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KB Home (NYSE:KBH)

Q4 2011 Earnings Call

December 21, 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

David Goldberg - UBS Investment Bank, Research Division

Michael Rehaut - JP Morgan Chase & Co, Research Division

Stephen F. East - Ticonderoga Securities LLC, Research Division

Unknown Analyst

Daniel Oppenheim - Crédit Suisse AG, Research Division

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Alex Barrón - Housing Research Center, LLC

Dennis McGill - Zelman & Associates, Research Division

Alan Ratner - Zelman & Associates, Research Division

Operator

Good day, everyone. Welcome to KB Home's 2011 Fourth Quarter and Year End Earnings Conference Call. Today's conference 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 December 28, 2011, by calling (719) 457-0820, and using the replay passcode of 4323387. 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, strategy and financial and operational results. These statements are not guarantees of future performance, and due to a number of risks, uncertainties and other factors outside of its control, KB Home's actual results could be materially different from those expressed and/or implied by the forward-looking statements. Many of these risk factors are identified on 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 of 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

Thank you, Melody. Good morning, everyone. I'd like to thank you all for joining us today to discuss the results of our fourth quarter and fiscal year 2011. With me this morning, as always, are Jeff Kaminski, our Executive Vice President and Chief Financial Officer; and Bill Hollinger, our Senior Vice President and Chief Accounting Officer.

As we have shared on our previous call this year, our objective at KB Home over the past several quarters has been to continue to realign our business consistent with the principles of our KBnxt Built to Order business model and to position ourselves to restore sustained profitability. Our presold model emphasizes choice and value for the consumer. This approach enhances sales revenue and customer satisfaction, while at the same time reaps the benefits of production and cost efficiencies, all of which improve operating margins. We know through experience that our Built to Order sales generate 4 to 5 percentage points of higher margin. And given our stronger backlog position today, we expect Built to Order homes to comprise a growing percentage of our deliveries as 2012 unfolds.

Establishing an adequate backlog to support our business model has been very challenging in the difficult housing market of the past few years. That is why we have taken a number of strategic and proactive steps this year to increase our backlog and, in particular, our presold backlog. Our fourth quarter net order and backlog comparisons reflect the diligent efforts of our entire team on this objective. Through the combination of new product lines, new communities and emphasis on our Built to Order process and industry-leading energy efficiency initiatives, we established the sales pace that led us to close the year with the highest year-end backlog we have had since 2008. We are confident this will improve the predictability of our deliveries and increase our margins going forward. And now that we have an adequate level of presold backlog to support even-flow production, they're even more potential synergies to be realized through overhead and cost-to-build efficiencies.

So while we were very pleased to report a profit in the fourth quarter of 2011, equally important for us was the success we achieved in reestablishing the right balance of backlog at year-end and setting up improved year-over-year results, starting with our first quarter of 2012. Our optimism in achieving better results in 2012 stems in large part from our ability over the past 6 months to generate a markedly improved sales pace over the prior year, despite the ongoing challenges of the market. We reported a 38% year-over-year improvement in net orders in the fourth quarter, keeping up the strong pace of our 40% year-over-year increase in net orders in the third quarter of 2011. As a result of our second half sales performance, we ended the year with positive year-over-year net orders for the full year of 2011 when compared to 2010.

Net orders were higher in all 4 of our operating regions in the fourth quarter, as was also the case in the third quarter of 2011. Net orders in our Central and Southeast regions were up 40% and 39%, respectively. We were especially pleased with the performance of our West Coast region, where net orders were up 48% and where our gross profits are also highest. Our average selling price for the quarter was $238,400, up both sequentially and year-over-year as we had guided it would be. This increase reflects the higher-priced product we are offering as a result of our strategic shift to opening new communities in more desirable submarkets. These submarkets feature higher median incomes and less inventory, allowing us to sell homes at higher price points with increased square footages and higher studio revenues.

Moving on to backlog, we ended 2011 with the highest year-end backlog we have had in 3 years, a compelling 61% increase in units and a 74% increase in dollars, representing $459 million of future housing revenues. Like our net orders, our backlog was once again higher in all 4 of our operating regions. We are moving closer to our per community backlog target and, in particular, we have increased the percentage of our backlog as sold and unstarted. This is pipeline is a reflection of the value of our business model and is a core prerequisite to realizing the cost efficiencies of even-flow production. This represents a sharp contrast to our relatively weak backlog position at the end of the fourth quarter of last year and as I mentioned, sets us up very well heading into 2012. Most importantly, our consumer is increasingly recognizing the value inherent in the Built to Order process, which gives them a new home experience with exactly the design and features they want in a build time that averages just over 3 months. This is a compelling advantage against our fiercest competitor, retail homes.

We delivered 1,995 homes in the fourth quarter compared to 1,918 in the fourth quarter of 2010, our first year-over-year delivery increase in 2011. We recognize that this delivery number is in line with analyst estimates, but we had a higher expectation for deliveries entering the quarter.

While we saw the difficult underwriting environment continue to hamper our customers' ability to obtain a mortgage, we attribute the shortfall primarily to issues arising from our transition to our new, non-exclusive marketing agreement with MetLife Home Loans. As of July 1, MetLife went to work mobilizing teams in our markets to compete for our customers' business. But as MetLife was in the process of gearing up, many of our customers chose to finance their home purchases with a variety of mortgage companies other than MetLife, most of which were not reliable in meeting a closing date. As a result, our consumers and our deliveries in the fourth quarter were adversely impacted by lender-related delays. Many homes that were completed and ready for delivery at year end will now close in the first quarter of 2012.

To give you some color on this, in the past, our preferred lender is providing mortgages for as many as 80% of our customers. But in the fourth quarter of 2011, this ratio was less than 40%. MetLife performed well for our customers during the quarter, and is achieving sequential month-to-month improvement in the share of our customers' business that it earns. We expect this ongoing trend to result in more predictable closing going forward.

As you may know, however, during the fourth quarter, MetLife announced their intention to sell their Home Loan business. Until there is a decision on MetLife's Home Loan business, and we are able to evaluate its impact, we expect to continue our existing arrangement. We have developed a contingency plan if the outcome is not advantageous to KB Home or our customers. It remains our strategic intention to reestablish a joint venture on the mortgage side, which can provide additional benefits in terms of predictability of loan closings, synergies and profits. Our lower than expected delivery volume in the fourth quarter also affected many other aspects of our business, including gross margins, SG&A ratios, profits and cash.

While we're pleased to see the positive results of our sales strategy, we still have challenges, foremost of which in the quarter was our disappointment with our gross margin. We understand that we cannot achieve our goal of sustained profitability without both volumes and margin growth. We are continuing to work diligently on improving our gross margins through better execution of our business model. As I mentioned, the margins on our Built to Order homes are historically 4 to 5 percentage points higher than on inventory sales. As further evidence that we're more fully realigned with our presold model, at year end, we had the lowest unsold inventory number we have had in quite some time, allowing our sales teams to primarily focus on Built to Order sales.

With an increased backlog in place, we expect to gain cost efficiencies and overhead and cost to build as we fully realize the benefits of our strategy and even-flow production. We are confident, this will lead to better growth and operating margins going forward.

Finally, we were pleased that the South Edge joint venture litigation was essentially resolved in the quarter at terms and conditions we had anticipated. Now that this matter is behind us, we are moving forward with our efforts to optimize the potential of this valuable asset in the highly land-constrained Las Vegas market. The city of Henderson is a very desirable community to live in, and was just recognized by Forbes magazine as the second safest city in America. We are working together with the city of Henderson and others to revise a development plan, which is the next step in the process, and are hopeful we will begin land development on these future phases by the end of 2012.

Now, I will turn the call over to Jeff Kaminski, who will offer some detail on our financials in the quarter. Jeff?

Jeff J. Kaminski

Thank you. As Jeff mentioned, we were pleased to post a profit in the fourth quarter of 2011 and we will continue to strive to expand this profitability in the feature. The momentum that we discussed during the last 2 quarterly calls continued into the fourth quarter and we are very well-positioned entering fiscal 2012.

KB Home reported net income of $13.9 million in the fourth quarter, or $0.18 per share, compared to net income of $17.4 million or $0.23 per share in the same period the prior year. The 2011 results included gains relating to the wind down of our mortgage banking joint venture and the resolution of South Edge legal matters.

For the fourth quarter, our housing gross margin, excluding impairments and land option contract impediments, was 15.1% of housing revenues. This was essentially flat from the third quarter, excluding the positive impact of $7.4 million of warranty adjustments in that quarter.

We had expected improvement over the 2011 third quarter from an increased mix of deliveries coming from newer communities, the positive impact of volume leverage and expected partial recovery of prior-year quarter expenditures relating to Chinese drywall. The mix of deliveries coming from new communities increased by less than we had anticipated during the quarter, in part due to some of the closing delays caused by mortgage issues. As a result, the favorable impact from this shift was not realized. In relation to the drywall expense recovery while this was not finalized in the fourth quarter, we do expect to see a positive impact on margin from recoveries in 2012. In addition, we continue to prioritize our Built to Order model and, as part of that process, continue to reduce our level of unsold inventory during the quarter, which had a moderately negative impact on margins. However, our spec reduction strategy was successful and we ended the fiscal year with an average of only about 1 unsold finished inventory unit per community.

Selling, general and administrative expenses in the fourth quarter were $75.6 million compared to $55.7 million in the fourth quarter last year, and $60.2 million in the third quarter of 2011. On a sequential basis, the increased cost in the quarter related primarily to a difference in legal reserves and insurance reimbursements. We had an insurance recovery of over $8 million in the third quarter, which we talked about on our last earnings call, and an increase of $4.5 million of noncash legal reserves during the current quarter, accounting for almost $13 million of the quarter-over-quarter variance in SG&A expenses.

In addition, higher volume drove an expected increase in variable selling expenses of $6 million which were partially offset by continued reductions in fixed costs, including salaries, professional services, rent and insurance. Overall, our SG&A expense ratio of 15.9% reflected our third consecutive quarter of improvement. While we still have more work to do, we believe we're making solid progress in aligning our overhead structure with revenue levels in a challenging market environment.

With regard to South Edge, in late October, the joint venture received quarter approval for its proposed reorganization plans and the plan was confirmed in November. This action allowed us to resolve and fund our share of South Edge's outstanding liabilities during the fourth quarter as we had guided on previous calls. Our final obligations related to the reorganization plan and the settlement of South Edge legal matters were favorable to our prior projections, and we recorded a gain of $6.6 million during the quarter.

A new joint venture has been established with 3 of the other builders, and as a result, we have recorded a joint venture investment on our books that essentially reflects the value of the underlying land. It is important to note that the new joint ventures for development planning purposes only and will be utilized while the builders conclude their discussions with the city and finalize their strategy for moving forward.

Turning now to our land acquisition development activity, our total investment in 2011 was approximately $478 million. When you consider the additional $75 million of South Edge land that was reflected as a new joint venture investment, our total land spend during the year was in line with our expectation and prior guidance of approximately $550 million. Despite our lower-than-anticipated deliveries and the substantial cash impact in resulting both the South Edge reorganization plan obligations and the related arbitration award during the quarter, we ended the year with a cash balance of $480 million. This balance does not include approximately $20 million of cash received during the first week of December in connection with the wind down of our mortgage joint venture.

The most significant use of cash in the quarter was the $252 million pertaining to the settlement of the South Edge-related liabilities for which we received a valuable land asset. On a per year basis, our cash outflows also included nearly $200 million of debt reductions, as well as the $478 million of land acquisition and development investments just discussed.

Our intent is to manage the business to a cash-neutral position for fiscal 2012, and as such, we are currently anticipating that our total spending on land investment for the year will be in the range of $400 million to $600 million, depending in large part of course on what we are seeing on the ground, in our markets as the year progresses. We are confident we have adequate liquidity to support our business needs today and to remain opportunistic going forward.

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

Jeffrey T. Mezger

Thanks, Jeff. The consumer benefits of KB Home's Built to Order business model are clear. No other builder can consistently provide customers with the unique combination of the customized new home experience they desire with the savings and value that our innovative designs and energy-efficient features can deliver. We believe this differentiation in the marketplace has been a real driver of the strong sales numbers we have reported over the past 6 months.

Our commitment to this model, which emphasizes quality, value and choice for the consumer, is reflected in our ongoing sustainability initiatives. We have put great emphasis on sustainability over the past few years primarily because it brings real and immediate economic benefits to our consumers in the form of low energy builds and thus a lower total cost of ownership.

During the quarter, for example, we expanded at our popular solar program in Southern California, were solar power systems now come as a standard feature in 28 communities. At the same time, KB Home began its nationwide rollout of net 0 energy options featured in model homes in Tampa, Austin and San Antonio.

KB Home's ongoing leadership in the realm of sustainability, best illustrated with our proprietary energy performance guide included in every home we sell, sends a clear message to buyers that we will continue to be innovative in offering homes that are competitively priced today and will also save them money for years to come, especially compared to a typical resale home. While our primary objective in this area has always been to bring value to our consumers, along the way, we continue to be recognized externally for our efforts. During the quarter, we were the first and only national builder to be named a WaterSense Partner of the Year by the EPA for our industry-leading water-saving features. We were also honored by the U.S. Green Building Council with the Outstanding Multi Family Project of the Year award for our LEED Platinum-certified Primera Terra community in Southern California.

As we look ahead, we are optimistic about the encouraging trends we are seeing in the broader marketplace. In the majority of our markets, house payments are now lower than rent, and it is incredible affordability that is driving demand. As the stabilization process moves forward, we are seeing inventory levels continuing to ease in many of our markets, which is a prerequisite for housing recovery. However, we are even more encouraged by the momentum we are building at KB Home. I want to especially thank all of our employees throughout the company for their efforts in 2011.

As we close the books on the year, I'd like to highlight some of our major accomplishments which include more fully aligning our business with our Built to Order model; our regional shift in land investment for the growth markets of coastal California and Texas; community count growth in more desirable submarkets; lowering our non-variable overhead expenses by a meaningful amount; resolving the South Edge liability and removing that uncertainty; eliminating all outstanding joint venture debt; achieving nearly $200 million in debt reduction; elevating our already-strong brand position as an industry leader in energy efficient homes; maintaining record levels of customer satisfaction; achieving accelerated second half sales growth; and establishing a significant year-end backlog of future revenues.

We also believe our successful land strategy, based on the discipline of our business model, will continue to provide opportunities for growth. We are committed to maintain adequate liquidity to support our business needs and remain opportunistic. This will allow us to further expand our competitive positioning in our served markets across the country.

While the challenges of the market certainly remain the same, we are in a very different business as we enter 2012. Now that we have established the sales pace and backlog that will allow us to fully reap the benefits of our Built to Order business model, we believe we have laid the foundation for improved financial and operating performance in the new fiscal year. In addition to delivering more homes at higher prices, we expect that operating margins will improve in 2012 on a year-over-year basis starting in the first quarter and will be positive for the year as we execute our Built to Order model. Most of all, we look forward to building on our current momentum to position the company for sustained profitability.

With that, we'll now open it up to your questions.

Question-and-Answer Session

Operator

[Operator Instructions] And we'll go to Joshua Pollard with Goldman Sachs.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

I wanted to start by clarifying a comment that you just made, Jeff. Did you say you wanted to be operationally or that your plan was to be operationally profitable? I'm trying to understand what line on the income statement you might be talking about, if that's the operating income line, if that's the pretax line or if that's the bottom line.

Jeffrey T. Mezger

It was the operating income line, operating margin.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Okay, and could you along those same levels talk about what you think a normal SG&A level should be? There's been a bunch of sort of moving items in there. You guys talked about a positive impact from drywall. There's a couple of things and I'm really just trying to understand what you guys felt like, a clean SG&A as a percent of sales figure should be for you guys as you look at 2012. I'd love to hear what your thoughts are on the impact as well on gross margins from the issues on the mortgage side of the business.

Jeffrey T. Mezger

On the SG&A side, Josh, as we shared, we made meaningful reductions. And I agree with your comment that some of them aren't clear because of the one-off adjustments that we have been making on those lines during the third quarter and the fourth quarter. And we're committed to continue to take actions to lower our fixed cost going forward. In normal times, our SG&A will run around 12% of revenue. But we are not in normal times and with our backlog position, we know that we will get SG&A leverage coming in 2012. So we'll have a nice mix of leverage and cost reduction in the year. I don't know, Jeff, if you want to give them any of your thoughts.

Jeff J. Kaminski

No, I think, Jeff summed it up. On the SG&A side, we're focused on a number of areas and we're going to see improvement coming off a number of initiatives that we had this year. I mean, first and foremost, probably the easiest way to forecast next year is to look at some of the full year impacts that we'll see coming off of 2011 initiatives. We'll continue to put focus on cost reductions and we do have several additional areas that we're focused on and will continue to focus on as we go throughout the year. And then finally, we do expect to see leverage impact on SG&A in 2012 based on their backlog that, we're entering the year and expected higher deliveries in '12 than we saw in '11. So we think the combination should give us a somewhat meaningful improvement in the SG&A percentage as we move forward.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Excellent, and 1 last follow-up, if I could. You guys have for the last 2 quarters been talking about growing or building momentum in the overall business. I'd love to understand what you guys think is driving that. You did call out in your prepared comments, the rent-to-price ratios and how much more favorable it is in many cities to own. But that hasn't changed dramatically in the last 6 months, and you've had a significant amount of negative commentary out of Washington, et cetera. I wonder what you think is driving the most recent momentum we see, not just for yourselves but also in metrics like housing starts and existing home sales.

Jeffrey T. Mezger

Josh, you threw a lot in there at the end. As you probably saw this morning, the resale numbers all just got adjusted. So I'll again hope that you can have a quality conversation on what's going on with resales right now. We do know in the communities that we're opening that we shared our strategy on, they're located in more desirable submarkets where there's not as much resale activity or inventory. There's definitely not as much foreclosure activity in those areas, and there's no new home competition. So it's a nice combination. And where we've opened these up, we've seen solid sales results. So I think in part, our selling effort, frankly the most part is that we're a little bit different company today in our positioning with where our communities are.

Operator

[Operator Instructions] We'll go to Bob Wetenhall with RBC Capital.

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

Nice job and it seems like will you got a very strong backlog going into next year. I was hoping if you could just give us a little view on what you're expecting from conversion rates next year.

Jeffrey T. Mezger

As I shared on the last call, Bob, in normal times, our conversion rate will be 65% or so. And it's pretty easy to calculate how to get there. We'd like to have enough on started backlog to continue to see even-flow and it takes you 3 months to build a home. So in balance, it'll be up, the 5-month backlog, in that community. We're not there yet. We're getting closer but we're still not there. On the last call, we guided I think 70% or 75% roughly for Q4. We're within range of that. I think we'll be a little above 65% in our first quarter deliveries, and you'll see the number migrate down to around 65% as the year unfolds.

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

Got it, got it. And just touching on gross margin, it seems like you're doing really well with average selling prices going up on a sequential basis and year-over-year. Do you think that's going to be something that's sustainable that will help drive better gross margins and on the other side of the gross margin question, can you just provide any color on incentives you're providing?

Jeffrey T. Mezger

Let me make a couple of comments, Bob, then I can hand it over to Jeff to give you more specific details. Our prices going up because of the products we're offering in better, more desirable submarkets. Along with that, our average home size is also going up. We're in locations where there is much higher median household income and they can afford more. So we have a higher price point submarket. We're offering a full array of floor plans to buyers selecting larger plans on average, and then they're spending more money in the studio. So you have a consumer with a lot more buying power and in these more desirable submarkets. So it's been a nice mix. I went through all of that because we're not getting pure price in today's market. And we're not assuming any price for next year. We think it will be basically where it is today and that's okay, because we know through execution we can lift our margins without having to raise price. That's the general strategy. I don't know sitting here where the ASP will go in '12 because it depends on where the buyers selections go in the floor plan array, whether it's the smaller homes or the larger homes. But on average, wouldn't expect prices to go down. But I'd say it's going to be fairly static with where it is right now year-over-year. Jeff, you've got to some more color?

Jeff J. Kaminski

Sure. yes, as Jeff mentioned in his prepared comments, improving our margin is a very important part of our strategy moving forward and we're placing significant focus on this area. You mentioned specifically the incentives remain relatively steady on the incentive side. We would obviously, as a business, like to continue to reduce those and we will place focus on that area but there haven't been any unusual movements either way in incentives up to this point.

Operator

We'll hear next from Adam Rudiger with Wells Fargo Securities.

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

I'm wondering if you would talk about your projected working capital needs. If you just take into account the $400 million to $600 million in land spend and then the widely seasonal build-up in inventory, what you think you'll need and potentially where you think your -- where you see your cash bottoming out at intra-year?

Jeff J. Kaminski

We're going to stay away from actual specific cash forecast on a quarterly basis. So we talked about the -- again, during the prepared remarks, that we have a cash-neutral and forecasted cash-neutral 2012. Obviously working capital moves up and down depending on whip in your backlog and the percentage of on your construction inventory that you have. We are going to manage our land spend as we go through the year and really manage it to current conditions. So you should expect in a weaker housing environment as you might expect a lower land spend closer to the bottom end of our range in a more robust environment, particularly as the spring selling season is strong, slightly higher land spend which will be funded of course by higher deliveries in the back half of the year. So we do see seasonal trends. You've seen it in prior years in our business. We'll keep an eye on that and we believe we have adequate cash to take us through those ups and downs during the year 2012. And I think importantly, coming out of the year at a neutral cash level.

Jeffrey T. Mezger

Adam, let me add a little more color too on "the inventory buildup". When you have a backlog, and you're rolling through more consistently with deliveries and starts that are close to imbalance, you don't use up as much cash as you do when you build a lot of houses and then they all deliver in 1 month at the end of a quarter, 2 quarters down the road. But we think we'll have a better flow of cash in and out of the web. And what will move our cash number up and down is how aggressive or conservative we are on land spend and that's why we committed to cash-neutral for the year.

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

That makes sense. On that backlog number, you mentioned in your earlier prepared remarks some efficiencies on even-flow production. Can you comment any kind or quantify or talk about that a little bit more, is there a specific level or general level of backlog where you think those efficiencies really kick in versus where they're a drag?

Jeffrey T. Mezger

Hard to quantify, Adam, because we haven't have the benefits for years, frankly. But when you have a backlog that sets up even-flow when you start the same number of houses each day or each week in a market, you can go to the contractors and work with them to negotiate a better price because they're able to better manage their overhead and their materials without the spikes that our industry has been creating as we've navigated through this thing. In the good old days, we saw couple of points of margin due to the synergies and efficiencies on cost to build and better leveraging your overhead. Right now, we're not getting that. We do know we'll see an improvement as the year unfolds and to be told, there is meaningful benefit to our margin either from a higher percentage of Built to Order sales, delivering through, or hopefully down the road this year, synergies and efficiencies on the even-flow side.

Operator

And Michael Rehaut, with JPMorgan has our next question.

Michael Rehaut - JP Morgan Chase & Co, Research Division

First question, I was hoping you could give us a sense of what community count was for the quarter, what that translates to on a -- comparing it sequentially and year-over-year. And given the land spend range, what you would expect that to I would assume that there'll be some modest growth in '12 expected. If you could share any of that with us.

Jeff J. Kaminski

Sure, community count in the fourth quarter, we ended the quarter at 234 communities, which was about the same, just up 1 committee from the end of the third quarter. Actually we had a fair amount of activity going into that. We had 29 new community openings in the fourth quarter and 28 closeouts. But at the end of the day, we're up just 1 community so basically flat quarter-over-quarter. Year-over-year, if you average it out, and you look at the averages by quarter, again, about 233.5 this year in the fourth quarter and about 210 last year in the fourth quarter. So we're up about 11% year-over-year in community count. When we look going forward, basically we're looking at opening about 25 new communities in the first half and the relative growth on that will be highly dependent obviously on the number of closeouts, which is difficult to predict based on deliveries. So we'll continue some new openings into the first of the year and then monitor conditions as we go out in the second half.

Michael Rehaut - JP Morgan Chase & Co, Research Division

Okay, I appreciate that. I guess the second question, I just want to kind of circle back to SG&A and gross margins. The SG&A, I guess what I'm getting at is how to think about 2012 for both line items. You have SG&A that -- I believe if you kind of strip out the gain, the benefit in the third quarter and the legal reserve increase in the fourth quarter, you're still are looking at about a 19% SG&A rate for 2012, actually slightly above -- I'm sorry, that's 2011, the 19%. You've also mentioned some improvements that you're doing that you did throughout the year. So I'm just trying to get a sense of how to think all else equal, obviously there's a leverage for revenue growth. But that aside, there's a core reduction in SG&A that we should take into account. Similarly, on the gross profit margin, you've had -- you've been calling for an improvement in the back half of the year, really hasn't fully materialized and you point to some factors in the fourth quarter that kind of pushed out that improvement. Just trying to get a sense of how we should think about 2012. What type of improvement we should be looking for given that it's fallen short in the last 2 or 3 quarters. Should we be thinking in terms of a 50, 100, 200? I mean, what's the type of degree of magnitude that we should be expecting?

Jeffrey T. Mezger

Mike, let me make a couple of strategic comments, and then I'll again hand it to Jeff for some specifics. If you look at 2011, and a lot of it ties back to your community count question, we really had a tale of 2 companies. We have a first half with no backlog entering the year, and a lot of expense tied to all the communities that we opened. In the second half, you had stronger sales and community counts that are now in place and opening which set us up for a 2012 with momentum. So that's why in part we guided, we know our operating margin will be higher year-over-year sequentially through '12. And we guided to positive operating margins for the year. It's a different world when you have sales momentum and you can pull levers and manage to a pace versus try to get models open and chase the pace. And now that the models are open, and with the number Jeff gave you, you don't have this need to push through a lot of model openings because they're there. So we can now manage far better to a business that's more in balance. And that's why we're confident that we're going to have a better result as we go into '12 because we're far better positioned, whether it's the backlog, the product types or the overhead structure in alignment with revenue. You want to give them any specific numbers, Jeff?

Jeff J. Kaminski

Yes, sure. I think what we're focused on, Mike, is the overall operating margin. We think that's important -- the most important component for the business. We do expect to see pretty significant improvement in operating margins in the neighborhood of 500 basis points for the year, coming of course the combination from both SG&A reductions, the leverage impact in SG&A, as well as margin improvement. So that's pretty much where we're pegging it at right now for plans leading us, a lot of the clarity will come to that number as we get through really the first quarter and into the spring selling season. And we're able to see better and have better visibility for the back half of the year. But at this point, we're pretty confident with that operating plan and operating forecast.

Operator

We'll go next to Dennis McGill with Zelman & Associates.

Dennis McGill - Zelman & Associates, Research Division

I just want to come back to the fourth quarter margins because realizing there's a lot going on probably would impact 2012. If we go back to your expectations, I think, Jeff, you had implied that margin could be up sequentially from the third quarter level which included the warranty reserve, and I think on our numbers, that leaves us about 250 basis points or so. The actual came in 250 basis points or so lower than that. And you mentioned some different things being mix, the loss of leverage on the top line and the drywall reversal. Can you kind of break those things done so we can understand what's temporary and what's potentially going to be pushed out into next year?

Jeff J. Kaminski

Sure, we have -- like I mentioned, there were several fairly significant impacts in the quarter versus our expectations. I think it is important to know, we didn't have a decline in operating margin quarter-over-quarter. We were more or less flat in gross profit margin, sorry, quarter-over-quarter more or less flat. The impact of each, if you look at, starting I guess with the spec deliveries in the impact going from that, it was less than 100 basis points impact on the gross margin. The most significant one was our expectation relating to the drywall recovery. We have a fairly significant recovery that we're expecting, and in fact we do plan to receive that and capture that in 2012. It was deferred for a number of reasons, not the least of which that we were not happy with the point in time in negotiations at the end of the year and feel there's much more in it for us. So we, as opposed to taking the trade off of booking a number into the fourth quarter, we decided to maximize that recovery and be a little more patient in order to fight for a stronger recovery out into 2012. And it's quite the most significant piece of margin improvement anticipated in the quarter, and makes that highest 200 basis points. In addition to those 2, the leverage impact slightly lower again. Less than 100 basis point impact on that side coming off that. I think that pretty much covers it up. That's basically the wrap up on that 1.

Dennis McGill - Zelman & Associates, Research Division

Okay, so if you were to exclude a lot of those items which -- that's very helpful to isolate those. If you exclude some of those and turn to warranty adjustments, things that I guess would be considered non-core within the year, your expectation into next year is really sort of that baseline plus or minus what happens with the pricing environment.

Jeffrey T. Mezger

Well, again, Dennis, we aren't giving guidance because there's a lot of moving parts still, and we are in the year unfold. We know we can improve our gross profits just through delivering a higher percentage of presold homes. And that's one of our primary objectives as we go into next year. We're delivering presold homes today, so you have that and what percentage was inventory and what percentage was presold and how much can you lift your margin through that. If you look at the receivable, that we would get on our warranty, you can say it's onetime but the costs were actually incurred into our margin at some point prior to that. So it's the offset to the negative that we took earlier in the year. So while it's onetime, it is balancing something that we took in part in earlier in '11 or prior years. So we think that there's margin opportunity. We're committed to it, whether it's more strategic pricing and what I keep getting back to when you have a backlog that can deliver at a pace now, there's a lot of leverage you can move whether it's price on this plan that's selling better than others or whether it's the cost side and efficiency you can get there. So there's a lot of levers we can now pull that we haven't been able to over the past few years, and we think that over time, you'll see the margin continue to improve.

Operator

We will go next to David Goldberg with UBS.

David Goldberg - UBS Investment Bank, Research Division

My first question -- I was hoping you could step back here and talk about the capture rate at MetLife. 40%, I think, Jeff, was the number you mentioned in your prepared remarks. It seemed like a very, very low level, and I'm kind of wondering if you could give us an idea, one, what it was that drove such a low capture rate. I think that was even lower than when you guys -- when you recently went to the JV structure 5 years ago. So what drove such a low capture rate? And was that a risk that you guys had identified when you're on a due diligence process of choosing a new partner that you could see a substantial drop-off in capture rates from where you had been?

Jeffrey T. Mezger

David, I have couple of comments I can share. But first off, when we sold our business to Countrywide many years ago, it took about 18 months to get up to the normalized capture rate. There's an integration period and at the time, we had a lot of backlog. The business was running well, the markets were good and they were very good at process, even with all those favorable elements. It still took 18 years to get to normalized retention. Or months. I'm sorry, months. I'm getting old, months to years. If you look at what we went through this year, our JV partner announced their intention to get out of the JV, and we did in the month of June. So on July 1, we literally had to start over. And MetLife's been a great business partner, but it took time for them to establish teams in every city, get them trained, get the synergies working with our sales teams and sales management. And there was this 90-day window in the third quarter, where they were getting traction on their teams and taking care of our customer. But the customers, hey if you can't handle me -- and there were cities where MetLife literally told us, "Don't send us the buyers yet, we're not ready." I say that because Met has one of the highest customer satisfaction levels in the industry, and they were sensitive in not taking on business that they could not handle. So there’s a quantity concern and we took our time and a lot of the deliveries in the fourth quarter were sold during this window of transition. And through the quarter, MetLife performed well. Their capture rate went up sequentially and is continuing to go up and we expect that, the hit we took is now behind us, that there's still some of it that we're working through. But as we go forward, we think we have far better predictability. We knew that there were some moving parts in our fourth quarter relative to these outside lenders, but it absolutely illustrated for me all the noise that you hear in the media about what buyers get put through to get qualified for a loan. And when you're dealing with lenders that aren't your partner and it's just want loan of a hundred for them, they don't have the priority and urgency, unfortunately, that we have. And we have a lot of closings with last-minute surprises with literally in some cases at the closing table, where customers were told they needed this document or weren't approved. And just a lot of things that when you have your own preferred lender, you don't have the deal with. So we were surprised. It was worse than we anticipated. But now it's behind us and we think that we got a far better predictability going forward.

David Goldberg - UBS Investment Bank, Research Division

Got it, and then second question. I guess this is a little bit more theoretical. On the prepared remarks, Jeff, you mentioned the cost of ownership being below the cost of renting with a lot of your markets at this point. I'm kind of wondering, as the product migrates up a little bit and you guys find land in committees where there's not a lot of land available and there's not a lot of inventory especially, as you move up maybe a little bit more move-up buyer versus pure entry-level or whatever, is the decision as much a question of existing home versus new home? I'm going to buy a home, but what kind of home am I going to buy? Or is it more am I going to stay a rent or be a homeowner? And I'm just interested because we do put a lot of stock in this. The cost of ownership is less than the cost of rental but it would seem to me that for a certain stage of life, you're already past being a renter. You already ready maybe to own a home at this point, and maybe you're in a renter and you've had some life-change experience that would make you more prone towards ownership. And now the question is, where am I going to buy a distressed home, a non-distressed home or a new home? And I'm just trying to get an idea how you're going to think about your buyer profile that way?

Jeffrey T. Mezger

I hate to answer this way, David, but I think it's all of the above. What we are seeing is with more communities opening in more desirable submarkets, you have higher income levels and we're selling expensive larger homes to first-time buyers in some cases. So it's a consumer that, over the frenzy of the 5 years ago, elected not to be an owner. They have good incomes, maybe a dual income and want to live in that area. And they're making the plunge because of the incredible affordability that's out there. They make the decision to be a homeowner. A lot of consumers are surprised frankly at how well home payments are compared to rent. So it's an education process for others. And when I say it's affordability that's driving it, you need consumer confidence and job growth to sustain it. So if you have the people that are comfortable with their economic situation, they recognize the incredible values today and they make that decision. But we need a higher level of confidence to get back to the traditional move upstream or first time buyer out of the rental. I believe our buyer profile, Jeff, I don't know if you have the numbers, but our buyer profile did not change much. It's still 65% first-time buyer. But it's a high-income, first-time buyer. That's what's different for some.

Operator

We will go next to Alex Barron with The Housing Research Center.

Alex Barrón - Housing Research Center, LLC

I wanted to ask you as far as your market footprint, I guess, are you guys still comfortable with every market or is there any market that you are thinking of entering or any markets you're thinking of exiting at the moment?

Jeffrey T. Mezger

Well, Alex, we're comfortable with our footprint today and every city has to stand on its own. The cities we're in are primarily Sun Belt, they're cities that are projected over the long term to have favorable population growth and economic growth, and there are cities that are compatible for volume builder. So we chose them with intent and we like where we're positioned today. We are not hung on staying in the city just to say we're in the city. Over time, it has to prove that we can get our returns and profitability in that city, or we may elect not to stay there. But at this time, we're focused on growing our backlog and run the business.

Alex Barrón - Housing Research Center, LLC

Okay, and then I guess related to that, I mean, what are you seeing on the land side? Are you finding attractive land deals at pencil for your expected returns or are you finding that, that's more difficult? And then just an extra side question, can you tell us what percent of your sales are to FHA buyers?

Jeffrey T. Mezger

Jeff has a concern that's statistically, Alex, but our strategy of going to more desirable submarkets, typically, they are more land-constrained. And it's not like you can walk down the street and identify parcels and turn them into revenue in 6 or 12 months. So there's an inherent constraint, and your success is tied to how good your land teams are on the ground. Whether it's Texas or California where we spend about 75% of our money in 2011. We have good land teams on the ground. So the fact that we spent $478 million on land actual development tells you that we're finding deals. But it's not everywhere, we're having to work hard in minus and it's tied to how good our teams are. Having said that, we are finding deals that's penciled. We're continuing to invest in our growth.

Jeff J. Kaminski

Yes, regarding the FHA percentages, historically we've run sort of in the mid-50s to low 60s in recent history. The 1 caveat I'll put on that is we have less visibility to that number of course, now after the inclusion of our JV the end of June. So those numbers are sort of from the beginning part of this year and through 2010. But I'd say they remain fairly stable, and I would estimate this still in about that same range.

Operator

And we'll go next to Dan Oppenheim with Credit Suisse.

Daniel Oppenheim - Crédit Suisse AG, Research Division

I was wondering in terms of the West Coast exposure talks about coast of California, how much of your business would you like that to become? And to the next, relatedly you talked about land, being tough to find land and the entitlement process and such taking longer there. How do you think about that given where the cash position and just sort of the ability to take on a lot more land?

Jeffrey T. Mezger

Dan, if we could find 100 communities in the Bay Area tomorrow, we'd buy them all and figured out because they perform well. It's not -- there's this built-in constraint in that it's not readily available. We'll continue to push the envelope there. I think a great reflection of our success has been if you look at the year-end backlog in California, it's primarily coastal California is up significantly year-over-year. We've been able to grow. And we'd love to grow more but there's a constraint because there's not that much land available as we prepared -- go ahead.

Alan Ratner - Zelman & Associates, Research Division

So are you saying you're looking for capital than if you can find the land now?

Jeffrey T. Mezger

We shared on our comments that we have adequate cash to run the business, and we will allocate it to where the best returns are. And as shared on the call, that California typically has the highest gross profit. So we like the returns there. It's where we've been spending the money and that's the $478 million last year, a big chunk of it was California.

Daniel Oppenheim - Crédit Suisse AG, Research Division

Okay, relatedly just wondering in terms of that. I imagine it more or less going to end up being attached homes and such. Are you comfortable with the risk in terms of increasing exposure to that area?

Jeffrey T. Mezger

Our product strategy primarily stops at townhomes or we've done 3 podium products that are delivering this year, but not a lot in the queue. It's not higher density stuff. It's typically small-lot, high-density detached or a townhome community that you can navigate through just like a detached home. So it's not going to higher densities. We're staying on our primary business model.

Operator

And Mike Widner with Stifel, Nicolaus has our next question.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Just kind of following up on that topic, one of the things we continue to struggle when understanding the progression of you guys and the vision is, you call yourself a merchant builder, which sort of implies to some degree sort of land right. I mean you're California-heavy so you're buying expensive lots and you're buying finished lots by and large. So again, even more expensive than kind of raw land. All of that requires a lot of interest, and a lot of interest carrying cost. And I sit here looking at you guys carrying 5 years or so of land and just scratching my head and saying, how do I reconcile that merchant builder with somebody with that much land and that much carrying cost on the land and how do I make it work?

Jeffrey T. Mezger

Well I'd have to say that our business model, while we're a merchant builder, it's morphed a little bit to the market conditions that we're in. We're doing well picking off these semi-infill locations in coastal California. We got our 60, 70, 80 lot positions. They're are not big positions and they're not taking years to bring to market, once you tie up the land. So you tie up the land -- they're not all finished lots by the way. We are doing some development deals in California because of the seasoned tenure of our team and the confidence we have in them in hitting their budgets on the cost to developing the timeline. But these are not long-term plays. You go in, you open the community and you get your cash out in a year or 2. So there's this rollover of this infill product and then you have to balance it where you can in the desirable submarkets and allow you to be more of a volume builder.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

So I mean I hear that, kind of heard that before. If I just tie this back to the operating metrics that you talked about, it sounds like between some additional cost-cutting rolling through and some kind of hoped-for gross margin expansion, you're kind of hoping to get back to something in the marginally operating profitable level next year. And yet, we sit here and look and you guys are still expensing 45% of your interest. And so I don't know, how that's going to look next year but it's going to be somewhere in the realm of, if it's anything that this year, $0.60 to $0.70 of interest expense flowing through outside of the operating profitability line. So again, that just makes me wonder, as I look at the book value having got cut in half in the past 2 years, look at how the stock has performed this year and you guys saying, hey everything is going to plan. There just seem to be some conflicts here that I'd like to give you the opportunity to tell us where we we're wrong, tell us where the market's kind of missing.

Jeff J. Kaminski

Again you threw a lot in there but we spent time talking about coastal California, but we also have a very nice business in many other states. And a good example of that is in Texas, where while we can talk about high-priced California product, we did a very nice addition in the second half of last year where we acquired the fieldstone assets in San Antonio in July and opened 9 communities, before the end of the year. It's going to be a very favorable impact on our business in 2012. I think if you look at where we're at with our backlog and the momentum we now have and you couple it with the confidence we shared and where our business is going, you can see the roadmap. Maybe it's not clear to you, but we have a lot of things going for us that we have not had in the years. It starts with the backlog in the community position. I don't know if you could give any more color, Jeff.

Jeffrey T. Mezger

I think when you start talking about book value, the #1 detriment to book value is the on-off in the South Edge situation. So it's separate from the operations and separate from the operating strategy moving forward. And I think, as Jeff said, we're pleased with some of the progress we've made. We know we have some work to do, particularly on the margin line. We're going to put a lot of focus on that. The SG&A, we have a very high level of confidence and improvements next year, especially on a ratio basis with more volume leverage coming, as well as full year impacts from the cost reductions that we already have behind us and additional opportunity going forward. So I think the combination of those factors is reason for our confidence going forward, and that's what we're looking at as our base operations.

Operator

Our next question comes from Stephen Kim with Barclays Capital.

Unknown Analyst

It's John Coil [ph] calling in for Stephen today. Just regarding the commentary around average selling price growing next year. Is this commentary specific to Southern California or is it more of widespread?

Jeffrey T. Mezger

No, it's company-wide. You can't say everywhere because we have a lot of communities. But if you look across our regions, this strategy of going to more desirable submarkets is in play everywhere. So our ASP is lifting in all the regions and we have the expectation because of the type of product we're bring in to market.

Unknown Analyst

Got it. As far as the margin impacts specifically to the average selling price increase, can you give a bit more color on that?

Jeffrey T. Mezger

It starts with a typical margin when we're underwriting a deal. The offset to the higher price point is the land typically costs more too. So playing at the higher price point doesn't automatically translate to a higher percentage profit. It's how you execute through the community, and whether you can leverage that buyer to grow the margin. I don't know if you have any thoughts on that?

Jeff J. Kaminski

No, I don't. I'm not sure where it's...

Operator

We'll go next to Stephen East with Ticonderoga Securities.

Stephen F. East - Ticonderoga Securities LLC, Research Division

Jeff, you've talked a lot about getting land in California, and how hard it is in the coastal areas. And you know that it's valuable. And I see your absorption rates ramping up pretty strongly. But your gross margin really hasn't followed along the same path. Would it behoove you all to slow down the sales pace in the California markets and drive your gross margin higher on that? And just sort of your thoughts between that market on the gross margin approach in, say, Texas and your other markets?

Jeffrey T. Mezger

Our mantra, Stephen, is to optimize every asset. We have strategy in place that sets an absorption rate at a margin that gets you the best return. We are mindful of communities that are in submarkets that you can't replace and those will run slower and will push margin there. And if you're in an area that's desirable but a lot of lots ahead of it, you're running a little faster and work more on the returns in the cash side as opposed to maximize margins, where every asset has its own strategy, and I think, we're not getting into the details, I think we're doing what you are suggesting in a lot of the replaceable communities.

Stephen F. East - Ticonderoga Securities LLC, Research Division

Okay, all right I appreciate that. And then just 2 other questions on the gross margin. One, given some of the gives and takes that you talked about in this quarter and what to expect in '12, one, what's the gross margin embedded in the backlog now? And then two, I know the energy efficiency has played really well in California. Another builder that's trying to do it in Texas is, struggling getting the consumer to pay for it. Are you seeing a similar phenomenon in Texas?

Jeffrey T. Mezger

Stephen, I'll talk about energy efficiency and Jeff can share his thoughts on the gross profit. We're absolutely seeing buyer response to energy efficiency programs we put out there. I can't speak to this other builder but we've been focused, as I said in my shared comments or my prepared comments, sorry, I shared in my prepared comments, we've been focused on driving energy efficiencies and value to the consumer without raising the prices materially. We aren't seeing a consumer that will not pay for it unless there's an economic trade-off over a couple-of-year period, where we're offering these net 0 option packages, it's going to give us a real insight into the consumer's thinking going forward, because they'll have a menu of things to pick from and can go every -- all the way down to no utility bills if they fully option it up. So we'll know what the consumer is going to -- where they're going to migrate to. But in the meantime, much of what we've done has had no impact on price. And then there are things that have moved price a little bit. If you look at our solar program in SoCal, where we were able to leverage our scale and relationship that frankly was created out of our concept home in Orlando last year, where a solar company saw the benefit of linking up with a volume builder, we got the solar panels at a great price. So there's an incremental increase of consumer, but it's more than offset by the utility savings and it's working very well. So you're not seeing our prices go up $30,000, $40,000 in order to cover some exotic things that we put in the home and standard. But we're very, very tied to affordability stuff. Any thoughts on the price?

Jeff J. Kaminski

Yes, on the backlog side and backlog question, the VC [ph] backlog right now, our variable contribution is about the same as we've experienced in the fourth quarter. But I think it's very important to understand with our backlog both the value of the backlog, as well as the contribution margin within the backlog. Neither those include anything coming out of our studio process or generally. So as our consumers are going into studio-making selections, you see lifts and ticks in both of those numbers as they complete that process. And that's one of the reasons why if you look out, for our company, ASP and backlog, we almost always surpass that in the following quarter because of that phenomena.

Jeffrey T. Mezger

And if you get back to just comment on the inventory we cleared out to get -- add some focus on our Built to Order approach, that inventory wasn't in backlog at the start of the fourth quarter, and it did negatively impact to a slight degree our margins. So we've also been able to eliminate some of that negative influence as the quarter unfolds.

Operator

And ladies and gentlemen, that is all the time we have for questions today. I'll turn the conference back over to Mr. Metzger for any additional or closing remarks.

Jeffrey T. Mezger

Thanks, Melody. Thanks, everyone, for joining us today. We want to wish all of you a very happy holiday season. We look forward to sharing our progress and success with you as we head into the new year. Have a great day.

Operator

And that does conclude today's conference. We thank you all for joining.

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