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KB Home (NYSE:KBH)

Q3 2011 Earnings Call

September 23, 2011 11:30 am ET

Executives

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

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

Analysts

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

Michael Rehaut - JP Morgan Chase & Co, Research Division

Nishu Sood - Deutsche Bank AG, Research Division

Stephen F. East - Ticonderoga Securities LLC, Research Division

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Daniel Oppenheim - Crédit Suisse AG, Research Division

Kenneth R. Zener - KeyBanc Capital Markets Inc., Research Division

Michael G. Smith - JMP Securities LLC, Research Division

Buck Horne - Raymond James & Associates, Inc., Research Division

Unknown Analyst -

Josh Levin - Citigroup Inc, Research Division

Operator

Good day, everyone. Welcome to KB Home's 2011 Third Quarter Earnings Conference Call. Today's conference call is being recorded and webcast on KB Home's website, at kbhome.com. The recording will be available via telephone replay until midnight, Eastern Time, on September 30, 2011, by calling (719) 457-0820 and using the replay passcode of 6973133. A replay will also be available through KB Home's website for 30 days.

KB Home's discussion today may include certain predictions and other forward-looking statements that reflect management's current expectations or forecasts of market and economic conditions and of the company's business activities, prospects, strategies and financial and operational results. These statements are not guarantees of future performance and due to a number of risk, uncertainties and other factors outside of its control, KB Home's actual results could be materially different from those expressed in or implied by the forward-looking statements. Many of these risk factors are identified in KB Home's filings with the SEC, which the company urges you to read with care.

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

I'll now turn the conference over to Mr. Jeff Mezger. Please go ahead, sir.

Jeffrey T. Mezger

Thanks, Melanie, and good morning, everyone. I'd like to thank you all for joining us today to discuss the results of our third quarter of 2011. 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.

While we all know current economic conditions remain difficult, one very encouraging trend that gained momentum in the third quarter was the growing number of homebuyers who are recognizing the extraordinary value and affordability inherent in today's housing market. This suggests that the stabilization process continues, although we will not have a full housing recovery without job growth and consumer confidence.

In the short term, we are managing the current market realities but we look forward to the point in time in which intrinsic demographic trends and economic expansion will inevitably move housing from a stabilizing environment to a growth environment once again.

What I would like to focus on during this call is the strategy we are continuing to adhere to at KB Home in order to maneuver successfully within this environment, to achieve profitability and to position our company for growth in the years ahead. This strategy, which we have been executing over many quarters, includes reinvesting in highly desirable submarkets, primarily in our targeted growth states of California and Texas; lowering our overhead levels and cost to build; and maintaining a balance sheet that both supports our current business and provides flexibility for future opportunities.

Most importantly, our results demonstrate that our strategy is working, and that we are making tangible progress toward our goal of profitability. In fact, despite the ongoing headwinds in the market, many of the key metrics of our business are now trending in a positive direction. We have substantially lowered our break-even point while establishing a sales pace that is setting us up for a brighter future.

So while the markets are not necessarily getting better, we are better as a company. And although we remain cautious in the current environment, the improvements in our results give us confidence that we are on the right path.

One of the primary drivers of our investment strategy and improved results is our deliberate weighting of resources and investment dollars to California and Texas. As we have shared on previous calls, since the beginning of 2009, over 75% of our land acquisition and development dollars have been going into these 2 states, each of which has its own intrinsic demand dynamics.

Regarding California, there is a different housing picture in the coastal regions than the one you see in the more inland regions of the state. From the Bay Area to Orange County and San Diego, the demand for new homes in these desirable markets was never met in the boom years. People have always wanted to live in these attractive areas near jobs, transit, recreation and good schools. And those who could not previously afford to are now coming back to buy.

These are submarkets where prices are stable, supply and demand are in balance, there are fewer foreclosures and new home competition is limited. As the coasts have stabilized and continued to improve, we would expect this positive trend to move out eventually to more of the commuter-oriented inland areas of California where we are also well positioned.

While California sales are being driven by demographics and affordability, in Texas, it is jobs and consumer confidence that are creating demand, particularly, in Austin and San Antonio. In these 2 cities, we are seeing inventory imbalance, less foreclosure pressure and a more favorable pricing environment.

Within our Texas business, our product offerings are appealing to higher income, first-time and move-up buyers. These buyers have a strong preference to own a new home and little interest in the headache and hassle associated with buying a foreclosure.

As we reported last quarter, a great illustration of our growth strategy in Texas was our sizable acquisition of 1,900 lots in 11 communities in San Antonio from Fieldstone Homes. I'm pleased to report that several new communities resulting from this acquisition will have models open in the fourth quarter, and these communities are expected to provide approximately 300 to 400 deliveries in fiscal 2012.

Even though we have prioritized California and Texas, there are still pockets of opportunity we are capitalizing on in many of our other markets. While our investment in these other markets is more measured, it is still the same strategy of opportunistically acquiring lots in A locations, close to job centers, transportation and good schools. We are maintaining this larger growth footprint for the future as we believe demand for new homes in these cities will return as the economy recovers.

I would emphasize, however, that we are not being overly aggressive in our land investment. As always, we have strict financial hurdles and strategic parameters in place based on our disciplined KBnxt Built to Order business model. It is not easy to find lots in these more land-constrained submarkets, but we have strong tenured land teams on the ground who are successfully identifying land opportunities that we know will perform well based on their attractive location and solid market fundamentals.

The $1.1 billion we have invested in land and development over the past 2 years has served to transform our product and community positioning. Our lot count is down slightly year-over-year, while inventory dollars have increased, reinforcing that we have moved in the higher price submarkets in desirable cities with product that is favorably priced.

Turning now to our results, I am pleased to report that many of our third quarter financial metrics, including deliveries, gross margin and SG&A percentages all continued their sequential improvement since the beginning of 2011. We reported positive operating income in the third quarter, and our bottom line results improved dramatically from the second quarter of 2011.

While our deliveries were lower year-over-year, due in part to the extraordinary tax credit influence of 2010, we were within range of the same net income result. This demonstrates that the combination of higher sales price and reduced overhead is essentially lowering our break-even point and positioning our company to achieve profitability.

Another highlight of the quarter was our sales pace. Net orders were 1,838, a 40% increase over the prior year period, with particularly strong comps in July and August. Year-over-year sales were higher in all 4 of our operating regions.

Our California divisions, which are a major part of our overall business, have performed particularly well, together posting comps that were over 70% higher than the prior year.

I also want to make special mention of our Las Vegas division where our team is doing a terrific job and achieved an 80% increase in sales over last year, while operating in a difficult environment. Our Las Vegas division continues to generate among the highest sales rates per community in the company.

Not only are we experiencing stronger sales in comparison to the weak post-tax credit levels of last year, we are also seeing the added benefit of sales from our new community openings. We opened over 60 communities in the first half of 2011 and another 33 in the third quarter, bringing our total community count opened for sale at quarter end to 233, a 10% increase over last year.

We have supported these new openings with an increased investment in marketing and advertising that highlights the advantages of our Built to Order homes and industry-leading, energy-efficient products versus resale homes.

As these new communities come online, our homebuyer profile is shifting to higher income, first-time buyers and move-up buyers who are responding to our unique Built to Order product positioning in the more expensive, highly desirable submarkets. In the process and underscoring this trend, we are seeing increases in the average square footage, selling price and studio revenue per home.

Also during the quarter, we continued to steadily rebuild our Built to Order backlog, which was up 22% over the prior year and like our sales, was higher in all 4 of our operating regions. Our backlog levels have improved sequentially throughout 2011.

We remain committed to our Built to Order business model for the many benefits it offers to our business and our customers. As we have efficiently reduced our cycle time to just over 4 months from contract to close, our buyers are more than happy to make the choice to buy a brand new Built to Order KB Home over other new home inventory or a resale home.

As we continue to refine our emphasis on our targeted markets, we are adjusting our overhead levels to reflect this strategy. We have been leveraging our resources and overhead in our priority markets, while continuing to reduce overhead and investment elsewhere. Our ongoing approach is to bring our costs into alignment with the market realities of today, while not giving up the growth platform we need for tomorrow.

At the same time, we remain dedicated to maintaining ample liquidity to support our current business, to be opportunistic in our markets and to fuel future growth. We are comfortable with our cash position and have confidence in our ability to generate cash as the $1.1 billion in land investments we have made over the last 2 years flows back into the business as revenue.

Before we turn to our financial highlights, I would like to say a few words about what we believe are KB Home's true differentiators in the marketplace. First among these is our Built to Order process, which I've already touched on, that is more relevant than ever especially as our buyer's profile evolves in the higher income, first-time and move-up buyers. Built to Order combines the choices of a custom homebuilding experience with the efficiencies of a high-volume builder. All KB Homes come with great standard features, and consumers then choose and pay for only the customized options that they want.

Our steady pace of studio sales throughout the downturn and the recent increase in these sales shows us that this model continues to be valued by the consumer. Our third quarter studio revenue per home was the highest it has been in over 2 years.

KB Home's industry-leading, energy-efficiency initiatives are a natural extension of our Built to Order model and a great selling point with consumers. All KB Homes are ENERGY STAR qualified, and come with our proprietary Energy Performance Guide that shows consumers their estimated monthly energy bill for their new KB Home, as well as their estimated monthly energy savings compared to a typical resale home.

Importantly, we have worked closely with our product design and suppliers to ensure that these improvements in energy efficiency are not making our homes more expensive to build or to buy. As a result, our standard homes can potentially offer incredible savings in energy bills, as much as 45% versus homes that are not ENERGY STAR qualified, which can translate directly into either more home buying power or additional discretionary spending for our customers.

Recently, we have added even more energy efficiency options that buyers can choose as they customize their home in our studio process. We have expanded our popular solar program in Southern Cal, where currently almost 70% of our communities include solar power as a standard or optional feature, and have started offering this program in select Austin communities as well.

Last week, we launched the first KB communities in the country that feature our new ZeroHouse 2.0, a net-zero energy home option that may eliminate the home buyer's monthly electricity charges entirely. The initial openings were met with tremendous response, bringing out hundreds of interested consumers. This is the next evolution of our Built to Order model, and truly a major differentiator over resale.

On another note, we have successfully transitioned into our new marketing agreement with MetLife Homes -- Home Loans, and believe that they will be a critical partner in serving our customers going forward.

Finally, I want to say a quick word about our South Edge joint venture in Las Vegas. We are cautiously optimistic that the reorganization plan, which was proposed by the majority of the builders and the banking group, will be approved and confirmed by the court. We anticipate this will occur in the fourth quarter of 2011, or potentially early in the first quarter 2012. We look forward to full resolution and ownership of this valuable asset in a very land-constrained market.

Now I'll turn the call over to Jeff Kaminski, who will provide more detail on our financials. Jeff?

Jeff J. Kaminski

Thank you. As Jeff mentioned, many of the key financial metrics of our business are moving in the right direction. We spoke of this positive momentum during the second quarter call, as we felt the improvement of our underlying operations would significantly enhance our future financial results.

I'm now pleased to summarize the results for the recently completed quarter. KB Home's net loss in the third quarter 2011 was $9.6 million or $0.13 per diluted share, a substantial improvement over the net loss of $68.5 million or $0.89 per share reported in the second quarter 2011. KB Home reported a loss of $1.4 million or $0.02 per share in the prior year's third quarter. Our results included $1.2 million of impairments in land option abandonments in the third quarter of 2011, compared to $20.6 million in the second quarter of 2011 and $3.4 million of such charges in the year-ago third quarter.

We were also pleased to report positive operating income of $1.4 million in the third quarter 2011. We delivered 1,603 homes in the quarter, a 31% decrease from the 2,320 homes delivered in the third quarter of 2010, which was favorably impacted by the federal tax credit. Our average selling price is $227,400, an increase of over 6% as compared to both the $214,200 in the same quarter last year and the $213,400 in the second quarter of 2011. This reflects our ongoing strategy of repositioning our business in higher-priced submarkets. Revenues were $367 million compared to $501 million in the third quarter of 2010 and $272 million in Q2 of 2011.

At quarter end, our backlog stood at 2,657 homes, representing a 22% unit improvement over the 2,169 homes we had in backlog a year ago and a 10% improvement over the 2,422 homes we had in backlog at the end of last quarter.

Housing gross margin, excluding impairments and land option abandonments, was 17.2% of housing revenues in Q3 2011, compared to 14.9% in the second quarter and 18.2% in the same period of the prior year. The decline as compared to the prior year was the result of shifts in product mix and reduced leverage from our lower volume of homes delivered, partly offset by the positive impact of $7.4 million of warranty adjustments. We expect that margins in the fourth quarter will be up sequentially from the third quarter 2011.

Our selling, general and administrative expenses in the third quarter were $60.2 million versus $78.6 million in the same quarter the prior year and $62.5 million in the second quarter of this year. In addition to the ongoing cost cutting efforts that Jeff mentioned, we received a net benefit from the recovery of legal expenses from insurance carriers in the quarter.

Now turning to our balance sheet. In relation to our accounting for South Edge, we reevaluated and made no adjustment to either the $226 million liability or the $75 million valuation of the underlying land. The resulting net obligation as of quarter end remained at $100 million.

Our land and land development investments in the third quarter were approximately $106 million, and we continue to anticipate our total investment for fiscal 2011 will be approximately $550 million, including the South Edge land investments of $75 million.

We ended the quarter with total cash of approximately $591 million, slightly favorable to our internal projections, and we reiterate our prior guidance of total cash at year end of over $500 million after funding the South Edge-related obligations previously mentioned.

Finally, as planned, we paid off $100 million of debt that matured in the quarter as part of our balanced approach to navigating the current environment. This action, along with an additional $89 million of other year-to-date debt repayments, will result in annualized reductions in interest incurred of nearly $9 million.

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

Jeffrey T. Mezger

Thanks, Jeff. Although macroeconomic conditions continue to be turbulent, we are successfully repositioning our company to achieve profitability. Our targeted investments in coastal California and Texas are paying off in the form of higher prices, increased sales and higher margins. This stronger community positioning in healthier submarkets, when combined with our lower overhead and value-engineered Open Series product offerings, has positioned us well for the future. We believe our company is poised for upside as our carefully chosen local markets continue to improve and our customers take advantage of our unique Built to Order offerings, our industry-leading energy efficiency initiatives and historic levels of housing affordability.

I would like to thank all of our employees across the country who have been working tirelessly to execute our strategy day in and day out. I recognize the total team effort that is required, and I appreciate everyone's talents and contributions.

As we head into the fourth quarter, we anticipate that our positive sequential and year-over-year momentum will continue in many key metrics. As a result, we are positioned to achieve a profitable fourth quarter of 2011.

With regard to sales, assuming housing market conditions stay as they are, we currently anticipate another meaningful increase in net orders in the fourth quarter when compared to the prior year. Our average selling price will increase sequentially and year-over-year as well.

Most importantly, we expect to end the year with a substantially higher backlog than we did entering 2011, and are confident that this hard-earned momentum will continue into next year. We look forward to updating you on all of these topics at our year-end call.

While we're pleased with our progress, we are mindful of the headwinds that still exist in our industry. KB Home has managed through many housing downturns in our 50-plus years in business, and we intend to continue to leverage that experience as we work diligently to drive profitability.

And now we will open it up to your questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Bob Wetenhall with RBC Capital Markets.

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

Could you just comment on your conversion rate and how you see that trending in next quarter?

Jeffrey T. Mezger

Bob, are you referring to backlog conversion or sales conversion or what?

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

Backlog conversion. I think you guys were at 66% in the quarter. And I wanted to see if you thought it would go down or be in line with that going into 4Q.

Jeffrey T. Mezger

I think that's a reasonable range for going forward. And it's a combination of things, Bob. We're reloading our Built to Order backlog, as I shared in my comments, which will include a portion that is not yet started at any given time. So you won't see us exceed 100% in a quarter or close to that like other builders because we're not converting specs. Last year in our fourth quarter, we were at 88%, which was on the high side. But with our build time, you can assume a 4-month build time from contract to close or 4-month cycle time, which equates to a 66%, 70% conversion.

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

Got it. And just one quick follow-up. Can you provide any color on traffic trends since the end of the quarter?

Jeffrey T. Mezger

Well, I'm not going to comment on September because our reports are only 16 days old so I'd hate to get into that one again. But I can tell you, we ended the fourth -- or the third quarter with momentum, and our traffic throughout the quarter was significantly higher than the prior year.

Operator

And we'll go next to David Goldberg with UBS.

Unknown Analyst -

It's actually Michael Clark [ph] on for David. It seems like your sale pace is ahead of your competitors’. Would you agree with that statement? And also how do you benchmark your sales pace versus the rest of the market?

Jeffrey T. Mezger

Well, relative to the recently reported sales, our comp was certainly stronger than some of the other numbers that I've seen. But Michael, I continue to look at our biggest competitor as resale. And if you look at the strategy we’ve deployed where we're doing rifle-shot investment in desirable communities, there's not as much new home competition in those locations as there would be in more of what I always refer to as the food court, where all the builders are out there. So we track each asset, we manage it to what I call optimize that asset, and we'll pace the sales rate and margin to the investment for what makes us the most money and the best returns. And most of our pricing is tracked to the resale environment in that submarket.

Unknown Analyst -

Great, okay. Thanks for that color. Also I'm wondering about the use of outside realtors. How does your commission structure compare for external agents versus your employees? And also what percentage of your sales would you say comes from them?

Jeffrey T. Mezger

Yes, Michael, we're very friendly with the realtors. They're a vital part of our business and have been for decades. The commission rate will vary per city, and we peg it to what the going rate is in that market. We don't throw a lot of commission incentives out to try to attract more realtors. We find that if we take care of their customer and deliver on our promise, the market rate commission works just fine. And it's typically higher than our internal commission. I don't like to give you one number because it varies around our system from division to division and community to community.

Operator

We'll take our next question from Michael Smith with JMP Securities.

Michael G. Smith - JMP Securities LLC, Research Division

So first of all, just a quick housekeeping question to make sure I understand this. As far as the warranty adjustment that was included in the gross margin, that's essentially you guys looking back at warranty claims on previous deliveries and adjusting what you think warranty claims will be on future deliveries, and that impacts the gross margin on what you delivered this quarter?

Jeff J. Kaminski

Yes, that's correct. Every quarter, we review all of our reserves in accordance with GAAP. We did the same thing this quarter. As we reevaluated the reserve on the warranty, we found that based on our past experience and really based on what we anticipate for the future, that we had a bit too much in the reserve. We took a really close look at it this quarter especially given that we pretty much winded down the drywall, the Chinese drywall issues in our Southeast region. And though there are still some lingering homes to be repaired and some investigations to go through, pretty much that's behind us and given that we took a very hard look and made the reserve adjustment.

Michael G. Smith - JMP Securities LLC, Research Division

Okay. So it wouldn't really be fair to characterize it as sort of a one-time item? I mean, it can change back obviously depending on what ends up happening with future warranty claims but it's not like a one-time benefit, that's not quite fair, right?

Jeff J. Kaminski

I don't like using the words one-time on adjustments that we need to make regularly. We've taken expense relating to that adjustment in prior quarters so the reserve didn't get there out of nowhere, and it was adjusted now based on our experience levels. And we think it came greatly as a result of efforts we've made internally not only to build quality homes but to keep our repair costs down and to really manage the warranty expense as a company. So there was a lot of effort that went into that. And we'll continue to evaluate it every quarter. And it can move up or down on a quarterly basis. In our normal margin, we take a set percentage and we reserve appropriately on our current sales. And like I said, you pause at the end of every quarter and do an overall assessment.

Michael G. Smith - JMP Securities LLC, Research Division

Okay, that helps. And then second question is just on land spend for 2012. As far as I know, you guys haven't given any guidance on that yet. But I'm just wondering if you can speak a little bit about kind of walking us through what you're thinking or how that process will take place as far as deciding on what land spend will look like in 2012. I mean, is anything -- I mean, this was a pretty strong quarter for you guys, order-wise, and on the sales pace, and your thinking over the last month or 2, seeing the strength in July and August change. And then also how does some of the liquidity questions that are out there figure into that land spend for 2012? And just any color you can give on thinking for that would be helpful.

Jeffrey T. Mezger

Michael, I can speak to that. As I shared in the comments, we've now spent $1.1 billion in the last 2 years on land acquisition and land development, and that is now starting to reward us nicely with the trajectory that we've shared in our many metrics. And frankly, our land spend going forward will be tied to our sales experience in every city and what type of opportunities we find in the cities that are strategically a priority for us right now. In these land-constrained markets, it's not like you can flip a switch and go buy a lot on every corner, they're just not out there. So you have to constantly be mining the environment and especially in coastal California, most of the transactions we do are not competitively bid in the marketplace. There’s things that we have found through our relationship that may not even hit the market, and we negotiate at a local level like that. So the sales pace will drive the land spend. And as I shared in our comments, we're comfortable with our cash, we have the ability to support our business and also continue to be opportunistic as things go forward. Past that, we'll probably give some guidance on '12 spend at our year-end call.

Operator

We'll take our next question from Dan Oppenheim with Crédit Suisse.

Daniel Oppenheim - Crédit Suisse AG, Research Division

I was wondering, you've talked about -- a lot about the West Coast in California, and it looks to be about 1/2 of the new order dollars you're bringing right now. It seems to be a fairly heated land market right now though. How are you looking at that in terms of future communities and such and approaching that?

Jeffrey T. Mezger

Dan, you broke up a little bit. Was your word fairly heated land market?

Daniel Oppenheim - Crédit Suisse AG, Research Division

Yes, yes.

Jeffrey T. Mezger

I would say that's not the case right now. The land markets have actually softened from -- we saw a little bit of feeding frenzy in the spring of '10 but they've rationalized quite well. And in coastal California, as I just mentioned to the previous question, a lot of the transactions that we tie up never hit the market. It's a very local relationship business, and we have land people on the ground that have been with our company for over 20 years in those markets. So we continue to find ample opportunity as evidenced by the $100 million we spent in the third quarter.

Daniel Oppenheim - Crédit Suisse AG, Research Division

Okay. And then second question, somewhat relatedly, if we look at the capital, there's some questions on the last call and then you put out a press release after it and you just had a filing more recently. Can you just give your thoughts in terms of your -- where you -- how you think about your balance sheet now after South Edge going forward and such, and your plans there?

Jeffrey T. Mezger

Okay. I'll let Jeff give a little color but I'd first like to, again, reiterate that we're comfortable with our guidance on the cash position at year end after South Edge. And we'll continue to support our business today and be opportunistic for tomorrow. And the $500 million in cash at year end, it provides all the firepower we need to continue to run the business. Jeff, you got any other color you want to add on?

Jeff J. Kaminski

Yes, just a little bit of color on the filing. The filing was just a renewal. We had a shelf registration that had been out there for almost 3 years. They have a 3-year life so it was just a normal renewal of shelf, and there should be nothing really read into that other than just want to maintain the shelf; we just think it’s good practice.

Operator

And we'll go next to Joshua Pollard with Goldman Sachs.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

You guys talked about positioning in higher-priced submarkets but it's unclear if you're still going after the first-time home buyer in those markets, or if you're inherently shifting to a move up buyer. Can you talk about what's happening on your, I'll say, your base customer? And also talk about your medium- to long-term view of the lower-priced market and the first-time home buyer.

Jeffrey T. Mezger

Sure. Good question, Josh. And we're -- I don't know that our targeted buyer profile has changed because we've always been first-time and first move up. Our price points are going up because of the submarkets where we're finding opportunities. And we have communities up in the Bay Area that are more than 50% first-time, where the average sales price is $600,000 or $700,000, yet it's still a first-time buyer. And then you have communities in Texas where the first or second move-up buyer is $200,000. So the beauty in our business model is we tie up the asset and with our product array, there's enough flexibility that we can respond and offer to whoever the demand is there. And if it's the first-time buyer, it would tilt to bigger homes and if it's -- I'm sorry, first move-up buyer, it would tilt to bigger homes, and if it's the first-time buyer, it will tilt a little to smaller homes. So our strategy hasn't changed. The submarkets drive a little higher ASP.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Understood. And then you gave a pretty thorough view of what you thought what happened in the fourth quarter as far as your sales profitability. But the sort of big piece missing was the gross margins. Are you expecting sequential improvement in gross margin? And can you talk about whether that sequential improvement, or not, includes or excludes the warranty claims?

Jeffrey T. Mezger

Okay. Jeff can talk to gross margin. I believe in our prepared comments, we shared that we expect sequential improvement into the fourth quarter.

Jeff J. Kaminski

Yes, it's true. We do expect sequential improvement. We see more deliveries coming from our new communities out into the fourth quarter, we believe that will help, and yes, we'll stand by that guidance.

Operator

We will take our next question from Ivy Zelman with Zelman & Associates.

Alan Ratner

It's Alan on for Ivy. Jeff, just to kind of follow up quickly on that gross margin. So the sequential improvement is off of this quarter's reported number? The one that includes that benefit from the warranty adjustment?

Jeff J. Kaminski

That's correct.

Alan Ratner

Okay. On the land side, it looks like, I think you said this quarter, it was $106 million. If I look back at the prior 2 quarters, that had been running a bit higher, maybe about $150 million per quarter. I think you said $300 million through the first half. So just curious if that was -- the reduction there was by design to kind of manage the cash position or if it was a function of fewer deals that you're seeing out in the marketplace.

Jeffrey T. Mezger

Yes, Alan, I think it's a function of all the above. We're always going to be mindful of our cash and our balance sheet tied to our business. If you look back over the year, in the first and second quarter, our sales weren't as strong. And my hunch is the teams didn't have as much of an appetite for continued land acquisition because they had to work through the inventory that they'd built up. And with the increase in sales now, you may see a delay in the time it takes to bring deals through the system and close. In the future, you would have to do more land activity to support the higher sales rate if they continue. So I think it moves up and down with the delay to whatever your selling experience is. However, with our internal planning for '12, we've pretty much identified and controlled all the lots we need for our '12 plan right now. And we'll continue to pull the levers of cash spend, lot count, sales pace, keep everything in balance.

Operator

We'll take our next question from Michael Rehaut with JPMorgan.

Michael Rehaut - JP Morgan Chase & Co, Research Division

First question, I was hoping to get a little bit better color in terms of the order trends during the quarter. At the end of your last call, you had mentioned that June was moderately up, and I think you again kind of maybe inherently referred to that in saying that July and August really picked up. If it's possible just to kind of give a month-by-month, year-over-year improvement color. And also you had mentioned Las Vegas doing extremely well in the Southwest region. Given that Arizona is the other part of that, I was wondering if you can kind of fill in the blank in terms of if Arizona was up or down or just up slightly.

Jeffrey T. Mezger

Well, that's your 2 questions in one, Michael. As I shared in the comments, July and August were particularly strong for us. In fact, the August comp was actually higher than July, and we had momentum coming out of the quarter. And it's a great example of how you can fall in the trap if you share just a one-month trend because June wasn't anywhere near the strength that we saw in July and August, yet the comments we made on June influenced everybody's view of where our sales were headed, and it obviously turned out to be much better than, frankly, anybody out there expected and we're pleased with our results. So July and August, we have momentum, and traffic was up and our new communities continued to perform and gained traction quite nicely. I don't know that any color -- Arizona's a small part of our business, Michael. It's a great example where -- we haven't invested a lot in Arizona because the market had been so turbulent and difficult, it's hard to get comfortable. And our community count and our asset level continues to go down. I don't have the number but my general sense is Phoenix and Tucson were down year-over-year and Las Vegas was up a bunch.

Operator

We'll take our next question from Adam Rudiger with Wells Fargo Securities.

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

I want to go back to the gross margin for a second. Excluding the warranty adjustment, it looks like on a sequential basis, it was pretty flat, maybe like a 30-basis point improvement, and I would have expected a little bit more operating leverage there. So can you touch on that? And then given that, can you talk about why you're expecting then maybe a 250-basis point or more improvement excluding the warranty adjustment going into the fourth quarter?

Jeff J. Kaminski

Yes, I think as everybody knows, the sales in the third quarter came from earlier orders in the year. So we had a pretty tough selling environment in the first and second quarter of this year that translated into the third quarter deliveries.

Jeffrey T. Mezger

Deliveries in the third quarter were a huge success.

Jeff J. Kaminski

And the sequential improvement was there, it was a second quarter sequential improvement. Modest as you term it without the adjustment, pretty good improvement as reported. And there was various factors in there. In the third quarter, the deliveries, less than 20% of those deliveries came from openings in 2011. We had 27 community closeouts in the quarter. And obviously, as you're trying to get out of communities and take down some of your expenses including selling, marketing and construction costs, generally, you do compromise a little bit on the margin in order to get a better overall financial result as you exit those communities. So with 27 exits in the quarter, that definitely had some impact. What we're seeing in our new openings, we're seeing 200 to 300 basis points of improvement versus our older communities. And as that percentage of deliveries coming from our newly opened communities increases in the fourth quarter, we're pretty optimistic about the margin. And we're definitely going to continue to push this. It's an important factor for the company. We're pretty happy with our new land performance in the new communities we opened. I think we saw a very strong reinforcement of that during the third quarter with our order rate, and we're very, very pleased with that order rate and very pleased with the new community performance. So like I said, we're going to continue to push it out into the rest of the year.

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

Okay. And then can you clarify how much the SG&A benefited this quarter from the, I think, you said insurance recoveries?

Jeff J. Kaminski

Yes. We had -- we highlighted that one particular item because it was a rather large adjustment. We did not highlight some of the other negatives that hit us every quarter and that you have to compensate for. So there were a number of smaller things offsetting it. In total, the insurance recovery was about $8 million, and that was coming off of some of the basically elevated expenses that we saw last year. So again, it's not another freebie as I think often people like to look at these things. I mean, it was hard work to get it. It was a recovery of the expenses that we ran through the P&L in 2010 for the most part, and we were pleased to have that.

Jeffrey T. Mezger

I was going to add to this comment that the important thing is that every quarter, we have pluses and minuses. There's always these miscellaneous adjustments up and down, whether it's to margin or to SG&A, and we've called out these 2, whether SG&A or the warranty on margin, because they were a little larger and substantial enough to flag them. And we're not calling out every little miscellaneous one. $7 million on the revenue we had in Q3 has more of a ratio impact than $7 million at a higher revenue would have. And as we continue to build our backlog and expect a higher revenue trajectory, it helps both of these ratios further. Small adjustments become a big percentage.

Operator

We will take our next question from Josh Levin with Citi.

Josh Levin - Citigroup Inc, Research Division

So you said you wanted -- you're going to finish the year with $500 million of cash. And as you go into the spring, I guess the spring -- the first half of the year is seasonally when you tend to use cash. So if you look in the first half of '11, you used about $280 million of cash. The first half of '10, you used about $113 million of cash. So as we think about going into 2012 and the seasonal use of cash, should we think that maybe your cash balance drops to $300 million in the spring? Is that, I mean, am I thinking about this correctly?

Jeff J. Kaminski

Well, there's a couple of things I want to point out on the cash. Number one, we typically end the year with a very strong quarter. Last year, with a lower delivery expectation or where we had lower deliveries than we expect for this year's fourth quarter, we ended with almost $210 million of operating cash flow prior to land investment. So we're looking forward to that in Q4. We stand by our guidance on the over $500 million, and we're very confident we're going to get there. As far as cash usage in the first half of the year, you have to balance it off with land spend as well and look at all the factors together. I mean, we spent over $300 million in land investment in the first 6 months of this year, which is a pretty healthy number. Most of our spending this year was in the first half, and we had the ability to control that and to mitigate that depending on the deliveries. I think another very important factor as we enter 2012 is the backlog level. We expect to be going in with a very strong backlog relative to what we went into the first half of 2011 and expect to see continued sales strength. So now there's a number of factors that come together on the cash side. Obviously, there's levers that you can pull and there's multiple cash levers that we see and have the ability to manage out into the first 6 months of 2012.

Josh Levin - Citigroup Inc, Research Division

Okay, that's very helpful. On a separate topic, what percentage of your sales over the past year were to first-time homebuyers? And then going forward, what percentage do you think will be to first-time homebuyers or what's your target?

Jeff J. Kaminski

Okay. As we look at this year, we had about 2/3 the last couple of quarters of our sales were going to first-time, and that had actually come down a bit from prior quarters especially in 2010. And it -- very straight in 2010 and even 2009, we were up over 70%, and at one point in 2009 approaching 80%. So the trend is definitely going the other way, although somewhat modestly quarter-over-quarter. I mean, it's dropping a few percentage points. And like Jeff said, I mean, we target our communities and we target our product as we have traditionally, and it's very difficult to predict, I think, where that's going out in the future.

Jeffrey T. Mezger

But Josh, that's the beauty of our business model. We don't strategically target a consumer. We target a price band that straddles the median income in that submarket. So if the first-time buyers are more prevalent there, that's who we'll cater to. If the move-up buyer's more prevalent, that's who we cater to. So I think our percentages are more a reflection of the consumer than they are a targeted buyer strategy.

Operator

We will take our next question from Stephen East with Ticonderoga Securities.

Stephen F. East - Ticonderoga Securities LLC, Research Division

Jeff, just to follow on Josh's question. It sounds like if I read between the lines, what you're talking about for next year, you would prefer to hold your land spend down and net generate cash through your homebuilding ops. Is that an accurate read on it?

Jeffrey T. Mezger

Yes, I don't know that I would jump that far, Stephen. Jeff was walking through the levers. If you look at it, our WIP spend is typically highest in July and August, as you're closing out a third quarter and setting up a larger fourth quarter as you deliver through your stronger spring sales. So WIP spend goes up in the third and fourth quarter. Land spend can vary from quarter-to-quarter, and your revenues typically dip in the first and second quarter because you're delivering through the sales from a seasonally softer period. So we know that we're going to end the year with higher backlog, and it gives us confidence that we'll be growing revenue into Q1 and Q2, compared to this year, and we'll continue to keep things in balance based on sales pace, land spend to support our business trajectory and mindful of keeping our cash in balance. So there's all these levers at play at all times. And if sales slow, we'll slow our land spend. We continue to be comfortable with the cash balance that we're managing to.

Stephen F. East - Ticonderoga Securities LLC, Research Division

Okay, alright, that's helpful. And then just the other thing. One, what you're sort of seeing on land deals? Are they getting tougher to pencil from that perspective? And then two, you've talked about the performance in Las Vegas. So with that type of volume, are you all actually able to get pricing there?

Jeffrey T. Mezger

Well, we have seen some price in Vegas where communities are selling faster than we need or we would like on that asset. And the term I keep using is we optimize the asset where we try to keep them down, say, minimum sales rate, that gets you profitable and gets your cash out with the best return. If your sales rate exceeds that hurdle, you'll push price. If the sales rate drops below, you'll get more aggressive. And we do what we call scalpel pricing per community literally every week, where we track our sales are and do we need to push price or pull back on price. We have a great story in Vegas where we grand opened a community in the third quarter that was actually a development deal in Henderson, of Versante, that came out of the gate very strong above our pro forma, and we were able to push price a little bit. So that was a nice story.

Operator

We'll go next to Nishu Sood with Deutsche Bank.

Nishu Sood - Deutsche Bank AG, Research Division

First, I wanted to ask about your order trends on a longer-term perspective. 40% year-over-year performance obviously, very, very strong relative to what we've seen out of some of the other folks. If I look back over the last 5 years through the downturn, through the peaks and the valleys of the tax credit, your numbers are always more volatile than your peers’. And so the highs are higher, the lows are lower, and we seem to be setting up for another quarter like that. So I wanted to ask a longer-term question, not just about this quarter. What do you think causes that? Is it something to do with management processes, your sales processes, your incentive, maybe your different fiscal year? So why are your numbers more volatile than your peers’?

Jeffrey T. Mezger

Nishu, I don't know how to even respond to that because I don't know that we are different than the peers over the long run. You had some pretty extraordinary influences in '09 and '10 with tax credits and with things we may have done to build inventory to cover a tax credit, your sales spike to tax credits go away. What's going on right now in our business is a growing community count in better locations with communities that are hitting our sales goals. And you can see the sales traction that's occurring. This isn't a one-time event that's gone. We shared we had momentum coming out of August, and it's a reflection of better performing communities, not that it's a market spike or something like that. And I would expect, since we're growing community count for the first time in many years, and our backlog is getting back in balance, that you'll see our sales be more even keel going forward.

Nishu Sood - Deutsche Bank AG, Research Division

Okay. And the second question I wanted to ask was on the cash to liquidity side. Have you folks -- with the credit market spreads, the CDS [credit default swap] widening out quite a bit, and you folks obviously have ruled out on equity offering post your last quarter, at least in the near to medium term. So I wanted to ask about lines of credit. Have you been having conversations with banks? How are you finding their receptiveness to perhaps set up a line of credit sometime in the next 12 to 18 months, let's say?

Jeffrey T. Mezger

Nishu, as again, I'd like to reiterate, we've guided we'll have $500 million in cash at the end of the year, which is more than ample to run a business at the revenue size that we're at and provide growth opportunities. So we don't have to do anything but run the business. And while CDS may spread or this instrument changes in value, we're focused on running the business and supporting ourselves today and providing opportunities for tomorrow. And we think we have that and we're comfortable at the $500 million. Unless you want to give any color on anything else?

Jeff J. Kaminski

Yes, on options and opportunities, I think with our current capital structure and the way our indentures are worded, we have plenty of flexibility on a capital structure if need be. We watch liquidity, we watch our forward forecast. And I think as Jeff said, we're very comfortable right now.

Operator

We'll take our next question from Ken Zener with KeyBanc.

Kenneth R. Zener - KeyBanc Capital Markets Inc., Research Division

I just have some questions on the -- in the first quarter, you highlighted the fixed gross margin because of the low revenue. Can you give us an update on both the gross margin kind of fixed cost? I think you said $15 million in the first quarter. Give us an idea where it is now given the higher community count, as well as previously, you've talked about 6% being variable on the SG&A?

Jeff J. Kaminski

Correct, yes. And just to clarify on the percentage on the SG&A, it's in the range of 6% to 7% of sales of the top line revenues, and you can look at that as a variable component. And it does range in between there and a lot of the variance and variability in that range just comes from our regional mix of business, though certain regions carry a slightly higher SG&A load than others. So that's one piece. On the fixed cost, I don't think it's changed materially from the beginning of the year. We're trying to hold that down as well as we can. We like the fact that we do have community count growth coming, and we've been able to hold those expenses down at a reasonable level, and it's really moving on a percentage basis more based on volume.

Jeffrey T. Mezger

And as we shared in Q1 and Q2, we were already incurring the overhead side of these communities to get them open, and we made the decision to carry the load to set up a better tomorrow, and you're now seeing that come back in the sales pace and the backlog and our trajectory. We have incredible leverage here. We could significantly raise our productivity per community from the first half of this year without adding a lot of overhead. So part of our strategy in getting to profitability is this leverage that we're now setting up. But the cost was there in the first half of the year.

Kenneth R. Zener - KeyBanc Capital Markets Inc., Research Division

Okay, good. No, that leverage is obviously critical for you guys. It sounded like – and the second question here is community count. You gave us 233. It sounded like you guys have a way of looking at it, and you gave us 10% year-over-year. Would you mind -- because I think those are kind of new, unless I've been missing something. Could you kind of just go back in time so we have a trend, A, talk about the methodology, talk about 2012, as well as give us your own lot count, both finished and total reported spec?

Jeff J. Kaminski

There's a lot in that final question, Ken. Look, I'll do my best. On the community count, yes, that is new. You picked that up correctly. We went to a very simplified approach on community count. And the way we're counting it is basically active selling communities. So when we get a community up and running and we start taking sales, it's entering the community count. And it's leaving the community count when we sell our last unit, so our last lot leaves and it comes off that quarter. The way I'm looking at it, we're taking quarter end snapshots. We're taking an average beginning and ending quarter, and then we're comparing it to a prior period. So if you look at the number we gave for this quarter, at the quarter end, we ended at 233. 233 communities at the end of the quarter. Last year, same quarter end, we had 211. So we were up about 10%, and those are the numbers that we offered up on that. Relating to lot counts, I think our lot counts stayed relatively stable from the end of the last quarter at 37,000 total, and just let me get some detail on the options. We had about 6,000 optioned, about 31,000 owned at the end of the third quarter, and I think that was relatively pretty close to where we ended the second quarter at.

Operator

And at this time, we will take our last question from Buck Horne with Raymond James.

Buck Horne - Raymond James & Associates, Inc., Research Division

I wanted to go to maybe more big picture thoughts here. Maybe talk about the mortgage market for a second. There’s been a lot of concern about the difficulties buyers are having qualifying for mortgages and navigating the verification process. Can you talk a little bit about how you see the mortgage underwriting environment affecting your buyers? And are you seeing any signs that standards are tightening still?

Jeffrey T. Mezger

Buck, we’ve spent a lot of time on this topic back in the fourth quarter and the first quarter where we had seen a strong shift, not so much in underwriting guidelines toughening but the documentation requirements were becoming extremely burdensome on the consumer. And I believe I shared on the second quarter call, we actually saw that it had eased a little bit, that maybe the pendulum had gone too far and may have eased a little bit on the documentation. I don't know since then we've seen any material toughening relative to where we were at. It's obviously much, much tighter than it was a few years ago, and FICO scores are up and ratios are tighter and documentation is still pretty thorough. So I believe that it is limiting demand in the marketplace. I do think people that have confidence in their job and in their personal life still find a way to get a loan. And we're evidencing that with our sales pace and our delivery trajectory. Financing’s out there; it’s readily available. It's just much tougher than it was a few years ago.

Buck Horne - Raymond James & Associates, Inc., Research Division

Okay. And my last thought is can you speak kind of broadly maybe just regards to this employee classification issue that the Labor Department is bringing, and they're kind of investigating across the industry. And just kind of wondering what your thoughts are, if there's any validity to it. And kind of what the potential cost may be or risk to the industry if certain employees had to be reclassed as employees instead of contractors?

Jeffrey T. Mezger

Buck, we will acknowledge, Buck, that we received the letter, and it's been widely covered in the news. We're continuing to evaluate the request from the Department of Labor as are all the other builders that received the same letter. And frankly, I think it's too early to tell. It's gotten a lot of activity in the media, not sure why. We're going to continue to work with the request and respond to what they've asked for. But at this time, we'd rather not give any color because we're still trying to understand it.

Operator

And that does conclude today's question-and-answer session. I'd like to turn the conference back over to our speakers for any additional or closing remarks.

Jeffrey T. Mezger

Okay. Thanks, everyone, for your time today. At KB Home, we're now reaping the rewards of our strategy on investment, our overhead reductions and our better market positioning. We believe the improvements we've made in sales, community count, average selling price, margins and backlog all bode well for our future. And we look forward to building on this momentum to achieve profitability and growth. Thank you, all, and have a great day. We look forward to talking to you again soon.

Operator

That concludes today's conference. We thank you for your participation.

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