KB Home (KBH) CEO Jeff Mezger on Q3 2020 Results – Earnings Call Transcript

KB Home (NYSE:KBH) Q3 2020 Earnings Conference Call September 22, 2020 5:00 PM ET

Company Participants

Jill Peters – SVP, IR

Jeff Mezger – Chairman, President and CEO

Matt Mandino – EVP and COO

Jeff Kaminski – EVP and CFO

Bill Hollinger – SVP and Chief Accounting Officer

Thad Johnson – SVP and Treasurer

Conference Call Participants

Matt Bouley – Barclays

Stephen Kim – Evercore ISI

Alan Ratner – Zelman & Associates

Truman Patterson – Wells Fargo

John Lovallo – Bank of America

Buck Horne – Raymond James

Mike Dahl – RBC Capital Markets

Michael Rehaut – JPMorgan

Jay McCanless – Wedbush

Good afternoon. My name is Devon, and I will be your conference operator today. I would like to welcome everyone to the KB Home 2020 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 22.

Now, I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may begin.

Jill Peters

Thank you, Devon. Good afternoon, everyone, and thank you for joining us today to review our results for the third quarter of fiscal 2020. On the call are Jeff Mezger, Chairman, President and Chief Executive Officer; Matt Mandino, 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.

Before we begin, let me note that 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 factors outside of the company’s control, including those detailed in today’s press release and in 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, I will turn the call over to Jeff Mezger.

Jeff Mezger

Thank you, Jill. Good afternoon, everyone. We hope you, your families and your colleagues continue to be healthy and safe. After navigating through the initial disruption from COVID19 that we experienced in the spring, we are encouraged by the robust recovery and housing market demand that has favorably impacted our business. We are very pleased with our solid third quarter results, a key highlight of which was our significantly higher margin reflecting the strong demand and a leaner, more efficient business.

Equally as important as the strength of our financial results this quarter was the acceleration in our net orders and growth in our backlog, which positions us very well as we move into 2021. Specific to the quarter, we generated total revenues of about $1 billion and diluted earnings per share of $0.83. We delivered higher profitability year-over-year on a lower revenue base with an operating income margin that expanded 180 basis points to 9.6% excluding inventory related charges.

Our operating margin growth was due almost entirely to the expansion of our housing gross margin, which increased to 20.6%. On a per unit basis, we grew our operating income to nearly $37,000, an increase of 23%. Finally, our execution during the quarter drove our pretax income 10% higher year-over-year to over $100 million.

Our balance sheet is solid with over $1.5 billion liquidity, no goodwill and a leverage ratio of 40.5%, which was down nearly 500 basis points year-over-year. On a net basis, our leverage ratio was 28.6%. From an inventory standpoint, we own all the lots we need to support our growth targets for 2021 and own or control all the lots we need for 2022. With our ability to generate significant levels of cash flow and the health of our balance sheet, we are operating from a position of strength and we have the ability to capitalize on future opportunities to drive growth and return.

One of the ways that COVID19 impacted us during our second quarter, was our temporary pause in our land development and construction of models. As a result, we opened only 19 new communities during our third quarter. At the same time, our sizable absorption rate contributed to selling through more communities than we had anticipated just three months ago, causing our average community count to decline by about 7%.

We’re working to rebuild our community count with over 30 new community opening planned for the fourth quarter. Additionally, as we look ahead to 2021, we anticipate approximately 135 new communities, the highest annual number of openings in many years. The composition of our portfolio continues to strengthen with our core communities expected to represent approximately 95% of our count next year.

Given the profile of deliveries from reactivated communities with lower ISPs and gross margins, the quality of our overall book of business continues to improve as we rotate out of these communities. On a macro level, mortgage interest rates remain at historically low levels underpinning favorable supply and demand dynamic. Existing single-family home inventory is just 3.1 months and below that level in many of our markets particularly at our price point.

This limited level of resale inventory and an underproduction of new homes over the last decade along with favorable demographic trends are fueling demand. In particular, the demand for new homes has risen because of the perceived health and safety benefits, energy efficiency advantages, smart technology features and a desire to move away from dense urban areas.

During the quarter, our monthly absorption pace per community accelerated to 5.9 net orders, representing year-over-year increase of 36%. This was our highest pace of any quarter in more than a decade even as we increased prices in the vast majority of our communities and was achieved within our overall objective to balance price and pace to optimize each asset and maximize return.

We continue to believe that the choice and personalization offered by our built order model are the key drivers of our absorption rate, which has long been one of the highest in the industry. Our business model also enables us to quickly shift our product offerings in response to consumer trends. To that point, we announced our new KB home office options in August we’re excited to have moved quickly to offer our features so relevant to buyers today and we look forward to seeing how our customers respond to this option as it continues to be rolled out in model homes across our footprint.

At the time of our last earnings call in June, our net orders were up 2% for the first three weeks of our third quarter. We gained momentum as the quarter progressed with year-over-year net order increases of 11% in June 23% percent in July and 50% in August. Overall, our net orders advanced 27% in the third quarter on top of a robust 24% year-over-year comparison in last year’s third quarter.

From a geographic standpoint, our order strength was broad based across our footprint, from a low of 5% year-over-year growth in our Southeast region to a high of 39% growth in our West Coast region. We believe our strategy of building communities in desirable areas and pricing our homes to be attainable to the median household income for that specific location are compelling for buyers.

Because of the cautious approach we took in reassessing our backlog in our second quarter, our cancellation rate has not only normalized, it declined to 17% in the third quarter. Looking at our underlying buyer data for orders in the third quarter, we see a few interesting post-pandemic shifts taking place that we view as favorable for our business.

First, we experienced a solid increase in our share of millennial buyers, which accounted for about 56% of our orders as compared to 51% in the prior year quarter. With population estimate showing that millennials are now the nation’s largest adult population and with millennials in their prime household formation years, this cohort will remain a key driver of home-buying demand. Gen Z is even larger in size at 90 million and is poised to follow as they are now at the start of their home buying year. Second, our percentage of first-time buyers increased to 64% of orders up more than 10 full percentage points from the third quarter of last year.

The third and final point is that buyers are expressing a preference for built to order homes, which represented 75% of our orders as compared to 70% in the third quarter of last year. While our base prices have risen and our first-time buyers share has increased, we are seeing buyers spending slightly more on personalized net homes in our design studio. Taken together, these data points reflect what we believe is a significant opportunity ahead as we continue capturing the demand from millennials and the emerging demand from Gen Z.

On the mortgage side, our joint venture KBHS Home Loans continues to effectively support and communicate with our customers, which in turn provides better predictability for us in managing through the closing process. The JV’s capture rate continued to rise in the third quarter to 79%, the highest since its inception, contributing to the increase in our deliveries and growth in the JV’s income of about 85% year-over-year.

With a significant level of net order growth in the third quarter, our net order value expanded 29% to $1.6 billion drive in our backlog value up to $2.6 billion on nearly 6800 units. We are working to convert this backlog to deliveries, pacing our starts with our order rate. We’ve historically operated with a roughly six month cycle time, which we define as the time from contracts to closing. As a result of the disruption from COVID, our cycle time has extended to approximately seven months.

We’ve incurred slight delays in various components of the process that all add up to about a 30-day extension. We are making progress in addressing the areas causing the delays and expect to return to more normalzed life cycle times on deliveries by the end of our 2021 first quarter.

Another factor we’re monitoring is the wildfires in California. While the fires have not had a material impact on our business to date, there is some unpredictability during this fire season with respect to utility crews potentially being redeployed for emergency purposes, which could cause some additional delivery delays.

Turning now to current trends, in the first three weeks of September, our net orders were up 32% over the comparable prior year period. For the remainder of the quarter, we expect to continue to be able to lean on price and our balance price and pace each week to optimize every asset. These price increases are also expected to help offset cost inflation and support our margin.

In closing, the resumption of housing market demand that marked our third quarter was remarkable and we are now poised to end the year with much higher revenue and margins than we expected just three months ago. Looking ahead, while we remain mindful of the pandemic, we expect continued favorable market conditions and a significantly higher backlog at the end of the year and we believe we are well positioned to support over $5 billion in revenues and expanded returns in 2021. We look forward to updating you on our progress on our next earnings call in January.

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

Jeff Kaminski

Thank you, Jeff and good afternoon, everyone. I will now review highlights of our financial performance for the 2020 third quarter, provide details on our outlook for the fourth quarter and discuss our 2021 housing revenue and community count expectation. During the third quarter, we produced strong results that reflected considerable improvement from our COVID19 impacted second quarter with higher than expected deliveries, significant growth in our gross profit margin, enhanced efficiency and an accelerated order pace.

In addition, we continue to strengthen our balance sheet and liquidity. In the third quarter, our housing revenues totaled $929 million compared to $1.15 billion in the prior year period, due primarily to a 16% decline in the number of homes delivered. The lower deliveries in housing revenues principally reflected this substantial impact to the COVID19 pandemic-related disruption on our net orders and cycle times during our second quarter.

Despite lower third quarter revenues, we generated double-digit percentage increases in both net income and earnings per share as compared to the year-earlier quarter. Reflecting the pandemic-related impacts in the second quarter, our backlog at the beginning of the third quarter was down 14% year-over-year. However, with our strong absorption pace driving a significant year-over-year increase in net orders, we ended the third quarter with 6,749 homes in backlog up 8% from 6,230 home a year ago.

Our ending backlog value increased to $2.6 billion up 12% versus the prior year. Both the number of homes in backlog and our backlog value were at the highest third quarter level since 2007. Considering our quarter end backlog, that [ph] of our homes under construction and current construction cycle time, we anticipate our fourth quarter housing revenues to be in the range of $1.05 to $1.15 billion. Due to our strong third-quarter delivery performance and higher fourth-quarter expectation, we expect our full year housing revenues at the midpoint of our guidance will be up over $200 million versus the midpoint of our prior guidance.

In the third quarter, our overall average selling price of homes delivered was up slightly year-over-year to approximately $385,000. We anticipate that with previously implemented selling price increases and a greater proportion of our deliveries coming from higher price communities, we will generate both sequential and year-over-year improvement in our average selling price in the fourth quarter to approximately $415,000.

Third-quarter homebuilding operating income increased to $88.9 million, reflecting a 150 basis point improvement in operating margin to 8.9%. Excluding inventory-related charges of $6.9 million in the current quarter and $5.3 million in the year earlier quarter, our operating margin was up 180 basis points year-over-year to 9.6%, primarily due to expansion in our housing gross profit margin.

For the fourth quarter, we expect our homebuilding operating income margin excluding the impact of any inventory-related charges will be in the range of 9% to 9.4%. Given our strong third-quarter operating margin performance and our raised expectations for the fourth quarter, we have looked at our full year projection by approximately 120 basis point at the midpoint as compared to our prior guidance.

Our housing gross profit margin for the quarter was 19.9% up 140 basis points from 18.5% for the prior-year period. The current quarter metric reflected favorable impacts from a mix shift of homes delivered, lower amortization of capitalized interest, reduced workforce expenses included in our construction cost and a favorable pricing environment during the period.

Excluding inventory-related charges, our gross margin for the quarter was up 170 basis points year-over-year to 20.6%. Our adjusted housing gross profit margin, which excludes inventory-related charges as well as the amortization of previously capitalized interest was 23.7% for the third quarter compared to 22.3% for the same 2019 period. Assuming no inventory-related charges, we expect our fourth quarter housing gross profit margin to be in a range of 20.0% to 20.4%.

Our selling, general and administrative expense ratio of 11% for the quarter improved slightly from 11.1% for the 2019 third quarter due to cost reductions implemented late in the second quarter partly offset by decreased operating leverage from lower housing revenues.

As we anticipate selectively adding resources to support the expected growth in topline revenues during 2021, we believe that our fourth quarter SG&A expense ratio will be in the range of 10.8% to 11.2%. Our effective tax rate for the quarter was approximately 23% reflecting $22.9 million of income tax expense net of a $3.1 million benefit from federal energy tax credit. We expect our effective tax rate for the fourth quarter to be approximately 24%. Overall, we reported net income for the third quarter of $78.4 million or $0.83 per diluted share compared to $68.1 million or $0.73 per diluted share for the prior-year period.

Turning now to community count, our third quarter average of 238 decreased 7% from 255 in the year-earlier quarter. We ended the quarter with 232 communities as compared to 254 communities at the end of the 2019 third quarter with over half of the decline due to a reduction in the number of communities that were previously classified as land held for future development.

Our lower community count reflects accelerated closeouts due to our net orders per community increasing to 5.9 per month as well as delays in opening new communities. We invested $410 million in land, land development fees during the third quarter, with $220 million for the total representing new land acquisitions. We ended the quarter with a strong supply of more than 60,000 lots owned and controlled, representing a 3.3 year supply of owned lots based on home deliveries in the last 12 months and lots controlled comprising 37% of the total.

As we expect continued robust absorption to drive additional community closeout, we anticipate our fourth quarter average community count will decline in the mid-to-high single digits range as compared to the 2019 fourth quarter. Favorable operating cash flow drove total quarter end total — sorry drove quarter and total liquidity to over $1.5 billion including $722 million of cash and $788 million available under our unsecured revolving credit facility. This compares very favorably to both our 2019 year-end total liquidity of $1.2 billion and a $611 million of total liquidity at the end of the 2019 third quarter.

Contributing to our substantial cash position was an AMT tax credits refund of $43 million we received during the third quarter. We currently expect to receive an additional $40 million refund in the fourth quarter. We have had no cash borrowings under our $800 million credit facility at any point in time during 2020. For 2021 with our anticipated higher yearend backlog, strong order pace per community and more normalized cycle times, we expect to generate full-year housing revenue in the range of $5.1 to $5.5 billion.

In addition, we believe our ending community count will remain relatively flat on a sequential basis for the next two quarters and then start to increase in the 2021 second quarter. We believe this relatively modest near-term progression will result in an approximately flat, full year average community count as compared to 2020. However, with planned community openings anticipated to exceed closeouts in the last three quarters of next year, we expect our community count at the end of 2021 to be up year-over-year in the mid to high single-digit range.

In summary, we are pleased with our third quarter financial performance and believe we are well-positioned to achieve our targets in the fourth quarter and beyond. We believe the improvement in our already strong sales pace per community, solid quarter end backlog, expanded gross profit margin and more efficient operating structures, support our goal of accelerating profitable growth and enhancing our return.

We will now take your questions. Devon, please open the lines

Question-and-Answer Session


[Operator instructions] Our first question comes from the line of Matt Bouley with Barclays. Please state your question.

Matt Bouley

Good afternoon. Thank you for taking the questions and congrats on the quarter. I wanted to start out asking around the cadence of orders that you disclosed the August of 50% and up September 32% for the first three weeks. I guess we could delve into that a little more, one thing we’ve seen in our checks is pretty minimal evidence of that typical seasonal slowing. So I guess if you could speak to maybe the year-over-year comparisons if you think September is actually indicating some normalization in housing here or things like the Labor Day shift or anything else comp wise on a year-over-year basis as distorting that? Thank you.

Jeff Mezger

Thanks Matt. The comp in September is sound because September last year was stronger for us than August and it’s one of the dangers when you’re given monthly trends, your orders can move up and down in one year in any given month and then it may distort what’s going on the following year. We can tell you for the first three weeks of September, we’ve seen no slowdown from August. It is purely the timing of the year-over-year comp. September demand is very strong.

Matt Bouley

Okay. Got it. Exactly that was what I was looking for. And then secondly just the gross margin guide that Jeff K. just gave, the sequentially lower in Q4, which is a little bit unusual for you guys, was just curious if you kind of walk through the pieces that are driving that, whether there’s an assumption of lumber and labor that’s starting to impact you already. Obviously, you’ve had some strong pricing trends, which seem to have already helped Q3. So just why that wouldn’t necessarily offset some of these inflationary impacts in Q4 and just any additional color in aggregate to getting that number. Thank you.

Jeff Mezger

Jeff, do you want through that? Jeff, are you out there?

Jeff Kaminski

So thanks for the question Matt. Relative to the third quarter, couple of things to keep in mind; one, we had a pretty strong quarter in the third quarter of higher margin deliveries. So the big — the strong belief in our topline in Q3 was doing part just in pull forward and that full quarter happened to be in the higher-margin communities. So that’s helped it.

The second one typically what we see in the fourth quarter is a lot more leverage on the fixed cost that’s included in our construction cost number. This year we are not expecting to see that, primarily for two reasons. One, we’re not seeing as much of a delta, as much of an increase in fourth-quarter revenues as guided as we just experienced in the third quarter. And number two, we are looking to add incrementally the sum of those fixed costs in the fourth quarter as we prepare for big surge in deliveries in revenues in 2021.

So that leverage factor that we normally see that helps in Q4 relative to Q3 is probably won’t be there at least not as strong as typical. So really when you look at it, if you shift back to looking at it on a year-over-year basis, the midpoint of our guide, we’re up about 30 basis point. If you consider the loss of leverage on a year-over-year basis, we’re actually up 60 basis points year-over-year, partially coming from reduced amortization, partially coming from our reduced headwind from reactivated communities and the rest of it just basically coming from mix.

So I think the guide is pretty solid through the fourth quarter. I think the highlights for me, absolute highlight is we were able to not only meet our expectations in Q3, but we were actually able to lift our expectation for Q4 and hopefully if not loss for anyone that this would be if we achieve our guidance range in the fourth quarter, this would be two quarters in a row, 20% plus gross margins, which is a big deal for us in a nice numbers we look for.


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

Stephen Kim

Yeah. Thanks very much guys. Obviously, with strong environment out there and your built to order model, it looks like we’re really not seeing yet all the goodness that is building up in your backlog. Your guidance assumes that the 40% backlog churn, which is much lower and you’ve addressed the cycle time issues. So what I’m really curious about is what’s happening in that backlog with the built to order model I would think that you are seeing an increase in upgrades like that home office set up you launched earlier in the quarter.

So I was curious, can you give us a sense for what did the trends look like in your backlog with respect to spend on up options and upgrade, where that stands relative to history and was there any impact that landed in 3Q I would guess not, but just thought that?

Jeff Mezger

Steve, it’s an astute observation that the best is yet to come. If you think about our built to order business and the cycle times, the strength in sales in July and August isn’t going to materialize till Q1 of next year, not Q4 and we didn’t do anything really to Q3 to speak of. I shared in the prepared comments that in our orders, we thought it would be helpful to compare our order mix because of the post-pandemic and there’s no noise and this is real buyers and what they’re doing.

We’re moving our sales prices up and we shared that and we’re seeing an incremental uptick in the studio spend, not dramatic. Our studio spend has been fairly consistent for a few years now, but it did tick up a little bit here in Q3 until it tells you that even a first-time buyer was paying a higher price for the home is still personalizing including a little more into the studio. We just rolled the office concept out in late August and it’s currently going across the footprint.

We think it’s a real appeal for today’s consumer and the shift to work from home more and we think it can help with not only selling homes, but the revenue side as people finish out their selections on the office, but most of the strength in the third quarter as you touched on, it’ll show up in Q1.

Stephen Kim

Got it. Yeah. That’s really encouraging. As we think about the cycle time issues, I think you said Jeff that you expected it to be pretty much back to normal by the end of your first quarter next year. So like February of next year. I just want to make and I assume that means like back to kind of a six-month cadence. So should we be thinking that normal means backlog turnover ratios similar to what you experienced in 2019 or does normal mean something different in light of any changes that may be have happened over the course of this kind of unusual year.

Jeff Mezger

Look, it’s certainly not a normal year and as our backlog ramps up, we’ll see how the conversion plays out in the 2021, but as things fully settle out, I think you’ll see us get back to a normal backlog conversion. You have a nice problem right now that your backlog is much higher than your run rate figure building up backlog and you can play it through as you fix the cycle times. As Matt Mandino is on the call, our Chief Operating Officer. Matt, do you want to talk a little bit about what we see in the cycle times and what we’re doing, what we’ve already done and what we’ve already accomplished to gain back some of what we lost in early Q3?

Matt Mandino

Steven, I do think we’re going to — we’re on the path to get it back to more traditional 2019 type rate. We look at an upfront before we start the house, what does that taking out, what’s our traditional built time as well as from final to close and if you break all three out, over the last 90 days, we made improvements across all three categories.

In large part, we’re relying on virtual and digital tools and kind of the hybrid approach, but it’s we’re making meaningful progress and a good example is even the time going through the studio profit for us. It is now, we’re at a 50-50 split between virtual appointment and in-person appointments and what originally started even as a means keep things going in the early stages of COVID has now turned into a unique way and capacity and potentially get customers throughout at a faster clip. So I do feel we’re on track and as you described the cadence of getting back into more of a norm.


Our next question comes from Alan Ratner. Please proceed.

Jeff Mezger

I was going to share it’s not only in the studio, the cities have had to learn how to handle permit applications and they all had a big logjam. So we final people in the studio and then you couldn’t pull the permit with the options I selected because the cities were backed up and we got past that, we get into starts and inspections get back up.

So there are always little things that were happening in June and July as the whole country pulled out of the initial disruption and we’re quickly seeing everyone figure out their part of the process out of the compressed time and that’s why we have confidence we’ll be right back to normal by deliveries at the end of Q1. Go ahead Alan.


And our next question comes from the line of Alan Ratner with Zelman & Associates. Please proceed with your question.

Alan Ratner

Hey guys, good afternoon and congrats on a really strong quarter. Glad to hear everyone is doing well. So my question is kind of a follow-up from that topic on cycle times and obviously it sounds like you guys are very focused on it. My question is and this might not be a data point that you have handy, but I guess the question is what are your starts trending at in terms of growth on a year-over-year basis because we’re seeing some pretty remarkable order numbers from you and others over last few days and its occurring to me that at some point these homes are going to have to be started.

So the time when you seem to be pretty confident, you’re going to be getting your cycle times back to normal levels. It seems like the industry is going to be wrestling with a pretty dramatic surge in starts, which might work against you. So I am just curious what you’re seeing on the start to growth side and if there’s still a lot of ground to be caught up here to match with your recent order success.

Jeff Mezger

I shared in the prepared comments that were mentioned starts with sales and there’s a little bit of a lag because our sales were in ramp up and your starts will ramp up 45 to 60 days after that. So we’re not to sell them unless we can start and then close them. So we’re pretty much in balance right now. Our starts are ramping up proportionate to the sales growth.

Alan Ratner

But with that 45-day, 60-day lag I am just looking at the trajectory in orders. Your August orders were up 50. So presumably your starts and that’s going to be more representative of maybe July right. So there is still a lot of growth that ahead of us.

Jeff Mezger

Well again I touched on it before, the August comp was stronger. Our gross sales were better in August than July, but part of the conference because August last year for whatever reason was a little softer than July or September. So our sales have been pretty constant for the last 8 to 12 weeks and we’re now starting to push those starts out of the door in alignment with the sale.

And I think there has been it to your point macro, there has been an uptick in housing activity in all the cities we operate in and the cities have had to figure out how to deal with it as well and they’ve all got their own nuances and stories but the cities are doing much better now on pulling permits and they were 90 days ago and once you get pass the permit and the starts then it’s the arm wrestle for the subcontractor base and we love our position there because we have scale in the cities we’re in with relationships that are in some cases 30 to 40 years long. So we don’t have any concern right now on sub capacity.

Alan Ratner

And then second on, I apologize if I missed this, but that with the price increases that you’ve been pushing forward over the last couple of months, do you have an estimate on what your apples to apples pricing, you’re doing on a price per square foot basis or however you guys look at it is up over the last call it six months since before the pandemic?

Jeff Mezger

I don’t know Jeff, if you have a sense of that. I certainly don’t because of the mix can change. I know there would be speculations.

Matt Mandino

Right. Same for me Jeff. You have the mix that comes in. So that’s what you have, the pricing relating to deliveries versus orders. So the account view though and I will say, the pricing activity that we’ve seen has obviously been a net positive for us. And we anticipate the ability to offset fairly large increase in costs as we have coming up.

If that were to happen in the next year, so we want to stay ahead of the cost moves for sure. And if the market allows it, we’d like to be able to price for that. And then the quarter, we had a lot of success and moving price and a lot of communities in small increments generally, but definitely help on the gross margin side.


Our next question comes from the line of Truman Patterson with Wells Fargo. Please proceed with your question.

Truman Patterson

Hi, good afternoon guys. Great results. First, you will essentially have the highest absorptions in the industry, a touch over four per month throughout an entire year. Third quarter absorptions were up really strong 36% or so. What is the absorption level that you’re assuming to really hit that 2021 community count targets? Do you think there’s a little, there’s room to run a bit harder or above that four per month? Or are you all really looking to curb it pretty meaningfully with pricing?

Jeff Mezger

Yes, a little of both, Truman because it is bouncing price and pace. We’ve raised our stated strategy, not five a month and we did that prior to the last quarter call frankly. But at 5.9 it tilted to the high side, but we’re playing a little catch-up relative to the backlog, we need to turn our assets. And as we laid out our plan for next year, it would be higher than the four but not at certainly not the 5.9, we ran in Q3 and if market conditions remained strong, we have the lot to do more than what’s in our plan.

So we like our position on that side and if you think about it heading into this year, our plan was higher than we’re going to deliver by a few thousand due to the disruption in Q2. So you already have all those ones. And then you had everything you had tied-up for the following year to grow from there. So we have a very solid land position right now to achieve our targets next year. And if the market holds like today, you’d have upside from our targets.

Truman Patterson

Okay, okay. And then Jeff, question for you on gross margin, it’s clearly been a key focus for you all, it’s really helped drive returns higher. But whenever I’m looking out to 2021, looks like you’re going to be turning over to maybe 60% of your communities. How should we think about gross margins going out a year? Is there any risk of them rolling over just due to the newness of the communities which usually have lower margins the start and then kind of netting out your reactivated land rolling-off lower interest expense et cetera. How should we kind of think about the moving parts?

Jeff Kaminski

Right, well couple things on it. As you know, we’re very focused on operating margin expansion, we really see that as a critical lever for us to drive increased returns, and we’d like to continue to focus on expanding that operating margin. Gross margin is a very key component of that. And the phenomenon that we’re seeing now with the rolling over communities and a lot of close outs, replaced a lot of grand openings, we’ve been in this space for actually several years now, we tend to turn over a lot of communities.

So you have different communities at different stages in their lifecycle and although land has been appreciating, so it’s pricing. So we do believe we can maintain gross margins, we like that 20% plus number. At this point, we’re not really prepared to guide on and give a lot of detail on the next year other than say we’re definitely targeting more expansion on the operating margin side. And that would put a lot of focus on that gross margin thing at or above those levels.

We also think for next year with the improvement on the top line and a pretty large step-up actually in top line housing revenues that we’ll see much better leverage on our SG&A. And we’ve been little disappointed with some of the volume fall-off this year in the SG&A percentage. And we’d like to see that moving back down. So we’re optimistic actually in our ability to drive further operating margin expansion. And we’ll come back in January and give you guys more details on the forecast and more details on the performance of the numbers.

But rest assured we’re targeting that.


Our next question comes from the line of John Lovallo with Bank of America. Please proceed with your question.

John Lovallo

Hey guys, good evening and thanks for taking my questions. The first one, Jeff and it seems that you’re pretty confident that you guys have balanced sales and starts pretty effectively. But do you think that the industry at large has done the same or you think that kind of this surge in sales that Alan was alluding to? Is that going to drive labor cost inflation and maybe sustain the rise in lumber that we’ve seen although it typically would pull back on a seasonal basis?

Jeff Mezger

Yes, well I don’t know that the lumber pricing is tied to a surge in volume, as much as it was tied to a shortage of supply, while the mill shut down. They had a heavy inventory position and COVID hits the mill shut down, and they end-up with no product. And that’s what pushed the prices up. And as the mills are reopening and gaining production again that’s why you’re seeing the lumber futures come back down already.

But I don’t know that that was necessarily homebuilding activity driven, couldn’t tell you about other builders and how they’re positioned with their starts. But what we feel in our approach, where we have these long-term relationships, we build to a cadence tied to a sales rate tied to our backlog, the subs value every week having starts and they’ll plant their teams in our communities and know that we can keep them busy and they stay there and there’s no peak in value.

So if we start eight a month for four months in a location and somebody else starts 16 and then none and then 16 and then none, the subs value, our approach far better and they’re more profitable at a lower price to us because they don’t have the peaks and valleys of managing their labor and their material.

So I do believe that the market is going to pick-up an activity, I didn’t touch on it before when Matt and I were talking about the cycle time bucket, but a lot of our subs have had to react to the disruption and now they’re rebuilding their teams. And it’s taking them some time to create the foreman to handle another crew, another foundation crew in this city but they’re not doing that as well. So I think the industry has the capacity, and I think you’ll see the industry create a lot of jobs out of this.

John Lovallo

Okay, that’s helpful. And then Southeast division seemed to lag a little bit in terms of orders, pick up 5.5% year-over-year, was this community count issue or is it something else?

Jeff Mezger

Absolutely, it’s community count driven. Jeff, you’ve got the detail, I think on the improvement in the absorption rate and what we’re looking for next year.

Jeff Kaminski

Right. Yes, specifically for the third quarter, the absorption pace increased 26% in Southeast. So that was offsetting the community count decline. And hoping to rebuild that community count beginning of next year.


Our next question comes from the line of Buck Horne with Raymond James. Please proceed with your question.

Buck Horne

Hey, thanks. Good afternoon. I’m curious on the third quarter order totals, just how many of those might have been repeat buyers that would have canceled their original order in April. Just wondering how you handled if those buyers showed back-up and were you able to reprice any of those cancellations that came through in April?

Jeff Mezger

I know that we had a handful buck of people that came back and purchased once they went from furlough to rehire or whatever, I don’t think it was significant. We quantified on our last call from the cans I think it was 250 units that can, we’re open to deliver in Q2, so we carried 250 units into Q3, we sold some and closed some. And then whatever else we had, we sell and closed or not delivered, because sold in Q4 and along the way, we were lifting price.

So it’s possible that we picked-up some margin through that process, but it’s certainly not a core strategy of ours because we’d rather focus on the bill to order, but there could have been a little margin left to it.

Buck Horne

Okay, got it. I appreciate that. And then maybe quick one on the land side is your reinvesting and obviously, I think you guys alluded to that land prices are appreciating here. Wondering if there’s any additional commentary, just in terms of what you’re seeing in terms of the tightness of the land market. But as you’re looking to replenish the land and things have certainly changed in terms of the buyer group and the demographics that are showing up now and maybe potentially, how far out they’re willing to live, is that opening up more options in terms of where you guys might be able to look in terms of further out locations or more suburban territory. Has the window opened a little bit further in terms of where you can reinvest in the land side?

Jeff Mezger

I think it has in part because prices are running up, it’s the classic. It’s the evolution in a cycle where the urban, the suburban urban areas not necessarily downtown, but the job clusters that ring of city are more desirable, because it’s less of a commuter, there’s more amenities around you. And then the further out you get prices go down because there’s compromises and as prices that lifted in those more desirable areas in the suburbs, it does push the next ring out because affordability is an issue.

And I think it has opened up some opportunities, but you have to be more mindful of the price for the consumer for the trade-off of being in a more remote location. And you have to underwrite that in what you can pay for the land. And if you go back through Q2 and Q3 for us, we didn’t walk on very many deals at all, we got time from sellers and for the most part then performed when the extension expired or we obtained the entitlements that had been delayed due to COVID.

So we kept replenishing lot of pipeline. That’s a lot of the spend we had in the third quarter, so the pricing was already in place. And to-date I would say there’s a healthy tension right now out in the land markets where there’s a lot of people looking for last, I think that will push pricing up. And the beauty for us as I shared in my prepared comments, we already own everything we need for 2021. We already own and control everything we need for 2022 to have solid growth in the company.

So we don’t have the pressure of doing deals just to do them. We’re going to stay diligent on our underwriting strategy, diligent on our price points and our product positioning and just continue to drive that process to help us grow into 2023. But for 2021 and 2022, we’re covered.


Our next question comes from the line of Mike Dahl with RBC Capital Markets. Please proceed with your question.

Mike Dahl

Hi, thanks for taking my questions and appreciate the color so far, had a couple of follow-ups on cost. So Jeff appreciate that there’s certainly not a tremendous amount of visibility on where lumber ultimately settle. But given what you’re looking at today in terms of your framing package, in terms of potential for labor inflation, what can you tell us about the level of direct costs that you do think you’re going to have to cover in costs and I know it might not hit next quarter given your built order model. But as you look out the first half of next year, what’s the magnitude that you can get cover?

Jeff Mezger

Well, I’ll kick that one to Matt to handle Mike. But you’re already seeing lumber come down, the lumber futures that the September futures 60 days ago, we’re at 900 and some, we’re already back down to 600 and some. And it’s a reflection of the product that’s now coming to market. So yes lumber spike. It’s already coming back down, typically won’t get all the way back to where it was. But it’ll come down more from where it is today.

And we’ve been in our lock process, we’ve been working that division specific, what’s your lock strategy? What do we have to do to pricing and we certainly already incurred some lumber increases that are reflected in our guide for our Q4 mark. So we’ve been able to manage it and navigate it pretty effectively. Matt, you want to give little more color and thoughts on what we’re doing on lumber and direct costs?

Matt Mandino

Yes, sure. And as Jeff said in our guide for Q4, we’ve anticipated that our direct are about 1.5% since the beginning of the year. The teams in the field, I think have done a good job and navigating through a very unique situation with the site that we saw. Each of our division takes an approach to their lock and to how they buy, we monitor that and kind of oversee it at a corporate level and provide guidance, we’ve got a very senior team of purchasing leaders that are helping us get through this.

But what we’ve been able to do from a pricing standpoint and lean on that price lever to more than cover for these costs is put us in a very good position as we move forward. We’ll continue to watch this and see how it plays out. But we anticipate lumber coming down as well as our pricing strength continuing as we move through over the next couple of quarters.

Mike Dahl

Okay, that’s helpful. Thanks. And my second question and maybe this will go back to Matt also. But Jeff in some of the other prepared remarks, you talked about layering in some cost strategically to help support the plan for next year, it sounded like that has an impact in both gross margin and SG&A. Can you just elaborate a little more on just give us some examples of what these costs are and the plan from here?

Jill Peters

Jeff, you want to handle that?

Jeff Kaminski

Yes, sure. I wasn’t sure which Jeff he is referring to. But yes, there is you’re right, it’s in both sides. It’s been the fixed costs that’s embedded in our construction costs and the costs in the SG&A. Starting with the fixed costs in construction, the two main categories and their construction supervisors as well as land resources. And with the large backlog that we’re building and the continued improvement in the backlog, we want to make sure we can achieve those deliveries going into next year. So we’re making selective resource enhancements in that area.

Same thing on the land side that we want to continue to grow the business and want to make sure we had the right resources there. So we had a fairly significant reduction in that category in the third quarter. And we’ll put a little bit back in not as much as where we’re at second or first quarter this year, but a little bit back into support future deliveries.

On the SG&A side, we’ve had efficiencies in many areas, most of the SG&A add back you’ll see, one good example is we had a very positive quarter in terms of advertising spend where our growth, our grand openings were down a little bit, you tend to expand a little bit more during grand opening periods, and the market frankly was just so strong.

We were able to ratchet that back a bit. So as the grand opening activity increases over the next few quarters, we anticipate a little bit more on the advertising spend side. There’ll be some support staff and resources that will put back into the business which we move forward. But I would say for the most part, it’s not terribly significant. I think it’s fairly measured. I think they’re definitely very smart investments to support growth in the top line.

We’re 30% plus growth year-over-year next year that we’re anticipating, so we want to make sure we can book those revenues and achieve those operating margins from that growth. And in terms of resources, we’re going to match it up to our sales phase, starts phase and delivery phase as we move forward.


Our next question comes from the line of Michael Rehaut with JPMorgan. Please proceed with your question.

Michael Rehaut

Thanks. Good afternoon, everyone. Thanks for taking my question. First, I just wanted to circle back a little bit to the order trends. And obviously the acceleration is really impressive and in line with that August number. It really gets you up there with a lot of your peers. You mentioned some of the comparisons going into September that a year-ago September was at a higher pace than August.

Just trying to get a sense, did you say for this September that you’re seeing a similar sales pace compared to August, so that sequentially the sales pace is similar and would you expect that to continue into October, November at this point?

Jeff Mezger

Yes, Mike I think that’s an interesting question. And we all have our own crystal balls in a normal year and this is not normal, but in a normal year with seasonality, August for us is typically softer than September in that year in Arizona, Florida, Nevada, Inland California, it’s a lot hotter. People taken vacations before the kids go back to school or they’re starting the school year. And we typically see a dip in August. And then right after Labor Day September’s pretty good. And that’s a normal cycle.

And then October is little less than September and November is a little less than October. So you have this little gradual decline through our fourth quarter. I don’t know what we’ll see this year, in that August was very strong. September is holding at strong levels. And there’s still enough pent-up demand out there. We may not see as much of a slowdown in October and November because of all these dynamics that the industry’s positive dynamics that the industry is facing on the demand side.

But in a normal year, you would expect October and November to start to slow a little bit due to the seasonality, it’ll play out and we’ll see. But certainly through the first three weeks it’s holding pretty good.

Michael Rehaut

And where would you peg, thanks for that, Jeff. Where would you peg the monthly sales pace throughout the third quarter, the average is 5.9. Were you hitting closer to a seven in August and maybe give us a sense of the month-to-month sales pace cadence?

Jeff Mezger

Yes, I would say that it got incrementally better from June to July and July to August. It wasn’t like July was good and August was great. They were all good. And it just we kept building little more momentum as each week went by in the three months and then from August till now has held at a high level. So August is strong but I don’t know that Jeff, maybe you have some?

Jeff Kaminski

Yes, Jeff on the release we put out the first week of August where we summarize the June, July sales or net order pace. We had peg at about five and a half a month. So yes, it got a little bit incrementally better in August and lifted that average to 5.9. But it was pretty solid even for the first two months of the quarter.


And our final question comes from the line of Jay McCanless with Wedbush. Please proceed with your question.

Jay McCanless

Hey, thanks for taking my questions. The first one just on the fiscal 2021 revenue guidance. Did you talk about what you guys are expecting in terms of average price growth versus volume growth in that guide?

Jeff Mezger

We did not, typically early on, we try to give a range of top line revenues and what it looks like the coming year. And then we’ll refine that again as we go further out on our fourth quarter and get into more detailed guidance numbers for 2021. We just thought we’d help out everyone with the top lines at this point forward.

Jay McCanless

Got it. And then I guess the second question in terms of did you walk me through where how you expect the community counts to develop through 2021 and then also is there going to be a heavier focus on one geography over another as we move through the year?

Jeff Mezger

Right, as I mentioned in the prepared remarks, we think actually the community count to be relatively flat for the next couple of quarters. So the ending community count at the end of the fourth quarter, as well as the end of the first quarter we think will pretty much be replenishing. So we’ll be grand opening communities about the same pace as we’re closing out. Starting in the second quarter of next year, we’re anticipating an absolute growth in net communities open during the quarter.

So by the end of the second quarter, we think we’ll be back on that growth path moving through the second half of next year and arrive at a number by the end of next year given that three quarters of grand openings in excess of close outs, we should be in that mid to high single digit up range as a final community count at the end of next year.

That said, given that at the five quarter average for the year and one of those points at the end of year this year, and then the first quarter of next year which should be relatively flat sequentially but down year-over-year, we think on an average basis year-over-year will be about flat to 2020 but with an improving trend. And I think that’s pretty important because as we start the year, the strength of our absorption pace that we’ve seen in the third quarter and what we expect in the fourth quarter will drive a really strong beginning backlog number for us.

And that should provide a lot of dry powder as far as accelerating revenues in the first half of the year and in the second half of the year, we should be getting our community count back up and providing some support for improved revenues and have to. So it’s a pretty nice trend that’s shaping up right now and we’re looking forward to rebuilding the scale in the business as we move through 2021.


Ladies and gentlemen, this concludes today’s question-and-answer session as well as today’s teleconference. Thank you for your participation. You may now disconnect your lines and have a wonderful day.

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