KB Home (KBH) 2013 Q4 法說會逐字稿

Good morning. My name is Kyle. I will be your conference operator today, and 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 a live webcast is available on KB Home's website at KBHome.com.

The Company will make a presentation and then open the lines for questions. (Operator Instructions).

KB Home's 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 the number of factors outside of its control, including those identified in the SEC filings, the Company's actual results could be materially different from those expressed and/or implied by the forward-looking statements.

A reconciliation of non-GAAP measures referenced today to the most directly comparable GAAP measures can be found in the Company's earnings 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, Kyle, and good morning, everyone. Thank you for joining us today for a review of our fourth-quarter and full-year results. With me this morning are Jeff Kaminski, our Executive Vice President and Chief Financial Officer; Bill Hollinger, our Senior Vice President and Chief Accounting Officer; and Thad Johnson, our Vice President and Treasurer.

I'd like to start today's call with a review of our results for 2013, a year in which we made significant progress, highlighted by our return to full-year profitability. I will then review highlights of our fourth quarter and the ongoing actions we are taking to further enhance our results. Jeff Kaminski will provide a detailed look at our financials, after which I will conclude with a few final comments about our expectations for 2014. We will then open the call to your questions.

As we look back on 2013, we are pleased with our achievements. First and foremost, we restored profitability. Moreover, we were successful in driving results through execution on our two key strategic initiatives for the year, enhancing profitability per unit and accelerating top-line growth.

We have been sharing updates on these initiatives during our quarterly calls and I am proud to say that the results of our actions are clearly reflected in our financial accomplishments.

For the year, we reported net income of $40 million. Revenues grew by 34% to $2.1 billion. Our operating income was $92 million, an improvement of $112 million over 2012. We grew our net order value by 24%. We are entering the new year with a healthy backlog value of $682 million that carries a much higher gross profit per unit than a year ago.

We invested more than $1.1 billion in land and development, and at year-end, owned and controlled over 61,000 lots, a 37% increase over the prior year. Along the way, we continued to take steps to strengthen our balance sheet and our well-positioned to fuel our growth moving forward.

Overall, it was a much-improved year compared to 2012. While we realize we have a lot more to do to achieve our targeted margins, our strategy is clearly working and we believe there is tremendous upside ahead for our business.

Let me highlight a few of the key actions that drove our profit improvement and growth this year. With our fact-based approach to community and product positioning, we focused our investments in attractive locations where housing demand is strong and median income levels are higher, which in turn supports higher price points.

These locations feature buyers who purchase larger homes, along with selecting structural options that create additional living space. As a result, the average size of the homes we delivered continued to increase throughout the year, with our average square footage delivered in the fourth quarter at 2293 square feet, an increase of 7% from a year ago.

In addition to purchasing larger homes, these consumers are investing more in customizing their homes at our studios. And with our Build to Order approach, we continue to successfully capture incremental revenue opportunities such as lot and elevation premiums.

The combination of these actions, along with favorable market conditions, resulted in an 18% increase in our average selling price versus the prior year, and also an expansion of our gross margins.

At the same time, our ability to contain fixed costs while leveraging our strategic growth platform provided solid SG&A leverage. For the year, we grew our homebuilding revenues by over $0.5 billion, with limited increase in our SG&A expense. Between our gross margin improvements and SG&A controls, we improved operating margin by 570 basis points in 2013 and expect additional improvement going forward.

Before reviewing our fourth-quarter results, I would like to offer a few comments on the state of the housing market and its relationship to the national economy. The fundamental drivers of a housing recovery remain in place, although conditions are not as favorable as they were six months ago.

Resale inventory levels have been slowly increasing, but still remain low by historical standards. Affordability is at attractive levels. Demographics remain strong. And there is pent-up demand due to delayed household formation. During the last half of the year, however, higher mortgage rates, higher home prices and lowered consumer confidence due to uncertainty in Washington triggered a pause among homebuyers, who are now being more cautious as they consider their purchase.

We believe this pause is short-term in nature as buyers digest higher rates and higher prices. In the meantime, we feel that less upward pressure on home prices is healthy for a measured, sustainable housing recovery. In this environment, we expect to continue to see a supply-constrained housing recovery, as some areas in most cities feature median home pricing that still does not support additional investment in new community development.

Housing starts remain well below historical averages, and while the long-term trend is positive, we believe it will still take time to reach normalized activity levels. As the recovery continues to move forward, we expect housing will resume its traditional role of creating jobs and helping to drive a stronger economy.

Against this backdrop, let me turn now to our fourth-quarter results. Revenue was $619 million, an increase of 7% from a year ago. Net income was $28 million, up from $8 million the prior year. Our gross margin continued to improve on a year-over-year basis, as did our SG&A ratio.

Due to our increasing land investments, our average community count for the quarter was up 12% versus the fourth quarter a year ago. Net orders were 1556, and net order value was $482 million. Our backlog value at year-end was up 10%, with per-unit gross profit that is nearly double that of a year ago.

At a high level, our financial results were very positive. Our strategic actions enabled us to continue the trend of increasing sales prices, expanding gross margins, levering SG&A and growing revenues, which led to substantially better bottom-line results.

While we delivered fewer homes this quarter than last year, we were significantly more profitable. And more importantly, it was our most profitable quarter in many years.

Moving on to sales, while net orders were flat, our net order value increased 5%. Our sales results varied by region across the country. Starting with California, unit sales were down by 248. This result was more related to our ongoing repositioning strategy and the timing of community openings and sellouts than it was a reflection of current market conditions.

In our inland business, which accounted for the majority of the shortfall, we continue to sell through existing communities and are experiencing a lag before our more recent investments come online.

In our coastal business, any given quarter can have a wide variance in unit comparables due to the timing of community openings, sellouts and the opening of the follow-on community. As a great example of this, we successfully grand-opened two communities in Irvine in the fourth quarter of 2012 that reported 46 sales for that quarter. Both were sold out by the fourth quarter of this year, and the follow-on communities in Irvine don't start opening for sale until January.

Looking forward, as we ramp up a more consistent flow of community openings with higher lot counts in California, we expect to see less quarter-to-quarter variance. We remain very bullish on our home state, where market demand remains strong, supply is limited, and we will continue to balance our sales pace to optimize margin.

An excellent illustration of the underlying strength of our California business is that while our backlog value in the state is down 17% at year-end, our profit in backlog is up 34%.

In our other three regions, our sales results were positive. Most significantly, our Central region, which includes Texas and Colorado, booked a 37% increase in net orders and is well-positioned entering the new year with a backlog value that grew 37%.

In the Southwest region, net orders were up a very healthy 34% and backlog value grew 26%. The Southeast region also generated increases in both net orders and backlog value, evidence that our strategy is working across our entire system.

Now I will turn the call over to Jeff for a detailed update on our financial performance, after which I will make a few final comments. Jeff?

Thank you, Jeff, and good morning. Our ongoing focus on repositioning our community and product mix, as well as enhancing the execution of our business strategies, led to improvements in the majority of our financial and operational metrics in the fourth quarter on both a sequential and year-over-year basis. We are committed to building on these favorable trends and continuing our earnings and revenue growth in fiscal 2014.

We believe that the primary driver for improved results has been the strategic targeting of our investments during the last few years towards land-constrained submarkets with strong economies and other attributes that appeal to higher-income, creditworthy customers, who want larger homes and more options and upgrades.

In continuing to open more new home communities in these areas and by balancing our sales pace and pricing, we have been able to drive increases in our average selling prices and housing gross profit margin over the past several quarters as the housing recovery has progressed. At the same time, we have streamlined and leveraged our overhead and improved our operating efficiencies, enhancing our profitability. The success we have achieved from these combined initiatives can be seen in our fourth-quarter and full-year performance.

For the fourth quarter of 2013, our net income grew to $28 million, or $0.31 per diluted share, representing a more than threefold improvement as compared to the prior-year period. The gains to our bottom line resulted from a combination of higher revenues from higher average selling prices, continued expansion in our gross profit margin and an improved SG&A expense ratio.

Fourth-quarter total revenues of $618.5 million increased by over $40 million, or 7%, compared to the same period of 2012, with year-over-year growth ranging from 22% to 43% in the Southwest, Central and Southeast regions, partially offset by a 12% decline in the West Coast region.

It is important to note that in the West Coast region, even with the decline in revenues, the pre-tax profit was up nearly 130% versus the fourth quarter of 2012 due primarily to significant improvements in housing gross profit margin.

Our overall average selling price for homes delivered during the fourth quarter was approximately $301,000, representing a year-over-year increase of 11%. This marks the fifth consecutive quarter of double-digit increases in our average selling price.

All four of our homebuilding regions also saw double-digit year-over-year Q4 increases, ranging from 10% to 29%. As I noted earlier, this trajectory of higher average selling prices stems from our ongoing operational initiatives, as well as generally favorable housing market conditions within our community footprint.

In addition, as we reported on our last call, our strategic moves have resulted in a more balanced mix of first-time and experienced buyers and contributed to sequential and year-over-year increases in the average square footage of our homes delivered, and these trends continued in the fourth quarter.

At the end of the year, we owned or controlled 61,095 lots, an increase of 37% as compared to 44,752 lots at the end of fiscal 2012. This significant increase reflected the success of our aggressive land acquisition strategy, and these lot positions are expected to drive continued growth in our community count and housing revenues in 2014.

The ongoing execution of our land acquisition and development repositioning strategy is quickly transforming our community profile. During 2012 and 2013, we closed out of 132 of the 198 active communities that were open as of the end of 2011. During that same time period, we opened 157 new communities and closed out of 32 of them.

As of the end of the fourth quarter, we operated from 191 active communities, 65% of which have opened since the end of 2011.

During the 2013 fourth-quarter alone, while we opened 22 new communities and closed out of 20, we had 15 scheduled community openings in the quarter that were impacted by land development and/or governmental delays, along with some weather-related issues experienced in Colorado. Virtually all of these communities have either opened or are expected to open during the first quarter of 2014.

We averaged 190 active communities for the fourth quarter of 2013, an increase of approximately 12% from an average of 169 active communities in the year-earlier quarter.

Positive trends in profitability per unit continued in the fourth quarter, in line with continued improvement in our housing gross profit margin. Our fourth-quarter gross margin was 17.9% as compared to 13.7% in the same quarter a year ago. The current-quarter gross margin included a $2.9 million charge for the abandonment of optioned land, mostly in the Bay area, an inventory impairment charge of $0.4 million, and an $8.5 million charge associated with water intrusion related warranty repairs at certain of our communities in Central and Southwest Florida.

In the fourth quarter of 2012, the housing gross profit margin included $5.6 million of inventory impairment and land option contract abandonment charges, and $2.6 million for water intrusion related repair costs.

As we indicated on previous earnings calls, we continue to assess our progress and refine the estimates of future costs relating to water intrusion related warranty repairs. We are actively managing, monitoring and analyzing this situation and will continue to update our repair cost estimates in the future as warranted.

Factoring in the adjustments that I just discussed, our housing gross profit margin improved from 15.1% in the fourth quarter of 2012 to 19.8% in the current quarter, a meaningful year-over-year improvement of 470 basis points, as well as a sequential increase over third-quarter adjusted gross profit margin.

As I noted earlier, controlling overhead costs is a crucial part of our profitability enhancement initiatives. In the fourth quarter, our selling, general and administrative expenses were $63.2 million, or 10.3% of housing revenues, compared to $63 million, or 11% of housing revenues for the same period the prior year.

The current quarter included the reversal of a previously established accrual of $8.2 million due to a favorable court decision.

During the fourth quarter, in connection with our retirement of senior notes due in 2014 and 2015, we recorded a $10.4 million loss on the early extinction of debt, which was included in interest expense. The retirement of these notes combined with the successful issuance of new senior notes in October, extended our near-term debt maturities, and as a result, the next maturity date for our public debt is in June 2015, when approximately $200 million of notes become due. This represents the only maturity of senior notes over the next 3.5 years.

As Jeff alluded to earlier, fiscal 2013 was a major turning point for KB Home. We achieved our first full year of profitability since 2006, we realized improvements in most of our metrics and we took several steps, both operationally and financially, to position the Company for profitable growth in 2014.

For the full year, we reported net income of $40 million, or $0.46 per diluted share, a substantial improvement of nearly $99 million over our 2012 fiscal year net loss of approximately $59 million, or $0.76 per share.

Housing revenues for the year were up 35% to $2.1 billion, driven by a 14% increase in homes delivered and an 18% improvement in average selling price.

Our adjusted gross profit margin increased by 490 basis points and our SG&A expense as a percentage of housing revenues improved by 300 basis points. Excluding the reversal of the $8.2 million accrual in 2013 and an $8.8 million court decision charge in 2012, our adjusted selling, general and administrative expense ratio improved by 200 basis points in 2013.

Finally, we reported operating profits in each quarter of 2013, and significantly enhanced our liquidity position and debt maturity profile through successful capital market transactions in the first and fourth quarters, and the establishment of an unsecured revolving credit facility in Q2.

We look forward to driving further improvements in our financial performance during the coming year as we continue to focus on generating profitable growth. 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 take a moment and recognize the hard work and commitment of all KB Home employees, who enable us to deliver the profitable results that will drive our business forward.

More importantly, I also want to thank our more than 7000 new homeowners who will be enjoying a brand-new KB Home this holiday season.

As I have shared, 2013 was a good year. Looking ahead, we have the fundamentals in place for an even better year in 2014. Our strategy is working, and I am confident that the expansion of our business will continue, driven by aggressive land investment and community development.

We have the backlog in place to start the year with momentum. And with a substantial number of community openings on the horizon, we expect to grow revenue while continuing to enhance margins.

While we continue to balance price and pace to optimize the returns for each community, the real profit driver going forward will be increasing community count. Growing our number of open communities remains a top priority for 2014. As I said earlier, we have a substantial pipeline of communities already acquired that are working through the process and toward a grand opening.

While some communities are taking longer than planned to get opened, we anticipate that our community count will grow moderately in the first quarter and build momentum from this level throughout the year. We expect to grand-open considerably more communities in 2014 than we did this past year.

While our community count at any one time is a function of the pace of grand openings and closeouts, we anticipate that our community count will be up in the range of 10% to 20% by the end of the year, with most of the growth occurring in the back half of the year.

Our community rotation should lead to continued growth in our average selling price for 2014, although we expect the percentage growth to moderate, as we are starting from a much higher base.

We anticipate that our ASP percentage growth will be in the mid- to high-single-digit range for the year. We will also continue to drive investment in land and development. We intend to build on the momentum of the $1.1 billion we invested in 2013 and we have a balance sheet in place to fuel this growth.

In 2014, our business will also start to benefit from a new profit stream, as Home Community Mortgage, our joint venture with Nationstar, becomes operational. We experienced a brief delay in regulatory approvals caused by the government shutdown, but the process is back on track and the new entity should begin operations in the first quarter. Nationstar has been a great business partner and the execution levels continue to elevate as our relationship matures.

The alignment as a joint venture should increase capture rates. And while the profit is important, more importantly, we should continue to benefit from more reliable loan approvals, better predictability in deliveries and outstanding customer service.

In closing, our strategy is working and we have momentum entering the year. We have the investments in place and we have a lot of upside opportunity inherent in our KBnxt business model. As the housing recovery continues to expand, our opportunities will become even greater, and we have the strategy to build on our 2014 momentum.

I look forward to sharing our progress with you throughout the year. Now be happy to take your questions.

(Operator Instructions). Michael Rehaut, JPMorgan.

Thanks. Good morning, everyone. First question I had was on the gross margins. You continue to demonstrate real solid improvement sequentially. And you continue to point to that improved mix and even further ASP gains in 2014 as the community count continues to bear out your investment there.

As you look backwards historically, you were able to do gross margins in midcycle, past cycle, in the low twenties. Can you give us a sense, assuming that you are going to get more of this moderate home price gains that you referenced over the next couple of years, more moderate pace than previously -- do you have a sense of when perhaps you could get back to that low 20s type margin? And any guidance in terms of what we could expect for 2014?

Sure, Mike, I can cover that. And you are right, on the gains, we have enjoyed some nice gains. I mean, if you look all the way back to the beginning of 2012, we were in the low double digits. By the end of the year, we were just touching a little over 15%. I am going to talk here about adjusted gross margin, so it takes out a lot of the noise in the various quarters.

I also want to point out that I am not adding back capitalized interest. These numbers are including the amortization of capitalized interest in the numbers.

Going into the first quarter, we were a little over 15%, second quarter, a little over 18%, third quarter, a little over 19%, and then almost 20% now in the fourth quarter. You know, we are pleased with the result. We are not say -- I would say pleased with the absolute end result at this point. We still have significant focus on further improvements. And admittedly, the improvements and the improvement trend will likely moderate a bit, as we saw this quarter. We were up only 50 basis points this quarter versus the third quarter then prior. But we are still striving to achieve, as you described, the normalized margin in that low to mid 20s area.

And as we are moving into 2014, I think I will talk first a little bit about the first quarter. We certainly expect the first quarter to reflect improvement on a year-over-year basis. But we are forecasting perhaps a slight decline versus our current fourth-quarter rate, and it is really due to two factors.

One, the typical loss on leverage on fixed costs that we include in SG&A due to seasonally lower Q1 revenues. And secondly, we are seeing a slight mix shift towards deliveries out of some of our lower-margin communities in the first quarter.

That said, for the full year, we still believe we will see improvements in gross margin, we are still targeting improvements. And I think actually even more importantly, continued expansion in operating margin, as we plan to achieve continued success in leveraging our SG&A fixed costs.

So the combination of those factors, I think, is positive for us as we look out into next year. As you pointed out, we do expect pricing to moderate in the markets, and we will redouble our efforts on cost control and on our strategies on community openings in order to offset that.

And I think one big point of understanding on the margin -- and it is why I went through a lot of the description I did in the prepared remarks on the churn of our communities -- is as we are repositioning communities and repositioning product within those communities, that is bringing the majority of the margin improvement, in fact.

So when you look at it as a business and you look how different we are in 2013 entering 2014 than we were even a year ago and particularly two years ago, it is had that pretty significant impact on our gross and on our operating margins.

Great. And I am just going to ask a quick follow-on and then my second question as well. When you say slight decline sequentially, Jeff, certainly that is inconsistent with historically. Does slight mean in the 50 to 100 bps range?

And just in terms of the overall second question, you know, the water intrusion charges continue to come up. Now we are looking at three straight quarters, and I think perhaps it is behind a little bit in the reaction in the stock today. I was hoping if you could just give us a broader update in terms of what is going on in Florida for this issue. If you could give us any further granularity in terms of -- it just kind of seems like it is an ongoing issue that we were hopeful may have been behind us last quarter. And are there any efforts in terms of recovery from the responsible -- if there is any issue in terms of responsible parties?

Sure, I think I will start with the margin question first. What we are seeing -- what I am seeing right now is in your range, 50 to 100 bps of impact coming just from the leverage issue. And then there is some additional impact that we think we may see from the shift to the lower-margin communities. That needs to play out and we obviously need to see what we deliver out of the backlog. But I think that would be incremental on top of the 50 to 100 basis points on the leverage issue.

Mike, a couple of comments I can add on to that. I don't know about the percentage because we didn't share that. But our dollars of gross margin are hirer in backlog today.

And what I keep trying to point out is as our ASP moves up, even though the gross margin percentage doesn't necessarily move up with it, your dollars of margin move up and it helps you on the SG&A side.

Looking forward, the guidance we gave on ASP is not assuming any inflation. That is just the rotation of our product mix. And a lot of our margin lift has been -- or the majority, I would say, is not the market lift; it is what we have done in rotating communities and changing product and all the things that I have shared over the years that we leverage in our business model.

So we are definitely on the quest to continue to pursue our normalized gross margins. And in a given quarter, it will move around some, because mix can still drive it at our scale. As our scale gets bigger and our new products continue to open, I think you will see us continue to advance toward our stated goal, even if prices stay where they are today. Because we are focused on how do we grow margin without growing price.

Back to water intrusion, I can say some high-level comments and then kick it back to Jeff. First and foremost in this situation, we are putting the customer first. It is important to us to take care of our customer and we are. I have very senior management involved in this deal and have for quite some time. We continue to keep our arms around it.

We like the trends. We will see what the future brings. But along the way, as I've shared on past calls, we are going to vigorously go after collection from contractors if they performed work that was substandard and created the problem.

So it is a frustrating situation for me, but it is one that we will continue to deal with, put our customers first and get it behind us.

And relating to the numbers, there are a lot of moving parts in this thing. We are trying to estimate costs on remaining homes to be repaired, as well as estimating how many potential future claims we will get and then the severity of the problems out of those future claims. So it is a very difficult situation to try to estimate.

And we are monitoring it very closely. We are making adjustments as we need to, as facts become known. We are using the most up-to-date information we have in order to book the accruals at the end of each quarter. And I do believe right now our understanding of the situation and ability to estimate its impact has continued to improve, although there is still a lot of uncertainty around it.

We are going to continue to manage it and monitor it, analyze the situation. We will continue to update our repair cost estimates as warranted, like I mentioned in the prepared remarks. And we will see where it goes.

Like Jeff said, there is a lot of focus and resource on it as a Company. We don't expect to complete all of the repairs until at least the end of 2014, as disclosed in our filings. So we do have some time to continue to deal with the situation. But just like we try to do every quarter, we try to peg it as best we know of what that future exposure is and book the appropriate accrual.

Thank you.

Dan Oppenheim, Credit Suisse.

Thanks very much. I was wondering if I could start off with the question of margins. You talked about some of the lower-margin communities impacting the first quarter. Is it really the communities or is it sort of a regional issue? And just trying to think about communities as some of the delays as those are coming online in the first quarter, is that likely to have some impact still in the second quarter more (inaudible) the mix towards the Central and Southeast as opposed to the West?

Dan, I don't think it will be as much regional shifts; it is more communities. When I look at, for example, our West region, the forecast right now in the West region in the first quarter is pretty similar to where we are at today. But within the West region, there is -- obviously, we have four divisions in the West region and there is some divisional differences and particular community differences within that.

And you are right in saying as some of those new communities come online that we had anticipated having open in the fourth quarter, and now, like I said, are either already open or will open sometime during the quarter, that will affect obviously that delivery mix slightly in the first quarter as to we need to get the communities up and running, make sales and build and deliver homes, which will likely happen towards either the end of the quarter now or more into the second quarter.

So it is more of a function -- like I said during the prior response, more a function of community mix.

Okay, thanks. And then I was wondering about -- I just talked about the community growth coming likely in the back half of the year. How are you thinking about that sort of across the different regions?

I guess first of all, starting with the West region, that is definitely following the Company trend as a back-half-weighted increase. A couple of the other regions, we are seeing a little more growth earlier in the year.

But overall, we will be comping to the prior year -- the comps will be pretty strong starting right in Q1, because we are already at 191 communities. And at the end of last year as a Company, we were only at 171 communities. So we are already ahead of the end of the first quarter of 2013, and we are intending to grow from here.

It is difficult, as we often point out on these conference calls, to actually forecast net communities due to just speed of closeouts and sales impacts it quite a bit, and then some of the uncertainty around openings and timing of openings.

But right now, that estimate of 10% to 20% by the end of the year up on the 191, I think is as best as we could see at this moment.

And Dan, if I could add a couple of comments. And you can relate to this since California is your home state now. It is not just the number; it is the quality of what is opening. I can give you a couple of examples.

Down here in SoCal, we are opening in January in two communities in Playa Vista, which is arguably the most land-constrained, dynamic housing market in California, possibly even in the whole country. And we are excited and the interest lists are strong. We have already got preapproval that it is going to be an incredibly successful community. And one community there could offset five communities in a much lower-price city somewhere else in our system.

Up in the Bay Area, we have a large -- we call it a mini master plan in San Jose, a 300-lot community with three product lines, that is in the process of opening right now, that initial response is great, prices are much higher than pro forma. We have a long list of reservations.

And that is why I made the comment in my prepared remarks on it is not just the number; it is the size of the communities. Because over the last couple of years in our coastal business, we were picking off a 30-lot distressed deal here, a 40- or 50-lot development deal there, and you are in and out of them in the same year.

Now with the scale that we are creating in these communities, like the San Jose example, they have a longer shelf life. And they will be around and it will help drive a much better business.

And having said that, we expect all four regions to grow community count through the year and think we have a nice growth engine going forward.

Great, thank you.

Bob Wetenhall, RBC Capital Markets.

Hey, thanks so much. First off, congrats on getting to profitability this year. It is obviously an important pivot for the Company, so that has got to be satisfying.

Just wanted to ask you what is going on with cancellation rates. And going into 2014, how should we be thinking about the conversion rate of backlog?

On the can rates, we disclosed in the release the numbers. I think important for me on that one. The first is what I like to do is look at -- I look at [net] sales. And irregardless of the cancellation rate, that is sort of the number that we really focus on.

In our case, you see a little bit of difference in the cancellation rate as a percentage of our gross sales versus the cancellation rate as a percentage of our backlog. And it's kind of interesting, this year, as a percent of backlog, our can rate really hasn't moved much as we have gone through the year. It was 30% in the first quarter, 29% in the second quarter, 27% in the third quarter and 29% in the fourth quarter. So it has been very consistent.

As a percentage of gross, it has moved around more. And you get that kind of relationship when your gross sales are varying as much as we do in this industry on a seasonal basis. So that is kind of how we look at it.

I often say, look, we look at can rate as an indicator. When we look at hotspots within the Company, if we have a division where we see the can rate spiking up a little bit, we try to dig in and see what is going on and see what the drivers are. But generally it is a net sales focus for us.

And conversion rate, just a little bit of housekeeping. How would you like us to think about conversion rates next year?

And final question, any thoughts on land spend? It was $1.1 billion. It seems like you have got a good supply, good visibility for the next two years. What should we be thinking about 2014? Congratulations on a very good year.

Thanks, Bob. On the conversion rate question, what we have been running is I would say give or take 60% for the last two years. It spikes up a little bit in the fourth quarter as we are closing out this year. I think this year we did 67%; last year we did 68%. But outside of those two quarters, that 60% range plus or minus is probably a good number.

On the land spend, as Jeff indicated, we are building off a $1.1 billion actually close to $1.2 billion year -- I think it was $1.140 billion in total -- as we go into next year. And we like the growth that has provided in our lot count. It has given us a really nice boost to what we see in community openings as we move forward.

And we are going to really look at market conditions as we move through the first quarter and opportunities -- I think very importantly land opportunities. So we are still staying very disciplined in our land investment approach. As those opportunities come in, we will aggressively invest, as we have been. If we don't see the right opportunities at the right returns and margins, then we will pull back a bit.

So at this point, we are not really giving number guidance on the spend in 2014. But directionally, we intend to continue with the aggressive land investments and development that we started and continue to build our community count.

Got it. Good luck. Thanks very much.

Alan Ratner, Zelman & Associates.

Hi, guys. Thanks for taking my question. Jeff, I was hoping to ask another question on the regional mix. Because when I look at your dollar backlog, California right now is about 30% and a year ago that figure was 40%. And that region has consistently been generating margins 500 to 1000 basis points above your other regions.

So when I hear your comments about improving margins in 2014, it would seem that you would either expect to see some pretty significant improvement in the other regions or maybe see the order declines that we have witnessed over the past few quarters in California reverse into gains throughout the year. So I am just curious if you could add some more color to that.

Alan, for starters, the gap in percentage margin closed a bunch from that range that you are raising. I think that was true in the past, but our other regions' margins are improving and it is not that big a gap in percent. The dollars are still huge because of the ASP.

Within backlog, it will move around a little bit from quarter to quarter, based on what I walked through in California. And outside of California, it has been fairly consistent as we go through openings and closings and the rhythm of building our backlog.

So as we have shared for a long time, our revenue out of California has typically been close to half of our business. I think you will see that go down a little bit as we strategically grow outside of California, with California growing along the way. And as I already shared on this call, it is our expectation all four regions are going to grow at the top line and the deliveries for the year.

So we are positioned to grow. And it has been an odd dynamic this quarter with openings and closings in California that we can quickly shore up and build as we get into 2014 here. You will see California continue to be the weighted business for us.

We will get the numbers in the K, but I would imagine that -- and we should expect to see that gap shrinking between California and the other regions. Because the range I gave -- at least was through the first three quarters of 2013.

Yes, that's right. And I think the other important thing is the community openings, as Jeff was referencing. We are very excited about some of the new community openings that we have coming onstream in the first half of 2014 out of the state. A large result from the land investment that we have put into place in 2013, as we are getting those communities developed and opened. Obviously, it takes longer to do that in California than it does in other parts of the country and we are very excited about some of those new openings that we have coming online.

Part of the other reason, Alan, I can share on why I think you will see the gap close a bit. If you think of the investment cycle we have been through a couple of years ago, we were only investing in coastal California and desirable areas in Texas. And as markets recovered and we put the open for business sign up at our investment committee around the system, we are now investing in higher price points in the cities we are in.

And a great example is Denver, where our business is performing very well and growing at a nice pace. We have got communities opening where the ASP isn't California-esque, but it is not $180,000 anymore. It will be $300,000, $350,000, $400,000, with very healthy margins.

And you will see that evolve around the system this year, as all the investing we started to do in 2012, in late 2012 and through 2013 will come to market at higher price points in all of our markets.

That is very helpful. And if I could just change gears for a second. I'm curious if you have had any conversations with the folks at Nationstar about some of the recent announcement of changes in the mortgage industry -- obviously the lower FHA loan limits as well as the increased [GSC] loan level pricing adjustments. And curious if you have had any early take on what impact that might have on your buyer.

We have definitely had discussions and definitely as an industry have been discussing things in Washington as well. And each one of these little changes on its own the housing industry absorbs, but they start to add up.

And we expect the FHA loan limits to drop to the $600,000s on the coast. And no problem with that, okay, fine let's move on. But with some of the inland cities, like a Phoenix or a Las Vegas, took a pretty significant drop as well. And that is where we were surprised at the level they dropped to.

As we got into our business, we found that with the mortgage insurance changes that had been ongoing at FHA, payments were actually much higher than comparable conventional product, even when the conventional product is at a higher rate. The mortgage insurance has been moving up for the last couple of years, and our FHA book of business has been going down along the way, because the customer was opting for a 5% conventional loan at a higher rate, but a lower payment.

So I think the impact will be somewhat muted on new home construction of that specific item.

This GFE change is going to raise rates over time. The dust is still settling on this announcement, and it is a risk-based GFE now, so the lower the FICO, the higher the rate will be. And it is the government's effort to try to get more private money into the mortgage world so they can withdraw a little bit.

And what our industry keeps pushing for is let's do things at a slow pace to make sure there is not some unintended consequence. In order of magnitude, if you are a 750 FICO, this GFE is an eighth of a percentage point. So it is not a big deal. You get down to a 650 or a 670 or 680, which historically is a good buyer, and your interest rate could go up a percent.

So there is a new head of FHFA coming in. They will have the ability to go adjust and monitor things. And we are trying to get our arms around those two, what is the impact and also QM and QRM finally getting resolved. So there is a lot of swirl in the mortgage markets that we are trying to get our arms around and understand, but none of it so far has created a tailwind for the consumer.

None of them on their own are significant, but each little one over time could be. And that is part of our -- we are being watchful right now on the trends and how this develops over the next 60 days.

Okay. Thanks for your thoughts.

Stephen Kim, Barclays.

Hey, guys, it's actually John filling in for Steve today. Just wanted to touch on cost. Land aside, what have you been seeing as far as materials and labor go? What we are hearing is things are generally up about 10% to 12%, but if you could weigh in there, that would be helpful.

I'm not sure what your comparison point is, the 10% to 12%, prior year, prior quarter --

Year ago.

Year ago (multiple speakers). Just trying to get a base on that.

What we've seen more recently in the fourth quarter is actually more of a net flattening. We have had some price inflation in the fourth quarter between materials and labor, but it has been more of an offset. Lumber has come down a bit. It has offset some of the labor increases that we've seen. And the from that point of view, it did not have as much impact on us in the fourth quarter as prior quarters.

We are concerned obviously going into next year, as we always are, about all of our costs, of what could happen, particularly in the spring on the labor cost side. But we are mindful of that and we have a lot of resources focused on it from the purchasing side.

We have been doing a lot with our supply base and really very actively working to develop additional suppliers in certain markets and to enhance the position of certain of our traditional suppliers across the network. And really just very cognizant that this could continue to have impacts on us as we get into next year and really looking to offset it as we go.

Thanks. Now on the price side, you have indicated that mix alone you think, prices will be up mid- to high-single digits. Kind of what inning are we at in the story of your product and market mix shift? Because last year, you meaningfully exceeded the industry. And to have another year of mid- to high-single digits in excess of inflation and broad home price appreciation -- maybe if you can help us there.

Let me start with what we said and what we have been saying for quite a few quarters on our ASP. The ASP growth that we have seen as a Company does not reflect as pure price, as you kind of implied there. We don't expect -- I don't expect market price to go up 5% to 10%. It would be nice if it does. We are not planning for it. But we do expect our ASP to increase in that range.

And the reason for that is continued strategic shifts for the Company, continued new community openings at higher price points, larger square footage of deliveries, and all the other factors that we talked about in the past that is really driving our ASP outperformance versus the industry. So it is not really just a pure price game, and I wanted to kind of clarify that before -- I don't know, Jeff, do you and make any comments on the general pricing that you expect in the marketplace?

We are not seeing anything in the markets that suggests there is a risk of deflation right now. While there has been a pause, the inventory levels are still low. The economy is getting better so we don't think there is a lot of downside pressure on pricing. It is just that the upside pressure has eased right now, which I observe is actually a healthy thing.

And what has gone on with our Company, as you look at our scale growing and where we were and where we are, you can move price pretty quickly by opening a handful of communities in coastal California and close out a handful in Houston. So part of our price was just simply that, the regional mix.

But strategically within the state of California, our investment tilted to the coast, and higher demand, land-constrained, hard to get deals. When you do, they work extremely well and they are significantly higher prices. So within California, that shift in strategy drove a much higher price.

As 2013 evolved, the recovery in California moved inland, which we shared, and we started investing more aggressively in the more desirable locations inland in California. And as the economy recovers further, we will grow our coastal business, but the unit growth will come more from inland than it will coastal. And it wouldn't surprise me at some point we will be a larger business, but our ASP in California could actually stop going up because the whole state has recovered and the more moderate-priced markets become a much bigger part of our business.

You are seeing some of that go on right now in that we are investing in the coast and we are going to grow our coastal business. But we invested a lot inland that is going to come online later here in 2013 -- or 2014. I'm sorry.

And as I say all that, it has taken us about-- if you look in California, there is not a lot of lots hanging around in solid locations. So you are either buying a partial developed, and those are mostly gone, or you are having to entitle. And when you get into entitlement and development, it is taking us 18, 24 months depending on the location to bring the lots to market. So there is a delay that is extended a little because of some of the staffing levels in the government agencies.

But it wouldn't surprise me if at some point in time our price goes down in California. Because a bigger chunk -- our margins will be great and our business will be great. But in the short run, it has been this mix shift to the coast that we invested in a couple of years ago.

Jeff, that is a really interesting point you make on California. Just to maybe take that one step further. As we see, more broadly speaking, outside of California more of the traditional first-time homebuyer coming back into the market, do you think that your companywide mix shift would maybe dial back a bit, and you could ultimately in years out see negative price? Not because of macro environment but just because your mix has to shift to where the market is in these years out.

You use the right term -- we will shift to where the market is in our business model. We have shared back in 2006 we were about 30% first-time. We were heavily weighted to move up. And then through the downturn, we shifted the other way and now we are pretty much 50/50, I guess, in range between first-time and move-up. And that is because that is where the demand has gone to.

If first-time buyers, their mortgage situation improves so they can get a loan and that demand opens up, that will be a beautiful thing. Because it will really trigger a solid housing recovery across the nation, and it is a sweet spot for our Company. And what you will see happen is we will open up more business to the lower-priced first-time buyer. They will be at similar if not higher margin percentages, and you will turn faster, because there is a bigger buying pool.

So that doesn't mean where we are today would shrink. It means you will just offset it by a bigger business with another segment. And as years unfold, we will continue to migrate to where the demand is. That is one of the strengths of our business model and the adaptability we have.

That is very interesting. Thank you for that, guys.

Mike Roxland, Bank of America.

Thanks very much. Just quickly, can we talk about the vintage of land flowing through the P&L currently and when you expect land that you purchased, whether it be over the last 12, 18, 24 months, to begin flowing through the P&L? Obviously, some of it is hitting now. But how should we think about how the land purchases you made over the last 1.5 years to 2 years hits the P&L?

I will go back to some of the prepared remarks on that one. That was one of the reasons why I went through, Mike, some of the detail I did on the communities.

In the last two years, like I had mentioned, we closed out of about 65% of the communities that were open at the end of 2011. So by default, almost all the -- other than 35%, that same percentage are all recent land acquisitions. So the vintage of the land in the current portfolio is actually fairly recent, and we are still working through some of the larger land positions that we had in place let's say in communities open at the end of 2011. But obviously, the vast majority now is more recent land.

Got it. So given rising land costs and the fact that you have aggressively acquired land in 2013 and will be opportunistic in 2014, how should we think about how you plan on getting back to low 20%s gross margins on a normalized basis, particularly given the fact that you are dealing with higher land costs that will continue to flow through the P&L?

The land cost is always going to flow with the market in normal times, whatever that may be. I'll qualify it. But in normal times, you will get a couple points of margin coming out of a community, and you will go into it at whatever margin you underwrote to.

Typically, as prices go up, all it does is cover cost that goes up. And you get your margin improvement through execution or changing your product. And that is why we keep sharing while we benefited from some price and we will always opportunistically take it, we don't count on it. And we think we can get to our historical margin levels again, and we are marching toward it through running a better business. You don't need the market lift at that time.

Because you are only going to build the homes if you can get a return. And if cost to build goes up, you factor that in and you will invest in that location if you can get to your margin. And you pick it up in opportunities like lot premiums and elevation premiums and our studios and the efficiencies of scale. There is a lot of different things we can do to get to our margin without having to bank on price.

Got it. Good luck in 2014.

Thanks.

David Goldberg, UBS.

Thanks, guys, and thanks for taking my call. I wanted to actually take a step back here and go back to Bob's question on the cancellation rate. And I appreciate the color about the variability of sales in the quarter. But if you look at the cancellations as a percent of backlog, it's actually been pretty consistent for some time.

And what I am trying to get an idea of is as you guys move forward with the home community mortgage and the JV, would you expect cancellation rates to come down in the business? In other words, is this a prescreening kind of thing where maybe a little bit more aggressively screening, you are not going to have as many kind of cancellations? Because I know they tend to be earlier in the process. Or is that kind of the right level for you guys in terms of the business model?

Let me make a few comments, because you went to a great topic. And because you have followed us for some time, you understand that we have really two different can rates. One is before start and one is after start.

And if you think about it, if someone is told they are approved, they final at the studio, and they have now released and they are watching their own custom home get built, your can rate drops significantly. And there is many divisions where post-start the can rate is single-digit. And their can rate will be from homes that haven't been started yet and haven't made it through the screening process.

Having said that, our capture rate right now with Nationstar, right around 60%, I'd say, their can rate -- or let me say their predictability after an approval is significantly higher than the other lenders, who will give us a letter that says they are approved, go ahead and start, and then later on, they will say, wait a minute, not so fast.

So we do think that our can rate will moderate some as capture rate elevates through Home Community Mortgage. But over the years, my hunch will be our can rate will be in the range I would say, settle down probably around 25%. It has always been that way, since we rolled out this business model. It may go down a little, but -- as Jeff said, we focus more on the net sales.

Sure, and that is very helpful. The other question I had was more of a general question with the land market. I think during the call, you have done a great job of touching on some of the potential hurdles that we face and also some of the upside opportunities.

But are you finding that as some of these hurdles are coming to light in land markets that have been more aggressive earlier in the year when prices were going up a lot, have you found you know the behavior of other builders has changed a little bit? In other words, here we are looking at a mortgage market that is less certain; we have the FHFA the GFEs, we have FHA loan limit changes, we potentially have higher rates and tapering. And all this stuff is kind of going along with all the other hurdles that we face in the market. Are you finding that is being reflected in buyer behavior in terms of the land market or is everyone still fairly aggressive to go out and buy a lot?

I think we are all aggressive to go buy lots in the right locations at the right prices. I think the builders have stayed fairly disciplined. And I can speak for KB. There has been many deals where there were two or three builders bid on a piece; we were not the high bid, we lose the bid. We are not going to chase it.

And then somebody will try to re-trade the deal before it closes, and the seller will come right back to us at a lower price than we bid. We do that all the time, because we are going to stay disciplined to the price points, the returns and the product strategies that we follow. And I would say for the most part, the public builders in particular are staying pretty disciplined in that regard.

Having said that, I also think that right now the land markets have softened a little bit. They are nowhere near as strong as they were back in May, June or July. And that is part of why I said it is healthy for pricing to take a pause and let the market just settle out, because it was running up pretty good back in the spring.

That's very helpful. Thank you again for taking the questions.

Ladies and gentlemen, this concludes 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.

Thanks, Kyle, and thank you, everyone, for joining us here today. I hope you all have a wonderful holiday season and we look forward to sharing our progress as 2014 unfolds. Have a great day. Thank you.

This concludes today's conference call. You may now disconnect.