KB Home's CEO Discusses Q1 2012 Results - Earnings Call Transcript

| About: KB Home (KBH)

KB Home (NYSE:KBH)

Q1 2012 Earnings Call

March 23, 2012 11:30 am ET

Executives

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

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

Analysts

William Wong - JP Morgan Chase & Co, Research Division

David Goldberg - UBS Investment Bank, Research Division

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

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Stephen Kim - Barclays Capital, Research Division

Ivy Lynne Zelman - Zelman & Associates, Research Division

William Alexis

Operator

Well, good day, everyone, and welcome to KB Home's 2012 First Quarter Earnings Conference Call. Today's conference is being recorded and webcast on the KB Home's website at kbhome.com. The recording will be available via telephone replay until 4:30 p.m., Eastern Time, on March 30, by calling (719) 457-0820 and using the replay passcode of 1668714. The 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 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 the 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.

And now it is my pleasure to turn the conference over to Mr. Jeff Mezger. Please go ahead, Mr. Mezger.

Jeffrey T. Mezger

Thanks, Kelsy, and good morning, everyone. Thank you all for joining us today for a review of our first quarter results. With me this morning are Jeff Kaminski, our Executive Vice President and Chief Financial Officer; and Bill Hollinger, our Senior Vice President and Chief Accounting Officer.

I'd like to start off by saying that we are encouraged by the favorable improvement we are seeing in the national economy, particularly on the jobs front and with consumer confidence. We also believe the overall housing market is improving and is stronger today than a year ago. As inventories continue to ease and prices in many markets have now stabilized, we feel that a modest recovery in housing has indeed begun in many markets across the country. Our traffic levels are up, affordability remains very compelling and prospective homebuyers coming to our sales offices are appearing more confident than we have experienced in some time.

Specific to KB Home for the quarter, many of our financial and operating metrics improved over the prior year, with the exception primarily of net orders. So this morning, I want to begin by addressing our order results for the quarter, which were impacted by a combination of circumstances. We do not believe that our net order results are reflective of current market conditions, and I also do not want them to cloud the underlying improvements in our business that I will discuss in detail during this call.

While our gross orders and traffic were up year-over-year, net orders in the first quarter were 1,197 compared to 1,302 in the prior year, a decrease of 8% or 105 homes. There were 3 key factors behind this negative result that I will review: first, a spike in the cancellation rate due to the unpredictability and lack of performance by mortgage companies other than our preferred lender, MetLife; second, our deliberate focus on improving gross margins; and third, the impact of our strategic shift in geographic footprint, all of which affected our sales results and year-over-year comparable for the quarter.

On our last earnings call, we shared with you that we missed deliveries that we had expected in the fourth quarter as a result of the nonperformance of outside lenders, which is a reference to mortgage lenders other than MetLife. As December progressed and we diligently worked to close these homes, we learned that even though the majority of these buyers had preliminary or full loan approval letters, the lenders subsequently changed their commitment and would not fund the loan, and therefore the customer could not perform. In many instances, we could not resolve the situation with our buyer and eventually canceled the sale. In addition, MetLife unexpectedly announced in the first week of January that they were immediately shutting down their retail mortgage operations, further impacting our customers' ability to perform. As a result of all of these, we experienced excessive cancellations versus our expectations in the range of 140 during the quarter.

We have taken measures to remedy the situation. In March, we were pleased to announce that Nationstar Mortgage will be KB Home's new preferred mortgage provider, which I will talk about in more detail in a moment. A second factor influencing our lower net orders was the strategic shift in our focus to prioritize margin improvement over sales pace. Coming into the new fiscal year, we had accomplished our goal of having a higher backlog level to better support our business model and overhead levels. With the backlog in place, we have moved on to prioritizing higher margins.

Additionally, in recognition of an improving housing environment, we felt that it was the appropriate time to strategically rebalance price and pace, particularly in our communities located in land-constrained submarkets. This is what I referred to on our last earnings call as optimizing each asset.

We also applied this strategy to the unexpected inventory associated with the higher cancellation rate. Contrary to the normal reaction of aggressively moving prices down to resell standing inventory, we opted to raise prices on many of these homes, which limited net sales to some degree in the first quarter. We are now successfully selling through these homes at higher margins than we otherwise would have generated.

Overall, we remain committed to our Built to Order model, which is reflected in the mix of our gross orders during the quarter, where Built to Order contracts were up 20% and inventory contracts were down 30% year-over-year. Part of the reduction in inventory contracts is attributable to having less inventory available for sale at this time, even with the cancellation issue.

The third factor that affected our year-over-year comp in sales was the evolution of our geographic footprint. As we previously announced, we have exited South Carolina and sold through the remaining communities in the first half of 2011. Early last year, we also made the decision not to invest further in the Charlotte market, and we had essentially sold out by the end of the year.

Additionally, we have intentionally reduced our community position in Arizona. As a result, our activity in this state is dramatically reduced from the prior year and will remain at low levels until the market supports new investment. Between leaving South Carolina and Charlotte and downsizing significantly in Arizona, our net orders for these markets were down 70% compared to the prior year or approximately 85 sales during the quarter.

To summarize, while we were not expecting our first quarter net order comp to be in the elevated range we experienced during the third and fourth quarters of 2011, we were disappointed with a negative comp. That being said, our gross orders were up year-over-year. And if you take into consideration the higher cancellations, which accounted for approximately 140 sales, and the reduced market presence, which accounted for approximately 85 sales, we would have been up by almost 10% over the prior year. This is without including any impact of our shift in pricing strategy.

Our first quarter sales are typically the lowest level for the year, and as a result, a small impact to results can create a big percentage move.

Let me add one more observation on sales. While monthly or quarterly sales comps can have a wide variation up and down, the swings typically even out over a longer period of time. In this regard and using the most recent 12-month public results released by our peer group, KB Home ranked #1 among all peers in net order growth, up a total of 582 units. For us, this unit increase represents a 10% order growth over the prior 12-month period.

I think it is important to reiterate that despite the factors that impacted our net sales in the first quarter, the results are not a reflection of the housing market as a whole, which we feel is improving. I wanted to go over these factors in detail, as we do not want our net sales over this 90-day period to cloud the many positive aspects of our actions as a company to improve our future profitability.

As I've said many times on these calls, jobs and consumer confidence will be the key drivers of the housing recovery, and both of these are trending positive right now. In fact, consumer confidence is the highest it has been in 4 years, underscoring what we are seeing on the ground in our markets. Although the housing recovery is uneven and very localized, in some cases literally ZIP code by ZIP code, inventories of unsold homes continue to ease and prices have stabilized in many markets across the country. Affordability is strong, with compelling prices and historically low interest rates.

In some of our submarkets, we are finding that homebuyers are no longer expecting home prices to decline further, which is creating some sense of urgency to buy now. Additionally, as rents continue to increase, prospective customers in many areas are now recognizing that they can own a home for a monthly payment lower than their rent. It is now common for me to hear anecdotes regarding the customer who is visiting our sales office because their rent just increased.

Having said all this, there's a great deal of media hype about the housing recovery taking off like a rocket. There's no question that things are better, but we continue to maintain that it will take some time for markets to fully recover.

More importantly, we are definitely getting better as a company. We significantly reduced our net loss in the first quarter compared to the prior year. Our deliveries were up 21%, and revenues were up 29%. Even with the negative sales comp, our backlog was still up 30% at the end of the quarter.

As we aggressively pursue profitability, we are continuing to reduce our overhead expenses, enhance margins and strategically position our communities in highly desirable submarkets. Our expectation for our average selling price is one of the most important takeaways of this call. Here is a place in your notes for a double asterisk. Our deliberate strategy of transitioning to more highly desirable, land-constrained submarkets allows us to sell larger, higher-priced homes, driving a strong increase in our average selling price. We were up 6% in the first quarter versus the prior year. Going forward, we expect our average selling price to continue to increase and to exceed an average of 240,000 for the year. It's important to note that this increase is the result of strategic product and community positioning and not from additional price increases.

Illustrating the impact of the actions we have taken, in the first 90 days of the year, our margin and backlog has increased by roughly 200 basis points. As this backlog converts to deliveries, it will have a greater impact on our financial results, especially in the second half of 2012.

We're encouraged by the progress we have made at KB Home during the first quarter, as well as encouraged by the strengthening economy and housing market. With a continued commitment to lowering our overhead costs and a strategic move that is creating a higher selling price, we can reaffirm that we expect as much as a 500-basis-point improvement in our operating margin for the year, inclusive of expected insurance recoveries that were discussed on our last call.

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

Jeff J. Kaminski

Thank you. As Jeff mentioned, although we had mixed results in the first quarter, we still made progress in our pursuit to profitability, and I will walk you through some of the details. The company posted a net loss of $45.8 million or $0.59 per diluted share, which narrowed substantially from the net loss of $114.5 million or $1.49 per diluted share reported in the first quarter of 2011.

The 2012 Q1 results included $6.6 million dollars in impairment charges, while the 2011 first quarter included $1.8 million of inventory-related charges and $77 million of charges relating to our investment in the South Edge joint venture. The first quarter of 2012 also included approximately $5 million of incremental interest expense as compared to the same period the prior year, which I will talk about in a moment.

In the first quarter of 2012, KB Home delivered 1,150 homes, an increase of 21% over the 949 homes we delivered in the same period of 2011. The current quarter deliveries represented approximately 53% of our year-end backlog, as compared to a backlog conversion of 71% in Q1 of last year.

This decline in the backlog conversion rate was the result of various factors, including a higher level of un-started homes in backlog at the beginning of the quarter and lower spec sales and deliveries during the quarter, both reflecting our sharpened focus on our Built to Order business model. In addition, the mortgage financing issues that Jeff discussed earlier also significantly impacted the conversion rate. We believe we will see backlog conversions at a lower rate than the normalized 65% that we discussed during the Q4 earnings call until the transition to Nationstar is completed.

The average selling price of our homes in the first quarter was $219,000 compared to $205,700 in the prior year, a 6% year-over-year increase, which as Jeff mentioned, is a reflection of our realignment of land investments towards higher-priced, better located communities in stronger submarkets. In addition, our Built to Order buyers in these stronger communities are selecting larger floor plans, which is driving both a higher average square footage and price. The reduction from Q4 2011 was mainly the result of a mix shift between our divisions and the significant impact from the closeout of one community in 2011 that I will discuss in more detail when describing the gross margin variance.

The higher beginning backlog and the increased average selling price in the first quarter of 2012, partially offset by the lower backlog conversion rate, resulted in total revenues of $255 million, growing 29% from the $197 million reported in the same period of the prior year. Our backlog at the end of February 2012 stood at 2,203 homes, representing approximately $460 million of potential future housing revenues. As mentioned earlier, this represents an improvement of 30% over year-ago levels with value increases in all 4 of our operating regions.

Housing gross margin, excluding impairments and land option abandonments, was 12.3% of housing revenues, compared to 13.4% in the first quarter of 2011 and 15.1% in the fourth quarter of 2011. As we have shared, community and product mix is a significant factor in margin variance between periods, which is exemplified by the fact that on a sequential basis, 140 basis points of margin impact can be attributed to a single community closeout during Q4 in Northern California, namely our Redwood Shores community. As we have discussed in the past, this was one of our most successful communities in the country, achieving margins approximately double the company average at sales prices of about $800,000. We experienced an additional 230 basis points of sequential decline due to the negative leverage impact of lower volume in Q1, given our level of fixed field overhead expenses. Partially offsetting these declines, favorable pricing actions contributed a full percentage point of sequential improvement to the first quarter gross margin.

We continue to make progress in reducing our selling, general and administrative expenses, which are approximately $56 million in the first quarter of 2012 compared to $50 million in the first quarter of 2011. As a percentage of housing revenues, our SG&A ratio improved by 3.3 percentage points in the first quarter of '12 to 22.1% from 25.4% in the first quarter of 2011. Our consistent goal has been to align our overhead with current revenue levels, and we are making progress as we continue to find new ways to reduce costs. While personnel costs are not the only area of focus in our overhead reductions, let me share with you that during the quarter, our headcount is down an additional 58 positions, a reduction of about 5% versus year end. As compared to the end of first quarter of 2011, we are down almost 14%, representing a reduction of 178 positions.

Turning now to the balance sheet. During the quarter, KB Home completed tender offers in which the company accepted for purchase approximately $340 million in aggregate principal amount of senior notes due in 2014 and 2015. As previously announced, we applied the net proceeds from a successful public offering of $350 million in aggregate principal amount of 8% senior notes due 2020, which closed on February 7, toward the payment of the accepted 2014 and 2015 notes. We were very pleased with the execution of this transaction, which generated a tremendous level of investor interest and was, in fact, highly oversubscribed.

As a result of these transactions, we improved our balance sheet and financial position by extending over 1/3 of our near-term debt maturities.

With regard to the increased interest that I mentioned earlier, the first quarter of 2012 includes a $2-million loss related to the early redemption of senior notes through the tender offers, while the interest expense in the same period of the prior year included a $3.6-million gain on early extinguishment of debt, accounting for the year-over-year variance.

Our total land and land development investment in the first quarter is approximately $113 million, with a continued emphasis on desirable markets in California and Texas. As always, the investments for the remaining quarters will depend heavily on market conditions as the year unfolds.

As we said on our fourth quarter 2011 earnings call, our intent is to manage our business to a cash-neutral position for fiscal 2012, and we are confident we have adequate liquidity to support our current business needs and remain opportunistic going forward.

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

Jeffrey T. Mezger

Thanks. As I mentioned earlier on the call, we have announced that Nationstar will be our new preferred lender. Nationstar is one of the nation's leading mortgage servicers, with a current portfolio of approximately $107 billion, representing 645,000 customers.

While we were exploring a new preferred lender relationship, Nationstar was also interested in a strategic alliance with KB Home as a way to continue to grow their origination platform and feed their servicing business. I am particularly excited about this alliance with Nationstar, as the strategic goals and values of both companies are aligned and should ultimately provide us greater predictability in deliveries.

We anticipate that the transition of our business will be completed by the end of the second quarter, and we should fully realize the benefits of this predictability by year end. We believe Nationstar's reputation for outstanding customer service standards will help ensure a seamless home buying experience for our customers. As we said in our last call, it remains our intention to reestablish a long-term joint venture on the mortgage side, which can provide not only the additional benefits in terms of predictability of closings, but also operational and financial synergies.

While I focused my remarks during this call mainly on our sales and financial performance, I do want to spend just a few minutes to highlight how we continue to set KB Home apart in the marketplace. Our marketing and advertising programs constantly reinforce the benefits of our Built to Order approach and innovative energy efficiency initiatives. Over the years, KB Home has been known for our creative marketing campaigns, such as our partnerships with Martha Stewart, Extreme Makeover, Disney and others.

This year, we have teamed up with The Ellen Degeneres Show, one of TV's highest-rated daily talk shows, to demonstrate all of the elements of our Built to Order process by giving a new KB Home to a very deserving single mother in Houston. The company will be featured on numerous episodes as we follow the lucky recipient through the process of selecting our home, customizing it at the KB Home Studio and watching it built. We specifically wanted to work with Ellen because we see this as an outstanding opportunity to showcase KB Home to millions of her fans across the country.

The response from the public has been incredibly positive, with favorable commentary about KB Home on both our social network and The Ellen Show website. Customers have come into our offices around the country, commenting on what they have seen so far on the initial Ellen Show coverage. We believe this campaign favorably exposes our brand nationally, will generate traffic and sales, and also allows us to give back to the community.

We're also continuing to lower the cost of homeownership for our buyers, by expanding the industry-leading energy-efficient features we offer as standard in our homes. Our strategy remains to increase energy efficiency in our homes without materially increasing the price to the customer. Now that our energy performance guide, or EPG, has been out for about a year, we are finding it to be an effective selling feature as customers are responding favorably to the prospect of lower energy costs. In fact, we recently invited our homeowners to take part in our marketing promotion on Facebook, in which hundreds of our enthusiastic buyers were bragging about their energy bills, which were posted for thousands of their Facebook friends to view.

As an example of some of the posts we received, let me read one from Elvira G. [ph] of Colorado, who writes, "My energy bill runs $118 per month, where I was paying over $300 at my last home. I am so happy about that." And this one from Sherika L. [ph] from Nevada. "My energy and gas bill is usually $80 each month combined, way cheaper than when I was living in my one-bedroom apartment. Thank you, KB."

These testimonials reinforce the impact of our energy efficiency initiatives to lower the cost of homeownership and that buyers are now getting it. If the homeowners take the time to brag about it on Facebook, we know our message is coming through and that the consumers are finding real value.

We also continue the rollout of our ZeroHouse 2.0 model homes that offer our buyers the opportunity to purchase a home that can generate as much energy as it consumes over the course of the year. This initiative serves to elevate our brand and has helped generate significant traffic and interest in our communities. At the same time, all of the features that make up the ZeroHouse 2.0 are offered as individual options so we can determine over time exactly which options the consumer is willing to pay for and adjust our standard energy packages accordingly.

While we are not in this just to win awards, we continue to be recognized for our sustainability initiatives. Last week, the EPA awarded KB Home with their highest honor, the 2012 ENERGY STAR Sustained Excellence Award, in recognition for continued leadership in protecting our environment through energy efficiency. We are the first and only national builder to receive this recognition.

I'd like to thank the dedicated and hardworking employees of KB Home, whose contributions and talents continue to move our business forward. All of us at KB Home had been working diligently to position our company to achieve consistent profitability and future long-term growth, and we are undoubtedly much closer to accomplishing these goals than we were a year ago.

Our strategy and actions remain the same. We continue to stay focused on the customer, leverage our growth platform, align our overhead structure with projected revenues and strengthen our balance sheet. As a result, we believe we have the momentum to continue to substantially improve our operating results going forward.

Before I close, let me reiterate the key takeaway messages from today's call:

The overall housing market is better. However, it is definitely a localized recovery and don't expect it to be a broad-based rocket ship trajectory, as it will take some time for overall markets to normalize.

As I said during my opening comments, don't let the extenuating circumstances surrounding our net sales results cloud the significant improvements we have made as a company. We have a stronger backlog in place, with higher gross margins in this backlog that are up roughly 200 basis points in the first 90 days of the year. This backlog provides us visibility to both increase deliveries and higher gross margin, particularly as we go into the third and fourth quarters.

We have a new preferred lender relationship in place with Nationstar, and we expect this to be a successful long-term alliance that will result in more predictable deliveries and higher customer satisfaction.

We expect our average selling price to increase throughout the year, particularly in the second half, with an average for the year in excess of $240,000.

As the year unfolds, we expect to see ongoing year-over-year improvements in our deliveries, average selling price, gross margin and SG&A ratio, all of which will contribute to better financial results. We expect that we will have a positive operating income for the year, and we are reaffirming that our operating margin will increase by as much as 500 basis points year-over-year.

Lastly, we expect to achieve profitability later in the year and to end this year with momentum. We look forward to improved results and sharing our progress with you as the year unfolds.

Now we will open it up to your questions.

Question-and-Answer Session

Operator

[Operator Instructions] We'll go first to Michael Rehaut with JPMorgan.

William Wong - JP Morgan Chase & Co, Research Division

It's actually Will Wong on for Mike. I was wondering if you could provide us with sort of the monthly orders sort of throughout the quarter in terms of December, January and February. And also if you could give us any color on what you're seeing terms of traffic in orders in the first few weeks of March, how that's stacking up versus your expectations, sort of both nationally as well as in sort of your main markets of California and Texas.

Jeffrey T. Mezger

Okay, Will, in terms of the first quarter results, they do get clouded because of the cancellation issue and the timing of when those occurred. What we can tell you is the trends through the quarter were stronger each month over the prior month, and our gross sales were up in each of the months. So it's a fairly typical seasonal cycle, where December is very soft relative to the rest of the quarter, and then it gets stronger each month after that. And past the quarter, as you get into March, and our sales results right now here are only through March 15, but as we look at March, the same sequence was continuing, where traffic is up and our gross orders are up. And we think it's a fairly normal trajectory for the year. But the first quarter number is difficult to totally gauge, whether it's the can rate or some of the other things that I raised in my comments relative to our intent to raise margins and do that through better price. On the regional side, California is the tale of 2 states, in that the coastal areas are performing well, in particular Southern California right now, where Orange County, LA County, San Diego County, our sales are strong. And if you go 50 miles inland, it's very, very soft right now. So it's a great example of how localized this recovery is. And I expect that to stay that way for a while in Southern Cal or Northern Cal, where the coastal regions will do well. There's less inventory; there's less price pressure; there's not as many foreclosures. And it's where everybody wants to live. So coastal is strong, and as -- the further inland you get, the softer it gets. Relative to Texas, which is in our central region, we're very pleased with our business there. Our sales in Texas as a whole were up 35% year-over-year, and it was -- we were up in all 4 of the major cities. So we're pleased with Texas, and it shows you the impact that a solid job recovery can have on the housing market.

William Wong - JP Morgan Chase & Co, Research Division

Great. And just as my follow-up, can you share with us what the community count was in the first quarter? And also which -- some color in terms of what you expect that to be by year end?

Jeff J. Kaminski

In terms of the community count, we ended the first quarter of 2012 with 229 communities that were open for sale, and that was about flat with the end of the first quarter last year and down slightly from year end. We opened 8 new communities in the quarter. We had 13 sold-out. So a net change of 5, obviously. We're still looking -- as we talked about during the last call, we're still looking for the first 6 months of the year to open about 25 communities in total. And it's -- I think an important point to note as we talk about communities is the rotation of the communities. We are rotating to better submarkets, and we have concentrated and continue to concentrate our investments in the stronger submarkets in the coast of California and Texas. And we do see a higher revenue potential coming from those communities, which as Jeff talked about, we expect to drive our average selling prices. For the remainder of the year, we expect to see a slightly declining community count, and we do expect to see a higher number to sell out and fewer openings over the remaining 9 months of the fiscal year compared to the same period in 2011, however, with the better locations and a better potential for product mix and certainly the better margin opportunities of the new communities than what we're closing out of.

Operator

We'll move on to David Goldberg with UBS.

David Goldberg - UBS Investment Bank, Research Division

My first question, I just want to try to understand, with the backlog now and the transition away from MetLife to Nationstar, have you kind of gone through the backlog and figured out, "Okay, this person is using an outside lender. We've run -- we've kind of prequalified again -- them again to make sure they can get a mortgage"? So you don't have the situation where guys come to the -- families come to close on the house and all of a sudden they really couldn't qualify and this lender that they're using has backed out. And do you have confidence with the backlog? Because it would seem like as Nationstar comes on, it's going to take a while to get the majority of your buyers using them to close homes, right? So this could be a problem as you kind of go through the year or so. Just trying to get some comfort with how confident you are in the backlog and the ability to qualify, given that you have a lot of outside lenders being used.

Jeffrey T. Mezger

Sure. David, let me just reiterate it. It's not as easy as they show up and you realize for 30 days that the buyers are no good. We literally had buyers with firm approval letters. But unless you call that lender's loan officer that signed the letter and ask, "Hey, are you really telling the truth here?" it's difficult to find this out until it's time to perform. We have a very, very good process in place that's been here for years to scrub the quality of the backlog before we start the home. Our mantra here is we do not want to start the home unless we know we will get paid for it when it's completed. So our controls are strong, and the -- with the fluid nature of underwriting and some of these outside lenders that have large businesses and no real interest with KB Home or the Smiths in getting this one loan closed, we've struggled with making it the priority for them than it is for us. While -- I've shared with you that we have an intensive process in place. We went deeper this quarter and flushed everything. And I am confident that the quality of our backlog is far better than it was 60 days ago, because we cleaned out things that we had been working on, where we just decided this lender is not going to get there. And we scrubbed it very well. The MetLife capture rate is about the same in the quarter. It was roughly 40%. So you still do have a lot of outside lenders there. But the divisions have reduced it -- the number of outside lenders that they're using. We think we have even better controls than we did previously. And we think the quality of the backlog is better, but the other issue that's impacting the delivery percentage is there's a bigger percentage of this backlog that's not started because of our Built to Order push. And over time in the business model, typically 2/3 of the backlog hasn't started yet. They're in the loan approval and customization process at the studio. So it's not like you can take 100% of our backlog and say, "Okay, that's all closeable," because it's not. And we think that we'll perform better going forward. We don't think we'll get to normalized conversion rates until Nationstar has a high capture rate through their service efforts. And in the meantime, there is some bumpiness in our backlog, but we think the worst is behind us.

David Goldberg - UBS Investment Bank, Research Division

Got it. And then just as a follow-up question. I was wondering, Jeff, if you could talk about the competitive environment for land in the coast of California. I mean, we've heard from a lot of builders that are trying to get land, especially in Southern California in the coast, and are kind of frustrated because there's not a lot of land out there for them. It sounds like you guys have been able to identify some opportunities that are somewhat unique. I'm just wondering if you can talk about kind of who you're competing against, how maybe you're finding some of these opportunities. And is the market getting more competitive for land, given that some of the coastal areas are performing better?

Jeffrey T. Mezger

A great question, David. And it's actually a point that I view as a real competitive advantage for our company in California. We have land teams both in Northern Cal and Southern Cal that have been with this company for at least 20 years. And with that experience and network, you get deals that other people don't even have offered to them through working with the land owners and the banks and everyone that you've established these relationships with over a 20-year period. So you get first look and maybe the only look at deals. Most of what we buy does not hit the open market and get into the bidding work. Once we are offered the asset, one of our other strengths is the ability to work with municipalities to lower, hopefully, the fees or some other exactions or change the density a little bit, where we can create value in that asset that other companies may not be able to. So you get the asset first and then you've got some expertise that's unique in Northern Cal and SoCal due to your tenure. And you contrast that with some of the markets that we're newer in like D.C. We don't have that expertise and we're not the builder of choice when land comes to market. And our team there will tell you it's very land-constrained, while I know other builders are spending a lot of money on land in D.C. So it really gets back to, how good is your team on the ground in that location? In the coastal areas, where it's land-constrained, most of the deals are entitlement plays, so it's not like there's finished lots on the corner and builders drive by and make an offer. You have to go mine the land and work the asset to bring it to market through development. It's a little different if you get inland in California, where there are a lot of lots, and in most cases it is far more competitive for the few that are available in a very good location in that suburb. So it's kind of a mixed bag, but it really gets down to, how good is your team? And in California, in particular, we have great teams, and we are able to get things done as evidenced by the $100 million-plus we spent in the first quarter.

Operator

Moving on to Bob Wetenhall with RBC.

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

You're mentioning the goal of getting a 500-basis-point improvement in operating margin, and I was hoping you could give us a breakdown between the improvement in gross margin relative to the improvement in SG&A.

Jeff J. Kaminski

Sure, Bob. Yes, we guided to the same number last quarter, and we're still looking at a forecast that's supporting about a 500-basis-point improvement for the year in total. We see most of that coming, quite frankly, from leverage on the SG&A as our revenues are increasing. We do expect to see some margin improvement through the year, but most of that will be focused on the SG&A line.

Jeffrey T. Mezger

Bob, if I could clarify a couple of things or expand on a couple of things. As we open these new communities that we keep sharing, pick California or the nicer suburbs of our Texas cities, you're rotating to a higher price point, yet you're still very affordable in that submarket. So it's part of our strategy, but it's not like we're going to second and third up product. We're just moving to higher price range locations. In our other markets, or other communities, where we're Built to Order and we have a broad footage range, we are seeing the customers select larger homes than they were even a year ago. So our footage is moving up in those cases because of what the buyer wants. And I think it's a reflection of the first-time buyer, and our mix didn't change, so about 65% of our deliveries were to first-time buyers. It's a higher-income first-time buyer because of the activity being in markets that are a little better off economically. And they're buying a higher-priced home than they were a year ago.

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

If you -- that's really helpful. On the gross margin side, if you have to specify, in order of priority, which factor is having the biggest impact on gross margin, is it the shift to Built to Order model as a percentage of what you're selling? Is it the higher ASP? Or what's really driving that? And with that, are we looking for a lot better upside in the second half of the year than the first half?

Jeffrey T. Mezger

Bob, I think it's a little of all of the above if you ask what the components are. And I'll expand on that here in a second, and Jeff can pile on. But to answer the second part of your question, absolutely, it is a driver in the second half. And if you hold on percentage for a moment, if our percentage held flat but our ASP goes up $20,000 or $30,000, you're getting more dollars of gross margin even at that percentage, which also then helps leverage your SG&A better because your revenue on the same unit is up significantly. So we know we'll have more dollars of margin. We think our new communities have higher margins. We know our Built to Order sales have higher margins. And we're not banking on any inflation, because I've always taken the view if you get price, it's because of the market being better and your costs are going to go up. So it's the product shift that we're going through, not because we'll be able to push price.

Jeff J. Kaminski

Yes, well, a couple of things I'd add, Bob. Just on -- from the point of view we mentioned in the script, our backlog margins right now are up about 200 basis points from what we saw at the beginning of the year -- beginning of the quarter. That's pretty significant for a number of reasons. We do expect to see most of that impact coming in the back half as opposed to second quarter deliveries. But we like what we're seeing there, and we like the trajectory of the backlog margins. Secondly, a pretty significant impact within the quarter was the impact that I talked about for pricing actions and adjustments, and that had about a 100-basis-point improvement as compared to the fourth quarter, and I think that is a reflection of both the more disciplined approach on the business model, a higher percentage of Built to Order versus specs. And particularly within the quarter, where we saw the cancellations that we had, we didn't go out into dump specs as a result or in reaction to it. So there's been a much more disciplined approach on the margin profitability side of our deliveries.

Operator

And Joshua Pollard from Goldman Sachs has the next question.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Great. Jeff, congratulations on being the very first builder to read Facebook messages on your conference call. I think...

Jeffrey T. Mezger

I don't have a Facebook account, Josh, so don't go look me up. But we definitely track it as a company. It's a phenomenal tool.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Well, awesome. My first question is actually around you guys shifting to more highly land-constrained market. Obviously, the focus over the last couple of years for you guys has been your balance sheet. And I'm trying to understand how this shift to actually more than likely a longer period of time to market, higher-priced land purchases, and if you're doing so on California, not really being able to utilize options -- how this fits into your strategy of keeping your cash flow neutral in '12 and ultimately repairing the balance sheet going forward.

Jeffrey T. Mezger

Well, Josh, I'll let Jeff talk to cash projection and the balance sheet. But just to clarify something, we don't buy this land and then entitle it and improve the value. We tie it up and then don't close on it until all the entitlements are in place and you've done what you can to improve the value. So, while it's not developed, when we close, we can quickly go to revenue as opposed to buying the land and then entitling. So it's not -- this isn't a 3- or 4-year cycle to get to revenue. Our mantra around here is to get to revenue even on these entitlement deals within 12 months of closing. They're not large positions. Most of these that I'm describing are 50- to 100-lot deals, so you're getting your cash in and out pretty quickly. And I think it reinforces that we've significantly rotated and are still guiding -- we'll do a lot of land spend this year, but we'll be cash neutral, because we're starting to pull the cash back out as the ones we've previously brought to market close out. And in the first quarter, we spent about $66 million on acquisition and development in California, and all these -- the spend that we had, we expect deliveries out of those assets within 12 months.

Jeff J. Kaminski

Yes, I'll just reinforce what Jeff said. I mean, it's a matter of making the land investments and having that land turn. At the same time is we're investing in California. A very large percentage, almost half of our business, is actually based in California, so we're turning a lot of cash out of previous land investments in the state. That's going to fund future land investments. So it does work from a cash flow basis, and we have modeled it that way.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Okay. And then my second question is a 2-part. First, I want to understand what -- how many more communities like this California community that hit you guys by 140 basis points on the gross margin line? How many more communities are out there like that? Because it seems like some of the 2000 -- early 2009 land purchases may be beginning to roll off, not just for KB Home but for the group. I'm wondering to what extent we could see more of that from you all and the rest of the group. And then the quick follow-up is 65% conversion, you guys are expecting lower. I'd love a better quantification to that.

Jeffrey T. Mezger

Okay, all right. Josh, let me talk to Redwood Shores again, and then Jeff can get to the conversion side. I would love to be bragging about 5, 6, 7, 8 Redwood Shores. There are just -- there aren't that many of them, frankly, in the country, not just our company but in the country. And with all the builders that you guys cover, how many of them have a community with an $800,000 ASP, with margins double their company average, selling 6, 7, 8 a month? I mean it was an incredible success, and we talked about it on prior calls. We use it here because it truly did distort what was going on underneath our business. I can tell you right now we don't have any other Redwood Shores out there today open for sale. If I could find 2, 3, 4, 5 more, we'd be a great company. So we're looking for them. But we always have fluidity in the mix, and I keep saying, hey, a delivery in San Jose, not Redwood Shores, but a $600,000 or $700,000 home at a 20% gross has a big impact on mix when it's offsetting a $150,000 house in Texas at a 17% gross. So it can really move your numbers, in particular in a lower revenue quarter like the first quarter. And lastly, the other thing I can add on Redwood, this closed in '09. We had this thing in the works for 7 years before we closed. That's part of the strength we have in our land teams. They help create value that took 7 years and actually powered through a cycle and still came out as an absolute grand slam. So it's not something we just had late in our lap and we wrote a check in '09 and then opened it up.

Jeff J. Kaminski

Yes. In reference to the conversion rates, as we talked about, we will continue the discipline of the company on our business model, the lower levels of spec sales and deliveries that we contemplate for future quarters. And also as the transition to the new mortgage provider and new preferred partner continues, we do feel that the conversion percentage will stay in the 50s, probably mid to high 50s, for at least the next couple of quarters until we get some of those issues on the mortgage side behind us.

Operator

We'll now hear from Stephen Kim with Barclays.

Stephen Kim - Barclays Capital, Research Division

Quick question for you related to your inventories. I was wondering if you could share with us sort of a pure sticks-and-bricks number. I'm looking for basically work in process without the value of the land underneath the home. Is that a number that you have available?

Jeff J. Kaminski

It is not, sorry.

Stephen Kim - Barclays Capital, Research Division

Is that a number that we'll be able to get from you, you think, going forward?

Jeff J. Kaminski

Well, we do have disclosure in the K and Q that split the inventory out in detail. I don't think we've ever split it really by sticks and bricks versus underlying land. It's just not how our system is set up.

Stephen Kim - Barclays Capital, Research Division

Okay. So when you -- just then switching gears if we can't get that, when you look at your land spend, you talked about $113 million. How much of that was development versus actually acquisition of lots?

Jeff J. Kaminski

In the first quarter of 2012, it was about 50-50.

Stephen Kim - Barclays Capital, Research Division

50-50, okay. And as you look forward, or rather, when you look at your inventory of land that you have, is there a way that you can give us a sense for how much of that land is developed? Maybe if you just sort of look across your land that you own, the -- let's say, the 33 million -- 33,000 lots that you own, would you say on balance they're about half developed? Or is there a better way that you can help us understand what the amount of committed dollars already in those lots look like?

Jeff J. Kaminski

Yes, I would say half to north of half is developed land. I mean, we do have some that's held for future development. Some of that land is held for a variety of different reasons. But, yes, I'd say over half of it is developed.

Operator

Our next question will come from Ivy Zelman with Zelman & Associates.

Ivy Lynne Zelman - Zelman & Associates, Research Division

Realizing the improvement, Jeff, that you spoke of, of your gross margins already in backlog as well as the onetime negative hit from the community that closed out, one of my questions would be, with the compression in margin is there possible changes in the business model that might be opportunistic with respect to the design centers, studios, knowing that those are higher-cost structures and might be adding to the compression in margins? Because even with the improvement you are looking forward to experience, that would still be very much lower than your peer group, recognizing gross margins aren't always apples-to-apples. But the design studio, I guess, is a high-cost business. I am wondering if in your strategy going forward, if there's any potential change that can reduce that compression in margin.

Jeffrey T. Mezger

Sure. Ivy, great question. Let me just share for the group. Our margins in the studio factor in the overhead cost of the studio, and we view the studio as a tool to sell houses, not to be a profit center, but also not to be a drag. So our margins in the studio cover the studio overhead and typically net out to our targeted normalized house margin, and we continue to see, on our Built to Order communities, margins that are -- our Built to Order sales, margins that are higher than our spec sales. And while I share the cans we took, we're going to have higher margin on the sales of that unexpected inventory, it's still going to be below our Built to Order margins. So we're committed to Built to Order. We think over time that it will deliver a much higher margin than the spec model.

Ivy Lynne Zelman - Zelman & Associates, Research Division

Right. But what about the design studios and the costs associated with having design studios? Are you better off with -- you could still do Built to Order but not necessarily have design studios. They're not especially mutually exclusive, correct?

Jeffrey T. Mezger

Well, in order to be a true Built to Order builder, you have to offer the choice that we do. And I'll hear other builders talk about being Built to Order, but the choice there is, do you want a home that's sheetrock? Or do you want the exact same home on this lot and we'll build it for you and you get to pick the color of the cabinet, the color of the counters and the color of the carpet? And we offer a significant array of choice. And we feel, especially in these communities that we're getting into, where there are higher price points, it's even more critical that the studio is a vital part of it. And as I shared, the studios aren't a cost drag because the cost of the studio is loaded into the margins, so it's not -- we actually think it helps our business. And as we guided, we do expect gross margin trajectory through the rest of the year, and we think we'll have momentum at the end of the year.

Operator

Moving on to Dan Oppenheim with Crédit Suisse.

William Alexis

This is actually Will on for Dan. Kind of going back to the gross margins again, thinking about the community closeout in Northern California. Just kind of where do margins go from here? And then I guess full year, do you expect gross margins in total to be higher than '11? Or how are you thinking about that?

Jeff J. Kaminski

Well, as we talked about earlier, we said that we did expect some gross margin improvement, but most of the improvement in our operating margin did come from SG&A reductions and SG&A leverage. So while we do expect some improvement, that's really how we're looking at the blend right now. We also expect the improvement to be more back half weighted, as we're seeing the improvements right now in our current backlog. Many of those backlog units will deliver out starting predominantly in the third quarter. We may see some of those delivered in the third -- or in the second, excuse me, but predominantly in the third quarter and in the back half of the year with our new community openings. We see that as being the major margin drivers.

William Alexis

Okay. And then my follow-up question will be on headcount reduction and the improving trends. Just trying to reconcile the -- trends are getting better and then reducing some of the headcount positions. Just trying to understand how you're thinking about demand and making sure you capture some incremental demand going forward.

Jeff J. Kaminski

You're talking reducing headcount versus an increase in top line and the dynamic there?

William Alexis

Or improving trends. Just trying to understand the thinking behind reducing headcount if trends are improving.

Jeffrey T. Mezger

Will, the mantra on headcount is, how do we do more with less? And as we've continued to share over the last few years on these calls, we're finding ways to get leaner without sacrificing the strategic side of things. And the strategic side would include not just the markets you're in but the people you need to take advantage of a spring coil. So we've retained solid land teams. We've retained the local managers, and the headcount would be through consolidation of administration, processes like purchasing or accounting and back-office things, or just aligning overhead with where that market is. If you're not going to deliver 500 homes and you have enough construction people for 500, but you have to align that with whatever your activity level is. But those aren't the critically strategic need that we've retained over time. So we're comfortable with the spring coil. We think that our current team could handle double today's volume, no problem, so we're ready.

Operator

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

Jeffrey T. Mezger

Thank you, and thank you, everyone, again, for joining us this morning. Have a great day, and we look forward to talking to you again soon.

Operator

And again, ladies and gentlemen, that does conclude our conference for today. We thank you all for your participation.

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