KB Home Management Discusses Q4 2012 Results - Earnings Call Transcript

Dec.20.12 | About: KB Home (KBH)

KB Home (NYSE:KBH)

Q4 2012 Earnings Call

December 20, 2012 11:30 am ET

Executives

Jeffrey T. Mezger - Chief Executive Officer, President and Director

Jeff J. Kaminski - Chief Financial Officer and Executive Vice President

Analysts

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

Daniel Oppenheim - Crédit Suisse AG, Research Division

Stephen Kim - Barclays Capital, Research Division

Anto Savarirajan - Goldman Sachs Group Inc., Research Division

Ivy Lynne Zelman - Zelman & Associates, LLC

David Goldberg - UBS Investment Bank, Research Division

Rob Hansen - Deutsche Bank AG, Research Division

Operator

Good morning. My name is Sarah, and I will be your conference operator today. I would like to welcome everyone to the KB Home 2012 Fourth Quarter and Year End Earnings Conference Call. [Operator Instructions] Today's conference is being recorded and a live webcast is available on KB Home's website at www.kbhome.com. The company will make a brief presentation and then open the lines for Q&A. [Operator Instructions]

Before we begin, I would like to remind everyone that KB Home's discussion today may include certain predictions and other forward-looking statements that reflect management's current expectations or forecasts of market and economic conditions of the company's business activities, prospects, strategy and financial and operational results.

These statements are not guarantees of future performance and due to a number of risks, uncertainties and other factors outside of its control, KB Home's actual results could be materially different from those expressed and/or implied by the forward-looking statements. Many of these risk factors are identified in KB Home's filings with the SEC, which the company urges you to read with care.

The discussions today may also include references to non-GAAP financial measures as defined in Regulation G. The reconciliation of these non-GAAP financial measures are the most -- to the most directly comparable GAAP financial measures and other Regulation G required information is provided in the company's earnings release issued earlier today, which is posted on the Investor Relations page of the company's website under New Releases on the left-hand side of the page.

I will now turn the conference over to the company's President and Chief Executive Officer, Mr. Jeff Mezger. Sir, you may begin.

Jeffrey T. Mezger

Thank you, Sarah, and good morning everyone. Thank you for joining us today for a review of our fourth quarter and full year 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.

During today's call, I will begin with a review of financial and operational highlights of our fourth quarter, then provide a brief overview of current housing market conditions, followed by an update on the significant progress we have made and position our company for profitability and long-term strategic growth. Then, Jeff Kaminski will take you through our detailed financial results after which, I will make a few final remarks before we open up the call for your questions.

Let me begin by saying that we are pleased with the results we've achieved in repositioning our company. Our efforts culminated in the fourth quarter, where we once again generated improvement in most of our key financial metrics. We grew revenues by 20%, increased gross margins and significantly reduced our SG&A ratio, the combination of which drove improved operating income and internal profit that resulted in reported earnings per share for the quarter of $0.10.

These solid improvements are the direct result of the decisive actions we have taken over the course of the past few years, where we have leveraged various components of our business model, driving strategy and gaining efficiency with the goal of restoring profitability.

Earlier this year, during our first quarter earnings call, we walked through the 2012 roadmap to profitability and the respective performance targets we were pursuing. When it became clear that we were on track to achieve our targets, we expanded our objectives to the dual focus of not only enhancing profits but also aggressively growing our top line. This growth strategy was outlined on our second quarter earnings call, where I declared that we are Going on Offense. We are doing very well in driving our growth initiatives, and I will provide an update on our progress in this regard in a few moments.

We're enthusiastic about the momentum we have created in both profitability and growth as we enter our new fiscal year. Our quarter end backlog value increased by 35% year-over-year, with $619 million in future revenues, the highest year-end level since 2007. This has us well positioned to continue to generate revenue growth in each quarter of 2013.

While we are pleased with our position entering the new year, we recognized that we have to continue to enhance our results in order to achieve normalized profit margins. In particular, one of our highest priorities is to continue to elevate our gross margin, which fell below our expectation in the fourth quarter. We have undertaken a number of steps to address this shortfall and are already seeing favorable impact of these actions. We expect to continue to expand our gross margins further going forward. That being said, as we sit here today, we are positioned to be profitable for the full year in 2013.

The national economy continues its gradual improvement with moderate job growth and slowly increasing consumer confidence. The housing markets are also strengthening, and new demand is now being created due to increased urgency to take advantage of incredible affordability as prices are now on the rise. At the same time, with rental rates having risen materially to their current levels, the out-of-pocket expense for homeownership is actually lower than rent in most markets. Further, household formation is once again growing, as millennials are now starting to leave their parents' homes and move out on their own as the economy improves.

While there's been a few years in the making, housing is becoming a bright spot for the economy, and the industry is once again positioned to play its historical role of being a job creator and leading the national economy into a full recovery. All of our served markets are experiencing positive recovery trends to varying degrees.

As I mentioned on our last call, the strength of the coastal California markets at that time was starting to expand inland. This dynamic has actually gained momentum this quarter, with resale inventory levels in many of the most desirable inland submarkets now measured in weeks of supply, not months.

You may have seen the release that was issued yesterday by the California Association of Realtors reporting on November sales and pricing. The report states that, "Year-to-year, statewide median prices were up 24.8% in November, marking the ninth consecutive month of annual price increases and the fifth consecutive month of double-digit annual gains." This increase occurred on volume of over 518,000 sales.

Within the counties where we operate, the year-to-year increase in Southern California range from a low of 12.4% to a high of 19.8%, and in Northern California the increase was more dramatic, ranging from a low of 18% to a high of 21.3%. We're really encouraged by the strength of these ongoing trends in a state where we have our largest business.

While the housing markets are definitely improving over the prior year, I do want to point out that 2011 was the worst year on record for new home sales, so the improvement we are experiencing is still well below normal activity levels. We are in the early innings of this recovery and with a more limited competitive playing field, we believe we have significant upside as the recovery continues to advance beyond today's volumes.

Now let's take a closer look at our sales results for the quarter. Our net order value grew year-over-year by 25% in the fourth quarter. This growth was accomplished against a very high bar set in the previous year, when we grew our year-over-year order value by 65%. In essence, we have more than doubled our order value this quarter versus the fourth quarter of 2010.

Our unit orders were up 4%, also against a very tough comp in 2011 that was up 38% over the prior year. As we guided last quarter, we expected that a positive sales comp would be difficult to achieve in the fourth quarter due to a temporary reduction in open communities as we sold through more communities, many of them underperformers, than we were now opening. We are pleased with the fact that we actually generated the positive unit and significant revenue comp in light of the fact that our year-end community count was down by 18% or 43 communities. We grew our sales per community by 23% in the quarter versus last year. Traffic levels remain strong, buyers are demonstrating urgency, and new homes have become the product of choice for homebuyers.

Growing our community count to further drive revenue growth remains one of our top priorities. And with our Going on Offense initiatives gaining traction, we expect to grow our community count sequentially each quarter in 2013.

Our average sales price continues to decline to nearly $271,000 for our fourth quarter deliveries. This average sales price is 14% above the fourth quarter of 2011 and results in our average sales price for the year settling at $247,000. This increase is primarily attributable to our strategy of investing in highly desirable, land-constrained submarkets and offering larger square footage homes. These locations are attracting higher-income consumers who are selecting these larger homes and, in turn, investing in more structural options.

Let me reiterate a critical point that is absolutely linked to this geographic and product evolution. We remain committed to our core first-time buyer niche. In the locations where we are now opening communities, it is a different type of first-time buyer, with a higher household income and a far better ability to obtain a mortgage in today's underwriting environment. For the fourth quarter, 61% of our deliveries were to first-time buyers, even with the significant increase in our average sales price. This strategy is working effectively in all of our operating regions and in particular, is having a desired impact in California. For the year, our average selling price in California was up 16% or $53,000.

As I discussed during my opening comments, fiscal 2012 proved to be a significant transition year for KB Home as we achieved the crossover from a total focus on restoring profitability to a dual focus on enhancing profitability and pursuing growth. With profitability in sight, we made a deliberate decision to implement our Going on Offense initiative.

Let me recap the 4 key elements of this plan: First, we introduced an aggressive land acquisition strategy; second, we activated communities which had previously been held for future development; third, we implemented an intensive weekly review of sales results per community with senior management participation that had a focus on actions to optimize each community sales pace, price and margin; fourth, we bolstered our division management teams to provide additional resources in large geographies identified for accelerated growth. We are very pleased with the tangible results produced by our growth initiatives and the momentum we have created in this area will be sustained. I'd like to share a few highlights.

During the second half of the year, we successfully increased our investment in land and land development to $369 million, which is more than double what we spent in the second half of 2011. We have the lots in place to achieve our deliveries, revenue and profit goals for 2013 and while we are now concentrating on 2014 and beyond, we continue to seek out opportunities to purchase finished lots, which can be opened for sale quickly and possibly converted into additional revenue in late 2013.

One of the strengths of our KBnxt business model is our ability to utilize our existing product lines and promptly move from land acquisition to open models, and in turn deliveries in a period of 6 months or less. We intend to continue our aggressive land investment strategy going forward.

In fact, in early December, we closed on 2 very exciting coastal California communities. The first was in San Marcos, a highly desirable suburb of San Diego where we acquired finished lots, expect to start models next week and plan to grand open from finished models in February and, in turn, deliver homes in the second half of 2013. This is a great example of our ability to move from acquiring finished lots to generating revenues in a relatively short period of time.

The second acquisition, announced earlier this month in the media, was for land to be developed in the 2 product lines at Playa Vista on the west side of Los Angeles. This highly acclaimed urban master-planned community is arguably located in one of the most vibrant and land-constrained areas in the country. This purchase illustrates one of the real strengths of our company; the ability to acquire property in land-constrained environments by leveraging our excellent, long-standing relationships and market expertise at a local level. As a result of these 4 growth initiatives, we are positioned to not only be profitable in 2013 but also to drive significant growth in 2013 and beyond.

Now, I'll turn the call over to Jeff Kaminski, who will offer the details on our financials for the quarter and year. Jeff?

Jeff J. Kaminski

Thank you, Jeff, and good morning. Our fourth quarter results reflect the continuation of the progress that we have made in improving our operations on our path to sustained profitable growth. We believe this progress, including sequential and year-over-year improvement in our operating results in each quarter of 2012, along with the net income generated in the second half of the year, sets us up well for our 2013 goal of full year profitability.

I am now pleased to provide you with some more detail on our fourth quarter, as well as the full year financial results. For the fourth quarter of 2012, we achieved a net income of $7.7 million or $0.10 per diluted share, as compared to net income of $13.9 million or $0.18 per share for the same period of the prior year. The fourth quarter of 2011 included a financial services gain of $19.8 million and a gain on loan guarantee of $6.6 million. Excluding these items, the current year Q4 net income improved by over $20 million or $0.26 per share as compared to the same quarter in 2011.

Total revenues for the fourth quarter were $578 million, a 20% increase over the $480 million we reported in the same period of the prior year. Our revenue growth resulted from both the increases in home delivered -- homes delivered, as well as higher average selling prices.

Housing revenues, as compared to the fourth quarter in 2011, increased in 3 of our 4 geographic regions. The majority of the total company increase was attributable to the strong performance of our West Coast region, which was up $75 million or 32%. On a sequential basis, our revenues increased in all 4 regions and in total, we were up by 36% in the current quarter as compared to Q3, slightly exceeding the guidance communicated during our second quarter call.

As Jeff already discussed, the overall average-selling price of our homes delivered during the fourth quarter increased significantly to nearly $271,000. The year-over-year increase of approximately $32,000 or 14% was driven by our land strategy of investing in desirable submarkets where higher-income, first-time homebuyers are selecting larger homes with more studio options. We were also helped by improvements in overall market conditions across all 4 of our geographic regions. This marks the 10th consecutive quarter of year-over-year increases in our overall average selling price.

On a sequential basis, average selling price increased by nearly $26,000 or 10% versus the third quarter of 2012. For the full year, the average selling price of homes delivered was about $247,000, a favorable result relative to the guidance provided since the first quarter of the year.

During our 2013 fiscal year, we anticipate that we will continue our streak of year-over-year increases in our quarterly average selling price, although the first quarter will likely reflect a modest sequential decline versus Q4 of 2012 due to geographic mix.

Our housing gross profit margin for the fourth quarter was 14.2% compared to the 14.7% reported for the same quarter of 2011. The quarter includes $5.6 million of inventory impairment and land option contract abandonment charges and a $2.6 million charge for water intrusion repairs at certain of our communities in Florida. Our fourth quarter 2011 housing gross profit included $2.3 million of inventory-related charges.

Excluding impairment and land option contract abandonment charges, the fourth quarter housing gross profit margin was 15.2% compared to 15.1% in the fourth quarter of 2011. As a reminder, in analyzing sequential improvement, our third quarter gross profit margin included $16.5 million of favorable insurance reimbursement, as well as $6.4 million of inventory impairments.

A relatively flat year-over-year gross margin performance, excluding inventory-related charges, was unanticipated as we expected sequential and year-over-year improvements. The current period water intrusion repair charge was clearly not expected, and we experienced slightly higher increases in labor and material costs than what we've projected. While we were able to offset these labor and material increases through pricing, in combination with the repair charge, they prevented us from fully realizing the net improvements in gross profit margin anticipated from the impacts of community and geographic mix, volume leverage and pricing.

One of the highlights of the quarter was the progress in our SG&A ratio, which strongly contributed to our operating margin improvement for both the fourth quarter and the full year. We continued our diligence and focus on cost containment during the fourth quarter, while at the same time implementing division resource enhancements as part of our Going on Offense strategy.

Our selling, general and administrative expenses were approximately $66 million in the fourth quarter of 2012 compared to roughly $75 million in the same quarter of 2011. This $9 million expense reduction was achieved in spite of an additional $99 million increase in housing revenues. In percentage terms, we are able to reduce our Q4 SG&A expenses by 12% as compared to a 21% rise in housing revenues.

Sequentially, versus Q3 2012, we contained the expense increase to only 5% as compared to a 36% revenue increase. Clearly, we have been able to leverage our operating structure and are seeing the benefits of the expense reduction actions taken over the past several years as we contain costs while increasing revenues. As we guided on our last call, we expect that a year-over-year improvement in our fourth quarter SG&A expense, as a percentage of housing revenues, as well as a sequential reduction. In fact, the Q4 2012 ratio was 11.5%, the lowest fourth quarter level since 2007.

Our operating income for the quarter increased to $15.6 million compared to $835,000 in the fourth quarter of 2011. Operating income as a percentage of homebuilding revenues for the fourth quarter improved 250 basis points to 2.7% compared to 0.2% for Q4 of 2011. We have reported year-over-year and sequential improvements in our operating results for each quarter of 2012, and expect to continue this trend during 2013.

We ended the year with 191 communities opened for sale. As Jeff has already discussed, this represents an 18% decline from the 234 communities at the end of fiscal 2011. As you may be aware, we currently consider a community that has one or more lots left to sell at the end of the quarter as an open community. We are currently reviewing this definition and are considering revising the threshold to 5 lots left to sell to improve consistency with the rest of the peer group when comparing absorption rates.

During the fourth quarter, we opened 18 new communities and had 30 closeouts, and we are planning to open more than 120 communities in 2013. We continue to anticipate that our community count will increase sequentially for each quarter during 2013, more heavily weighted towards the second half of the year, as our land acquisitions and development activities convert into open communities. Depending on absorption rates and the resulting pace of closeouts, we believe we can increase our community count by a minimum of 15% to 20% by the fourth quarter of next year.

We invested approximately $182 million in land acquisitions and development during the fourth quarter. Our total investment for the fiscal year, including land acquisitions partially funded by seller financing, was approximately $565 million. This exceeds the guidance communicated during our second and third quarter calls of $550 million, as we were able to act quickly and opportunistically to secure additional land during the quarter.

We generated positive operating cash flow of over $110 million during the fourth quarter, net of the $182 million of land acquisition and development spending just discussed. This compares to a cash usage of almost $38 million in the prior-year quarter, with land-related spending of $63 million. For the 2012 fiscal year, our operating cash flow improved by $382 million compared to the prior year. Our strong fourth quarter and full year cash flow performance enabled us to increase our total cash to $567 million at year end.

Our preferred mortgage relationship with Nationstar continues to have positive effects on our business with reduced cancellations, better predictability of deliveries and a more favorable experience for our customers. As we discussed on previous calls, we have seen sequential increases in their sales capture rates throughout the startup period, and they are on track to hit the 70% goal. We expect to realize more of these benefits from the increase in the percentage of closings handled by Nationstar as we deliver year-end units and backlog during fiscal 2013.

While we are committed to further improvements in our financial performance and remain focused on a number of key profitability and growth-related initiatives, we are pleased with the progress we made during the 2012 fiscal year. Our strategy has resulted in improvements in most of our financial metrics across our operating footprint. For the full year, we reported a net loss of $59 million or $0.76 per diluted share, a significant improvement of nearly $120 million over our 2011 fiscal year net loss of approximately $179 million or $2.32 per share. Revenues for the year were up 19% to $1.56 billion as compared to $1.32 billion for 2011.

In 2012, we improved our operating margin by 660 basis points compared to the prior year and on an adjusted basis, we achieved the lower end of our 400 to 500 basis point improvement goal. Finally, we reported positive net profit in each of the last 2 quarters and significantly enhanced our debt maturity profile with 2 successful capital market transactions, refinancing nearly $600 million of senior notes.

We look forward to driving continued improvements of our financial performance during the coming year as we focus on achieving profitable growth.

Now I will turn the call back over to Jeff for some final remarks.

Jeffrey T. Mezger

Thanks, Jeff. Before I make my concluding comments, I would like to acknowledge and thank the team of enthusiastic and talented employees of KB Home, who are the driving force behind our ability to deliver on our commitments and continue to propel our business forward.

As Jeff and I have shared today, KB Home accomplished many objectives in 2012 that advanced our business, and we are now positioned for full year profitably in 2013 and beyond. At the same time, we remain relentless in our focus on further enhancing our financial results. We now have a fully articulated growth strategy in place and expect to grow our communities each quarter in 2013.

The combination of adding more communities, coupled with one of the highest sales rates per community in the industry and an increasing average sales price as a result of our investment strategy, provides an opportunity to generate meaningful revenue growth as we move forward.

KB Home continues to provide a compelling value proposition for our customers. Our Built to Order process allows our buyers to select the home they want to be built on the lot they desire and only include the structural and decor options that meet their lifestyle and their needs. This is a critical and positive differentiator for our company.

Another key differentiator is the significant benefit our consumers can realize in reducing the total cost of homeownership as they take advantage of lower utility bills as a result of our industry-leading energy-efficiency innovations.

Our ability to produce predictable deliveries and also to realize the cost savings of even-flow production in our Built to Order model is predicated on having a reliable mortgage support. With the Nationstar alliance, we once again have a solid partner whose goals in servicing the customer are aligned with ours. As Nationstar serves more and more of our customers, we expect that going forward we will be able to sell more homes, reduce cancellations, have more predictable start and delivery dates and improve customer satisfaction levels. All of these benefits should result in improvements to our bottom line.

Furthermore, while many companies will participate in the overall recovery in housing, we feel KB Home's market positioning and industry expertise is a distinct competitive advantage. We like our geographic footprint as all of our markets are strengthening today. And they are all also projected to experience favorable, long-term job growth, economic expansion and population growth. In particular, we like our position in California, which accounted for nearly half of our 2012 revenues and where we are the largest homebuilder today. California's large population base with diverse economies and a desirable climate and lifestyle is once again experiencing significant demand and limited supply, and we intend to capitalize on the opportunity.

We are entering the new fiscal year with momentum and strength. As the housing markets continue to recover, we are positioned in the right markets and focused on the deepest buyer segments where demand is highest. We expect to continue our progress on improving our financial and operational results. With profitability in place and our growth strategies gaining momentum, we look forward to sharing continued positive results as 2013 unfolds.

Now we'll be happy to take your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Michael Rehaut from JPMorgan.

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

First question I had was on the gross margins. You mentioned that they fell a little bit below your expectations but at the same time, I believe the water intrusion charges were about 60 bps of a hit. So excluding that with 15.7% margin, that does seem like some improvement. So I'm wondering, number one, if that margin was closer to your expectations, the 15.7%, what were the key drivers of that improvement? And as you look into 2013, what would be the drivers of additional improvement? In particular, I'm thinking of the new communities coming online and if the underwriting of those communities have more favorable margins?

Jeffrey T. Mezger

Mike, as always, you ask more than one question there. But the gross margin result, there's always a combination of many small items that will impact and influence that number. And we did have a higher expectation than the one you just shared in our own plans. And my expectation is that we're not happy until we get back to full gross margins. So we have many, many different actions in play right now to continue to elevate this. And as we shared in our prepared comments, we expect to grow our gross margin going forward. So we're nowhere near done with where we want to get to. Jeff can share some of the specifics with you.

Jeff J. Kaminski

Yes, Mike. As Jeff said, we were slightly disappointed with the results in the gross margin percentage, but we were happy that we had some upside in our SG&A expense to keep our operating margin closer to target for the quarter. Talking about gross margin for a second, 2 main issues in the quarter that each one of them impacted the overall by 50 to 60 basis points. First, as you mentioned, the charge for water intrusion in Florida was $2.6 million. In some respects, I mean, you can look at that as a bit of an offset to the upside that we had earlier in the year. We made some warranty accrual adjustments early in the year. This was not a warranty, but it was somewhat related to that. We don't like it, but we did have some issues that came to light in the quarter. We think we took very quick and decisive actions to address those issues and fix problems for our homeowners, so that was one thing that we hope is behind us now. Secondly, we did see some cost increases for labor and materials that impacted us by about 50 basis points more than what we had anticipated. We are still seeing some price pressures on labor and some of the materials in various markets around the country. On the other side of that, we have put actions in place and currently have a company-wide initiative underway to contain and potentially reduce construction costs as we move forward. We're launching projects to offset the risk of additional negatives as we start building homes in 2013, and we're very aggressively moving to successfully implement these actions and secure a plan for expanding gross margin in the coming fiscal year. I think it's also important to point out that despite the negative impact on the margin improvement for the quarter, we were still able to offset the overall labor and material increases that we experienced with pricing. We had a cost impact of about $5,000 per delivery, and we believe we are north of that with our price increases. And speaking of pricing, just to talk about it just for a second, we did see a nice trend this year. We reported early in the year that we successfully implemented price increases across our divisions in various communities during the first and second quarters in about 2/3 of our communities. And during the third quarter, this number increased about 75% of our communities. And we were up to almost 85% of our communities in Q4. And like I said, the increases more than offset the actuals. I'm now talking about drivers for the future. You kind of asked about '13 a little bit. We do believe the continued pricing actions that we took throughout the year will be realized as we get into 2014, as we have -- or 2013, excuse me, as we have a lot of those booked in our backlog for orders placed in Q3 and Q4, the construction cost containment or reduction opportunities I talked about. We are underwriting new land deals in better submarkets, targeted to higher first time -- higher income first-time buyers. We hope that higher square footage strength continues, as well as the studio option trends that we're seeing. We hope to get volume leverage. I think we'll certainly get volume leverage as the revenues continue to increase. We do believe Nationstar and our mortgage partner situation, which is now in firm footing, will provide more consistency with our closings and we'll see fewer cancellations after start with that arrangement. And we also, and I think very importantly a strong leading indicator of future improvement, we are seeing steady increases in both dollar and percentage margins for units in backlog. So to sum it up, we do a very spot focus on it, on margin improvement as a company. I believe directionally, we'll have improving margins on a year-over-year basis in '13. We do typically experience, and I'm sure you're aware, we do typically experience and anticipate a sequential dip in Q1 gross margin versus Q4 due mainly to the lower deliveries and the resulting loss of leverage on certain fixed costs, so we do include our margin. So however, we do believe on a full-year basis we'll have a favorable year-over-year comp for the quarter, as well as for the full year, adjusting out any unusual items out of both periods.

Michael Jason Rehaut - JP Morgan Chase & Co, Research Division

Great. That was a really comprehensive answer. I appreciate it, given I had a lot of parts to that question. One topic, but I guess several parts of that question. Secondly, just on the ASPs, great improvement on that throughout the year. Any thoughts in terms of rough idea, at least for a range perhaps of what you would expect the average closing ASP to be for fiscal '13?

Jeffrey T. Mezger

Michael, we're not going to give guidance today on '13. We did share that we expect our average sales price to continue to go up. And as Jeff referenced, with the sales price increases that we were able to recognize last year covered some cost increases, I'd much rather raise margin through lowering cost and not rely on a sales price increase. Having said that, we continue to push price wherever we can. One of the action plans that we deployed in our growth strategy was these weekly calls. And we will review our sales pace and ensure that we have an optimal pace. If we're selling too fast, we slow it down by pushing price, because gross margin’s our top priority. And if something is not selling at the pace we need, we'll take steps to go improve the sales. I think that's one of the key drivers also in our prices moving up. So all in next year we expect our ASP to continue to increase, but we're not going to give guidance to a degree right now.

Operator

Your next question comes from the line of Dan Oppenheim from Credit Suisse.

Daniel Oppenheim - Crédit Suisse AG, Research Division

I was wondering as it relates in terms of thinking about selling prices margins as well. Given the -- you talked about community count growth for 2013 and the substantial land investment taking place, how do you think about the number of communities that will be coming online in the West [indiscernible] regions in '13? What do you expect the mix to be over the course of the year? But more importantly, what's your desired mix in terms of what a target would be if you could target something there?

Jeffrey T. Mezger

Dan, I'm not sure I understood the question. A target for what percentage?

Daniel Oppenheim - Crédit Suisse AG, Research Division

Thinking about the communities that are coming online, how many -- how -- what's the percentage overall over the course of the year will end up being in the West in terms of communities? And you talked about the significant land investment in the West, California and then also some in Texas. What would be desired in terms of the mix of communities in which we think about in terms of 2013?

Jeffrey T. Mezger

Well, one of the things that we've also evolved in, Dan, if you recall, 2 years ago we were investing primarily and heavily in California first and then also in Texas, our 2 largest markets. As we went on offense early this year, we opened up our investment strategy to desirable submarkets in every city. When you talk about dollars invested, it's a different topic than lot count or community count because the dollars in California are much larger per lot and they’re also typically, if it's in an A location, it's not going to be anywhere near the lot counts you can acquire in a Houston community for a lot less dollars. So we have a strategy in every city for growth targets and community count ramp-up. And in no city are we viewing it as hey, we've got too much today. So our position right now is there's opportunity in every market, we'll continue to push them all. Even in '12, the investment was heavily weighted to California and Texas, but more evenly distributed than prior years. And so we'll keep pushing it. I don't know that we've said we want this percent in this city and this percent over there. It's more or less grow everywhere right now.

Daniel Oppenheim - Crédit Suisse AG, Research Division

Got it. Okay. And then just thinking about, you talked about the city options and such. How much is coming through in terms of the C options? How do you think about that in terms of just the margins on that and the trends that you've been seeing there as of late?

Jeffrey T. Mezger

I can let Jeff give you whatever numbers he has here today. Our first -- the first item for the studio was to help us sell houses. We do not start with the studio as a big profit center. We do make money in the studios. But first and foremost, it helps us sell houses. And in the cities where we have a fully loaded studio, many of the customers visit the studio before they buy the home, so it's part of the selling process. As we've gone to larger homes, higher price points, the percent of revenue that they're spending is holding. So all in, they're spending more dollars. I don't know if you have a breakout with you, Jeff.

Jeff J. Kaminski

Yes, it's about 10%.

Jeffrey T. Mezger

Yes. About 10%. So it's in our historical range, Dan, but as your ASP goes up and -- so it's same size homes, so it's a higher ASP. They're spending a little bit more.

Jeff J. Kaminski

Just to add to that, just for a second, Dan. As Jeff mentioned, it's primarily a sales tool for us and a differentiator. However, on the margin side, our average margins in this geo do tend higher than our housing margins. So it provides a small increase, I guess, on an overall basis, which obviously we like. But more importantly, it provides choice to the customers in a sales differentiation point for us.

Jeffrey T. Mezger

I've shared on previous calls, our pricing strategy in the studio is after overhead still accretive to the base margin on the home. So it covers its own overhead and then is accretive.

Operator

Your next question comes from the line of Stephen Kim from Barclays.

Stephen Kim - Barclays Capital, Research Division

First question relates to -- well actually before I get to my question, I just wanted to see if you could provide, from a housekeeping perspective, the homes under construction numbers, basically the inventory breakout if you've got that. First question I had for you, Jeff, was, Jeff Mezger, was a comment about the buyer that you're seeing today being a different kind of first-time buyer. This is something that I think folks that look at you -- at the industry kind of wonder if we look out over the next couple of years and the mortgage market does open up to something a little more normal, does this mean that the average price that we should be modeling in will come down by virtue of reversing that unusual mix shift? And the reason why I'm asking you the question is because I believe that you obviously are positioning your company in terms of the communities that you're planning to open over the next couple of years, with a certain price point in mind and a certain type of product. So the question that I'm asking specifically is, do you believe that as the mortgage market opens up, that the more typical first-time buyer will be additive to your sales volume, and that you will still continue to have the sort of higher-quality first-time buyer in addition? Or do you believe that we are probably working through a limited supply of these higher-quality first-time buyers, and that, that will be supplanted or replaced by a more typical first-time buyer who's buying a more affordable house?

Jeffrey T. Mezger

Well, Steve, that's a great question. And we're certainly -- we have not tapped out the higher-income first-time buyer. There's a lot of them out there. And when I say our buyer is different today, we've been able to flex our business model and take our product lines to higher-priced submarkets. And if you look at an Orange County, California or a Bay Area, even parts of Houston, we have first-time buyers that make over $100,000. These people are -- they have good jobs. They make good money. They have great credit. In a lot of cases, they sat on the sidelines through the frenzy when prices run up so fast, and now they're able to buy in better locations at a much lower price than they would have back in '06 or '07. So they're moving to a great location and can afford, frankly in a lot of cases, more house than they're buying. So it's a nice niche that we've, in an odd way, kind of had to go find because underwriting remains tight. And I would -- just a hunch, but I'll bet that the lower half of the first-time buyer pool has been taken out of the market right now because of underwriting being so tight. I shared in my comments, we remain committed to that niche. And I do expect, as underwriting normalizes over time, that we can flex -- we'll hold their current business because it's a great business and we're executing well on it. But we'll hold that business scale and add to it by going back out to different communities at a lower price point, because there's a lot of demand and you can make a great return on investment there as well. Depending on the volume mix between those 2 components, it could conceivably lower price. It wouldn't surprise me if it did, but you would be raising your margins and your returns along the way because it's a very good business. So that could be. But as we sit here today, there are so many questions on underwriting and it has not loosened up. If anything, it has probably gotten a little tighter. So we will play where the business is. And it's a nice business for us right now.

Stephen Kim - Barclays Capital, Research Division

So just to paraphrase. Your hunch is that as we go forward, there's enough depth ongoing in the sort of higher-end, first-time buyer that when the lower-end, first-time buyer comes in, it will truly be additive, not a replacement. And that's essentially what you're thinking?

Jeffrey T. Mezger

Correctly. And it has to come back, Steve. And for the housing market to have a full and sustained recovery, you have to start with the true first-time buyer, not this upper-tier first-time buyer that we're catering to.

Operator

Your next question comes from the line of Anto Savarirajan from Goldman Sachs.

Anto Savarirajan - Goldman Sachs Group Inc., Research Division

My first question is given the robust price appreciation in many of your markets, I would be curious to hear your thoughts on how your underwriting criterion is evolving.

Jeffrey T. Mezger

Underwriting for investment?

Anto Savarirajan - Goldman Sachs Group Inc., Research Division

Yes, for land investment.

Jeffrey T. Mezger

We're not banking on inflation. It's part of our core investment guidelines. And it's a very interesting balance right now, because there is a frenzy going on especially in the most desirable submarkets, where land prices, as always, go up faster than home prices as the market starts to recover. And we're staying disciplined to, you don't underwrite to inflation and you have to hit the combination of IRR and margin that we've set. And it's a nice balance because it's a built-in governor where you don't just run out and buy everything that's out there because you can. You have to stay disciplined on your strategy, disciplined on the price point and the income of the consumer. And we've been able to find opportunities in every marketplace today. So as prices go up, you would have to reset what you could pay for a lot in that submarket, but we wouldn't bank on additional price. That's a dangerous game.

Anto Savarirajan - Goldman Sachs Group Inc., Research Division

Understood. My next question, it's been interesting to see that your inventory balance in the 0- to 2-year bucket has been growing over the year. Post your 4Q land spend, can you update us on where that bucket would now stand?

Jeff J. Kaminski

Yes, I'll address that a little bit. The chart -- you're referring to the chart in the Q or in the K?

Jeffrey T. Mezger

I'm asking a question. And we're going to have to guess at what you're asking. It sounds like you dropped off the call. If you're talking about the chart in the K or the Q, that does vary a fair amount every quarter. It's based on final closeout deliveries in the community, and that's the way we age it in the chart. So it's -- while it's insightful to a degree, it moves around quite a bit depending on sales rates and staff at communities and lots left. And I guess just one other housekeeping item before we get back to the general Q&A, sorry about that Stephen, it sounded like you had dropped as well. The homes under construction, the dollar amount there at the end of the quarter is roughly $450 million. So hopefully, that addresses your question. If not, we can follow up later after the call.

Operator

Your next question comes from the line of Ivy Zelman from Zelman & Associates.

Ivy Lynne Zelman - Zelman & Associates, LLC

With respect to the community count, can you just clarify, Jeff, either one of you, the year-over-year growth, we understand your expectations significantly increased. But can you talk about the actual, which quarter we should start to see year-over-year growth commence. Because it appears, just looking at the numbers, you began the year with -- in 2012, you began the year with 234, you're now at 191, so it would appear that your significant growth in '13 but it looks like at least the beginning portion of the year, you should be down year-over-year continuing, is that correct? My first question, if I could have a follow-up, please.

Jeffrey T. Mezger

Ivy, I'll let Jeff give you the numbers. But in the comments, we've referred to sequential improvement each quarter going forward, so we'll see how -- depends on what we close out and what we open in Q1. But the comment was sequential from here running up through the year. And Jeff can share some of the numbers with you.

Jeff J. Kaminski

Right, right. Right, Ivy, yes, we did say it's back-end loaded, so you're accurate in your review on the numbers. We do expect to open about 55 communities within the first 6 months of the year, within the first 2 quarters, so depending on level of closeouts, we'll have a various comp to prior year. But we are rebuilding the community count. And as we said, the growth in actual year-over-year would be more back-end loaded but the sequential improvements...

Ivy Lynne Zelman - Zelman & Associates, LLC

No, no, that's helpful. That's exactly what we just wanted to clarify. Sorry, to interrupt. I was scared about getting cut off. But my second question related to your prior comments to the analyst asking about your Q disclosure. There are portions of that Q disclosure that's very helpful and it provides great transparency. Your peers should look at that or competitors, I should say.

Jeffrey T. Mezger

We agree.

Ivy Lynne Zelman - Zelman & Associates, LLC

With respect to the -- you have in there that 35% of the inventory is now expected to deliver homes for at least 6 years, and 10% is not expected to generate returns for more than a decade. Can you tell us where that land is? How much is Inspirada? What, if anything, do you think that you can do to accelerate returns on these communities? And are these long time lines due to the fact that they can't generate acceptable margins. Just help us understand it because that's actually the best disclosure we've seen, but we’d like some more clarity, please.

Jeff J. Kaminski

Right. No, I'm glad you're asking that, Ivy. The disclosure is -- I mean, there was a couple of ways we could have gone about it, and one way was based on first delivery and bucketed by time horizon based on first delivery, and the second way was based on last delivery. We took the more conservative, so we bucketed the disclosure based on last delivery. And what that gives you is really a very, very conservative look at the land. So if you had, for example, a large land position, Inspirada’s a great example or anything where you had multiyear lot supply, it shows up in the buckets in the disclosure in the latest possible period of last delivery. So if you had an asset that you thought was going to last 7 years, for example, and your last delivery was 7 years out, the full balance is shown on that 7-year bucket or in the category that includes a 7-year bucket. So it's a very conservative disclosure. We think it is somewhat insightful, but it does move around quite a bit based on absorption rates inside the community.

Ivy Lynne Zelman - Zelman & Associates, LLC

Is it geographically concentrated? Is that part or a big piece of that?

Jeff J. Kaminski

It's -- yes, it's right. It is a big piece because it's a large lot count, although that's actually classified in the joint venture. They're still outside of the inventory balance. So Inspirada hasn't even hit that yet, but there's other large parcels that are in that, that extend out...

Ivy Lynne Zelman - Zelman & Associates, LLC

Hey, if you're a leader, Jeff, which you are showing that you are in disclosure, maybe you can help us to at least geographical, if there's concentrations or percentages for the future Ks.

Jeffrey T. Mezger

Okay. We'll have a look at it, Ivy.

Operator

Your next question comes from the line of David Goldberg from UBS.

David Goldberg - UBS Investment Bank, Research Division

My first question, I want to go back to the conversation about the design studios and the design studios being a tool to help accelerate sales. And I think given the environment that we've been in the last 4, 5 years, that makes a lot of sense trying to capture more customers. What I'm trying to get an idea of is would you guys think about kind of repositioning the strategy there to make that more of a margin leader, given that it really is a big differentiator between you and the competitors. And you are hitting a higher-end kind of first-time buyer that maybe has more borrowing capacity. Would you think about trying to make that a tool that would drive margin as you look forward into that recovery? And what would kind of drive you to do so?

Jeffrey T. Mezger

David, we did that in the run-up. Once you're above normalized margins and holding your sales pace, that's one of the places you can go to lift margins further. But at this time, I would rather use it to sell houses and lift the margin on the base home, because it's been a very predictable margin and the studio can move -- sales can move around on you, where versus a home sale is a home sale. And I think if you tie it to my observation that we've always had just about every quarter, one of the highest sales paces per community in the industry, we think one of the reasons for that is the studio process. I'd rather have predicable margin in the base home, use it to sell houses. It is accretive to margin. Don't think that it's an anchor. It's just not the profit center. And if the profits on the core home sell a lot of houses, it -- hold your pace, lift the normal margins and then you go tweak things a little more. But in the short run, we'd rather get back to normal margins first.

David Goldberg - UBS Investment Bank, Research Division

Got it. And then as follow-up question. The water intrusion issue, it sounds like it was fairly geographically concentrated. Is this a subcontractor-based problem? Do you feel like you guys have properly reserved for it? Are there any kind of issues out there from a similar establishment like that? Or is it taken care of?

Jeffrey T. Mezger

I'll let Jeff talk to the financial side, David, but we had some issues in a couple of multi-family communities where there were some applications that weren't done right. You don't recognize the issue initially, it takes time to develop. And as it developed, we've gone back in, done the right thing and taken care of our customers. So we did incur the cost and we've booked an accrual for whatever the additional cost is projected to be. And once we've settled it all out and resolved things with our customer, we'll go back and collect whatever we can for whoever was accountable that we can go after.

Jeff J. Kaminski

Right, yes. As to do we think we had the right amount accrued at the end of the year, of course. We did a very careful analysis of it at year end. It was a large issue for us during the quarter, and there was a lot of resources placed on it. And we do think we have it properly accounted.

Operator

And your last question comes from the line of Nishu Sood from Deutsche Bank.

Rob Hansen - Deutsche Bank AG, Research Division

This is Rob Hansen on for Nishu. I just -- I wanted to see if you could talk a little bit about your impairments this year. Other than 2Q '11 last year, it's been kind of a noticeable increase. So are these impairments on any newly acquired land, or are these all kind of legacy issues? And what's the state of your watch list as it's shrinking?

Jeffrey T. Mezger

Now, the watch list is shrinking quite dramatically as the markets have been improving. The issue in the quarter was really predominantly one landholding with 2 product lines on it. So technically, it was kind of those 2 communities. With a community that's into a second phase and we had to make a decision whether to keep going with the community or to basically close it down and put it back in 'moth ball' status. It was a community that we have taken out of moth ball earlier in the year, and we actually took an impairment on the same community in the first quarter. It's generating a tremendous amount of cash per lot for us, and it was very close to the mark on even having the taken impairment. But we were seeing good pace. We're seeing good pricing development in that community. It was something that we wanted to continue to work through. And we made the business decision to continue to go through it and take the pain of the impairment in the quarter. But like I said, the earlier impairment, we sold through all those lots very successfully during the year, and that was a decision we'd wanted to make.

Rob Hansen - Deutsche Bank AG, Research Division

Okay. And then just on your cancellation rates. I know you had the issue with the mortgage company earlier this year. But on the back half of the year, it looks like that's been cleared up. But the cancellation rates have kind of remained kind of elevated where everybody else's has declined to more kind of normal levels. So I just wanted to see what's going on there. Any other factors we should be thinking about? And what you'd kind of -- where you expect that to kind of go next year?

Jeffrey T. Mezger

A couple of comments I can make, Rob. If you look at the can rate as a percent of backlog, it's continued to improve through the year. And while we've now gained momentum in our Nationstar integration and they're taking more of our customer's loan apps, we are still cleaning out whatever was in the backlog that was scattered around to the outside lenders. And they're approaching their capture rate that we targeted, and we'll continue to deliver at a higher percentage next year. We're continuing to have a decline in other lender's business, and that's where a lot of the can rate was again this quarter. So we expect that our can rate will go down next year from here. We would hope that it would because we'll have a more predictable business. Within the can rate, and I've shared this a lot, it's important to understand, we actually have 2 can rates: one is before start and one is after start. And once a buyer's told their loan’s approved and they have finalized at the studio, our can rate is significantly lower than it is on a home that hasn't been started yet. So while the can rate is still elevated in my view, and we're -- we expect it to come down some more after start, it's actually at historical levels again. It's pretty predictable, 10% or so, maybe a little over 10%. So we think you'll see it trend down a little bit more through the 2013.

Jeff J. Kaminski

That was it.

Jeffrey T. Mezger

Okay. Well thanks again, everyone, for joining us this morning. Have a happy holiday season and a happy new year. And we look forward to talking to you after first of the year. Thank you.

Operator

And this concludes today's conference call. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!