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KB Home (NYSE:KBH)

Q3 2012 Earnings Call

September 21, 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

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Nishu Sood - Deutsche Bank AG, Research Division

William Wong - JP Morgan Chase & Co, Research Division

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

Ivy Lynne Zelman - Zelman & Associates, Research Division

Megan McGrath - MKM Partners LLC, Research Division

Michael Dahl - Crédit Suisse AG, Research Division

Operator

Good day, everyone, and welcome to the KB Home 2012 Third Quarter Conference Call. Today's conference is being recorded and webcast on KB Home website at kbhome.com. The recording will be available via telephone replay until 3:30 p.m. Eastern Time on September 29 by calling (719) 457-0820 and using the replay pass code of 7442358. The recording 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 in the KB Home's filings with the SEC, which the company urges you to read with care.

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

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

Jeffrey T. Mezger

Thank you, Anne, and good morning to everyone. Thank you for joining us today to discuss our third 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.

On today's call, I will take you through highlights of our third quarter financial results, then I will provide insight in the KB Home strategy and business evolution over the past few years, after which I will provide you with an update on our progress to position the company for profitability and long-term growth. Jeff Kaminski will then take you through our detailed financial results, after which I will make a few closing comments. And I will be pleased to take your questions.

The most encouraging theme I want to express during this call is that we are making real and substantial progress towards our objective of profitable growth. We are pleased with our third quarter results, which reflect improved performance on all of our key financial metrics.

Our third quarter revenues increased 16% over the same period last year. We generated positive operating income. And our net income for the quarter was $0.04 a share as compared to a loss of $0.13 a share for the prior year.

We grew our backlog substantially, ending the quarter with $745 million in potential future housing revenues, a 33% increase over the prior year and the highest third quarter backlog level since 2008. Net orders increased in both units and value with value for the quarter increasing 16% over the same period a year ago.

We reduced our SG&A ratio significantly and improved our gross margin. We ended the quarter with $467 million in cash and invested $187 million in land and land development.

While we still have more hard work to do, our path to profitability is now clear, and we are turning our focus to also driving top line growth.

Turning back the clock to 2009. We recognized at that time that our top priority was to rebuild a profitable foundation for the company. We elected to withdraw from many markets that were not achieving returns, and we reduced our investment in other key markets until they stabilized. Many of the markets that we decided to exit had been entered late in the peak years of the last cycle, which made it extremely challenging to be profitable in those markets as the downturn continued. We narrowed our focus to our core markets where we had greater scale, stronger management teams, a proven ability to execute and a great brand.

The markets in which we operate today generated around 26,000 deliveries in our peak year, so we believe we have retained a substantial growth platform we can leverage as the housing market continues to gain momentum. Most notably, we maintained our strong #1 position in California by a wide margin, which is a significant competitive advantage for KB Home that I will elaborate on further during the course of this call.

In essence, our strategy was to concentrate on fewer markets with larger businesses in key submarkets with the right product while retaining a spring coil for growth. This evolution has taken time to manifest in our financial results as we continued to reduce overhead, build margin and bring our SG&A into alignment with revenues. But clearly, we are turning the corner in 2012.

As a result of our actions, during the past few years, we are positioned to be profitable at much lower delivery levels. We now have a much higher average selling price, a higher gross margin, and our SG&A ratio is approaching a more appropriate level. The fundamentals of our business are much stronger as a result of this evolution. In fact, now that we have a clear path to profitability, we are ready to leverage our current structure and business model for meaningful growth.

During our last call, I made the statement that KB Home is going on offense. I want to explain a little further what I meant by this because it is much more than just increased spending on land. Having positioned the company for profit, Going on Offense is my rally cry for growth. Now it is time to start moving forward again as a leaner, more efficient, better positioned company to take advantage of a market that is clearly recovering. It is a fresh mindset, and it is energizing for our team. Around the company, I am encouraging everyone to be bold and aggressive in pricing, gross margin enhancement, model opening timelines, land acquisition and compression of cycle times. As I said last quarter, going on offense is my personal #1 priority for this company.

We have established aggressive growth targets for each of our operating divisions and are monitoring performance against those targets. Part of this growth strategy is to continue to drive a higher average selling price through investing in choice locations within highly desirable and more affluent submarkets where we are modeling larger floor plans with more structural options. As a result, we are tracking first-time and first move-up homebuyers who have higher incomes and who in turn are selecting floor plans and structural options with larger square footage, leading to a higher average selling price.

As this strategy has been deployed, our average selling price has increased on a year-over-year basis for 9 consecutive quarters, now standing at $245,000. This is an 8% increase over the same quarter last year and, as impactful, is up 5% over the second quarter of this year. The average square footage of homes delivered in the third quarter was 2,117, up over 160 square feet versus the third quarter average in 2011. Based on our current backlog, we project that the trends of higher average selling prices and larger homes will continue going forward.

This product positioning and geographic evolution is working and is the primary reason we are generating significant average sales price growth. Along the way, when the market will allow, we are also opportunistically increasing prices.

While we are on this topic, let me make one thing very clear. We remain committed to our core consumer segment, the first-time homebuyer, which constituted 67% of our deliveries in the third quarter. We have not shifted from our core. We are simply attracting a different mix of first-time homebuyers in this market environment. To further illustrate our commitment to this segment, since the first quarter of 2011, our average selling price has gone up nearly $40,000 or 19%, while our percentage of deliveries to first-time buyers has remained constant.

Turning now to community count and net orders, we recognized that growing our community count is a key driver for unit growth. And as we discussed last quarter, we are focused on this as a top priority. As we shared on the last call, we are working through a short-term trend of closing out communities more rapidly than we are reloading new communities. This has resulted in a temporary reduction in community count in the quarter of about 13% year-over-year.

It's important to note that despite this short-term decline in our community count, we still achieved a positive year-over-year sales comp of 3% versus an extremely strong 40% up in the third quarter of 2011. This result illustrates our stronger sales pace for community, which in the third quarter was the highest it has been in years.

Looking forward, we anticipate that our community count year-over-year will be down in the fourth quarter given the number of communities at the start of this quarter that had only a few homes left to sell. Notwithstanding the lower community count, we have a goal of achieving a slightly positive year-over-year sales comp again in Q4. This will be difficult to achieve given the 38% increase in net orders reported in Q4 of last year, but it is our goal.

With the momentum we have in growing our average sales price, a slightly positive unit comp would still generate a significantly positive sales value comp. Going forward, we are targeting sequential community count growth for all of 2013 beginning with the first quarter as current land acquisition and development activities are converted into open communities.

As we continue on offense with our plug-and-play product series, we are able to go from identified lots to models opened very quickly. Just this week, at our investment committee meeting, we approved 6 communities that will provide deliveries in 2013 in Northern California, Arizona and Las Vegas. As we move through 2013 and beyond, we expect the combination of a growing community count, a high sales pace per community and the maturation of our relationship with Nationstar to provide real growth opportunities.

Now I would like to provide some regional color. As I have already mentioned, the market recovery is clearly gaining momentum in all 4 of our geographic regions. I am particularly excited about the opportunities we are seeing in our own backyard right here in California.

I have often referenced on these calls our top-performing California coastal communities that have maintained their high prices, sales pace and high margins throughout the downturn. While demand remains extremely strong in the coastal markets, in the Bay Area, San Diego and Orange County and coastal L.A. County, I'm especially pleased to report that we are now seeing dramatically improved market conditions in the inland regions as well. It's simply a different market than it was 6 months ago in the inland areas as inventories have declined significantly and prices are now rising.

Earlier this week, The Wall Street Journal reported on the August resale data and observed that 13 of the 15 cities with the largest year-over-year declines in inventories were located in California. The drop in inventory range from a low of a 40% reduction in San Jose to a high in year-over-year inventory reduction of 60% in Oakland, which represents the East Bay. Inventory declines of this magnitude are normally a precursor to strong price gains. This market dynamic will be a real tailwind for our company if the trend continues.

Our West Coast region is a true engine of growth and profits for KB Home. It is our largest business with our highest level of land investment in highly land-constrained markets and features seasoned management teams that execute at the highest levels.

To further emphasize the point on our California potential, for the first 9 months of this year, our average selling price in California increased to $377,000, up $55,000, or 17% increase, compared to the same period in the prior year.

Moving to our Central region, which includes Texas and Colorado, we continue to see strong sales in San Antonio and Austin, which are arguably 2 of the best real estate markets in the country. We are currently ranked #2 in each city. And over the past 12 months, we have grown our market share more than any other builder. The markets remain solid in Houston, Dallas/Fort Worth and Denver as well, and this region continues to be a strong growth driver for the company.

The Southwest region, our smallest region on a revenue basis, features markets that are now in full recovery with significant demand at lower price points and very low levels of inventory. Our Las Vegas business continues to be a shining star for our company, generating strong community sales pace at high margins. In particular, we are pleased with the results at our Inspirada community, where we posted 52 net sales in the quarter from 3 product lines.

In the Southeast, Raleigh remained a solid market driven by job growth, and we are working to open more stores. And in our 3 major markets in Florida, Tampa, Orlando and Jacksonville, we're now also benefiting from an accelerated recovery. We continue to expand our presence in the Washington, D.C. market with 3 grand openings planned during this quarter.

In addition to our improved operating performance and these favorable market trends, we're also extremely pleased with Nationstar's progress. Since the transition commenced on May 1, the Nationstar capture rate on new sales has been steadily increasing month-over-month. Their capture rate on sales is already approaching 60%, and they are definitely on track to achieve the 70% or more capture rate by year end that we have guided.

While the Nationstar percentage of deliveries was low in the third quarter, we are already seeing a favorable impact in the form of more predictable performance as compared to other lenders. Nationstar has been meeting projected dates for approvals and closings and so far has experienced fewer cancellations. Going forward, we expect to see significant positive impacts on our business with a better quality backlog, enhanced predictability, improved efficiencies and higher customer satisfaction levels as this capture rate on sales converts to deliveries in 2013.

Let me now update you on the 4 key growth initiatives behind our Going on Offense strategy. Our first initiative involves plans for aggressive investment in new land assets and communities. And during the third quarter, we invested $187 million in land and land development. As we guided on our previous earnings call, we anticipate that our land spend for the second half of the year will be in the range of $350 million. My direction to our land acquisition teams has been explicit. If we identify opportunities which would cause us to exceed $350 million in the second half, we will aggressively pursue those investments.

While the highly preferred submarkets are typically land constrained, we are successfully finding opportunities that align with our strategy. We have seasoned land teams on the ground that are leveraging our strong local relationships. Two great examples of this are acquisitions we recently closed and announced this quarter. The first was in Danville, California, a highly desirable, very land-constrained city in the East Bay; and the second, Mason Ranch in Austin, which provides more than 1,000 lots and a master plan in one of the city's premiere submarkets.

The second initiative we outlined is our plan to activate communities previously held for future development. Last quarter, we identified 10 communities primarily in Florida and Arizona, representing nearly 500 lots. All 10 of these communities are well under way with model openings and sales timelines that provide for 2013 deliveries.

In recent weeks, we have targeted an additional 11 communities, the first phases of which represent 550 lots that we are processing for reactivation. Our expectation is that the majority of these additional communities will be opened and generating sales by the end of 2013. It is very encouraging to get more of our asset base working for us once again.

The third initiative we have been focusing on is increasing revenues per community by driving sales performance and refining product offerings for today's consumer. We conduct intensive weekly reviews of community performance to optimize revenues, margins and sales pace and have established a practice such that any division which does not meet its weekly sales goal is required to participate on a sales strategy review call with senior management. I personally participate on these calls each week.

The fourth initiative we have been driving is bringing additional resources to the markets where we operate to further strengthen our division management teams while leveraging our existing infrastructure. Last quarter, we told you about our decision to divide our Northern California division into 2 management teams: one prioritizing the Bay Area, and the other prioritizing the inland markets. While this was a recent change, we are already seeing tangible benefits in both regions. During the third quarter, we made a similar move in Southern California, where we split the division team into 2 management teams: one to prioritize the coastal markets, and another dedicated to the rapidly improving inland empire. These types of actions are not limited to California. We have now commenced the split of the Central Texas division into 2 management teams, one each for San Antonio and Austin.

In addition, we have augmented our land acquisition teams with 15 additional hires in the last 4 months to enhance our land search and acquisition efforts. We have established specific growth targets and timelines for each division, and we are continuing to evaluate markets to determine the optimal management structure and dedicated resources needed to achieve our goals.

Going on offense is bringing out the best in all of us. We are seeing tangible results from our intensified growth strategies and remain committed to growing our business, increasing our revenues and enhancing our profitability.

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

Jeff J. Kaminski

Thank you. As Jeff had said, we are pleased with the third quarter improvements in our financial metrics and our reported bottom line profit for the quarter. At the same time, we remain focused on opportunities to further improve several areas of our business to continue to drive favorable results in the fourth quarter and into next year.

During the third quarter, we generated net income of $3.3 million, or $0.04 per diluted share, as compared to a net loss of $9.6 million, or $0.13 per diluted share, for the same period of the prior year. The 2012 results included $6.4 million of inventory impairment charges, while the 2011 third quarter included $1.2 million of inventory-related charges.

Total revenues for the quarter increased to $425 million, up 16% from the $367 million we reported in the same period of 2011. Our revenue growth was driven by a higher average selling price and an increase in the number of homes delivered.

Housing revenues were up in 3 of our 4 geographic regions compared to the prior year, with the West Coast and Central regions up by 18% and 14%, respectively, and our Southeast region reporting an increase of over 31% driven by significant improvements in Florida. In our Southwest region, where we had previously pulled back on land investments, housing revenues declined by about $4 million or 10%.

As we guided last quarter, our third quarter revenues reflect a conversion rate of approximately 58% of beginning backlog. We expect to reach a conversion rate of about 70% in the fourth quarter and still anticipate a significant sequential increase in Q4 revenues of around 35% over the third quarter.

The average selling price of our homes delivered during the third quarter increased to approximately $245,000, representing a year-over-year increase of about $18,000 or 8%. On a sequential basis, it increased by more than $12,000, or 5%, versus the second quarter of the current year.

The average selling price increase in Q3 extended our trend to 9 consecutive quarters of year-over-year increase. These improvements primarily reflect the result of our solid progress in transitioning toward communities located in more desirable submarkets with higher income buyers selecting larger homes with more studio options.

We expect our average selling price to continue to increase in the fourth quarter, and we are on track to achieve an average selling price of over $240,000 for fiscal 2012, as we have been guiding since the first quarter of this year.

Our housing gross profit margin for the third quarter improved 60 basis points to 17.5% compared to the 16.9% reported for both the same quarter of 2011 and the second quarter of this year. Excluding impairment and land option contract abandonment charges for all periods, the third quarter housing gross margin was 19% compared to 17.2% in the third quarter of 2011 and 20.3% in the second quarter of 2012.

We recorded an insurance recovery of $16.5 million in the quarter, representing a settlement with an insurance carrier for previously incurred expenses, including costs associated with Chinese drywall. This third quarter recovery represents a conclusion of the negotiations with an insurance carrier relating to this issue.

Our gross profit margin in the current quarter was favorably impacted by this insurance recovery. As you will recall, in the second quarter of 2012, our gross margin reflected a related $10 million insurance recovery, along with a favorable $11.2 million warranty adjustment. Excluding these items and inventory-related charges in both quarters, we realized a sequential improvement of 190 basis points in our housing gross margin as compared to the second quarter, in line with prior guidance. As a reminder, we also realized 90 basis points of sequential improvement in Q2 versus Q1 that we discussed during last quarter's call.

In terms of adjusted gross profit dollars, we have improved by approximately $10,000 per delivery in the third quarter compared to the first quarter of 2012, reflecting the significant improvement in our average selling price and the overall improvement in our gross profit margin percentage.

We continue to experience higher costs for labor and direct construction materials. In the first 3 quarters of 2012, we have been able to offset these impacts with sales price increases implemented in a majority of our communities. Despite these cost pressures, we still believe that the positive momentum of the past 2 quarters will continue, and we anticipate improvements in our fourth quarter gross profit margin on both a sequential and year-over-year basis, excluding the same items I referenced earlier. This should also result in a positive year-over-year comparison of gross margins for the second half of 2012, giving us momentum as we enter 2013.

Our selling, general and administrative expenses were up only slightly to $63 million in the third quarter compared to $60 million in the third quarter of 2011. We were very pleased with this result considering that our top line increased by over $57 million and the Q3 2011 SG&A expense benefited from a legal recovery of $8.3 million. Sequentially, as compared to the second quarter 2012, our total SG&A decreased by about $4 million with an increase in revenues of over $120 million. This decrease in expenses was primarily due to cost containment initiatives and the $8.8 million legal reserve recorded in the second quarter. This progress is an example of the operating leverage potential that we believe we have in our current business structure, and we expect to realize further gains as we continue to grow our revenues.

As we guided on our last call, as a percentage of housing revenues, our SG&A ratio improved both sequentially and year-over-year. In fact, the Q3 2012 ratio of 14.9% was the lowest third quarter level since 2007. Looking ahead, we expect to see both sequential and year-over-year improvements in the fourth quarter.

Our operating income for the quarter increased to $10.9 million compared to $1.4 million in the third quarter of 2011. Operating income as a percentage of homebuilding revenues for the third quarter improved 220 basis points to 2.6% compared to 0.4% for the third quarter of 2011. For the first 9 months of 2012, the operating margin increased by 880 basis points compared to the same period of the prior year.

As we have previously discussed, we have recorded a number of favorable and unfavorable adjustments in addition to inventory-related charges that have impacted our operating results in 2012 and 2011. In 2012, we had favorable warranty adjustments and insurance recoveries and a charge associated with an unfavorable court decision. In 2011, we had a favorable warranty adjustment, a legal recovery, a gain on the sale of an apartment complex and a loss on loan guaranty.

After adjusting our operating results for these items in both years, we have realized a year-over-year operating margin improvement of 390 basis points for the first 9 months of 2012. Entering the final quarter of '12, we remain on track to meet the lower end of our targeted range of 400 to 500 basis points of improvement for the full year.

Moving to our community count. We ended the quarter with 203 communities opened for sale compared to 233 communities at the end of the third quarter of 2011. During the third quarter, we opened 11 new communities and had 25 closeouts, and we are currently planning to open over 20 new communities during the fourth quarter.

We're actively pursuing additional opportunities to acquire land and develop land already owned to support additional top line growth in 2013 and beyond. During the third quarter, we invested approximately $187 million in new land and development, including land acquisitions partially funded by seller financings, and remain on track to invest a total of about $550 million for the fiscal year.

Our expectation is that our community count will be down again in Q4, and we are targeting sequential community count growth for all of 2013 beginning in the first quarter as land acquisitions and development activities are converted into open communities.

We were very pleased with the execution of the new debt issuance and tender offers which we completed during the quarter. The debt was issued at favorable terms, which reflects investor perception of our improved balance sheet as well as the continuing strength in the debt markets. We extended the maturities on roughly $245 million of debt and increased our cash position by approximately $92 million net of expenses.

As compared to the third quarter of 2011, we have significantly improved our debt profile through the transactions executed this fiscal year. We have extended the maturities of a majority of the near-term bonds. And as a result, at the end of the third quarter, our ratio of unrestricted cash to 4-year maturities was 1.01, and our next maturity, which is not until 2014, is an easily manageable $76 million.

During the third quarter, we generated a positive operating cash flow of $14 million versus a cash usage of $39 million in the prior year, an improvement of $53 million. For the first 9 months of this year, our operating cash flow improved by over $230 million compared to the same period of 2011. We ended the quarter with $467 million in total cash. This provides us with ample liquidity to run the business and still allow for both planned and opportunistic growth. We anticipate that our cash position will grow further during the fourth quarter even with the elevated land spend.

In summary, while we recognize that we have more work to do, we are realizing improvements in our key operating and financial metrics. We believe these improving trends, in combination with significant progress in the mortgage lending situation and our Going on Offense growth strategy, provide a clear road map to achieving and sustaining full year profitability in 2013 and beyond.

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

Jeffrey T. Mezger

Thanks, Jeff. Before I wrap up my comments, I would like to thank all of the hard-working employees of KB Home whose contributions, dedication and talents continue to propel our business forward. Now before we open the call for questions, I want to review today's key takeaway messages.

We now have a clear path to profitability, and we are gaining momentum in our financial and operational measures. Our investment strategy and product repositioning is working. And as a result, we are growing revenues and margins through dramatic increases in our average selling price, while at the same time remaining committed to first-time homebuyers as our core consumer segment.

We're on offense and pursuing our growth targets through our 4 key strategic initiatives involving investment, activation, execution and people. The housing market recovery is accelerating as inventory continues to decline and prices are now rising. In particular, we are excited about the dramatic improvement in market conditions in California, where we are currently the largest builder by a wide margin and we can really leverage opportunities. We expect our community count to grow as we head into 2013. And the combination of this increasing community count with our high sales pace per community and the benefits of Nationstar will drive future unit growth.

As a result of all of these efforts, we expect that we'll be profitable in the fourth quarter of 2012 and to be profitable for the year in 2013. With that, I would like to take your questions. Anne?

Question-and-Answer Session

Operator

[Operator Instructions] We will take our first question from Joshua Pollard with Goldman Sachs.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

I have a couple of questions because I really want to make sure that investors understand what you guys are doing in terms that we like to have them. You walked through your 4-point plan and a number of things that you guys want to do. Can you put some financial and operational numbers around some of those targets? You talked about larger square footage. You talked about higher ASPs. You talked about more options, more affluent markets. Can you dig into some of the operational metrics and how we should see those change over 2013? I understand what you just said about EPS. I think a lot of people would love to understand that, that includes and excludes adjustments, but also some of the core operational metrics that we should be looking for that gets you to that profit in 2013.

Jeffrey T. Mezger

Okay, well, we haven't shared any guidance for '13 yet, Josh. I can share with you some of the expected trends as our strategy continues to play out. We think the higher sales price will hold. We shared that we expect it to be higher in Q4. And with that, you have better leverage of SG&A. We always are trying to find ways to be more efficient, but the heavy lifting is done on SG&A. We think the ratio will continue to improve going forward, primarily out of leverage. On the gross margin side, we continue to expect our gross margin to trend upward, both in percentage and dollars, because our ASP is continuing to rise. And the point I tried to make clear on the call is our prices are not going up because of market conditions, they're going up because we're a better company and we're far better positioned with better assets today. So it's a real meaningful shift in price point, while at the same time, we're staying committed to the first-time buyer.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

Okay. If I can just follow up to that. There has been some concern about the rise in land prices. You made it clear that in North Cal, Vegas and Arizona, you guys just approved deals that will deliver homes in 2013. Have you baked the price increases into that land such that you're able to win those deals? Are you finding of a value-added way to find those deals where others can't such that you're able to not pay high prices and it still result in net margin improvement? Can you just talk about the margin profile of what you expect to deliver on those homes? I think the concern is that land prices have risen a bunch over this year and trying to deliver in '13 what you're paying for now might be too expensive.

Jeffrey T. Mezger

Sure. Look, Josh, one thing I failed to state in my prepared comments, which is absolutely a given, we are not compromising our underwriting standards on the investments that we make. Every deal we do has to underwrite based on today's prices and today's sales rates in that general area. I've always taken the view any prices you could achieve on the top line are offset by cost increases because, normally, prices go up in better times and contractors come along with you on price. There's no question that the land markets, especially in the more desirable locations, are seeing inflation on the lot prices or land that you can acquire. A lot of the things that get covered in the media are the "auctions" where somebody puts something out to bid and there's a frenzy that pushes the price up, frankly, in a lot of cases, by people that aren't end users. And we're not playing in that arena. That's something we just -- we stay away from. And I specifically identified the deal in Danville, which we love, and the deal in Austin, which we absolutely love, because both of those were mined and contracted because of our relationships in the marketplace. So you don't have to go around the market and play retail if you have a great land team with great relationships on the ground. In our newer markets like the D.C., we don't have those relationships yet. So we're more careful and thoughtful in that you have to play in a more competitive bid environment. Those are the book ends. We have a different situation in every market, but our expectation is the new investments will be one of the drivers in our continued improvement in profitability.

Joshua Pollard - Goldman Sachs Group Inc., Research Division

I appreciate that. If I can just make one last one in. I think investors understand the operational leverage in your business model. Revenues, obviously, can increase a heck of a lot more than your SG&A. But could you talk about the indirect gross leveraging your model? When we think about it, there are things like superintendent salaries, taxes, landscaping, things of this nature that ultimately gets some leverage off of them once sales begin to pick up for you guys or as prices go up in your business model. Can you talk about how that works in your business model? What percentages of your gross -- or of your cost of goods sold may not see increases in lock-step with your revenues?

Jeffrey T. Mezger

Sure. Well, Josh, as you know, every builder reports their gross a little differently, and we do capitalize some of the indirect construction into cost of goods. So it's -- it is a leverage item. Jeff can share some of the sensitivities with it. Our goal is to hold the cost and grow revenue, so there's obviously leverage, but Jeff can share the impact at different levels.

Jeff J. Kaminski

Sure. I'm looking at 2 different things, Josh. I mean, on the SG&A leverage side, our full intent is to contain cost as much as possible as we see top line revenue growth and we've been very successful in that so for this year and intend to continue it. And while we're allowing some isolated expansions, and as Jeff mentioned, one of the 4 points in our growth plan is to enhance some of the local management teams, it's paying off in a big way with top line revenue that's more than offsetting. So we're seeing nice leverage on that side. As far as gross margin leverage is, as I think as you are aware, we do carry a small portion of fixed cost within our gross margin. I believe it's about $12 million a quarter right now with increasing top line revenues. We're getting nice leverage off that piece as well. Specifically, when you start talking about field resources, it's a nice thing that's happening right now with the markets picking up and absorption rates being as strong as they are to be able to utilize some of those field resources in a more efficient manner. So when times are really tough and deliveries were down, we're having to share some of the construction supervisors, for example, across multiple communities, leading to some inefficiencies. There's traveling efficiencies, et cetera, on being able to concentrate those resources now more on a volume basis is helping us. But at the same time, we're also trying to hold those costs down, so we think there's efficiencies in all of these aspects of the business. We're being very, very cautious about expanding resource. At the same time, we're being aggressive in expanding resources in the areas that we think will bring meaningful growth to the company.

Operator

And we'll take our next question from Nishu Sood with Deutsche Bank.

Nishu Sood - Deutsche Bank AG, Research Division

I wanted to ask about the ability to grow here. You mentioned the strategic repositioning lowering your community count, obviously you're going to be growing going forward from here. If I -- if you just think from a balance sheet perspective, your higher debt to capital would seem like it would be a break on your growth relative to some of your peers. So I was just wondering, given, obviously, the run in the builders' stocks, would you consider an equity offering here to kind of reload your balance sheet and give you greater ammunition for growth?

Jeffrey T. Mezger

Nishu, let me make a couple of comments and then I'll refer it over to Jeff. If you look at what we just shared, we have a lot of liquidity today to go grow our business. And our strategy is to continue to rotate assets, generate operating cash and then reinvest it in the business. So we have a very nice rhythm going today. Just looking at third quarter, how much better our operating cash was than a year ago. And people keep claiming that our balance sheet is getting in the way of growth. But we have $470 million in cash on hand that we would love to invest and put to work as we diligently pursue more acquisitions. In the past, we were preserving more of the cash to ensure if there was a significant economic downturn, we could still power through the downturn and we're not as worried with that because of the underpinnings that have built up in the housing market and the economy. So our balance sheet to us is not in the way of growing our business, and we think we can have significant percentage growth with our current position. Jeff, do you want to share anymore?

Jeff J. Kaminski

Sure, yes, I'll pick up a couple of points here. Regarding our capital structure, I do think it's best to kind of discuss where we're at today and where we come from because we've come a long way in past year. And if you flash back to last year's third quarter, we are facing a pretty large settlement payment in Q4 on the South Edge issue, $250 million to be exact. We had 2014 and 2015 maturities in our bond portfolio of $1 billion. And we've made tremendous progress over that time period. First of all, we settled those liabilities in the fourth quarter. We now have a nice land asset and a very valuable land asset on our books relating to our Inspirada communities, and we're selling quite nicely out of those and have a long-term growth plan there. Secondly, we've completed 2 very successful bond transactions and tender offers this year, the most recent I talked about the prepared remarks happening in the third quarter. And as a result, we pushed out nearly 2/3 of our original near-term maturities. We brought our 2014 tower down to about $76 million, which I described as easily manageable in the prepared remarks and we really feel that way. And I think, very importantly, we now have a ratio with unrestricted cash and near-term maturities of a little over 1. We're in a vastly improved situation today. I think the other comment I've made in echoing some of Jeff's, I think the best source of funds for the company and I think it's always this way, our internal operations. We've been improving in almost all of our metrics over the past couple of quarters. The first 9 months of this year, as I mentioned, we generated cash flow that was over $230 million better than the same period last year, and we did that while spending almost $340 million on land acq and land development. So we're really sitting in a pretty good position. We're also sitting on a backlog level right now that's up 33% versus the prior year. It's the highest it's been in quite a time -- quite some time. And obviously, we're now just starting into the fourth quarter. And the fourth quarter, if you recall, is what our CEO calls our ATM quarter. So we do believe we'll add to our cash during the quarter and enhance our position even more. I think a couple of the other factors that sometimes investors miss, we do have $1.8 billion of inventory on our books. And we can and will use that inventory to support our growth objectives. And like I said, I think we're in a very good position. So to sum it up, we have solid growth targets. We're working towards those growth targets as a company. Obviously, we've modeled the results if we're going on offense strategy, and we're comfortable with our ability to support the resulting growth. And when and if we reach a point in time when we actually have a need for additional liquidity, we'll evaluate the situation and make the appropriate decisions at that point.

Nishu Sood - Deutsche Bank AG, Research Division

Great. That's a very good answer. Let me ask you a second question here. On -- Jeff, you're talking in your prepared remarks about pricing has gone up 20% over the past. I think you said 6 quarters or so. But the first-time buyer’s percentage has remained at about 2/3. And then obviously, in the context of your strategic repositioning, you mentioned going after a different sort of first-time buyer. I just wanted to understand that a little bit more clearly. How much of that's different just because, let's say, going back to California, a California first-time buyer is probably going to be twice, at least what a Texas first-time buyer, let's say? So how much of that is just market mix? And other part of it, capturing a different type of the first-time buyer, maybe you could just give us some more color on what exactly that means.

Jeffrey T. Mezger

I'm sorry, Nishu, could you -- what was your -- the final part of that question? I got the first part. What did you just close with?

Nishu Sood - Deutsche Bank AG, Research Division

Oh, just the -- to the extent that it's due to your strategic repositioning, what exactly does it mean? Are you saying you're capturing a different sort of first-time buyer?

Jeffrey T. Mezger

Okay, okay, I got it, I got it. As everyone on the call knows, the mortgage underwriting system is still very difficult. And the biggest impact was to the true median income first-time buyer, which, for decades, was our core business. And I think that as the economy improves and people feel better about housing, we're hopeful that mortgage underwriting improves with it. And if it does, you're going to unlock incredible demand at the median for the first-time buyer. In the meantime, we have shifted to the, I call it, the upper 1/3 or whatever you'd say of the first-time buyer, where I'd say high blue collar, low white collar, working couple or single that makes way more money in living, wants to live in a more desirable area. So it's not unusual. For instance, in Orange County, we opened a community in Irvine a couple of weeks ago where the first-time buyer, sadly, is paying $700,000 and we're selling very well. At the same time, the first-time buyer, even in Houston, we have found a niche where it's a higher income Houston first-time buyer. In many cases, people that just stayed on the sidelines as the frenzy played out and now were taking advantage of the incredible affordability that's out there and they know that it's now time to buy. And I believe -- Jeff, I don't know if you have the numbers, I think our ratio of first time is fairly consistent across the regions. It's not like Houston is all first time and California is not. It's very similar across all of our regions. So we're targeting higher price, more desirable markets, where we still are the affordable housing alternative within that market.

Operator

We'll go next to Michael Rehaut with JPMorgan.

William Wong - JP Morgan Chase & Co, Research Division

This is actually Will Wong on for Mike. I was wondering if you could talk about the components of the gross margin improvement, the 190-basis-point sequential improvement, so basically excluding the one-time items. What are sort of the main components of that improvement? And also, going into the fourth quarter and 2013 also, what do you think will be the main drivers of the gross margin improvement that you guys talked about?

Jeffrey T. Mezger

Sure, Will. First of all, I guess, let's talk about some of the headwinds we're facing. We did mention we're seeing some labor and material cost increases, and that's the first thing I'll talk about here. We had about a 70-basis-point hit, we think, in the quarter. This is sequentially due to direct construction costs and labor costs. That was more than offset by pricing actions we took in a number of our communities. And as we've been talking over the past couple of quarters, we have been able to move price in a majority of our communities, not significant huge price increases. And our ASP, as Jeff mentioned, was more due to community repositioning than to pricing. But we have been able to offset the cost, so that's helped us. The remaining pieces of the improvement on the quarter really coming from both cost leverage contained in the margin, as well as favorable mix where we're seeing our better positioned communities being able to deliver higher margins for the company. Continuing into Q4, we have guided -- we guided last quarter -- we're kind of reaffirming the guidance this quarter that we do believe we will hit a crossover point and actually have a year-on-year comp that's clean, let's say, that's favorable this year. And coming from many of the same factors, we do expect to see some continued headwind on the cost side. We do expect to see some recovery on the price side and with increased volumes. And certainly, with the favorable community mix, we expect to see some improvement in the overall margin picture.

William Wong - JP Morgan Chase & Co, Research Division

Great. And in terms of California, I know you guys noted a big improvement in California. What do you think was driving that? Is it just job growth or prices spurring people to buy quickly? Or just -- I know, Jeff, you mentioned a reduction in inventory. But how sustainable do you think that is?

Jeffrey T. Mezger

Well, I mean, I wanted to share the reduction inventory because those were incredible numbers, just incredible that a market could drop 60% in 12 months. The people -- a lot of people don't understand California. For starters, it's a huge demographic and everybody wants to live near the coast. And the closer to the coast, the stronger the demand. Even in the peak years, the housing industry does not meet demand within California. As many homes as we started, most of the markets are land constrained or process constrained and it takes time to bring lots to market. So we never caught up with the demand and the demographic of the state, and you have these huge populations north and south that are now reacting to the incredible affordability. And it's a pretty typical recovery cycle that has started in that, first, the coast ramps up, and it has, and then the prices slowly will ripple out and people will continue to compromise a little bit of location in order to be a homeowner. And the demand for homeownership is still very strong. And while I shared that the Inland Empire, in particular, has improved significantly, it's the western end of the Inland Empire, the side that's closest to the coast, while there's pockets of the eastern part of the Inland Empire that haven't improved at all. But again, it's a typical recovery. And with the size of the population here, the lack of inventory and the interest due to affordability, I think this can sustain for some time. In fact, I'm now starting to believe that we're once again facing an economic cycle where housing activity will be a growth driver and a job creator going forward. So this actually could feed on itself a little bit.

Operator

We'll go next to Bob Wetenhall with RBC Capital Markets.

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

I just wanted to get a real kind of on-the-record comment from Jeff Mezger. Are you intentionally sacrificing new order growth at this point in the cycle to achieve better ASP performance and drive gross margin?

Jeffrey T. Mezger

Good question, Bob. First off, we're not sacrificing anything, so I don't like the word sacrifice. In my prepared comments, I used the term optimizing each community. So we evaluate what is the best sales pace at the best price and at the best margin that will generate the highest returns for that asset. So we don't target a top line goal and then get to it. We start ground up and manage to each asset. And I've had a lot of people ask me that because they think we're pushing price to slow down sales. We're not. We're changing our product. And as I shared, our sales per community were the highest in the quarter that we've had in many years. So it's hard for people to justify that we're sacrificing pace right now. We're picking up price and pace.

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

So with this approach of optimizing lot sales, how do you feel this will impact land spend requirements going forward? And I think this is for -- more for Jeff Kaminski. What do you feel the impact to this will be in the future from a return on invested capital and balance sheet liquidity?

Jeff J. Kaminski

Right, yes, thanks, Bob. The frequency and the pace of sales, obviously, helps returns tremendously. And we're seeing it in our markets right now. We're -- as Jeff mentioned, we have one of the highest absorption rates in the industry, and it does gives us the ability to generate a lot of cash out of our operations through that land churn. And particularly, in the higher priced markets, you generate very significant cash flow on the deliveries coming out of those markets and you're able to reinvest at that point. We watch investment returns very carefully. It's a very key component of our land investment strategy. And we meter our return requirements against our margin requirements and look at both sides of that and balance them as we make those decisions. So it's very key component of our company strategy and our land investment strategy and that's really how we look at it. I think, from the point of view, higher absorption has obviously typically lead to better IRRs and returns, assuming you're getting the margin, and we are working very hard on margin improvement as a company. We've seen a couple of quarters now, consecutively and sequentially, of growth and intend to continue that trend. So we're focusing on both pieces of it. Like Jeff said, we don't think we're sacrificing anything on the way of absorptions due to some of activity and some of the community shifting that we're doing and we're very pleased with the result at this point.

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

So just to wrap that. You're comfortable then with the shifting to offense, funding that move with cash on the balance sheet, cash from internal operations to move forward and support the growth you need?

Jeffrey T. Mezger

Bob, I'll answer for Jeff. The answer is absolutely. But let me give you a little more color. If you think through the market conditions I've described and our sales pace per community, one of the things that's different for us right now is sales rates are predictable, and we haven't been able to say that for quite some time. You may have to do something with your positioning on price or whatever to achieve your sales rate but you can achieve the sales rate. In past years, you could flog a community as hard as you want, doing all kinds of things and sales may not have materialized anyway. So now that we have a predictable sales pace, we also have a predictable rhythm of deliveries and cash needs. So we know what our land spend will be and we can align it with our revenue generation going forward and keep things in balance and grow the business. That's what I referred to before as a very nice rhythm in our business right now.

Operator

And we'll take our next question from Ivy Zelman with Zelman & Associates.

Ivy Lynne Zelman - Zelman & Associates, Research Division

I think you've answered a lot of questions and just going to be quick. In terms of your land that you're purchasing today, what percent of it would be likely to deliver in '13? And what's going to be delivered in '14, '15, if you just sort of break it out, understanding the pipeline?

Jeffrey T. Mezger

Yes, Ivy, it's difficult to answer that because every community and every state has a different story. In some cases, we shared in our last call, we acquired some lots in Irvine in June in 2 communities where we've already grand opened. And they'll have deliveries in November, December and all of next year and into '14. And depending on the size of those communities, you'll hit your run rate and they build through. In some cases like that where you can move very quickly, you pop your business big time in '13. If it's a development deal, like the Austin, Mason Ranch, it's a development deal, we won't have deliveries there until '14. And what we're putting together is a nice portfolio of new acquisitions and activations where we can build a plan and expect to grow sequentially.

Ivy Lynne Zelman - Zelman & Associates, Research Division

Let me -- just let me ask in a different way, let me ask it in a different way then. Of your plan for '13, how much of your plan has already been purchased? And how much of your business plan in '14 has already been purchased?

Jeffrey T. Mezger

Yes, almost all of '13, Ivy. What we're doing now is opportunistically playing in things that come to us that would help us plus '13. We own and control everything we need for '13 right now.

Ivy Lynne Zelman - Zelman & Associates, Research Division

Okay, okay. And so just to -- sort of a legacy question. As we recognize you're incrementally adding and going to be able to fulfill your business plan for '13 and beyond, much like to what extent you can comment on what you have of your business plan for '14, what would you say if you were looking at legacy would still represent the land that you own and control? And how much of that would be peripheral stuff that you had to go and expand here because of the affordability factor when you're underwriting at the peak?

Jeffrey T. Mezger

Most of those things, Ivy, are long gone, that were out in the, what I call, the exurbs. And as these markets continue to correct, and I shared inventory drop in Riverside, I didn't share the prices were also up 15% in the year. And when prices are moving like that, a community that had a less-than-normalized margin, you change your thinking all of a sudden and that's a pretty nice margin. So as these markets cure, it's causing us to continue to scrub these assets and we think they're a real opportunity to grow the top line, grow the bottom line and generate cash and be a nice complement to the new acquisitions we're doing at the same time.

Ivy Lynne Zelman - Zelman & Associates, Research Division

Great. And your '14 business plans, how much have you got of that satisfied?

Jeff J. Kaminski

Over half.

Jeffrey T. Mezger

Yes, over half.

Operator

We'll take our next question from Megan McGrath with MKM Partners.

Megan McGrath - MKM Partners LLC, Research Division

I guess I just wanted to follow up specifically on your Southeast and Southwest divisions, which were the underperforming ones this quarter. You talked about 2 things, one repositioning, but also about selling out of communities faster than expected. So I guess I'm still a little bit confused about actually what's happening in those divisions. Is it that you have the land and the communities, but you are literally repositioning them and the product and that's slowing you down? Or is it that you haven't actually opened new communities and you're having to speed up that process?

Jeffrey T. Mezger

Yes. Megan, let me tweak one of your comments. It's not that our communities in those regions are underperforming. We have fewer communities. And if you look back over the last couple of years, we were sharing on these calls that the vast majority of our investment was in Texas and California, and that's been going on for 8 quarters. And if you look within our regions in both Texas and California, you have very nice growth trajectories occurring, both in units, in revenue and at the bottom line. So our strategy is playing out. In the meantime, we made the decision not to invest in some markets until they stabilized. And we don't want to take an investment risk until prices were settled and we knew that things weren't going to erode further. And Arizona was a great example of that, in that this time last year, we had 12 communities. Today, we have 2. The 2 we have are selling very well. We're actively out investing in Arizona again. And we'll grow our business from here. But we just couldn't get comfortable buying lots in Arizona a year ago. And if anything, I might have missed the early recovery because things have improved, frankly, faster than we expected they would. But this recovery isn't over. It's just beginning and there's plenty of opportunity for us. If you go over to the Southeast region, we announced that we pulled out of Charleston. We significantly reduced in Charlotte while it settled out and focus primarily on Raleigh, where our investment strategy was in highly preferred land-constrained markets and it takes time to mine in that area. And therefore, you have a little dip in activity, and in both cases, we expect sequential growth going forward. So it was really a strategic investment move we made while we're restoring profitability. And now that we have this path, we're back investing in all 4 regions.

Operator

And we will go next to Dan Oppenheim with Credit Suisse.

Michael Dahl - Crédit Suisse AG, Research Division

It's actually Mike on for Dan. Jeff, I was hoping you could drill down into your comments on Mason Ranch earlier. Clearly, a non-auction-type deal is better, but I would still think that with such a large piece of land and an attractive submarket, there's some level of competition. So could you describe what the competition was like there? What really differentiated KB? And maybe expand on when you talked about a self-mined deal. What type of work really goes into that?

Jeffrey T. Mezger

Okay. Well, 2 different questions there, Mike, and I'll go to the self-mined deal. As an example, the Danville community that we just announced we closed on. Danville's a great submarket. There's no new home competition to speak of at all in the East Bay in Danville. It took us years, frankly, to bring this one to market. A relationship that allowed us to tie it up and then leverage a land team that's been together for 2 decades in the Bay Area and can navigate through an entitlement process that's pretty intimidating. And that's a real strength of this company. So we leverage the relationship, tie up the land, work through a city that we have experience with and can now bring something to market that most builders in California couldn't even dream of doing. In the case of Mason Ranch, that one did get shopped to the market to a degree, and we happen to have a very good personal relationship with the owner and sellers. And one of the things that held a lot of people back in Austin was the size. And a beauty to me in Texas as opposed to California, you can control a lot of lots for a much smaller check than you do out here on the West Coast. So while it's a lot of lots and big acreage, the land basis is not that much and we love the fact of having 1,000 lots in a master plan in literally the most active submarket in Austin. So my challenge to the team there is how do we get it open faster because this thing is going to be a real nice boost to the company. In the Austin example, while we know the seller, we also, again, have a very skilled and seasoned land team that was able to navigate and understand some of the offsite requirements and entitlement issues in Leander where we've built before and have a great reputation. So it's a combination of seasoning, skill, expertise and then, in turn, the relationship. Contrast that to some of the markets we entered more recently, we don't have that advantage, and it's a different dynamic. But the 2 examples I gave you in 2 different states and 2 totally different environments are very nice outcomes for this company.

Operator

And that does conclude the question-and-answer portion of today's call. I'd like to turn the call back over to Jeff Mezger for any additional or closing remarks.

Jeffrey T. Mezger

All right. Thank you, and thanks, once again, everyone, for joining us today. And have a great weekend. We look forward to talking to you soon. Thank you.

Operator

This does conclude today's conference. We enjoy -- we appreciate your participation.

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