| Sales and  marketing                                                      |       | 10,443     |       | 13,834     |       |
| Depreciation                                                              |       | 303        |       | 254        |       |
| Total homebuilding  expenses                                              |       | 189,271    |       | 273,865    |       |
| Equity in (loss)  income of unconsolidated joint ventures                 |       | (15,708    | )          | 500        |       |
| Minority  interests in net losses (earnings) of consolidated partnerships |       | 10         |       | (76        | )          |
| Homebuilding  loss before income taxes                                    |       | (52,582    | )          | (34,612    | )          |
| MORTGAGE BANKING:                                                         |       |       |       |       |       |
| Revenues:                                                                 |       |       |       |       |       |
| (Loss) gain on  sales of mortgage loans                                   |       | (164       | )          | 1,742      |       |
| Total mortgage  banking revenues                                     |       | (164       | )          | 1,742      |       |
| Expenses:                                                                 |       |       |       |       |       |
| General and  administrative                                               |       | 1,216      |       | 1,204      |       |
| Depreciation                                                              |       | 27         |       | 22         |       |
| Total mortgage  banking expenses                                          |       | 1,243      |       | 1,226      |       |
| Equity in income  of unconsolidated joint ventures                        |       | 83         |       |       |       |
| Mortgage banking  (loss) earnings before income taxes                     |       | (1,324     | )          | 516        |       |
| LOSS BEFORE  INCOME TAXES                                                 |       | (53,906    | )          | (34,096    | )          |
| BENEFIT FROM INCOME TAXES                                                 |       |       | (7,521     | )          | (13,127    | ) |
| NET LOSS                                                                  |       | $          | (46,385    | )          | $          | (20,969 | ) |
|                                                                      |       |       |       |       |       |

* *

*See notes to unaudited condensed consolidatedfinancial statements.*

* *

 

4

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**KimballHill, Inc. and Subsidiaries**

**UnauditedCondensed Consolidated Statements of Cash Flows**

 
| **For the three months ended  December 31, 2007 and 2006**                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| **(in thousands)**                                                                                       | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| **Cash flows from operating activities:**                                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                                                 |       | $          | (46,385    | )          | $          | (20,969 | ) |
| Adjustments to  reconcile net loss to cash flows from operating activities:                              |       |       |       |       |       |
| Depreciation                                                                                             |       | 330        |       | 276        |       |
| Inventory  valuation adjustments                                                                         |       | 13,194     |       | 39,988     |       |
| Write-off of  land option costs                                                                          |       | 81         |       | 469        |       |
| Amortization of  deferred expenses                                                                       |       | 1,715      |       | 1,407      |       |
| Unrealized loss  on derivatives                                                                          |       | 21         |       | 33         |       |
| Equity-based  compensation                                                                               |       |       |       | 205        |       |
| Distributions of  income from investments in unconsolidated entities                                     |       | 198        |       | 195        |       |
| Net losses  (earnings) from investments in unconsolidated entities                                       |       | 15,625     |       | (500       | )          |
| Gain on sale of  property and equipment                                                                  |       | (1,639     | )          |       |       |
| Minority  interest in consolidated (losses) earnings                                                     |       | (10        | )          | 76         |       |
| Deferred income  taxes                                                                                   |       | 28,117     |       | (14,731    | )          |
| Changes in  operating assets and liabilities:                                                            |       |       |       |       |       |
| Receivables                                                                                              |       | 18,323     |       | 13,218     |       |
| Mortgage loans  held for sale                                                                            |       | 677        |       | 1,349      |       |
| Inventory                                                                                                |       | 44,290     |       | 29,882     |       |
| Deferred  expenses and other assets                                                                      |       | (669       | )          | (3,067     | )          |
| Accounts payable  and accrued expenses                                                                   |       | (24,962    | )          | (33,731    | )          |
| Deposits and  other liabilities                                                                          |       | (661       | )          | (433       | )          |
| Income taxes,  net                                                                                       |       | (32,504    | )          | (5,970     | )          |
| Net cash  provided by operating activities                                                               |       | 15,741     |       | 7,697      |       |
| **Cash flows from investing activities:**                                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Purchases of  property and equipment                                                                     |       | (1,361     | )          | (525       | )          |
| Proceeds from  sale of property and equipment                                                            |       | 2,306      |       |       |       |
| Proceeds from  sale of interest in investments in unconsolidated entities                                |       | 900        |       |       |       |
| Contributions  and advances to investments in unconsolidated entities                                    |       | (1,208     | )          | (4,856     | )          |
| Net cash provided  by (used in) investing activities                                                     |       | 637        |       | (5,381     | )          |
| **Cash flows from financing activities:**                                                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Proceeds from  issuance of notes and mortgage loans payable                                              |       | 48,213     |       | 74,474     |       |
| Repayments of  notes and mortgage loans payable                                                          |       | (72,872    | )          | (84,796    | )          |
| Proceeds from  sale of land with option to repurchase                                                    |       | 2,895      |       |       |       |
| Debt issuance  costs                                                                                     |       |       |       | (850       | )          |
| Net proceeds  from issuance of common stock                                                              |       | 90         |       | 39         |       |
| Repurchases of  common stock                                                                             |       | (48        | )          | (2         | )          |
| Contributions  from minority interests                                                                   |       |       |       | 3,000      |       |
| Net cash used in  financing activities                                                                   |       | (21,722    | )          | (8,135     | )          |
| **Net decrease in cash and cash equivalents**                                                            |       | (5,344     | )          | (5,819     | )          |
| Cash and cash equivalents—Beginning of period                                                       |       | 31,055     |       | 18,665     |       |
| Cash and cash equivalents—End of period                                                             |       | $          | 25,711     |       | $          | 12,846 |   |
| **Reconciliation  to cash and cash equivalents reported on the condensed consolidated balance  sheets:** |       |       |       |       |       |
| Homebuilding                                                                                             |       | $          | 22,811     |       |       |   |
| Mortgage banking                                                                                         |       | 2,900      |       |       |       |
| Total                                                                                                    |       | $          | 25,711     |       |       |   |
| **Supplemental disclosure of cash flow  information:**                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for  interest                                                                                  |       | $          | 18,302     |       | $          | 17,296 |   |
| Cash (received  from) paid for income taxes                                                              |       | $          | (3,134     | )          | $          | 7,574 |   |
| **Supplemental disclosure of noncash investing and  financing activities:**                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Increase in  inventory related to lots distributed by unconsolidated entities                            |       | $          | 2,405      |       |       |   |
| Non cash  contributions to unconsolidated entities                                                       |       | $          | 271        |       |       |   |
| Increase in  other liabilities related to receipt of restricted cash                                     |       | $          | 538        |       |       |   |
| Notes issued for  repurchase of common stock                                                             |       | $          | 2,706      |       |       |   |
| Increase in  liabilities related to inventory not owned                                                  |       | $          | 3,175      |       | $          | 10,515 |   |
|                                                                                                     |       |       |       |       |       |

* *

*Seenotes to unaudited condensed consolidated financial statements.*

 

 

5

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** **

**Kimball Hill, Inc. andSubsidiaries**

**Notes toUnaudited Condensed Consolidated Financial Statements**

** **

**1.  Basis ofPresentation and Significant Accounting Policies**

** **

Theaccompanying unaudited condensed consolidated financial statements include theaccounts of Kimball Hill, Inc. and all of its wholly-owned, majority-ownedand controlled subsidiaries (the “Company”), as well as certain variableinterest entities from which the Company is purchasing land or lots underoption agreements and purchase contracts. All significant intercompanyaccounts, transactions and balances have been eliminated in consolidation. Theunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (“GAAP”) for interim financial information and in accordance withthe instructions to Form 10-Q and Article 10 of Regulation S-X. Suchfinancial statements do not include all of the information and disclosuresrequired by GAAP for complete financial statements. As a result, thesefinancial statements should be read in conjunction with the auditedconsolidated financial statements and accompanying notes for the fiscal yearended September 30, 2007 in the Company’s Annual Report on Form 10-K.In the opinion of management, all adjustments (consisting of normal, recurringaccruals) necessary for fair presentation have been included in theaccompanying financial statements.

 

***Seasonal Variability******—***Historically, the homebuilding industryhas experienced seasonal fluctuations; therefore, the operating results for thethree month period ended December 31, 2007 are not necessarily indicativeof the results that may be expected for the fiscal year ending September 30,2008.

 

***Going Concern******—*** The Company’s ability to continue as agoing concern is dependent upon its ability to return to profitable operationsin the future and to retain the necessary financing to meet its obligations andpay its liabilities when they come due.

 

Asof December 31, 2007 and September 30, 2007, the Company was not incompliance with certain of the amended covenants of its senior credit facility,including the covenant requiring the Company to maintain a minimum tangible networth (as defined in the senior credit facility). The Company’s failure to meetthese covenants allows the lenders under the senior credit facility to declareall amounts outstanding thereunder, together with accrued interest, to beimmediately due and payable. Acceleration under the senior credit facility wouldalso trigger a cross-default under the indenture governing the seniorsubordinated notes, thereby allowing the bondholders to accelerate therepayment of all amounts outstanding on the senior subordinated notes. Inaddition, certain other credit facilities within the Company’s joint venturesto which it has provided guarantees include provisions for acceleration orevents of default in the event of a default under the senior credit facility.

 

Although,the Company obtained a limited duration waiver and amendment in January 2008with respect to its senior credit facility (see notes 5 and 11), the Company isno longer in compliance with the covenants set forth therein as a result ofrecording additional impairment charges in connection with the preparation andreview of the condensed consolidated financial statements for the period ended December 31,2007. The Company intends to continue discussions with its bank group regardingfurther amendments or waivers to the senior credit facility upon reasonableterms, however, there can be no assurance that the Company will be able tofurther amend or obtain waivers under the senior credit facility uponreasonable terms, or at all. The Company currently has no alternative financingin place and if it is unable to find alternative financing or obtain furtheramendments or waivers, the Company may not have sufficient assets to repay theoutstanding debt if accelerated. Working with Alvarez & Marsal NorthAmerica, LLC, a financial advisory and consulting firm, the Company isconsidering a number of alternatives, including the appointment of a chiefrestructuring officer and whether to seek a complete restructuring underChapter 11 of the United States Bankruptcy Code.

 

Dueto the uncertainties mentioned above, there are substantial doubts aboutwhether the Company will be able to continue as a going concern, and therefore,the Company may be unable to realize its assets and discharge its liabilitiesin the normal course of business. The Company’s consolidated financial statementshave been prepared on a going concern basis, which contemplates the realizationof assets and the settlement of liabilities and commitments in the normalcourse of business. The accompanying financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or to the amounts and classification of liabilities that may benecessary if the Company is unable to continue as a going concern.

 

 

6

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***Stock Plans******—******Effective October 1, 2006, the Company adoptedSFAS 123R,******Share-Based Payment******, which requires that the cost resulting from allshare-based payment transactions be recognized in the financial statements andestablishes fair value as the measurement objective in accounting forshare-based payment arrangements. SFAS 123R applies to all awards granted,modified, repurchased or cancelled by the Company after the effective date ofadoption. The Company has not granted, modified, repurchased or cancelled anyawards since the effective date. Since the Company previously used the minimumvalue method under SFAS***123, *Accounting for Stock-Based Compensation*, the Company willcontinue to account for any portion of awards outstanding at October 1,2006 using the accounting principles originally applied to those awards.

 

Duringfiscal 2005, the Company granted 37,500 deferred stock units, representing aright to receive 37,500 shares of the Company’s common stock at a future date.Under the terms of the agreement, one-third of the deferred stock units fullyvested on each of October 1, 2005, 2006, and 2007, respectively, with theshares being issued on the earlier of: a) the fifth anniversary of the date ofgrant, b) the executive’s separation of service, c) the executive’s death ordisability, or d) a change in control. Each period, the Company recognizedcompensation cost, for the relative service period covered, equal to the marketvalue of the underlying common shares of the Company on the date of grant. Duringthe three months ended December 31, 2006, compensation cost of $0.2million related to deferred stock units is included in the Company’s condensedconsolidated statements of operations.

 

***Redeemable Common Stock******—***Under the terms of the Company’s amendedstock option plans, the Company has contractual obligations to purchase sharesof its outstanding common stock at fair value from certain of its directors,executive officers and other key employees in the event of termination of boardmembership or employment, as applicable, by reason of specified circumstances,including death, disability, involuntary termination or retirement.

 

Atthe time outstanding shares qualify for this redemption right, the redemptionamount is transferred from shareholders’ equity to redeemable common stock.Subsequent changes to the redemption amount are transferred from shareholders’equity to redeemable common stock in the case of an increasing redemptionamount, or, from redeemable common stock to shareholders’ equity in the case ofa decreasing redemption amount. Certain outstanding options would qualify forthis redemption right after exercise of the options.

 

TheCompany establishes the fair value of its stock on a quarterly basis. Theevaluation of fair value is significantly impacted by the homebuilding industryclimate and the Company’s relative performance. Considering the continueddeterioration in market conditions and the Company’s uncertainties about itsability to continue as a going concern, the estimated fair value of theredeemable common stock includes significant subjective assumptions, butrepresents the Company’s best estimate as of the dates of the condensedconsolidated balance sheets.

 

Basedupon the most recent valuation of the Company as of December 31, 2007, the fairvalue of redeemable common stock was valued at $6.55 per share.

 

7

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**2.  Inventory**

** **

Inventoryconsists of the following:

 
| ** **                                            | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| **(in thousands)**                                    | ** ** | **2007**              | ** ** | **2007**               | ** ** |
| Residential lots—developed and under development |       | $                     | 407,419    |                   | $          | 407,002 |   |
| Finished homes and construction in progress           |       | 168,535               |       | 201,882                |       |
| Deposits on land purchases                            |       | 3,009                 |       | 3,179                  |       |
| Land held for future development or sale              |       | 25,736                |       | 50,203                 |       |
| Total                                                 |       | $                     | 604,699    |                   | $          | 662,266 |   |
|                                                  |       |                  |       |                   |       |

 

***In accordance with Statement of FinancialAccounting Standards No. 144,******Accounting for theImpairment or Disposal of Long-Lived Assets******(“SFAS 144”), the*** Companyassesses housing projects, land held for development or sale, and property andequipment for recoverability whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.Recoverability of assets is measured by comparing the carrying amount of anasset to future undiscounted net cash flows expected to be generated by theasset. If these assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount exceeds thefair value of the assets.

 

Forpurposes of measuring impairment, SFAS 144 distinguishes between long-livedassets held for sale and long-lived assets to be held and used. Long-livedassets held for sale should be reported at the lower of the carrying amount orfair value, less costs to sell the assets. Long-lived assets to be held andused with a carrying value that will not be recoverable from futureundiscounted cash flows should be reported at the lower of the carrying amountor fair value.

 

Whenreviewing for impairment, the Company evaluates the future undiscounted netcash flows expected to be generated by each asset based upon the Company’sintentions at the time of its review. For purposes of these impairmentcalculations, the Company determines the fair value of each asset determined tobe impaired either by using internal project modeling software to determine thepresent value of the estimated future cash flows on a community-by-communitybasis using discount rates which are commensurate with the risk of thecommunity or by referring to independent project-specific appraisals or bycomparing to recent comparable land sales and recent discussions with landbrokers and potential buyers where the Company is actively marketing the landfor sale.

 

***These evaluations for impairment aresignificantly impacted by estimates of revenues, costs and expenses and otherfactors. The Company will continue to monitor the homebuilding climate in eachof its markets and could change its intentions about whether to continuehomebuilding activities related to any assets in the future. Changes in theCompany’s intentions or its expectations of market performance could have amaterial impact on the carrying value of its assets as certain of the assetsdetermined to be recoverable on an undiscounted cash flow basis may havecarrying values greater than fair value.***

 

Duringthe three months ended December 31, 2007 and 2006, the Company recordedinventory impairment charges of $13.2 million and $40.0 million,respectively. These charges are included in cost of sales in the Company’scondensed consolidated statements of operations.

 

TheCompany’s current operating strategy includes selling certain land inventoryto: reduce debt, adjust the balance of its land holdings by region and reduceits overall investment in land. ***The Company has identified certainland parcels it intends to sell and is actively marketing the properties fordelivery within the next 12 months.******As of December 31, 2007, theCompany has $24.8 million of land inventory that is held for sale.***

 

8

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Giventhe continued deterioration in market conditions and uncertainty about thetiming and pace of any recovery, the Company has tightened its land acquisitioncriteria and is working with land sellers to renegotiate land purchase andoption contracts to extend purchase dates and reduce purchase prices. If theCompany is unable to obtain satisfactory terms, the Company will not exerciseits land option agreements and will abandon its earnest money if contractuallyobligated to do so. During the three months ended December 31, 2007 and2006, the Company wrote-off $0.1 million and $0.5 million of costs related tothe abandonment of land option contracts.

 

The Company capitalizes interest during development andconstruction. Capitalized interest is charged to cost of sales as residentialunits are closed. Interest costs for the three months ended December 31,2007 and 2006 are as follows:

 
| **(in thousands)**                            | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|
| Capitalized interest—beginning of period |       | $        | 69,865     |     | $          | 59,409 |   |
| Interest incurred                             |       | 12,111   |       | 11,827   |       |
| Interest included in cost of sales            |       |     | (14,267    | )        | (8,771     | ) |
| Capitalized interest—end of period       |       | $        | 67,709     |     | $          | 62,465 |   |
|                                          |       |     |       |     |       |

 

Inventoryimpairment charges are recognized against all inventory costs of a community,such as land, land improvements, costs of home construction and capitalizedinterest. The amounts included in the above table reflect the gross amount ofcapitalized interest before allocation of any impairment charges recognized.

 

**3*.* **Inventory Not Owned

** **

Inventorynot owned consists of options on land that have been consolidated in accordancewith FIN 46R, *Consolidation of Variable Interest Entities*,and property that has been sold to a third party in which the Company hasretained a continuing interest in that property and does not qualify for saletreatment under GAAP.

 

UnderFIN 46R, a variable interest entity (“VIE”) is created when (i) the equityinvestment at risk is not sufficient to permit the entity to finance itsactivities without additional subordinated financial support from other partiesor (ii) equity holders either (a) lack a direct or indirect abilityto make decisions about the entity, (b) are not obligated to absorbexpected losses of the entity or (c) do not have the right to receiveexpected residual returns of the entity, if they occur. FIN 46R requires theconsolidation of VIEs in which an enterprise absorbs a majority of the entity’sexpected losses, receives a majority of the entity’s expected residual returns,or both, as a result of ownership, contractual or other financial interests inthe entity.

 

TheCompany has applied, as required, FIN 46R to all variable interests and hasdetermined that many of its options on land represent a variable interest inVIEs. The Company has determined it is the primary beneficiary of certain ofthese option contracts, and although the Company does not have legal title tothe optioned land, under FIN 46R, it is required that the Company consolidatethe land under option at initial fair value.

 

AtDecember 31, 2007, the Company had consolidated optioned land with a fairvalue of $30.4 million for which it paid cash option deposits of $0.7 million.At September 30, 2007, the Company had consolidated optioned land with afair value of $30.1 million for which it paid cash option deposits of $0.7 million.The Company estimated the initial fair value of the consolidated optioned landbased upon the Company’s option contract price. In many cases, the Company wasunable to obtain the relevant financial information from the selling entities, therefore,the Company has used the information available to make an assumption as towhether the selling entity has additional assets or has debt obligationsoutstanding. The difference between the fair value of the land under contractand the Company’s non-refundable deposit is recorded in liabilities related toinventory not owned unless it is determined by the Company that the sellingentity does not carry debt in which case the difference is recorded as minorityinterest in inventory not owned.

 

9

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Duringthe three months ended December 31, 2007, the Company entered into twoseparate agreements to sell land for $2.9 million to a third party thatprovides for an option for the Company to repurchase the land at later dates.Due to the Company’s continuing involvement, the transaction did not qualify asa sale under GAAP and was classified as a financing activity in the condensedconsolidated statement of cash flows. At December 31, 2007, the Companyhad recorded $2.9 million of inventory not owned and $2.9 million ofliabilities related to inventory not owned for transactions with continuinginvolvement. At September 30, 2007, the Company had not recorded anyinventory not owned for transactions with continuing involvement.

 

**4.  Investments In and Advances to UnconsolidatedEntities**

** **

Investmentsin and advances to unconsolidated entities represent the Company’s ownershipinterest in entities accounted for under the equity method when it has asignificant influence over the entity but holds less than a controllinginterest in the entity or it is not the primary beneficiary in a VIE as definedby FIN 46R. The Company’s business partners generally are unrelatedhomebuilders, land sellers or other real estate entities. The Company uses thecost method for ventures over which it does not have a significant influence.The Company reviews all investments for reductions in fair value that areconsidered other than temporary. When indicators exist that the Company’s equityand cost method investments are impaired, the Company considers whether thatimpairment is other than temporary. If the impairment is determined to be otherthan temporary, the Company records an impairment by the amount which thecarrying amount of the investment exceeds its fair value.

 

Inthe ordinary course of business, the Company periodically enters intoarrangements with land developers or other homebuilders to acquire land anddevelop lots. These arrangements include the creation of joint ventures, inwhich the Company’s current interests range from 6.29% to 49.90%. The Companyaccounts for its interest in these joint ventures under the equity method, andthe Company’s condensed consolidated balance sheets include investments in andadvances to joint ventures totaling $14.0 million and $24.9 million at December 31,2007 and September 30, 2007, respectively. These joint ventures typicallyobtain secured acquisition, development and construction financing. At December 31,2007 and September 30, 2007, the Company’s unconsolidated joint ventureshad outstanding third party borrowings of $810 million and $940 million,respectively. From time to time the Company has issued completion guarantees,repayment guarantees and/or loan-to-value maintenance guarantees in respect ofthis indebtedness. These guarantees require the Company to repay debt of thejoint venture in the event of a payment default or in the event that the debtof the joint venture exceeds the value of the property securing the debt. Set forth below are the significant changes relatedto the Company’s investments and advances to unconsolidated entities during thethree months ended December 31, 2007.

 

In January 2005, the Company entered into a joint venture, in which ithas a 9.59% interest, to acquire and develop land in Nevada (“Nevada JV No.1”). As of September 30, 2007, the Company determined that its investment inNevada JV No. 1 was more than temporarily impaired and recorded a $21.5 millioncharge to write-down the investment balance to zero. At December 31, 2007,Nevada JV No. 1 had third party debt of $435 million under a secured creditfacility, of which each member has guaranteed payment of its pro rata share inthe event of specified bankruptcy events or in the event of certain improper orfraudulent actions involving Nevada JV No. 1. The Company’s pro rata portion ofthe debt is $41.7 million at December 31, 2007. The Company has also providedpro rata completion guarantees for this joint venture. The repayment guaranteerequires that the Company be in compliance with the financial covenantscontained in the Company’s senior credit facility and, thus, the Company’scurrent default under its senior credit facility constitutes an event ofdefault under Nevada JV No. 1’s secured credit facility. Failure to cure suchdefaults could result in the acceleration of Nevada JV No. 1’s repaymentobligations under its secured credit facility, which could trigger across-default under the indenture governing the Company’s senior subordinatednotes, thereby allowing the bondholders to accelerate the repayment of allamounts outstanding under the senior subordinated notes. 

 

Recently, Nevada JV No. 1 received notice from the administrative agentunder its secured credit facility that it was not in compliance with certaincovenants thereunder, including a performance covenant requiring that Nevada JVNo. 1 make a specified amount of progress with respect to the projectscontemplated under the secured credit facility. Breach of such covenantconstitutes an event of default under its secured credit facility. Failure tocure such defaults could result in the acceleration of Nevada JV No. 1’srepayment obligations under its secured credit facility. To the Company’sknowledge, the lenders under this facility have not indicated they willaccelerate amounts due under the facility as a result of these defaults,however, there can be no assurance that they will not.

 

Further, on May 31, 2008, the Company will be required to purchase landin connection with Nevada JV No. 1 for a purchase price of approximately $15.4million subject to certain credits for past investments in the joint ventureand the obligation to fund future development costs. The Company believes thereis a substantial likelihood that it will not have sufficient liquidity to makethis purchase. Failure to make this purchase will, among other things,constitute an event of default under Nevada JV No. 1’s secured credit facility,upon which the lenders may terminate their commitments thereunder and accelerateNevada JV No. 1’s repayment obligations thereunder and, if the lenders arepermitted to accelerate the repayment obligations, it will constitute an eventof default under the Company’s senior credit facility which could result in theacceleration of the Company’s repayment obligations under its senior creditfacility. Acceleration of either Nevada JV No. 1’s or the Company’s repaymentobligations could trigger a cross-default under the indenture governing theCompany’s senior subordinated notes, thereby allowing the bondholders toaccelerate the repayment of all amounts outstanding under the seniorsubordinated notes. The Company may have additional liabilities associated witha breach of its Nevada JV No. 1 obligations. 

 

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In May 2004, the Company entered into a joint venture, in which it hasa 6.29% interest, to acquire and develop land in Nevada (“Nevada JV No. 2”). Asof December 31, 2007, the Company determined that its investment in Nevada JV No.2 was more than temporarily impaired and recorded a $17.1 million charge towrite-down the investment balance to zero and to accrue for an outstandingletter of credit. At December 31, 2007, Nevada JV No. 2 had third party debt of$325 million under a secured credit facility, of which each member hasguaranteed payment of its pro rata share in the event of specified bankruptcyevents or in the event of certain improper or fraudulent actions involvingNevada JV No. 2. The Company’s pro rata portion of the debt is $20.4 million atDecember 31, 2007. The Company has provided pro rata completion guarantees forNevada JV No. 2. The repayment guarantee requires that the Company be incompliance with the financial covenants contained in the Company’s senior creditfacility and, thus, the Company’s current default under its senior creditfacility constitutes an event of default under Nevada JV No. 2’s secured creditfacility. Failure to cure such defaults could result in the acceleration ofNevada JV No. 2’s repayment obligations under its secured credit facility,which could trigger a cross-default under the indenture governing the Company’ssenior subordinated notes, thereby allowing bondholders to accelerate therepayment of all amounts outstanding under the senior subordinated notes. 

 

On April 15, 2008, the Company is required to purchase land inconnection with Nevada JV No. 2 for a purchase price of approximately $43.1million subject to certain credits for past investments in the joint ventureand the obligation to fund future development costs. The Company believes thereis a substantial likelihood that it will not have sufficient liquidity to makethis purchase. Failure to make this purchase will, among other things,constitute an event of default under Nevada JV No. 2’s secured credit facility.If such default occurs and remains uncured, the lenders under Nevada JV No. 2’sfacility may terminate commitments under the facility and may accelerate NevadaJV No. 2’s repayment obligations and, if the lenders are permitted toaccelerate the repayment obligations, it will constitute an event of defaultunder the Company’s senior credit facility which could result in theacceleration of the Company’s repayment obligations under its senior creditfacility. Acceleration of either Nevada JV No. 2’s or the Company’s repaymentobligations could trigger a cross-default under the indenture governing theCompany’s senior subordinated notes, thereby allowing the bondholders toaccelerate the repayment of all amounts outstanding under the seniorsubordinated notes. In addition, in connection with a previous purchase underthe facility, letters of credit for $12.5 million were issued under theCompany’s senior credit facility. Subject to a limited cure period, upon anevent of default under Nevada JV No. 2’s secured credit facility, theadministrative agent thereunder may, in addition to its other remedies, drawupon this letter of credit in full and apply such amounts to repay theCompany’s pro rata portion of Nevada JV No. 2’s debt. The Company may haveadditional liabilities associated with a breach of its Nevada JV No. 2obligations.

 

InOctober 2007, the Company’s mortgage banking subsidiary (KH FinancialL.P., or “KHF”), and Wells Fargo Bank, N.A. and its wholly owned subsidiaryWells Fargo Ventures, LLC (collectively, “Wells Fargo”) formed a new jointventure, KH Mortgage, LLC (“KH Mortgage”). KHF contributed $250,000 in cash andcontributed various assets to establish KH Mortgage. Then, pursuant to theAssignment of Interest Agreement between the parties, Wells Fargo paid $900,000in cash to KHF, opened a one year certificate of deposit in KHF’s name for$538,000 and agreed to waive certain management fees with an estimated benefitto KHF of $437,000 in exchange for a 50.1% interest in KH Mortgage. KHFretained ownership of the remaining 49.9 % of KH Mortgage. The sale of theinvestment in KH Mortgage generated a deferred gain of $1,219,000 that isincluded in other liabilities in the condensed consolidated balance sheets. Thedeferred gain will only be recognized in earnings in the event the Companydiscontinues its relationship with KH Mortgage or otherwise satisfiesapplicable contractual requirements for the recognition of the gain. TheCompany’s wholly-owned mortgage subsidiary began to wind down its operations inNovember 2007, and it will cease day to day operations during the secondfiscal quarter of 2008 after it has fully satisfied all commitments toborrowers for loans.

 

**5.  Financing**

** **

The Company’s notespayable consist of the following:

 
| ** **                                               | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|----------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| **(in thousands):**                                      | ** ** | **2007**              | ** ** | **2007**               | ** ** |
| Senior credit facility                                   |       | $                     | 309,342    |                   | $          | 322,759 |   |
| Senior subordinated notes (net of unamortized  discount) |       | 201,091               |       | 201,019                |       |
| Other senior secured credit facilities                   |       | 27,425                |       | 39,945                 |       |
| Other senior debt                                        |       |                  | 3,984      |                   |       |   |
| Total                                                    |       | $                     | 541,842    |                   | $          | 563,723 |   |
|                                                     |       |                  |       |                   |       |

 

InDecember 2005, the Company entered into a new senior credit facility tofinance its business operations. Proceeds of the new senior credit facilitywere used to retire its existing senior secured revolving credit facilities andsubstantially all of its other senior secured credit facilities. The seniorcredit facility had a maximum availability of $500 million, subject to aborrowing base as well as sublimits of $100 million for the issuance of lettersof credit and $10 million for swing line loans. The Company had the right,without the consent of its lenders (other than those participating in theincrease), to increase the commitment by an amount of up to $200 million, providedthat no such 

 

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increaseshall cause the senior credit facility to exceed $700 million. The Companyamended the senior credit facility in December 2006 to amend certaincovenants; amended and restated the senior credit facility in August 2007to further amend certain covenants, require that the senior credit facility besecured by all properties to be included in the borrowing base for the seniorcredit facility and related assets and prohibit the incurrence of anyadditional secured debt; and amended the senior credit facility in January 2008to reduce the maximum availability thereunder to $400 million to better matchthe Company’s financing needs.

 

Theapplicable borrowing base is determined regularly throughout the life of thesenior credit facility. The composition of the borrowing base is limited toparameters set forth in the senior credit facility agreement and certain typesof real estate (such as unimproved entitled land and lots under development)are removed from the borrowing base if held beyond specified maturity dates. Asa result of the August 2007 amendments to the senior credit facility, theproperty of certain non-wholly owned subsidiaries cannot be included in theborrowing base calculation unless and until such subsidiaries are able toguarantee the senior credit facility (on a secured basis), which will besubject to the consent of minority interest holders and there is no assurancethat the Company would be able to obtain such consent. New properties that areproposed to be included as borrowing base property would also be mortgaged andpledged to secure the senior credit facility and also would need to satisfyspecified parameters or otherwise be approved by the majority lenders.

 

Borrowingsunder the senior credit facility generally bear interest based on an applicablemargin plus LIBOR or an alternate base rate. The applicable margin for interestranges from 1.5% to 2.25%, depending upon the Company’s senior leverage ratio,which is defined as the ratio of total liabilities to consolidated net worth.Fees for letters of credit are based on LIBOR plus a margin of 1.5%. An unusedcommitment fee equal to 0.2% to 0.3% per year accrues on the undrawn portion ofthe senior credit facility and is payable quarterly in arrears. The August 2007amendments provide that the applicable interest margins are subject to increaseby 0.375% to 0.875% in the event that liquidity (as defined below) is more than$50 million but less than or equal to $100 million.

 

The covenants under the senior credit facility, as amended,require the Company to: maintain a minimum tangible net worth of at least $300million plus 50% of positive net income earned subsequent to September 30,2006; maintain a ratio of total liabilities to adjusted tangible net worth notto exceed 2.0x (decreasing to 1.75x as of June 30, 2007 and increasing to2.5x as of December 31, 2008); maintain a ratio of total debt to adjustedtangible net worth not to exceed 1.5x; maintain a ratio of total land(including undeveloped land, land under development and finished lots on whichhome construction has yet to begin) to adjusted tangible net worth not toexceed 1.5x; and maintain an interest coverage ratio of no less than 1.75xthrough December 31, 2006 (decreasing to 1.5x through March 31, 2007,decreasing to 1.4x through June 30, 2007, decreasing to 1.35x through September 30,2007, increasing to 1.5x through December 31, 2007, increasing to 1.75xthrough March 31, 2008 and then increasing to 2.25x through the remainingterm of the senior credit facility). For purposes of these tests, adjustedtangible net worth is benefited by adjustments of 50% of the Company’soutstanding senior subordinated debt (up to a maximum $100 million adjustment)and 100% of minority interests in consolidated entities (up to a maximum $50million adjustment). The August 2007 amendments: (1) permit theCompany to ignore, for purposes of financial covenant calculations (but not forinterest margin calculations), up to $40 million of tangible net worthreductions due to impairment and abandonment charges; (2) suspend theinterest coverage ratio covenant until March 31, 2009 and add a minimumrequirement of adjusted earnings before interest, taxes, depreciation andamortization (as defined in the senior credit facility) of $25 million on atrailing four-quarter basis, and a minimum $50 million liquidity requirement(defined as unrestricted cash, available borrowings under the senior creditfacility and other available lines of credit and receivables from homeclosings); (3) require the Company to test liquidity monthly; and (4) reducepermitted unsecured debt from $25 million to $15 million and permitted jointventure investments from 30% of tangible net worth to 25% of tangible networth.

 

 

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Asof December 31, 2007, the Company had $309 million of borrowings under thesenior credit facility at an effective interest rate of 6.33%. As of December 31,2007 and September 30, 2007, the Company was not in compliance withcertain of the covenants in the senior credit facility, including the covenantrequiring the Company to maintain a minimum tangible net worth (as defined inthe senior credit facility). The Company’s failure to meet these covenantsallows the lenders under the senior credit facility to declare all amountsoutstanding thereunder, together with accrued interest, to be immediately dueand payable. Acceleration under the senior credit facility would also trigger across-default under the indenture governing the Company’s senior subordinatednotes, thereby allowing the Company’s bondholders to accelerate the repaymentof all amounts outstanding on the senior subordinated notes, subject to certainpayment blockage periods. In addition, certain other credit facilities withinthe Company’s joint ventures to which the Company has provided guaranteesinclude provisions for acceleration or events of default in the event of adefault under the Company’s senior credit facility.

 

Althoughthe Company obtained a limited duration waiver and amendment in January 2008with respect to its senior credit facility (see note 11), the Company is nolonger in compliance with the covenants set forth therein as a result ofrecording additional impairment charges in connection with the preparation andreview of the condensed consolidated financial statements for the period ended December 31,2007. The Company intends to continue discussions with its bank group regardingfurther amendments or waivers to the senior credit facility upon reasonableterms, however, there can be no assurance that the Company will be able tofurther amend or obtain waivers under the senior credit facility uponreasonable terms, or at all.

 

InDecember 2005, the Company issued $203 million aggregate principal amountof senior subordinated notes due December 2012 in a private placementpursuant to Rule 144A promulgated under the Securities Act of 1933. In May 2006,the Company exchanged all of the senior subordinated notes issued in theprivate placement for an issue of notes registered with the SEC with termssubstantially identical to the notes issued in the private placement. Thesenior subordinated notes were sold at 98.796% of par and accrue interest at acoupon rate of 10.5% per annum. Interest is paid semi-annually in June andDecember. The net proceeds were used to repay amounts outstanding under workingcapital loans and certain senior secured revolving credit facilities. TheCompany may redeem the notes, in whole or part, at any time on or after December 15,2009, at a redemption price equal to 100% of the principal amount, plus a 5.25%premium declining ratably to par on December 15, 2011, plus accrued andunpaid interest. At any time prior to December 15, 2008, the Company mayalso redeem up to 35% of the aggregate principal amount of the notes with theproceeds of qualified equity offerings at a redemption price equal to 110.5% ofthe principal amount, plus accrued and unpaid interest. In addition, if theCompany experiences specific kinds of changes of control, the Company isrequired to make an offer to purchase all of the notes at a purchase price of101% of the principal amount thereof, plus accrued and unpaid interest. Thenotes are unsecured senior subordinated obligations and subordinated in rightof payment to all of the Company’s existing and future senior debt, includingborrowings under the Company’s senior credit facility described above. All ofthe Company’s wholly owned subsidiaries, other than the Company’s mortgagesubsidiary, have fully and unconditionally guaranteed the notes on a joint andseveral, unsecured senior subordinated, basis. The guarantees are generalunsecured obligations of the guarantors and will be subordinated in right ofpayment to all existing and future senior debt of the guarantors, whichincludes their guarantees of the Company’s senior credit facility. Theindenture governing the senior subordinated notes contains a number ofsignificant covenants that restricts the Company’s ability and that of itsrestricted subsidiaries to, among other things: incur additional indebtedness,make certain distributions, investments and other restricted payments, createcertain liens, enter into transactions with affiliates, and merge, consolidateor sell substantially all of the Company’s assets. As of December 31,2007, the Company was restricted from incurring additional indebtedness(excluding available borrowings under the senior credit facility), except undercertain limited circumstances.

 

The Company is party to a senior secured project-specificacquisition and development loan. This loan bears interest at LIBOR plus 2.25%with maturity tied to the sale of the underlying inventory. As of December 31,2007, the Company had $19.1 million outstanding related to thisproject-specific acquisition and development loan.

 

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TheCompany has a term loan for an office complex in Rolling Meadows, Illinois. Theterm loan is secured by the office complex and bears interest at 7.0%. TheCompany makes monthly interest payments with the balance due October 2010.As of December 31, 2007, the Company had $3.5 million outstanding on the termloan.

 

TheCompany has a term loan of for an office building in Rolling Meadows, Illinois.The term loan is secured by the office building and bears interest equal to theprime rate. The Company makes monthly interest payments with the principalbalance due March 2009. As of December 31, 2007, the Company had $4.8million outstanding on the term loan.

 

Asof December 31, 2007, other senior debt consists of $1.4 million ofunsecured lines of credit and a $2.6 million term loan to repurchase stock froma former officer (see note 9).

 

**6.  Commitments and Contingencies**

** **

Inthe normal course of business, the Company acquires rights under optionagreements to purchase land for future development and/or developed lots. Theagreements generally are contingent upon municipality approvals. As of December 31,2007, the Company has rights, under such agreements, to purchase approximately6,228 lots, within 31 separate developments, with an aggregate contractprice of $258 million. Approximately 1,600 of the lots contain specificperformance requirements, with an aggregate purchase price of $45 million, ofwhich the Company is obligated to pay $1 million within the next twelve monthsand the remaining $44 million at various dates beginning in March 2009.Approximately 2,100 of the lots, with an aggregate purchase price of $128million, are to be purchased from joint ventures in which the Company has anequity investment.

 

At December 31, 2007, excluding inventory not owned (see note 3), theCompany was contingently liable to banks and financial institutions forapproximately $107 million for outstanding letters of credit and performancebonds securing performance of certain contractual obligations and land optioncontracts.

 

The Company has land purchase obligations in connection with two of itsjoint ventures (see note 4) for purchase prices of $43.1 million and $15.4million, which the Company will be obligated to purchase on April 15, 2008 andMay 31, 2008, respectively. The Company believes there is a substantiallikelihood that its liquidity will be insufficient to support these purchaseobligations. Failure to make either purchase could, among other things, resultin an event of default under the applicable joint venture’s secured creditfacility. If such default occurs and remains uncured, the lenders under suchjoint venture’s secured credit facility may terminate commitments under thefacility and accelerate the repayment obligations and, if the lenders arepermitted to accelerate the repayment obligations, it will constitute an eventof default under the Company’s senior credit facility which could result in theacceleration of the Company’s repayment obligations under its senior creditfacility. Acceleration of the repayment obligations of either one or both ofthe joint venture credit facilities or the Company’s repayment obligations couldtrigger a cross-default under the indenture governing the company’s seniorsubordinated notes, thereby allowing the bondholders to accelerate therepayment of all amounts outstanding under the senior subordinated notes.

 

Underthe terms of the Company’s amended stock option plans, the Company hascontractual obligations to purchase shares of its common stock, includingshares issuable under outstanding options, from certain of its directors,executive officers and other key employees in the event of termination of boardmembership or employment, as applicable, by reason of specified circumstances,including death, disability, involuntary termination or retirement. As of December 31,2007, the Company’s aggregate repurchase obligation, net of proceeds to bereceived from any stock option exercises, would have been approximately $1.4million in the event that all of these obligations were triggered. TheCompany’s ability to satisfy its repurchase obligations is subject to certainlimitations set forth in the indenture governing the senior subordinated notesissued by the Company. In addition, if Mr. Hill’s employment is terminatedby reason of his death or permanent disability, his family trust may requestthe Company to purchase up to 500,000 shares of its common stock, and uponreceipt of such request the Company will reasonably determine in its solediscretion how many shares to purchase in light of the Company’s financialcondition and prospects and the limitations, restrictions and constraints inits loan and financing arrangements at the time. The purchase price payable bythe Company will be the fair market value at that time.

 

TheCompany is involved in litigation incidental to its business, the dispositionof which should not have a material effect on the Company’s financial positionor results of operations.

 

TheCompany provides product warranties to its customers covering workmanship,materials, and certain mechanical systems for two years, and structural systemsfor ten years. The Company estimates and records warranty liabilities based onhistorical experience and known risks at the time a home closes, and in thecase of unexpected claims, upon identification and quantification of theobligations. The Company’s warranty accrual is included in accounts payable andaccrued expenses in its condensed consolidated balance sheets.

 

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Changes in the Company’swarranty liability for the three months ended December 31, 2007 and 2006are as follows:

 
| **(in thousands)**                | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|
| Balance at beginning of period    |       | $        | 5,218      |     | $          | 5,798 |   |
| Warranties issued                 |       | 610      |       | 964      |       |
| Settlements and other adjustments |       | (1,055   | )          | (1,355   | )          |
| Balance at end of period          |       | $        | 4,773      |     | $          | 5,407 |   |
|                              |       |     |       |     |       |

 

**7.**   Segment Information and Concentrations

** **

Inaccordance with Statement of Financial Accounting Standards No. 131, *Disclosures about Segments of an Enterprise and Related Information*(“SFAS 131”)*,*the Company has identified fivereportable homebuilding segments, conducting business in 9 states, and onemortgage banking reportable segment. The Company’s homebuilding segments areengaged in the acquisition and development of land, and construction and saleof residential homes. The Company’s mortgage banking segment originatesmortgages, which are sold to third parties.

 

TheCompany’s chief decision maker, its chief executive officer, routinely reviewsinformation on the Company’s operating segments. Management evaluates asegment’s performance based upon a number of factors including segment earningsbefore income taxes.

 

TheCompany’s corporate departments provide certain services that are advantageousto perform in a centralized manner, given certain cost efficiencies or requiredtechnical expertise. The Company’s corporate functions include: financialanalysis, human resources, information technology, legal, planning, riskmanagement, sales training and treasury. Only corporate costs that are deemedto directly benefit certain operating segments are allocated to those operatingsegments.

 

Operationswithin the Company’s reportable homebuilding segments have been determined tohave similar economic characteristics, including: similar historical andexpected future operating performance, employment trends, land acquisition andland constraints, and municipality behavior and meet the other aggregationcriteria in SFAS 131. The reportable homebuilding segments include operationsin the following geographical regions:

 

Florida

 

Midwest:Illinois, Ohio and Wisconsin

 

Nevada

 

PacificCoast: California, Oregon and Washington

 

Texas

 

In March 2006, the Company decided to exit theCleveland market based on its perception regarding local market conditionscurrently and in the foreseeable future. The Company completed all constructionand sales activities during its second fiscal quarter of 2007.

 

InMay 2007, the Company decided to exit the Milwaukee, Wisconsin market. TheCompany’s decision to exit the Milwaukee market reflects its perceptionregarding local market conditions currently and in the foreseeable future.

 

InMay 2007, the Company decided to exit the Portland, Oregon and Vancouver,Washington markets. A decision to continue in these markets would have requirednear term investments to provide lots for the future to sustain its operations.The Company decided to redeploy its capital and narrow its management focus tothe other existing markets.

 

15

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InOctober 2007, the Company entered into a definitive agreement with Wells FargoVentures, LLC, a wholly-owned subsidiary of Wells Fargo Bank, N.A., to form ajoint venture that will operate as a full-service mortgage bank to theCompany’s homebuilding customers. The Company has a 49.9% interest in the newventure and believes the new venture will provide competitive mortgage productsto its customers and that the joint venture’s cost structure will provide theCompany with profit opportunities as the homebuilding market continues to workthrough this down cycle. The Company’s wholly-owned mortgage subsidiary beganto wind down its operations in November 2007, and it will cease day to dayoperations during the second fiscal quarter of 2008 after it has fullysatisfied all commitments to borrowers for loans.

 

TheCompany’s internal measurement system has established accountabilities tocontinually improve business focus and increase its ability to react quickly tochanges in particular markets as well as changes to the overall homebuildingbusiness cycle. This measurement system, which is not based on GAAP, isintended to motivate behavior of employees and drive performance. The sales andcost information used for internal purposes varies from the Company’sconsolidated, externally reported information resulting in reconciling items.

 

Thefollowing tables illustrate the revenue, earnings before income taxes andassets of the Company’s reportable segments. Included are reconciliations tothe amounts reported in the condensed consolidated financial statements.

 
| **Revenues (in thousands)**                       | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|------------|------------|------------|------------|
| **For the three months ended  December 31:** | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| Florida                                           |       | $          | 13,188     |       | $          | 23,941 |   |
| Midwest                                           |       | 30,982     |       | 46,122     |       |
| Nevada                                            |       | 27,235     |       | 55,030     |       |
| Pacific Coast                                     |       | 26,010     |       | 39,269     |       |
| Texas                                             |       | 52,128     |       | 69,916     |       |
| Mortgage banking                                  |       | (164       | )          | 1,742      |       |
| Segment revenue subtotal                          |       | 149,379    |       | 236,020    |       |
| Corporate and unallocated (a)                |       | 1,990      |       | 177        |       |
| GAAP adjustment (b)                          |       | 854        |       | 4,374      |       |
| Consolidated total revenues                       |       | $          | 152,223    |       | $          | 240,571 |   |
|                                              |       |       |       |       |       |

 
| (a)    | Corporate and unallocated includes land sales where the  asset was held in the Company’s corporate department rather than one of the  Company’s operating segments. Rental and other income are also included  within corporate and unallocated revenues.                                                                                                                                                                                 |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| (b)    | The GAAP adjustment is for certain closing costs and  brokers commissions that are included as reductions to revenue in the  Company’s internal measurement system that are reported as expenses in  accordance with GAAP. Additionally, during the three months ended December 31,  2007, we sold land to a third party with an option to repurchase the land at  a later date, which was excluded from revenue in accordance with GAAP. |

 
| **(Loss) Earnings Before Income  Taxes (in thousands)** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|
| **For the three months ended  December 31:**       | ** ** | **2007**   | ** ** | **2006**   | ** ** |
| Florida                                                 |       | $          | (1,601     | )          | $          | (7,385 | ) |
| Midwest                                                 |       | (12,518    | )          | (11,530    | )          |
| Nevada                                                  |       | (18,670    | )          | 19,662     |       |
| Pacific Coast                                           |       | 2,941      |       | (16,261    | )          |
| Texas                                                   |       | 1,837      |       | (241       | )          |
| Mortgage banking                                        |       | (1,324     | )          | 516        |       |
| Segment loss before income taxes subtotal               |       | (29,335    | )          | (15,239    | )          |
| Corporate and unallocated                               |       | (8,010     | )          | (7,717     | )          |
|                                                    |       | (37,345    | )          | (22,956    | )          |
| Homebuilding interest expense                           |       | (14,267    | )          | (8,771     | )          |
| GAAP adjustment (c)                                |       | (2,294     | )          | (2,369     | )          |
| Consolidated loss before income taxes                   |       | $          | (53,906    | )          | $          | (34,096 | ) |
|                                                    |       |       |       |       |       |

 
| (c) | Included in the GAAP  adjustment are (i) timing differences for certain capitalizable indirect construction  costs that are expensed as incurred in the Company’s internal measurement  system and (ii) minority interest  expense which is not included in the Company’s internal measurement system. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

16

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| ** **                | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|---------------------------|------------|-----------------------|------------|------------------------|------------|
| **Assets (in thousands)** | ** ** | **2007**              | ** ** | **2007**               | ** ** |
| Florida                   |       | $                     | 50,884     |                   | $          | 58,730 |   |
| Midwest                   |       | 165,304               |       | 185,839                |       |
| Nevada                    |       | 168,972               |       | 188,619                |       |
| Pacific Coast             |       | 72,693                |       | 84,700                 |       |
| Texas                     |       | 136,032               |       | 154,930                |       |
| Mortgage banking          |       | 5,187                 |       | 6,529                  |       |
| Segment assets subtotal   |       | 599,072               |       | 679,347                |       |
| Corporate and unallocated |       | 181,235               |       | 182,430                |       |
| GAAP adjustment (d)  |       | 15,166                |       | 19,631                 |       |
| Consolidated assets       |       | $                     | 795,473    |                   | $          | 881,408 |   |
|                      |       |                  |       |                   |       |

 
| (d) | The GAAP adjustment to assets relates to a  general inventory accrual which was not included in our internal measurement  system. |
|-----|-----------------------------------------------------------------------------------------------------------------------------------|

 

**8.  Recent Accounting Pronouncements**

** **

In July 2006, the FASB issued Financial Interpretation No. 48, *Accounting for Uncertainty in Income Taxes* (“FIN 48”), whichclarifies the accounting for uncertainty in income taxes recognized in thefinancial statements in accordance with SFAS No. 109, *Accountingfor Income Taxes*. FIN 48 provides that a tax benefit from anuncertain tax position may be recognized when it is more likely than not thatthe position will be sustained upon examination, including resolutions of anyrelated appeals or litigation processes, based on the technical merits. Incometax positions must meet a more-likely-than-not recognition threshold at theeffective date to be recognized upon the adoption of FIN 48 and in subsequentperiods. This interpretation also provides guidance on measurement,derecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006.

 

The Company adopted the provisions of FIN 48 on October 1, 2007. Theimplementation of FIN 48 did not have a significant impact on the Company’sfinancial statements. The Company recognizes interest and penalties related tounrecognized tax benefits within the provision for income taxes in theaccompanying condensed consolidated statement of operations. The Company issubject to taxation in the U.S. and various states jurisdictions. The Company’stax years for 2004, 2005 and 2006 are subject to examination by the taxauthorities. With few exceptions, the Company is no longer subject to U.S.federal, state or local examinations by tax authorities for years before 2004.

 

InSeptember 2006, the SEC issued Staff Accounting Bulletin No. 108, *Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements* (“SAB 108”),which provides guidance as to how the effects on prior year uncorrectedmisstatements should be considered when quantifying misstatements in thecurrent financial statements. SAB 108 was issued in order to eliminate thediversity of practice surrounding how public companies quantify financial statementmisstatements. SAB 108 requires the Company to quantify misstatements usingboth a balance sheet and income statement approach, with adjustment required ifeither method results in a material error. The Company adopted the provisionsof SAB 108 on October 1, 2007. The adoption of SAB 108 did not have asignificant impact on the Company’s financial statements.

 

InSeptember 2006, the FASB issued SFAS No. 157, *Fair ValueMeasurements*(“SFAS 157”), which defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosure about fair value measurements. SFAS 157 is effective forfinancial statements issued for fiscal years beginning after November 15,2007, and interim periods within those fiscal years. However, the FASB didprovide a one year deferral for the implementation of SFAS 157 for certainnonfinancial assets and liabilities. The Company is in the process ofdetermining the effect, if any, the adoption of SFAS 157 will have on its financialstatements.

 

InFebruary 2007, the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities, including anamendment of FASB Statement No. 115*(“SFAS 159”). SFAS 159permits a company to measure certain financial instruments and other items atfair value. SFAS 159 is effective for financial statements issued for fiscalyears beginning after November 15, 2007, with early adoption permitted.The Company is in the process of determining the effect, if any, the adoptionof SFAS 159 will have on its financial statements.

 

InDecember 2007, the FASB issued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements* (“SFAS 160”) - anamendment of ARB No. 51. SFAS 160 establishes accounting and reporting standardsfor noncontrolling interests in consolidated financial statements. SFAS No. 160is effective for fiscal years, and interim periods within those fiscal years,beginning on or after December 15, 2008. Early adoption is prohibited. The

 

17

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Companyis in the process of determining the effect, if any, the adoption of SFAS 160will have on its financial statements.

 

**9. Related Party Transactions**

** **

InOctober 2007, the Company sold an office building in its corporate complexto an entity controlled by its controlling shareholder’s brother for $1.7million. The majority of the space in the building has been leased to an entitycontrolled by the controlling shareholder’s brother for over 12 years.

 

TheCompany entered into a separation agreement with a former officer, Mr. EugeneRowehl, pursuant to which he resigned from the Company effective as of October 19,2007. Pursuant to the agreement, Mr. Rowehl agreed to sell to the Companyat fair market value his 55,000 shares of common stock for $2.7 million.Pursuant to the terms of the agreement, the Company repurchased 55,000 sharesfrom Mr. Rowehl and issued him a $2.7 million non-negotiable promissorynote for the purchase price. The note bears interest at the prime rate andmatured on January 31, 2008. The Company made a $90,000 partial payment ofthe note in November 2007. The Company has determined that pursuant to theterms of the separation agreement the additional payments on the note areprohibited at this time.

 

**10. **SummarizedFinancial Information

** **

TheCompany’s senior subordinated notes and amended and restated senior creditfacility are fully and unconditionally guaranteed, on a joint and severalbasis, by all of the Company’s wholly owned subsidiaries (“GuarantorSubsidiaries”), other than the Company’s mortgage subsidiary. The Company’smortgage subsidiary and majority owned and controlled subsidiaries arenon-guarantors (“Non-Guarantor Subsidiaries”) of the senior subordinated notesand the senior credit facility. In lieu of providing separate financialstatements for the Guarantor Subsidiaries, consolidated condensed financialstatements are presented below. Separate financial statements and otherdisclosures concerning the Guarantor Subsidiaries are not presented becausemanagement has determined that they are not material to investors.

 

18

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| **As of December 31, 2007**                         | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| **(in thousands)**                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                               | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| HOMEBUILDING:                                            |       |       |       |             |       |              |       |             |       |             |       |
| Cash and cash  equivalents                               |       | $          | 595        |             | $          | 22,166            |       | $                | 50         |             | $          | — |   | $ | 22,811 |   |
| Receivables                                              |       |       |       | 16,793           |       |              |       |             |       | 16,793           |       |
| Income taxes  receivable                                 |       | 55,472     |       |             |       |              |       |             |       | 55,472           |       |
| Inventory                                                |       |       |       | 555,171          |       | 49,528            |       |             |       | 604,699          |       |
| Inventory not  owned                                     |       |       |       | 33,441           |       |              |       |             |       | 33,441           |       |
| Deferred  expenses and other assets                      |       | 8,777      |       | 8,885            |       |              |       |             |       | 17,662           |       |
| Investments in  and advances to unconsolidated entities  |       |       |       | 13,684           |       |              |       |             |       | 13,684           |       |
| Deferred income  taxes                                   |       | 14,031     |       |             |       |              |       |             |       | 14,031           |       |
| Property and  equipment, net of accumulated depreciation |       | 8,867      |       | 2,826            |       |              |       |             |       | 11,693           |       |
| Investments in  subsidiaries                             |       | 37,184     |       | (19,222          | )          |              |       | (17,962          | )          |             |       |
|                                                     |       | 124,926    |       | 633,744          |       | 49,578            |       | (17,962          | )          | 790,286          |       |
| MORTGAGE BANKING                                         |       |       |       |             |       | 5,187             |       |             |       | 5,187            |       |
| TOTAL ASSETS                                             |       | $          | 124,926    |             | $          | 633,744           |       | $                | 54,765     |             | $          | (17,962 | ) | $ | 795,473 |   |
| **Liabilities and equity**                               | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| HOMEBUILDING:                                            |       |       |       |             |       |              |       |             |       |             |       |
| Accounts payable  and accrued expenses                   |       | $          | 314        |             | $          | 77,771            |       | $                | 89         |             | $          | — |   | $ | 78,174 |   |
| Deposits on  sales of residential units                  |       |       |       | 4,145            |       | 215               |       |             |       | 4,360            |       |
| Liabilities  related to inventory not owned              |       |       |       | 5,850            |       |              |       |             |       | 5,850            |       |
| Notes payable                                            |       | 522,717    |       |             |       | 19,125            |       |             |       | 541,842          |       |
| Intercompany                                             |       | (512,303   | )          | 471,299          |       | 41,004            |       |             |       |             |       |
|                                                     |       | 10,728     |       | 559,065          |       | 60,433            |       |             |       | 630,226          |       |
| MORTGAGE BANKING                                         |       |       |       |             |       | 1,641             |       |             |       | 1,641            |       |
| Total  liabilities                                       |       | 10,728     |       | 559,065          |       | 62,074            |       |             |       | 631,867          |       |
| MINORITY  INTEREST IN CONSOLIDATED PARTNERSHIPS          |       |       |       |             |       | 12,825            |       | (583             | )          | 12,242           |       |
| MINORITY  INTEREST IN INVENTORY NOT OWNED                |       |       |       | 37,166           |       |              |       |             |       | 37,166           |       |
| REDEEMABLE EQUITY                                        |       | 1,079      |       |             |       |              |       |             |       | 1,079            |       |
| SHAREHOLDERS’ EQUITY                                |       | 113,119    |       | 37,513           |       | (20,134           | )          | (17,379          | )          | 113,119          |       |
| TOTAL LIABILITIES AND EQUITY                             |       | $          | 124,926    |             | $          | 633,744           |       | $                | 54,765     |             | $          | (17,962 | ) | $ | 795,473 |   |
|                                                     |       |       |       |             |       |              |       |             |       |             |       |

 

 

19

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| **As of September 30, 2007**                        | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| **(in thousands)**                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                               | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| HOMEBUILDING:                                            |       |       |       |             |       |              |       |             |       |             |       |
| Cash and cash  equivalents                               |       | $          | 18,475     |             | $          | 9,471             |       | $                | 50         |             | $          | — |   | $ | 27,996 |   |
| Receivables                                              |       |       |       | 33,339           |       | 646               |       |             |       | 33,985           |       |
| Income taxes  receivable                                 |       | 22,834     |       |             |       |              |       |             |       | 22,834           |       |
| Inventory                                                |       |       |       | 606,322          |       | 55,944            |       |             |       | 662,266          |       |
| Inventory not  owned                                     |       |       |       | 30,100           |       |              |       |             |       | 30,100           |       |
| Deferred  expenses and other assets                      |       | 8,899      |       | 10,412           |       |              |       |             |       | 19,311           |       |
| Investments in  and advances to unconsolidated entities  |       |       |       | 24,936           |       |              |       |             |       | 24,936           |       |
| Deferred income  taxes                                   |       | 42,148     |       |             |       |              |       |             |       | 42,148           |       |
| Property and  equipment, net of accumulated depreciation |       | 8,403      |       | 2,900            |       |              |       |             |       | 11,303           |       |
| Investments in  subsidiaries                             |       | 83,569     |       | (11,839          | )          |              |       | (71,730          | )          |             |       |
|                                                     |       | 184,328    |       | 705,641          |       | 56,640            |       | (71,730          | )          | 874,879          |       |
| MORTGAGE BANKING                                         |       |       |       |             |       | 6,529             |       |             |       | 6,529            |       |
| TOTAL ASSETS                                             |       | $          | 184,328    |             | $          | 705,641           |       | $                | 63,169     |             | $          | (71,730 | ) | $ | 881,408 |   |
| **Liabilities and equity**                               | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| HOMEBUILDING:                                            |       |       |       |             |       |              |       |             |       |             |       |
| Accounts payable  and accrued expenses                   |       | $          | 239        |             | $          | 96,494            |       | $                | 172        |             | $          | — |   | $ | 96,905 |   |
| Deposits on  sales of residential units                  |       |       |       | 4,497            |       | 204               |       |             |       | 4,701            |       |
| Liabilities  related to inventory not owned              |       |       |       | 2,675            |       |              |       |             |       | 2,675            |       |
| Notes payable                                            |       | 532,079    |       |             |       | 31,644            |       |             |       | 563,723          |       |
| Intercompany                                             |       | (511,103   | )          | 482,050          |       | 29,053            |       |             |       |             |       |
|                                                     |       | 21,215     |       | 585,716          |       | 61,073            |       |             |       | 668,004          |       |
| MORTGAGE BANKING                                         |       |       |       |             |       | 873               |       |             |       | 873              |       |
| Total  liabilities                                       |       | 21,215     |       | 585,716          |       | 61,946            |       |             |       | 668,877          |       |
| MINORITY  INTEREST IN CONSOLIDATED PARTNERSHIPS          |       |       |       |             |       | 12,835            |       | (583             | )          | 12,252           |       |
| MINORITY  INTEREST IN INVENTORY NOT OWNED                |       |       |       | 37,166           |       |              |       |             |       | 37,166           |       |
| REDEEMABLE EQUITY                                        |       | 10,367     |       |             |       |              |       |             |       | 10,367           |       |
| SHAREHOLDERS’ EQUITY                                |       | 152,746    |       | 82,759           |       | (11,612           | )          | (71,147          | )          | 152,746          |       |
| TOTAL LIABILITIES AND EQUITY                             |       | $          | 184,328    |             | $          | 705,641           |       | $                | 63,169     |             | $          | (71,730 | ) | $ | 881,408 |   |
|                                                     |       |       |       |             |       |              |       |             |       |             |       |

 

 

20

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| **For the three months ended**                                 | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|----------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| **December 31, 2007 (in  thousands)**                     | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| HOMEBUILDING:                                                  |       |       |       |             |       |              |       |             |       |             |       |
| Revenues:                                                      |       |       |       |             |       |              |       |             |       |             |       |
| Sales of  residential units and land                           |       | $          | —     |             | $          | 147,662           |       | $                | 2,718      |             | $          | — |   | $ | 150,380 |   |
| Rental and other  income                                       |       | 1,201      |       | 804              |       | 2                 |       |             |       | 2,007            |       |
| Total  homebuilding revenues                                   |       | 1,201      |       | 148,466          |       | 2,720             |       |             |       | 152,387          |       |
| Expenses:                                                      |       |       |       |             |       |              |       |             |       |             |       |
| Cost of sales of  residential units and land                   |       |       |       | 150,585          |       | 11,094            |       |             |       | 161,679          |       |
| General and  administrative                                    |       | 8,690      |       | 8,141            |       | 15                |       |             |       | 16,846           |       |
| Sales and  marketing                                           |       |       |       | 10,242           |       | 201               |       |             |       | 10,443           |       |
| Depreciation                                                   |       | 73         |       | 230              |       |              |       |             |       | 303              |       |
| Total  homebuilding expenses                                   |       | 8,763      |       | 169,198          |       | 11,310            |       |             |       | 189,271          |       |
| Intercompany  charge                                           |       | 7,562      |       | (7,562           | )          |              |       |             |       |             |       |
| Equity in losses  of unconsolidated joint ventures             |       |       |       | (15,708          | )          |              |       |             |       | (15,708          | )          |
| Minority  interests in net losses of consolidated partnerships |       |       |       |             |       | 10                |       |             |       | 10               |       |
| Homebuilding  loss before income taxes                         |       |       |       | (44,002          | )          | (8,580            | )          |             |       | (52,582          | )          |
| MORTGAGE BANKING:                                              |       |       |       |             |       |              |       |             |       |             |       |
| Revenues:                                                      |       |       |       |             |       |              |       |             |       |             |       |
| Loss on sales of  mortgage loans                               |       |       |       |             |       | (164              | )          |             |       | (164             | )          |
| Total mortgage  banking revenues                               |       |       |       |             |       | (164              | )          |             |       | (164             | )          |
| Expenses:                                                      |       |       |       |             |       |              |       |             |       |             |       |
| General and  administrative                                    |       |       |       |             |       | 1,216             |       |             |       | 1,216            |       |
| Depreciation                                                   |       |       |       |             |       | 27                |       |             |       | 27               |       |
| Total mortgage  banking expenses                               |       |       |       |             |       | 1,243             |       |             |       | 1,243            |       |
| Equity in income  of unconsolidated joint ventures             |       |       |       |             |       | 83                |       |             |       | 83               |       |
| Mortgage banking  losses before income taxes                   |       |       |       |             |       | (1,324            | )          |             |       | (1,324           | )          |
| EQUITY IN LOSS  OF CONSOLIDATED SUBSIDIARIES                   |       | (53,906    | )          | (8,580           | )          |              |       | 62,486           |       |             |       |
| LOSS BEFORE INCOME TAXES                                       |       | (53,906    | )          | (52,582          | )          | (9,904            | )          | 62,486           |       | (53,906          | )          |
| BENEFIT FROM INCOME TAXES                                      |       | (7,521     | )          | (7,336           | )          | (1,382            | )          | 8,718            |       | (7,521           | )          |
| NET LOSS                                                       |       | $          | (46,385    | )                | $          | (45,246           | )          | $                | (8,522     | )                | $          | 53,768 |   | $ | (46,385 | ) |
|                                                           |       |       |       |             |       |              |       |             |       |             |       |

 

 

21

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| **For the three  months ended**                   | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| **December 31, 2006  (in thousands)**                  | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| HOMEBUILDING:                                                    |       |       |       |             |       |              |       |             |       |             |       |
| Revenues:                                                        |       |       |       |             |       |              |       |             |       |             |       |
| Sales of  residential units and land                             |       | $          | —     |             | $          | 231,493           |       | $                | 6,919      |             | $          | — |   | $ | 238,412 |   |
| Rental and other  income                                         |       | 36         |       | 380              |       | 1                 |       |             |       | 417              |       |
| Total  homebuilding revenues                                     |       | 36         |       | 231,873          |       | 6,920             |       |             |       | 238,829          |       |
| Expenses:                                                        |       |       |       |             |       |              |       |             |       |             |       |
| Cost of sales of  residential units and land                     |       |       |       | 232,813          |       | 10,338            |       |             |       | 243,151          |       |
| General and  administrative                                      |       | 6,003      |       | 10,590           |       | 33                |       |             |       | 16,626           |       |
| Sales and  marketing                                             |       |       |       | 13,351           |       | 483               |       |             |       | 13,834           |       |
| Depreciation                                                     |       | 62         |       | 192              |       |              |       |             |       | 254              |       |
| Total  homebuilding expenses                                     |       | 6,065      |       | 256,946          |       | 10,854            |       |             |       | 273,865          |       |
| Intercompany  charge                                             |       | 6,029      |       | (6,029           | )          |              |       |             |       |             |       |
| Equity in income  of unconsolidated joint ventures               |       |       |       | 500              |       |              |       |             |       | 500              |       |
| Minority  interests in net earnings of consolidated partnerships |       |       |       |             |       | (76               | )          |             |       | (76              | )          |
| Homebuilding  loss before income taxes                           |       |       |       | (30,602          | )          | (4,010            | )          |             |       | (34,612          | )          |
| MORTGAGE BANKING:                                                |       |       |       |             |       |              |       |             |       |             |       |
| Revenues:                                                        |       |       |       |             |       |              |       |             |       |             |       |
| Gain on sales of  mortgage loans                                 |       |       |       |             |       | 1,742             |       |             |       | 1,742            |       |
| Total mortgage  banking revenues                                 |       |       |       |             |       | 1,742             |       |             |       | 1,742            |       |
| Expenses:                                                        |       |       |       |             |       |              |       |             |       |             |       |
| General and  administrative                                      |       |       |       |             |       | 1,204             |       |             |       | 1,204            |       |
| Depreciation                                                     |       |       |       |             |       | 22                |       |             |       | 22               |       |
| Total mortgage  banking expenses                                 |       |       |       |             |       | 1,226             |       |             |       | 1,226            |       |
| Mortgage banking  earnings before income taxes                   |       |       |       |             |       | 516               |       |             |       | 516              |       |
| EQUITY IN LOSS  OF CONSOLIDATED SUBSIDIARIES                     |       | (34,096    | )          | (4,010           | )          |              |       | 38,106           |       |             |       |
| LOSS BEFORE INCOME TAXES                                         |       | (34,096    | )          | (34,612          | )          | (3,494            | )          | 38,106           |       | (34,096          | )          |
| BENEFIT FOR INCOME TAXES                                         |       | (13,127    | )          | (13,326          | )          | (1,345            | )          | 14,671           |       | (13,127          | )          |
| NET LOSS                                                         |       | $          | (20,969    | )                | $          | (21,286           | )          | $                | (2,149     | )                | $          | 23,435 |   | $ | (20,969 | ) |
|                                                             |       |       |       |             |       |              |       |             |       |             |       |

 

 

22

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| **For the three  months ended**                                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| **December 31, 2007  (in thousands)**                                               | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash flows from operating activities:**                                                     | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net loss                                                                                      |       | $          | (46,385    | )                | $          | (45,246           | )          | $                | (8,522     | )                | $          | 53,768 |   | $ | (46,385 | ) |
| Adjustments to  reconcile net loss to net flows from operating activities                     |       | 40,559     |       | 67,054           |       | 8,281             |       | (53,768          | )          | 62,126           |       |
| Net cash (used  in) provided by operating activities                                          |       | (5,826     | )          | 21,808           |       | (241              | )          |             |       | 15,741           |       |
|                                                                                          |       |       |       |             |       |              |       |             |       |             |       |
| **Cash flows from investing activities:**                                                     | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Purchases of property and equipment                                                           |       | (1,062     | )          | (299             | )          |              |       |             |       | (1,361           | )          |
| Proceeds from sale of property and equipment                                                  |       | 2,306      |       |             |       |              |       |             |       | 2,306            |       |
| Proceeds from  sale of investments in unconsolidated entities                                 |       |       |       |             |       | 900               |       |             |       | 900              |       |
| Contributions to  investments in unconsolidated entities                                      |       |       |       | (958             | )          | (250              | )          |             |       | (1,208           | )          |
| Net cash provided  by (used in) investing activities                                          |       | 1,244      |       | (1,257           | )          | 650               |       |             |       | 637              |       |
|                                                                                          |       |       |       |             |       |              |       |             |       |             |       |
| **Cash flows from financing activities:**                                                     | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Proceeds from issuance of notes payable                                                       |       | 48,213     |       |             |       |              |       |             |       | 48,213           |       |
| Repayments of notes payable                                                                   |       | (60,353    | )          |             |       | (12,519           | )          |             |       | (72,872          | )          |
| Proceeds from  sale of land with option to repurchase                                         |       |       |       | 2,895            |       |              |       |             |       | 2,895            |       |
| Net proceeds from issuance of common stock                                                    |       | 90         |       |             |       |              |       |             |       | 90               |       |
| Repurchases of common stock                                                                   |       | (48        | )          |             |       |              |       |             |       | (48              | )          |
| Intercompany                                                                                  |       | (1,200     | )          | (10,751          | )          | 11,951            |       |             |       |             |       |
| Net cash used in  financing activities                                                        |       | (13,298    | )          | (7,856           | )          | (568              | )          |             |       | (21,722          | )          |
| **Net (decrease)  increase in cash and cash equivalents**                                     |       | (17,880    | )          | 12,695           |       | (159              | )          |             |       | (5,344           | )          |
| Cash and cash  equivalents—   Beginning of period                                        |       | 18,475     |       | 9,471            |       | 3,109             |       |             |       | 31,055           |       |
| Cash and cash  equivalents—   End of period                                              |       | $          | 595        |             | $          | 22,166            |       | $                | 2,950      |             |       |   | $ | 25,711 |   |
|                                                                                          |       |       |       |             |       |              |       |             |       |             |       |
| **Reconciliation  to cash and cash equivalents reported on the consolidated balance sheets:** | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Homebuilding                                                                                  |       | $          | 595        |             | $          | 22,166            |       | $                | 50         |             |       |   | $ | 22,811 |   |
| Mortgage banking                                                                              |       |       |       |             |       | 2,900             |       |             |       | 2,900            |       |
| Total                                                                                         |       | $          | 595        |             | $          | 22,166            |       | $                | 2,950      |             |       |   | $ | 25,711 |   |
|                                                                                          |       |       |       |             |       |              |       |             |       |             |       |
|                                                                                               |            |            |            |                  |            |                   |            |                  |            |                  |            |  |  |  |  |  |

 

 

23

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| **For the three  months ended**                                 | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| **December 31, 2006  (in thousands)**                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiaries**  | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash flows from operating activities:**                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net loss                                                                       |       | $          | (20,969    | )                | $          | (21,286           | )          | $                | (2,149     | )                | $          | 23,435 |   | $ | (20,969 | ) |
| Adjustments to  reconcile net loss to net cash flows from operating activities |       | 4,097      |       | 57,556           |       | (6,827            | )          | (26,160          | )          | 28,666           |       |
| Net cash (used  in) provided by operating activities                           |       | (16,872    | )          | 36,270           |       | (8,976            | )          | (2,725           | )          | 7,697            |       |
|                                                                           |       |       |       |             |       |              |       |             |       |             |       |
| **Cash flows from investing activities:**                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Purchases of property and equipment                                            |       | (252       | )          | (265             | )          | (8                | )          |             |       | (525             | )          |
| Contributions  and advances to investments in unconsolidated entities          |       |       |       | (4,856           | )          |              |       |             |       | (4,856           | )          |
| Contributions to  investments in subsidiaries                                  |       |       |       | (4,213           | )          |              |       | 4,213            |       |             |       |
| Net cash used in  investing activities                                         |       | (252       | )          | (9,334           | )          | (8                | )          | 4,213            |       | (5,381           | )          |
|                                                                           |       |       |       |             |       |              |       |             |       |             |       |
| **Cash flows from financing activities:**                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Proceeds from  issuance of notes and mortgage loans payable                    |       | 67,616     |       |             |       | 6,858             |       |             |       | 74,474           |       |
| Repayments of  notes and mortgage loans payable                                |       | (62,643    | )          | (9,801           | )          | (12,352           | )          |             |       | (84,796          | )          |
| Debt issuance costs                                                            |       | (850       | )          |             |       |              |       |             |       | (850             | )          |
| Net proceeds from issuance of common stock                                     |       | 39         |       |             |       |              |       |             |       | 39               |       |
| Repurchases of common stock                                                    |       | (2         | )          |             |       |              |       |             |       | (2               | )          |
| Contributions from minority interests                                          |       |       |       |             |       | 3,000             |       |             |       | 3,000            |       |
| Contributions from parent and guarantors                                       |       |       |       |             |       | 4,213             |       | (4,213           | )          |             |       |
| Distributions to parent and guarantors                                         |       |       |       |             |       | (2,725            | )          | 2,725            |       |             |       |
| Intercompany                                                                   |       | 14,057     |       | (23,170          | )          | 9,113             |       |             |       |             |       |
| Net cash  provided by (used in) financing activities                           |       | 18,217     |       | (32,971          | )          | 8,107             |       | (1,488           | )          | (8,135           | )          |
| **Net  increase (decrease) in cash and cash equivalents**                      |       | 1,093      |       | (6,035           | )          | (877              | )          |             |       | (5,819           | )          |
| Cash and cash  equivalents—   Beginning of period                         |       | 1,518      |       | 14,511           |       | 2,636             |       |             |       | 18,665           |       |
| Cash and cash  equivalents—   End of period                               |       | $          | 2,611      |             | $          | 8,476             |       | $                | 1,759      |             |       |   | $ | 12,846 |   |
|                                                                           |       |       |       |             |       |              |       |             |       |             |       |
|                                                                                |            |            |            |                  |            |                   |            |                  |            |                  |            |  |  |  |  |  |

 

 

24

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**11. Subsequent Events**

** **

InJanuary 2008, the Company obtained a limited duration waiver and amendmentwith respect to its senior credit facility. The amendment and waiver agreementprovided the Company with immediate access to $10 million as well as continuedaccess during the waiver period to the proceeds from the ordinary course saleof homes, reduced the maximum availability of the senior credit facility from$500 million to $400 million and amended the financial covenants thereunder forthe periods ended September 30, 2007 and December 31, 2007. However,as a result of recording additional impairment charges in connection with thepreparation and review of the condensed consolidated financial statements forthe period ended December 31, 2007, the Company is no longer in compliancewith the covenants set forth in the waiver and amendment. As such, the bankgroup may terminate the waiver and amendment and declare all amountsoutstanding under the senior credit facility, together with accrued interest,to be immediately due and payable. The Company intends to continue discussionswith its bank group regarding further amendments or waivers to the seniorcredit facility upon reasonable terms, however, there can be no assurance thatthe Company will be able to further amend or obtain waivers under the seniorcredit facility upon reasonable terms, or at all.

 

Inaddition to the items set forth above, the waiver and amendment agreementamended the senior credit facility to, among other things, (1) requirethat the net cash proceeds of all dispositions (each as defined in the seniorcredit facility, and which do not include proceeds from ordinary course salesof housing units) be deposited into a cash collateral account under the controlof the bank group, which account shall be available in the bank group’s solediscretion for the Company’s general corporate purposes or to repay obligationsunder the senior credit facility, (2) generally prohibit the Company fromincurring any additional indebtedness, except pursuant to the senior creditfacility, (3) amend certain financial covenants of the Company for theperiods ending September 30, 2007 and December 31, 2007, includingreducing the Company’s minimum tangible net worth (as defined in the seniorcredit facility from $302.0 million to $160.0 million and increasing theCompany’s maximum leverage ratio from 1.75 to 2.75, (4) reduce theCompany’s required minimum liquidity from $50.0 million to $1.0 million, (5) generallyrequire that interest is payable at the base rate (as defined in the seniorcredit facility) and (6) increase the margin for commitment fees to 0.30%.

 

Inaddition, the waiver and amendment agreement permits the Company to borrow anadditional $5.0 million if on or before January 31, 2008, the Company providesto the bank group a 13-week cash flow forecast in a form reasonablysatisfactory to the bank group and such forecast demonstrates that the Companyhas or thereafter will have additional liquidity needs. The Company submittedan acceptable 13-week cash flow forecast to the bank group prior to January 31,2008 and the Company borrowed the additional $5.0 million.

 

25

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**Item 2. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

*Thefollowing discussion provides an assessment of our results of operations,liquidity and capital resources and should be read in conjunction with thecondensed consolidated financial statements and notes thereto includedelsewhere in this report.*

 

**Overview**

** **

Weare one of the largest privately-owned homebuilders and one of the 30 largesthomebuilders in the United States, as measured by home deliveries and revenues.We design, build and market single-family detached, single-family attached andmulti-family homes. Since we were founded in 1969, we have delivered over48,000 homes to a broad range of customers, including first-time buyers andfirst- and second-time move-up buyers. Throughout this period, we have grownour business organically and we currently operate within 12 markets, including,among others, Chicago, Dallas, Ft. Worth, Houston, Las Vegas, Sacramento andTampa, in five regions: Florida, the Midwest, Nevada, the Pacific Coast andTexas.

 

Ourrevenues are primarily generated from designing, building, marketing anddelivering for sale single-family detached, single-family attached andmulti-family homes. We also sell land and lots to third parties as a means ofmanaging inventory and obtaining the desired asset mix for our near-termhomebuilding operations.

 

Aspart of our current operating strategy, we are selling certain land inventoryto: manage our debt, adjust the balance of our land holdings by region andreduce our overall investment in land. During the three months ended December 31,2007, we sold $19.6 million of land inventory. As of December 31, 2007, wehave identified $24.8 million of land inventory that we intend to sell and areactively marketing the properties for delivery within the next 12 months. Inaddition to the land identified for sale, we intend to further match ourinvestment in land to current and foreseeable market conditions by continuallyevaluating and selling land that is not critical to our homebuilding operationsover the next 24 months. These or future actions may not be sufficient to allowus to continue our operations.

 

Dueto the continued deterioration in market conditions and the overall nationalhomebuilding climate, we recorded inventory impairment charges of $13.2 millionduring the three months ended December 31, 2007. Additionally, during thethree months ended December 31, 2007, we recorded $17.1 million of chargesto write-down our investments in joint ventures.

 

Wealso conduct mortgage origination and title services for the benefit of our homebuildingoperations, although revenues generated by these ancillary services havehistorically comprised less than 1% of our total consolidated revenues, and arenot expected to be significant in the future.

 

**Recenttrends**

** **

Marketconditions for new home sales have continued to deteriorate significantly overthe last few years. Inventory levels of both new and existing homes havecontinued to climb and aggressive price competition has continued to putpressure on already strained profit margins. Significant home priceappreciation combined with fluctuating interest rates and tightening creditstandards in the mortgage industry have negatively affected affordability andconsumer sentiment for housing. We do not see conditions in the homebuildingmarket improving significantly in the near term, which will continue tonegatively impact both our revenues and earnings.

 

Thefollowing describe certain recent negative market trends:

 

*·**                 **decreased levels of customer traffic, buyer sentiment andnet sales;*

 

*·**                 **increased frequency and level of customer incentivepackages;*

 

 

26

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*·**                 **decreased availability of mortgage financing for ourpotential customers;*

 

*·**                 **increased use and compensation of real estate brokers;*

 

*·**                 **depressed market conditions for land sales; and*

 

*·**                 **increased abandonment of earnest money related to landoption agreements and purchase contracts.*

 

*All of these trends and others which may arise in the futurehave adversely our financial condition and results of operations.*

 

*Given the significant market deterioration and uncertaintyabout the timing and pace of any recovery, we have adopted a strategy to manageour business through this current downturn. Our strategy focuses on:*

 

*·**                 **tailoring our product offerings and option packages toaddress affordability constraints;*

 

*·**                 **refining our pricing strategy to achieve the proper balancebetween our sales price and gross margin and to reduce the number of completedbut unsold homes;*

 

*·**                 **providing our customers access to a variety of mortgageproducts with which they can finance their home purchase;*

 

*·**                 **renegotiating with vendors and independent contractors tomanage our construction costs;*

 

*·**                 **sizing our operating structure to match our perception ofcurrent and likely future market conditions;*

 

*·**                 **retaining key members of our senior management, regionalpresidents and other key employees to ensure continuity in our operations;*

 

*·**                 **tightening land acquisition criteria and working with landsellers to renegotiate land purchase and option contracts to extend purchasedates and reduce purchase prices;*

 

*·**                 **marketing and selling lots to generate cash and reduce ouroverall land holdings; and*

 

*·**                 **managing our debt and interest costs and maximizing ourliquidity.*

 

*Actions we have taken, and continue to take, to implementour strategy may not be sufficient to allow us to continue our operations.*

 

**Financing Overview**

** **

As of December 31, 2007, we were not in compliance withcertain of the covenants in our senior credit facility, includingthe covenant requiring us to maintain a minimum tangible net worth (as definedin our senior credit facility). Our failure to meet these covenants allows thelenders under our senior credit facility to declare all amounts outstandingthereunder, together with accrued interest, to be immediately due and payable.Acceleration under our senior credit facility would also trigger across-default under the indenture governing our senior subordinated notes,thereby allowing our bondholders to accelerate the repayment of all amountsoutstanding on the senior subordinated notes. In addition, certain other creditfacilities within our joint ventures to which we have provided guaranteesinclude provisions for acceleration or events of default in the event of adefault under our senior credit facility.

 

Although we obtained a limited duration waiver and amendmentin January 2008 with respect to our senior credit facility, we are nolonger in compliance with the covenants set forth therein as a result ofrecording additional impairment charges in connection with the preparation andreview of the condensed consolidated financial statements for the period ended December 31,2007. We intend to continue discussions with our bank group regarding furtheramendments or waivers to the senior credit facility upon reasonable terms,however, there can be no assurance that we will be able to further amend orobtain waivers under the senior credit facility upon reasonable terms, or atall. We currently have no alternative financing in place and if we are unableto find alternative financing or obtain further amendments or waivers, webelieve there is a substantial likelihood that we will not have sufficientliquidity to pay the cash interest payment due in June 2008 under oursenior subordinated notes. Further, if obligations under our senior creditfacility or our senior subordinated notes are accelerated, we believe we willhave insufficient assets to meet the obligations thereunder. Working withAlvarez & Marsal North America, LLC, a financial advisory andconsulting firm, we are considering a number of alternatives, including theappointment of a chief restructuring officer and whether to seek a completerestructuring under Chapter 11 of the United States Bankruptcy Code.

 

 

27

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Duringthe three months ended December 31, 2007, we entered into two separateagreements to sell land for $2.9 million to a third party that provide for anoption for us to repurchase the land at later dates. Due to our continuinginvolvement, the transaction did not qualify as a sale under accountingprinciples generally accepted in the United States of America (“GAAP”). Assuch, the inventory remains on our condensed consolidated balance sheets ininventory not owned as of December 31, 2007. Additionally, the $2.9million of net cash received from the transaction was recorded in liabilitiesrelated to inventory not owned in the condensed consolidated balance sheets andclassified as cash flows from financing activities in the condensedconsolidated statement of cash flows.

 

**Resultsof operations and other data**

** **

Ourability to continue as a going concern is dependent upon our ability to returnto profitable operations in the future and to retain the necessary financing tomeet our obligations and pay our liabilities when they come due. Due to theseuncertainties, there are substantial doubts about whether we will be able tocontinue as a going concern, and therefore, we may be unable to realize ourassets and discharge our liabilities in the normal course of business. Ourconsolidated financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the settlement of liabilitiesand commitments in the normal course of business. The accompanying financialstatements do not include any adjustments relating to the recoverability andclassification of recorded asset amounts or to the amounts and classificationof liabilities that may be necessary if we are unable to continue as a goingconcern. See note 1 to our consolidated financial statements for furtherinformation.

 

 

28

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The following tablepresents selected statement of operations and other data for the three monthperiod ended December 31, 2007 and 2006:

 
| ** **                                                                | ** ** | **Three  months ended** | ** ** | **2007**   | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                                                | ** ** | **December 31,**   | ** ** | **vs.**    | ** ** |
| **(Dollars in thousands)**                                                | ** ** | **2007**                | ** ** | **2006**   | ** ** | **2006** | ** ** |
| **Statement of operations data:**                                         | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total homebuilding revenues                                               |       | $                       | 152,387    |       | $          | 238,829 |   | (36.2 | )% |
| Cost of sales of residential units and land(1)                            |       | 161,679                 |       | 243,151    |       | (33.5 | )% |
| Gross homebuilding loss                                                   |       | (9,292                  | )          | (4,322     | )          | 115.0 | % |
| Homebuilding operating expenses                                           |       | 27,592                  |       | 30,714     |       | (10.2 | )% |
| Equity in (losses) income of unconsolidated entities                      |       | (15,708                 | )          | 500        |       | — |   |
| Minority interests in net losses (earnings) of  consolidated partnerships |       | 10                      |       | (76        | )          | (113.2 | )% |
| Homebuilding loss before income taxes                                     |       | (52,582                 | )          | (34,612    | )          | 51.9 | % |
| Mortgage banking (losses) earnings before income  taxes                   |       | (1,324                  | )          | 516        |       | (356.6 | )% |
| Loss before income taxes                                                  |       | (53,906                 | )          | (34,096    | )          | 58.1 | % |
| Benefit from income taxes                                                 |       | (7,521                  | )          | (13,127    | )          | (42.7 | )% |
| Net loss                                                                  |       | $                       | (46,385    | )          | $          | (20,969 | ) | 121.2 | % |
|                                                                      |       |                    |       |       |       |   |   |
| **Other financial data:**                                                 | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest incurred(2)                                                      |       | $                       | 12,111     |       | $          | 11,827 |   | 2.4 | % |
| Depreciation and amortization                                             |       | 330                     |       | 276        |       | 19.6 | % |
| EBITDA(3)(4)                                                              |       | (39,309                 | )          | (25,049    | )          | 56.9 | % |
| Gross homebuilding margin(5)                                              |       | (6.1                    | )%         | (1.8       | )%         | — |   |
|                                                                      |       |                    |       |       |       |   |   |
| **Other data:**                                                           | ** ** | ** **              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net new home orders (units)(6)                                            |       | 447                     |       | 722        |       | (38.1 | )% |
| Homes delivered (units)                                                   |       | 568                     |       | 799        |       | (28.9 | )% |
| Average sales price of homes delivered                                    |       | $                       | 230        |       | $          | 270 |   | (14.8 | )% |
| Backlog at end of period (units)(7)                                       |       | 472                     |       | 681        |       | (30.7 | )% |
| Backlog at end of period (contract value)(7)                              |       | $                       | 116,844    |       | $          | 190,796 |   | (38.8 | )% |
|                                                                      |       |                    |       |       |       |   |   |   |   |

 

(1)      Inventory impairment and land optionabandonment charges of $13.2 million and $0.1 million are included in cost ofsales of residential units and land for the three months ended December 31,2007. There were $40 million and $0.5 million of impairment and land optionabandonment charges recorded during the three months ended December 31,2006.

 

(2)      Interest incurred is the amount ofinterest paid and the net amount accrued (whether expensed or capitalized), andthe amortization of debt issuance costs.

 

(3)      “EBITDA” represents net earnings beforeinterest expense, depreciation and amortization and provision for income taxes.It is included in this report because we use it to assess our operationalperformance. We believe it is useful to securities analysts, investors andother interested parties in the evaluation of companies like ours becauseinterest, taxes, depreciation and amortization can vary significantly betweencompanies due in part to differences in structure, accounting policies, taxstrategies, levels of indebtedness and interest rates. EBITDA is not a measureof our liquidity or financial performance in accordance with GAAP and shouldnot be considered as an alternative to our net earnings or any otherperformance measure derived in accordance with GAAP, or as an alternative tocash flows from operating activities. EBITDA has limitations as an analyticaltool, and you should not consider it in isolation, or as a substitute for ananalysis of our results as reported under GAAP. Some limitations are:

 

·                  EBITDAdoes not reflect our cash expenditures, future requirements for capitalexpenditures or contractual commitments;

 

·                  EBITDAdoes not reflect changes in, or cash requirements for, our working capitalneeds;

 

·                  EBITDAdoes not reflect the significant interest expense, or the cash requirementsnecessary to service interest or principal payments on our indebtedness;

 

·                  EBITDAdoes not reflect the significant expense or cash requirements for federal andstate income tax obligations;

 

·                  althoughdepreciation and amortization are non-cash charges, the assets beingdepreciated and amortized will often have to be replaced in the future, andEBITDA does not reflect any cash requirements for such replacements; and

 

 

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·                  othercompanies in our industry may calculate EBITDA differently than we do, limitingits usefulness as a comparative measure.

 

Becauseof these limitations, EBITDA should not be considered as a measure ofdiscretionary cash available to us to invest in the growth of our business orto service our indebtedness. We compensate for these limitations by relyingprimarily on our GAAP results and using EBITDA only supplementally. See thecondensed consolidated statements of operations and cash flows presented in ourcondensed consolidated financial statements included elsewhere in this report.The following is a reconciliation of EBITDA to net earnings, the most directlycomparable GAAP measure:

 
| ** **                        | ** ** | **Three  Months Ended December 31,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| **(Dollars in thousands)**        | ** ** | **2007**                             | ** ** | **2006** | ** ** |
| Net loss                          |       | $                                    | (46,385    | ) | $ | (20,969 | ) |
| Benefit from income taxes         |       | (7,521                               | )          | (13,127 | ) |
| Interest expense in cost of sales |       | 14,267                               |       | 8,771 |   |
| Depreciation and amortization     |       | 330                                  |       | 276 |   |
| EBITDA                            |       | $                                    | (39,309    | ) | $ | (25,049 | ) |
|                              |       |                                 |       |   |   |

(4)      In contrast to EBITDA, our amended andrestated senior credit facility contains an adjusted EBITDA financial covenant.The most significant difference between adjusted EBITDA and EBITDA is the addback of inventory impairment and land option abandonment charges.

 

(5)  Represents gross homebuilding (loss) profitdivided by total homebuilding revenues.

 

(6)      Net new home orders represents the numberof new sales contracts executed with customers, net of sales contractcancellations.

 

(7)  Backlog represents homes under sales contractsbut not yet delivered at the end of the period.

 

***Homebuilding revenues.*********Homebuilding revenues decreased 36.2% to $152.4 million for the three monthperiod ended December 31, 2007 from $238.8 million for the three monthperiod ended December 31, 2006. New home deliveries decreased by 28.9% andthe average sales price of homes delivered decreased by 14.8%. Land sales were$19.6 million for the three months ended December 31, 2007 as compared to$22.6 million for the three months ended December 31, 2006.

 

***Home sales and backlog.*********Net new home orders for the three month period ended December 31, 2007were 447, a 38.1% decrease from 722 net new home orders for the three monthperiod ended December 31, 2006.

 

At December 31, 2007, the contract value of our backlogwas $116.8 million, as compared to $190.8 million at December 31, 2006. AtDecember 31, 2007, the average sales price per home in backlog was$248,000 down $32,000, or 11.4%, from the average sales price per home inbacklog of $280,000 at December 31, 2006.

 

***Gross homebuildingmargin.********* During the three month period ended December 31,2007, we experienced margin pressures across all of our regions. Gross homebuilding loss increased to (6.1)% ofrevenue for the three month period ended December 31, 2007, compared to(1.8)% of revenue for the three month period ended December 31, 2006. Includedin gross margin for the three months ended December 31, 2007 are inventoryvaluation charges of $13.2 million related to our expectations regarding therecoverability of certain assets from both active residential constructionprojects and land held for sale. Includedin gross profit for the three months ended December 31, 2006 are inventoryvaluation charges of $40.0 million. Included within the gross profit for thethree month periods ended December 31, 2007 and 2006 are $0.4 million and$13.6 million from land sales, respectively.

 

***Homebuilding operatingexpenses.********* Homebuilding operating expenses, which consistof all homebuilding expenses other than cost of sales, decreased 10.2% to $27.6million for the three months ended December 31, 2007 from $30.7 millionfor the three months ended December 31, 2006. Homebuilding operatingexpenses were 18.1% and 12.9% of homebuilding revenue for the three monthsended December 31, 2007 and 2006, respectively.

 

Thedecrease in homebuilding operating expenses is attributed to lower compensationexpense, due to a reduction in headcount and incentive pay, partially offset bya one-time $1.7 million payment to C. Kenneth Love, our President and ChiefExecutive Officer, to offset the personal negative tax impact and perceivedfinancial consequences realized 

 

 

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byMr. Love upon the lump sum settlement of pension benefits attributable tohis former position prior to joining Kimball Hill.

 

***Income Taxes.*********We recorded an income tax benefit of $7.5million and $13.1 million for the three month periods ended December 31,2007 and 2006, respectively, and our effective tax rates were 14.0% and 38.5%,respectively, for the same periods. The reduction in our effective tax rate isattributed to an additional valuation allowance recorded against all deferredtax assets that rely on future taxable income in order to be realized.

 

**Segmentanalysis**

 

Weaggregate our homebuilding operating segments into five reportable segments andour mortgage banking operations into one reportable segment. Our homebuildingsegments are engaged in the acquisition and development of land, andconstruction and sale of residential homes. Our mortgage banking segmentoriginates mortgages, which are sold to third parties.

 

The five reportablehomebuilding segments include operations in the following geographic regions:

 

Florida

 

Midwest: Illinois, Ohio and Wisconsin

 

Nevada

 

Pacific Coast: California, Oregon and Washington

 

Texas

 

In March 2006, we decided to exit the Cleveland marketbased on our perception regarding local market conditions. We completed allconstruction and sales activities during our second fiscal quarter of 2007.

 

InMay 2007, we decided to exit the Milwaukee, Wisconsin market. Our decisionto exit the Milwaukee market reflects our perception regarding local marketconditions currently and in the foreseeable future. We completed all construction and sales activities during our first fiscalquarter of 2008.

 

InMay 2007, we decided to exit the Portland, Oregon and Vancouver,Washington markets. A decision to continue in these markets would have requirednear term investments to provide lots for the future to sustain our operations.We decided to redeploy our capital and narrow our management focus to our otherexisting markets. We completed all constructionand sales activities during our first fiscal quarter of 2008.

 

InOctober 2007, we entered into a definitive agreement with Wells FargoVentures, LLC, a wholly-owned subsidiary of Wells Fargo Bank, N.A., to form ajoint venture that will operate as a full-service mortgage bank to ourhomebuilding customers. We have a 49.9% interest in the new venture and believethe new venture will provide competitive mortgage products to our customers andthat the joint venture’s cost structure will provide us with profitopportunities as the homebuilding market continues to work through this downcycle. Our wholly-owned mortgage subsidiary began to wind down its operationsin November 2007, and it will cease day to day operations during thesecond fiscal quarter of 2008 after it has fully satisfied all commitments toborrowers for loans.

 

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The following tablepresents financial and operational information for our five reportablehomebuilding segments:

 
| ** **                 | ** ** | **Average**         | ** ** | ** **    | ** ** | ** **        | ** ** | ** **             | ** ** | **Backlog**            | ** ** |
|----------------------------|------------|---------------------|------------|---------------|------------|-------------------|------------|------------------------|------------|------------------------|------------|
| **Three Months Ended**     | ** ** | **sales  price of** | ** ** | ** **    | ** ** | **Net  new**      | ** ** | **Backlog**            | ** ** | **(contract**          | ** ** |
| **December 31,**      | ** ** | **homes**           | ** ** | **Homes**     | ** ** | **home**          | ** ** | **(units)  at**        | ** ** | **value)  at**         | ** ** |
| **(Dollars in thousands)** | ** ** | **delivered**       | ** ** | **delivered** | ** ** | **orders****(1)** | ** ** | **period  end****(2)** | ** ** | **period  end****(2)** | ** ** |
| **2007**                   | ** ** | ** **          | ** ** | ** **    | ** ** | ** **        | ** ** | ** **             | ** ** | ** **             | ** ** |
| Florida                    |       | $                   | 189        |          | 64         |              | 62         |                   | 72         |                   | $          | 13,261 |   |
| Midwest                    |       | 320                 |       | 73            |       | 33                |       | 113                    |       | 39,795                 |       |
| Nevada                     |       | 283                 |       | 101           |       | 101               |       | 48                     |       | 13,387                 |       |
| Pacific Coast              |       | 302                 |       | 67            |       | 39                |       | 29                     |       | 9,614                  |       |
| Texas                      |       | 177                 |       | 263           |       | 212               |       | 210                    |       | 40,787                 |       |
| Total                      |       | $                   | 230        |          | 568        |              | 447        |                   | 472        |                   | $          | 116,844 |   |
| **2006**                   | ** ** | ** **          | ** ** | ** **    | ** ** | ** **        | ** ** | ** **             | ** ** | ** **             | ** ** |
| Florida                    |       | $                   | 302        |          | 82         |              | 65         |                   | 56         |                   | $          | 17,380 |   |
| Midwest                    |       | 326                 |       | 139           |       | 116               |       | 136                    |       | 47,816                 |       |
| Nevada                     |       | 382                 |       | 97            |       | 116               |       | 64                     |       | 24,511                 |       |
| Pacific Coast              |       | 440                 |       | 92            |       | 107               |       | 95                     |       | 39,466                 |       |
| Texas                      |       | 175                 |       | 389           |       | 318               |       | 330                    |       | 61,623                 |       |
| Total                      |       | $                   | 270        |          | 799        |              | 722        |                   | 681        |                   | $          | 190,796 |   |
|                       |       |                |       |          |       |              |       |                   |       |                   |       |   |   |

 

(1)      Net new home orders represent the numberof new sales contracts executed with customers, net of sales contractcancellations.

 

(2)      Backlog represents homes under salescontracts but not yet delivered at the end of the period.

 

 

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Ourinternal measurement system is intended to establish accountabilities tocontinually improve business focus, motivate behavior and drive performance.The following table presents financial information based on our internalmeasurement system, which is not in accordance with GAAP.

 

 
| **For the three months ended  December 31:** | ** ** | ** **   | ** ** | **(Loss)  earnings before** | ** ** |
|---------------------------------------------------|------------|--------------|------------|-----------------------------|------------|
| **(Dollars in thousands)**                        | ** ** | **Revenues** | ** ** | **income  taxes**           | ** ** |
| **2007**                                          | ** ** | ** **   | ** ** | ** **                  | ** ** |
| Florida                                           |       | $            | 13,188     |                        | $          | (1,601 | ) |
| Midwest                                           |       | 30,982       |       | (12,518                     | )          |
| Nevada                                            |       | 27,235       |       | (18,670                     | )          |
| Pacific Coast                                     |       | 26,010       |       | 2,941                       |       |
| Texas                                             |       | 52,128       |       | 1,837                       |       |
| Mortgage banking                                  |       |         | (164       | )                           | (1,324     | ) |
| Segment subtotal                                  |       | 149,379      |       | (29,335                     | )          |
| Corporate and  unallocated                        |       |         | 1,990      |                        | (8,010     | ) |
|                                              |       | 151,369      |       | (37,345                     | )          |
| Homebuilding  interest expense(1)                 |       |         |       | (14,267                     | )          |
| GAAP adjustment(2)                                |       |         | 854        |                        | (2,294     | ) |
| Consolidated  total                               |       | $            | 152,223    |                        | $          | (53,906 | ) |
| **2006**                                          | ** ** | ** **   | ** ** | ** **                  | ** ** |
| Florida                                           |       | $            | 23,941     |                        | $          | (7,385 | ) |
| Midwest                                           |       | 46,122       |       | (11,530                     | )          |
| Nevada                                            |       | 55,030       |       | 19,662                      |       |
| Pacific Coast                                     |       | 39,269       |       | (16,261                     | )          |
| Texas                                             |       | 69,916       |       | (241                        | )          |
| Mortgage banking                                  |       |         | 1,742      |                        | 516        |   |
| Segment subtotal                                  |       | 236,020      |       | (15,239                     | )          |
| Corporate and  unallocated                        |       |         | 177        |                        | (7,717     | ) |
|                                              |       | 236,197      |       | (22,956                     | )          |
| Homebuilding  interest expense(1)                 |       |         |       | (8,771                      | )          |
| GAAP adjustment(2)                                |       |         | 4,374      |                        | (2,369     | ) |
| Consolidated  total                               |       | $            | 240,571    |                        | $          | (34,096 | ) |
|                                              |       |         |       |                        |       |   |   |
|                                                   |            |              |            |                             |            |  |  |  |

 

(1)      Forinternal measurement purposes, we measure our homebuilding operating resultsexclusive of any interest expense or other financing costs.

 

(2)      TheGAAP adjustment to revenues is for certainclosing costs and brokers commissions that are included as reductions torevenue in our internal measurement system that are reported as expenses inaccordance with GAAP. Additionally,during the three months ended December 31, 2007, we sold land to a thirdparty with an option to repurchase the land at a later date, which was excludedfrom revenue in accordance with GAAP. The GAAP adjustment to (loss)earnings before income taxes relates to: (a) timing differences of certaincapitalizable indirect construction costs that are expensed as incurred in ourinternal measurement system, and (b) minority interest expense which isnot included in our internal measurement system.

 

***Florida.  ***Homebuilding revenues decreased in thequarter ended December 31, 2007, compared to the quarter ended December 31,2006, primarily due to a 22.0% decrease in the number of homes delivered and a$113 thousand decrease in the average sales price of homes delivered.Homebuilding gross profit margins were (7.9)% in the first fiscal quarter of2008, compared to (21.0)% in the first fiscal quarter of 2007. Gross profit forthe three month period ended December 31, 2006 was negatively impacted by$7.5 million of inventory valuation charges.

 

***Midwest.  ***Homebuilding revenuesdecreased in the quarter ended December 31, 2007, compared to the quarterended December 31, 2006, primarily due to a 47.5% decrease in the numberof homes delivered and a $6 thousand decrease in the average sales price of homesdelivered. Homebuilding gross profit margins were (38.3)% in the first fiscalquarter of 2008, compared to (18.2)% in the first fiscal quarter of 2007. Grossprofit for the three month period ended December 31, 2007 was negativelyimpacted by $11.1 million of inventory valuation charges. Grossprofit for the 

 

 

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threemonth period ended December 31, 2006 was negatively impacted by $10.6million of inventory valuation charges.

 

***Nevada.  ***Homebuilding revenues decreased in thequarter ended December 31, 2007, compared to the quarter ended December 31,2006, primarily due to a $99 thousand decrease in the average sales price ofhomes, offset partially by a 4.1% increase in the number of homes delivered.Homebuilding gross profit margins were (8.0)% in the first fiscal quarter of2008, compared to 36.1% in the first fiscal quarter of 2007. Gross profit for the three month period ended December 31,2007 was negatively impacted by $2.1 million of inventory valuation charges.Included within gross profit for the quarter ended December 31, 2006 is$13.2 million from land sales. During the quarter ended December 31, 2007,we determined that our investments in one of our joint ventures was more thantemporarily impaired and recorded a $17.1 million charge to write-down theinvestment balances and accrue for an outstanding letter of credit.

 

***Pacific Coast.  ***Homebuilding revenues decreased in thequarter ended December 31, 2007, compared to the quarter ended December 31,2006, primarily due to a 27.2% decrease in the number of homes delivered and a$138 thousand decrease in the average sales price of homes delivered.Homebuilding gross profit margins were (1.1)% in the first fiscal quarter of2008, compared to (36.3)% in the first fiscal quarter of 2007. Gross profit forthe three month period ended December 31, 2006 was negatively impacted by$18.4 million of inventory valuation charges.

 

***Texas.  ***Homebuildingrevenues decreased in the quarter ended December 31, 2007, compared to thequarter ended December 31, 2006, primarily due to a 32.4% decrease in thenumber of homes delivered, offset partially by a $2 thousand increase in theaverage sales price of homes delivered. Homebuilding gross profit margins were8.3% in the first fiscal quarter of 2008, compared to 4.8% in the first fiscalquarter of 2007. Grossprofit for the three month period ended December 31, 2006 was negativelyimpacted by $3.5 million of inventory valuation charges.

 

***Mortgage banking.  ***Mortgagebanking earnings before taxes decreased to a net loss of $1.3 million in thefirst fiscal quarter of 2008, compared to net earnings of $0.5 million in thefirst fiscal quarter of 2007. The decrease in earnings before taxes wasprimarily due to a decrease in home closings, a decrease in the averagemortgage loan size and a reduced mortgage capture rate.

 

***Corporate and unallocated.  ***Corporateand unallocated costs totaled $8.0 million in the first fiscal quarter of 2008and $7.7 million in the first fiscal quarter of 2007. The increase in corporateand unallocated costs is primarily attributed to a $0.4 million increase inprofessional fees and a $1.7 million payment to C. Kenneth Love, our Presidentand Chief Executive Officer to offset the personal negative tax impact and perceivedfinancial consequences realized by Mr. Love upon the lump sum settlementof pension benefits attributable to his former position prior to joiningKimball Hill. These increased costs were partially offset by a $1.6 milliongain on the sale of property and equipment. Corporate and unallocated costs asa percentage of total consolidated revenues were 5.3% for the three monthsended December 31, 2007 and 3.2% for the three months ended December 31,2006.

 

**Liquidity and Capital Resources**

** **

Our principal uses of cash are land purchases, lotdevelopment, home construction and the funding of debt service. As a result,our financing needs depend principally on sales volume, land acquisition andinventory balances. We fund our operations with available cash flows fromoperating activities, borrowings under our senior credit facility, other bankdebt and minority interests in consolidated partnerships. We do not hold cashfor investment purposes and we generally manage our cash and debt positions tominimize financing costs.

 

***Operating cash flowsactivities***

*** ***

Cashprovided by operating activities totaled $15.7 million the three months ended December 31,2007, compared to $7.7 million during the three months ended December 31,2006. Lower sales volume and margins during the three months ended December 31,2007 reduced the amount of cash generated by home deliveries. However, lesscash was 

 

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usedin the three months ended December 31, 2007 when compared with the threemonths ended December 31, 2006 to fund land purchases, lot development andhome construction.

 

***Investing cash flowsactivities***

*** ***

Cashprovided by investing activities totaled $0.6 million during the three monthsended December 31, 2007, compared to cash used in investing activities of $5.4million during the three months ended December 31, 2006. The increase innet cash provided by investing activities was primarily due to $2.3 million ofproceeds received from the sale of property and equipment and a decrease in thenet contributions to investments in unconsolidated entities during the threemonths ended December 31, 2007 as compared with the three months ended December 31,2006.

 

***Financing cash flowsactivities***

*** ***

Cashused in financing activities totaled $21.7 million during the three monthsended December 31, 2007, compared to $8.1 million during the three monthsended December 31, 2007. During the three months ended December 31,2007, we decreased our outstanding debt obligations by $24.6 million.

 

InDecember 2005, we entered into a new senior credit facility to finance ourbusiness operations. Proceeds of the new senior credit facility were used toretire our existing senior secured revolving credit facilities andsubstantially all of our other senior secured credit facilities. The seniorcredit facility had a maximum availability of $500 million, subject to aborrowing base as well as sublimits of $100 million for the issuance of lettersof credit and $10 million for swing line loans. We had the right, without theconsent of our lenders (other than those participating in the increase), toincrease the commitment by an amount of up to $200 million, provided that nosuch increase shall cause the senior credit facility to exceed $700 million. Weamended the senior credit facility in December 2006 to amend certaincovenants; amended and restated the senior credit facility in August 2007to further amend certain covenants, require that the senior credit facility besecured by all properties to be included in the borrowing base for the seniorcredit facility and related assets and prohibit the incurrence of anyadditional secured debt; and amended the senior credit facility in January 2008to reduce the maximum availability thereunder to $400 million to better matchour financing needs.

 

Theapplicable borrowing base is determined regularly throughout the life of thesenior credit facility. The composition of the borrowing base is limited toparameters set forth in the senior credit facility and certain types of realestate (such as unimproved entitled land and lots under development) areremoved from the borrowing base if held beyond specified maturity dates. As aresult of the August 2007 amendments to the senior credit facility, theproperty of certain non-wholly owned subsidiaries cannot be included in theborrowing base calculation unless and until such subsidiaries are able toguarantee the senior credit facility (on a secured basis), which will besubject to the consent of minority interest holders and there is no assurancethat we would be able to obtain such consent. New properties that are proposedto be included as borrowing base property would also be mortgaged and pledgedto secure the senior credit facility and also would need to satisfy specifiedparameters or otherwise be approved by the majority lenders.

 

Borrowingsunder the senior credit facility generally bear interest based on an applicablemargin plus LIBOR or an alternate base rate. The applicable margin for interestranges from 1.5% to 2.25%, depending upon our senior leverage ratio, which isdefined as the ratio of total liabilities to consolidated net worth. Fees forletters of credit are based on LIBOR plus a margin of 1.5%. An unusedcommitment fee equal to 0.2% to 0.3% per year accrues on the undrawn portion ofthe senior credit facility and is payable quarterly in arrears. The August 2007amendments provide that the applicable interest margins are subject to increaseby 0.375% to 0.875% in the event that liquidity (as defined below) is more than$50 million but less than or equal to $100 million.

 

The covenants under the senior credit facility, as amended,require us to: maintain a minimum tangible net worth of at least $300 millionplus 50% of positive net income earned subsequent to September 30, 2006;maintain a ratio of total liabilities to adjusted tangible net worth not toexceed 2.0x (decreasing to 1.75x as of June 30, 2007 and increasing to2.5x as of December 31, 2008); maintain a ratio of total debt to adjustedtangible net worth not to exceed 1.5x; maintain a ratio of total land(including undeveloped land, land under development and finished lots on whichhome 

 

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construction has yet to begin) to adjusted tangible networth not to exceed 1.5x; and maintain an interest coverage ratio of no lessthan 1.75x through December 31, 2006 (decreasing to 1.5x through March 31,2007, decreasing to 1.4x through June 30, 2007, decreasing to 1.35xthrough September 30, 2007, increasing to 1.5x through December 31,2007, increasing to 1.75x through March 31, 2008 and then increasing to2.25x through the remaining term of the senior credit facility). For purposesof these tests, adjusted tangible net worth is benefited by adjustments of 50%of our outstanding senior subordinated debt (up to a maximum $100 millionadjustment) and 100% of minority interests in consolidated entities (up to amaximum $50 million adjustment). The August 2007 amendments:  (1) permit us to ignore, for purposes offinancial covenant calculations (but not for interest margin calculations), upto $40 million of tangible net worth reductions due to impairment andabandonment charges; (2) suspend the interest coverage ratio covenantuntil March 31, 2009 and add a minimum $25 million trailing four-quarteradjusted EBITDA requirement (as defined in our senior credit facility) and aminimum $50 million liquidity requirement (defined as unrestricted cash,available borrowings under the senior credit facility and other available linesof credit and receivables from home closings); (3) require us to testliquidity monthly; and (4) reduce permitted unsecured debt from $25million to $15 million and permitted joint venture investments from 30% oftangible net worth to 25% of tangible net worth.

 

As of December 31, 2007, we had $309 million ofborrowings under the senior credit facility at an effective interest rate of6.33%. As of December 31, 2007 and September 30, 2007, we were not incompliance with certain of the covenants in our senior credit facility,including the covenant requiring us to maintain a minimum tangible net worth(as defined in our senior credit facility). Our failure to meet these covenantsallows the lenders under our senior credit facility to declare all amountsoutstanding thereunder, together with accrued interest, to be immediately dueand payable. Acceleration under our senior credit facility would also trigger across-default under the indenture governing our senior subordinated notes,thereby allowing our bondholders to accelerate the repayment of all amountsoutstanding on the senior subordinated notes, subject to certain blockageperiods. In addition, certain other credit facilities within our joint venturesto which we have provided guarantees include provisions for acceleration orevents of default in the event of a default under our senior credit facility.

 

InJanuary 2008, we obtained a limited duration waiver and amendment withrespect to our senior credit facility. The amendment and waiver agreementprovided us with immediate access to $10 million as well as continued accessduring the waiver period to the proceeds from the ordinary course sale ofhomes, reduced the maximum availability of the senior credit facility from $500million to $400 million and amended the financial covenants thereunder for theperiods ending September 30, 2007 and December 31, 2007. However, asa result of recording additional impairment charges in connection with thepreparation and review of the condensed consolidated financial statements forthe period ended December 31, 2007, we are no longer in compliance withthe covenants set forth in the waiver and amendment. As such, the bank groupmay terminate the waiver and amendment and declare all amounts outstandingunder the senior credit facility, together with accrued interest, to beimmediately due and payable. We intend to continue discussions with the bankgroup regarding further amendments or waivers to the senior credit facilityupon reasonable terms, however, there can be no assurance that we will be ableto further amend or obtain waivers under the senior credit facility uponreasonable terms, or at all.

 

Inaddition to the items set forth above, the waiver and amendment agreementamended the senior credit facility to, among other things, (1) requirethat the net cash proceeds of all dispositions (each as defined in the seniorcredit facility, and which do not include proceeds from ordinary course salesof housing units) be deposited into a cash collateral account under the controlof the bank group, which account shall be available in the bank group’s solediscretion for our general corporate purposes or to repay obligations under thesenior credit facility, (2) generally prohibit us from incurring anyadditional indebtedness, except pursuant to the senior credit facility, (3) amendcertain financial covenants for the periods ending September 30, 2007 and December 31,2007, including reducing our minimum tangible net worth (as defined in thesenior credit facility from $302.0 million to $160.0 million and increasing ourmaximum leverage ratio from 1.75 to 2.75, (4) reduce our required minimumliquidity from $50.0 million to $1.0 million, (5) generally require thatinterest is payable at the base rate (as defined in the senior credit facility)and (6) increase the margin for commitment fees to 0.30%.

 

Inaddition, the waiver and amendment agreement permits us to borrow an additional$5.0 million if on or before January 31, 2008, we provide to the bankgroup a 13-week cash flow forecast in a form reasonably satisfactory to thebank group and such forecast demonstrates that we have or thereafter will haveadditional liquidity needs. We submitted an acceptable 13-week cash flowforecast to the bank group prior to January 31, 2008 and we borrowed theadditional $5.0 million.

 

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In December 2005, we issued $203 million aggregateprincipal amount of senior subordinated notes due December 2012 in aprivate placement pursuant to Rule 144A promulgated under the SecuritiesAct of 1933. In May 2006, we exchanged all of the senior subordinatednotes issued in December 2005 for an issue of notesregistered with the SEC with terms substantially identical to the notes issuedin the private placement. The seniorsubordinated notes were sold at 98.796% of par and accrue interest at a couponrate of 10.5% per annum. Interest is paid semi-annually in June andDecember. The net proceeds were used to repay amounts outstanding under workingcapital loans and certain senior secured revolving credit facilities. We mayredeem the notes, in whole or part, at any time on or after December 15,2009, at a redemption price equal to 100% of the principal amount, plus a 5.25%premium declining ratably to par on December 15, 2011, plus accrued andunpaid interest. At any time prior to December 15, 2008, we may redeem upto 35% of the aggregate principal amount of the notes with the proceeds ofqualified equity offerings at a redemption price equal to 110.5% of theprincipal amount, plus accrued and unpaid interest. In addition, if weexperience specific kinds of changes of control, we are required to make anoffer to purchase all of the notes at a purchase price of 101% of the principalamount thereof, plus accrued and unpaid interest. The notes are unsecuredsenior subordinated obligations and subordinated in right of payment to all ofour existing and future senior debt, including borrowings under our seniorcredit facility. All of our wholly owned subsidiaries, other than our mortgagesubsidiary, have fully and unconditionally guaranteed the notes on a joint andseveral, unsecured senior subordinated, basis. The guarantees are generalunsecured obligations of the guarantors and will be subordinated in right ofpayment to all existing and future senior debt of the guarantors, whichincludes their guarantees of our senior credit facility described above. Theindenture governing the senior subordinated notes contains a number ofsignificant covenants that restricts our ability and that of our restrictedsubsidiaries to, among other things: incur additional indebtedness, makecertain distributions, investments and other restricted payments, createcertain liens, enter into transactions with affiliates, and merge, consolidateor sell substantially all of our assets. As of December 31, 2007, we wererestricted from incurring additional indebtedness (excluding availableborrowings under the senior credit facility), except under certain limitedcircumstances.

 

In November 2006, we entered into a two year interestrate cap agreement to protect $100 million of our borrowings from sharpincreases in the prevailing short-term interest rates. Under the terms of theagreement, the LIBOR rate is capped at 5.5% per annum.

 

We are party to a senior secured project-specificacquisition and development loan. This loan bears interest at LIBOR plus 2.25%with maturity tied to the sale of the underlying inventory. As of December 31,2007, we had $19.1 million outstanding related to this project-specificacquisition and development loan. We are also party to several unsecured loanagreements that fund our operations on an ongoing basis.

 

We are also party to a $100 million flexible earlypurchase facility agreement which allows us to sell qualifying mortgage loansto the holder of the flexible early purchase facility after such loans havebeen originated subject to our obligation to sell the loan to an investor inthe secondary market. At December 31, 2007, the facility held$3.2 million of loans sold by KH Financial, L.P.

 

Our current levels of cash flow have not been sufficient toallow us to pay principal and interest on our debt, including our senior creditfacility and senior subordinated notes, support our operations and meet ourother obligations without continued reliance upon additional borrowings underour senior credit facility. Our ongoingability to meet our substantial debt service and other obligations, includingcompliance with financial covenants in our senior credit facility and seniorsubordinated notes, will be dependent upon our future performance which will besubject to business, financial and other factors. We will not be able tocontrol many of these factors, such as the continued deterioration in thehomebuilding industry, economic conditions in the markets where we operate andpressure from 

 

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competitors. If we do not have enough money, or access toadditional borrowings, or are unable to maintain compliance with financial andother covenants in our senior credit facility and senior subordinated notes, wemay be required to seek to refinance all or part of our existing debt, sellassets or borrow more money. We currently have no alternativefinancing in place and if we are unable to find alternative financing or obtainfurther amendments or waivers, we may not have sufficient assets to repay theoutstanding debt if accelerated. Working with Alvarez & Marsal NorthAmerica, LLC, a financial advisory and consulting firm, we are considering anumber of alternatives, including the appointment of a chief restructuringofficer and whether to seek a complete restructuring under Chapter 11 of theUnited States Bankruptcy Code.

 

**Contractualobligations**

** **

Ourprimary contractual cash obligations for our operations are payments under ourdebt agreements and purchase obligations with specific performance requirementsunder land option agreements and purchase contracts. These land optionagreements and purchase contracts may require us to purchase land contingentupon us and the seller meeting certain obligations.

 

The following summarizes our aggregate contractualcommitments at December 31, 2007:

 
| ** **                    | ** ** | **Payments  due by period** | ** ** |
|-------------------------------|------------|-----------------------------|------------|
| ** **                    | ** ** | ** **                  | ** ** | **Less  than** | ** ** | ** ** | ** ** | ** ** | ** ** | **More  than 5** | ** ** |
| **(Dollars in thousands)**    | ** ** | **Total**                   | ** ** | **1  year** | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **years** | ** ** |
| Notes payable(1)              |       | $                           | 689,388    |   | $ | 65,427 |   | $ | 379,658 |   | $ | 244,303 |   |   |   |
| Operating leases              |       | 12,756                      |       | 4,438 |   | 6,780 |   | 1,293 |   | 245 |   |
| Purchase obligations(2)  |       | 45,153                      |       | 1,097 |   | 21,346 |   | 22,710 |   |   |   |
| Total                         |       | $                           | 747,297    |   | $ | 70,962 |   | $ | 407,784 |   | $ | 268,306 |   | $ | 245 |   |
|                          |       |                        |       |   |   |   |   |   |   |   |   |
|                               |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| (1)    | Includes our senior subordinated notes, senior credit  facility, other homebuilding debt and related interest payments for the life  of the debt. Interest on variable rate obligations is based on rates  effective as of December 31, 2007.                                                                                                                       |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                     |
| (2)    | Represents obligations under land option agreements and  purchase contracts with specific performance provisions, net of cash deposits.  Amounts do not include the purchase  obligations with respect to our unconsolidated joint venture’s of  approximately $43.1 million and $15.4 million, which come due April 15, 2008  and May 31, 2008, respectively. |

 

Underthe terms of our stock option plans, we may be required to purchase shares ofour common stock at fair market value, including shares issuable underoutstanding options or deferred stock units, from certain of our directors,executive officers and other key employees, in the event of termination ofboard membership or employment, as applicable, by reason of specifiedcircumstances, including death, disability, involuntary termination orretirement. As of December 31, 2007, the aggregate repurchase obligation,net of proceeds to be received from any stock option exercises, would have been$1.4 million in the event that all of these obligations were triggered.Our ability to satisfy our repurchase obligations is subject to certain limitationsset forth in the indenture governing our senior subordinated notes. Inaddition, if Mr. Hill’s employment is terminated by reason of his death orpermanent disability, his family trust may request us to purchase up to 500,000shares of our common stock, and upon receipt of such request we will reasonablydetermine in our sole discretion how many shares to purchase in light of ourfinancial condition and prospects and the limitations, restrictions andconstraints in our loan and financing arrangements at the time. The purchaseprice payable by us will be the fair market value at that time.

 

Weare contingently liable to banks and financial institutions for approximately$107 million for outstanding letters of credit and performance bonds securingperformance of certain contractual obligations and land purchase contracts.Approximately $2.2 million of the outstanding letters of credit have beenissued by a wholly owned subsidiary.

 

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**Land and lot position and homes in inventory**

** **

At December 31,2007, we owned and controlled 17,183 lots, approximately 36% of which werepursuant to option agreements and purchase contracts. The following is asummary of our land/lot position as of December 31, 2007:

 
| ** **                                                         | ** ** | **Number  of lots** | ** ** |
|--------------------------------------------------------------------|------------|---------------------|------------|
| Finished lots owned                                                |       | 4,248               |       |
| Lots under development owned                                       |       | 6,185               |       |
| Lots held for sale                                                 |       | 522                 |       |
| Total lots owned                                                   |       | 10,955              |       |
| Lots controlled under option agreements and purchase  contracts(1) |       | 6,228               |       |
| Total land/lots controlled                                         |       | 17,183              |       |
|                                                               |       |                |       |

** **
| (1) | Includes  1,895 lots included in inventory not owned on our condensed consolidated  balance sheets and 2,090 lots that are controlled through our equity  investments in unconsolidated entities. |
|-----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

 

**Off-balance sheet arrangements**

** **

Ourprimary use of off-balance sheet arrangements is to secure desirable lots onwhich to build homes in a manner that we believe reduces the overall risk tous. Our off-balance sheet arrangements relating to our homebuilding operationsinclude land option agreements and purchase contracts and joint ventures.

 

***Landoption agreements and purchase contracts***

*** ***

Inthe ordinary course of business, we enter into option agreements and purchasecontracts to secure land for the construction of homes. These agreementsgenerally require us to pay a deposit to the seller as consideration for theright to acquire land during a specified period, usually at predeterminedprices. Some of these option agreements and purchase contracts contain specificperformance clauses, which require us to purchase the land upon satisfaction ofcertain requirements. Otherwise, our exposure under option agreements andpurchase contracts are generally limited to forfeiture of the nonrefundabledeposits, letters of credit and other nonrefundable amounts incurred. Below isa summary of the aggregate exercise price of all option agreements and purchasecontracts as of December 31, 2007:

 
| ** **                                                                     | ** ** | ** **                        | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                     | ** ** | **Aggregate  exercise**           | ** ** |
| **(Dollars in thousands)**                                                     | ** ** | **price  of land options****(1)** | ** ** |
| Land option agreements and purchase contracts with  specific performance       |       | $                                 | 1,098      |   |
| Land option agreements and purchase contracts  without specific performance(2) |       | 209,068                           |       |
| Total land option agreements and purchase contracts                            |       | $                                 | 210,166    |   |
|                                                                           |       |                              |       |

** **
| (1)    | Excludes  $50 million of purchase obligations related to inventory not owned included  on our consolidated balance sheets at fair value of $33 million, of which $44  million of the purchase obligations contains specific performance  obligations.                                                                                                                                                                                                                                                                                    |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| (2)    | Includes  $128 million related to purchases from joint ventures in which we have an equity  investment. We believe there is a substantial likelihood that we will not  have sufficient liquidity to make all of these purchases. Failure to make  such purchases may trigger our guarantee obligations under the joint  ventures’ financing arrangements and may expose us to other liabilities for  breach of the related joint venture agreements. See “—Investments in and  advances to unconsolidated entities.” |

 

Giventhe continued deterioration in market conditions and uncertainty about thetiming and pace of any recovery, we have tightened our land acquisitioncriteria and are working with land sellers to renegotiate land purchase andoption contracts to extend purchase dates and reduce purchase prices. If we areunable to obtain satisfactory terms, we will not exercise our land optionagreements and will abandon our earnest money if contractually obligated to doso.

 

***Investments in and advances tounconsolidated entities***

*** ***

Investments in and advances to unconsolidated entitiesrepresent our ownership interests in entities accounted for under the equitymethod when we have a significant influence over the entity but hold less thana controlling interest 

 

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in the entity or we are not the primary beneficiary in avariable interest entity as defined by FIN 46R. Our partners generally areunaffiliated homebuilders, land sellers or other real estate entities.

 

Inthe ordinary course of business, we periodically enter into arrangements withland developers or other homebuilders to acquire land and develop lots. Thesearrangements include the creation of joint ventures, in which our currentinterests range from 6% to 49%. We account for our interest in these jointventures under the equity method, and our consolidated balance sheets includeinvestments in and advances to joint ventures totaling $14.0 million and $24.9million at December 31, 2007 and September 30, 2007, respectively.These joint ventures typically obtain secured acquisition, development andconstruction financing. At December 31, 2007 and September 30, 2007,our unconsolidated joint ventures had outstanding third party borrowings of$810 million and $940 million, respectively. From time to time we have issuedcompletion guarantees, repayment guarantees and/or loan-to-value maintenanceguarantees in respect of this indebtedness. These guarantees require us torepay debt of the joint venture in the event of a payment default or in theevent that the debt of the joint venture exceeds the value of the propertysecuring the debt. Set forth below are thesignificant changes related to our investments in and advances tounconsolidated entities during the quarter ended December 31, 2007.

 

In January 2005, we entered into a joint venture, in which we have a9.59% interest, to acquire and develop land in Nevada (“Nevada JV No. 1”). Asof September 30, 2007, we determined that our investment in Nevada JV No. 1 wasmore than temporarily impaired and recorded a $21.5 million charge towrite-down the investment balance to zero. At December 31, 2007, Nevada JV No.1 had third party debt of $435 million under a secured credit facility, ofwhich each member has guaranteed payment of its pro rata share in the event of specifiedbankruptcy events or in the event of certain improper or fraudulent actionsinvolving Nevada JV No. 1. Our pro rata portion of the debt is $41.7 million atDecember 31, 2007. We have also provided pro rata completion guarantees forthis joint venture. The repayment guarantee requires that we be in compliancewith the financial covenants contained in our senior credit facility and, thus,our current default under our senior credit facility constitutes an event ofdefault under Nevada JV No. 1’s secured credit facility. Failure to cure suchdefaults could result in the acceleration of Nevada JV No. 1’s repaymentobligations under its secured credit facility, which could trigger across-default under the indenture governing our senior subordinated notes,thereby allowing the bondholders to accelerate the repayment of all amountsoutstanding under the senior subordinated notes. 

 

Recently, Nevada JV No. 1 received notice from the administrative agentunder its secured credit facility that it was not in compliance with certaincovenants thereunder, including a performance covenant requiring that Nevada JVNo. 1 make a specified amount of progress with respect to the projectscontemplated under the secured credit facility. Breach of such covenantconstitutes an event of default under its secured credit facility. Failure tocure such defaults could result in the acceleration of Nevada JV No. 1’srepayment obligations under its secured credit facility. To our knowledge, thelenders under this facility have not indicated they will accelerate amounts dueunder the facility as a result of these defaults, however, there can be noassurance that they will not.

 

Further, on May 31, 2008, we will be required to purchase land inconnection with Nevada JV No. 1 for a purchase price of approximately $15.4million subject to certain credits for past investments in the joint ventureand the obligation to fund future development costs. We believe there is asubstantial likelihood that we will not have sufficient liquidity to make thispurchase. Failure to make this purchase will, among other things, constitute anevent of default under Nevada JV No. 1’s secured credit facility, upon whichthe lenders may terminate their commitments thereunder and accelerate Nevada JVNo. 1’s repayment obligations thereunder and, if the lenders are permitted toaccelerate the repayment obligations, it will constitute an event of defaultunder our senior credit facility which could result in the acceleration of ourrepayment obligations under our senior credit facility. Acceleration of eitherNevada JV No. 1’s or our repayment obligations could trigger a cross-defaultunder the indenture governing our senior subordinated notes, thereby allowingthe bondholders to accelerate the repayment of all amounts outstanding underthe senior subordinated notes. We may have additional liabilities associatedwith a breach of its Nevada JV No. 1 obligations. 

 

 

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In May 2004, we entered into a joint venture, in which we have a6.29% interest, to acquire and develop land in Nevada (“Nevada JV No. 2”). Asof December 31, 2007, we determined that our investment in Nevada JV No. 2 wasmore than temporarily impaired and recorded a $17.1 million charge to write-downthe investment balance to zero and to accrue for an outstanding letter ofcredit. At December 31, 2007, Nevada JV No. 2 had third party debt of$325 million under a secured credit facility, of which each member hasguaranteed payment of its pro rata share in the event of specifiedbankruptcy events or in the event of certain improper or fraudulent actionsinvolving Nevada JV No. 2. Our pro rata portion of the debt is$20.4 million at December 31, 2007. We have provided pro ratacompletion guarantees for Nevada JV No. 2. The repayment guarantee requiresthat we be in compliance with the financial covenants contained in our seniorcredit facility and, thus, our current default under our senior credit facilityconstitutes an event of default under Nevada JV No. 2’s secured creditfacility. Failure to cure such defaults could result in the acceleration ofNevada JV No. 2’s repayment obligations under its secured credit facility,which could trigger a cross-default under the indenture governing our seniorsubordinated notes, thereby allowing bondholders to accelerate the repayment ofall amounts outstanding under the senior subordinated notes. 

 

On April 15, 2008, we are required to purchase land in connection withNevada JV No. 2 for a purchase price of approximately $43.1 million subject tocertain credits for past investments in the joint venture and the obligation tofund future development costs. We believe there is a substantial likelihoodthat we will not have sufficient liquidity to make this purchase. Failure tomake this purchase will, among other things, constitute an event of defaultunder Nevada JV No. 2’s secured credit facility. If such default occurs andremains uncured, the lenders under Nevada JV No. 2’s facility may terminatecommitments under the facility and may accelerate Nevada JV No. 2’s repaymentobligations and, if the lenders are permitted to accelerate the repaymentobligations, it will constitute an event of default under our senior creditfacility which could result in the acceleration of our repayment obligationsunder our senior credit facility. Acceleration of either Nevada JV No. 2’s orour repayment obligations could trigger a cross-default under the indenturegoverning our senior subordinated notes, thereby allowing the bondholders toaccelerate the repayment of all amounts outstanding under the seniorsubordinated notes. In addition, in connection with a previous purchase underthe facility, letters of credit for $12.5 million were issued under our seniorcredit facility. Subject to a limited cure period, upon an event of defaultunder Nevada JV No. 2’s secured credit facility, the administrative agentthereunder may, in addition to its other remedies, draw upon this letter ofcredit in full and apply such amounts to repay our pro rata portion of NevadaJV No. 2’s debt. We may have additional liabilities associated with a breach ofits Nevada JV No. 2 obligations.

 

InOctober 2007, our mortgage banking subsidiary (KH Financial L.P., or“KHF”), and Wells Fargo Bank, N.A. and its wholly owned subsidiary Wells FargoVentures, LLC (collectively, “Wells Fargo”) formed a new joint venture, KHMortgage, LLC (“KH Mortgage”). KHF contributed $250,000 in cash and contributedvarious assets to establish KH Mortgage. Then, pursuant to the Assignment ofInterest Agreement between the parties, Wells Fargo paid $900,000 in cash toKHF, opened a one year certificate of deposit in KHF’s name for $538,000 andagreed to waive certain management fees with an estimated benefit to KHF of$437,000 in exchange for a 50.1% interest in KH Mortgage. KHF retainedownership of the remaining 49.9 % of KH Mortgage. The sale of the investment inKH Mortgage generated a deferred gain of $1,219,000 that is included in otherliabilities in the condensed consolidated balance sheets. The deferred gainwill only be recognized in earnings in the event we discontinue ourrelationship with KH Mortgage or otherwise satisfy applicable contractualrequirements for the recognition of the gain. Our wholly-owned mortgagesubsidiary began to wind down its operations in November 2007, and it willcease day to day operations during the second fiscal quarter of 2008 after ithas fully satisfied all commitments to borrowers for loans.

 

**Seasonality and variability in quarterly results**

** **

Our homebuilding operating cycle typically reflectsincreased new order activity in our second and third fiscal quarters andincreased deliveries in our third and fourth fiscal quarters. We believe thatthis seasonality reflects the tendency of homebuyers to shop for a new home inthe spring with the goal of closing in the fall, as well as the scheduling ofpaving and construction to accommodate seasonal weather conditions. However,the historical norms have been disrupted in recent years as a result of the continueddeterioration in market conditions.

 

**Backlog**

** **

Oursales contracts require cash deposits in line with respective market practicesand may be subject to certain contingencies such as the buyer’s ability toqualify for financing. Homes covered by such sales contracts but not yetdelivered are considered “backlog.” We do not recognize revenue upon the saleof a home until it is delivered to the homebuyer and other criteria for saleand profit recognition are met. We sometimes build homes before obtaining asales contract, however, these homes are excluded from backlog until a salescontract is signed. At December 31, 2007 and September 30, 2007, wehad 214 units and 327 units, respectively, of completed homes in inventorywithout sales contracts which represented 26% and 32%, respectively, of ourtotal home inventory (in units). Our cancellation rates for the three monthsended December 31, 2007 and 2006 were 31% and 26%, respectively.

 

**Interest rates and inflation**

** **

Our business is significantly affected by the level ofinterest rates. Higher interest rates may decrease demand for our homes bymaking it more difficult for homebuyers to qualify for mortgages or to obtainmortgages at interest rates that are acceptable to them. Higher interest rateswould also increase our borrowing costs because a portion of our bank loansfluctuate with LIBOR and prime lending rates. In November 2006,we entered into a two year interest rate cap agreement to protect $100 millionof our borrowings from sharp increases in the LIBOR lending rate.

 

We may be adversely affected during periods of highinflation because of higher land, financing, labor and material costs. Weattempt to pass to our customers any increases in our costs through increasedsales prices, although this is becoming increasingly difficult given the recentdeterioration in the homebuilding market. To date, inflation has not 

 

 

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had a material adverse effect on our results of operations.However, there is no assurance that inflation will not have a material adverseimpact on our future results of operations.

 

**Critical Accounting Estimates and Policies**

** **

Thediscussion and analysis of our financial condition and results of operations isbased upon our condensed consolidated financial statements which have beenprepared in accordance with GAAP. The preparation of these financial statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities. We evaluate our estimates on an on-goingbasis. We base our estimates on historical experience and on various otherassumptions that we believe are reasonable under the circumstances, the resultsof which form the basis for making judgments about the carrying values ofassets and liabilities that are not readily apparent from other sources. Actualresults may differ from these estimates under different assumptions orconditions.

 

Managementbelieves that the following critical accounting policies affect its moresignificant judgments and estimates used in preparation of its condensedconsolidated financial statements:

 

                ·              Revenue recognition;

 

                ·              Homebuilding inventory and costsof sales;

 

                ·              Variable interest entities;

 

                ·              Investments in and advances tounconsolidated entities;

 

                ·              Warranty costs;

 

                ·              Litigation reserves;

 

                ·              Insurance claims costs;

 

                ·              Valuation of deferred tax assets; 

 

                ·              Stock-based compensation; and

 

                ·              Redeemable common stock.

 

There have been no significant changes in the above criticalaccounting policies, as compared to those we disclosed in our AnnualReport on Form 10-K for the fiscal year ended September 30, 2007.

 

**Recent Accounting Pronouncements**

 

In July 2006, the FASB issued Financial Interpretation No. 48, *Accounting for Uncertainty in Income Taxes* (“FIN 48”), whichclarifies the accounting for uncertainty in income taxes recognized in thefinancial statements in accordance with SFAS No. 109, *Accountingfor Income Taxes*. FIN 48 provides that a tax benefit from anuncertain tax position may be recognized when it is more likely than not thatthe position will be sustained upon examination, including resolutions of anyrelated appeals or litigation processes, based on the technical merits. Incometax positions must meet a more-likely-than-not recognition threshold at theeffective date to be recognized upon the adoption of FIN 48 and in subsequentperiods. This interpretation also provides guidance on measurement, derecognition,classification, interest and penalties, accounting in interim periods,disclosure and transition. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. 

 

We adopted the provisions of FIN 48 on October 1, 2007. Theimplementation of FIN 48 did not have a significant impact on our financialstatements. We recognize interest and penalties related to unrecognized taxbenefits within the provision for income taxes in the accompanying condensedconsolidated statement of operations. We are subject to taxation in the U.S.and various states jurisdictions. Our tax years for 2004, 2005 and 2006 aresubject to examination by the tax authorities. With few exceptions, we are nolonger subject to U.S. federal, state or local examinations by tax authoritiesfor years before 2004.

 

InSeptember 2006, the SEC issued Staff Accounting Bulletin No. 108, *Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements* (“SAB 108”),which provides guidance as to how the effects on prior year uncorrectedmisstatements should be considered when quantifying misstatements in thecurrent financial statements. SAB 108 was issued in order to eliminate thediversity of practice surrounding how public companies quantify financialstatement misstatements. SAB 108 requires us to quantify misstatements usingboth a balance sheet and income statement approach, with adjustment required ifeither method results in a material error. We adopted the provisions of SAB 108on October 1, 2007. The adoption of SAB 108 did not have a significant impacton our financial statements.

 

InSeptember 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”),which defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles and expands disclosure about fairvalue measurements. SFAS 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007, and interim periods withinthose fiscal years. However, the FASB did provide a one year deferral for theimplementation of SFAS 157 for certain nonfinancial assets and liabilities. Weare in the process of determining the effect, if any, the adoption of SFAS 157will have on our financial statements.

 

InFebruary 2007, the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities, including anamendment of FASB Statement No. 115*(“SFAS 159”). SFAS 159permits a company to measure certain financial instruments and other items atfair value. SFAS 159 is effective for financial statements issued for fiscalyears beginning after November 15, 2007, with early adoption permitted. Weare in the process of determining the effect, if any, the adoption of SFAS 159will have on our financial statements.

 

 

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InDecember 2007, the FASB issued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements* (“SFAS 160”)- anamendment of ARB No. 51. SFAS 160 establishes accounting and reportingstandards for noncontrolling interests in consolidated financial statements.SFAS No. 160 is effective for fiscal years, and interim periods withinthose fiscal years, beginning on or after December 15, 2008. Earlyadoption is prohibited. We are in the process of determining the effect, ifany, the adoption of SFAS 160 will have on our financial statements.

 

**Cautionary Factors That May Affect Future Results**

** **

Ourdisclosure and analysis in this report contain forward-looking statements aboutour financial results and estimates and business prospects that involvesubstantial risks and uncertainties. From time to time, we also may provideoral or written forward-looking statements in other materials we release toanalysts, debt holders and the public. Forward-looking statements give ourcurrent expectations or forecasts of future events. You can identify thesestatements by the fact that they do not relate strictly to historic or currentfacts. They use words such as “anticipate”, “believe”, “estimate”, “expect”,“forecast”, “goal”, “intend”, “objective”, “plan”, “projection”, “seek”,“strategy”, or other words and terms of similar meaning. Any or all of theforward-looking statements included in this report and in any other of our reportsor public statements may not approximate actual experience, and theexpectations derived from them may not be realized, due to known or unknownrisks and uncertainties. As a result, actual results may differ materially fromthe results discussed in and anticipated by the forward-looking statements. Thefollowing risks and uncertainties relevant to our business include factors webelieve could adversely affect us:

 

                                                 ·                                         continued deterioration in homebuilding industry;

 

                                                ·                                          our abilityto continue as a going concern and to return to profitable operations andretain financing to meet our  obligationsand pay our liabilities when they become due;

 

                                                 ·                                         our substantial level of indebtedness and the impact of the restrictionsimposed on us by the terms of this debt;

 

                                                 ·                                         our ability to maintain compliance with financial covenants;

 

                                                 ·                                         inventory risk;

 

                                                 ·                                         our purchase obligations and other guarantees that we have provided forcertain investments in unconsolidated entities;

 

                                                 ·                                         fluctuations in inventory values and carrying costs;

 

                                                 ·                                         borrowing limits under our senior credit facility are subject toredetermination;

 

                                                 ·                                         the indenture for our senior subordinated notes and other debt agreementsimpose significant operating and financial restrictions;

 

                                                 ·                                         availability and affordability of mortgage financing;

 

                                                ·                                          ourfinancial statements, which describe certain uncertainties related to ourability to continue as a going concern and includean audit report from an independent register public accounting firm that refersto that uncertainty, reductions in our credit rating and difficulty obtainingsufficient capital and bonding could limit our ability to raise additional capitaland result in delays in the completion of projects;

 

                                                 ·                                         our ability to develop our communities successfully;

 

                                                ·                                          our ability to compete effectively against homebuilders in our markets andwith sales or rentals of existing homes in our markets;

 

                                                 ·                                         the availability and quality of independent contractors and raw materials;

 

 

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                ·            our ability to retain certain members of our seniormanagement and other key employees;

 

                ·            high interest rates, changes in tax laws andinflation;

 

                ·            changes in macroeconomic conditions in our marketsand regions;

 

                ·            expenses related to construction defect, soilsubsidence and home warranty claims;

 

                ·            the future availability of insurance at reasonablecosts;

 

                ·            poor relations with residents of our communities;

 

                ·            our obligation to repurchase issued and outstandingshares of our common stock;

 

                ·            utility shortages and price increases;

 

                ·            adverse weather conditions or natural disasters inour markets;

 

                ·            our ability to acquire desirable lots or land forresidential buildout;

 

                ·            changes in our legal and regulatory environment;

 

                ·            changes in environmental laws and regulations;

 

                ·            geopolitical risks and market disruption; 

 

                ·            the growth or expansion of our operations; and

 

                ·            our controlling stockholder’s interests may conflictwith the interests of other stakeholders.

 

Otherfactors beyond those listed above could also adversely affect us. Given theseuncertainties, you are cautioned not to place undue reliance on theseforward-looking statements. These forward-looking statements are made as of thedate of this report. We undertake no obligation to update or revise anyforward-looking statements, whether as a result of new information, futureevents or otherwise. However, any further disclosures made on related subjectsin subsequent reports or communications should be considered. Additionalinformation about factors that could lead to material changes in performance iscontained in our Annual Report on Form 10-Kfor the fiscal year ended September 30, 2007. You should understand that itis not possible to predict or identify all such factors. Consequently, youshould not consider any such list to be a complete set of all potential risksor uncertainties.

 

# **Item3.     Quantitative and QualitativeDisclosures About Market Risk.**

#  

We are exposed to a number of market risks in the ordinarycourse of business. Our primary market risk exposure for financial instrumentsrelates to fluctuations in interest rates. We do not believe our exposure inthis area is material to cash flows or earnings. As of December 31, 2007,we had a total of $335 million of floating rate debt outstanding, including oursenior credit facility and other facilities. Borrowings under these facilitiesgenerally bear interest based on applicable margins plus LIBOR or an alternatebase rate. Holding our variable rate debt balances constant as of December 31,2007, each one percentage point increase in interest rates would result in anincrease in interest incurred for the next twelve month period of approximately$3.3 million. A one percentage point increase in interest rates on our averagevariable rate debt outstanding during the twelve month period ended December 31,2007 would have resulted in an increase in interest incurred of approximately$3.4 million.

 

From time to time, we enter into interest rate swap orinterest rate cap agreements to manage interest costs and hedge against risksassociated with fluctuating interest rates with respect to our floating ratedebt. Currently, we hedge exposure on $100 million of our variable rate debtfrom interest rate fluctuations through the use of an interest rate 

 

 

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cap. Under the terms of the agreement, the LIBOR rate iscapped at 5.5% per annum. We do not enter into or hold derivatives for tradingor speculative purposes.

 

# **Item 4.     Controls andProcedures.**

#  

***Disclosure controls and procedures.***  We maintain disclosure controls andprocedures (as defined in Rule 13a-15(e) of the Securities ExchangeAct of 1934, as amended (the “Act”)) that are designed to provide reasonableassurance that information required to be disclosed by us, including ourconsolidated entities, in the reports that we file or submit under the Act, isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms and that suchinformation is accumulated and communicated to management, including thePresident and Chief Executive Officer (the “Principal Executive Officer”) andVice President, Chief Financial Officer and Treasurer (the “Principal FinancialOfficer”), as appropriate, to allow timely decisions regarding requireddisclosure. Prior to the filing of this report, we completed an evaluationunder the supervision and with the participation of senior management,including our Principal Executive Officer and our Principal Financial Officer,of the effectiveness of the design and operation of our disclosure controls andprocedures as of December 31, 2007. Based on this evaluation, ourPrincipal Executive Officer and our Principal Financial Officer concluded thatour disclosure controls and procedures were effective at the reasonableassurance level as of December 31, 2007.

 

***Changes in internal control over financial reporting.***  There were no changes in our internal controlover financial reporting that occurred during the first fiscal quarter of 2008that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting. However, as previously reported,Edward J. Madell, Vice President, Chief Financial Officer and Treasurer, hadbeen absent on an unexpected medical leave during December 2007 and partof January 2008. In his absence, certain incremental responsibilities wereborne by individuals who have significant roles in the preparation and reviewof our periodic reports. Bradley R. Grining, Vice President and Controller, wasacting as the principal financial officer, in addition to principal accountingofficer, for purposes of the Annual Report on Form 10-K for the fiscalyear ended September 30, 2007.

 

 

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**PART II—OTHERINFORMATION**

** **

**Item 1.    Legal Proceedings.**

** **

Weare involved in various routine legal proceedings incidental to our business,some of which are covered by insurance. With respect to the majority of pendinglitigation matters, our ultimate legal and financial responsibility, if any,cannot be estimated with certainty and, in most cases, any potential lossesrelated to these matters are not considered probable. We accrue for legalexpenses and settlement costs where our ultimate exposure is consideredprobable and the potential loss can be reasonably estimated. Most of thesematters relate to construction defect and general customer claims. We believethat none of these matters will have a material adverse impact upon ourconsolidated financial condition, results of operations or cash flows.

 

**Item 1A.  Risk Factors.**

** **

Therehave been no material changes in our risk factors from those disclosed in Part I,Item 1A of our Annual Report on Form 10-K for the fiscal year ended September 30,2007 other than the inclusion of the risk factors listed below. The riskfactors disclosed in our Annual Report on Form 10-K as amended by thisreport, in addition to the other information set forth in this report, couldmaterially affect our business, financial condition or results. Additionalrisks and uncertainties not currently known to us or that are deemed to beimmaterial also may materially adversely affect our business, financialcondition or results.

 

**Our financial statements have been preparedassuming that we will continue as a going concern. However, if we do not returnto profitable operations in the future and retain the necessary financing tomeet our obligations and pay our liabilities when they come due, we may have toliquidate assets, curtail our operations or seek protective relief under theUnited States Bankruptcy Code.**

** **

Thefactors described in our Annual Report on Form 10-K and this report,including in the footnotes to our consolidated financial statements, raisesubstantial doubt about our ability to continue as a going concern. Ourfinancial statements do not include any adjustments that might result from thisuncertainty. In addition, our independent registered public accounting firm hasincluded an explanatory paragraph expressing substantial doubt about ourability to continue as a going concern in their audit report for the fiscalyear ended September 30, 2007. We also cannot assure you that we will beable to return to profitable operations in the future and retain the necessaryfinancing to meet our obligations and pay our liabilities when they come due.If we cannot return to profitable operations and/or retain the necessaryfinancing on acceptable terms, we will need to liquidate assets orsubstantially curtail our operations and an investor could suffer the loss of asignificant portion or all of its investment in Kimball Hill.

 

Giventhe significant market deterioration and uncertainty about the timing and paceof any recovery in the U.S. homebuilding industry, we have adopted a strategyto manage our business through this current downturn. See “Management’sDiscussion and Analysis of Financial Condition and Results of Operations—RecentTrends.” Actions we have taken, and continue to take, to implement our strategymay not be sufficient to allow us to continue our operations. No assurances canbe made regarding our ability to satisfy our liquidity and working capitalrequirements or our ability to restructure our capital structure. Theaccompanying consolidated financial statements do not include any adjustmentsto reflect the possible future effects on the recoverability and classificationof assets. Failure to restructure our capital structure, including our seniorcredit facility, would result in depleting our available funds and not beingable to pay our obligations when they become due. Further, such restructuringwould not assure that we would be able to satisfy any of our other obligations,including those under the indenture governing our senior subordinated notes.Failure to satisfy such obligations and our other liquidity and working capitalrequirements may require us to seek protective relief under the United StatesBankruptcy Code.

 

 

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**Oursubstantial level of indebtedness could adversely affect our financialcondition and prevent us from fulfilling our debt obligations.**

** **

Wehave substantial indebtedness. As of December 31, 2007, we had$542 million of indebtedness. In addition, subject to restrictions in oursenior credit facility and the indenture for our senior subordinated notes, wemay incur substantial additional indebtedness. The high level of our indebtednesscould have important consequences, including the following:

 

*·**                 **additional financing for working capital, land acquisition,building costs, other capital expenditures or general corporate purposes(including debt service) may not be available to us;*

 

*·**                 **we will need to use a substantial portion of our cash flowfrom operations to pay interest and principal on our indebtedness, which willreduce the funds available to us for other purposes;*

 

*·**                 **we have a higher level of indebtedness than some of our competitors,which may put us at a competitive disadvantage and reduce our flexibility inplanning for, or responding to, changing conditions in our industry, includingincreased competition; and*

 

*·**                 **we will be more vulnerable to economic downturns and adversedevelopments in our business.*

 

Weexpect to obtain the money to pay our expenses and to pay the principal andinterest on our indebtedness from cash flow from our operations, assupplemented by additional borrowing under our senior credit facility as necessaryand available. Our ability to meet our expenses thus depends on our futureperformance and continued funding availability under our senior creditfacility, which will be affected by financial, business, economic and otherfactors. We will not be able to control many of these factors, such as economicconditions in the markets where we operate and pressure from competitors. Inaddition to our general operating expenses and payments required under oursenior credit facility and our indenture, we have land purchase obligations inconnection with two of our joint ventures totaling $43.1 million and $15.4 million,which purchase obligations become due on April 15, 2008 and May 31,2008, respectively. See “Off-balance sheet arrangements—Investments in and advancesto unconsolidated entities.” We believe there is a substantial likelihood thatour cash flow will be insufficient to allow us to pay principal and interest onour debt, fulfill financial or operational guarantees that we have provided forcertain unconsolidated joint venture transactions, support our operations andmeet our other obligations. If we do not have enough money, we may be requiredto refinance all or part of our existing debt, sell assets or borrow moremoney. We cannot guarantee that we will be able to do any of these on termsacceptable to us, if at all. The terms of existing or future debt agreements,including our senior credit facility and the indenture for our seniorsubordinated notes, may restrict us from pursuing certain alternatives. Inaddition, increased debt levels, decreased earnings and/or continuingdeterioration in the U.S. homebuilding market could result in furtherdowngrades in our credit ratings, which, in turn, could impede access toadditional borrowings and/or raise our debt borrowing costs.

 

Communitydevelopment or improvement districts in which certain of our communities arelocated may utilize bond financing programs to fund construction or acquisitionof certain on-site and off-site infrastructure improvements. The obligation topay principal and interest on the bonds issued by the districts is assigned toeach parcel within the district. If the owner of the parcel does not pay suchobligation, a lien will be placed on the property to secure the unpaid obligation.The bonds, including interest and redemption premiums, if any, and theassociated lien on the property are typically payable, secured and satisfied byrevenues, fees or assessments levied on the property benefited.

 

**We are not in compliance with the financialcovenants contained in our senior credit facility. If we are unable to enterinto a permanent amendment or waiver of such financial covenants, we will beunable to borrow additional amounts and may be forced to declare bankruptcy.**

** **

 

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Ourexisting, and any future, senior credit facilities require us to maintainspecified consolidated financial ratios and satisfy certain consolidatedfinancial tests. Our ability to meet those financial ratios and financial testsmay be affected by events beyond our control, including the continueddeterioration in market conditions. At September 30, 2007 and December 31,2007, we were not in compliance with certain of the covenants, limitations andrestrictions under our existing senior credit facility, including the covenantrequiring us to maintain a minimum tangible net worth (as defined in our seniorcredit facility). As such, we are unable to borrow additional amounts under oursenior credit facility. In addition, the lenders under our senior creditfacility could declare all amounts outstanding thereunder, together withaccrued interest, to be immediately due and payable. Acceleration under oursenior credit facility would also trigger a cross-default under the indenturegoverning our senior subordinated notes, thereby allowing our bondholders toaccelerate the repayment of all amounts outstanding on the senior subordinatednotes, subject to certain payment blockage periods. Our assets may not besufficient to repay in full such indebtedness or any other indebtedness. Inaddition, any default under the senior subordinated notes, our senior creditfacility or the instruments governing our other indebtedness (including certainguaranteed indebtedness) would or could constitute a cross-default under one ormore of our senior subordinated notes, our senior credit facility and otherdebt instruments. If an event of default under one or more debt instruments wasto occur, and we are unable to find alternative financing or obtain a waiver,we may not have sufficient assets to repay the outstanding debt that isaccelerated. Further, any subsequent senior credit facilities we enter into, aswell as any other agreements we may enter into in the future governing ourindebtedness, may impose additional restrictions on us, any of which mayadversely affect our ability to finance our future operations or capital needsor to pursue available business opportunities. We intend to continuediscussions with our bank group regarding further amendments or waivers to thesenior credit facility upon reasonable terms, however, there can be noassurance that we will be able to further amend the senior credit facility uponreasonable terms, or at all.  We currentlyhave no alternative financing in place and if we are unable to find alternativefinancing or obtain further amendments or waivers, we may not have sufficientassets to repay the outstanding debt if accelerated. Working with Alvarez &Marsal North America, LLC, a financial advisory and consulting firm, we areconsidering a number of alternatives, including the appointment of a chiefrestructuring officer and whether to seek a complete restructuring underChapter 11 of the United States Bankruptcy Code. See Note 1 to “Notes toUnaudited Condensed Consolidated Financial Statements” and “Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Financing Overview,” and “—Off Balance SheetArrangements—Investments in and advances to unconsolidated entities.”

 

**Item 5.     Other Information**

** **

OnDecember 20, 2007, we entered into a retirement and consulting agreementwith William E. Long, the former president and chief executive officer of KHFinancial, L.P., which agreement was amended on February 11, 2008 (as amended,the “Consulting Agreement”). Pursuant to the Consulting Agreement, Mr. Longagreed to perform certain consulting services for the Company from February 1,2008 through September 30, 2008. Mr. Long will be entitled to$37,087.50 a month for his services (which amount shall be increased to amutually agreeable amount if Mr. Long works in excess of 60 hours in agiven month), a target bonus of $148,350 (which amount shall be adjusted basedupon the average bonuses of the company’s senior management actually receivedfor fiscal year 2008 (excluding Messrs. Love and Hill) in relation to suchexecutives’ target bonuses for 2008), and continuing group health carebenefits.

 

TheConsulting Agreement also contains customary non-solicitation andnon-disclosure provisions and a waiver and release of all claims against theCompany arising out of the Mr. Long’s employment with, or separation from,the Company. 

 

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#  

# **Item 6.      Exhibits.**

 
| **Exhibits** | ** ** | ** **                                                                                                                                                                                                                                                                |
|--------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|         |       |                                                                                                                                                                                                                                                                      |
| 10.1         |       | Limited Duration Waiver  Agreement and Amendment, dated as of January 25, 2008, by and among  Kimball Hill, Inc., the Guarantors party from time to time thereto, the  Lenders party from time to time thereto and Harris Bank, N.A., as  Administrative Agent. |
|         |       |                                                                                                                                                                                                                                                                      |
| 10.2         |       | Confidential Retirement  and Consulting Agreement, dated as of December 20, 2007, between Kimball  Hill, Inc. and William E. Long.                                                                                                                              |
|         |       |                                                                                                                                                                                                                                                                      |
| 10.3         |       | Amendment to  Confidential Retirement and Consulting Agreement, dated as of February 11,  2008, between Kimball Hill, Inc. and William E. Long.                                                                                                                      |
|         |       |                                                                                                                                                                                                                                                                      |
| 31.1         |       | Rule 13a-14(a) /  15d-14(a) Certification of C. Kenneth Love, President, Chief Executive  Officer and Director.                                                                                                                                            |
|         |       |                                                                                                                                                                                                                                                                      |
| 31.2         |       | Rule 13a-14(a) /  15d-14(a) Certification of Edward J. Madell, Vice President, Chief  Financial Officer and Treasurer.                                                                                                                                     |
|         |       |                                                                                                                                                                                                                                                                      |
| 32.1         |       | Section 1350  Certification of C. Kenneth Love, President, Chief Executive Officer and  Director.                                                                                                                                                                    |
|         |       |                                                                                                                                                                                                                                                                      |
| 32.2         |       | Section 1350  Certification of Edward J. Madell, Vice President, Chief Financial Officer  and Treasurer.                                                                                                                                                             |

 

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                          | KIMBALL HILL, INC.                                     |
|-------------------------------|--------------------------------------------------------|
|                          | Registrant                                             |
|                          |                                                   |
| Dated February 14,  2008 | /s/ C. KENNETH LOVE                                    |
|                          | C. Kenneth Love                                        |
|                          | President, Chief  Executive Officer and Director       |
|                          | (Principal Executive  Officer)                         |
|                          |                                                   |
| Dated February 14,  2008 | /s/ EDWARD J. MADELL                                   |
|                          | Edward J. Madell                                       |
|                          | Vice President, Chief  Financial Officer and Treasurer |
|                          | (Principal Financial  Officer)                         |

#  

#  

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#  

# **EXHIBITINDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                           |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1                |       | Limited Duration Waiver  Agreement and Amendment, dated as of January 25, 2008, by and among  Kimball Hill, Inc., the Guarantors party from time to time thereto, the  Lenders party from time to time thereto and Harris Bank, N.A., as  Administrative Agent. |
|                |       |                                                                                                                                                                                                                                                                      |
| 10.2                |       | Confidential Retirement  and Consulting Agreement, dated as of December 20, 2007, between Kimball  Hill, Inc. and William E. Long.                                                                                                                              |
|                |       |                                                                                                                                                                                                                                                                      |
| 10.3                |       | Amendment to  Confidential Retirement and Consulting Agreement, dated as of February 11,  2008, between Kimball Hill, Inc. and William E. Long.                                                                                                                      |
|                |       |                                                                                                                                                                                                                                                                      |
| 31.1                |       | Rule 13a-14(a) /  15d-14(a) Certification of C. Kenneth Love, President, Chief Executive  Officer and Director.                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                      |
| 31.2                |       | Rule 13a-14(a) /  15d-14(a) Certification of Edward J. Madell, Vice President, Chief  Financial Officer and Treasurer.                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                      |
| 32.1                |       | Section 1350  Certification of C. Kenneth Love, President, Chief Executive Officer and  Director.                                                                                                                                                                    |
|                |       |                                                                                                                                                                                                                                                                      |
| 32.2                |       | Section 1350  Certification of Edward J. Madell, Vice President, Chief Financial Officer  and Treasurer.                                                                                                                                                             |

 

 

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