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KB Home (NYSE:KBH)

Q2 2014 Earnings Conference Call

June 27, 2014 11:30 ET

Executives

Jeff Mezger - Chief Executive Officer

Jeff Kaminski - Executive Vice President and Chief Financial Officer

Bill Hollinger - Senior Vice President and Chief Accounting Officer

Thad Johnson - Vice President and Treasurer

Analysts

Michael Rehaut - JPMorgan

Eli Hackel - Goldman Sachs

Bob Wetenhall - RBC Capital Markets

Ivy Zelman - Zelman & Associates

Stephen Kim - Barclays

David Goldberg - UBS

Dan Oppenheim - Credit Suisse

Megan McGrath - MKM Partners

Operator

Good morning. My name is Rob and I will be your conference operator today. I would like to welcome everyone to the KB Home 2014 Second Quarter Earnings Conference Call. At this time, all participants will be in a listen-only mode. Today’s conference is being recorded and a live webcast is available on KB Home’s website at kbhome.com. Following the company’s opening remarks we will 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 of its control, including those identified in its SEC filings, the company’s actual results could be materially different from those expressed and/or implied by the forward-looking statements.

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

It is now my pleasure to introduce your host, Chief Executive Officer for KB Home, Mr. Jeff Mezger. Mr. Mezger, you may begin.

Jeff Mezger

Thank you, Rob and thank you everyone for joining us today for a review of our second quarter results. With me are Jeff Kaminski, our Executive Vice President and Chief Financial Officer; Bill Hollinger, our Senior Vice President and Chief Accounting Officer; and Thad Johnson, our Vice President and Treasurer.

Today, I will begin with an overview of our performance for the quarter. I will then provide an update on the progress we have made on our three key initiatives and how we are continuing to drive our profitable growth trajectories. We are proud of our performance in the second quarter as we continue to build momentum. Once again, we improved in all of our key financial metrics, which reinforces that our strategy is working. We are achieving our growth targets and continue to enhance our execution to further improve profitability. We remain on offense and are continuing to invest in land to support future growth.

We are now consistently putting points on our strategic scoreboard for growth and profitability and are winning. This is a new chapter at KB Home. We have restored solid profitability and are well-positioned strategically. We look forward to capturing additional profit opportunities in the current housing environment, which is characterized by steady yet moderate growth at levels which vary dramatically in strength from city to city. After I share comments on our strategy and a macro view of housing, Jeff Kaminski will provide details on our financial results. Then, I will provide concluding remarks before opening the call up for your questions. As I have already said, we are very pleased with our improved performance in the second quarter. Let me share some of the highlights with you.

Revenues for the quarter increased to $565 million and net income rose to $27 million. Our average selling price was $319,700, a 10% increase over the prior year. We improved our operating margin by 440 basis points year-over-year. Our gross profit margin rose 380 basis points to 18.9% and we reduced our SG&A ratio to 12.8%. Both of these results were our best performance for a second quarter since 2006. Net order value increased 19% year-over-year to $763 million on a net order unit increase of 5%, our quarter end backlog value increased by 24% year-over-year to just over $1 billion reinforcing our expectation that our favorable trajectory will continue.

Our solid financial improvement in the second quarter is a direct result of our strategic shift to highly desirable and land constrained submarkets that support both higher prices and higher margins. We are seeing the impact of the successful repositioning of our communities reflected in our average selling price which increased 10% to $319,000 marking the seventh consecutive year-over-year quarter of double-digit growth. By opening communities in more desirable submarkets and introducing products that resonate with higher income consumers, we have been able to materially shift our product mix to higher price bands while maintaining a strong sales pace and achieving significant revenue growth. An important point is that our community repositioning is working across all four regions. This is illustrated in our quarter end backlog value of over $1 billion, an increase of approximately $200 million or 24% on a 9% backlog unit growth.

California is a great example of our strategy at work. During the quarter our net order value per unit was just over $591,000, an increase of about $92,000 over the prior year. Within the Northern California portion of the region a decline in net orders from the Central Valley in Sacramento was offset by an equal sized 38% increase in net orders in the Bay Area where prices and margins are significantly higher. As a result of our success in repositioning our community mix net order unit value in California reached an all-time high in the second quarter. Our Central region, which includes Texas and Colorado, is our second largest region by revenue and reported solid growth in markets that feature vibrant economies. In the current quarter, net order value in the region increased by 26% while net orders rose 12% year-over-year. With the quarter end backlog value of over $400 million, the highest level of any region Central is positioned to become a meaningful revenue and profit contributor over the second half of the year.

In both the Southeast and Southwest regions we generated positive sales value growth and ended the quarter with a backlog value in place that was up appreciably over the prior year. In the Southwest we are looking forward to the July grand opening of multiple product lines at our Inspirada master plan community in Las Vegas which we believe offers an incredible growth opportunity for many years. At the same time we are expanding our community presence in Arizona which had a positive impact on our backlog comp as well. In the Southeast while units and backlog were flat at quarter end, our backlog value was up almost 14% providing another example of our community positioning at work. Going forward as our community count growth accelerates across all four regions both our net orders and deliveries should accelerate as well. Having said that, as a result of the success of our product and community positioning, we expect that our revenue growth will continue to outpace our unit growth.

Let me now provide updates on our progress with our three key initiatives to increase community count, grow revenue per community and enhance profitability per unit. All three of these initiatives help fuel our success in the quarter and will continue to be key drivers of growth and profitability going forward. As a result of our increased land investment, we expect our community count to continue to grow. Since we announced that we are going on offense in mid-2012, we have opened roughly 190 communities and our average community count is now up 17% from the low point in the third quarter of 2012. We expect our community growth to accelerate in the second half of the year with more than 80 community openings planned.

Our second strategic initiative is to grow revenue per community and we are achieving this through a nice combination of our product mix, capturing higher ASPs while maintaining one of the highest sales rates per community in the peer group. We will continue to focus on the balance of price versus pace in each community in order to optimize the returns on every asset.

Our third initiative is to enhance profit per unit. And as I have shared with you on many calls, our built-to-order process offers both revenue opportunities and cost efficiencies. On the revenue side, as we continue to attract higher income consumers we are capturing additional revenue through premiums on preferred lots, structural floor plan options and exterior elevations. We have also been on offense with our design studios through both opening additional stores and expanding the size of existing while introducing new product displays that resonate with today’s consumers. We are finding new ways to capture additional revenue per unit as we expand the array of appealing choices available to our customers.

In our business model, where a consumer is selecting their home on their lot with only the features they value, they are willing to pay more for this benefit. On the cost side, with our backlog growing, we are now in a position to capture more of the efficiencies made possible by inflow production. In addition, with our larger scale combined with our standardized product series and value engineering, we are constantly identifying opportunities to lower our cost of built helping to offset the labor and material cost pressures the industry has been facing. We also remain committed to containing our overhead costs while growing our top line as we leverage our growth platform for further SG&A improvements.

At our quarterly Division Presidents Meeting earlier this month, we spent an entire day exploring opportunities to grow profit margins and our time together was high-energy and very productive. When you operate with one business model across the system, it is easier to introduce new ideas and deploy best practices quickly that can help grow revenues and improve margins. Through our collective efforts, we will continue to push toward our stated goal of a gross margin over 20% and an operating income margin in excess of 10%.

Typically, at this point on the call, I would now discuss trends in the macro economy and housing. You have all seen the economic models that suggest a slow and steady recovery as ongoing. There were many favorable data reports this week that reinforce that the housing recovery is proceeding. Consumer confidence reached its highest level since 2008. Resales were reported at a healthy annualized rate of 4.9 million units, while resale inventory levels remain in balance.

On Tuesday, new home sales were reported at an annualized rate of over 500,000 the highest level in many years. And as just reported yesterday by the Labor Department that the private sector has grown 200,000 jobs per month for the last four months in a row, a leading indicator of future demand. Meanwhile, interest rates remain at historically low ranges supporting favorable affordability levels. While mortgage underwriter remains tight, we are seeing signs of loosening among the mortgage companies. And in our served markets, we are beginning to see evidence of the reemergence of the first-time homebuyer.

While these favorable trends are very encouraging, it is still going to take some time until we reach historical new home activity levels. As a result, many outlooks on the housing industry are measured, but we are optimistic as we are building a real growth story in the current environment. As I always maintain, homebuilding is a local business and as our business has evolved we are really operating today in two distinct market environments that are being driven by different dynamics.

The first is in the highly desirable markets, such as Costal California, which are driven by strong demand due to large populations and very low inventory. In these land-constrained densely populated areas where it is very difficult to bring new communities to market, our strategy is working quite well. In these areas there is a price driven recovery. And as prices continue to increase, this trend will spread to adjacent areas with more readily available buildable land. While I use Coastal California as the example, this dynamic exists in the most desirable areas of many of the cities in which we operate.

The second market dynamic that we are targeting features the more traditional demand we are seeing in Texas, Orlando or Denver fueled by employment and population growth. It is in these markets with their more traditional recovery where we are starting to see the reemergence of the first-time buyer, a critical consumer segment necessary to assure a broad based housing recovery. The important takeaway is that our business model allows us to move with demand and by leveraging our strengths we feel that we have real role growth stories emerging in both market scenarios. The buyer of $160,000 KB Home in Houston is responding just as favorably to our core value proposition as the buyer of $1.6 million KB Home in Northern California. We execute equally well on delivering a built-to-order experience in either location. This is our roadmap in today’s environment. We move with demand.

While advancing our strategic initiatives, we are well positioned to fuel our growth engine in the coming years. Our local land teams continue to identify opportunities in premium locations that are aligned with our product and price point strategy and that meet our financial underwriting criteria. I was happy to host many of you on the call today at our investor conference last month where we were able to showcase our two product lines at Playa Vista on the west side of Los Angeles. Some of you shared that it helped you appreciate that our Coastal business is different and is a key differentiator for us. Playa Vista is located a mile from the beach in an extremely desirable and land constrained area. What those in attendance who are able to experience was a sophisticated product presentation that at $1.5 million is affordable by Westside standards. With decades of experience in our own backyard, we are leaders in acquiring communities in the highly land constrained Coastal California market.

I would like to share two significant California acquisitions we made in the second quarter that featured desirable and land constrained submarkets similar to Playa Vista. Patterson Ranch located in Fremont, California is a perfect example of the types of investments we are pursuing. This is a 500 lot, fully entitled property in the East Bay with convenient commuter access to both the Silicon Valley and Sam Francisco and is located in what many view as the strongest housing market in the country. We have been operating in Fremont for decades. We understand the city and how to successfully do business there. We were very familiar with this particular property and the seller new we would perform. It was a relationship driven transaction.

Similarly in Southern California we acquired 278 finished or partially finished lots in the Plum Canyon area of Santa Clarita, a highly desirable suburb of Los Angeles. We had specifically identified these lots as a very desirable opportunity located across the street from one of our own active communities. Once again we have operated in Santa Clarita for decades, an area that is highly desirable land constrained and considered to have one of the strongest job markets and best school systems in the state. We were able to acquire this property due to our relationships and expertise in Santa Clarita which we have built over the last 30 years. We announced this acquisition in early May and we have already started models in this new location.

I wanted to share some of the specifics behind these two exceptional acquisitions due to their size and very land-constrained locations and the positive impact they will have on our results in 2015. I could have just as easily shared successful acquisitions that have occurred in many of our other cities such as Denver, Houston, Phoenix or Jacksonville.

We have seasoned land teams on the ground across this system, who are strategically utilizing our business model tools and their local knowledge relationships and expertise to identify the right types of acquisitions and drive the right kind of profitable growth. This is why we are continuing to find compelling investments opportunities. Why we already own or control the lots we need to support our 2015 growth targets, we continue to see incremental opportunities for upside. At the same time, our primary focus now is on meeting our needs for 2016 and beyond.

Another key KB Home differentiator is our industry leadership and energy efficiency. We are committed to lowering the total cost of home ownership through introducing new, more efficient technologies. We have made incredible progress in a few short years and consumers are responding to the value offered by our extremely efficient homes. According to the EPA, the homeowners of 82,000 ENERGY STAR homes that we have now delivered saved an aggregate of $24 million on utility bills just in 2013. We know leading on energy efficiency pays dividends for our company. It appeals to our homeowners. It is good for the communities we operate in. It is good for our shareholders and our employees and it’s good for the environment.

We also strongly believe the water will continue to become more scarce and costly in the years to come. And as a result, we are expanding our efforts in water conservation, with products like the greywater recycling system we shared on our last earnings call. We are constantly challenging ourselves as to how we can improve the efficiency of our homes without materially increasing the cost to the homeowner. Our common business model allows us to standardize products and leverage economies of scale to reduce cost and make these energy efficient features more affordable to our homebuyers.

Our KB Home design studios also serve as consumer laboratories, where we present and explain energy conservation choices and benefits to the consumer and in turn monitor interest and willingness to pay for any given feature. I believe our leadership in this area is a key differentiator for KB Home and is one of the reasons we achieved one of the highest sales rates per community in the industry.

Now, I would like to provide an update on our progress in launching Home Community Mortgage, our jointly owned venture with our preferred lender, Nationstar. I am pleased to report that we have finally secured the necessary regulatory approvals and have commenced the rollout. In this challenging credit environment, streamlining the mortgage process offers a great benefit to our customers. We anticipate that launching Home Community Mortgage will align our two companies’ respective interest and we expect to see the venture capturing a high percentage of our customers’ mortgage business while providing superior levels of customer satisfaction. With the high capture rate and consistent execution, we expect more predictable deliveries. Down the road, Home Community Mortgage should also provide a material income stream for our company.

As I have stated, we are very encouraged by our progress during the quarter, which reinforces that our strategy is working. We have entered a new chapter at KB Home, where we are positioned today for significant growth and as housing markets continued to recover, we anticipate even greater opportunities.

Now, I will turn the call over to Jeff Kaminski who will go through our financial results. Jeff?

Jeff Kaminski

Thank you, Jeff and good morning. We are pleased with the earnings improvement and continued progress across our core financial and operational metrics that we achieved during the quarter. In addition to year-over-year growth in revenues and operating margin, we generated significant increases in both our net order value, which was up 19% and quarter end backlog value, which at more than $1 billion was 24% higher than a year ago. These results support our performance expectations for both the third and fourth quarters of this year. To help sustain the performance improvements we made in the second quarter, we also continued our aggressive strategic investment in land and land development to support future growth in both open communities and top line revenues in the remainder of 2014 and beyond.

During the second quarter 2014, net income grew to $26.6 million or $0.27 per diluted share, representing a substantial improvement from the same period a year ago. Higher revenues driven by a rising average selling price combined with improvements in both our housing gross profit margin and our SG&A expense ratio were the main drivers of our earnings growth in the quarter.

Second quarter revenues totaled $565 million, up 8% from $524 million in the year earlier quarter. This top line growth was fueled by an increase of more than $52 million or 43% in the central region. Revenues in the Southwest and Southeast regions were essentially flat year-over-year and the West Coast region was down about 5% compared to an exceptionally strong Q2 2013 when regional revenues more than doubled versus 2012. For the second half of the year, we expect our West Coast region to generate higher revenues compared to the second half of 2013 as both our regional unit deliveries and average selling price are expected to increase.

The increase in current quarter revenues was driven by continued growth in our overall average selling price, which climbed to nearly $320,000 representing a year-over-year increase of 10% or more than $29,000 per home. This marks the seventh consecutive quarter of double-digit year-over-year percentage growth in our ASP. Our higher average selling price is a direct result of strategically shifting our land investments toward highly desirable submarkets that generally feature higher medium household income levels, strong demand, including demand for larger homes, and low inventory of homes available for sale. All four homebuilding regions reported strong growth in average selling prices, with increases ranging from 9% in our Southeast region to over 23% in our Southwest region.

While we expect continued year-over-year improvement, we reiterate guidance shared on prior earnings calls that we expect our ASP growth to moderate during the latter half of 2014 in the range of high single-digit to low double-digit percentage growth. Our current ASP trends reflect the favorable impact of our 2012 going on offense initiative to strategically reposition our land assets and our complementary emphasis on growing revenues in each open community in our targeted submarkets. These steps along with refining our products to meet consumer demand and generating continued growth in design studio revenues from our higher income buyers have boosted our average selling prices over the past several quarters while enhancing our margins.

During the quarter, our results also continued to reflect the success of our focus on enhancing profitability per unit as we realized improvements in both our housing gross profit margin and our SG&A expense ratio. Our gross profit margin increased to 18.9% for the second quarter 2014 as compared to 15.1% for the same period the prior year. Our adjusted housing gross profit margin improved 70 basis points from 18.2% in the second quarter of 2013, marking the sixth consecutive quarter of year-over-year improvement as we work to drive this metric above 20%.

Turning now to selling, general and administrative expense, as a result of our ongoing efforts to control costs and improve operational efficiency, we lowered our SG&A as a percent of housing revenues by 60 basis points during the current quarter versus the same period last year. This brought our selling, general and administrative expense ratio to 12.8%, the lowest second quarter ratio since 2006 when revenues were nearly $2.2 billion. We believe we can leverage our operating business model to drive further expense efficiency as well as additional improvement in our SG&A ratio as we generate increased deliveries and higher revenues by expanding our community count.

As Jeff said, increasing our community count is one of our three key strategic initiatives and is at the core of our efforts to grow our business. We are successfully launching new communities while laying the foundation for even more grand openings in 2015 and beyond. During the quarter, we opened 42 new communities and closed out of 36. Our average community count was 191 during Q2 2014 versus 178 during the same period the prior year, marking a 7% year-over-year increase. With 71 new community openings during the first two quarters of this year, we are currently on track to reach our target of opening over 150 new communities during 2014, including the reactivation of approximately 15 communities previously held for future development.

Combined with a forecasted decline in closeouts, particularly in the fourth quarter, we are also still on track to achieve our previous guidance of 220 to 230 open communities as of the end of the year. To support our future community count goals, we invested $505 million during the quarter in land acquisition and development. For the first half of 2014, our investments have totaled $860 million, up from $575 million a year ago. Moving forward, we believe our significant investment in land and land development will fuel our future growth.

We continue to aggressively invest development dollars into land that we own and we are still finding attractive land acquisition opportunities to support our continued expansion within the markets we currently serve. We now expect our full year investment in land acquisition development to be approximately $1.6 billion, which is at the higher end of the range of our prior guidance. We remain confident that our improved performance, our current and expected future profitability and generally favorable housing market trends support our anticipated reversal of a significant amount of our deferred tax asset valuation allowance prior to the end of the year. We are projecting that this will be a fourth quarter event for the company, which will significantly increase our book value and substantially improve our net debt to capital ratio to less than 60%. At the end of the second quarter, the DTA valuation allowance was $844 million.

In conclusion, we are pleased with the broad and continued improvement we are observing in our operating and financial metrics and are committed to executing on our strategic initiatives in order to accelerate future growth in revenues and earnings.

Now, I will turn the call back over to Jeff Mezger for his concluding comments.

Jeff Mezger

Thanks, Jeff. Before concluding this morning’s call, I would like to recognize the hard work of all of our employees at KB Home who come in each day with energy and commitment to advancing our results. In summary, we are solidly profitable and we are gaining momentum. Our business model, investment strategy and community positioning are working. We are successfully growing revenue through a combination of higher ASPs while sustaining one of the top sales rates per community in the industry. We plan to open more than 80 communities in the second half of the year, which should increase net orders and unit deliveries.

Our balance sheet will be significantly enhanced with our expected fourth quarter reversal of our DTA and we intend to continue investing strategically to support future profitable growth. We look forward to capturing the tremendous opportunities ahead of us. Thank you all for your time and attention today. And now we’ll be happy to open it up for your questions. Rob?

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Thank you. Our first question is from the line of Michael Rehaut with JPMorgan. Please go ahead with your question.

Michael Rehaut - JPMorgan

Thanks. Good morning, everyone and nice quarter.

Jeff Mezger

Thanks Mike.

Michael Rehaut - JPMorgan

The first question I had was on gross margins, you continue to have some nice progression there and the second quarter number was a little bit better than we were looking for and I’d venture to say general expectations. So I was hoping you could kind of give us a sense, Jeff, perhaps what drove the sequential improvement from 1Q to 2Q if there was any regional mix there or if it was just further execution of either pricing etcetera and certainly just any thoughts in terms of that you continue to expect further expansion from these levels as we get into 3Q and 4Q?

Jeff Kaminski

Well, Mike, yes, I can provide some details on that. First of all on the sequential it’s basically what we have been talking about for quite some time I mean it’s the communities that are driving it. The openings versus the close outs and also progression with communities that were open both quarters, so at that level for our sequential improvement there is nothing that really stands out as a huge one-off driver, it’s just continuing the path we have been on. The 18.9% we just reported on adjusted basis was the sixth consecutive quarter of improvement. And I think significantly as we look at it the dollars per delivery, the gross margin dollars at over $60,000 in the quarter was the highest since the third quarter 2006.

So we have been pretty pleased with the progression for the rest of the year. I think we will continue to see sequential improvement in both the third and fourth quarter. And I would expect to be let’s say in 19s in both of those quarters which at least is very close to our initial goal of getting to the 20%. And like we are all saying I mean we are facing some headwinds out there in both material and labor cost inflation as well as some level of increasing land costs but up until now we have proven that we have been able to overcome those factors as we continue to close that gap against our own targets. So and we are pretty optimistic on that and like the trends we are seeing. We are also seeing support for that in our backlog margins.

Michael Rehaut - JPMorgan

That’s great. I appreciate that. And I guess second question for Jeff Mezger, as there are two Jeffs I have to distinguish. Jeff, you mentioned that in your opening remarks that there was evidence of a reemergence of the first-time buyer and I was hoping you could expand on that a little bit in terms of that if that’s something you are seeing in your own business itself and particularly given that you continue to perhaps shift to maybe away from the historically traditional first-time buyer more of a financially – more financially a stronger type of first time buyer that’s more financially able and more perhaps the move up community, so I was just wondering if this was something that you kind of saw specifically within your own business or if it was more just kind of general comments as it relates to perhaps mortgage lending standards or other trends that you see out there?

Jeff Mezger

Mike, it’s part of why I split it into the two different business dynamics we are dealing with today. In the higher income land constrained areas I don’t know that our first-time buyer mix has changed. It’s a different first-time buyer I know it’s a higher income buyer than we would have seen 10 years ago. What I was trying to point out in the cities pick Texas City because all four of the larger cities has solid job growth and real population growth going on today. And it’s because of the job growth we are seeing more first-time buyers. They are not – it’s a well heeled first-time buyer, but it’s not the high income first-time buyer like you would see in Orange County or up in the Santa Clara County. So I think it’s because you have job growth going on in those cities and that’s within our own business we are seeing this.

Operator

Thank you. Our next question is from the line of Eli Hackel with Goldman Sachs. Please proceed with your question.

Eli Hackel - Goldman Sachs

Thanks and good morning. You have talked about tremendous upside just remaining in the current markets, so I am not going to new ones, you clearly are getting a lot of SG&A leverage, could you talk about SG&A leverage as your community count growth accelerates given the land investment that you have done?

Jeff Mezger

I can make some high level comments Eli and then I can kick it to Jeff for any numbers he wants to share. If you think about we have walked through this trajectory of community counts accelerating as we come out of the year and you always have cost incurred in your SG&A before you get to the revenue down the road. So we have been able to continued to contain costs even with this ramp up that’s occurring and have been able to improve our SG&A ratio while carrying some load for the future growth. So it’s a reflection on our commitment to keeping things in balance and you touched on another side of it where the markets that we are in today one time we did over 25,000 houses. So our strategy right now is to continue to grow larger businesses, where we are at our current market footprint and continued to leverage SG&A just like you saw in the second quarter.

Jeff Kaminski

And to add to that, I guess just a little bit, on our increasing revenues, how we generally think of it is on increase in revenues, we have about a 5% variable cost component included in our SG&A. And that’s basically there to cover things like commissions and other related costs of new communities. So, we do and we have shown that with our results, achieve tremendous leverage as we are increasing that top line and increasing the top line through community count is really the path to stronger bottom line profits for us.

Eli Hackel - Goldman Sachs

Great. And then maybe just one follow-up on the community count growth, you talked about a measurable increase in ‘15, there is a potential to give us a magnitude of ‘15 growth versus ‘14 growth, clearly you have had a lot of land development spend and land acquisition over the past 12 to 24 months?

Jeff Kaminski

Right, right. Well, I think first of all, just talking about 2014 for a moment. What we have seen in the first two quarters, we saw 10% up in the first quarter. We are up 7% in the second quarter. Our expectation right now for the third quarter is around that same pace call it, high single-digits maybe hitting 10% in Q3. Q4 will see an acceleration in that, I would say would be somewhere in the mid-teens maybe even high-teens and these are averages. So, when we look at it, we look beginning and at quarter end, we just have a 2 point average. So, on an average basis, we will drive it higher. We are still on pace as we mentioned earlier to hit our end of year target, where we expect that end of year to be 15% to 20% up versus the end of 2013. And that’s pretty important as it relates to 2015 first quarter, because now we have a beginning number that’s already at least we believe is at least 15% higher than the beginning number of the 2014 first quarter. And we think we can grow it from there. So, particularly in the first half of the year of 2015, where obviously we have our best visibility right now, we do expect to see acceleration and we expect to see community count in those quarters closer to what we are seeing in the fourth quarter this year.

Operator

Thank you. Our next question is from the line of Bob Wetenhall of RBC Capital Markets. Please go ahead with your question.

Bob Wetenhall - RBC Capital Markets

Hey, good morning. You guys have done a lot of hard work in increasing profitability and delivering on your target, so you have been talking about for gross margin performance kind of bumping up in that 19%, 20% range, how much room can you get through the model the way you are designing it with mix and locating in some very good ASP areas? Can that go to 22, can that go to 24 in the next couple of years?

Jeff Mezger

Well, go ahead, if you got a number.

Jeff Kaminski

Yes. Look, we really haven’t guided out a couple of years out. I mean, what we talked about right now is an initial target within the company and we believe that very much. I mean, when we were negative operating earnings, our initial target was positive operating earnings and it was positive net income. Now, it’s driving expansion in the operating earnings margin and in our net income and same thing on the margin side. Our initial targets is 20% and we feel confident we are going to get there. I do believe there is more room to expand beyond that. Our highs in the prior cycle are well above that. And when you look at normalized rates in prior cycles, we were in basically the low to mid 20s. So, I do believe there is the ability to get there.

We are continuing to very carefully balance pace and price and you can see it in our sales absorptions. On a year-over-year basis, for example, this quarter, we are down 2%. On a per community basis, it was like one-tenth of a sale per community per month in the quarter. So, we have been very carefully balancing that and really emphasizing the margin side of the business. We think it’s important for the health of the business going forward. And we will continue to strive to achieve these higher margins we can go to, but like I said normalized, it’s higher than the 20%. We are very confident with the 20% as our annual target.

Bob Wetenhall - RBC Capital Markets

Glad to hear that. If you could give a little bit more color or granularity on the new mortgage structure, it seems like it allows you guys to have a little bit better control over your own destiny by putting things in your hands? Would this also have a P&L impact and what do you think it does strategically for the company? Thanks.

Jeff Mezger

Bob, I touched on that in my comments and it’s a basically 50:50. They are the managing partner. And as I shared it, we know it will help our predictability of deliveries, because you will have a mortgage partner that you can trust when they commit to doing something that they will perform and they have been doing that even today in our marketing relationship. So you have a good business partner. You will have better visibility on buyers closing dates which gives the salespeople confidence and with consistently in underwriting. The salespeople will have confidence when they are writing contracts whether the buyer is going to qualify or not. So I think it will actually help our sales as well and we will see how that plays out. But in the past in our previous venture it became a profit stream for the company and that’s not the primary purpose, the primary purpose is to control your business better and have a predictable delivery and raise the customer satisfaction with the consumer and that’s our top priorities. But we expect it down the road it should bring income into company as the JV matures.

Operator

Thank you. Our next question is from the line of Ivy Zelman, Zelman & Associates. Please proceed with your question.

Ivy Zelman - Zelman & Associates

Good afternoon guys. Good quarter. Maybe on the same vein Jeff if you can chat a little bit about the specifics on underwriting, you mentioned that you are seeing some easing with respect to the mortgage availability, maybe you can give us some specifics and what you are seeing as compared to others that are not seeing as much, but that’s the first question. And secondly as you are incrementally adding to your land position you talked about the two different types of markets land constrained markets and higher priced versus what’s driven by the entry level consumer coming in with job growth maybe when you think about the land market what percent would say is being more acquired for that more entry level type product offering versus the more affluent higher end? So those are my questions. Thank you.

Jeff Mezger

Thanks Ivy. On the mortgage side, you can see it even in the bonds that are being pooled right now. The FICO scores are coming down. They are still not to normalized levels if you think of the what the agencies allow and whether it’s FHA or GSE, so 680 is a pretty good FICO score. The pools are still 720, 730, but they are down from 750 or 760. So the FICO scores are coming down a little bit. And anecdotally with some of the mortgage companies we have done business with their overlays are easing. And I think the more clarity that is out there on QM and QRM and the put back risk and reserves and everything that’s coming to a head right now. They are coming to the close on writing all those. I think as you see more clarity it should continue to loosen up.

As far as what you call first-time buyer communities which I would call first-time first move up and move down is just a different price point in a more readily available land market I will call it. And we see opportunities in both because of the land constraint in the higher priced areas I think you will see in the future more growth as the markets recover. You will see more were community investment in the more traditional markets. We are going to continue to chase everything that we can in these land-constrained areas. And it’s hard to answer that because the land-constrained areas also come with a higher price per acre or higher price per lot, but there is not as many of them. So I would – I can just say we intend to field both of them and think we have a nice growth trajectory now in either market segment.

Operator

Thank you. Our next question comes from the line Stephen Kim with Barclays. Please proceed with your question.

Stephen Kim - Barclays

Thanks very much guys. I had a question regarding the use of land options as you go forward, obviously the move towards more desirable land constrained parcels, usually we think of those as being parcels where if you try to tie them up your options usually you have to put more earnest money down. Internally your company has not actually put a lot of earnest money down as percentage of total purchase price, so we are kind of curious to see if you could sort of talk about are you intending to sort of change that in anyway, what kind of levels of deposits or earnest money should we be expecting from the company going forward? Thanks.

Jeff Kaminski

Are you talking – Steve are you talking about the consumer on land deals, you confused me with the question?

Stephen Kim - Barclays

Sorry, land deals.

Jeff Kaminski

Okay. Well, every deal is going to have a different story, it’s kind of interesting. I keep talking about this relationships are very critical in the terms of deals and the types of businesses you can put together. And if you think about Irvine as an example, where we have a great business relationship with them and we have a large presence, all of those are option deals in a very land-constrained environment and it’s because of relationship and the trust and the structure that they prefer as sellers. So, you have high-priced lots, high-priced product, yet you are still getting friendly terms on the deal.

When you go to the Playa Vistas of the world, it’s just flat out cash. You are paying cash for those, because there is 20 people lined up behind you that would buy it and the seller doesn’t need to take terms. So, those are the bookends. Interestingly, I have shared in the past we have done some option deals in the Bay Area, large acquisitions, because of the relationship between the seller and our team. And at the same time, there is other deals we have done up there, where we have had to write a check. So, it’s as you get to less land-constrained areas, you will see more favorable options and terms and we are open to doing both and primary focus for us is which gives us the highest margin.

Stephen Kim - Barclays

The highest margin, not necessarily the highest return or in your view are they similar enough that you can collapse that down to a margin analysis?

Jeff Mezger

But you have to balance both, but if it’s a phase taken, it’s buy it six months later, you are going to buy it or you can buy it today at a lower price and raise your margin will go for the higher margin.

Stephen Kim - Barclays

Got it.

Jeff Mezger

But it’s a balance of both, you have to hit your returns on the cash and what gives you the most margin between the different structures.

Stephen Kim - Barclays

Sure. It makes sense. Jeff, do you have a target for actually, Jeff Kaminski, do you have a target for inventory turnover that we could be thinking about as we go forward?

Jeff Kaminski

Right now, Stephen, we are really focused on community count growth and driving that growth through the acquisitions through the strategy where we are putting forward into our model. At a point in time, I do believe we will start ratcheting back on that as we get happier with the trajectory on the growth. And I think we could share some targets at that point in time.

Operator

Thank you. The next question is from the line of David Goldberg with UBS. Please proceed with your question.

David Goldberg - UBS

Thanks. Good morning and thanks for taking the call.

Jeff Mezger

Good morning, David.

David Goldberg - UBS

Good morning. So, my first question was on the design studios and if you could talk about kind of the take per buyer, if you have seen any change in that, Jeff Mezger you made some – I think some interesting comments beginning about changing some of how you are showing some of the product to emphasize some of the things you found very unique in the KB offering. Can you just tell us a little bit kind of what’s going on the design studios? Have you seen any change in buyer behavior? And I guess that’s my first question.

Jeff Mezger

Well, it’s interesting, David, because as our business has evolved, we have had to operate a different studio approach in the higher priced high income areas than we would in the more median price ranges. A good example would be down in Irvine, where you don’t offer one level of granite counters, you would offer six and you – and the consumer will go to level 6 out of the gate whereas in the Inland Empire, they may want to upgrade the granite and they are happy with level 1. And five, six, seven years ago, we may not have had as many high-priced goods offered in the Irvine studio as we do today. And then out in the more traditional areas, it will be a little lower.

And the other interesting thing for us and its shame on us through the downturn and I have shared this before, we somewhat neutered our studios and that the intent of the studio was to help you saw house is first and foremost. And then it should be a profit stream as well. And in some of the markets, where we dropped to a very low volume level and you can’t support a studio, we just put them into a double-wide trailer or a garage somewhere, which helps you still sell some level of options, but as you lose the positive in favorable retail environment to get people excited about selling homes. And we are hearing anecdotes now that several out of Sacramento for instance were after the opening in the next group of sales half of them visited the studio before they bought a home. And I just heard one this week in Phoenix, where we have opened up a new studio and someone made an appointment for their studio final before they had even contracted on the house. And we didn’t lose sight of it in the downturn, but you have to do what you have to do to, to keep your overhead in check. And as we roll these things out, we are seeing them help us on the selling floor as well. So, I think you will hear a lot from us in the future as this continues to evolve and get back to what it was.

David Goldberg - UBS

Is it fair and we had read something earlier this month about a design studio and a mall environment to try to drive more traffic to the community? Is it fair to say that if that successfully would see more of those kind of opportunities as using the design studio as more of an advertising tool?

Jeff Mezger

Absolutely. It’s no different than another model. And our Sacramento studio by the way is right across the loop road from a Nordstrom in the number one mall in Sacramento. So, it’s exactly what we did.

David Goldberg - UBS

And then my question was in terms of the profitability, if we kind of think about this divide between the more land constrained areas, more coastal areas in California as an example and maybe what would be a little bit more of an inland area? When you think about the uptake for buyer, is it significantly different in the design studio and when you think about the profitability, you mentioned having the six kind of granite for the move-up buyer is paying a little bit more and maybe a little bit more down market or maybe from a fewer options in the different market? Are the margins on that different as you kind of get back to more of an entry-level buyer over time? And then are the price points or the uptake I guess when we think about it, how significant is the difference there?

Jeff Mezger

Well, I don’t want to get into the specifics of it in terms of one studio versus another, but to start with the understanding, it’s the same size home, whether it’s in the Inland Empire or Irvine or Playa Vista, they are both 2,000 feet, they are 2,000 feet and there is only so much flooring that goes in and the kitchen is only so big. What’s interesting about it is that we are seeing a similar percent of the home price in either location, so if it’s a $400,000 home in the Inland Empire, they may spend $35,000, I don’t know, 9%. And if it’s $800,000 or $900,000 home along the coast, they will spend $70,000 or $80,000. So, the percentages are similar. And what they will do in the higher-priced areas is go to more upgraded product of the same type of component, whether its cabinets or the counters or flooring is much higher. And what we also see more money spent on structural options in the higher-priced areas, where they will – they want the accordion doors to the patio or those type of things.

And what it tells you in either case, they are designing the home and plan to live in it. And they are making the home the way they wanted and it’s tied to a budget and now in Inland Empire maybe I want a bigger home or I need another bedroom and level 1 granite and in Irvine it’s given me all the way to the top, I want it exactly like the model. And we always price our studios to be accretive to margin after studio overhead. So, it’s not a drain on our SG&A and it’s typically it will add a little bit to our margins and every $1,000 of studio revenues is critical to us as every $1,000 of home price for lot premium.

Operator

Thank you. Our next question comes from the line of Dan Oppenheim of Credit Suisse. Please proceed with your question.

Dan Oppenheim - Credit Suisse

Thanks very much. You talked a lot about going to the higher price point in especially the first time buyers there are not so affluent, but just little higher end, some other builders have talked about taking more cost out to bring the ASP down. Have you given any thought to it and just how do you view it overall?

Jeff Mezger

Dan, we do both. In the land-constrained areas, the land deal is where it starts the key to your success. And if its $1 million home on whatever the lot cost is the better you buy the land, probably has more impact on the margin then if you take $500 out of the sheet rock bid. We still go for those things in the coastal area, because every dollar is important, but it starts with the land deal on the more traditional demand markets, as I call it. Our strategy is to bracket the median income. And it will go above the median income and depend on how large the submarket is, how big the buying pool is, we will go a little bit higher than the median, but we always target the median. So, there in our view, there is a constraint on how much that income that you target can afford. There is a limit to it. And we have to keep lowering our cost in those areas, because every time you raise price, you move away from the market. So, we drive our cost down best we can and in those cases, the lot has a much lower percent of the revenue and therefore you have to get it out of your direct.

Dan Oppenheim - Credit Suisse

Got it. Okay. And then two early remarks, you talked about some of the recent stats and talked about the May new home sales with the increase, is that what you saw in terms of your results for May and any color you can offer on June?

Jeff Mezger

I can say just in general I will turn it over to Jeff, Dan. But there was a lot of coverage I will say of the spring selling season and what happened this monthly or that month. We saw a pretty typical rhythm March, April, May, our traffic is up year-over-year very nicely. There is a lot of buyer interest out there. And for us the term I have been using it was the most predictable selling quarter I have seen around here where a week in and week out there was a rhythm to it and we continue to balance price and pace. So I would say it was a solid quarter from month to month. So I don’t know that will say May was better than April or worse than March. We had a pretty nice rhythm all the way through.

Jeff Kaminski

Right, I obviously agree with that. The traffic trend was nice as Jeff said we were up about 13% on a per community basis for the whole quarter and trends continued into June. So what we see is – what we saw I think in the second quarter as we made reference earlier to our absorption rate per community on a year-over-year basis was a market that although the absorptions didn’t progress from last year they maintained nicely what we thought was a pretty good pace last year and we were able to achieve higher margins on the sales and certainly on the deliveries in a quarter. So the market right now is good, I wouldn’t say it’s great, but what we are seeing in the communities has been pretty consistent performance and certainly nice performance on the traffic side.

Jeff Mezger

I would add we think our traffic levels were up because of the locations were opened and they are typically in areas with higher consumer confidence and stronger economics and market dynamics and that’s probably why our traffic levels were up.

Operator

Thank you. Our final question today is coming from the line of Megan McGrath with MKM Partners. Please proceed with your question.

Megan McGrath - MKM Partners

Good afternoon or good morning to you. I would like you to sort of address one of the issues I think that folks get concerned about which is you have aggressively bought land specifically in California over the last couple of years and if that market slows I think there is some concern that you could see a squeeze on your margin if you aren’t able to raise price, so can you talk about your ability to continue to raise price or keep prices steady in California outside of any product mix benefits?

Jeff Mezger

Sure Megan I have to keep reiterating this. It is a very, very local business and interestingly in the land constrained areas where we are investing, take the Fremont deal as an example. The price points for our product are much closer to resale medians than the price for new product out in the lesser submarkets. We actually are closer to median than the median incomes in the more land constrained areas because you have such large populations and such depths of demand with no product out there. Where we tend to see softening when the market turns as the communities that are in a B minus location where job growth isn’t there yet and people as prices may adjust they have a choice of move to closer end but take that flyer community as an example. The people that are buying there they don’t even know there is any kind of an economic issue. They feel good about things. They have a good job. They have solid incomes.

And the other thing I would add the things that we are opening today are part of what’s been a frustration for me that we are attacking if the time to get things open has extended. And a lot of things that we are opening right now were acquired two, three years ago and are just now coming to market, so everything is performing as we open them and we think our investments are working out nicely.

Megan McGrath - MKM Partners

Great. Thank you. And then Jeff just a quick modeling question for you obviously you saw a big decline in interest expense in the last couple of quarters should we expect it to kind of flatten out from these levels or to continue to go down as we move through the year and into 2015?

Jeff Kaminski

You are modeling on the SG&A ratio?

Megan McGrath - MKM Partners

No. Sorry, interest expense?

Jeff Kaminski

Interest expense, yes. So on the interest if you look at it in the first half of’13 we are about 7.6% in total, that’s the combination of the interest expense plus the amortize. For the full year ’13 we are about 6.7%. The first half of this year we are up 5.7%, so we pulled a couple of points off that first half of ‘13 number. And I’d say for the full year we will probably be close to right around the range of 5%, so almost 2 points off the full year as well. So, hopefully that’s helpful.

Operator

Thank you. At this time, we have reached the end of our question-and-answer session. I will now turn the floor right to Mr. Jeff Mezger for closing comments.

Jeff Mezger

Okay. Thanks again Rob and thank you all for joining us today and we look forward to showing more success as the year continues to unfold. Have a great day and weekend.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time and we thank you for your participation.

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Source: KB Home's (KBH) CEO Jeff Mezger on Q2 2014 Results - Earnings Call Transcript
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