KB Home (KBH) Earnings Call Transcript & Summary

Good morning. Thanks for joining us. My name is Mike Rehaut. I'm the senior analyst covering the homebuilding and building product sectors for JPMorgan Equity Research. We're excited to continue our morning session with KB Home on day 2 of our 15th Annual Homebuilding and Building Products Conference being held virtually, hopefully next year in person. We're excited to have with us CEO, Jeff Mezger; CFO, Jeff Kaminski; and Vice President of Investor Relations, Jill Peters. This will be a fireside chat. I'll be asking several questions of management. [Operator Instructions] So before I begin my questions, I'm going to turn it over to Jill for a few opening remarks.

Thank you, Mike, and thank you for hosting us today. KB Home is one of the largest homebuilders in the U.S. with the primary focus on serving first-time and affordable first move-up buyers who accounted for 76% of our deliveries in our 2022 first quarter. Our personalized build-to-order model emphasizes choice from lot to elevation to features and options, all of which are buyers finalize and obtain loan approval for before we start the home. We believe the ability for buyers to choose what they value and can afford is a key factor driving our absorption rate, which is among the highest in the industry and generates strong customer satisfaction. We are proud to be the #1 customer ranked national homebuilder in third-party customer surveys, including TrustBuilder and ConsumerAffairs. Our homes also offer the highest energy efficiency among national homebuilders based on an average home energy rating system, or HERS Index, score of 49, an industry-leading publicly reported score. We recently released our 15th Annual Sustainability Report, the longest-running publication of its kind in the homebuilding industry, detailing our achievements and goals across environmental, social and governance factors. As you have likely seen in April, we announced that our Board approved a new $300 million share repurchase authorization. Generally, it has been our practice to refresh our authorization from time to time and when the prior authorization is close to being completed. The Board's approval gives us flexibility to repurchase shares opportunistically, as we continue to evaluate the returns generated on the next incremental dollar of cash flow, whether that be invested in our future growth, which remains our top capital priority or return to shareholders through dividends and/or share repurchases. I would like to note that with our approaching May quarter end, we will not be providing an update on net orders or related metrics today. In addition, our reference points will be the commentary we provided on our 2022 1st quarter earnings call on March 23. In closing, with an ending first quarter backlog of over $5.7 billion, we believe we are positioned to deliver significant year-over-year growth in 2022 across our key financial metrics, contributing to a return on equity of over 27% this year. And with that, we would be happy to address your questions.

Thanks, Jill. Appreciate it. I guess I'll have to cross off my first question, which was the orders during the second quarter, so I have to move on from that. But I wanted to start, as I said before, with a few industry-level questions that's very helpful for us and investors in terms of trying to baseline some answers across the industry. And then we certainly have several KB Home specific questions to dive into your positioning and recent results. So first, on the industry level side, the first question I've asked most builders is you're coming off of -- obviously, KB Home reported in March, several other builders have obviously reported late April, early May. But the message has been the same that demand trends have remained strong despite a significant move in interest rates and mortgage rates. So the question is, just to kick it off is, what mortgage rate do you believe would be -- what mortgage rate do you think needs to be in the marketplace where we would reach to finally push demand supply a little bit more in balance as opposed to this still very favorable spread where we've seen demand trend -- demand levels trend, let's say, stronger than normal?

Mike, if I had to summarize the shift in the market, it's probably moved from an absolute frenzy down to very strong. And as you look at our buyer profile -- I don't know how much rates would have to move, everybody will have their crystal ball, but we haven't seen any impact yet on our customer from the rates moving up. And if you look at our buyer profile, when people ask what's different this cycle, we're catering to a totally different buyer profile than we did in previous cycles. We're about 60% first-time buyer. And I shared out in the earnings call that our average down payment is $70,000 for a first-time buyer, the average FICO is in the 730s, income well over $100,000. So if interest rates move and the payment goes up $300, $400 a month over a couple year period, $500 a month, that's not enough to move the needle. Other than whatever it does with our confidence and our psyche and how do we digest a higher interest rate; economically, they still qualify. And rates are going to continue to move up a little bit, and we're watchful of it for any shift in behavior. We're not seeing a big move to arms. People are still locking their loan rate and going ahead and closing, we see strong demand. So it is a math formula. We don't know how much higher it has to move to really impact demand, but we're not seeing it yet.

Okay. I appreciate that, Jeff. Just on that same line of questioning, in terms of changes on the margin, I mean, you kind of mentioned moving from a frenzies to still a very strong, robust market. Some of the -- as part of that, let's say, moderation again to still very strong levels. Builders have talked about priority lists maybe being reduced or taking a few days longer to sell a home. Have you seen any of that in your own communities? And if so, roughly what percentage would you say that that's impacted?

Well, Mike, as we shared, I can't give you a real-time feedback because we're in a blackout period now. It's still very good out there. So as we release lots, we're selling homes. What you have to put it in the context, Mike, is not just the economics of the purchase, there's demographic bulge and absolutely no inventory. And if you put it in the perspective of 70 million millennials that are out there wanting to be homeowners, now you have 60 million Gen Zs right behind them, you have 130 million people. If the homeownership rate is 65% of those 2 cohorts, it tells you how strong the demand is right now. And at the same time, resale doesn't exist in most of the markets we operate in. And with some of the supply chain issues, I'm sure we'll talk about, the new home industry hasn't been able to catch up. There's still no inventory out there. So it's not just interest rates going up. It's a strong demographic creating the demand and literally no supply.

Right. Right. Another facet of this past earnings season over the last several weeks has been an increased discussion around rate locks and extended rate locks. One builder even went so far as to offer it to their entire backlog that was a build-to-order. Actually, they weren't necessarily a built-to-order builder, they had more on the spec side. How do you see rate locks for your own business? Is this something that you've considered particularly as a build-to-order builder with all else equal, a bit longer backlog? And have you seen this kind of been more pervasive across the industry in the last couple of months?

Yes. It's definitely more pervasive across the industry. In our case, we actually started moving to encouraging our customers to lock the rate back in January because you could see the interest rate increases come in and we offer programs up to 270-day locks. Initially, it's always interesting human nature, the customer really didn't want to lock yet because they thought rates would go back down, and they didn't want to lock at a higher rate and miss out. And as it gained momentum and the interest rate rise, they started moving quickly to lock their loans. So we're pretty aggressive right now. We can't lock for them. They need to make the decision, but we're sharing the data and encouraging them to protect the backlog, and a high percentage of our backlog is locked today.

Okay. And when they do that, is that something where -- is that kind of part of your incentive package to them? Or is that cost completely borne by the customer?

For the most part, it is, Mike, there's a little bit here and there if somebody were to cancel and we had covered a lot, there may be a little bit, but it's all baked into our financial assumptions. You won't see any of this what we've been doing...

So it's part of what you offer to the customer. But it's part of the standard package. Okay.

Yes.

Maybe just one last one on a -- couple of last ones on an industry level. We're kind of working through questions at a good clip here. So on the gross margin side, on the incentive side, not obviously talking about your second quarter. But one of the questions we've posed to most builders is, if you were to just kind of isolate incentives as -- and I know you have your own approach to incentives. But relative to where, let's say, incentives might be typically 3% of the home sale price, today, for most builders, it's minimal, if that, in terms of what's being offered in the marketplace. If incentives were to normalize, what would that mean for KB from a gross margin? If you just isolate the incentive impact itself, would it be -- other builders have been talking about a 200 to 300 basis point impact, understanding that perhaps there would be other offsetting actions potentially to do. But just on that incentive normalization, how would that impact KB Home?

As you touched on, Mike, our business model really is incentive focused. If you think about it, the incentive is necessary if you're -- if you have a spec inventory home and you have to make the deal better for the customer to want to buy the home, and if the home sits around a while, the longer it sits, the bigger the incentive gets to move the inventory. In our case, it's a buyer-driven value creation. They pick the home they want at that price. They add in their features. So we've never really been a big incentive company. Back in the previous financial cycle, our incentives stayed under 1%. We just -- we're not a big incentive company. Historically, in the industry, it's been about 3%. And we'll just keep positioning for the best value to the customer and move forward. So I'm not too worried. The builders are pretty rational about this. I'm not too worried about a big incentive war coming.

Okay. Lastly, just on the industry level, and I know it might be hard to talk about current market trends, given your blackout period. But maybe just more broadly, as you observe in the markets, not just, let's say, KB specific, has there been any change regionally across the country over the last couple of months from a market perspective, as we've seen the -- as we've had it now a couple of months at least at these higher rate levels?

Not that we've seen, Mike. We covered on our earnings call, across our footprint, all the cities are performing very well, very similar dynamics. I do think if rates continue to rise, certain markets will perform better than others. They always do, and you'll have winners and you'll have losers and we're a strong demographics, good job growth, good economies that will continue to perform better than other areas that may have been lifted in this housing demand and may settle back down. But in our footprint, we think we'll continue to see strong market conditions.

Okay. I appreciate that. So now moving to some of the more company-specific questions. [Operator Instructions] More on KB specific, Jill mentioned in her opening remarks, and I think you've alluded to the fact that you're roughly 60% exposed to the first-time buyer. And as a result, affordability is a key focus. In the event of a slowdown for this segment, what type of flexibility do you have to reduce your price point to mitigate the impact of a softer market where consumer still wants to buy a home, but just might need to buy a lesser priced home. And maybe if you could frame that flexibility from a timing standpoint, because obviously, you have a certain set of communities and it takes a while to make adjustments. But if you kind of hit on that, the flexibility and the timing of reacting when you need to maybe make an adjustment to the ASPs?

Sure. That's a softball for us, Mike. So thanks for the question. But for starters, we shared on our call, we started all the homes and we sold all the homes for '22 and the backlog is protected, and we are set up for an incredible year. So we're now working on setting up an even better '23. And instead of walking through what we do, I'll just use an example from what we did in '18 and '19 back when rates ticked up and the FHA insurance premium went up and prices have moved up and the buyers pushed back a little bit in the second half of '18 and into '19. We quickly retooled model parts. We have product series in every WIP around our system. So we will position the model park with a footage range, and we have products available today that have similar room counts but are smaller footage. And with the way the cost to build has been rising over the last couple of years, it's a more meaningful savings to move to a little bit smaller home. It's 200 feet, it could be $20,000 to $30,000 in price. It's very meaningful. And back in '18 and '19, we rolled it out in all our communities in a 6-month period, built new models, positioned smaller houses, same lots. The dollars of margin per unit go down, the percentage is held. But lo and behold, in early '19, rates came back down, and we didn't need it, but it's there. And we have it today, and we're actually monitoring that. And in some of our newer communities right now, we're actually retooling model parks to position a little smaller than we did when we underwrote the deal. So it's already underway in our system.

Good to hear. Don't mind throwing the softball if it's still hard for people to understand.

It's the beauty of being a build-to-order company. We don't have a bunch of houses out there that may be overpriced that you have to move and sell your inventory. We just retool a product and sell them the other home and they picked a lot and then we go right back to work. So it's a good position to be in right now.

Okay. Another question relative to your own business and positioning. Your option lot percentage today is -- as of the first quarter was 42%. Many other builders have goals of being well over 50% in terms of return on investment and risk profile. What is your approach towards lot optioning? And how do you view other builders with higher goals relative to your own business?

First and foremost, Mike, it's grow the business with good investments in the best submarkets that meet our product and price point needs. And typically, when you get into the more desirable submarkets, they're land constrained and it's very difficult to get options on property in those locations. We focus on the inventory turns and how quickly can we get our money back. And whether it's an option or whether it's owned, we turn the inventory pretty quickly. And that's job one in achieving our returns. Relative to option versus owned, well option every lot we can around the system. A lot of what people are doing is more financial management, if you will, through structure of deals, not necessarily a pure rolling option with a small deposit up. So we don't have a stated goal other than we'd like to option as much as we can. But it's all about turning the inventory. And with the size of the communities we're investing in, we're turning them very quickly right now. I'd like to do them even quicker, but that's our primary focus. It's not the stated goal of what percent is option.

Right, Right. Next, I just wanted to hit on your current footprint and scale. How do you view your current footprint in terms of offering sufficient and competitive scale and leverage in your key markets? Maybe you could kind of walk us through the number of markets you're in today, and where you're top 5 or a sufficient scale that you feel that you're -- where you want to be versus other markets. And how does M&A play a role in perhaps getting you bigger in the markets that you're currently not?

Sure. It's a good question, Mike. The current footprint, if you ignore, Boise and Charlotte, which I'll talk to in a minute, the current footprint outside of those 2, in our previous peak, we delivered 25,000 houses. We're not there today. The 25,000 may have been influenced by crazy mortgage money in subprime, so say it was 20,000 or 22,000, not 25,000, but still significant upside from where we are today. And we have teams in those cities that had already delivered at a bigger scale. So number one, go push scale, where we're at today, and we're doing it across the footprint. And at the same time, we have the ability to do these bolt-on start-ups like we did in Seattle a few years ago. That's been very successful. Now we're back in Charlotte where we once were and about to open our first community there. We're in Boise, about to open our first community there. And as you look at those start-ups, it takes a little longer to get to scale. You have to have the right person on the ground to start the team and be into the land network, which we do. But you avoid the dumb tax, you avoid the goodwill, and it takes you a couple more years, but you get to scale. And we can afford to do it because we have enough growth potential in the current footprint today. We're always looking at M&A. Valuations are tough. The M&A that seems to work best is the private builder that wants out that has a lot position in a city we're already in or in some cases, we may look at an arena market, but really haven't felt the need to do that right now. So our goal is get to scale. Most of our divisions are top 3, the others are top 5 with a couple of exceptions. And our quote mandate, with all of our divisions is get into the top 3. Once you're there, shoot for #1. And there's a lot of benefit to that scale, whether it's labor, the land market, employees, all those things, cost synergies, overhead leverage and our biggest businesses are our most profitable typically. So the challenge is to get to scale where we're at.

So just maybe diving into that a little deeper, trying to assess the opportunity of where you're still, again, not necessarily in the top 5 or top 3, but that's the goal. So if you could just kind of review again maybe do it even as a percent of closings, you don't necessarily have to do it as a percent of the number of markets you're in, but what part of your business is non-top 5 or outside of the top 5? What percent is top 5, what percent is top 3?

I don't have it off the top of my head, Mike. I know throughout California, Las Vegas, we're top 3; Arizona, we're not, and that's one of our real opportunities for growth right now. It's in our backyard. We've done well in Phoenix over the years, and they're probably top 10, but heading up. Texas, we're top 3 in the big cities outside of Dallas/Fort Worth. We're growing our business in Dallas/Fort Worth. The Southeast is really a great story, whether it's Florida or North Carolina, where we're not top 3 anywhere, but closing very quickly on that. It's kind of fun to see the teams mature and take market share. And that was the last region we lit the match on, so to speak, to really push growth because we had to fix the business. All the repair is done, profits are growing, margins are growing, and you'll see a lot of growth out of the Southeast over the next couple of years.

Right, right. That sounds good. I just have one last one for me. Like I said, we've run through these questions a little faster than normal, so appreciate it. [Operator Instructions] Your build-to-order model, you talked a lot about that in your slide deck and the advantages, including mitigating risk, allowing buyers to purchase more options. There's a counterargument to the build-to-order model in terms of some of the cons, I guess, in that there's a bit more of a level of construction complexity as opposed to having kind of more of a standardized spec approach, which is in a supply constraint, labor-constrained backdrop that does matter for some builders. Also maybe if you price the home ahead of your cost with today's inflationary backdrop that could be a risk as well. So how do you view those concerns in terms of managing a build-to-order business?

Sure. A couple of thoughts, Mike. For those that say it's more complex, they don't really understand our business. We have standardized floor plans around the system. We have certain footprints in the company that sold over 1,000 houses in the last 12 months. So it's -- there's scale to the floor plans. And it's standardized options. This isn't a custom approach. It's a personalized approach. So all the options are prebid, they're standardized. We know over time which ones are most important to the customer. And I like having the visibility and clarity to our current pipeline, the backlog, the consistency of the deliveries. And I've already shared, we're working on '23 right now. '22, we have to execute, but it's set up extremely well to hit our guidance. And as you look forward to '23, the last thing I would want to do is have a WIP that's 50% unsold that you have to start incentivizing to get rid of. And we think the personalization that we offer and the choice to the buyer on floor plans allows us flexibility. If the market moves, we can move with it very quickly. And it's one of the reasons our sales rates are one of the highest in the peer group. People really value choice, it makes sense. If you're buying the biggest investment in your life, you want it to be personalized. So we offer that. But I think over time, if the markets were to cool, I think you would see that we're extremely well positioned to weather the storm and just keep on -- keeping on.

Right. And about managing the price cost dynamics, if you're setting -- closing on a price earlier on in the construction process and you might have some variability in costs, how do you manage that over the past year or 2?

For the most part, Mike, the costs are locked when we start the home. If not when we sell the home, very close time frame there. We did get some curveballs over the last 18 months with this extreme disruption where you have a contract with a framing contractor in the city. And they'll come to you and say, I'm not doing it for the price I've contracted for. And that's something that I've never really had to experience before. That's starting to settle down. So we're not getting the curveballs that we did earlier in this expansion that the industry has been. So that's why I think it's -- cost side is actually settling down a little bit. And we have visibility when we sell the home. So I think we had an extremely extraordinary dynamic going on that's now starting to settle down, and we're not worried about it. If you look at our margin guide for the year, it's going to continue to go up through the year. Our exit margin is going to be higher than our average for the year. We shared that on our earnings call. And there's this lag because it's built-to-order. But the backlog is there and the pricing dynamics covering costs are all there for us as well as just a little bit of a lag due to the way we go about it.

Right. If the market -- talking about -- and maybe we'll close out on this, but it's an important question, you mentioned that the gross margin trajectory for this coming year -- for this current year. Obviously, there's a lot of talk by investors trying to triangulate, figure out what's -- how do we get back to normal, at what rate do we get back to normal? Any thoughts around that, given your land book today, if home price appreciation were to settle down to normalized levels, let's say, that would match what you've underwritten at in terms of land in the pipeline, what type of timing would we expect to see companies get back to normal pre-pandemic levels? And perhaps if also that means that -- or if there's any changes that have occurred in the last couple of years that maybe the new normal is something better than pre-pandemic.

Well, I was going to tweak your question because in our case, we know we'll be better than we were pre-pandemic. We had other things going on in our business that we're helping our margin along the way that they had all got blurred with the pandemic disruption, whether it was the improvement in our book of communities closing out of all the legacy assets, which are, for the most part, gone and lowering our interest capitalization per unit 1, 1.5 of margin there. So as we continue to mature out of the strong market cycle that we're in, we think we'll be well above where we were pre-pandemic. The communities we're opening today are performing extremely well. And in a lot of cases, they were acquired post-pandemic. They may have been tied up pre-pandemic and then we deferred the closing, then you finally get the land ready to close, you close on the land, you develop it, you build models. There's a lag there, 18 months to 2 years. So we're probably a book of business today from 50% pre-pandemic, 50% right after the pandemic. So the right after pandemic side of things still has pretty significant margins built in. So I think over time, margins will peak at some point and then they'll come back down. But in our case, it's not going back to pre-pandemic, it's -- we continue to think we'll be above where we were.

Okay. Great. Well, with that, we're just about at the end of our session. So I'll close it out here. Jeff, I want to thank you for your time, both Jeff Mezger and Jeff Kaminski as well as Jill Peters. Thanks so much for joining us today. This concludes the morning session of our day 2. In the afternoon, we'll be resuming at 1:15 with Stanley Black & Decker followed by TopBuild and closing out the day with Century Communities and Forestar Group. So thanks, again. Jeff, Jeff and Jill, I really appreciate it. Have a great rest of the day.

You too, Mike. Thank you.

Thank you. Mike.

Thanks, Mike.