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Executives

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

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

Analysts

Robert C. Wetenhall - RBC Capital Markets, LLC, Research Division

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

Ivy Lynne Zelman - Zelman & Associates, LLC

Stephen S. Kim - Barclays Capital, Research Division

Eli Hackel - Goldman Sachs Group Inc., Research Division

Megan McGrath - MKM Partners LLC, Research Division

Joel Locker - FBN Securities, Inc., Research Division

Daniel Oppenheim - Crédit Suisse AG, Research Division

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

KB Home (KBH) Q3 2013 Earnings Call September 24, 2013 12:00 PM ET

Operator

Good morning. My name is Michelle, and I will be your conference operator today. And I would like to welcome everyone to the KB Home 2013 Third Quarter Earnings Conference Call. [Operator Instructions] 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, then open the line 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 a number of factors outside its control, including those identified in the SEC filings, the company's actual results could materially differ from those expressed and/or implied by the forward-looking statements.

A reconciliation of non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in the company's earning release issued earlier today and/or on the Investor Relations page of the company's website.

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

Jeffrey T. Mezger

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

I'd like to start off today's call with an overview of the significantly improved results we delivered in the third quarter, highlighted by our solid bottom line profit. We are now profitable over the first 9 months of our fiscal year, the first time we have achieved cumulative profits at this point of the year since 2006. We also have the backlog and gross margin in place to drive even stronger bottom line results in our fourth quarter. This momentum reflects the continued positive impact of the strategies we put in place to reposition our geographic footprint and product offerings, along with leveraging our business model to drive revenue growth and enhanced profitability.

Next, I'll review current market conditions and provide a few comments on how we believe we are well positioned for sustained improvement in our bottom line results, as we continue to navigate a housing market that is strengthening in its recovery. Jeff Kaminski will then take you through the details of our financial results. After which, I will wrap up our prepared remarks with a few observations about our positive momentum and expectations as we head into 2014.

As I mentioned, the significant improvements in our business results reinforce that our growth and profitability initiatives are playing out as we intended. While we grew revenues 51% in the first 9 months of this year, I am especially pleased with the continued progress in our housing gross margin, which at 18.2% for the quarter, continued our trajectory toward our stated goal of returning the gross margin levels in the low- to mid-20s. Between revenue growth and a continued focus on containing fixed cost, we are also leveraging our growth platform for significant SG&A ratio improvement along the way. For the third quarter, the combination of gross margin and SG&A improvements resulted in an operating income of $36 million.

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

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

As we continue to invest in growth and our community mix continues to evolve, and in order to sustain our favorable revenue and profit trajectory, we are maintaining a delicate balance among 3 interconnected components of this strategy: Optimizing the sales pace while maximizing margin and growing community count. The best and most critical example of this is the evolution of our California business over the past 18 months. In the third quarter, 66% of our California revenue came from our coastal divisions, which is a significant flip from where our mix has been historically. The difference in sales price and margin is considerable between the coastal and inland regions, in many cases more than double. And as a result, we have been able to generate significantly more revenue and profits on fewer units. In our third quarter, we delivered 14 additional units in California compared to the prior year, yet our revenue was up by approximately $60 million.

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

In this context, I would like to address our lower unit sales comp for the third quarter. Our approach to optimizing each community asset and our investment strategy favoring coastal California contributed to our significantly higher profits for the quarter, but it came with a reduction in unit sales caused by 2 interrelated factors. The first was the shift to a more coastal business and a related drop in community count in our inland regions. Specifically, for the quarter, our Inland California divisions had a combined year-over-year negative unit comp of 164 sales. But I was okay with this, because in the third quarter of last year, we sold through many communities in our Inland business where we booked unit sales that, frankly, had mediocre margins and the communities were intentionally not replaced until local market dynamics improved.

The second factor that impacted our California unit comp was the timing of new openings. We had 7 communities opened in August that had been delayed. And as a result, they contributed less than 1 month of sales to our quarterly totals. In these land constrained areas, finished lots are all but gone, and we are now acquiring more land that typically requires some level of entitlement and development, and both municipal processing and development times have extended. When these 7 communities opened, they all opened to a very favorable buyer response with pricing and gross margin well above projections, and all are expected to be strong contributors to our fourth quarter results. In addition to these 7 openings, we have 12 more community openings planned in the state for the fourth quarter.

In essence, this intentional shift to quality locations has resulted in significantly more profit for the company, along with revenue growth, albeit at lower unit volumes in the short term. We expect our community count in California to be about flat in the fourth quarter versus last year, and tilted toward slower absorbing coastal communities. As a result, we are projecting a negative unit comp but a positive sales value comp for California. Most importantly, we are projecting a significantly higher gross margin value from our fourth quarter sales versus last year. As the coastal markets has strengthened, demand and strong pricing power is spreading to the Inland areas, and we have recently been investing more aggressively in the most desirable submarkets of the Inland regions as well. With the investments we have already made, we anticipate our year-over-year community count in the state to increase in the first quarter of next year, and expect a positive unit sales comp for 2014.

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

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

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

Some who follow our company view KB Home as a builder catering primarily to first-time homebuyers. This is somewhat of a misconception that I would like to address. Our business philosophy is to focus on demand within the largest consumer segments of first-time and move-up buyers. We can flex up or down in square footage, features and price point, and our Built to Order approach appeals to consumers across the spectrum. Over the past 10 years, as we have endeavored to follow demand in a fluid and changing housing market, our first-time buyer mix has ranged from a low of 37% to a high of 78%. Today, we are appealing to many more experienced buyers who are drawn to our locations and appreciate the value of our Built to Order process. These experienced buyers also typically have an easier time qualifying for a mortgage. As a result, our percentage of first-time buyers was down in the third quarter to 54% from 67% just a year ago. The shift has been most pronounced in California, where first-time buyers now represent only 47% of our business.

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

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

Finally, a key factor driving our solid and growing profitability is our relentless focus on cost containment while leveraging our growth platform. We feel we have a significant opportunity to grow the top line with our current platform without expanding to new geography. As a result of our success in this area, in the first 9 months of 2013, we grew home building revenues by approximately $500 million while increasing our SG&A expenses by only $19 million. This is a great illustration of the potential of our operating leverage.

Before I turn to a discussion of our land investments, let me take a moment to comment on the contribution of our mortgage partner, Nationstar. Nationstar continues to gain traction and is having a very positive impact on the predictability of deliveries and the home buying experience for our customers. We are on track with the regulatory approval process for our jointly owned Home Community Mortgage. And when deployed, will further strengthen our alliance while also providing a positive financial benefit. In addition to accelerating revenue and enhancing profit per unit, our third strategic initiative is investing in future growth. We have now invested $890 million in land and land development through the first 9 months of the year and are on pace to spend about $1.2 billion for the full year. This will be more than double what we spent in 2012. As of August 31, our lots owned and controlled is about 56,000, an increase of 25% since the end of last year.

We continue to find investment opportunities in all of our markets that are aligned with our growth and product strategies and meet our financial hurdles. At the same time, we have many assets in our balance sheet that we continue to put to work. I'd like to tell you about one in particular. You may have seen the news out of Las Vegas regarding the Inspirada master plan, where the Henderson City Council approved our development agreement. We are working to complete the final steps in the approval and documentation process and are hopeful, a full resolution around the end of the year. It is our expectation that once Inspirada comes fully online, we can support 5 to 6 open communities and up to 400 deliveries per year going forward. Land values in Las Vegas have gone up significantly over the last few years, and Inspirada has become a real crown jewel for KB Home.

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

Jeff J. Kaminski

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

For the third quarter of 2013, our net income grew to $27.3 million, or $0.30 per diluted share, representing a significant improvement as compared to the prior-year period. The improvement in our bottom line was driven by a combination of higher revenues from increased deliveries and higher average selling prices, continued significant progress in expanding our gross profit margin and a lower SG&A expense ratio. We have now reported net income in 3 of the last 5 quarters, and generated positive cumulative net income over that period.

Third quarter total revenues of $549 million grew by over $124 million, or 29%, compared to the same period of 2012 with healthy year-over-year increases across all 4 homebuilding regions ranging from 25% to 33%. The largest contributors in dollar terms were the West and Central regions, which were up $97 million on a combined basis. We currently expect an increase of approximately 40% in our full year housing revenues as compared to 2012, based on the projected fourth quarter backlog conversion rate of about 70% and an average selling price of over $300,000. Our overall average selling price for homes delivered during the third quarter was approximately $299,000, representing a year-over-year increase of 22%. This marks the fourth consecutive quarter of double-digit year-over-year increases in our average selling price.

This trend, in combination with our improved housing gross profit margin, clearly reflects a significant favorable impact of our strategic focus on opening communities in desirable locations with limited housing inventory and higher household incomes. A key result of this strategic positioning has been a shift in our buyer profile from first time towards more experienced buyers. It has also contributed to the continued trend of sequential and year-over-year increases in the average square footage of our homes. This favorable ASP trend and our housing gross profit margin improvements are rooted in our ongoing execution of a very substantial repositioning of both our active communities and the products sold within those communities.

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

Complementing our community transition and to maximize the performance potential of the premium submarkets we have been targeting, we also adjusted our model home strategy within our new communities to focus on displaying larger floor plans with enhanced option packages. This tactical shift has favorably impacted the mix of deliveries in our new communities, and along with the related increases in KB Home's Studio sales and lot premiums, is driving both higher selling prices and enhanced margins. These factors, along with rebounding market conditions across our footprint, drove double-digit year-over-year Q3 increases in our average selling prices in each of our 4 homebuilding regions, ranging from 15% to 28%.

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

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

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

Getting back to our community count, we opened 27 new communities during the quarter and closed out of 23. We averaged 187 active communities for the third quarter 2013 as compared to an average of 172 active communities for the same period of the prior year, an increase of approximately 9%. As we discussed during the second quarter earnings call, our primary revenue growth related goals for 2013 are to generate net order and backlog values that will enable us to achieve our fiscal year revenue targets. While at the same time, opening the new communities necessary to support future revenue growth. Therefore, to maximize the value realized from our active communities, we have been carefully balancing pace and price and focusing on top line revenue growth and margin expansion, with less emphasis on unit net order comparisons between reporting periods.

As I mentioned earlier, we expect a year-over-year increase in housing revenues for fiscal 2013 of approximately 40% with a significant improvement in our housing gross profit margin and overall financial results, while we continue to work to generate sustained growth in our community count across all 4 of our homebuilding regions. Looking ahead, we believe our increased investment and attractive land assets and development during 2013 will drive continued increases in our community count throughout 2014. We believe this will be a primary driver of increased future revenues in combination with expanding average selling prices and sales pace for community.

We currently expect our full year land acquisition development investments to be approximately $1.2 billion, the upper end of the range of our prior guidance and more than double the level of investment during 2012. We are also still on track to achieve our targeted new community openings of approximately 120 and an increase in our year-end community count in the range of 15% as compared to 2012. We expanded net cash of $133.9 million from operating activities during the third quarter, as compared to $14.1 million of cash provided for the same period of 2012. Yet, excluding cash used for land acquisition and development activity from both periods, we generated $180.7 million of operating cash during the third quarter of 2013, an improvement of more than $32 million or 22%, as compared to the same period of last year.

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

Jeffrey T. Mezger

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

As pleased as we are with our progress, we understand there is plenty more work to be done. Sales unit growth is critical to maintaining a healthy backlog and leveraging the benefits of even-flow production. We're focused on ramping up our community count to drive unit volume increases. Thanks to our continued success in acquiring and developing land in premium locations, we are confident our expansion of communities will accelerate in the fourth quarter and continue throughout 2014. The housing recovery is firmly in place across our markets. And we are beginning to reap the financial rewards of this strategy, scale and consumer values that we have worked diligently to establish in our business. Our current results, combined with our quarter-end backlog value of more than $800 million, has set us up for continued revenue growth, margin expansion and cost leverage and provide a strong foundation as we head into 2014. We look forward to sharing our progress and more positive results with you at the end of the year.

With that, we'll open up the call for your questions.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from Bob Wetenhall.

Robert C. Wetenhall - RBC Capital Markets, LLC, Research Division

On a very nice quarter, just wanted to see how much upside is there to ASP slot given the fact you're up 22% year-over-year? And I was hoping, Jeff, if you could give us a little bit more color on your outlook for Inspirada as we go into '14?

Jeffrey T. Mezger

Okay. Well, as Jeff shared in his comments, Bob, we do expect our sales price to go up a little bit more in the fourth quarter. 299 in the third quarter and a little above 300 is what we guided for the fourth quarter. Moving forward, a lot of it will depend on mix of what's opening and closing, and we think we'll continue to be able to push our overall pricing up through the mix of the communities that we're bringing to market. We don't bank on prices going up as we project our business, and my hunch is that the little uptick in interest rates probably slowed down the inflation side of things for awhile in housing, which I actually think is healthy for the recovery in the long run. As to Inspirada, there's a few moving parts to it, as you know, and the development agreement applies to the villages, primarily, 3, 4, 5 and beyond. We do have assets in village 2 that are in the entitlement process that we intend to open up in 2014, hopefully in the spring, and we'll come right behind that as the development agreement turns into actual development on sites and all the builders are hopeful of getting communities opened later in the year in the ensuing villages beyond. So it's a pretty exciting development in a very land-constrained market, and we think it's an incredible opportunity for us now.

Robert C. Wetenhall - RBC Capital Markets, LLC, Research Division

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

Jeff J. Kaminski

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

Operator

Your next question comes from Michael Rehaut from JPMorgan.

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

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

Jeff J. Kaminski

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

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

Right. And just to be clear though, in terms of like what base to think of in terms of from 3Q, and given that I wouldn't expect you to be -- obviously, you think you're fully reserved hopefully for the water intrusion that, that...

Jeff J. Kaminski

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

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

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

Jeff J. Kaminski

Right. I'll make a few comments on the SG&A, just to add a little context to the number in the quarter. First of all, as most of you guys are aware, we've always looked at it as a variable component in our SG&A and what we call a fixed component. On the variable side, we're running at about 4.5% of our top line revenue right now, and while that can range 10, 20, 30 basis points up or down in a particular quarter, a 4.5% number on top line revenue is a pretty good number to use for the variable piece. And the fixed component side, it does include certain expenses that are not tied to top line revenue, but very based on other factors. And one such item was referenced in the press release, which was cash-based comp that's tied to our equity value, the dollar amount of impact in the current quarter on that was about $6 million. And we also have a couple of other legacy benefit programs that vary quarter-to-quarter as well and those were actually about a negative $1 million in the quarter. So on a net basis between all those plans, it contributed about $5 million of income, or an SG&A offset depending on how you look at it during the current quarter. As far as repeatability, it all really depends on stock price and with our benefit plans, the overall performance of the stock market, actuarial valuations and other things. So while we call that piece fixed, there are, like I said often times in the past, there are variations in it, but not tied to the top line.

Operator

Your next question comes from Ivy Zelman from Zelman & Associates.

Ivy Lynne Zelman - Zelman & Associates, LLC

Jeff, maybe if you can just help us with a little bit more clarity around the trends today. You talked about your pleasure or you were pleased with the fact that your community count year-over-year -- your orders, I'm sorry, may not have shown the same increases and you explained the negative comp but you attributed it to the profitability per unit was much more where you'd like to see it going forward. Can you talk about the impact from rising rates and whether you're using selling incentives and what you're seeing in traffic? And about the first-time buyer with the affordability with pricing up so much? Because you're -- it sounds like you're confident that you can continue to see price appreciation. And also, it looks as if gross margins are in an upward trajectory benefiting from add-ons in the design studios that you spoke of. So I just don't want anyone to be confused where the expectations are, so if your gross margins were certainly a lot higher than where we thought they would be. In fact, you're about a year ahead of where we modeled you. So I just want to appreciate what your current trends are and how it impacts profitability going forward, if you could revisit that, please?

Jeffrey T. Mezger

Sure. Ivy, I want to clarify, I wasn't pleased with the unit comp down. I was okay that we didn't have the same sales experience we did a year ago in the inland regions of California. And I went through that at length because this transformation of our California business, sometimes people, especially from New York that may not understand the geography, don't fully comprehend the difference between well inland and coastal housing within the state. And if you think about how California has recovered, it's been fairly typical that coast show the strength first, the closer to the ocean you are, the more desirable and valuable the real estate is, and once that lists, it slowly ripples inland. And at the time of the downturn, we had far more assets inland than we did along the coast. So you work through those, and you're not going to invest heavily in the inland areas because they haven't shown signs of recovery. The coast recovers first. You invest over there. And we went through this dynamic this year where the coast became the lion's share of our business, 66% of the revenue in the quarter. So we closed out of the communities where land is plentiful and you would typically run more unit volumes and have opened up a lot along the coast where you love every lot and you'll take your time and maximize the margin. And now that the coast has strengthened so much, it's moving back inland. So we're investing in the closer and desirable inland areas and we'll have a nice one too going forward. Underneath that, within the state, and you look at the consumer, a lot of our communities in the coastal areas, we have waiting lists still today, and the interest rate moved, it's not even a blink for that consumer. The incomes are probably $200,000-ish or more. And a payment going up a couple of hundred bucks does not even come close to moving them off of their buying decision. And the lower you go in price points around our company, the more impact it could have. But it still hasn't been enough to really change the qualifying. We've had very few cancels due to inability to qualify with the rate uptick. We have had cancels due to buyer's remorse, where the buyer just didn't -- wasn't comfortable. Not a big number, but we did have some when rates moved the way they do. With the quality of the buyers that we're attracting today, it is more -- it is not whether they can qualify, it's how much they want to spend on the house. So they'll take their money and put it into maybe a smaller house and more into Studio, maybe a bigger house and less with the Studio and we're able to flex up or down with whatever the consumer wants. And through that, we're finding ways with those buyers that have the desire to spend more in the Studio. We're finding ways to enhance our revenue specifically with those consumers while others don't spend as much as is typical in the Studio. So it's a nice flex for us. And I think, overall, while I -- as I referred to it, there's been a slight pause in the market that we saw. I think it's very short term in nature. I do think with inventory at the levels that, that is at in every market that we're open in today, you're not going to see any real pressure on price. I think prices will hold. And as the economy continues to improve and demand comes back, I think you'll see them continue to go up, albeit at a much lower rate than we saw over the last 18 months.

Ivy Lynne Zelman - Zelman & Associates, LLC

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

Jeffrey T. Mezger

Well, as I shared, Ivy, and you know over the years, we've had years with our margin up low to mid-20s, and that's our stated goal. We've already guided that margins will be higher in Q4, and we're hopeful of sustaining that trajectory in 2014. And the inland areas where we're investing now, the margins are just fine, percentage-wise, albeit at a lower dollar value than what you'll get on a higher ASP. But the percentages on the communities we're opening now more inland are just as strong...

Ivy Lynne Zelman - Zelman & Associates, LLC

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

Jeffrey T. Mezger

Absolutely.

Jeff J. Kaminski

Yes, we believe so. And Ivy, it's Jeff K, a couple of other comments, I think, in gross margin. We often get asked that question of what's driving the improvement in the future and whether we see additional runway, which we do. I think, at this point, I always believe margin improvement is an incremental gain. You get 10, 20, 30 basis points out of a number of different activities and they accumulate to significant margin improvement over time. As Jeff mentioned, we mentioned during the prepared remarks, we are targeting that normalized range as a minimum to get back to as a business, and we have a fairly long list of actions and activities that we're looking at. And by way of example, just to provide a few, we're working very hard right now on product standardization, we're value engineering some of the standardized product again and again and again to get our bill cost down. Of course, on the pricing side, we'll continue to look opportunistically for some market conditions that would imply that we could again raise prices in certain of those submarkets. We're focusing on lot premiums. Studio revenue increases should continue to contribute. We -- as we're selling higher-priced homes to more creditworthy buyers that have more disposable income, we're seeing increases certainly in the dollar amount of Studio revenue that's coming through the system. We have supply rationalization initiatives in place. We're looking at synergies on purchasing side, both from a national and a regional level. And we're also seeing a positive impact of our higher ASP due to all the factors we mentioned earlier on the higher ASP, but not to mention, the changing buyer demographics, but that higher ASP is leveraging our land cost more favorably. So while each of those may be small on the increment, a long list of small improvements, we hope to drive continued gross margin improvement based on that.

Operator

Question comes from Stephen King of Barclays.

Stephen S. Kim - Barclays Capital, Research Division

It's Steve Kim from Barclays. I guess, my first question relates to the strategy of moving a little bit more up in terms of the price point, I know you talked about flexibility there. And in particular, what I'm curious, Jeff, is if you could provide a little bit of color as to what you think the duration of this opportunity is going to be for your company. Is this something that we should be getting accustomed to from a longer-term perspective? And is that reflected in sort of the land purchases you're anticipating to make over the next year or so, given that you will then ultimately deliver out maybe as far out as 3 to 5 years? Or is this sort of more of a near-term opportunity that you see that exists in the market today?

Jeffrey T. Mezger

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

Jeff J. Kaminski

Right. And I think, for the purposes of short term, long term, how you want to look at it, I mean, we now have 13 quarters in a row of improving ASP, and the last 4 quarters were all double-digits. So we've been pretty successful with the strategy. And like Jeff said, we'll see what conditions hold in the future. But we don't think it's run out yet at this point.

Eli Hackel - Goldman Sachs Group Inc., Research Division

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

Jeffrey T. Mezger

Stephen, that was what I refer to as a misconception. And maybe it goes back to even the Eli road days of the '60s and '70s. But in '06, we were around 35%, 40% first time. We were predominantly move-up builder at the peak of the market. And that's why I wanted to say that people think we're just a first time builder. The beauty of our business model is we go where the demand is and we can flex up and down. And right now, it's 2 things. It's a flex to higher-priced areas where our model's working well. And in many cases, it's the bigger homes being modeled than we have over the last 4 or 5 years. So I think what we've recognized is the ability to push both ends, whether it's a first-time buyer business, which will come back as underwriting loosens up and continue to attack the demand of the move-up buyers, so I think we can be more balanced than we have been in the past.

Operator

Your next question comes from Megan McGrath from MKM Partners.

Megan McGrath - MKM Partners LLC, Research Division

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

Jeff J. Kaminski

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

Megan McGrath - MKM Partners LLC, Research Division

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

Jeffrey T. Mezger

Megan, I'll let Jeff talk the numbers because I don't know how much guidance we're going to give you within each of the regions right now for '14. But I shared in my prepared remarks that our strategy is working company-wide. There's a part of every city where demand is the strongest, and it's land-constrained and we're going upstream in products a little bit to cater to that demand. And that was in large part what triggered the ASP increase you saw by region in the quarter. It wasn't just a California ASP. And as each market recovers at its own pace, we would expand our business to the next layer of suburbs depending on how that economy's recovered and how our returns are working in that city. But we have a growth mandate for every business right now. And it all rolls up to a nice projection for where we can get to as a company. And we're not going to invest anywhere unless our margins are going to hit our hurdles and our returns. So it's a broad base, but the margin upside, I think, is more driven by the price, similar percentages, but by the price of any given community that we open. You want to make any more comments on that?

Jeff J. Kaminski

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

Operator

Your next question comes from Joel Locker from FBN.

Joel Locker - FBN Securities, Inc., Research Division

Just I was looking at your community count change out west, if -- what had ended the quarter on a year-over-year basis?

Jeff J. Kaminski

I'm sorry, I missed the end of that.

Joel Locker - FBN Securities, Inc., Research Division

Just in the west, what was the year-over-year change in community count?

Jeff J. Kaminski

Year-over-year change on average for the quarter, we were down 22% in the west region.

Joel Locker - FBN Securities, Inc., Research Division

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

Jeffrey T. Mezger

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

Joel Locker - FBN Securities, Inc., Research Division

Right. Just last question on the -- if you look to the fourth quarter for orders, are you trying to hold it at 3 a month or if you have to increase incentives, do it that way or would you let it fall below there and just kind of maximize mortgages like you kind of have?

Jeffrey T. Mezger

Joel, my comment across the company is optimize every asset. So we will set our run rate in a margin that you toggle back-and-forth to, per community. And if it's a coastal California community like I talked about, a high-margin, high-priced, can't be replaced, we'd rather hold on those and let them play out and take another sale or 2 in the first quarter. If it's an area with a lot of lots that are replaceable, the run rate may be a little higher and we'll take steps to move the run rate, if it were to fall behind the absorption. So as a company on average right now, we're targeting around 4 a month with the move-up stuff a little less and the first-time buyers stuff a little more, and it will vary with every community in every division. But we'll take the steps to make sure that we hit the margin and the sales pace that we targeted.

Jeff J. Kaminski

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

Operator

Your next question comes from Dan Oppenheim from Crédit Suisse.

Daniel Oppenheim - Crédit Suisse AG, Research Division

I was wondering if you can just talk in terms of the change in mix and saying the high-end buyers won't blink at all, but you also talked about some of the buyer's remorse. So should we interpret that as much more of that buyer's remorse was sort of the fact that half of the buyers were first-time buyers that we were seeing most of the impact there?

Jeffrey T. Mezger

I wouldn't just lay it on the first-time buyers, Dan. It's just things change. And when things change, people get unsettled. And there was a lot of talk in the media that interest rates were going up and housing markets were going to stall and the economy is going down and I think it rattles consumer confidence. So it was more buyer remorse than consumer confidence than it was that they don't qualify. Now having said that, there's obviously more pressure the lower you go in income, but if you look at our ASP, I remember, I forgot to share before, but in the Nationstar powers, I want to say our average income was $91,000 in the quarter. So a payment moving up $100 or whatever it was in the quarter is not going to move that buyer. If that went up another 1.5, I think, it starts to become material, but the move that we had, it was just -- it was so quick, I think, it caught people off guard.

Daniel Oppenheim - Crédit Suisse AG, Research Division

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

Jeffrey T. Mezger

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

Operator

Your next question comes from Adam Rudiger from Wells Fargo Securities.

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

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

Jeff J. Kaminski

Right, yes, I think, it's been pretty consistent with what we've seen for the earlier parts of the year and the earlier quarters. The category, I mean, generally, labor, we've seen labor pressures across one of the businesses. It's subsiding in certain areas, other areas we're still seeing some concerns there.

Concrete has been a hotspot for us. Of course, earlier in the year, the drywall increases continue to ratchet through the system and provide a negative on a year-over-year basis in each of the quarters. Lumber was up earlier in the year, it has come down off the highs. But I think, in certain divisions where we have lumber locks, it still may have had a slight negative on the third quarter results and we're hoping to see some positive benefit or some retraction, I guess, of that in the future. I think, in the quarter in total, it was about 400 basis points compared to prior year in movements in commodities and labor, and we see that as being mainly offset by what I call pure market price increases as distinct and separate from the pricing and the lift in top line that we've seen from some of the strategic initiatives that we've taken. So we think our market -- the market movements in prices is offsetting the commodity increases and we're looking to control that further as we go into the fourth quarter and into 2014.

Operator

Your next question comes from Eli Hackel from Goldman Sachs.

Eli Hackel - Goldman Sachs Group Inc., Research Division

Just 2 questions. So rates seem to have stabilized for a little bit now. Clearly, the move-up was quite quick. Just curious, in your view, as in previous cycles, how long does it take people to sort of realize, okay, maybe they steadied here, they're going a little bit lower, to get some of that momentum coming back? And then, just on California, do you have all the land you need for 2014 in California and now it's more 2015 and beyond?

Jeffrey T. Mezger

Eli, on the interest rates, I think, the consumer has already adjusted to them. If you think about it in a recovery, normally, you'll get activity levels, the economy gets better, you get price, and then rates would slowly tick up because the Feds worried about inflation. This time around, they've kept rates on the floor. We didn't get activity, we've got price because there ended up being no inventory out there. Then you had the price -- this price spike, and I think, the little rate uptick -- and rates do need to go up over time. The rate uptick probably cooled the pricing down some. so I think, again, it's the normal push and pull and twist and turn you'll see in a market recovery. We don't expect rates to move up dramatically until the economy is in much better condition. It's improving. But it's a slow recovery. And I think everybody's watchful of what happens in D.C. relative to the housing policy and the GSEs and all the other things we all keep reading about in the paper. But we don't expect a significant rate increase. We think it will just slowly grind up and we'll manage to it along the way. But I don't think it's the big driver right now in demand as I've said.

Jeff J. Kaminski

If underwriting were going to loosen -- if underwriting were to loosen up, it will more than offset any kind of interest rate uptick.

Eli Hackel - Goldman Sachs Group Inc., Research Division

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

Jeffrey T. Mezger

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

Eli Hackel - Goldman Sachs Group Inc., Research Division

And just on the California land position?

Jeffrey T. Mezger

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

Operator

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

Jeffrey T. Mezger

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

Operator

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

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