KB Home (KBH) Earnings Call Transcript
May 17, 2023
Earnings Call Speaker Segments
Good morning. Thanks for joining us as we're rounding out the morning of our -- of Day 2 of our 16th Annual JPMorgan Homebuilding and Building Products Conference. My name is Mike Rehaut. I'm the senior analyst covering the homebuilding and building product names for JPMorgan. We're excited to have with us KB Home CEO, Jeff Mezger; CFO, Jeff Kaminski; and VP of Investor Relations, Jill Peters. Well, this presentation will be a fireside chat. I'll be asking a series of questions. [Operator Instructions] I'll turn it over to Jill for some brief remarks, and then we'll go into Q&A.
Good morning, everyone, and thank you, Mike, for hosting us today. For those investors who are newer to the KB Home story, we are one of the largest homebuilders in the U.S. with the primary focus on serving first-time and affordable first move-up buyers, who accounted for 73% of our deliveries in our 2023 first quarter. Our personalized go-to-order model emphasizes choice, including the selection of the floor plan, lot, square footage and finishes. A complement to this choice offering is the availability of quick move-in homes in every community to serve the buyer who prioritizes a near-term move-in date over personalization. We believe the ability for buyers to choose what they value and can afford generate strong customer satisfaction. We are proud to be the #1 customer ranked national homebuilder in third-party customer surveys such as ConsumerAffairs. Our homes offer the highest energy efficiency among national homebuilders based on an average home energy rating system or HERS Index Score 48, an industry-leading publicly reported score. We recently published our 16th Annual Sustainability Report, the longest-running publication of its kind in the homebuilding industry detailing our achievements and goals across environmental, social and governance factors. I would like to note that with our approaching May quarter end date, we will not be providing an update on orders or related metrics today. In addition, our reference points will be the commentary we provided on our 2023 first quarter earnings call held on March 22 and/or contained in our Form 10-Q, which was filed with the SEC on April 7. And with that, we'd be happy to answer your questions.
Great. Thanks so much, Jill. Welcome Jeff and Jeff and Jill to the conference. Again, really appreciate seeing you here and participating. It's great to have you.
Good to see you, too.
So I'm going to skip my first couple of questions on demand trends and pricing given Jill's guidelines, which I understand. And again, appreciate given the fact that you're more or less within a couple of weeks of closing out your quarter. So I'd like to shift a little bit towards some of the company-specific questions that I have in store. And maybe to kick it off, you highlighted the 73% exposure to entry-level. And obviously, putting out an affordable product is central around satisfying that consumer. How do you think -- given all the concerns around affordability today, how do you think about your price point and your closing ASPs going forward against the backdrop of those concerns outside of, obviously, market trends or future home price appreciation in your markets, how should we think about your average selling price over the next couple of years as you continue to address affordability confirmed?
Mike, it's a good question. And we're working hard to keep our products affordable. Prices ran up pretty significantly over the last few years and interest rates ran up. So it was a double combo on affordability squeeze. When we open a community and invest in a new community, we always try to target the median income or that area or the median sales price for that area and what cost pressure we had in interest rates moving and prices going up, we move them away from the median incomes. The community still sold well because there was no inventory in those submarkets. And so there was stronger demand, and we were able to accommodate all that. While going through that, we've remained very sensitive to affordability, and we're hard at work right now, retooling product, simplifying, introducing smaller floor plans across the footprint as models, not just floor plans that are available, and we'll continue to work to lower our costs. The labor side has been a little sticky because things picked up again this spring. So we haven't had the continued progress in labor cost reductions we thought we would as we entered the year. So we're having to do it other ways. And one of the things that the investors may not appreciate or understand when times are good, it's not just that our prices go up and our products get bigger, the cities start asking for more. And then when things slow down and their permit activity drops and they need revenue, they're more accommodating on changing things in the product. And a lot of what we're doing right now is going back into cities and getting approval for a little less expensive exterior or allowing us to go to a little smaller footprint on the lot. So we're continuing to see costs come down. I don't know that you'll -- we should expect our ASP to go up any further for a while because whatever we can do to stay affordable, we're going to go do. And there's a lot going on right now in that regard.
Great. And so I appreciate -- I mean, that was kind of part of my question was direction of ASP, you said maybe it shouldn't go up for a while. With kind of shifting maybe the smaller floor plans or value engineering, is there potential in a steady market for ASPs to maybe moderate a little bit, come in maybe a few percent in the next year or 2?
It's certainly possible. We'll see how things unfold. But along the way, the ASP may go down, but we're not expecting our margin percentages to go down with it. So you'll have a little less dollars of margin but the percentages will hold, if not even go up depending on the community and the product mix. But one of the other things I didn't mention that we're working on is trying to increase densities on communities where we may not even have closed on the land yet and have an approved map and we're going back in and requesting smaller lots in order to, again, lower the price to the end product to the consumer. So that's another thing that could keep our pricing down a little bit from where it's been, but we'll see.
Right. Right. Understood. In Jill's opening remarks, she also hit on kind of your approach to market in terms of being build to order. And when you think about build-to-order versus spec, and you kind of also highlighted the fact that you try and keep quick move-in homes available in each of our communities. But I think broadly speaking, it's fair to say that you've kind of remained steadfast in your build-to-order approach as opposed to a lot of other builders that have significantly increased their spec exposure or spec percentage, a small cap builder kind of well known in this space for being build-to-order is now maybe a little bit build-to-order, but they really shifted pretty hard towards the spec model. So maybe you could just kind of review where spec is today as a percent of your business versus normally? And how do you think about to the extent that you're pivoting? How do you think about over the next year or 2, where you want to be in a more movable backdrop?
Sure. Well, we're actually in a very good spot right now, Mike. And one of the things I keep reminding people of in our business, our build-to-order sales typically have a margin that's 300 basis points higher. And so we feel we make more money in our build-to-order approach, but it's much more than that. It's also consistency in the deliveries and more visibility on where our revenue is headed because we've already sold the homes. As we look back on the first quarter, we did have a spike in inventory tied to some of the cancellations that we experienced in the third and fourth quarter of last year. We were able to sell through it. We shared on our call that our range would be 70% to 75% sold in our WIP, which is right where we are, and we're coming out of the first quarter. So we're in a good balance. We feel inventory is part of choice to the consumer. There is a buyer that has to move in, in a hurry. But we continue to see demand for our build-to-order product. People, when they're making the largest investment in their lives, they want to have some input into what goes in the home. And we just think it's a better way to create that value and satisfaction for the customer, and we make more money along to it. So we have not strayed, frankly, good and bad for 20 years now. We've been very consistent in our approach and like the business. We think there's a lot of benefits, and we'll continue to range 70%, 75% sold before start.
Right. Maybe just -- you hit on gross margins a little bit in terms of the typical spread. Is that 300 bp difference now kind of in line with that range. Where you're selling today in terms of spec versus build-to-order? Have we seen that kind of revert to normal at this point?
We are. In fact, we shared that on our Q1 call that spreads are pretty normal. And what happens when you're in a build-to-order approach, the buyer is going to pay more for a lot premiums because they're picking their lot and putting their home on it. And when you get to an inventory home a lot of times, the first thing that goes away is the lot premium because you're already trying to incentivize to sell the home because it's finished and may not have the things the buyer wants and they'll still buy it if you give them a deal. So it's a different way to create value, but you can lose your ability to garner lot premiums. You lose some of the revenue out of the studio that we experienced in the inventory sales. So the -- we've always seen a 200 to 300 basis point spread, and that's right where we are again to be.
Right. Okay. Perfect. Maybe just focusing on gross margins for the full year. In your prior earnings call, you talked about guidance around back half gross margins being roughly flat from the second quarter. At the same time, obviously, construction costs have been moderating over the last 2 or 3 quarters. Net pricing across the industry has started to improve a little bit. Could those trends drive upside to your back half guidance? Or is it something where we wouldn't expect that to more hit until '24, just given maybe the build-to-order lag or other -- perhaps other offsetting tailwinds that we're not aware of?
Jill won't let me reconfirm guidance, so I'm not going to tell you that, that was a good or a bad number that we gave. But you're right that the markets have firmed up some. When we gave the guidance, we -- there was a wild card, what the second half demand is going to look like. So that was part of our consideration. And then there is a lag. So as lumber has come down, a lot of our lumber benefit will actually be in the first and second quarter of next year due to the cycle time that we run through. So we feel good about our business and what's going on right now. But as the year unfold, we'll see if there's more lift or not.
Right. Okay. Fair enough. Maybe just on a longer-term basis, how to think about gross margins would also be helpful? Between 2013 and 2020, your gross margins averaged 18%. So is this kind of a level of profitability that we should expect going forward or as the market normalizes? Or can KB or is there a potential to generate something a little higher, perhaps due to scale or operational efficiencies?
That's absolutely going to be higher, Mike. As you know, we had to go through some retooling of our business coming out of the -- whichever housing crash, we call that one now, there was a couple ago. But coming out of '07, '08, '09, we had to fix the balance sheet. We had our returns-focused growth plan that we shared and you were familiar with. But where our margins are today, we feel is pretty much where it's at or the floor. So we're -- '18 is well below what our expectations are, and we target that we should be able to sustain a double-digit operating margin.
Right. Right. Okay.
Much higher than that average. That average was distorted on the low side.
Yes. Just on one data point alone, Mike. Okay, so Jeff mentioned the leverage impact on fixed costs and cost of sales. But the difference in interest amortization is 300-plus bps between that 13% to 18% period and where we're at today. So we would be -- we are definitely targeting a 2 [indiscernible] our margins in the foreseeable future and have a lot of improvements within the business that have supported that. So yes, we don't see ourselves going back to sub-20%.
Okay. We got a question from the -- and I appreciate that clarification, Jeff. We had a question from the audience. On the incentives front, what's resonating most with buyers today? What incentives and which incentives impact sales price versus cost of goods sold?
Jeff can walk you through the accounting side but every buyer has a little different set of needs. Most of the time, it's either a buyer that doesn't have the cash to close, who doesn't have enough cash cushion to close. So you help with closing costs or if it's a qualifying issue, you'd offer them a little bit of a rate buydown in order to get them to qualify. If they qualify and they have cash, they typically tilt to give me a price discount and get the best price that they can. And those have -- those all have a different nuance to our accounting, Jeff, you can fill them out and how they get treated.
Right. So the largest incentive we've seen over the last 12 months, and as you know, Mike, and Jeff mentioned, we're not an incentive-based company. So usually, it's a point or less and kind of just gets lost in the round and hasn't been a really much of an issue or an impact on the business. Been a little bit different this time because of the spike in mortgage rates. So as we've been offering incentives on those spikes, they are coming off the ASP. So it's getting booked as an offset to selling price in our opinion, what's the most appropriate GAAP treatment for that.
Okay. Perfect. Maybe shifting a little bit to your geographic footprint. How do you view it currently? In other words, is there -- and in terms of every builder kind of has a balance of investing or trying to go deep in your existing markets or perhaps going into some new markets. How do you balance that? And where do you see either the greatest opportunity or different opportunities across your existing and potentially new markets as part of your [ treatment ]?
Well, we have a few growth engines all working together right now that we're setting up what we feel is a very favorable trajectory. If you look at the core footprint in our peak, we delivered approximately 25,000 homes. So we're nowhere near where we once were, and we know the markets will give it to us if we can get the community count up and keep growing our scale. So in the markets we've been in a while across the footprint, every division has a growth plan with targets to get into the top 3 in that market. And if we do that, there's significant upside. Along the way, we've entered a few markets through a de novo process that takes some time to get up to scale and to get up to profits. But in the meantime, we've been able to absorb the overhead of the ramp up without really impacting our financial results. And Seattle is a great example of that, where we entered that market 4, 5 years ago. We're now on top 5 builder in Seattle. We're targeting top 3. We've entered Boise, and we've also reentered Charlotte with both very good economic engine growth cities, and we expect big things out of those markets. Within the regions, one of the things I'm proudest of is how our Southeast region has finally matured and developed and is quite a growth engine for us, both in revenue and in profit. So it's a nice complement to the West and Southwest and then our big business in Texas. So a lot of growth opportunities where we're at, the new market entries are maturing and starting to contribute. So we think we have a nice combination of things that will continue to drive our growth.
Kind of shifting to land and your land strategy for a moment, most builders prioritize optioning lots due to a combination, at least in their view, of driving higher returns and mitigating risk. Currently, your land book is about 25% option, down from a peak of 45% a couple of years ago before the recent market downturn. And obviously, that decline like many of your peers, as you walked away from options that -- or land that didn't make sense as much but still at 45%, maybe less than some of your other public peers. So how do you think about optioning land? Where would you want that percentage to get back to, let's say, over the next couple of years? And how do you think about optioning as a tool for drive returns for the company?
Sure. But -- as you touched on, our option percentage went down because we abandoned a lot of the options we had when the market reset. You always hate to book abandonments, but it's far better than paying for lots that may not pencil and get your return anymore. And we're pretty aggressive in that regard. We're only going to do something if it makes sense to us. Ideally, we would option every piece of land we could. As you know, the land sellers are pretty savvy. And when you're in a preferable submarket, it's harder to get terms and the way you could make it an option is to go do some type of off-balance sheet financing, which we don't necessarily like to do because you give up too much margin. So we focus on the inventory turn and making sure we get it open as quickly as we can. We phase development and go for our targeted absorption pace to optimize the asset and get our returns through execution. And along the way, that's worked well for us. Ideally, but I would guess we'll get back to that historical ratio. You touched on 55-45, 60-40 in that range. And we try to option everything we can. It's -- but you also want to be in the right submarkets at the right price point. And our balance sheet allows us to move quickly and get those and same time now we turn the inventory fast and it's helping our returns. So I'd say 55-45, 60-40 is a good spread.
Right. Okay. Perfect. Last one for me, and again, for those dialed in, we do have a little bit of time on the back end here. People have questions. Again, please feel free to -- you can even shoot me a Bloomberg guy, if you like, or that's easier or hit the Ask a Question icon on the dashboard. But last one for me is on capital allocation and specifically share repurchase. In 2021 and 2022, you spent about $350 million on share repurchase and you took your share count down about 10% during that time. This compares to much lower levels in the prior years. How should we think about share repurchase going forward, particularly as your balance sheet is pretty solid at this point, cash flow positive? How should we think about share repurchase in the coming years?
Great question, Mike. And as you may recall, we announced at our earnings call, we had just had a refresh and upsized by the Board to authorize a $500 million repurchase program. And if you go back and look at what we've done and how our balance sheet has evolved, we've continued this balanced approach of managing our debt, fueling our growth and then bringing capital back to the shareholders. And over the last few years, that well under control. We're at -- we're below our -- the low end of our range on our targeted debt ratios. So that's a good thing. And we don't expect that we'll be taking more debt out as we go ahead, and we're still generating a lot of cash. So priority one, you put it back into your business, you can get the returns and then priority 2 is how do we share it with the shareholders. And as we've looked at it with where our stock has been trading, we feel it's well below value. It's been trading below book value. So every share we buy back is accretive. And in '22, I don't recall that, Jill, I think the number -- the average price on the buybacks was about $30. It was the best investment we could have made with those dollars for the shareholder, and we continue to feel that. So as long as we're trading at the levels we're at, we'll continue to exercise and keep our discipline of the balanced approach. We'll continue to take shares out with the cash and the authorization we have because it's the best investment we can make for the shareholder.
Right, right. No, I appreciate that. We actually do have another question coming in from the audience. Can you please help quantify the drivers of gross margins going from roughly 24% in 2022 to roughly 21% at the midpoint of your 2023 guidance?
Jeff, do you want to go over that?
Sure. Yes. I'd say the bulk of that, Mike, is just top line price and what's been happening with incentives in the marketplace as well as average selling price in general at a lease level. It is encouraging now of being able to back off some lease incentives and see in the market, I would say, gaining some acceptance of rates being in the low 6s, low to mid-6s as opposed to years -- a few years back 4% or 5%. So people are starting to get more comfortable with that and I think a little less likely to demand incentives on every single sale. So we're seeing that back off nicely. And -- but that was the main impact. It was really top line. You have all the moving pieces in there though. I mean it's all blended in. You have community mix, geographic mix, you have cost changes depending on when you started the home and where the costs were at that time. So it's -- there's a lot to it. But in our case, the majority of it was just on the net price of the home, net of incentives.
Right. Right. All right. Well, I think that does it. Appreciate your time today, Jeff, Jeff and Jill. It's always a pleasure to have you. And again, we really appreciate the participation at our conference. We're going to go into a short or the lunch break. We'll resume at 1:15 Eastern Time with Taylor Morrison followed by PGT Innovations and then Forestar Group. Thanks again. Great to see everyone. We'll talk soon.
Thanks, Mike.
Thank you, Mike.
Thanks, Mike.
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