KB Home (KBH) 2013 Q3 法說會逐字稿

Good morning, my name is Michelle and I will be your conference operator today. I would like to welcome everyone to the KB Home 2013 third-quarter earnings conference call. At this time, all participants will be in a listen-only mode. Today's conference is being recorded and the live webcast is available on KB Home's website at kbhome.com. The Company will make a presentation then open the lines for questions.

(Operator Instructions)

KB Homes' discussion today may include forward-looking statements that reflect management's current views and expectations of market conditions, future events and the Company's business performance. These statements are not guarantees of future results and the Company does not undertake any obligation to update them. Due to a number of factors outside of its control, including those identified in the SEC filings, the Company's actual results could materially differ from those expressed and/or implied by the forward-looking statements. A reconciliation of non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in the Company's earning release issued earlier today, and/or on the Investor Relations page of the Company's website. I will now turn the conference over to the Company's Chief Executive Officer, Mr. Jeff Mezger. Sir, you may begin

Thank you, Michelle. Good morning, everyone. Thank you for joining us today for a review of our third-quarter financial results. With me this morning are Jeff Kaminski, our Executive Vice President and Chief Financial Officer; and Bill Hollinger, our Senior Vice President and Chief Accounting Officer.

I would like to start off today's call with an overview of the significantly improved results we delivered in the third quarter, highlighted by our solid bottom-line profit. We are now profitable over the first nine months of our fiscal year, the first time we have achieved cumulative profit at this point of the year since 2006. We also have the backlog and gross margin in place to drive even stronger bottom line results in our fourth quarter. This momentum reflects the continued positive impact of the strategies we put in place to reposition our geographic footprint and product offerings, along with leveraging our business model to drive revenue growth and enhanced profitability. Next, I will review current market conditions and provide a few comments on how we believe we are well-positioned for sustained improvement in our bottom line results as we continue to navigate a housing market that is strengthening in its recovery. Jeff Kaminski will then take you through the details of our financial results, after which, I will wrap up our prepared remarks with a few observations about our positive momentum and expectations as we head into 2014.

As I mentioned, the significant improvements in our business results reinforce that our growth and profitability initiatives are playing out as we intended. While we grew revenues 51% in the first nine months of this year, I am especially pleased with the continued progress in our housing gross margin, which at 18.2% for the quarter continued our trajectory toward our stated goal of returning to gross margin levels in the low to mid 20s. Between the revenue growth and a continued focus on containing fixed cost, we're also leveraging our growth platform for significant SG&A ratio improvement along the way.

For the third quarter, the combination of gross margin and SG&A improvements resulted in an operating income of $36 million. Our inventory balance continues to grow, ending the quarter at $2.2 billion, evidence that our investment strategy is positioning us for future growth. We are putting our balance sheet to work more effectively, and in turn, through having a higher level of qualified inventory, also lowering our interest expense. Taken together, our margin improvements, cost discipline and investment strategy led to a third-quarter profit of $27 million or $0.30 per diluted share. With our current backlog value and its embedded margin, along with the community openings we have in the pipeline, we expect to deliver not only stronger financial results in the fourth quarter, we also expect to be positioned to drive further improvements in our financial results in 2014.

Today, we are a different business than we were even 12 months ago. We continue to push for accelerated growth, and the land investments we have made are reshaping the dynamics of our geographic mix, our product mix and our customer base across our business. By repositioning our community footprint, we have been able to expand our customer base, and today achieve a better balance of first-time and move-up buyers. For the quarter, our first-time buyer percentage on deliveries dropped to 54%, the lowest level since 2007. In addition, the first-time buyers we are attracting today have much higher income levels and stronger credit ratings. They're typically buying larger homes at higher price points, and also spend more at our Studios. This transformation, that is attracting a better-qualified buyer base, has led to substantial improvements to both our top and bottom line.

As we continue to invest in growth and our community mix continues to revolve, and in order to sustain our favorable revenue and profit trajectory, we are maintaining a delicate balance among three interconnected components of this strategy. Optimizing the sales pace while maximizing margin and growing community count. The best and most critical example of this is the evolution of our California business over the past 18 months. In the third quarter, 66% of our California revenue came from our coastal divisions, which is a significant flip from where our mix of been historically. The difference in sales price and margin is considerable between the coastal and inland regions, in many cases more than double. And as a result, we have been able to generate significantly more revenue and profits on fewer units.

In our third-quarter, we delivered 14 additional units in California compared to the prior year, yet our revenue was up by approximately $60 million. This ability to successfully identify, acquire and open high-priced communities in the coastal region is a direct reflection of the distinct competitive advantage of our KB Home brand, our knowledge of the markets, and almost 50 years of experience in California, building relationships with land sellers, developers and cities. New communities, located in these land-constrained areas are highly sought after and take time to replace. Accordingly, the last thing we would want to do is push absorption rates, compromise margin and in turn, sell through these communities before our new acquisitions are brought online. Our coastal business continues to grow, as we have made significant investment in communities that have not yet opened for sale. We will continue to maintain this discipline of balancing price and pace with the goal of growing revenue, expanding gross margins and elevating profitability.

In this context, I would like to address our lower unit sales comp for the third quarter. Our approach to optimizing each community asset and our investment strategy favoring coastal California, contributed to our significantly higher profits for the quarter, but it came with a reduction in unit sales caused by two interrelated factors. The first was the shift to a more coastal business and a related drop in community count in our inland regions. Specifically for the quarter, our inland California divisions had a combined year-over-year negative unit comp of 164 sales. But I was okay with this, because in the third quarter of last year, we sold through many communities in our inland business where we booked unit sales that frankly, had mediocre margins and the communities were intentionally not replaced until local market dynamics improved.

The second factor that impacted our California unit comp was the timing of new openings. We had seven communities open in August that had been delayed and as a result, they contributed less than one month of sales to our quarterly totals. In these land-constrained areas, finished lots are all but gone and we are now acquiring more land that typically requires some level of entitlement and development, and both municipal processing and development times have extended. When these seven communities opened, they all opened to a very favorable buyer response with pricing and gross margin well above projections, and all are expected to be strong contributors to our fourth-quarter results. In addition to these seven openings, we have 12 more community openings planned in the state for the fourth quarter. In essence, this intentional shift to quality locations has resulted in significantly more profit for the Company, along with revenue growth, albeit at lower unit volumes in the short term.

We expect our community count in California to be about flat in the fourth quarter versus last year and tilted towards slower absorbing coastal communities. As a result, we are projecting a negative unit comp but a positive sales value comp for California. Most importantly, we are projecting a significantly higher gross margin value from our fourth-quarter sales versus last year. As the coastal markets have strengthened, demand and strong pricing power is spreading to the inland areas, and we have recently been investing more aggressively in the most desirable sub-markets of the inland regions as well. With the investments we have already made, we anticipate our year-over-year community count in the state to increase in the first quarter of next year and expect a positive unit sales comp for 2014.

While I focus my comments on California due to its relative scale and impact on our third-quarter sales comp, our investment and product strategy is working across our business. Outside of California, our business generated positive unit and sales value comps for the quarter, and as a result, even with a Company-wide unit sales drop of 9%, our sales value increased 7%. We anticipate the trend of sales value growth outpacing unit count growth to continue.

Let me turn now to the broader housing market and economy. A lot has been written lately about higher mortgage rates potentially putting a damper on things. The housing recovery is fully in place and continuing to gain strength. Inventory levels remain tight across our markets. Housing affordability is still at attractive levels. There is large pent-up demand due to demographics and increasing household formation. And the desire for home ownership continues to be strong. There is no question that a rise in interest rates increases monthly mortgage payments and impacts affordability, but is only one of many factors influencing the current recovery. When interest rates moved as quickly as they did over the last few months, it caught some buyers by surprise and a few backed out of their purchases. We are also seeing some potential buyers who are taking a little longer to make the home-buying decision, as they digest the combination of increased mortgage rates and higher prices in any given market. We believe both of these events are short-term in nature and are fairly typical of the twists and turns housing markets experience in a recovery.

We continue to maintain that tight underwriting standards and employment growth have more of an impact on demand than higher interest rates. Several of the large mortgage lenders recently announced that they plan to ease underwriting overlays. It is an encouraging sign and we hope that they do. When underwriting normalizes and credit becomes more readily available, you will see significant pent-up demand unleashed.

Some who follow our Company view KB Home as a builder catering primarily to first-time home buyers. This is somewhat of a misconception that I would like to address. Our business philosophy is to focus on demand within the largest consumer segments of first-time and move-up buyers. We can flex up or down in square footage, features and price point, and our build-to-order approach appeals to consumers across the spectrum. Over the past ten years, as we have endeavored to follow demand in a fluid and changing housing market, our first-time buyer mix has ranged from a low of 37% to a high of 78%. Today we are appealing to many more experienced buyers, who are drawn to our locations and appreciate the value of our build-to-order process. These experienced buyers also typically have an easier time qualifying for a mortgage. As a result, our percentage of first-time buyers was down in the third quarter to 54% from 67% just a year ago. The shift has been most pronounced in California, where first-time buyers now represents only 47% of our business.

Moving back to our results, once again this quarter our average sales price increased at a much greater rate than the overall market, up 22%. Our ASP growth was healthy due to the shift in California deliveries to higher-priced coastal areas along with higher ASPs in every other region. To reiterate a point that I've raised in the past, while we are always going to opportunistically increase prices where the market allows, it is our investment in product strategy that is the primary driver of our ASP and revenue growth. As a result of our evolution in product and community mix during the quarter, while deliveries increased 6%, we grew our revenues by 29% and our profits were significantly higher as well.

We have many initiatives in play to drive gross margin improvements. As I have discussed in this past there are unique levers available in our KB next business model that provide profit opportunities. When customers are enabled through our build-to-order approach to select their specific lot, floor plan, exterior, structural options and design finishes, we can recognize additional revenue enhancements. I outlined a strategy on revenue enhancement opportunities on a previous call, where I noted that one of the first things you concede in a downturn is lot premiums. We have really focused in this area and have made a lot of progress. The average lot premium per delivery for the third quarter was the highest we've seen in many years. We also continue to see increased revenue per unit through the KB Home Design Studios. Our Studio sales per home are up $5,300 or 22% since the start of the year. Moving forward we will continue to work on ways to realize additional revenue enhancements through our build-to-order model.

Finally, a key factor driving our solid and growing profitability is our relentless focus on cost containment while leveraging our growth platform. We feel we have a significant opportunity to grow the top line with our current platform without expanding to new geography. As result of our success in this area, in the first nine months of 2013 we grew homebuilding revenue by approximately $500 million, while increasing our SG&A expenses by only $19 million. This is a great illustration of the potential of our operating leverage.

Before I turn to a discussion of our land investments, let me take a moment to comment on the contribution of our mortgage partner, Nationstar. Nationstar continues to gain traction and is having a very positive impact on the predictability of deliveries and the home-buying experience for our customers. We are on track with the regulatory approval process for our jointly-owned home community mortgage, and when deployed will further strengthen our alliance while also providing a positive financial benefit.

In addition to accelerating revenue and enhancing profit per unit, our third strategic initiative is investing in future growth. We have now invested $890 million in land and land development through the first nine months of the year and are on pace to spend about $1.2 billion for the full year. This will be more than double what we spent in 2012. As of August 31, our lots owned and controlled is about 56,000, an increase of 25% since the end of last year. We continue to find investment opportunities in all of our markets that are aligned with our growth and product strategies and meet our financial hurdles. At the same time, we have many assets in our balance sheet that we continue to put to work. I'd like to tell you about one in particular.

You may have seen the news out of Las Vegas regarding the Inspirada master plan, where the Henderson City Council approved our development agreement. We are working to complete the final steps in the approval and documentation process and are hopeful of full resolution around the end of the year. It is our expectation that once Inspirada comes fully online, we can support five to six open communities and up to 400 deliveries per year going forward. Land values in Las Vegas have gone up significantly over the last few years, and Inspirada has become a real crown jewel for KB Home.

In closing, we are proud of our results in the third quarter. We have momentum and we'll continue to refine and enhance our strategies to set us up for a strong 2014. I would now like to turn the call over to Jeff Kaminski for a closer look at the numbers

Thank you, Jeff, and good morning. We continue to make substantial progress across our business, as evidenced by our third-quarter financial results. A number of ongoing operational enhancements and strategic moves produced meaningful improvements in the majority of our financial metrics in Q3, on both a sequential and year-over-year basis. We are committed to achieving further gains in the fourth quarter and accelerating our earnings and revenue growth in fiscal 2014 and beyond.

For the third quarter 2013, our net income grew to $27.3 million or $0.30 per diluted share, representing a significant improvement as compared to the prior year period. The improvement in our bottom line was driven by a combination of higher revenues from increased deliveries and higher average selling prices, continued significant progress in expanding our gross profit margin and a lower SG&A expense ratio. We have now reported net income in three of the last five quarters and generated positive, cumulative net income over that period. Third-quarter total revenues of $549 million grew by over $124 million or 29% compared to the same period of 2012, with healthy year-over-year increases across all four home-building regions, ranging from 25% to 33%. The largest contributors in dollar terms were the West and Central regions, which were up $97 million on a combined basis.

We currently expect an increase of approximately 40% in our full-year housing revenues as compared to 2012, based on a projected fourth-quarter backlog conversion rate of about 70% and an average selling price of over $300,000. Our overall average selling price for homes delivered during the third quarter was approximately $299,000, representing a year-over-year increase of 22%. This marks the fourth consecutive quarter of double-digit year-over-year increases in our average selling price. This trend, in combination with our improved housing gross profit margin, clearly reflects a significant, favorable impact of our strategic focus on opening communities in desirable locations with limited housing inventory and higher household incomes.

A key result of this strategic positioning has been a shift in our buyer profile from first-time towards more experienced buyers. It has also contributed to the continued trend of sequential and year-over-year increases in the average square footage of our homes. This favorable ASP trend and our housing gross profit margin improvements are rooted in our ongoing execution of a very substantial repositioning of both our active communities and the products sold within those communities.

From the launch of our going on offense strategy in early 2012, to the end of the 2013 third quarter, we have sold out and closed 110 of the 188 active communities that were open as of the end of the 2012 first quarter. During that same time period, we opened 124 new communities, closed out of 13 of them, and continue to operate from the remaining 111 new communities, in addition to 78 older communities as of the and of our most recent quarter. Approximately 60% of our active communities at the end of the most recent quarter were opened within the last 1.5 years, which reflects how quickly and successfully we were able to implement this transition. Reflecting our strategic priorities, many of these communities are in land-constrained growth markets that feature credit-worthy customers who desire larger homes and purchase more options. This dynamic from our strategic community shift has favorably impacted our average selling prices and housing gross profit margin over the last several quarters, contributing significantly to our strengthening financial performance.

Complementing our community transition and to maximize the performance potential of the premium sub-markets we have been targeting, we also adjusted our model home strategy within our new communities to focus on displaying larger floor plans with enhanced option packages. This tactical shift has favorably impacted the mix of deliveries in our new communities and, along with the related increases in KB Home Studio sales and lot premiums, is driving both higher selling prices and enhanced margins. These factors, along with rebounding market conditions across our footprint drove double-digit year-over-year Q3 increases in our average selling prices in each of our four home-building regions, ranging from 15% to 28%.

We continue to enhance profitability per unit in the third quarter through ongoing improvements to our housing gross profit margin. Our third-quarter gross margin was 18.2%, as compared to 16.7% in the same quarter of 2012. In the third quarter of 2012, the housing gross profit margin included insurance recoveries of $16.5 million, partially offset by inventory impairment charges of $6.4 million. The current quarter gross margin included the impact of a $5.9 million charge associated with water intrusion-related warranty repairs. As we indicated during the second-quarter earnings call, we continue to assess progress in completing repairs on affected homes in Central and Southwest Florida as part of our normal process. Our further analysis of the repair effort during the current quarter led us to increase our estimate of repair costs for one attached-home community which, while unexpected, represented the majority of the charge. We are actively managing, monitoring and analyzing the situation, and we'll update our repair cost estimate in the future as warranted.

After adjusting for the items I just discussed, our housing gross profit margin improved from 14.3% in the third quarter 2012, to 19.3% in the current quarter, a notable year-over-year improvement of 500 basis points, as well as a solid sequential increase compared to our second quarter. This sizable improvement primarily reflected the impact of the strategic initiatives we have implemented, our ongoing emphasis on pricing discipline and the strengthening housing market. Partly offsetting these positive gross profit margin factors was the impact of higher direct construction costs. We are pleased with the significant progress that we have made in expanding our housing gross profit margin closer to what we see as our normalized level of the low to mid 20s. We're working on implementing a number of specific profit-enhancement initiatives to continue the success we have achieved to date from our land investment and product strategies, and to take advantage of the generally more favorable housing market conditions.

Our focus on enhancing profitability also clearly includes controlling overhead costs, which we believe can be seen in our third-quarter results. Our selling, general and administrative expenses for the quarter were $63.5 million, or 11.6% of housing revenues, a solid improvement as compared to the 14.1% ratio for the same period of the prior year. The current quarter ratio was also favorably impacted by higher housing revenues and income associated with outstanding cash-settled equity-based compensation awards. As we ramp up revenues we plan to continue to realize the potential of our operating leverage to drive further improvement in our operating earnings and net income.

Getting back to our community count, we opened 27 new communities during the quarter and closed out of 23. We averaged 187 active communities for the third quarter of 2013, as compared to an average of 172 active communities for the same period of the prior year, an increase of approximately 9%. As we discussed during the second-quarter earnings call, our primary revenue growth-related goals for 2013 are to generate net order and backlog values that will enable us to achieve our fiscal year revenue targets, while at the same time opening the new communities necessary to support future revenue growth. Therefore, to maximize the value realized from our active communities, we have been carefully balancing pace and price and focusing on top-line revenue growth and margin expansion, with less emphasis on unit net order comparisons between reporting periods. As I mentioned earlier, we expect a year-over-year increase in housing revenues for fiscal 2013 of approximately 40%, with a significant improvement in our housing gross profit margin and overall financial results, while we continue to work to generate sustained growth in our community count across all four of our home-building regions.

Looking ahead, we believe our increased investment and attractive land assets and development during 2013 will drive continued increases in our community count throughout 2014. We believe this will be a primary driver of increased future revenues in combination with expanding average selling prices and sales pace per community. We currently expect our full-year land acquisition and development investments to be approximately $1.2 billion, the upper end of the range of our prior guidance and more than double the level of investment during 2012. We're also still on track to achieve our targeted new community openings of approximately 120, and an increase in our year-end community count in the range of 15% as compared to 2012.

We expended net cash of $133.9 million from operating activities during the third quarter, as compared to $14.1 million of cash provided for the same period of 2012. Yet, excluding cash used for land acquisition and development activity from both periods, we generated $180.7 million of operating cash during the third quarter of 2013, an improvement of more than $32 million, or 22% as compared to the same period of last year.

In conclusion, we are pleased that nearly all of our underlying operating and financial metrics reflected significant improvement as compared to the third quarter of 2012, and the second quarter of 2013. We believe our solid operating momentum leaves us well-positioned to deliver strong performance for the fourth quarter of 2013 and beyond. Now, I will turn the call back over to Jeff Mezger for some final remarks.

Thanks, Jeff. Before sharing my concluding comments, I would like to first recognize the outstanding contributions of all KB Home employees, who enable us to deliver the strong results that drive our business forward. Today, we are not only profitable, we are well-positioned to keep elevating our business to higher levels of growth and profitability going forward. We have momentum and expect to benefit even more from the transformation of our business across markets and products in the fourth quarter and into 2014.

As pleased as we are with our progress, we understand there is plenty more work to be done. Sales unit growth is critical to maintaining a healthy backlog and leveraging the benefits of even-flow production. We're focused on ramping up our community count to drive unit volume increases. Thanks to our continued success in acquiring and developing land in premium locations, we are confident our expansion of communities will accelerate in the fourth quarter and continue throughout 2014.

The housing recovery is firmly in place across our markets and we are beginning to reap the financial rewards of the strategy, scale and consumer values that we have worked diligently to establish in our business. Our current results, combined with our quarter-end backlog value of more than $800 million has set us up for continued revenue growth, margin expansion and cost leverage, and provide a strong foundation as we head into 2014. We look forward to sharing our progress and more positive results with you at the end of the year. With that, we'll open up the call for your questions.

(Operator Instructions)

Bob Wetenhall.

(technical difficulty) on a very nice quarter. Just wanted to see, how much upside is there to ASP (technical difficulty), given the fact you are up 22% year over year? And I was hoping, Jeff, you could give us a little bit more color on your outlook for Inspirada as you go into '14.

Okay, as Jeff shared in his comments, Bob, we do expect our sales price to go up a little bit more in the fourth quarter. $299,000 in the third quarter and up a little above $300,000 is what he guided for the fourth quarter. Moving forward, a lot of it will depend on mix of what's opening and closing. We think we'll continue to be able to push our overall pricing up through the mix of the communities that we're bringing to market. We don't bank on prices going up as we project our business. My hunch is that the little uptick in interest rates probably slowed down the inflation side of things for a while in housing, which I actually think is healthy for the recovery, in the long run.

As for Inspirada, there's a few moving parts to it, as you know. The development agreement applies to the Villages, primarily Three, Four, Five and beyond. We do have assets in Village Two that are in the entitlement process that we intend to open up in 2014, hopefully in the spring. We'll come right behind that as the development agreement turns into actual development on-site. All the builders are hopeful of getting communities open later in the year in the ensuing Villages beyond. So, it's a pretty exciting development in a very land-constrained market and we think it's an incredible opportunity for us now.

Good. And just as a follow-up, Jeff, you've done a great job on managing costs. Are we at the end of the rope in terms of getting the SG&A ratio to where it's at? Or is their room for improvement as sales continue to grow?

Right, Bob. We believe there's generally some room for improvement. Obviously we've made tremendous progress over the last 18 months or so in improving the SG&A ratio. But as the volume continues to come in the top line, and we're continuing to contain costs within the operations and control basically both resources and where we're spending, we do believe there's some incremental improvement. We are starting to put the money back into the Business to continue to generate top-line growth, as we've mentioned in previous quarters. We've added quite a few land resources, for example, supporting what we're estimating to be about $1.2 billion of land investment this quarter. We think we're making some pretty wise decisions as far as what areas of the Business to invest in, to drive future revenues and profits and where we look to continue to control costs to drive a consistently improving SG&A ratio.

Thanks very much, good luck.

Michael Rehaut, JPMorgan.

Thanks, good morning and congrats on continued progress, particularly on the margin side. My first question, on actually the gross margins, you noted that you actually hit a little bit above 19% excluding the water intrusion charge. Given the trends you're seeing in backlog in ASPs, et cetera, is that a good number to work off of in terms of going into 4Q in 2014, from which would it be reasonable to expect incremental improvement from that 19.3% level?

Right. Mike, specifically talking about Q4, I guess, first we do see in our backlog the potential for improved sequential increase in our gross margin, and we are expecting a sequential increase in the fourth quarter. We've seen some nice increases as we've moved through this year, particularly year over year and also sequentially, and we think that trend will continue through the fourth quarter. We're really, at this point, not guiding out into 2014 yet, but based on what we're seeing in our new communities and the communities we currently have in the portfolio, we're certainly not looking to step backward.

Just to be clear though, in terms of what base to think of in terms of from 3Q, given that I wouldn't expect you to be -- obviously you think you've fully reserved hopefully for the water intrusion that that --

I would move it off our adjusted base of about 19.3%

Perfect. Also on the SG&A, you mentioned that benefit a little bit by a change in income associated with equity compensation. What was the amount of that benefit roughly on a dollar basis point level? Is that something that we should think about as an ongoing improvement or think of that SG&A on an ongoing basis that maybe if that was more of a one-time adjustment?

Right. I will make a few comments on the SG&A just to add a little context to the number in the quarter. First of all, as most of you guys are aware, we've always looked at it as a variable component in our SG&A, and what we call a fixed component. On the variable side, we're running at about 4.5% of our top-line revenue right now. While that can range 10, 20, 30 basis points up or down in a particular quarter, a 4.5% number on top-line revenue is a pretty good number to use for the variable piece.

And the fixed component side, it does include certain expenses that are not tied to top-line revenue, but very based on other factors. One such item was referenced in the press release, which was cash-based comp that's tied to our equity value. The dollar amount of impact in the current quarter on that was about $6 million. We also have a couple of other legacy benefit programs that vary quarter to quarter as well.

And those were actually about a negative $1 million in the quarter. So on a net basis, between all those plans, it contributed about $5 million of income or an SG&A offset depending on how you look at it, during the current quarter. As far as repeatability, it all really depends on stock price and whether benefit plans, the overall performance of the stock market, actuarial valuations and other things. While we call that piece fixed, there are, like I said oftentimes in the past, there are variations in it, but not tied to the top line.

Ivy Zelman, Zelman and Associates

Thank you. Good job, guys. Excited to see the profitability improving so much. Jeff, if you can help us with a little bit more clarity around the trends today? You talked about your pleasure or you were pleased with the fact that your community count year over year, your orders, I'm sorry, may not have shown the same increases. And you explain the negative comp, but you attributed it to the profitability per unit was much more where you'd like to see it going forward. Can you talk about the impact from rising rates? And whether you're using selling incentives? And what you're seeing in traffic? And about the first-time buyer with the affordability with pricing up so much?

Because you're -- sounds like you're confident that you can continue to see price appreciation. It also looks as if gross margins are in an upward trajectory, benefiting from add-ons and the Design Studios that you spoke of. I just don't want anyone to be confused where the expectations are. Your gross margins were certainly a lot higher than where we thought they would be. In fact, you're about a year ahead of where we modeled you. I just want to appreciate what your current trends are and how it impacts profitability going forward. If you could revisit that, please?

Sure. Ivy, one clarifier, I wasn't pleased with the unit comp down. I was okay that we didn't have the same sales experience we did a year ago in the inland regions of California. I went through that at length, because this transformation of our California business, sometimes people especially from New York that may not understand the geography, don't fully comprehend the difference between well-inland and coastal housing within the state. If you think about how California has recovered, it's been fairly typical. The coasts show the strength first. The closer to the ocean you are, the more desirable and valuable the real estate is, and once that lifts it slowly ripples inland.

At the time of the downturn, we had or more assets inland than we did along the coast. So you work through those. You are not going to invest heavily in the inland areas because they haven't shown signs of recovery. The coast recovers first, you invest over there and we went through this dynamic this year where the coast became the lion's share of our business, 66% of the revenue in the quarter. So we closed out of the communities where land is plentiful and you would typically run more unit volumes, and have opened up a lot along the coast where you love every lot and you'll take your time and maximize the margin. And now that the coast has strengthened so much, it's moving back inland so we're investing in the closer-in, desirable inland areas. We'll have a nice one-two going forward.

Underneath that within the State, and you look at the consumer, a lot of our communities in the coastal areas, we have waiting lists still today. The interest rate move, it's not even a blink for that consumer. The incomes are probably $200,000-ish or more. A payment going up a $200s, that does not even come close to moving them off of their buying decision. The lower you go in price points around our Company, the more impact that it could have. But it still hasn't been enough to really change the qualifying. We've had very few cancels due to inability to qualify with the rate uptick. We have had cancels due to buyer's remorse, where the buyer just wasn't comfortable. Not a big number, but we did have some, when rates move the way they do.

With the quality of the buyers that we're attracting today, it is not whether they can qualify, it's how much they want to spend on the house. They'll take their money and put into maybe a smaller house and more at the Studio, maybe a bigger house and less at the Studio. We're able to flex up or down with whatever the consumer wants. Through that, we're finding ways, with those buyers that have the desire to spend more in the Studio, we're finding ways to enhance our revenue specifically with those consumers, while others don't spend as much as typical in the Studio. So it's a nice flex for us.

I think overall, as I refer to it, there's been a slight pause in the market that we saw. I think it's very short-term in nature. I do think with inventory at the levels it is at in every market that we're open in today, you're not going to see any real pressure on price, I think prices will hold. As the economy continues to improve and demand comes back, I think you'll see them continue to grow up, albeit at a much slower rate than we saw over the last 18 months

Thank you, that's helpful. To clarify, if you were to look at your gross margins without specifying guidance, in terms of the ability to still see home price inflation, as well as the investments you've made in new communities that you're opening today, is there any reason, even if we see this pause, that we shouldn't see the continued improvement in margins? Or do you hit a wall because your mix associated with inland versus coastal? How do we think about it, longer-term gross margin trajectory?

As I shared, Ivy, you know over the years, we've had years with our margins up low to mid 20%s, and that's our stated goal. We've already guided that margins will be higher in Q4, and we're hopeful of sustaining not trajectory in 2014. The inland areas where we're investing now, the margins are just fine percentage-wise, albeit a lower dollar value than what you'll get on the higher ASP. But the percentages on the communities we're opening now more inland are just as strong. (multiple speakers)

That is what I was looking for. So your new communities are going to be able to perform up to the Company average now even though they're inland?

Absolutely.

Yes, we believe so. Ivy, it's Jeff K, a couple other comments on gross margin. We often get asked that question of what's driving the improvement in the future and whether we see additional runway, which we do. At this point, I always believe margin improvement is an incremental gain. You get 10, 20, 30 basis points out of a number of different activities and they accumulate to significant margin improvement over time.

As Jeff mentioned, we mentioned during the prepared remarks, we are targeting that normalized range as a minimum to get back to as a business. We have a fairly long list of actions and activities that we're looking at. By way of example, just to provide a few, we're working very hard right on product standardization. We're value-engineering some of the standardized product again and again and again to get our build cost down. Of course, on the pricing side, we'll continue to look opportunistically for some market conditions that would imply that we could again raise prices in certain of those sub-markets, we're focusing on lots premiums. Studio revenue increases should continue to contribute.

As we're selling higher-priced homes to more credit-worthy buyers that have more disposable income, we're seeing increases certainly in the dollar amount of Studio revenue that's coming through the system. We have supplier rationalization initiatives in place. We're looking at synergies on the purchasing side, both from a national and regional level. We're also seeing a positive impact of our higher ASP due to all the factors we've mentioned earlier on the higher ASP, but not to mention the changing higher demographics. But that higher ASP is leveraging our land costs more favorably. So, while each of those may be small on the increment, a long list of small improvements, we hope to drive continued gross margin improvement based on that.

Stephen Kim, Barclays. Mr. Kim, your line is open.

I'm sorry. It's Steve Kim from Barclays. I was muted. My first question relates to the strategy of moving a little bit more up in terms of the price point. I know you've talked about flexibility there. In particular what I'm curious, Jeff, is if you could provide a little bit of color as to what you think the duration of this opportunity is going to be for your Company? Is this something we should be getting accustomed to from a longer-term perspective? Is that reflected in the land purchases you're anticipating to make over the next year or so, that you will then ultimately deliver out, maybe as far out as three to five years? Or is this more of a near-term opportunity that you see that exists in the market today?

Frankly, Stephen, it's both. What's happened here, we were very successful in investing more money in the coastal area a few years back and it takes time to bring it through to revenue. We intend to continue to grow that business. So you'll see us pay a high percentage until markets have fully recovered and we can be more broad-based in our activity levels out in the inland areas. The inland areas we're still fairly selective. While I'll say they're strengthening, they're strengthening in the geographies that are closest to the urban cores. You get out where the land is plentiful, the markets aren't that strong yet. I think this will take a little while before we would tilt back to more revenue inland, but it will happen at some point in time as the markets recover. At the same time I think you'll see us continue to push this business probably to a bigger percentage than it's been in the time I've been with this Company. Because we're finding it pretty successful and it's working extremely well.

I think for the purposes of short-term, long-term, however you want to look at it, we now have 13 quarters in a row of improving ASP, and the last four quarters are all double-digit. So we've been pretty successful with the strategy. And like a Jeff said, we'll see what conditions hold in the future, but we don't think it's run out yet at this point

I guess -- thanks for that -- I guess where this is going in my mind is the ultimate opportunity for KB Home as you approach mid-cycle or even later, beyond. In particular, where you were at the peak of the last cycle was obviously a level of revenue was quite high relative to where we are today. But it was also one where you were somewhat more focused on the entry-level than it sounds like you might be this cycle. As a result, I'm curious as to whether you've thought about longer-term, what the size or the ability to scale this business might be, given that you now have what you see as a competitive advantage or a core competency now in moving higher up the price point? Do you think you could have maybe a bigger opportunity set later this cycle than you had last cycle?

Yes, Stephen, I referred to as a misconception, and maybe it goes back to even the Eli Broad days of the '60s and '70s. In '06 we were around 35%, 40% first time. We were predominately move-up builder at the peak of the market. That's why I want to say people think we're just a first-time builder. The beauty of our business model is we go where the demand is, and we can flex up-and-down.

Right now it's two things. It's a flex to higher-priced areas where our model is working well, and in many cases it's bigger homes being modeled than we have over the last four or five years. So, I think what we've recognized is the ability to push both ends, whether it's the first-time buyer business, which will come back as underwriting loosens up, and continue to attack the demand of the move-up buyers. So, I think we can be more balanced than we have been in the past

Okay, great. That's very clear, thank you.

Megan McGrath, MKM Partners.

Just a follow-up question. You gave a lot of good color on California and your expectations in the fourth quarter that you would see a unit comp decline. Can you give us any more color outside of California around community count openings and your expectations? So we have a clear idea of how that community count growth is going to play out over the next couple quarters?

Right. First, starting with California, we do expect to be basically flat to prior year in community count in California in the fourth quarter. For the Business overall however, we are still on target to achieve about a 15% year over year increase by the end of the year, in community count. We're going to continue to drive openings in the fourth quarter to achieve that. So we're seeing nice growth across the Business. As Jeff mentioned, we are seeing different -- a changing mix in our communities. We're seeing an increase in our move-up buyers in the buyer profile and some other factors that may or may not be impacting absorption rates. But that's what the community count profile looks like going forward.

Okay, great. And then, you talked a lot about inland empire versus coastal. Again, can you give us any color on margins, California margins versus other parts of the US where you're focused? If we see a somewhat, even somewhat temporary, mix away from California as you try to get those communities open, is that something we should be aware of as we move into 2014? If you start to mix away temporary from California into Texas or the Southeast?

Megan, I'll let Jeff talk to the numbers because I don't know how much guidance we're going to give you within each of the regions right now for '14. I shared in my prepared remarks that our strategy is working Company-wide. There's a part of every city where demand is the strongest and it's land-constrained and we're going upstream in product a little bit to cater to that demand. That was in large part what triggered the ASP increase you saw by region in the quarter, it wasn't just the California ASP. As each market recovers at its own pace, we would expand our business to the next layer of suburbs, depending on how that economy is recovered and how our returns are working in that city.

But we have a growth mandate for every business right now. It all rolls up to a nice projection for where we can get to as a Company. We're not going to invest anywhere unless our margins are going to hit our hurdles and our returns. So it's a broad base, but the margin upside, I think, is more driven by the price, similar percentages, but by the price of any given community that we open. You want to make any more comments on that?

Other than, I wouldn't really have much to add to that, other than the mix of the California business has been pretty consistent as we go through the year. We're investing at a rate that will keep it at least consistent, if not drive it further up. As Jeff mentioned, some of the communities in the State are taking a little bit longer to open because of longer development time frames. But it's an important component of our business, and one that we fully expect to continue to drive into the future.

Okay, thanks.

[Joel Locker, SBN].

Was looking at your community count change out West. If what it ended the quarter on a year over year basis?

I'm sorry? I missed the end of that?

In the West, what was the year over year change in community count?

Yes, year over year change on average for the quarter, we are down 22% in the West region.

Down 22%. Do you guys carry, from your mortgage division, if you have a DTI in backlog, both front end and back end?

We don't really get those numbers, Joel. Our mortgage relationship is still independent with Nationstar, where we have a preferred marketing relationship. So they're not going to give us the credit and the ratios of their customers. I do know on average one of the things that shifted a little bit that they did share, is in their closings between Q1 and Q3, our buyers put in 2 more percentage points of down payment, which is a nice trend. It's another way to reinforce that the quality of our buyers is getting better. In the third quarter our average at Nationstar was an LTV under 87%, so about 13.5% down.

Right. Just last question, if you look to the fourth quarter for orders, are you trying to hold it at three a month? If you have to increase incentives, do it that way? Or would you let it fall below there and maximize margins like you have been?

Joel, my comment are across the Company as optimize every asset. So, we will set a run rate and a margin that you toggle back and forth to per community. If it's a coastal California community like I talked about, a high margin, high-priced, can't be replaced, we'd rather hold on those and let them play out and take another sale or two in the first quarter. If it's an area with a lot of lots that are replaceable, the run rate may be a little higher and we'll take steps to move the run rate if it were to fall behind the absorption. As a Company, on average right now, we are targeting around four a month, with the move-up stuff a little less, and the first-time buyer stuff a little more. It will vary with every community in every division. But we'll take the steps to make sure that we hit the margin and the sales pace that we target

Right. I just want to come back, Joel, just for a second on the community count in the West region just to reinforce a point we made earlier. In the fourth quarter we do expect a catch-up to get at least equal to last year with that community count, with some of the delayed openings and other initiatives we have in place, and the investment that we've put into this State. We are looking to rebuild that community count in California, just is lagging a little bit the overall Company, in that rebuilding process. So we are expecting flat in Q4 and then building from there as we go into 2014.

Dan Oppenheim, Credit Suisse.

I was wondering if you can talk to, from a lot, in terms the changing mix in saying the high-end buyers won't blink at all. But you also talked about some of the buyer's remorse. So should we interpret that as that much more of that buyer's remorse was the effectively 50% of the buyers who are first-time buyers that we are seeing most of the impact there?

I wouldn't just lay it on the first-time buyers, Dan. Things change and when things change people get unsettled. There was a lot of talk in the media that interest rates were going up and housing markets were going to stall and the economy is going down. I think it rattles consumer confidence. So it was more buyer remorse and consumer confidence than it was that they don't qualify.

Now having said that, there's obviously more pressure to the lower you go in income, but if you look at our ASP, you got to remember that I forgot to share before, but in the Nationstar borrowers, I want to say our average income was $91,000 in the quarter. So a payment moving up $100 or whatever it was, in the quarter, is not going to move that buyer. If it went up another 1.5 point, I think it starts to become material. But the move that we had, it was so quick I think it caught people off guard.

Got it, okay. And then with the communities that ended up opening late, but opened in August rather than a little bit earlier, can you talk about the success you ended up having with those in terms of some of the initial results there and strength and the trends in August?

I touched on that in my comments, Dan. They all opened strong. The buyers were waiting on us, frankly. And when you have the type of community locations we have, you're going to take your time and open them right. We will not open them until they are fully presented, merchandised, landscaped, decorated. The waiting lists grow. You actually can take that buyer enthusiasm and turn it into a little bit even better price and sales out of the opening, if you're successful with your opening. All of them exceeded our projections on price and margins. This is not that the market was different or anything, it's that we didn't get them open as early as we thought in the quarter. It's a great reinforcement that the market's still there

Great, thank you

Adam Rudiger, Wells Fargo securities

Thank you. In your opening remarks you commented a little bit on some pressure on direct construction cost. I was wondering if you'd elaborate a little bit there and quantify how much, and if there was any -- what the specific categories that you were seeing the most pressure?

Right. Yes, I think it's been pretty consistent with what we've seen for the earlier parts of the year and the earlier quarters. The category -- generally labor we've seen labor pressures across a lot of the Business. Some subsiding in certain areas, other areas we're still seeing some concerns there. Concrete has been a hot spot for us. Of course earlier in the year, the drywall increases continue to ratchet through the system and provide a negative on a year over year basis in each of the quarters.

Lumber, while it was up earlier in the year, has come down off the highs, but I think in certain divisions where we had lumber locks, it still may have had a slight negative on the third-quarter results. And we're hoping to see some positive benefit or some retraction with that out into the future. I think in the quarter in total, it was about 400 basis points compared to prior year, in movements on commodities and labor. We see that as being mainly offset by what I call pure market price increases, as distinct and separate from the pricing and the lift in top line that we've seen from some of the strategic initiatives that we've taken. We think our market, the market movements and prices, is offsetting the commodity increases and we're looking to control that further as we go into the fourth quarter and then out into 2014

Okay, thank you. The rest of my questions have been answered.

Eli Hackel, Goldman Sachs.

Just two questions. Rates seem to have stabilized for little bit now. Clearly the move up was quite quick. Curious in your view, having looked at some previous cycles, how long does it take people to realize okay maybe they've steadied here, they're going a little bit lower, to get some of that momentum coming back? Then on California, do you have all the land you need for 2014 in California? Now it's more 2015 and beyond? Thank you.

Eli, on the interest rates, I think the consumer has already adjusted to them. If you think about it, in a recovery normally you'll get activity levels, the economy gets better, you get price and then rates would slowly tick up because the Fed is worried about inflation. This time around they kept rates on the floor. We didn't get activity, we got price because there ended up being no inventory out there. Then you had this price spike, and I think the little rate uptick, and rates do need to go up over time, the rate uptick probably cooled the pricing down some.

So I think, again, it's the normal push and pull and twist and turn you'll see in a market recovery. We don't expect rates to move up dramatically until the economy is in much better condition. It's improving, but it's a slow recovery. I think everybody's watchful of what happens in DC relative to housing policy and the GSEs, and all the other things we all keep reading about in the paper. We don't expect a significant rate increase. We think it will just slowly grind up and we'll managed to it along the way. I don't think it's the big driver right now in demand, as I said.

If underwriting were to loosen up, it'll more than offset any kind of interest rate uptick.

No, I agree with you. From the big sharp uptick that we had, did it cause a little bit of a pause that you were talking about? Your view now is that consumers have already adjusted and things are, as you moved into September, a little more back to, I don't know if normal is the right word, but adjusted?

An analogy for me would be when gas prices go way up. People are shocked and then they settle in, and then people wonder prices are going to go back down, and then they don't go back down. Rates were so low, I think the consumer got a little complacent. We had a lot of people that weren't even thinking about locking their interest rates because rates hadn't moved in such a long period of time. Now everybody's sensitized to rates and our buyers are more savvy and in touch. When they make the buying decision they're protecting their mortgage rate a little more than they were back in April, May and June. It's one of those dynamics you deal with in a recovery market

Thanks. And on the California land position?

We're covered for '14. We will operate. If we can find some opportunities, we'll take them for '14 and we're working on '15 as well. But '14 is covered right now

Great, thank you very much.

Ladies and gentlemen this will conclude today's question-and-answer session. I would now like to turn the call over to Mr. Jeff Mezger for closing remarks. Please go ahead, sir.

Okay, thanks again, everyone, for joining us today. We are pleased with our progress and excited about our future. We look forward to sharing our results with you again in the very near term. Thank you.

Thank you, everyone. This concludes today's conference call. You may now disconnect.