KB Home Q3 2024 Earnings Call Transcript

Quartr
Provided by Quartr
September 24, 2024

There are 14 speakers on the call.

Operator

Good afternoon. My name is John, and I will be your conference operator today.

Speaker 1

I would

Operator

like to welcome everyone to the KB Home 20 24 Third Quarter Earnings Conference Call. Currently, all participants are in a listen only mode. Following the company's opening remarks, we will open the lines for questions. Today's conference call is being recorded and will be available for replay at the company's website, kbhome.com, through October 24, 2024. And now, I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations.

Operator

Thank you, Jill. You may begin.

Speaker 2

Thank you, John. Good afternoon, everyone, and thank you for joining us today review our results for the Q3 of fiscal 2024. On the call are Jeff Mezger, Chairman and Chief Executive Officer Rob McGibney, President and Chief Operating Officer Jeff Kaminski, Executive Vice President and Chief Financial Officer and Bill Hollinger, Senior Vice President and Chief Accounting Officer. During this call, items will be discussed that are considered forward looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future results, and the company does not undertake any obligation to update them.

Speaker 2

Due to various factors, including those detailed in today's press release and in our filings with the Securities and Exchange Commission, actual results could be materially different from those stated or implied in the forward looking statements. In addition, a reconciliation of the non GAAP measure of adjusted housing gross profit margin, which excludes inventory related charges and any other non GAAP measure referenced during today's discussion to its most directly comparable GAAP measure can be found in today's press release and or on the Investor Relations page of our website at kbhome.com. And with that, here is Jeff Mezger.

Speaker 3

Thank you, Jill, and good afternoon, everyone. We achieved double digit year over year growth in revenues and diluted earnings per share in the Q3. With these results and our expectations for the remainder of this year, we believe we are well positioned to produce about $6,900,000,000 in revenues in 2024 at a gross margin exceeding 21%. As we work to finish the year strong, we remain focused on growing our community count, maintaining our high levels of customer satisfaction and executing our personalized built to order model, offering customers choice and flexibility based on what they value and can afford. As for the details of our results, we generated total revenues of over $1,750,000,000 and diluted earnings per share of $2.04 We delivered more homes during the quarter than we had anticipated as cancellation rates remained low and our build times have compressed.

Speaker 3

Our gross margin was slightly lower than we have seen in the past two quarters at 20.6%, which we will provide some detail on in a moment. Although our operating income margin was within our guided range at 10.8%. Our performance drove our book value per share up 13% year over year. Long term housing market conditions remain positive supported by an undersupply of new and resale homes, solid employment, wage growth and favorable demographics and household formations. Although resale inventory is rising in certain of our markets, it remains well below historically normalized levels, is very limited at our price points and days on the market are still low.

Speaker 3

We generated 3,085 net orders in the 3rd quarter flat with the year ago period. Our monthly absorption pace per community of 4.1 homes was in line with our 3rd quarter average over the past decade, although slightly below the 4.3 pace in last year's Q3. Our cancellation rate remains stable sequentially at a historically low level, indicating a solid pool of buyers ready and able to close on their homes when completed. The desire for homeownership is strong and we saw evidence of this during the Q3 with higher year over year traffic within our communities and increased leads from our digital marketing efforts. That said, buyers were hesitant as interest rates remained elevated and concerns about a slowing economy increased and demand began to soften in late June through July.

Speaker 3

In this environment, we took steps to adjust pricing as necessary to hold our pace. Rates moderated in August and demand strengthened with our weekly net orders improving sequentially in each of the last 3 weeks of August. We are encouraged by this positive trend and we continue to see solid sales quarter to date in September. With the Federal Reserve lowering interest rates by 50 basis points last week, we believe this will further benefit consumer confidence and affordability. Given the soft comparison in the year ago Q4, even normal seasonality will produce a strong year over year comparison in our 2024 Q4 net orders, setting us up with momentum as we enter the New Year.

Speaker 3

And with that, I'll pause for a moment and ask Rob to provide an operational update. Rob?

Speaker 1

Thank you, Jeff. I will begin by providing additional color on our net order results. Although traffic increased 8% year over year, some buyers hesitated on their purchase decision due to concerns about transacting too early given the uncertainty around interest rates and news headlines fueling an expectation of interest rate cuts by the Federal Reserve. Ultimately, lower mortgage rates do help to stimulate demand and we saw evidence of this in August with net orders increasing sequentially week by week as the month progressed. While buyers are rate sensitive, we believe the primary motivation of most customers is to secure a home that meets their needs at the best price, not the biggest incentive or rate buy down.

Speaker 1

Understanding this and considering the price increases we had taken in most of our communities in the first half of this fiscal year, we strategically and selectively adjusted pricing at the community level as needed to stimulate demand and optimize the pace price balance of each asset, which favorably impacted our net orders in August. Our pricing strategy focuses on offering the best possible price versus continually increasing incentives. Although we achieved the same gross margin by offering a reduction in price or an equivalent dollar value of incentives, buyers care about the price of the home and our teams emphasize the value of the personalized home in the community more than an incentive or mortgage rate. That said, we did continue to utilize mortgage concessions in the 3rd quarter with net orders that had some form of mortgage concession, whether a rate lock or a buy down in the low 60% range, consistent with the past 3 quarters. We began to reduce the dollar amount of mortgage concessions on our net orders in August in conjunction with the lower prices that I just spoke of, and we expect to be able to lower our use of this incentive in the Q4 considering improved affordability levels provided by the recent relief in mortgage rates.

Speaker 1

As to mortgage concessions on homes delivered in the 3rd quarter, they averaged just under 2% of housing revenues. We started nearly 3,000 homes in the quarter, ending the quarter with over 7,700 homes in production, including models. Our expectation is to end the year having started roughly 20% more homes in 2024 than we did in 2023. Given our production, backlog and lower build times, we have returned to more historical levels of converting our backlog to deliveries. Going forward, we plan to continue aligning our starts with sales, which will help keep our production in balance with the majority of those starts already sold.

Speaker 1

Our build times on homes delivered during the quarter was about 150 days, a 2 week improvement sequentially and a factor in delivering more homes in the Q3 than we projected. Going forward, we are focused on continued progress to drive build times down to 4 months, which is the lower end of our historical range. We reduced cost on our homes started during the Q3, which were down sequentially in a low single digit range, helping to offset the impact of pricing changes, incentives and land costs. The categories where we have seen the biggest changes recently are in lumber and stucco. We are aggressively pursuing additional opportunities to further reduce our direct cost, enhancing affordability and expanding our reach to a wider range of potential customers.

Speaker 1

Before I wrap up, I will review the credit metrics of our buyers who finance their mortgages through our joint venture KBHS Home Loans. We had a solid year over year increase in our capture rate with 88% of the mortgages funded during the quarter having been financed through our joint venture as compared to 84% in the prior year quarter. Higher capture rates help us manage our backlog more effectively and provide more visibility in closings, which benefits our company as well as our buyers. In addition, we see higher customer satisfaction levels from buyers who use KBHS versus other lenders. The average cash down payment was stable both sequentially and year over year at 16%, equating to about $77,000 On average, the household income of customers who use KBHS was nearly $133,000 and they had a FICO score of 742.

Speaker 1

Even with about 1 half of our customers purchasing their first home, we are attracting buyers who can qualify for their mortgage while making a significant down payment. As we head into year end, we do so with a continued daily emphasis on maintaining our high customer satisfaction levels, further improving build times and value engineering our products to lower direct cost. Our objectives remain consistent in increasing our scale, profitability and returns. We expect to execute on these goals by reinvesting in our growth, opening our communities on time, offering a compelling value proposition to our customers and optimizing each asset on a community by community basis to increase our margins and returns. And with that, I will turn the call back over to Jeff.

Speaker 3

Thanks, Rob. During the quarter, we invested $845,000,000 in land acquisition and development, an increase of over 50% year over year with more than $425,000,000 going toward acquiring new land. Year to date, we have invested $2,100,000,000 in acquiring developing land more than we spent in all of fiscal 2023. As we continue to accelerate our land investment in 2024, we remain diligent with respect to our underwriting criteria, product strategy and price points. We increased our lot position 21% year over year ending the quarter with over 69,000 lots owner controlled positioning the company for future growth.

Speaker 3

Overall, we remain focused on capital efficiency, developing lots in smaller phases wherever possible, balancing development with our start space to manage our inventory of finished lots. The composition of our land portfolio is strong, aligned with our product and pricing strategy and provides opportunities for us to gain share in our served markets. In addition to growing our established divisions, we are also beginning to see solid growth in our newest markets, Boise and Charlotte, as well as Seattle, which had its first deliveries only 5 years ago and is already on the cusp of a top three market share position. These three divisions are a great representation of our geographic expansion strategy as we can absorb the overhead costs of a new market entry in our existing business and as these new markets mature, they become meaningful contributors to our results. We maintain a balanced approach in allocating our cash, enabling us to meaningfully reinvest in our growth, which remains our top priority, while also returning capital to stockholders.

Speaker 3

With the $150,000,000 in share repurchases that we completed in our Q3, the highest quarterly amount this year, we have already achieved the increased level of buybacks for the year that we shared on our last earnings call. We do plan to continue repurchasing our shares in the remainder of this fiscal year and intend for it to be an ongoing part of our capital allocation plans beyond 2024. Since we began repurchasing shares on a regular basis in 2021, we have repurchased more than 24% of the shares then outstanding accretive to both our diluted earnings per share and return on equity. Over that timeframe, we have returned nearly $1,200,000,000 in cash to our stockholders including dividends. In closing, I want to recognize the entire KB Home team for their commitment to serving our homebuyers and contributing to our performance in the 3rd quarter.

Speaker 3

Our company is well positioned for future growth as we meaningfully invest in the expansion of our business and diversify our geographic footprint. We have an experienced management team and a business model that provides customers choice and flexibility in purchasing a home that meets their needs and budgets. With about 2 months remaining in this fiscal year, we are on track to achieve about $6,900,000,000 in revenues with the highest level of deliveries in many years, which will drive well over $8 in diluted earnings per share, representing significant year over year growth. This increase in scale and profitability together with the favorable impact of share repurchases will contribute to a return on equity of around 16.5%. As we look ahead to fiscal 2025, our initial guidance for revenue next year is about $7,500,000,000 We are committed to enhancing stockholder value by profitably expanding our volume, driving higher returns, as well as continuing to return cash to stockholders through both share repurchases and our quarterly dividend.

Speaker 3

With that, I'll now turn the call over to Jeff for the financial review. Jeff?

Speaker 4

Thank you, Jeff, and good afternoon, everyone. I will now review highlights of our financial performance for the 2024 Q3 and provide our current outlook for the Q4 and full year. We are pleased with our execution during the Q3 as our housing revenues increased 11% compared to the prior year and reached the high end of our guidance range. Combined with our healthy operating margin of nearly 11%, we generated robust cash flow that enabled us in the quarter to invest approximately $845,000,000 in land and development and return roughly $168,000,000 to our stockholders through share repurchases and our quarterly dividend. Our housing revenues grew to $1,750,000,000 for the quarter compared to $1,570,000,000 for the prior year period.

Speaker 4

The growth in our overall housing revenue was driven by increases of 8% in the number of homes delivered and 3% in their overall average selling price. Our 3rd quarter deliveries of 3,631 represented a backlog conversion rate of 58%, a significant improvement from 46% in the year earlier period. Our current quarterly quarter delivery performance was favorably impacted by continued improvements in construction cycle time and lower cancellation rates. We anticipate these factors will also benefit our 4th quarter deliveries and have considered them in our guidance. Based on our current backlog and expected construction cycle times, we project our 2024 4th quarter housing revenues will be in the range of $1,940,000,000 to $2,040,000,000 In the Q3, our overall average selling price of homes delivered was approximately $481,000 up from approximately $466,000 in the prior year period.

Speaker 4

This increase primarily reflected a mix shift in homes delivered towards our higher priced West Coast region. Looking ahead to the Q4, we are projecting a year over year increase of $23,000 in the overall average selling price to approximately $510,000 mainly driven as in the Q3 by an expected higher proportion of deliveries from our West Coast region. Our homebuilding operating income for the Q3 increased to $189,000,000 as compared to $179,000,000 for the year earlier period. Operating income margin of 10.8% compared to 11.3% in the prior year. For the Q4, we expect improvements in both our housing gross margin and SG and A expense ratio to drive expansion in our homebuilding operating income margin to the range of 11.4% to 11.8%, assuming no inventory related charges, representing both a sequential and year over year improvement.

Speaker 4

Our housing gross profit margin for the quarter was 20.6% as compared to 21.5% for the prior year period. The margin result relative to the prior year was primarily due to product and geographic mix shift of homes delivered along with other factors, including the impact of pricing adjustments to support demand, partly offset by reduced total homebuyer incentives. The mix impact mainly resulted from a higher percentage of revenues in the West Coast region with gross margins below the company average. Excluding inventory related charges of $1,200,000 in the quarter $600,000 a year ago, our margin of 20.7% for the quarter was down 80 basis points year over year. We expect to see a sequential improvement in our 4th quarter gross margin.

Speaker 4

Assuming no inventory related charges, we believe our 4th quarter housing gross profit margin will be in the range of 21% to 21.4%. Our selling, general and administrative expense ratio of 9.8 percent for the quarter improved by 40 basis points as compared to 10.2% in the prior year, primarily due to increased operating leverage from higher housing revenues. Supported by another expected sequential increase in quarterly housing revenues, we believe our SG and A expense ratio will further improve in the 4th quarter to approximately 9.6%. Our income tax expense for the Q3 of $50,100,000 represented an effective tax rate of 24.2% compared to 22.9% for the prior year period. We expect our effective tax rate for the 2024 Q4 to be approximately 24%.

Speaker 4

Overall, we reported net income for the Q3 of $157,300,000 or $2.04 per diluted share compared to $149,900,000 or $1.80 per diluted share

Speaker 3

for the prior year

Speaker 4

period. The 13% increase in our diluted earnings per share reflected higher earnings as well as the stock repurchases we have completed over the past several quarters. Turning now to community count, our 3rd quarter average of 251 increased 5% from the year earlier quarter. We ended the quarter with 254 communities open for sales, up 10% as compared to 230 communities at the end of the 2023 Q3. We still believe our 2024 year end community count will be in the range of 250 to 255, resulting in a 7% to 8% increase in the 4th quarter average community count.

Speaker 4

As Jeff mentioned, we invested $845,000,000 in land and development during the Q3, a significant increase from the same quarter of the prior year. 50% of the current quarter investment represented new land acquisitions contributing to the growth in our land pipeline to over 69,000 lots at quarter end, of which 58% were owned and 42% were under contract. At quarter end, we had total liquidity of $1,460,000,000 including $375,000,000 of cash and $1,080,000,000 available under our unsecured revolving credit facility with no cash borrowings outstanding. During the Q3, in addition to significantly increasing our land investments, we repurchased roughly 1,900,000 shares of our common stock at a total cost of $150,000,000 while maintaining our historic low leverage ratio of 29.8%. With $800,000,000 remaining under our current common stock repurchase authorization, we intend to continue to repurchase shares with the pace, volume and timing based on considerations of our operating cash flow, liquidity outlook, land investment opportunities and needs, the market price of our shares in the housing market and general economic environments.

Speaker 4

Year to date, we have repurchased 3,460,000 shares at an average cost of $72.24 per share, helping to drive an improvement in our expected full year return on equity to approximately 16.5%. In summary, we are pleased with our solid third quarter financial performance and operational execution and believe we are well positioned to both achieve our goals for the 2024 Q4 and drive higher housing revenues in 2025. Using the midpoints of our Q4 guidance, we expect full year housing revenues of approximately $6,900,000,000 with an operating income margin of over 11%, exceeding both our 2023 results and our initial expectations for 2024 as shared during our January earnings call. As Jeff mentioned, we also expect growth in our 2025 housing revenues reaching approximately $7,500,000,000 We believe our ongoing focus on accelerating profitable growth and expanding our returns by leveraging our larger scale, strong community portfolio and uniquely compelling built to order business model will produce measurable expansion in our book value per share and enhance long term stockholder value. We will now take your questions.

Speaker 4

John, please open the lines.

Operator

Thank you, sir. We will now conduct a question and answer And the first question comes from the line of Matthew Bouley with Barclays. Please proceed with your question.

Speaker 5

Good afternoon, everyone. Thank you for taking the questions. Maybe I'll start on that $7,500,000,000 revenue outlook for 2025, see if we can unpack that a little bit. It sounds like you're talking to an ASP of around 5.10, here in Q4 due to mix, but I'm not sure if we should really draw that into next year. So I guess we talk about $7,500,000,000 Is this going to be more kind of volume driven, price driven?

Speaker 5

And I guess how does the community growth sort of play into that volume side? Thank you.

Speaker 4

Yes. On a high level, Matt, we decided to provide some high level guidance this quarter. We believe our community count, our backlog, our starts, our absorption assumptions all support our estimate of the $7,500,000,000 Given where we're at today economically and particularly with some of the uncertainty around what the Fed actions will be for the rest of the year, the election results and macroeconomic, geopolitical, etcetera, etcetera. We decided to keep it very high level and really keep our guidance really only that line number. So at this point in time, we're

Speaker 6

not going to provide

Speaker 4

a lot of detail or dive into some of the components of it. As typical, you see pretty much all the above usually when you're driving volume from the point of view absorption growth, community count and price. Probably fair to assume the same for next year, but we're going to wait until we come back to you guys in January and discuss all of our key metrics and guidance and expectations at that point in

Speaker 6

time like we normally do.

Speaker 5

Okay. Fair enough. Thanks for that, Jeff. Secondly, you mentioned your strategy of sort of focusing on adjusting home prices rather than really toggling incentives to a significant degree, if I heard you correctly. Obviously, now you've got lower mortgage rates relative to a few months ago.

Speaker 5

So my question is really around how you will approach a lower rate environment between it sounds like you're willing to kind of pull back a little on the mortgage concessions here in Q4. But what should we expect around home prices, right? How did that trend as you got into August as you did start to see demand improve? And is there a scenario where you could sort of turn around here and start adjusting home prices in the other direction given where have gone or is that a little bit too early? Any color on how you're going to approach that lower rate environment?

Speaker 5

Thank you.

Speaker 3

Rob, you want to take that?

Speaker 1

Sure. So obviously lower rates are good for us. They're good for the consumer, for our buyer. Affordability has been a big challenge. Rates have been a big piece of that.

Speaker 1

So we're certainly happy to see them come down. As we mentioned in our prepared remarks, we are focused on selling the home and the value of that home versus just who can offer the biggest buy down or the biggest mortgage incentive. And we put that in play throughout the quarter. June started off fairly strong from a sales perspective and then it got weaker as we move through the latter part of June, a little weaker still in July and then better in August. And as we've done that, as the market was weakening, we found the need to lower prices in some of our communities to drive pace and optimize that asset.

Speaker 1

At the same time, we had others where we were lifting price again. So it really just gets to managing each asset individually and what that buyer needs or what that community needs to hit the volume levels that we're pursuing and to optimize each of those assets. But certainly as rates come down and if they continue to come down, we expect to be able to lower our incentives and do that without having to further lower revenue, which should expand our overall gross margins on orders.

Operator

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

Speaker 6

Yes, thanks very much guys. I'm going to follow-up on Matthew's question. Just because that $7,500,000,000 is a really encouraging figure, and it implies closings probably of $15,000 or more. And so, you've talked about I think you addressed absorptions. I just want to make sure that I'm understanding the interplay of absorptions and community count from this point forward.

Speaker 6

Is it right that you think that there's headroom on your absorptions from the level that you're currently at? And in terms of community count, it's going to be, I think, kind of flattish here in the next couple of months. But when is this inflection in community count, likely to happen? Is it imminent or is it something that you expect to sort of reach by the end of next year?

Speaker 4

Yes. Like we said, Steve, we're not really going to comment too much more in detail on the outlook for next year. Wanted to range the top line target for the company and let you guys know where we're heading. I think a lot will play out here over the next few months with the macroeconomic situation and particularly as we get through the election cycle and whatnot. And we look forward to hopefully a very strong spring selling season.

Speaker 4

As far as absorptions and room on absorptions, yes, there's always room for us to improve in that area. We've had to as we've talked quite a bit quite extensively over the last several quarters, we're not an incentive based company. We've had to incentivize a bit on a mortgage rate more than we'd like to. And as demand conditions improve and as the rate, hopefully the mortgage rates start coming down, we see less need to do that. And we do think that will be a demand driver going into next year.

Speaker 4

From a personal point of view outlook, I don't have a crystal ball any more than any of you do, but with a lower rate environment and given that the consumer has been a little more conditioned on these higher rates for the past couple of years or so, we could we're expecting to see a pretty strong spring selling season given the right conditions. But there's a lot of ground to cover before we get to that point. So we're kind of holding back on a lot of the details until we have more visibility into the macro. But we did want to kind of range out next year for you. So just please forgive us for lack of details at this point.

Speaker 4

Like I said, we'll provide a lot more in January and we'll come back to you.

Speaker 6

Great. Well, I mean, it's certainly a higher level of revenues and I think most people were looking for. So, that is encouraging to hear that you're targeting that level and you see the internal opportunity for it. From a longer term perspective, I wanted to talk about your margin. If I think about your operating margin, I know over the past several years, you've had issues like mothballed communities, you had your interest expense running through cost of goods sold.

Speaker 6

And by the time at this point, I think most of those issues are kind of behind you and things have improved. So I'm trying to figure out whether or not the long term operating margin opportunity for the company is materially higher than where you're at today, call it like 11% or so or not. So can you give us a sense for what you think is kind of an appropriate long term operating margin range for the company?

Speaker 4

Sure. So I'll talk maybe non quantitative a little bit on this one. But as we have a lot of focus on growing our scale through obviously through market share gains, through growing community count And hopefully, we'll see some market expansion as well with affordability maybe coming a little more favorable for the consumer. We think with that additional scale, there's certainly upside in operating margin. You've seen us break that double digit, that 10% mark on the SG and A ratio here for several quarters and we think that's attainable, especially with a higher top line.

Speaker 4

And with the margins where they've been trending over the past 12 months, given that we've been offering a lot of incentives at the same time, just purely just a pullback in incentives at the same price points that we have today could add incrementally to the gross margin. So short of guiding where we're going next year on that operating margin, I think there is potential for the company to improve in that area. It's certainly goal of the company to improve in that area and we'll see again based on the macro environment if we can get there.

Operator

Thank you. And the next question comes from the line of John Lovallo with UBS. Please proceed with your question.

Speaker 7

Hey guys, thanks for taking my questions as well. I know you gave some of the factors on the gross margin, but I'm just curious in the quarter the 20.7% relative to the 21% to 21.4% outlook, just maybe if you could just kind of bucket those a little bit, help us understand what the delta was there? And then along the same lines, what's the driver of that sequential increase as

Speaker 1

we move into the Q4, please?

Speaker 4

Yes, yes. Both very good questions. So on the quarter itself relative to guidance, as I mentioned in the prepared remarks, a lot of it was just driven by the West Coast mix in the quarter. Virtually all of the upside that we had on the top line relative to the midpoint of our guidance came from our West Coast business. And currently that business is carrying margins lower than the company average.

Speaker 4

So that was a little bit of a drag on the percent margin that we had for the quarter in dollar terms. Obviously, it was nice to have it. The other two factors that I mentioned was pricing was a negative. So we did see some price moves. But on the positive side, total incentives, total homebuyer concessions in the quarter were actually a little bit favorable.

Speaker 4

So those three factors were really the drivers, but the largest of the 3 as far as the guidance miss was the West Coast mix. When you look at it sequentially, we will have some additional West Coast deliveries and revenues in the Q4, but the delta won't be as high as it was, especially on a year over year basis as it was in the 3rd quarter. So there'll be a little bit of drag there. But on the upside, we're also looking at the West Coast margins improving between Q3 and Q4. So there'll be a little less going into it.

Speaker 4

And as always, I mean, we guide margins based on a very detailed forecast. So we start actually with our backlog, which is actually house by house. It gets rolled up to community, gets rolled up to division and gets consolidated. So the vast majority of our deliveries in the quarter are already on the books with known pricing and known costs. The swing factor often for us is just which homes get closed.

Speaker 4

So what does the mix factor look like in the quarter? And also we typically run about 20% of quarterly deliveries that are sold and closed in the same quarter. So those are obviously just estimates that we have to do at the beginning of the quarter. But that sequential improvement looks pretty solid to us at this point and we'll see how the quarter progresses and see where we get our deliveries. But we're pretty confident in the guidance numbers that we provided.

Speaker 7

Okay. That's really helpful. And I can tell you some of the more cautious feedback that we're getting from folks is that well, rates are coming down. This is not a new story, but that existing home inventory is going to come back into the market. We're already seeing the builders put up lower than expected gross margins as they're battling that.

Speaker 7

That doesn't seem to be the case. You guys are talking about existing home inventories to being pretty much in check, going up in some markets and the expectation that you will be able to pare back on incentives as rates come down. Just I want to make sure I'm understanding your thoughts on that correctly and how you do sort of see that dynamic of existing home inventory coming back in certain markets?

Speaker 3

John, I think you shaped it the right way. I think if there's more resale inventory, it will help the overall housing market. There's a lot of people that are locked out of moving up because there's not enough product or they don't want to sell their current home, but they need to move up. I think the whole thing opens up. What we call the housing food chain will all unlock it if inventory would come up a little bit.

Speaker 3

And as I shared in the prepared remarks, the days on the market is still very favorable. So while inventory is ticking up, it's clearing pretty quickly in most of the markets. And you have to look at it submarket by submarket in every city. And when you do, there's been a lot of headlines on pricing coming down and inventory up, but it's in at the higher price point submarkets than where we operate. Down at the more affordable levels that we operate at, the inventory is pretty limited still.

Speaker 3

So we think we're in a good position to compete very favorably as resale opens up some.

Operator

Thank you. And the next question comes from the line of Michael Rehaut with JPMorgan. Please proceed with your question.

Speaker 8

Hi, guys. It's Andrew Ozzie on for Mike. Thank you for taking my questions. I just wanted to follow-up maybe with the recent NAR settlement. I wanted to ask if there are any potential changes that you're making with brokers, if any, and kind of any net impacts from those and maybe your views more generally on brokers?

Speaker 3

It's still very early in the process and like everyone else we're watching the movements and trying to come up with whatever our strategy would be. But Rob why don't you share what we're seeing right now?

Speaker 1

Yes. It's like Jeff mentioned, it's a process. It's kind of influx. I think it's a process that will continue to evolve over time, but we are seeing that evolution speed up a little bit now that buyers are required to sign an agreement with their realtor that defines the terms of the compensation. And we've had some interesting situations in the field over the last couple of months where buyers some buyers had signed agreements and didn't really know what they had signed up for.

Speaker 1

And we've also had customers come into our sales office and tell us that they chose not to work with a realtor because they didn't want to be on the hook for covering that commission. So now we're working directly with them and they're working with our team. We value the realtors and the relationships that we have with them. And if they bring us business, we wouldn't otherwise be getting and they're the procuring cause for the sale, if you will. We truly value that and want to continue cooperating with them and compensating them fairly for it.

Speaker 1

But at the same time, it's a pretty significant cost addition to the home and affordability is can be tough and we're focused on removing any extra cost that we can. And one change that we have in play is now that we require the buyer to show us that compensation agreement with their realtor. And we typically pay up to 2%, but not more. Sometimes it's a flat fee. If that agreement says that the buyer is paying 1%, then that's what we're going to pay.

Speaker 1

So still in flux. We'll adjust our approach and our strategy as we learn more about it and see how things are playing out. But our main focus is going to continue to be trying to reach that buyer, working to reach that buyer directly through our digital marketing programs, our website and other outreach and advertising and just offer a straightforward simple process for purchasing a home. I would say it's interesting one statistic that our Q3 orders, we saw that realtor participation was down about 5 percentage points sequentially. So not sure if that's a direct correlation to the NIR settlement or if that's just kind of movement around in the numbers and the new process, but something that we're going to continue watching closely.

Speaker 8

Thank you for that. That was very thorough and helpful. Maybe moving on to kind of your build cycle times having somewhat normalized recently. Do you think maybe there's an opportunity to bring those cycle times lower than your historical average over time?

Speaker 1

Yes, absolutely. We still got a little ways to go to get to the lower end of our historical average about another 30 days. But we've got a lot of divisions, many divisions today that are building lower than that. Some of them are in the 110 day build time range. So other divisions were not quite as much available labor.

Speaker 1

It's a little slower, but I think we've got programs in place to continue accelerating those build times. It just does so much for us, whether that's pulling in deliveries from a future quarter or all of our return ratios. So definitely something we're focused on. I think it's an opportunity for us. If we can just get kind of our outlier divisions that are building longer down to even our company average, I think we'll get much closer to that 4 months.

Speaker 1

And I was nobody on our team likes to hear this, but at one point when I was in Vegas, we were building houses in about 90 days from sale to close. That may be a little too high of a goal, but we're going to get what we can.

Operator

Thank you. Our next question comes from the line of Alan Ratner with Zelman and Associates. Please proceed with your question.

Speaker 9

Hey guys, good afternoon. Thanks for all the detail so far. First, I guess, Jeff Kaye, on the 20 25 outlook, I'm going to be very careful not to ask you to parse it too finally. Your message was clear, but one of the things that you mentioned that gives you the confidence in growth next year, you pointed to your backlog and kind of the homes under production. I just want to make sure I'm thinking about this right because on a year over year basis, your backlog has been pretty consistently down roughly 15%.

Speaker 9

I believe the homes under production number you gave is roughly flat year over year. So I'm just trying to figure out like from a spec mix standpoint, you came into this year building more specs and that allowed you to grow closings even though your backlog was lower. Should we expect an incremental increase in spec building ahead of next spring given your optimism there or are you just taking a forward view of what demand is going to be in the spring and given your improving cycle times are confident that you can get those homes built and delivered and hit that closing target?

Speaker 4

Yes, you said it the right way. I should have actually combined that cycle time with the backlog in that comment, because that's pretty important factor for us and the improving cycle time has been a big generator and nice increment on our revenues. But yes, it's our forward look of where we expect things to go based on home starts, start plans and what we expect to see going into the spring.

Speaker 9

Got it. Okay. That's helpful. And then second question, kind of on the balance sheet asset efficiency side, you guys have done a really great job with the capital allocation and buying back stock. And as I look at your cash balance today and the cash flow year to date, you're roughly breakeven on a free cash basis.

Speaker 9

Your option share of land has increased, but the owned supply is still kind of sitting 3 to 4 years, which is similar to where it's been of late. So how should we think about your free cash generation going forward? Other builders have kind of set a target of roughly 100% conversion earnings to cash flow. I'm assuming Q4 will be a solid cash generation quarter for you guys, but it would seem like in order to get to that 100% number or something close, you would need to see that year's supply of owned land move closer to maybe 1 or 2 years where some other builders are?

Speaker 4

Right. We focus mostly on asset efficiency, Allen, from the point of view of inventory turn. And what we're doing with the communities that we have there, we're relatively high paced company from absorption point of view, typically one of the tops in the industry on turning our inventory once the communities are up and running. So that's really the primary focus for us as far as asset efficiency goes and that can generate a lot of cash. The reduction of build times has been a big cash generator for the business and we don't think we're as Rob mentioned earlier, we think there's still a room on that to generate some incremental cash on a go forward basis and that's where we're focused.

Speaker 4

And of course, if we can achieve some operating margin expansion, that's just a bonus on top of it. So land monetization for us is very important, big cash driver and we'll continue to allocate capital very carefully based on our forward outlook on cash flow and balance sheet. The one nice thing for us is we can really focus on, I would term it as more shareholder friendly allocation to capital, particularly with our balance sheet in a condition as in today, which I don't think it's ever been better from a leverage point of view. So that's a big favorable for us as well.

Operator

Thank you. Our next question comes from the line of Rafe Jadrosich with Bank of America. Please proceed with your question.

Speaker 10

Hi, good afternoon. Thanks for taking my question. First, I just wanted to, you mentioned that direct cost had come down a little bit. You'd seen some opportunity. Can you talk about the outlook going forward on the direct cost side?

Speaker 10

And then also what are you seeing on land inflation today?

Speaker 3

Rob, that's right up your alley.

Speaker 1

Okay. So yes, we've driven direct cost down sequentially. I still think on directs,

Operator

some of it's going

Speaker 1

to be based on market conditions and how busy our suppliers and our trade partners are. But I think we've got opportunities to continue driving it down. It may not necessarily come from simple things like rebidding, but we've got initiatives going on throughout the company in an effort to get to better affordability for our buyers of driving costs out of those homes, whether it's the elevation, the look of the outside of the home, whether that's simplifying the options that we offer that we've been working on. It's an ongoing process, and we're seeing relief in costs from that, and just value engineering the projects. We've got San Antonio, for example, as we're trying to get to a more affordable price point, we're introducing new models with they're a little less elevated and more simplified in terms of their box on box type construction, getting rid of offsets and overhangs and things like that.

Speaker 1

So a real opportunity that we're continuing to drive there that I expect to see more cost decreases on the direct cost side coming. And of course, we'll take everything the market will give us as well in terms of rebidding and just negotiating lower costs. I'm sorry, what was the question on land?

Speaker 10

Just what you're seeing in terms of land cost today, what level of inflation and how has it changed?

Speaker 1

Well, there's an ongoing land grab in most of our markets. So it certainly puts pressure on both the raw land side and the development cost. I'd say that that's definitely slowed down and stabilized some from what we saw back in 2022 and 2023. So that's on the land side. Development cost, I would say they've generally stabilized, but now stabilized at a higher level.

Speaker 1

So, yes, between land and land development, we do see higher overall lot cost, not necessarily as a percentage of our revenue, but we're incorporating that into all of our underwriting. And we're only doing deals that make sense to us. So as the land costs go up or something else has got to move down, maybe that's directs like we talked about. But still just focused on making sure each deal that we do hits our underwriting hurdles and we feel good about our portfolio and the process going forward.

Speaker 10

And then the second question is just where is your spec versus BTO mix right now? And how do we think about the margin differential between the two segments?

Speaker 1

So the in terms of sales, it's a little it's roughly sixty-forty on what we've had. We expect that probably to come down more in the historical range. It's been more like eighty-twenty. And we do see a drop off in we get higher margins when we're selling a BTO home and somebody is personalizing that home for themselves, which is one of the reasons we'd like to keep that ratio closer to the eighty-twenty. That's our primary focus.

Speaker 1

Our primary business model is selling personalized homes and that's what we're going to continue doing.

Operator

Thank you. Our next question comes from the line of Trevor Allison with Wolfe Research. Please proceed with your question.

Speaker 11

Hi, good afternoon and thank you for taking my questions. I want to follow-up on Alan's question regarding your land bank. Your option lot percentage has really jumped the last couple of quarters. Is that a function of just timing, or has there been a different approach there? And do you expect that to stay near these higher levels or over the next several quarters kind of gravitate back towards your 25% option level that you've been at recently?

Speaker 3

Trevor, Rob touched on the fact that most of the markets we're in land is very competitive. And you'd love to buy every deal on a rolling option. And some markets you can do it and some you can't. We have been successful with a lot of our bulk purchases going to a phase takedown where you may buy half of it today and half of it 18 months out. And as you look at our percentage movement, as we're investing more in our growth, I would say it's all the above.

Speaker 3

We're seeing more option deals. We're seeing more phase takedowns. We're also buying some deals both within it.

Speaker 4

And I

Speaker 3

think over time, you'll see the option percentage go up a little more from where it is today. But our primary mission right now is to create a bigger growth platform and capture the business that we can and grow our share.

Speaker 11

Yes, makes a lot of sense. And then a second question on geography. Clearly, Florida and Texas have gotten a lot of attention in the last few months. From an order standpoint, it looks like the Central was maybe a little bit softer for you guys sequentially, but the Southeast was improved relative to your overall company average, only moved down modestly quarter over quarter. Can you just talk about how Florida and Texas demand trended throughout the quarter?

Speaker 11

How that compares to your business overall? Thanks.

Speaker 3

Rob?

Speaker 1

Yes. It was a little we talked about the resale and inventory. Just to give you an example, we've got it really is market by market. Look at a division like Jacksonville where the resale inventory, it's about 5.5 months of supply now, which is approaching the longer term historical average and it's up more than 2 months year over year. So there is more pressure on there from resales and I think that was a factor.

Speaker 1

Orlando is similar, some of the Florida markets that we've got. So as we looked at the moves that we needed to make to lift our sales pace, those were some of the areas that we did lower prices in. And we've seen that those have been fairly effective and sales have bounced back in August. Texas, I would say, is similar, really different if you go from Austin to San Antonio as far as buyer profile and price point. But both of those markets too, we've seen resale inventory start to climb back up.

Speaker 1

It's become a bigger competitor and we've taken a similar approach there. We've taken steps to find the market. Some of that included lowering prices in certain communities and again saw it come back and we're pleased with where things headed in August with sales improving each week of the month and continuing on into September. As we look at early September, we're also seeing really strong activity on our leads and traffic. So it gives us good optimism here as we look through the Q4.

Operator

Thank you. Our next question comes from the line of Jade Rahmani with KBW. Please proceed with your question.

Speaker 12

Thank you very much. Absorption pace dip to 4.1. Could you just comment on what your target is and what you're expecting say for next year?

Speaker 3

Sure. And I could have answered Stephen's question earlier along his line. So thanks for the question. If you look back at 2022 when the markets were really strong in the early part of the year, we were at 6, 6.5 a month in the springtime. And that's it's an illustration that we're going to optimize the asset, take the price, balance price and pace.

Speaker 3

And what we have found over time is you have to hold at about 4 a month minimum. So you do what you're take the steps you have to get to 4. And if it's a large lot position in a submarket that's easily replenishable, you'll let it run at 6 or even 7 or 8 like we've done in some of our communities. So as we look at this year, we've been navigating some real volatility in market demand and we're going to run right around 4 a month at the end of the day based on where we're at and where we're headed. But that's certainly not a ceiling, it's a floor.

Speaker 3

So I think if the markets were to improve, you'd see us lift above the 4.

Speaker 11

Our stated range that

Speaker 3

I'm sorry, the stated range that we've given is we'll average 4 to 6. Every community has got its own story though.

Speaker 12

Thank you very much. And honing in on California, how would you characterize the demand trends you saw in the quarter, because that's your largest market?

Speaker 3

Rob, do you want to handle that?

Speaker 1

Yes. California has been strong for us. Southern California has done really well. Inland Empire has been one of our strongest divisions in terms of sales and they kept on chugging in Q3. Overall, pleased with our demand in California and continues to do very well.

Speaker 1

I don't have a lot to add to that. It's been a good story for us.

Operator

Thank you. And our final question comes from the line of Susan Maklari with Goldman Sachs. Please proceed with your question.

Speaker 13

Thank you. And thank you for taking the questions. My first question is around buyer sentiment. The election, housing has gotten a lot more attention from both of these candidates. Do you think that that's having an effect on people's decision making process and their willingness to perhaps step into the market today?

Speaker 3

It's pleasing, Susan, to hear both sides talking about doing things to help housing, but that's encouraging for us. Our industry continues to under build. We have real affordability issues that we're navigating as an industry and anything that they can do would be a help. So that would be a good thing. And whatever they do, it will still take some time to catch up if we ever catch up frankly because there are some structural things that we're dealing with.

Speaker 3

The consumer has a lot of triggers when they make a home buying decision. Most of them are life changing, whether it's getting married, having a baby, relocating, promotions, demotion, all those things, retire. All those things drive the need to change your homeownership and all those have been going on all year. So I think there was a pause because interest rates stuck. Everybody thought they were at a peak and sooner or later the Fed would move and they now have.

Speaker 3

And if as interest rates slid, we saw almost an instant reaction out of the consumer where in the month of August, leads went up, traffic went up, business to the community. Everything was very favorable. And I think that's just the human nature of things, not necessarily somebody's platform for what they're going to do for housing. So I think if either side does something, I think it will be helpful, but I don't think that's the principal driver right now with the decisions we have made.

Speaker 13

Yes. Okay. That's helpful color. And then just one last question on the Design Studios. As we move through the quarter and you saw the movements on the demand side and thinking about the outlook for the Q4 and even into next year, Any changes in the options and things that people are picking there and the amount that they're spending in the design studios?

Speaker 3

It's been pretty static. We keep sharing that. The buyers are spending what they're spending and the percentage on the price really hasn't moved in a couple of years.

Operator

Thank you. And ladies and gentlemen, that does conclude the question and answer session. And this also concludes today's teleconference. Thank you for your participation. You may now disconnect your lines.

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Earnings Conference Call
KB Home Q3 2024
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