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spk11: Good afternoon. My name is Alex, and I will be your conference operator today. I would like to welcome everyone to the KB Home 2022 third quarter earnings conference call. At this time, 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 21st. Now, I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may begin.
spk00: Thank you, Alex. Good afternoon, everyone, and thank you for joining us today to review our results for the third quarter of fiscal 2022. On the call are Jeff Mezger, Chairman, President, and Chief Executive Officer. Rob McGibney, Executive Vice President and Chief Operating Officer. Jeff Kaminski, Executive Vice President and Chief Financial Officer. Bill Hollinger, Senior Vice President and Chief Accounting Officer. And Thad Johnson, Senior Vice President and Treasurer. 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. 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 measures referenced during today's discussion to their most directly comparable GAAP measures 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.
spk06: Thank you, Jill. And good afternoon, everyone. We delivered another order of strong financial results with meaningful year-over-year growth in most of our key metrics, highlighted by more than 600 basis points of expansion in our home building operating income margin to approximately 18%. These results reflect the strength of our company, our larger scale, and the size and composition of our backlog. At the end of our third quarter, our backlog stood at over 10,700 homes, valued at more than $5.2 billion, placing us in a good position with respect to deliveries in our 2022 fourth quarter and into the first half of 2023. Approximately two-thirds of our buyers are either locked on their mortgage rate or paying in cash, and for the most part, these buyers are closing when their homes are completed. Our buyers tend to have an emotional attachment to their purchases that stems from creating their personalized homes on a lot they have selected with features and finishes they have chosen. As for the details of the quarter, We produced total revenues of $1.84 billion, up 26% as compared to the prior year period, and diluted earnings per share of $2.86, which grew almost 80% year over year. While we achieved a low end of our revenue guidance, we experienced an extension in bill times due to ongoing supply chain issues, which affected delivery in the quarter. Rob will provide more detail on cycle times and a supply chain shortly. Our gross margin of 27 percent is a particular highlight of the quarter, demonstrating the impact of our internal initiatives along with our effective management of pace, price, and starts to optimize each asset during the robust demand environment earlier in our fiscal year. In addition, we successfully managed costs driving our SG&A expense ratio down 100 basis points year over year. We remain committed to balancing our overhead with our revenues as we continue to open additional new communities. The factors supporting demand for homeownership remain strong, including favorable demographics, population and job growth in our served markets, and rising rental rates. coupled with a limited supply of homes due to the industry's underproduction of new homes and low levels of existing home inventory, particularly at the more affordable price points. Although the long-term outlook remains positive, many prospective buyers have paused and moved to the sidelines amid higher mortgage rates, along with ongoing inflation and a range of macroeconomic and geopolitical concerns. As we manage through these uncertain times, we remain committed to our bill-to-order approach. Our focus is to provide the best value to customers based on their budget and the features that are most important to them, and not to offer the best incentive on a standing inventory home. Homebuyers are making the largest investment of their lifetime, and many desire a personalized home with the ability to select their lot, floor plan, included or upgraded interior finishes and exterior elevation. This flexibility is also important to our customers if affordability is a constraint as our buyers can select a smaller square footage home at a lower price with the same number of rooms and functionality and also reduce their spend in our studios. We believe our approach is compelling and can make the difference in whether a customer is able to purchase a home. By emphasizing choice and personalization, as well as the partnership our community teams offer, we provide an important service to our buyers. We think this is a key driver in our consistent achievement of the highest customer satisfaction rating among production home builders. Net orders of 2040 We're down relative to a strong 4,085 in the year-ago third quarter. Let me discuss the components of our net orders by first providing some color on our gross orders with a separate discussion of cancellations. At the start of the third quarter, given the size of our backlog and with only 69 finished homes available for sale, we made the decision not to chase sales. The quarter unfolded. with June's average weekly gross orders coming in softer than May's. July's gross orders held consistent with June's, and we then experienced an acceleration in gross orders in August. We had taken steps in July with respect to pricing in some underperforming communities, while at the same time mortgage rates had declined slightly since June. We were pleased with the activity in August, But following Labor Day, interest rates have again risen, and we've experienced a softening orders trend. We will continue to monitor market dynamics and individual community performance and will adjust pricing as necessary to maintain the balance between preserving our backlog and achieving minimum absorption rates to optimize each asset. Over the years and throughout cycles, we have typically generated one of the highest sales rates per community in the industry, and that remains our objective going forward. With respect to cancellations, due to the unusually low level of gross orders and large beginning backlog of 12,300 homes, we believe looking at cancellations relative to backlog is a better way to understand the dynamics during the quarter. At 9%, Our cancellation rate on beginning backlog did increase sequentially, but it was still well below historical levels. The number one reason for cancellation was buyer's remorse. It was not necessarily that the buyers did not qualify. They did not feel comfortable moving ahead with the purchase. We ended the quarter with only 12% of our homes in production unsold, consistent with our second quarter level, and with less than one finished and unsold home per community. We expanded our community count in the third quarter due to fewer communities selling out, partially offset by some deferred openings. In this market environment, we are not opening communities for sale until models are 100% completed to optimize the selling effort, which contrasts with the past 12 months during which we opened for pre-sales while models were still being constructed. We expect another sequential increase in our ending count in the fourth quarter and year-over-year growth in 2023. This will be an important contributor to our future net orders, given the moderation in absorption rates. The credit profile of buyers that use our Mortgage Joint Venture, KBHS, home loans remains strong and consistent sequentially. For loans funded during the third quarter, 67 percent of these customers qualified for a conventional mortgage and nearly all used fixed rate products. The average loan to value ratio was 84 percent, translating to a cash down payment of over $80,000. The average household income of these buyers was $130,000, and their FICO score was 734. While we target the median household income in our sub-markets, we are attracting buyers above that income level with healthy credit that are able to qualify at higher mortgage interest rates. With that, let me pause for a moment and ask Rob to provide an operational update. Rob?
spk03: Thank you, Jeff. We continued to face difficulties in completing and delivering homes in the third quarter. And as a result, we were short about 160 deliveries or 4% relative to the midpoint of the guidance that we provided in June. While we had seen build times improve modestly in May, which we shared with you on our last earnings call, they extended significantly from that point, illustrating the larger industry-wide challenge in finding a consistent footing in build times. During the third quarter, Built times for our homes under construction expanded by 11 days from the framing stage to completion. This drove the delivery miss in the quarter and is also having an impact on our fourth quarter delivery projection, which we have reduced. There were several factors that contributed to this extension. Building material shortages continued to delay the completion of homes. We are seeing improvement in the availability of some products, such as appliances, garage doors, insulation, and HVAC flex ducts, While other areas are still challenging, including electrical materials, cabinets, HVAC equipment, and flooring products. As to trade labor, the dynamics are mixed, with availability on the front end of the construction cycle improving, although continuing to be more difficult in the back end. The home building industry has been dealing with power infrastructure issues for quite some time, and this has intensified. We had completed homes that we could not deliver in the third quarter because our utility providers could not get transformers and electric meters, and many of our divisions that build attached product experienced delays in obtaining switchgear and wire. In Houston, there were 77 homes across three communities that were completed and scheduled to close in the third quarter but were postponed due to the lack of transformer. In addition, we continue to experience delays with city inspections in most of our markets due to municipal staffing shortages and elevated production levels in the back end of construction. We are factoring the longer municipal lead times, ongoing supply chain issues, and labor shortages we experienced in the third quarter into our future delivery projections. Our teams are working relentlessly through the challenges and finding ways to progress homes through the construction cycles. We are focused on what we can control, and we are optimistic that with starts slowing in most of our markets and our greater scale, we can transition back to our historical build times, although this will take time to achieve. The lower level of starts is also providing us with an opportunity to reduce our cost to build as we renegotiate them where possible. And with that, I will turn the call back over to Jeff.
spk06: Thanks, Rob. Last quarter, We shared with you our expectation of reducing our land investment in light of current market conditions and then redeploying this cash to our stockholders. In the third quarter, we did just that with a year-over-year reduction in land acquisition and development spend of almost 30%. With near-term visibility limited as to the direction of the economy and its impact on homebuyers, we expect to continue at a lower level of land spend for the foreseeable future. We have been renegotiating land contracts to reduce prices and extend closing timelines. In certain cases where we are no longer comfortable that we can achieve our required returns on the investment, we have terminated the contract. In the third quarter, we canceled contracts to purchase nearly 8,800 lots. Our lot position stands at just under 80,000 lots owned or controlled. Of these, 51,000 are owned and only about 18,300 are finished lots, with 11,000 of these having a house under construction. We are balancing our development phasing with our start space so as not to build up a large inventory of finished lots, which supports higher inventory terms. Relative to the vintage of our own lots, we contracted approximately 40% of these lots in 2019 or prior, and another 40% were tied up during 2020. As a result, the vast majority of our own lots were underwritten before the run-up in average selling prices, which we believe supports our ability to sustain solid gross margins. The balanced approach we take towards capital allocation has resulted in 100 million of stock repurchases in the past two quarters driving a 5% year-over-year reduction in our diluted share count in the third quarter. With strong profitability and healthy cash flow expected in our fourth quarter and ongoing caution in land investments, we expect to be in a position to redeploy additional capital to our stockholders before the end of this year. In closing, I would like to recognize and thank our entire KB Home team for their hard work an ongoing commitment to serving our homebuyers. We believe the differentiation we offer in our built-to-order approach, providing the choice and flexibility that creates an emotional connection between buyers and their personalized homes, has contributed to our leading absorption rates in the industry over many years. We're focused on preserving our backlog and achieving our minimum net order targets as we navigate current market conditions. All of the homes that we need to complete a strong 2022 fiscal year are already in our backlog, although we acknowledge that longer build times and ongoing supply chain disruptions have impacted the timing of some of our deliveries. With about $7 billion in revenues expected for this year, reflecting over 20% year-over-year growth and a gross margin of 25%, We anticipate that we will generate a return on equity of about 26%, representing meaningful returns-focused growth. With that, I'll now turn the call over to Jeff for the financial review. Jeff.
spk04: Thank you, Jeff, and good afternoon, everyone. I will now review highlights of our financial performance for the 2022 third quarter and discuss our current outlook for the fourth quarter. In the third quarter, we produced measurable year-over-year improvements in most of our key financial metrics, including a 26 percent increase in our housing revenues, a 610 basis point expansion of our operating margin, and a 79 percent rise in our diluted earnings per share. We also completed several significant transactions to improve our capital structure and strengthen our balance sheet, which I will detail shortly. Our housing revenues grew to $1.84 billion compared to $1.46 billion for the prior year quarter. This improvement reflected a 6% increase in the number of homes delivered and a 19% rise in their overall average selling price. As Rob discussed, our current quarter deliveries were tempered by extended build times in most of our served markets driven by building material shortages, trade labor challenges, power infrastructure issues, and delayed city inspections. We have moderated our fourth quarter revenue outlook to reflect an anticipated continuation of these industry challenges. Considering our quarter-end backlog of $5.3 billion, the status of homes under construction, and expected construction cycle times, we anticipate our fourth quarter housing revenues will be in a range of $1.95 to $2.05 billion. Our overall average selling price of homes delivered in the quarter rose to $509,000 from $427,000. Average selling prices were higher in each of our four regions with year-over-year increases ranging from 12% in our West Coast region to 26% in our Central region. For the fourth quarter, we are projecting an overall average selling price of approximately $503,000, which would represent a year-over-year increase of 12%. Our home building operating income improved to $325.1 million as compared to $169.9 million in the year earlier quarter. Operating income margin increased 610 basis points to 17.7%, due to meaningful improvements in both our gross profit margin and SG&A expense ratio. Excluding inventory-related charges of $8.5 million in the current quarter and $6.7 million in the year earlier quarter, our operating income margin was up 600 basis points year-over-year to 18.1%. The current period inventory-related charges were comprised of $5.9 million of abandonment charges associated with our housing operations and a $2.6 million impairment charge relating to a planned future land sale. We expect our fourth quarter home building operating income margin, excluding the impact of any inventory-related charges, will be approximately 16.7 percent compared to 12.9% in the year earlier quarter. Our housing gross profit margin was 26.7%, up 520 basis points from 21.5% for the prior year quarter. This margin expansion mainly reflected the favorable selling price environment supported by healthy housing market dynamics when most buyers contracted to purchase these homes. Excluding the $5.9 million of current quarter abandonment charges and $6.7 million of inventory-related charges in the prior year quarter, our gross margin was up 500 basis points year-over-year to 27%. Assuming no inventory-related charges, we believe our fourth quarter housing gross profit margin will be in the range of 25% to 26%, which is lower than our prior expectation due mainly to the anticipated impact of selling price adjustments in response to softening housing market conditions and a loss of leverage on lower expected housing revenues. At the midpoint, our fourth quarter gross profit expectation represents a 310 basis point improvement as compared to the prior year period. Our selling general and administrative expense ratio of 8.9%, improved by 100 basis points as compared to 9.9% for the 2021 third quarter, primarily due to a 70 basis point decrease in external sales commissions and increased operating leverage from higher revenues in the current quarter. Considering an anticipated increase in revenues and our continuing actions to contain and reduce costs, we believe our fourth quarter SG&A expense ratio will be approximately 8.8% a 100 basis point improvement as compared to the year earlier quarter. Our effective tax rate was approximately 22%, reflecting $70.9 million of income tax expense, net of $15.3 million of federal energy tax credits we earned from building energy-efficient homes. We were able to recognize the tax credits largely due to recently enacted legislation. We expect our effective tax rate for the fourth quarter to be approximately 24%, including an expected favorable impact from additional energy tax credits. Overall, we reported net income of $255.3 million, or $2.86 per diluted share, compared to $150.1 million, or $1.60 per diluted share, for the prior year quarter. Turning now to community count, Our third quarter average of 221 increased 8% from the year earlier quarter. We ended with 227 communities open for sales as compared to 210 communities at the end of the 2021 third quarter. On a sequential basis, we were up 13 communities. We expect another sequential increase in the fourth quarter and believe our 2022 year-end community count will be in the range of 235 to 250. Using the midpoint, this would represent a 10% year-over-year rise in our fourth quarter average community count. Our forecasted year-end count is lower than our prior expectation as we anticipate fewer fourth quarter openings due to many of the same challenges that affected our third quarter deliveries. We invested $556 million in land, land development, and fees during the third quarter with only $135 million of the total representing new land acquisitions as compared to $467 million in the prior year period. The 71% year-over-year decline in land acquisitions reflects a pivot toward a more selective land investment strategy in response to softening housing market conditions and our ability to develop land positions already owned or controlled to drive future new community openings. In addition to being more selective on new land acquisitions, we abandoned approximately 8,800 previously controlled lots during the quarter. At quarter end, we had total liquidity of approximately $928 million, including approximately $195 million of cash and $733 million available under our unsecured revolving credit facility. During the quarter, we issued $350 million of 7.25% eight-year senior notes and used the net proceeds together with cash on hand to redeem $350 million of 7.5% senior notes prior to their September 15, 2022 maturity. recognizing a $3.6 million loss on this early redemption of debt. In August, we entered into a senior unsecured term loan with $310 million of lender commitments. We are pursuing additional lender commitments and can draw up to the total committed amount at any time through November 23rd, 2022. We intend to use the proceeds of the term loan to redeem our 7.58% senior notes due May 15, 2023, which have a par call date six months in advance of their maturity. After retiring the May 2023 notes, our next senior note maturity will be in June 2027. During the quarter, we repurchased approximately 1.6 million shares of common stock at a total cost of $50 million. Year-to-date, we have deployed $100 million of cash to repurchase approximately 3.1 million shares, leaving $200 million available for repurchases under our current Board of Directors authorization. We ended the quarter with a book value per share of $40.79, a year-over-year increase of 26%. In summary, while current housing market and supply chain conditions have negatively impacted our expectations for the fourth quarter, our outlook for the 2022 full year reflects significant year-over-year improvements across most of our key financial metrics with notable increases in our scale, housing gross margin, operating margin, and returns. We believe we will generate a full-year return on equity based on our fourth quarter expectations of around 26%, as compared to 19.9% for 2021. In addition, during the fourth quarter, we plan to complete the refinancing of our May 2023 senior notes and continue measured common stock repurchases. We intend to carefully manage our business through the current housing market conditions and believe we are well positioned to achieve solid returns and drive book value accretion in the fourth quarter and into 2023. We will now take your questions. Alex, please open the line.
spk11: Thank you. At this time, we will be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. We ask that you please limit to one question and one follow up. Our first question comes from the line of John Lavallo with UBS. Please proceed with your question.
spk15: Hey guys, thank you for taking my question. First one is I guess maybe you help us think about maybe quantify the incentive activity on a sequential and year over year basis. What type of incentives are you using? Are buyers responding? And then along the same lines on the fourth quarter gross margin, being now down sequentially, does that imply that incentives were used in the backlog as well?
spk06: John, I can make a few comments on incentives, and I'll kick it to Jeff for the specifics on the slight move in the gross. As I shared in my prepared comments, we really don't focus on incentives. We look at providing the buyer with the best value, which to us is the most square footage for the best price. and then let them personalize at the studio. And as a result of that, the buyer builds up their own value versus us building a home and then pushing incentives on them to force a value. And therefore, we don't really use a lot of incentives. We may move pricing in a community if it's not selling, and we'll take some steps to pick up our sales rate But I think in the quarter, if I'm not mistaken, Jeff, our incentives are less than a percent, like a half a percent, which is what they typically have run over the years. So for us, the incentives, closing costs, any kind of mortgage financing, freebies here and there, less than 1%. And that would hold true for our fourth quarter deliveries as well. You want to talk about the sequential?
spk04: Sure, John. Yeah, on the sequential gross margin guide, I think first of all, it's important to point out, you know, with our guide at 25 to 26%, at the midpoint, it's up 310 basis points year over year, which is a phenomenal level of improvement on a year over year basis. So first of all, we're really pleased with that gross margin progression and what we've seen there. There have been a few impacts that have changed that outlook a bit from what we were expecting at the end of last quarter. A couple of them relate to pricing. One is, you know, we took a more cautious approach reflecting current market conditions on pricing expectations relating to any quick-moving homes, and those would be homes either sold in the third quarter or in the fourth quarter for fourth-quarter delivery. So that had some impact. We did include some potential selective price adjustments that may be required for some of our customers in backlog. You know, in certain cases, some of our communities now have pricing bit below where some of the customers have locked in. And with current market conditions, we wanted to make sure we had some provision in there to cover that in the event we need it. We've also lost some leverage on the lower fourth quarter revenue expectation. And we explained that a little bit with what we're seeing in the supply chain for the most part. So that had a small impact as well on our fourth quarter gross margin. And then finally, we did see some mixed impacts. We beat the third quarter guide by over 100 basis points at the midpoint of the guide. And as a result, or part of the driver of that was closing higher margin deliveries in the third quarter that we expected to close in the fourth. So we saw some mixed impact also coming into play there.
spk15: That was really helpful. Thank you. And then You know, the order cadence you provided with June being worse than expected, July, I think, down, and then August, you know, actually firming up and being positive, you know, relative to July. I guess the question is, was this gross orders or net orders? And then, you know, with September softening again, are you getting any sense that people are adjusting to a higher interest rate environment, or is this still in the works?
spk06: John, it's... I'd call it a stair-stuff process. So rates ran up, then actually softened a bit in August. And at that time, the buyers seemed to have digested the higher rate, and they were OK, and they moved ahead. And we were encouraged with the activity that we saw in August. When you look at September, I want to qualify it a little bit. It's 15 days in September, and it includes a Labor Day weekend. So there's always a little noise with that. And there's no question the market It's softer than it was last September, and we saw it turn down a bit. And in August, if you go back to that point in time, we had also taken some steps in some communities that weren't hitting their sales rates, and we think that helped. And as we go forward, if things stay sluggish, we'll take some steps to further generate sales. But even since I've made my prepared comments Since I assembled them over the last week, rates have run up again. And with the Fed comments today, we think they'll move a little more. What's interesting that I can share also, and we didn't include it in our mortgage comments, we have some great and compelling interest rates on adjustable rate mortgages where it's a 10-year fixed. And if I were a buyer, I would take that in a minute. And those are a couple hundred basis points lower than the 30-year fixed. And nobody's taking it. So far, it's a very limited number of people that have shifted to arms yet. And if you take that dynamic and pair it up with the buyer profile I shared, I don't know that they need the arms yet. Everyone's just kind of paused. As I said, they've moved the sideline and they're waiting to see how things play out, whether it's our interest rates running up more, our inflation concerns, all these things that you're hearing about in the media, that the buyers just put it on pause. They haven't gone away.
spk07: They're just not buying at the level they were.
spk11: Thank you. Our next question comes from the line of Stephen Kim with Evercore ISI. Please proceed with your question.
spk13: Thanks very much, guys. And, Jeff, yeah, thanks for that commentary about the nature of the slowdown in demand. It certainly sounds like the issues are more mental than math, and so that's encouraging. I did want to pick up though, Jeff Kaye, on the comment about the gross margin outlook. And I believe you mentioned that anticipating that you're going to maybe do some more discounting or something to move your quick move-in homes was a part of that. And so regarding that, one of the interesting things that we have been hearing recently is that quick move-in homes are actually in greater demand by the buyers. because they would like to consummate the deal quickly. And so I was curious, are you generating lower gross margins currently on your quick move-in homes than on your BTOs? And then tied to that, you don't have a lot of standing inventory. So I'm curious, it seems like you're maybe selling your QMIs or your quick move-in homes pretty quickly. So, you know, again, are you generating a lower margin because, you know, you're selling them pretty quickly? There seems to be a lot of demand for it, that kind of thing.
spk04: My comments really, Steve, were relative to where we were at a quarter ago. So, you know, with our expectations on pricing a quarter ago versus today, obviously those expectations have come down a little. So it wasn't meant to imply that we're having a deeply discounted quick move-ins or anything else. Most of our quick move-ins are coming from cancellations, as you know, So it's just the dynamic between where it was written at as a BTO order and where we end up transacting at on a QMI. But overall, it was really more of a relative comment, third quarter versus fourth quarter as far as our expectations.
spk13: Okay, that's good. So it doesn't sound like quick-movement homes are particularly a problem for you at this point. Not at all. And you already talked about the fact that the can rate on backlog was only 9%, which isn't very much either. So then sort of a follow-up here, I wanted to talk about investor buyers and basically landlords. Would you consider selling more QMIs or more quick move-in homes to investor buyers if higher mortgage rates were to slow retail demand to the point where you do have more standing inventory than you would like? And is it your expectations that sales to landlords would come at a... line average margin or better on an operating basis?
spk06: Steve, let me make a few comments on that. First off, on your previous question, I wouldn't say that buyers prefer spec over built-to-order. We offer the customer a nine-month lock. So they get today's rates not going up on them. I share the percent of our buyers that are locked or cash. And... they still value the ability to personalize their home. So I wouldn't take the position that people prefer a spec home. We really limit or, uh, try to get away from any investor sale activity. And one of the things that I'm sensitive to is having a bunch of, uh, renter churn, I'll call it, uh, mixed into our community. So we're not a company that would go sell a bucket of inventory and, uh, put rental investors in next to our customers on a broad-based approach. Maybe a house over here or a house over there that have investors purchasing and renting. But where we may consider it, and we've looked at it and haven't penciled yet, but we may do it if we have a larger land holding and there's a distinct pod of lots that you could identify as single-family rentals and they have their own streets in and out, and they aren't mingled in with our purchasers, then we may look at something like that. I would think on a bulk basis, even though we're not doing it, I would think that the bulk purchaser is going to expect some type of discount due to buying bulk. I can't believe they're going to just pay market rate pricing right now.
spk11: Thank you. Our next question comes from the line of Matthew Boulay with Barclays. Please proceed with your question.
spk14: Good evening, everyone. Thanks for taking the questions. So on the topic of ASPs, I know you mentioned making some price adjustments in underperforming communities. I think the order ASP overall was maybe down 12% sequentially. And if I'm doing the math right, it looks like on the West Coast, it might have been down more than 20% sequentially. Are you finding that these price adjustments are I guess, reinvigorating sales pace in those communities? Or should we expect to see, you know, perhaps more reductions? And I guess just given the magnitude of that, you know, do owned land impairments start, you know, becoming more realistic, you know, given that move in pricing? Thank you.
spk06: Matt, I'll talk to the price move and then Jeff can give you the impairment thoughts. California is primarily totally mixed. We had several communities that sold extremely well in the second quarter and either sold out or approached sellout, where the ASP was a million five, million seven, up to two. And when you get a few of those communities in our coastal business and they sell out and you're replacing them with townhomes for $600,000 in Anaheim, It can really move your ASP down, and that's what happened in California. That's not price cuts. That's a mixed shift. So when we looked at it, of the change in ASP, about two-thirds of it was the California mixed shift. And then the rest may have been adjustments or further mixed in the other regions. But don't look at that as a pure price cut because that's not what – what happened in our business. Jeff, you want to give them your impairment thoughts?
spk04: Yeah, in relation to the impairment question, you know, Jeff spent a little bit of time during the preparatory remarks talking about the vintage of our lots and when those lots were locked in as far as pricing goes. And we're pretty proud of our inventory right now and our lot position in our communities. Exiting the year as we guided, you know, in the mid-20s from a gross margin point of view, puts us in my tenure with the company at about the safest point we've had with the most room between where we're currently selling homes at and what would even start to cross the line of an impairment. So it's not high on the list right now of concerns for us at the moment. Obviously, we'll continue to carefully monitor what we're doing with land and particularly with new investments, but it's not a particular concern right now with those type of margins.
spk14: Got it. Okay, that's really helpful. Thanks for that clarification, particularly on the mix side there. I guess second one, you know, you mentioned at the top, I think Rob spoke about the potential to, you know, begin renegotiating with, you know, certain construction materials, if I heard you correctly, around, you know, the decline in housing starts. Just curious if you could I guess expand a little bit on that and sort of where you see the opportunities to maybe, you know, reduce some of your input costs there. Thank you.
spk03: Rob, you want to speak to that? Sure. Yeah. You know, on the directs, we're starting to see some relief on the front end, and I think that's how we would all expect it to happen because the starts slow down. The houses that are moving through the front end of the construction cycle, there's just not as much out there, so the trades and the suppliers get hungrier. So, you know, that's what we're attacking right now and really working to drive the cost out of the business. We haven't seen the same success, and I wouldn't expect to, you know, until we get probably through this year on the back end because there's a lot of production volume out there in all of the markets that we operate in on the new home side. So the trade base and the product associated with, you know, The homes that are, say, drywall and beyond is still pretty tough, but that's going to flow through. Some of the slowdown we're seeing it start to first get relief on slab and then framing, and it moves on through the system. So that's really the way that our teams are approaching it and attacking it today.
spk11: Thank you. Our next question comes from the line of Alan Ratner with Zellman and Associates. Please proceed with your questions.
spk08: Hey, guys. Good afternoon. Thanks for taking my questions. First one, we'd love to get a little bit more color on the roughly 9,000 lots you guys walked away from in the quarter. I'm curious, was there an attempt to renegotiate those deals and the sellers, for one reason or another, just didn't want to play ball? Or were those lots that just based on your kind of view of where the market is going just didn't make sense to move forward on either at any price or any kind of takedown schedule that you could have potentially renegotiated?
spk06: Alan, I think it would be across the board. You answered some of it. In some cases, the land sellers are sticky and they're not willing to reduce price and they're not extending because they think they've got other people in the wings that will come in and take your position. We said, okay, fine, but we're not comfortable and you walk. Then there's others where at the price point or in that city and what was going on around it, we decided we just don't, we can't support the returns. And as we look at our land activity now, it starts with the underwriting on the price and the pace. And unless that sub-market has stabilized and we have demonstrated pace at a similar or less, or similar price point, We can't get comfortable. It's not going to get a little tougher out there. But it's a full mix of things. We're doing everything and anything to preserve these positions. But if it doesn't make sense, we are prepared to walk.
spk08: Got it. And just in terms of the, you know, kind of vintage or duration on these deals, were these primarily lots that would have been community account growth in, you know, call it 24 and beyond, or were these deals that you were kind of on the edge of, you know, potentially taking down that could have contributed for more near-term community account growth?
spk06: There might have been one or two where it's a fringe 23 deal. Late in 23 it would open, but for the most part it's beyond. Okay. And part of it is we have... We've had a very successful run at filling a very good lot pipeline over the years here. And if you look at the lot count that's owned, we don't have the urgency to go tie up more right now to have a growth trajectory. We have a nice position, softer trajectory than we thought two or three years ago, but still a very favorable growth trajectory. So we don't have any urgency right now. We can afford to be particular.
spk08: Got it. That makes a lot of sense. Jeff, you brought up the underwriting, and I remember earlier in the year you answered a question of mine related to some of those assumptions on your underwriting. And I recall at the time you said on land underwriting you were generally assuming monthly absorption rates in the 4 to 6 range, and that was when your sales space was obviously much higher. Today it's lower, and it's a point in time, of course. But should we think about your current sales space at 3 where – four to six is really that desired pace you guys want to be at. And until you get there, you know, price is probably going to be a lever that you're, you're pulling maybe more significantly than you did this quarter. Or have you, have you changed that view at all? Are you more comfortable, you know, in this maybe three to four range for the time being?
spk06: I'd say three to five. If I said four to six, it'd be three to five now. And, uh, every, it depends on how many lots and is it replaceable and what's the price point and all those things we always, we always talk about. But, uh, At three to five, we can make very good profits and very good returns at the kind of margins we can run.
spk11: Thank you. Our next question comes from the line of Michael Rehart with JP Morgan. Please proceed with your question.
spk10: Hi. Thanks. Good afternoon. Thanks for taking my questions. First, I just wanted to circle back and clarify from an earlier question around margins on spec or quick move-in. You know, it was cited as a driver, you know, reduced pricing expectations on quick move-in or spec, I guess, in the fourth quarter. So it would suggest that that margin on spec is a lower margin than your homes and backlog, at least, I would presume. I just wanted to get that right. And number two, you know, Jeff Kaye, I think you mentioned, you know, four drivers to the reduced gross margin expectations, and I think versus your prior guidance is about 250 bps. You cited four different drivers, and I'm just trying to get a sense of the degree of magnitude of what each of those drivers represent on the guidance reduction.
spk04: Sure. I'll try to address both those. So first of all, the QMI, again, it was relational. It was related to where we were at a quarter ago versus any type of comparison between QMI homes and bill-to-order homes or anything else. We've done very, very well with anything that we have needed to sell on a spec basis, particularly over the last couple of years. And there hasn't been much. Our spec homes and deliveries have been pretty small. So that's really actually a pretty small impact on the fourth quarter gross margin. But it is one of the factors. When you look at order of magnitude, I mentioned four things. The mix and leverage probably being on the lower end of things. The QMI impact probably being on the lower end. Probably the largest impact was just provisions that we made in the event that potential selective price adjustments are required on the backlog. And it was judgmental a bit, and we don't know yet where that will land for the fourth quarter, but we wanted to be prudent and a bit conservative on that piece of it in the event that conditions keep deteriorating. So that's how we see it today. The mixed impact also was somewhat impactful when you look at the overperformance in Q3, and those homes were in backlog. Some of those lower margin homes will be closing in the fourth quarter, and some of the higher margin homes actually close in the third. So there's a little bit of a trade-off there as well. But that's how we see it right now. Every time we redo a forecast, we don't go through... community by community, home by home, and quantify all of the differences, but those are the main drivers as we see it.
spk10: Right. Okay. No, I appreciate that, Jeff. And maybe just to drill down a little further on your answer, I guess, when you say that the bigger portion of the 4-2 gross margin guidance reduction is from these, an assumption around selective price adjustments. So if I'm hearing that right, it sounds like you're saying you haven't made those adjustments yet. These are assumptions of what you might need to do through the end of November. And so, you know, to me, that's a little surprising in that, you know, you have another 10 weeks to go. Obviously, that's a decent amount of time. But, you know, you're talking about a large number of closings. So I was a little surprised to hear that I would have thought that those price adjustments would have already been made. Just curious if that assumption is based on some price adjustments that you've already had to do in the last month or two, and you're kind of projecting out a run rate on that. or is it something where these are kind of active and ongoing and maybe you haven't hit the finish line yet, but it's certainly in progress?
spk04: Now, price adjustments on homes that are in backlog, Mike, are generally made very close to the closing date, so that if you decrease prices below someone's contracted price but later increase the price, slightly beyond that, you're not hitting the lowest common denominator. So it's always pretty close to a closed state on those. Yeah, there's definitely a lot of extrapolation that's in the numbers right now because we just don't know what that environment will look like over the next couple months and how many buyers may need some help or encouragement to get their homes closed.
spk11: Thank you. Our next question comes from the line of Susan McClary with Goldman Sachs. Please proceed with your question.
spk12: Thank you. Good afternoon, everyone. My first question is, can you talk a little bit about the studio sales and how are your buyers thinking about some of the options and the features that they're putting into the homes and any changes there that you're seeing?
spk06: It's interesting, Susan. You start with the recognition on the lag between contract and close. So a lot of our Our Q3 closings actually were sold December, January, February, and into March. But the spend in the studio actually went up year over year. And I didn't really get into the guts of it. I don't know whether we... I don't think it's the buyer preferences changed. I think our studio pricing changed because the costs were going up. But the type of items they were choosing and the... The spend went up, but the type of items were pretty much the same as prior years. So we haven't seen a shift there yet. The other interesting thing to me are the size of our homes has not changed. While interest rates have gone up and pricing's moved and everything, the footage in the deliveries was similar to a year ago, and the footage on orders was almost identical. So buyers are not changing their preference yet. I think in part it's the profile the buyers we're catering to can afford all this still. And so it may shift if rates keep going up, moving ahead, but so far we haven't seen anything change.
spk12: Okay, that's helpful, Collar. My second question is, you know, you mentioned that despite the fact that you are offering 10-year arms and some other alternatives that are several basis points lower than a fixed rate mortgage now. You're seeing that people are really just choosing to kind of pause the overall spend by decision. I guess, how are you thinking about the buyer psychology? What are they waiting for in order to decide to make that decision? And how are they weighing the rent versus buy decision today, especially considering that rents are also still moving higher?
spk06: I just heard a report today saying driving into work that observed that, on average, single-family rental payments are up 12% year over year. It's a pretty big move, and I think that continues to be a compelling reason to be a homeowner and lock in the value and build up equity over time. I think the buyer is primarily, to me, just confidence in the state of play out there, whether it's inflation and whether it's interest rates, and they hear the news coverage on the Fed today, or what's going on in the Ukraine war, and all these things are weighing on the consumer today. They're not going away. I was joking with somebody yesterday on how each month there's millions more Gen Zs now in their home buying years, and they're not going away. So they have to make a decision to own versus rent, and there's arguments for both, but I think people want to be a homeowner And right now they've taken a pause, and we keep monitoring it. And that's part of why we elected not to start out chasing sales. One, we didn't need them because we didn't have any inventory, and we already have the backlog for several quarters of deliveries. And two, I think the buyer's inelastic right now. If they just have locked down and said, I'm not going to do anything in the short run, you're not going to get them off the fence by throwing more at them. So we thought we'd just pause and see how it all plays out. But the buyers are still out there. That has not changed.
spk11: Thank you. Our next question comes from the line of Mike Dahl with RBC Capital Markets. Please proceed with your question.
spk05: Hi. Thanks for taking my questions and the color so far. I wanted to ask a little bit more about the comments on monthly cadence and You know, obviously with orders down 50% net, gross down 35, there can be a lot of moving pieces from month to month. Could you just give us a sense of on a year-on-year basis, the order trends through the quarter, and then when you talk about the softening in September, maybe what pace or what type of year-on-year decline should we really be thinking about that you're tracking to?
spk07: even track it year on year. Yeah, not for two weeks.
spk06: Mike, I don't know if we can even give you any color on that because it's a two-week period in September. So I couldn't tell you what we did last year in the first two weeks. I just know it's a little softer than August.
spk05: Okay. Well, I guess can you at least speak to the kind of June, July, August trends more specifically, either sales pace, in each month or the year-on-year decline in net orders in each month. And then I guess with respect to September, even if there's something on, well, at this weekly sales pace, it's down X versus August, anything like that.
spk06: I don't have the numbers ahead.
spk04: I mean, Jeff went through a little bit on the quarterly trending during the prepared remarks and talked about August. I'm not sure it's terribly relevant right now with the rate moves we've seen since August. I mean, one of the things that happened in August was we saw a little relief on the rates and a little bit of a, I don't know if you call it a relief rally or whatever. Same with the market. The stock market had some signs of life as well during the month, so that may have had some impact on buyer behavior. But, you know, as far as trying to get too detailed on just a short period in September, we typically don't go there and probably won't do it again on this call either.
spk09: Okay.
spk05: Fair enough. Maybe I'll ask, I guess, a slightly different way. I think, Jeff, you also mentioned the kind of new targets, three to five on PACE. I'm not sure if that was kind of underwriting when you're thinking about your land deals or if you're thinking about that as a current selling pace. But, you know, given seasonality in the latter part of the calendar year, things like that, things like what you're seeing with this step up in rates, I mean, should we be thinking that we see seasonality in terms of seasonally lower versus the pace that you saw in 3Q or or could you potentially be a little more stable to that as you've adjusted prices?
spk06: Yeah. Well, if you assume, just say four to five, but I was talking about four on the previous question on the three to five, and yeah, I thought it was relative to land packages and go forward underwriting. But if we're going to operate our community, just say four to five or four and a half. So if you're going to run a four and a half through a year in a typical year, you'll be at five and a half through March, April, May, and June in that period. And then in the fourth quarter, you'll drop down under four. And that would be a pretty typical seasonal trajectory for us. If you're trying to model where our sale is headed, you're going to do less in the fourth quarter than you did in the third quarter than you did in the second quarter due to seasonality. And I do think we're returning to more normalized seasonal patterns.
spk11: Thank you. Our next question comes from the line of Truman Patterson with Wolf Research. Please proceed with your question.
spk02: Hey, good afternoon, everyone. First, just wanted to follow up on one of Matt's questions and look for a little bit of clarity. Jeff, I believe you said that two-thirds of the decline in order ASP sequentially of that 12% was purely a function of product makeshift, implying that base pricing is the remaining third or down about 4% quarter over quarter, making sure that I heard that correctly. And if so, that's kind of a direct four-point headwind to gross margin, kind of all else equal. And Jeff Kay, on your fourth quarter gross margin guidance, You ran through some of the items, reasons why it's down quarter over quarter, but are you all seeing any benefit from lower lumber costs that'll be hitting the P&L in the fourth quarter sequentially? I believe lumber pricing kind of peaked in February, March timeframe.
spk04: Yeah, the lumber, we expected the lumber to be peaking, you know, sort of third, fourth quarter. So we'll see some relief, I think, going forward on that. You know, I think certainly we'll see, you know, as the numbers come back kind of within range, as I call it, we should see some nice benefits as it sets a large cost factor. And not just on the lumber. I think as the market softens and, you know, we're working pretty hard on suppliers and subcontractors and everything else in terms of pricing. There's usually some pricing benefits to help or cost benefits to help offset any pricing issues that we've seen. And then the other question was on the industry.
spk06: Yeah, Truman, the two-thirds, I was referring to the California mixed shift only. It's hard to say prices are down X because you have ins and outs every month and every quarter, whether it's you open something in Denver and you close something in Tampa, and the prices are different. But two-thirds of the price shift was directly tied to all the high-priced goods that we sold through in coastal California, north and south.
spk02: Yeah, I'm just trying to understand because, you know, the West ASP falling 21% in a quarter, I realize mix shift can impact that, but I was assuming that, you know, there's price concessions included in that as well.
spk06: Go back to the order price, though, from the second quarter was significantly higher than any price we've guided on deliveries. It was a blip because of the mix.
spk02: Right. Gotcha. Okay. Okay. And similar for, I believe, two of the other three regions, the order ASP also kind of declined. Anyways, I think what everybody's trying to understand is what level of base price cuts you all have been seeing nationwide, but I'll leave it alone. On the new communities that you all have coming online, You know, we've heard of builders, you know, maybe not cutting price across all of their existing communities. They're more, you know, adjusting pricing on the new communities coming online, wanting to understand if that's your strategy and maybe, you know, any sort of magnitude relative to, you know, new communities versus existing communities that you have down the road. And are you seeing, you know, consumers respond to these new communities? Are they hitting your absorption targets?
spk06: For the most part, the openings are working very well. I would reshape the answer, Truman, in that as I shared in the prepared comments, a lot of these assets have been tied up at a price from three, four years ago, five years ago even. And therefore, the margins that we would plan on are much higher than our underwriting margins because of the market list. So now if prices come down, We adjust and we have a reservation process that helps us focus in on what the right price points are in the community. So we may tweak them down to ensure a successful opening, but you're still well above the margins that they were underwritten at. But we want to make sure that the community is a successful opening. You can only open them once, and if they aren't successful, it gets painful. So we like to set the pricing where the... the community works out of the gate and typically good markets or bad new openings bring a lot of excitement and energy and generate a lot of sales. So ours are working pretty well.
spk11: Thank you. Our final question comes from the line of Deepa Raghavan with Wells Fargo Securities. Please proceed with your question.
spk01: Hey, good evening. Thanks for squeezing me in. Jeff, appreciating that your backlog cancellation rate was 9% versus the overall 35% cancellation rate, can you talk through the risk to the backlog you have? I mean, have you scrubbed the backlog fully again for a higher qualification rate? Maybe had conversations with those buyers again? I mean, what can you proactively do to ensure the backlogs are resilient?
spk06: Well, we're constantly scrubbing the backlog deep. The lesson we would want is to have a name on a home that's under construction that isn't prepared to close when the home's completed. So all those processes are intact, and we have a quality backlog. What we're seeing to some degree, we've had buyers that their loan was approved, their loan was locked, the home gets completed, and then they say, I just don't feel good about it. going forward with his purchase, even though their interest rate that they locked us in the threes and they have 20, 30, 40 grand of equity in the home, they still say, I'm done. There's too much noise in the world and I don't feel comfortable with this. And we really can't control that. But if you look within the quarter at our deliveries, the cans didn't really impact our deliveries at all. And they didn't impact our percent of width that's unsold. It's The same level at the end of the third quarter it was at the end of the second quarter. And as I shared in my comments, for the most part, these buyers are closing when the home is completed. It's still been very predictable.
spk01: Okay. That's helpful. A bigger picture question. If rates stay in the 6 to 6.5 kind of range, is there potential we could see a normalized spring selling season or is it too late to expect demand recovery given just how September has been playing out with these higher interest rates?
spk06: Well, it depends on what's going on with the economy, jobs, interest rates, inflation, everything else that drives consumer confidence. But I think if rates held where they were and the consumer digested and they still qualified like our buyers do, I think you could see a more normalized spring. So I wouldn't suggest that a couple-week trend right now with everything going on is a precursor for what would happen next spring. It's way too early to say that.
spk11: Thank you. Ladies and gentlemen, this concludes today's teleconference. Thank you for your participation. You may now disconnect your lines.
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