KB Home

NYSE:KBH

Earnings Call Transcript 2018-Q1

[Operator]

Good afternoon. My name is Devon and I'll be your conference operator for today. I would like to welcome everyone to the KB Home 2018 First 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 April 22nd.

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

[Jill Peters, SVP, IR]

Thank you, Devon. Good afternoon everyone and thank you for joining us today to review our results for the first quarter of fiscal 2018. With me are Jeff Mezger, Chairman, President, and Chief Executive 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 the Jeff Mezger.

[Jeffrey Mezger, Chairman, President, and CEO]

Thank you, Jill. Good afternoon everyone. We continue to build on the strength of our 2017 performance with solid results in the first quarter. We've been on a path of producing quarterly organic revenue growth for more than six years now and we extended that trend once again this quarter.

Equally as important, we improved our profitability with substantial operating margin improvement of 200 basis points. As a result, we drove pretax income to $46 million from $21 million in the year ago quarter.

Market conditions remain strong where we operate. Job growth has pushed unemployment to the lowest it's been in a decade and consumer confidence remains high. As a result of these factors, housing demand remains healthy, fueled in part by the growing strength of the millennial homebuyer.

Millennials were the largest and most active generation of homebuyers in 2017 for a fifth consecutive year according to a recent report published by the National Association of Realtors.

Serving this buyer is a core strength of ours given our expertise with the first-time buyer segment. A considerable proportion of our buyers are millennials with roughly one-third of our deliveries in each of the past two years and, again, in the first quarter of 2018, going to buyers between the ages of 25 and 34. And consistent with our average over the past five years, about 50% of our total deliveries were to first-time buyers this quarter.

On a supply side, resell inventory is at record low levels at 3.4 months of supply nationally. At the same time, our industry is still not building enough homes each year to meet current demand, let alone closing the gap on the significant shortfall created over the last several years.

Based on these dynamics, we anticipate that the inventory will remain tight and demand will remain steady for the foreseeable future. As the economy continues to strengthen, interest rates have slowly moved up over the past six months, we have yet to see a change in home buying behavior.

Traffic levels are solid and the desire to be a homeowner remains strong, driving our absorption pace up meaningfully in the first quarter from an already robust pace in the year ago quarter.

We are not seeing homebuyers trade down to a smaller house as evidenced by the average square footage of our homes in backlog which, at roughly 2,200 square feet, is very similar to the home size delivered over the past five years.

In addition, dollar spent per home in our design studios has remained consistent with our historical trend. However, we are mindful of the impact that higher rates can have on buyers. We are watching for any changes in behavior that might suggest a shift in consumer preference, and we're prepared to respond.

Our first quarter results reflect a healthier, more profitable business. We increased total revenues by 6% to $872 million. Over the past year, we have been rotating our community mix as we open new communities that are performing better, and we continue to balance pace and price to optimize each asset in this strong market environment.

These factors contribute to a 160 basis point improvement in our gross margin in the first quarter to 16.7%, excluding inventory-related charges. At the same time, we continued to effectively manage our cost structure while growing revenue on our current footprint and improved our SG&A ratio by 50 basis points relative to the year-ago quarter. As a result, we produced another record low first quarter SG&A ratio of 11%.

Looking at our results on a per unit basis, we generated $22,000 in operating income per delivery in the first quarter of 2018 as compared to $13,000 per delivery in the year ago quarter, an improvement of over 65%.

As we communicated on our last earnings call, we recorded a non-cash accounting charge of $111 million in the first quarter due to tax legislation that was enacted in December, which reduces our federal income tax rate beginning this calendar year. Excluding this one-time charge, our underlying operating results reflect net income and earnings per share that more than doubled from the prior year quarter.

The spring selling season is off to a strong start. Net order value increased 8% to $1.2 billion on an 8% increase in net orders. The solid momentum that we reported in January, five weeks into our first quarter, positioned us to push price where possible and purposefully moderate our pace, which is contributing to the improvement in our gross margin guidance, as Jeff will speak to in a moment.

Orders per community increased 17% in the first quarter to 4.2 per month. We have long believed that our differentiated Built to Order approach is a competitive advantage that produces one of the highest absorption rates in the industry.

As part of our fact-based approach, we have conducted surveys of homebuyer preferences for many years and our recent survey data reinforces that consumers value choice.

In our surveys, we ask new and resell buyers the question, “if you had an additional $10,000 to spend on your home purchase, how would you choose to spend it?” About 85% of respondents chose either personalizing finishes or floor plans, both at the heart of our Built to Order model as opposed to more square footage.

Providing choice and personalization remains very relevant to today's homebuyers. We are committed to growing our community count and invested $465 million in land acquisition and development in the first quarter.

With the year-over-year increase in our lots owned and controlled and a healthy deal pipeline, thanks to the experienced land teams we have on the ground, we continue to expect a slightly higher community count coming out of 2018 and to be well-positioned for further growth in 2019.

With ongoing strong cash flow generated by our Returns-Focused Growth Plan, even with the robust land spend, we ended the first quarter with $560 million in cash, a significant increase relative to a year ago.

Moving on to the regional updates. The West Coast experienced a 2% decline in net orders against the difficult comparison of 49% net order growth in the first quarter of the prior year.

Demand was strong along the coast and in the inland areas, driving absorption pace up in every division. Overall, net orders per community were up 21% to more than five per month.

Our strategy is to offer products that are affordable relative to local median household incomes. And as a result, demand is strong at our price points. Although, as expected, we experienced a year-over-year decline in community count, we open to plan 13 new communities in California during the quarter.

We anticipate additional community openings in each of the next three quarters, driving community count growth in this region and ending the year with a considerable increase relative to 2017.

Our Southwest region produced a 34% increase in net order value on a 25% net order increase, despite a difficult comparison to the prior year when we reported a 27% increase in net orders.

Las Vegas drove the region's overall performance, sustaining one of the highest absorption rates in the company. Our net order results continued to be particularly strong at Inspirada, which again ranked as one of the top 10 Masterplan Communities in 2017 and where we are currently offering five distinct product lines.

We also produced healthy net orders in Arizona with a double-digit net order comparison. Over the past two years, our Arizona business has consistently increased its scale and is becoming a growth engine for the company.

In the Central region, our largest region in terms of units, north -- net order value increased 9% on a 4% increase in net orders. In particular, our net order comparisons were very favorable in Houston and Austin where demand for our affordably priced product is strong. We are well-positioned at price points that are obtainable relative to the median household incomes with ASPs in Houston below $240,000 and at roughly $280,000 in Austin.

Wrapping up the regional updates, both net orders and net order value were up 22% in the Southeast region. While the region had a relatively easy comparison from the first quarter of the prior year, the positive momentum that began in the fourth quarter of last year continued into the first quarter of 2018.

Orlando was the largest contributor to this region's net order growth in the quarter as our business execution improves and as a reflection of a strong economy driven by job and wage growth.

Over the remainder of 2018, we are planning to open more communities in this attractive market. And Jacksonville's performance was also notable, consistently producing positive net order growth comparisons since the beginning of last year. We look forward to further expansion in our Southeast business as it becomes a larger contributor to our overall results.

As a result of our solid net order value in the first quarter, we expanded our ending backlog value to $2 billion, up 10%. This considerable backlog provides good visibility on deliveries and reinforces our confidence in achieving our targets this year.

In closing, our business is much stronger and more profitable today as we continue to build on the momentum of the past few years, and we are well-positioned to sustain this trend over the balance of the year.

We are investing in our growth, continuing to drive our topline from our current footprint as we further leverage the benefits of scale and expanding our profitability while enhancing returns. Our results are moving us closer toward achieving the targets under our Returns-Focused Growth Plan.

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

[Jeff Kaminski, EVP and CFO]

Thank you and good afternoon everyone. We're off to a great start to the year, with the effective execution of our Returns-Focused Growth Plan continuing to deliver measurable improvements across our key financial metrics in the first quarter. Overall, we believe that during 2018, we will extend our track record of generating profitable growth and increasing stockholder value.

In the first quarter, our housing revenues grew 7% from a year ago to $867 million, reflecting a 7% increase in our overall average selling price with essentially the same number of homes delivered.

Three of four regions reported housing revenue increases ranging from 2% in the Central region to 29% in the Southwest. We ended the first quarter with a backlog value of nearly $2 billion, which is up 10% from the year-earlier period. This was our highest first order backlog value in over a decade and we believe it provides strong support for both our second quarter and full year housing revenue expectations. We currently anticipate second quarter housing revenues in the range of $990 million to $1.05 billion.

For the full year, we have narrowed our housing revenue range from our January guidance to $4.55 billion to $4.85 billion. In the first quarter, our overall average selling price of homes delivered increased 7% as compared to the prior year to approximately $390,000, reflecting increases in three or four homebuilding regions.

Our average selling price in the Southeast region decreased due to the wind down of our Metro D.C. operations in 2017, which had the highest ASP in that region. For the 2018 second quarter, we are projecting an overall average selling price in the range of $400,000 to $405,000. We have increased our full year forecast for average selling price relative to prior guidance and now believe our ASP for 2018 will be in the range of $400,000 to $410,000.

Homebuilding operating income increased 74% from the year earlier quarter to $44 million. Excluding inventory-related charges of $5 million from the current year and $4 million from the prior year period, our first quarter homebuilding operating margin increased 200 basis points to 5.6%, driven by meaningful improvements in both our housing gross profit margin and our selling, general and administrative expense ratio.

For the second quarter, we expect our operating margin, excluding the impact of any inventory-related charges, will be in the range of 5.9% to 6.4%. For the full year 2018, we expect this metric to be in the range of 7.4% to 8.0%, an increase versus our January guidance.

Our housing gross profit margin for the first quarter improved 150 basis points on a year-over-year basis to 16.1%. Excluding the $5 million of inventory-related charges, our gross margin for the quarter was 16.7%.

Our adjusted housing gross profit margin, which excludes inventory-related charges as well as amortization of capitalized interest, was 21.4%, also up 150 basis points compared to the same period in 2017.

The year-over-year improvement was primarily due to our community-specific action plans, including opportunistic selling price increases calibrated with demand and deliveries from newer, higher-margin communities, partly offset by headwinds due to both deliveries from reactivated communities and increases in land, trade labor and material costs.

Assuming no inventory-related charges, we expect our second quarter housing gross profit margin to increase to the range of 16.8% to 17.2%. And considering the strength -- the continued strength of the housing market and the favorable community level results we experienced in the 2018 first quarter, we have increased our full year gross margin expectations, excluding inventory-related charges, to the range of 17.4% to 17.9%, which would represent an improvement of 50 to 100 basis points as compared to 2017.

Our selling, general, and administrative expense ratio of 11.0% for the first quarter improved 50 basis points from the year earlier quarter. Higher housing revenues, our ongoing cost control initiatives and favorable legal recoveries and settlements in the quarter contributed to our achieving a new first quarter record low.

This marked the seventh consecutive quarter that we achieved a record low ratio for the period. As we continue to make containment of overhead costs a high priority and expect to realize an additional favorable leverage impact from higher housing revenues, we are forecasting our second quarter SG&A expense ratio to be in the range of 10.6% to 11.1%. We still anticipate that our full year 2018 SG&A expense ratio will be in the range of 9.7% to 10%.

Income tax expense for the quarter of $117 million reflected a one-time non-cash charge of $111 million related to the impact of the Tax Cuts and Jobs Act, including the accounting remeasurement of our deferred tax assets based on a reduction in the federal corporate income tax rate.

The tax provision for the first quarter also included the favorable impacts of $4 million of federal energy tax credit for qualifying energy-efficient homes delivered in 2017 as well as $2.2 million of benefits from our adoption in the quarter of a new accounting standard relating to stock-based compensation.

The federal energy tax credits for the quarter resulted from legislation enacted last month that extended the availability of the tax credit through December 31st, 2017 from the previous December 31st, 2016 expiration date.

Excluding the impact of the $111 million charge, our effective tax rate was 13% for the quarter, primarily as a result of the tax credits and benefits I just mentioned. We still expect our effective tax rate for the remaining quarters of 2018 to be approximately 27%.

Due to the noncash accounting charge, we reported a first quarter net loss of $0.82 per share. As you can see on the reconciliation provided in the earnings release we issued earlier today, excluding the charge, our adjusted net income was $39.9 million or $0.40 per share, a significant improvement as compared to the net income of $14.3 million or $0.15 per share in the first quarter of 2017.

For modeling purposes, earnings per diluted share for both the remaining quarters and the full year 2018 should be calculated using approximately 101.5 million diluted shares outstanding, which includes the effect of our convertible senior notes and share based payments.

Turning now to community count, our first quarter average of 222 is down 7% from 238 in the same quarter of 2017. We ended the quarter with 219 communities, including 34 communities, or 16%, that were previously classified as land held for future development.

On a year-over-year basis, we anticipate our second quarter average community count will be down mid-single digits as compared to the 238 communities in the second quarter of 2017. We currently expect our community count at the end of 2018 to be up slightly as compared to year-end 2017 and our full year average community count to be between flat and 5% down year-over-year.

In addition, there are two trends relating to our community portfolio that I would like to highlight. First, as Jeff mentioned, we believe our West Coast region's community count will be trending up for the remainder of 2018 and into 2019. We ended the fourth quarter of 2017 with 51 West Coast region communities.

After opening 13 and closing out 11 communities in the first quarter, we ended the quarter with 53 open selling communities. We expect this growth trend to continue and believe our West Coast region's community count at year end will be up 15% to 20% as compared to year end 2017.

The second trend relates to our reactivated communities. As we have discussed in prior earnings calls, deliveries from these communities on average negatively impact our consolidated gross margins by approximately 100 basis points, have an average selling price that is below our overall ASP and sell at a slightly slower pace than our core communities.

From the fourth quarter of 2016 through the fourth quarter of 2017, our ending community counts included between 41 and 43 reactivated communities open for sales. As I mentioned earlier, we ended the 2018 first quarter with 34 reactivated communities, reflecting our success in selling through these assets in alignment with our Returns Focused Growth Plan.

We expect our reactivated communities to remain at approximately the same level for the rest of the year, which means that we would end this year with roughly 20% fewer reactivated open selling communities than we had at the end of last year, providing a tailwind to our 2019 gross profit margin.

We expect these two trends will improve the composition of our overall portfolio towards higher margin communities, producing better returns along with stronger absorptions and higher average selling prices. We believe this mix shift will enhance our future revenues and margins starting in 2019.

During the first quarter, to drive future community openings, we invested $465 million in land, land development and fees, with $285 million or 61% of the total representing new land acquisitions.

Our total investments in the quarter were up about 54% from the prior year quarter. We ended the quarter with total liquidity of approximately $1 billion, including $560 million of cash and $463 million available under our unsecured revolving credit facility.

In summary, we delivered solid first quarter results, with 6% growth in revenues and 200 basis points of improvement in our operating income margin contributing to a healthy increase in our adjusted net income versus the prior year quarter.

We entered the second quarter with good momentum for the spring selling season and a backlog value of nearly $2 billion, up 10% versus prior year. We expect to generate continued improvements in our financial performance during the remainder of 2018 as we keep executing on our Returns-Focused Growth Plan.

We are driving strong and consistent execution within our operating divisions and believe we are well positioned to meet our strategic objectives for the year, including higher revenues, operating margin expansion and meaningfully improved earnings.

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

[Operator]

At this time, we're conducting a question-and-answer session. [Operator Instructions]

Our first question is with Alan Ratner with Zelman & Associates. Please proceed with your question.

[Alan Ratner, Zelman & Associates]

Hey guys. Good afternoon. Thanks for taking my questions and thanks for all the detail, very helpful. So, Jeff, just wanted to dig in a little bit more on the comments about kind of pushing price in the second half of the quarter. Obviously, you've got off to a great start in January -- December and January. You pushed price at a time when rates were going up pretty significantly, and it sounds like you're -- you've been pleased with the reaction from the consumer.

But I'm just curious if you can give us a little bit more detail on how much you were pushing price and if there were any markets where you thought maybe the consumer started to push back a little bit on those price increases given the move in rates we've seen.

So, I know you mentioned you haven't really seen much change in their overall willingness to spend on options or anything but just curious on a market level basis if there were any -- kind of any examples where that might not have been the case?

[Jeffrey Mezger, Chairman, President, and CEO]

Alan, you touched on the guidance we shared at our year end call in January and we gave an update on the results for the quarter because we're so deep into our first quarter at the time. The comp that we shared, as I recall, we were up 14%, and it's the slowest five weeks of the quarter because you're going through the holiday season, so it wasn't a large number. The percentage was much larger than the gross number was. And we guided that we expected that it would come down through the quarter in large part because if we're running sales ahead of our plan, we will go for price.

I've shared in my prepared comments that we're not seeing any impact yet to the customer, and I would say that that's broad-based across all of our cities that we operate in. We were able in the quarter to successfully push price and hold up a solid sales pace through the quarter.

As we keep sharing, it's community-specific. Every community has its own story and its own optimal balance and if we're hitting the sales pace, we'll go get price where we can. There's nowhere that I can -- that comes to mind for me in the company where there's pushback from the consumer right now.

[Alan Ratner, Zelman & Associates]

Great. That's good to hear. And then second, just on the price versus volume dynamic. I'm just curious you mentioned where you're hitting your desired sales pace, that's where you're going to push price harder. So, where you sit today, obviously, you had a great year last year in terms of driving absorption growth and you're at high levels right now.

So, how should we think about, just for the remainder of the year, are you looking to effectively keep absorptions flat with what you achieved a year ago and anything above that, you'll get more aggressive pushing price? Or do you still think there's room to drive the absorption rate higher even off of last year's levels?

[Jeffrey Mezger, Chairman, President, and CEO]

Well, it's community-specific, Alan. Our stated desire would be to run at least 4 a month per community. As I recall, we are slightly under that last year. Not much, but slightly. If the market remains very strong and we can get a little bit of additional pace and also continue to enhance our margins, we'll do both. But we'll share more with you as the spring selling season moves along here. But right now, we're very encouraged with the strength in demand.

[Operator]

Our next question is from Stephen East with Wells Fargo. Please proceed with your question.

[Stephen East]

Thank you. Good afternoon guys and congratulations on a nice [Indiscernible] pretty much across the Board here. So, in -- the order of demands that Alan asked about, I guess, what surprised us a little bit was the gross margin strength and what you all were seeing.

And it sounds like you feel really comfortable despite the acceleration in costs that are coming through, your ability to outprice that. I guess, a couple questions here. One, is that 5% cost inflation still what you expect to flow through?

And were there -- asking Alan's question a little differently, are there any markets as you look out that you think you'll be unable to pass that cost through or a lot tougher to do?

[Jeffrey Mezger, Chairman, President, and CEO]

Stephen, we are expecting similar cost. As this year goes forward, there's pressure on a few of the commodities and what we're all doing with some of the labor pressures that have been in the news. So, we expect that you'll continue to see some pressure. And in the first quarter, we were able to outpace the cost pressure with price.

If you look at our -- the size of our backlog right now, most of those costs are locked in, if not all of them. And we already know the price, so we know where our margins are headed based on our backlog. And going forward, we'll continue to toggle price and pace versus what the market will give us and how our cost trend there, but it's our expectation we'll be able to continue to expand margin as this year unfolds.

[Stephen East]

Okay, got you. And then a few quarters ago, you talked about you're moving a little bit toward offering fewer options, et cetera. Can you give us an update on that? It sounds like, with the demand that you've got going, maybe that doesn't need to be as big of a focus. But I don't want to put words in your mouth. Are you still doing that? How much have you rolled out, if you are, across the country? And can you see any measurable difference in your gross margin from it?

[Jeffrey Mezger, Chairman, President, and CEO]

It's interesting Stephen. We've dropped our SKUs about 50%, and it was more the cost and efficiency side than it was for the consumer. Over time, you keep adding things into your studios and then lo and behold, the buyers don't care about some of them, so why continue to bid them out and offer them on display and whatnot. So we've cleaned out about 50%. And you're never done with that, so we'll go back in this year and continue to tweak that.

I shared in my comments, our revenue was held consistent with what we've seen over the last four or five years. So, taking the SKUs out of the system didn't really affect what the consumer was selecting. So, there's less cost for us, and it's a better environment for the consumers. So, it's a win-win right now.

[Operator]

Our next question is with Megan McGrath with MKM Partners. Please proceed with your question.

[Megan McGrath, MKM Partners]

Thanks. I guess, I wanted to switch to the balance sheet a little bit. You've obviously made some really good progress there on your balance sheet goals that you pointed out in the release. And curious, does that give you any more -- how are you looking at that? Are you feeling like you have more flexibility now in terms of your land spend and what you're willing to go after this year? Have you increased your budget at all because you've reached your goals a little quicker than you had initially thought?

[Jeff Kaminski, EVP and CFO]

Right. I guess, speaking about the balance sheet, we're very pleased with the improvement we've seen. We generated a lot of cash in 2017, and we're able to take some reductions in the debt. As we run through the year, we'd certainly expect the cash generation to be there again in 2018.

We have much more flexibility than we've had at any point in probably the last eight or 10 years as a company and liquidity and positive cash flow coming out of the operations, both from monetizing land assets, the DTA is really coming out to pay off for us big time right now with 0 cash tax payments as well as just gross margin and operating margin as we go quarter-to-quarter.

So, yes, the flexibility is there. We have delevered nicely, I'd say a little bit ahead of our plan. And we'll see how the rest of the year goes, but we certainly have the flexibility to really grow the business and continue to delever if conditions are right as we move forward.

[Megan McGrath, MKM Partners]

Great thanks. And just to follow-up on the mortgage rate issue. It's great to hear that you're not seeing any change in behavior. And Jeff, I think you mentioned looking at the options as well. Is that where you would expect -- if you were to see a change in behavior, is that where we would likely see it first?

And maybe talk a little bit about what you're hearing, if anything, from your sales guys, in your calls, in terms of how they're -- you talked about reacting to it, when it comes, about how you're prepared to react if you do start to get a little bit of pushback.

[Jeffrey Mezger, Chairman, President, and CEO]

Sure. Megan, everyone's going to have a different set of priorities and preferences in their home purchase. I would expect that before you see -- the first shift I would think would be in the type of mortgage product that the customer is taking. Right now, within our higher profile, very, very low percentage is arms, the last number I saw was 1% to 2%. So, buyers are not taking arms. And typically, when rates move up, that's the first thing a consumer will go to, their sophisticated products, do they have five-year, seven-year, and that's a way to offset a little bit higher rate. We're not seeing that yet.

Out in the field, it depends on whether the buyer wants a certain size home or a certain number of bedrooms or they want the granite counters. And the beauty for us is we don't care. It's just please buy the home. And we listen to their needs and we accommodate the home and help them determine what's the best combination of footage, room use, bedroom count, upgrades, the floor plan layout.

And as I again shared in my prepared comments, today's buyer, there's a strong desire to be a homeowner. They want to live in that area. So, they may take a little smaller home, and that's what we're working on right now, it's to make sure we have smaller footages available that offers the same room count. So, if they have to drop from 2,000 feet to 1,700 feet, but it's still a four-bedroom house in that neighborhood, they may take that or they may just, on their own, choose less in upgrades or options in the studio. So, that's why we've always looked at our business model as one that can move with demand and accommodate whatever the buyers' preferences are at that time.

[Operator]

Our next question is with Michael Rehaut with JPMorgan. Please proceed with your question.

[Michael Rehaut, JPMorgan]

Thanks. Good morning or good afternoon everyone. Thanks for taking my questions. First, Jeff, I'd love to focus on -- a little bit on the continued strong success you've had with the SG&A, I believe this quarter coming in nicely below your guidance. And it's interesting that you raised -- and correct me if I'm wrong, but it seems like a lot of the raise on operating margin came from the gross margin raise. I just wanted to make sure I was looking at that right. And if that is the case, then not as much from the SG&A upside that we see.

So, on the first quarter, how to think about the rest of the year and were any kind of I don't know if you could call them one-time benefits or areas of upside that you don't think might repeat? Because, obviously, it's been a big source of upside, not just for this quarter but for several quarters now.

[Jeff Kaminski, EVP and CFO]

Right. We've been actually very, very pleased with the efforts of the company and the efficiency we've been able to drive throughout the company on the SG&A side. We see it as a very important factor of being a company that's focused on the first-time homebuyer with generally lower ASPs, and so you have to be very efficient especially on a cost per unit basis. So, it's right in line with our strategy, and I think the teams and the operations are doing a great job in controlling that and bringing it down.

In relation to -- I'll first talk about the first quarter then the rest of the year. I mentioned in the prepared remarks that we did see some favorable legal recoveries and settlements in the quarter that we didn't anticipate. That was about $3 million, 30 or 40 basis points of favorability in the SG&A ratio. It's always hard to say it's a one-off, it will never repeat, things like that, because you tend to get them from time-to-time.

But that was certainly what I would say out of the ordinary, just operating flow on the SG&A. When you peel that back, we came in about $2.5 million below the lower end of our guidance, at 11.7% to 12%. We came in at about $2.5 million below that, excluding the legal. So it's just general favorability across the divisions, general cost control, whatnot, over a few [lines of] business. So that really wasn't enough to move the needle on our full year guidance. It's going to help, obviously, maybe bias it a little more [Indiscernible] but we did maintain -- hey, Mike, maybe you can mute your line, we're getting a lot of noise on our side. Thanks. We did maintain our guidance for the full year at 9.7% to 10% and you are absolutely correct in the operating margin guidance, it all -- the improvement all came from the gross margin line.

[Michael Rehaut, JPMorgan]

Okay. Hopefully, this is better. I appreciate it. I'm obviously at the airport here. Second question, on the gross margin, and working off of your comments on the reactivated community count, expected to be down 20% year-over-year by the time -- fiscal 2018 end over 2017 end, and that should be a positive driver for gross margins next year.

How does that tie into the fiscal 2020 guidance that you've given? Is the reduction in reactivated communities kind of -- was that baked into your -- over the next two or three years as you laid it out last year? Is it ahead of schedule? Or is it kind of on-track or on-plan to help -- one of the components of improving gross margins over the next couple of years?

[Jeff Kaminski, EVP and CFO]

Right, yes. No, it's progressing nicely, pretty much according to our plan. I wouldn't say it's necessarily ahead or behind schedule. We have a number of communities open with the bulk of what we have left in the inactive category now, a large portion of it is actually just continuation of communities that are already open. So, next phase is we'll make decisions whether to activate them and develop them and sell through them when we need to as we're selling currently.

So, I'd say the pace is about right, it's pretty much where we expected. We've talked all along about several tailwinds, actually, that the company has that we think is pretty unique and was pretty unique to our situation when we first rolled out the three-year plan. One of those was the reactivated communities. And we've gone through great lengths of explaining the headwind that we're facing right now and also the upside of that as we start selling through them and they become a lower percentage of our overall mix.

And the other one is the interest amortization. We only saw two -- 10 basis points of favorability in the current quarter year-over-year. We're still expecting to see 20 to 30 basis points for the full year 2018 and we do expect that to continue as well into 2019.

So, I'd tell you, when you look at our three-year plan and all the various subcomponents and metrics that we put out there, guidance points, I would say we're generally ahead of schedule on that plan and it's progressing very, very nicely.

In fact, the top end of our operating margin guidance this quarter for the full year at 8% is right at the lower end of what we said for 2019. So, we're really pleased with the progress so far all the way across the Board.

[Operator]

Our next question is with Nishu Sood with Deutsche Bank. Please proceed with your question.

[Nishu Sood, Deutsche Bank]

Thank you. I wanted to ask about SG&A, kind of a longer-term question. Very impressive performance, I think you mentioned the seventh quarter record low for that particular quarter.

If you were to look at the structure of SG&A now versus earlier in the recovery or even in the prior cycle, let's call it, what are the big buckets of savings? So what are the main drivers that are allowing you to achieve these record low SG&A levels relative to the business as it was before?

[Jeff Kaminski, EVP and CFO]

Yes. Going all the way back is a little tough, but I could tell you, over the last few years, I mean a lot of it has just been scale and efficiency in the way we've been growing the business. The organic growth has helped us tremendously as we've seen our divisions improving and increasing the level of deliveries per year. It's -- and they've been able to leverage basically all the administrative costs within those divisions on a higher revenue base with more communities open, et cetera.

So, you're really talking about just the incremental cost, which we generally like to think about as 5% to 6% of any incremental revenue increase quarter-over-quarter. So as long as you're obviously above that 5% to 6% range, you can keep levering your SG&A down as long as you maintain discipline and efficiency across the company. It gets tougher. It's obviously a lot easier to go down from the mid-teens, down to the level we're at today.

With that increment, it is getting harder to continue to drive it down, but we've been very pleased with the success. I think, probably predominantly, it's just been the efficiency of the growth that we've had that's helped us tremendously and a lot of discipline across the whole company on the cost side.

[Nishu Sood, Deutsche Bank]

Got it, got it. Okay. And the community count which you expect to be slightly up, I think, year-over-year at the end of the year, California, I think you mentioned, is going to be up much higher than that, 15%. Obviously, the benefit of the California shift has been great. I think, Jeff K., I think you even cited that as one of the drivers -- potential drivers for gross margins next year. Is there -- how long can that trend continue? How much are you folks willing to lean into California? Is there a limit to it from a risk perspective or a concentration perspective? Or is this a trend that could continue beyond 2018 into 2019 and 2020 as well?

[Jeffrey Mezger, Chairman, President, and CEO]

Nishu, I can take a stab at it, and then Jeff can pile on. We're sharing the trend in California. And it's real, and that's where we're going in the state. It's not necessarily that strategically we've said we're just going to push community count only in California. We have a big business in Central, our Southwest region is doing well and the Southeast region is coming on.

So, our green light is to grow in every state and every region. What we have right now is a dynamic that's going on where -- and last year, it was a different region that had a community count growth. This year, and coming out of the fourth quarter, you'll see the biggest uptick in California.

We continue to expect to drive our community count growth across all of our regions in 2019. To get back, specific to California, we're less than half of what we once were. You've seen a lot of the media coverage on the housing shortage in the state.

The governor and a lot of the mayors have put a stake in the ground that they're going to increase units built by 100,000 a year. I don't know how they'd do it, but we'd love to see it and help them get there. It's our backyard and it's where we have our most seasoned teams. So, we're nowhere near close to saturation in this state. I think we could double from where we are today, and we'd still have upside.

[Jeff Kaminski, EVP and CFO]

Right. And yes, just in terms of numbers, I mean it's still only about 25% of our communities. I think at the end of the first quarter, we had 53 open selling communities in California, and we had 219 across the company. So, it's still not a -- I don't believe in overconcentration in one market. Another piece of the trend, we did decline a fair amount during 2017. So we're rebuilding that community count through the end of the year, and then we believe we can grow it from there moving into 2019. So we're pretty comfortable with the split of the business right now

[Operator]

Our next question is with Jay McCanless with Wedbush Securities. Please proceed with your question.

[Jay McCanless, Wedbush Securities]

Good afternoon. Thanks for taking my questions. Jeff K., I was going to ask, since you guys gave the detail for California, could you maybe give us the community counts by region at the end of the quarter and how that compared to last year?

[Jeff Kaminski, EVP and CFO]

Sure. Yes, this is just ending community count, so there'll be more detail in the Q where we cover average community count for the quarter and the comparison year-over-year. But I'll just kind of page through it pretty quickly. So at the end of the first quarter for California, you have, for the Southwest, we ended the quarter at 35, we ended last year's first quarter at 41; in the Central region, we ended the quarter at 92, we ended last year's first quarter at 91; and for the Southeast region, we ended the first quarter at 39, and we ended last year's first quarter at 42.

[Jay McCanless, Wedbush Securities]

Thanks for the detail. And then just wanted to ask on Texas, I think you guys called out Houston and Austin as the two markets that did the best. Could you talk a little bit about what's going on at Houston with oil prices and how the demand is coming back there and then also maybe touch on Dallas a little bit?

[Jeffrey Mezger, Chairman, President, and CEO]

In Houston, Jay, things seemed to have quieted down from the oil prices. I am hearing anecdotally from our team that the higher price points have slowed some, in particular in the energy corridor at the higher price points, not sure if it's heavy supply or employment or whatever. We like to keep reference in the fact that at our price point, there's a lot of demand. And in Houston, through the hurricanes, through the oil downturn, we've sold very well. I believe it's primarily because of the price points that we've been very successful of executing at

So down at the $240,000 ASP that we're at today, demand is very strong. I'm hearing the slowdown is occurring above $300,000. Again, that's anecdotal from our teams. DFW, we're a small business. We like our future and where we're headed there. Again, I've heard that it slowed a bit at the higher price points. I think there's a lot more inventory on the ground in DFW at the higher price points, but the affordable communities that we have opened there today are doing quite well. I was just reading the census data before the call today, and they were estimating 149,000 people moved to DFW in 2017, so that tells you there's a lot of demand there.

[Operator]

Our next question is with Stephen Kim with Evercore ISI. Please proceed with your question.

[Stephen Kim, Evercore ISI]

I wanted to talk about the land spend. It was a pretty big number. And the last time we saw a really big number like that, it kind of led to subsequent year -- provided you were to maintain that kind of ratio of revenues for the whole year. The last time you did that, it resulted in a pretty big pop in your community count the subsequent year. So, I was just curious if I could follow up on Megan's question about your land spend. Do you think this kind of rate of land spend acquisition, in particular, is something that we may see throughout the year? Or was there something kind of unusual about this 1Q that led you to spend as much as you did and that would be -- we shouldn't look for that level going forward?

[Jeffrey Mezger, Chairman, President, and CEO]

Stephen, I'm going to make a couple of opening comments and again, Jeff can pile on. In 2017, for the year, we spent roughly $1.5 billion. If you look at our revenue and that our lot cost-off is 35% to 40% of revenue, that's about neutral to slight growth in land spend. So, if last year, we spent $1.5 billion and this first quarter it was $450 million, it's a slight uptick from what we spent last year.

And I think if you toggle between our cost-off and our investment, you'll see the investment will be incrementally larger than the cost-off because we're trying to grow our community count and our land pipeline.

If you look at the numbers in the quarter, and we'll disclose more in the Q, we did grow our lot count own and controlled by about 1,800 in the quarter. So, it was -- and year-over-year. So, that's a pleasing trend that we hope to continue and really think we're barely staying ahead of the cost-off right now.

[Jeff Kaminski, EVP and CFO]

And yes, just adding to that a little bit. We've been talking for several quarters about the focus of the company on growing the top line that comes from both absorption growth, ASP growth as well as community count growth. And we're actually getting -- I'm very optimistic about the growth in the new communities coming in, mostly from the point of view of when you look at what's driving the margin improvement right now, there's a tremendous amount of margin improvement that's coming from recently acquired land. Despite the generally higher land cost, it has been an incremental positive to gross margin.

So, what we've seen is, as we've been reloading the land pipeline and, over the last 4 quarters, we grand opened about 100 new communities and we closed out around the same number, so the community counts stayed relatively flat, but those new communities coming in are performing very, very well and are providing incremental gross margin and improvement in gross margin that's really been the primary driver of the margin improvement that we saw year-over-year in the first quarter and, in fact, for the past couple of quarters.

So, we're optimistic about it. I think the plan is very solid. And because of the performance at the division level and the performance to our underwriting criteria, we're kind of open to continue to invest.

[Operator]

Our next question is with Matthew Bouley with Barclays. Please proceed with your question.

[Matthew Bouley, Barclays Capital, Inc.]

I just wanted to go back to the gross margins. So, you came in at the top end of the guide for the first quarter. And based on what you're guiding to the second quarter, it seems like the full year guide is implying maybe a slower ramp in the second half than we would have expected, potentially even a year-on-year decline in the fourth quarter. So, the question is, are you embedding some conservatism in that full year guide? Is it around cost inflation? Or just what else is driving that?

[Jeff Kaminski, EVP and CFO]

Right. First of all, I would say no, we're not really embedding any undue conservatism in the forecast. We're still looking at the high end of the range, 100 basis points of improvement in gross margin, which we think would be a really good result for the year. I think you'll have to dissect the numbers a little bit after the call and look at it.

I mean, number one, we had a pretty weak first quarter last year in terms of margin, we only did a 15.1% gross margin in the first quarter, and it grew to 18.6%. And these are adjusted numbers without impairments or abandonments in it. So, a part of it was just, honestly, just a little bit of an easier comp.

One of the reasons though that I feel really good about the first quarter is usually a great years start with great first quarters, and we believe we're off to a really good start in 2018. So, no, we're not anticipating quarterly year-over-year declines in gross margin. The rent probably will -- well, it will, just by math, be slightly less than what we saw in the first quarter, but most of that is a result of just a very weak first quarter in 2017, a pretty easy comp.

[Matthew Bouley, Barclays Capital, Inc.]

Okay, got it. Second question, just going back to the acceleration in California communities that you're expecting this year, could you comment on just any notable differences in cost structure in California? So I guess, how should SG&A be affected by that ramp in communities in California? And just, I guess, labor versus material inflation in California versus other markets. Thank you.

[Jeff Kaminski, EVP and CFO]

Okay. I think on the inflation side, it is really very specific market-to-market, commodity-by-commodity, labor force-by-labor force. So, I don't really think there's anything that's all that different in California. Do you think--?

[Jeffrey Mezger, Chairman, President, and CEO]

Labor and materials are a much lower percent of then cost than at home.

[Jeff Kaminski, EVP and CFO]

But outside of that, as far as inflation goes, I think it's more or less the same. The only thing I'd say is you get stronger leverage on your fixed cost base in California because of the high ASPs. So, certainly, any shift in top line revenues towards the West Coast region does provide an opportunity to lever even more your fixed costs against your revenue base just because of the high ASPs in the state. So, that is helpful from that point of view on a go-forward basis.

[Operator]

Our next question is with Jade Rahmani with KBW. Please proceed with your question.

[Jade Rahmani, KBW]

Thanks very much. I was wondering if you could give any color on your buyers, types of products they look at. Did they solely focus on new homes as their product set? Or are they also looking at existing homes? And therefore, does your sales pace potentially benefit from the tight resale market?

[Jeffrey Mezger, Chairman, President, and CEO]

Jade, it definitely benefits from tight resale. People want to buy a home in a certain area, and if there's not a lot of resale choice, they'll migrate to a new home. New homes are typically higher priced so there's a tradeoff there, but there's also a lot of benefits in the product, like better energy efficiency and 10-year warranty, and it's new.

The last time I looked at the data, about 85% of our buyers were also looking at resale. We've always taken the view in our business that we compete more with resales than we do with the other new homebuilders. If you think about it, there's 600,000 or 700,000 new home sales a year and there's 5.5 million resales, so who's your real competitor?

[Jade Rahmani, KBW]

And turning to ask that efficiency, is there an opportunity to accelerate this initiative by selling or JV-ing non-core assets potentially with land developers or perhaps single-family rental developers?

[Jeffrey Mezger, Chairman, President, and CEO]

Jade, we're managing to our portfolio. And any time we've ever looked at those type of opportunities, we end up concluding we're better off creating the value ourselves because we can optimize it better than others. And if you're just going to sell it, somebody's going to want a certain profit.

And we think we can create more value on our own -- we've stayed away from the JVs and the [Indiscernible] structures, and we'll just manage to book a business. And as Jeff shared with the community count or you look at our balance sheet, the things that were held for development, it's a much smaller percent of our business than it's been for years.

[Jeff Kaminski, EVP and CFO]

Right. Yes, in terms of asset efficiency, we focus on, obviously, on absorption pace, inventory turnover and the inactive assets, which we define the inactive inventory and we do have a small portion of the inventory held for sale. But generally, like Jeff said, I mean, our strategy is our core business strategy and we'll continue to implement that.

[Operator]

Our next question is with John Lovallo with Bank of America Merrill Lynch. Please proceed with your question,

[John Lovallo, Bank of America Merrill Lynch]

Hey guys. Thank you for taking my question. The first one, realizing that there's regional variances, just curious about lumbar cost, in general being up, call it, 25% to 30% year-over-year here, up to the first three months of the year.

Do you view this as a structural change here? Or do you think it's kind of more seasonal and maybe driven by the Canadian tariffs, fires, things of that nature? In other words, do you think that we'll see kind of the normal pullback in prices in the second half of the year?

[Jeff Kaminski, EVP and CFO]

Yes, it's tough to call. I don't have a crystal ball any better than anyone else's. But lumber does tend to, in cycles, go up and down. I think the tariffs that -- with the Canadians last year cost us the latest run on lumber prices and I think, at some point, it almost has to moderate. But we'll see how it go as we travel through the year.

Up to now, we've been pleased with our ability to offset that, both through cost savings and other commodities, BAV [ph] initiatives and as well as pricing. We're very watchful of it. Obviously, it's a concern for the business, but it hasn't knocked us off our path or off our improvement initiatives or our strategic objectives at this point.

[Jeffrey Mezger, Chairman, President, and CEO]

John, if you look at our business model and the size of our backlog and how we can take starts in every city, we can do pretty well locking lumber pricing because there's visibility to our starts going forward. So, we know what our demand is today for the five-month period. And it's helpful on getting the better pricing in the lumber buys.

And the only other thing I can offer is, if you look at history, lumber typically peaks in the spring and pricing comes down in the fall. So, they track the demand and activity levels. They're trying to optimize their products. So, typically, this time of year, lumber will run up and peak. And in September and October, it will hit the troughs for the year. You've touched on some other influences, the fires or the tariffs and international demand and all those things, but we just manage to it and do the best we can of prices and tracking to our sales and backlog.

[John Lovallo, Bank of America Merrill Lynch]

Okay. That's helpful, guys. And then maybe just quickly on the financial services operating margin, a little bit lower than we were looking for. Some of your competitors, I think, have talked about some of the big banks being a little bit more aggressive now that the refied market has dried up a bit. Are you seeing that as well and perhaps being just a little bit more competitive on pricing, just to try to maintain some of that business?

[Jeffrey Mezger, Chairman, President, and CEO]

John, we're still just getting going in our, what we call, KBHS, our JV with Stearns. We're really pleased with the progress, but we're just now getting to a capture rate where you can start tracking things and it can have an impact on your business.

I do feel that the mortgage market is competitive because those companies will chase market share if the refis go away. Our capture rate in the first quarter was around 50%. Internally, we have a goal to get it to 70% if we can, and it'll be a combination of the products that are offered and the service levels that come out of the mortgage company.

[Operator]

Our final question is with Susan Maklari with Credit Suisse. Please proceed with your question.

[Susan Maklari, UBS Investment Bank]

Thank you. I just wanted to talk a bit about the community count growth that you do expect in California. Given some of the headwinds that can sometimes come up in terms of the underlying development and some of the labor and things there. Is there any headwinds that you see out there? Is there anything that could potentially sort of slow that growth down as we move through the year?

[Jeff Kaminski, EVP and CFO]

Really, I think the only headwind that would probably be more of a positive for the business than anything would be more closeouts. In the quarter, we had 13 openings, we have planned for 13 openings. We have more openings scheduled as we go out -- go throughout the year. And that's always a little bit varied on the openings, but we've been doing a really nice job of getting things open on time, once in a while something will push a couple weeks into the next quarter or we'll be able to pull something forward.

But we're pretty confident in our ability to continue on that side. We're almost through winter here in California. And with the rains and everything else, that can somewhat delay things at times, but it's been a pretty stable winter so far. So, we're pretty confident in the ability to grow that as we go through the year.

[Susan Maklari, UBS Investment Bank]

Okay. Thank you. And then you also highlighted the fact that you're looking to grow in the Southeast and I think that you mentioned Orlando is one of those markets. Can you just kind of talk to maybe the land position that you have there and how you're thinking about your ability to acquire lots and kind of realize that growth?

[Jeffrey Mezger, Chairman, President, and CEO]

Yes, it's been an interesting story. And we've shared for a few years, in the Southeast region, we had to fix our business and fix our asset base before we could start growing again. It took a while. We've now done that. We're executing well and we're out actively investing and growing our community count within the region.

And specific to Orlando, it's one of those cities that grows in all directions. It's not that tight of a land market and it seems fairly rational. So, nobody seems to be pushing the envelope on price there. The more desirable areas are tighter for lots than the B ring or the C ring. But we're investing, and we're excited about the opportunity there.

[Operator]

Ladies and gentlemen, this concludes today's teleconference. Thank you for your participation. You may now disconnect your lines.