KB Home - Q4 2023

Transcript

Operator (participant)

Good afternoon. My name is John, and I will be your conference operator today. I would like to welcome everyone to the KB Home 2023 fourth 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 February 9, 2024. And now I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Thank you, Jill. You may begin.

Jill Peters (Senior VP of Investor Relations)

Thank you, John. Good afternoon, everyone, and thank you for joining us today to review our results for the fourth quarter of fiscal 2023. On the call are Jeff Mezger, Chairman, President, and Chief Executive Officer, Rob McGibney, Executive Vice President and Chief Operating Officer, Jeff Kaminski, Executive Vice President and Chief Financial Officer, Bill Hollinger, Senior Vice President and Chief Accounting Officer, and Thad Johnson, Senior Vice President and Treasurer. During this call, items will be discussed that are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future results, and the company does not undertake any obligation to update them.

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

Jeff Mezger (Chairman, President and CEO)

Thank you, Jill. Good afternoon, everyone, and Happy New Year. We finished the year strong with a fourth-quarter performance that exceeded our guidance across our key financial metrics. We produced total revenues of $1.7 billion and diluted earnings per share of $1.85. Our outperformance on closings at just over 3,400 homes was driven primarily by our continued improvement in build times, along with a strong backlog of buyers who are committed to a timely closing when their home is completed. With respect to margins, they remained solid at just under 21% in gross and 11% in operating income margin. In addition, we returned nearly $180 million of capital to shareholders, primarily through share repurchases. These results contributed to a healthy financial performance for 2023.

We delivered more than 13,200 homes, driving revenues of $6.4 billion and diluted earnings above $7 per share. Our top line, together with an operating margin exceeding 11% and the repurchase of 11% of our shares outstanding at the start of the year, contributed to 15% growth in book value per share to over $50. The strength of our results is notable when considering that our initial 2023 revenue guidance was about $5.5 billion, equating to roughly 11,400 deliveries, given the uncertainty in market conditions at the start of the year. As our new fiscal year gets underway, market conditions are improving, with rates having declined and consumer confidence increasing, all while resale inventory remains low.

We believe our company is well-positioned, given shorter build times, a solid backlog, normalized cancellation rates, and planned community count growth. The same factors that characterize the market today, low inventory levels, solid employment and wage growth, are those that we believe will sustain the longer-term health of the housing market. Demographics have been and will continue to be a significant factor, with the largest generational cohorts, Millennial and Gen Z, demonstrating a strong desire for homeownership. One of our most important operational achievements of this past year was a significant reduction in our build times, which favorably impacted our business in several respects. Rob will share the details in a moment, but for now, I will highlight the shorter construction times helped to drive the outperformance in our deliveries and revenue relative to our expectations.

In addition, the quicker conversion of homes in production to deliveries has unlocked a meaningful amount of cash. Going forward, faster build times will boost our selling efforts as a Built-to-Order home with quicker delivery dates becomes even more compelling to a homebuyer, and the cost to lock the interest rate on the mortgage for a shorter period of time will be lower. We begin 2024 with a healthy backlog of more than 5,500 homes, valued at approximately $2.7 billion. Typically, our ending backlog represents about 40% of our subsequent year's deliveries, which aligns with our anticipated closings for this year. We expect our remaining deliveries in 2024 to come from net orders in the first half of the year that will drive starts, as well as sales of inventory homes.

We have nearly 7,000 homes in production, of which approximately 30% are unsold. On our last earnings call in September, we shared our projection of a monthly absorption pace per community and range of net orders for our 2023 fourth quarter based on normal seasonality, assuming then current market conditions. As the quarter progressed, interest rates increased each week from late September through the end of October, which over this period, significantly curbed demand and impacted our net order results. We elected not to take a sales at any price approach and pursue lower margin orders in a softer demand period, as we did not need additional orders to achieve our fourth quarter delivery target, and we're also well-positioned for deliveries in our 2024 first quarter. As interest rates have now declined since the end of our fiscal year, demand has improved significantly.

For the first 5 weeks of our first quarter, our net orders are 904, as compared to 403 in the comp period of the prior year. Our orders in December were higher than November, which is unusual, given that December is typically a slower sales month. To us, this speaks to the pent-up demand for homeownership. That said, on a year-over-year basis, the comparison is somewhat distorted due to the low net orders in the prior year period. While we expect our net order comparison to moderate from the quarter to date level for the full quarter, we do expect it will be very favorable. We believe we are well positioned to respond to this strengthening in buyer demand, given our product positioning and price points, as well as planned community count growth.

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

Rob McGibney (EVP and COO)

Thank you, Jeff. I will begin by providing some additional color on our fourth quarter net order result and discuss the steps we took to help buyers address higher mortgage interest rates. Our business strategy remains consistent in optimizing each asset on a community-by-community basis, balancing pace, price, and margin. As a component of that strategy, we elected not to chase a sales target at significantly lower margins during the fourth quarter, amid the rapid rise in interest rates and their impact on affordability. Mortgage rates on the average 30-year fixed loan rose approximately 60 basis points from the time of our last earnings call in September to their peak in late October.

To put it in perspective, this has the same effect as a nearly 6% increase in the purchase price of a home, an impactful change that would have been costly for us to offset, particularly in a slower demand period. With our Built-to-Order model, we work from a large backlog, which allows us to thoughtfully execute our sales strategy without the pressure of having to cover inventory at any price to achieve our quarterly delivery plan. We worked with buyers as they adjusted to the rising rate environment during the fourth quarter and took steps to promote targeted rate buydown programs. Roughly 60% of our orders had some form of mortgage concession associated with them, including rate locks. This is an important tool, especially for our Built-to-Order buyers, as we provide customers the ability to lock their rate up front.

As a result, there is a higher degree of confidence, both for buyers and for us, of the likelihood of closing, even if rates continue to rise. Our lock program comes with a one-time float-down option that customers can utilize if rates decline between the time of the initial lock and the close of escrow, which lessens rate-related anxiety in the buying decision. For buyers that use our rate buydown program, the cost of the lock is built into the rate. With mortgage rates retreating, the selling environment has become more favorable, and we've resumed a faster pace of sales at higher margins than we would have otherwise achieved during the fourth quarter. To position ourselves for 2024 deliveries and increase the number of homes available to close during the spring selling season, we ramped up our starts during the fourth quarter.

We started 2,589 homes, ending the quarter with nearly 7,000 homes in production, of which about 70% are sold, consistent with our targeted range. Shifting now to operations. Once again, our divisions did an excellent job in reducing their build times during the quarter, contributing to substantial improvement over the course of 2023. In December 2022, our construction times exceeded eight and a half months. By year-end in 2023, they were five and a half months. Our progress earlier in the year was primarily on the front end of the build cycle. We maintained those improvements and picked up nearly 2 weeks in the fourth quarter in the latter stages, from drywall to final, which is the bucket that most of our deliveries came from.

We expect to continue driving efficiency throughout our construction process to return to our historical build times of between 4 and 5 months. While compressing our build times, we also reduced our direct construction cost. We finished the year with an average savings of about $18,000 per home, relative to peak cost in August of 2022. Although the cost of some materials, such as stucco, masonry, flooring, and concrete, pressured the cost of homes started in the fourth quarter, we experienced a reduction in lumber cost, which offset some of the cost increases. Most importantly, we were able to maintain the vast majority of our savings throughout the year. Our key operational priorities remain consistent for 2024, executing our Built-to-Order model and providing the combination of best price and value to our customers, while continuing to deliver high satisfaction levels to our buyers.

We are focused on the reduction in our build times, incremental cost reductions through value engineering, and community count growth from on-time grand openings. With that, I will turn the call back over to Jeff.

Jeff Mezger (Chairman, President and CEO)

Thanks, Rob. Switching gears to our mortgage joint venture, KBHS Home Loans, 87% of the mortgages funded during the quarter were financed through our JV, which is more than 10 percentage points higher year-over-year. This is a positive development, as higher capture rates help us manage our backlog more effectively. The average cash down payment was 16%, consistent throughout the year, equating to roughly $78,000. The household income of our KBHS customers averaged $127,000, and they had an average FICO score of 741, the highest credit score reported for the past several years. Even with one-half of our customers purchasing their first home, we are attracting buyers with strong credit that are able to qualify at elevated mortgage rates while making a significant down payment.

We spent approximately $485 million to acquire and develop land during the quarter, contributing to a full year investment of $1.8 billion. The majority of which was spent on developing land we already owned. In 2024, we expect to accelerate our investment activity to support our future growth while remaining diligent with respect to our underwriting criteria, product strategy, and price points. As to our lot position, it stood at roughly 56,000 lots owner-controlled at quarter end, of which 40,800 are owned. About 65% of these owned lots were tied up in 2020 or prior, before the run-up in land prices. We remain focused on capital efficiency, developing lots in smaller phases, and balancing development with our starts pace to manage our inventory of finished lots.

We believe we are well-positioned, as we currently own or control essentially all the lots we need to achieve our delivery growth targets through 2025. Our objective remains to achieve at least a top five position in each of our served markets, and all our divisions have a roadmap in place to achieve this ranking. Our ending community count was essentially flat relative to the prior year. We opened 24 new communities during the fourth quarter, achieving nearly all our planned grand openings, although many opened at the end of November, which limited their contribution to net orders. That said, these new communities, along with our first quarter openings, have us well positioned for the spring selling season. We expect our ending community count to grow sequentially as the year unfolds, and we believe we will exit the year with a meaningfully higher number of open communities.

Our balance sheet is in excellent shape, and we intend to continue allocating our strong operating cash flow toward reinvestment in growth and a return of capital to our shareholders in 2024. Since we began our share repurchase initiative in our 2021 third quarter, we have deployed approximately $750 million to buy back over 20% of the outstanding shares at that time, at an average price of $39.79 per share, which has been significantly accretive to both our book value and diluted earnings per share. During the same time frame, including our regular quarterly dividends, we have returned roughly $885 million to shareholders. In closing, I want to recognize the entire KB Home team for their dedication to our buyers and their contributions to our achievements in 2023.

It was another year during which we navigated changing market conditions while remaining strategic and flexible with a focus on the longer term. Our business is solidly profitable, and we remain an industry leader in third-party customer satisfaction rankings. We have a recognized brand that consumers trust and an award-winning sustainability program. We look forward to sharing our results with you as 2024 unfolds. With that, I'll now turn the call over to Jeff for the financial review. Jeff?

Jeff Kaminski (EVP and CFO)

Thank you, Jeff, and good afternoon, everyone. I will now cover highlights of our financial performance for the 2023 fourth quarter and full year, as well as comment on our outlook for 2024. In the quarter, we produced solid results, with housing revenues exceeding the high end of our guidance range and an operating income margin of nearly 11%. In addition, our robust cash flow supported significant share repurchases, along with $483 million in land investment. Entering our 2024 first quarter, improving housing market conditions and our well-positioned portfolio of open selling communities have generated strong momentum, with significantly higher net orders in the first five weeks compared to the corresponding year earlier period.

In the 2023 fourth quarter, our housing revenues were $1.66 billion, compared to $1.93 billion in the prior year period, reflecting a 10% decrease in the number of homes delivered and a 5% decline in our overall average selling price. Though fourth quarter deliveries were down relative to our 2022 results. We achieved our third consecutive quarter of sequential cycle time improvement, which contributed to the higher-than-expected number of homes delivered. Looking ahead to the 2024 first quarter and the full year, we anticipate improved housing market conditions and continued favorable supply chain trends. As a result, for the first quarter, we expect to generate housing revenues in a range of $1.4 billion-$1.5 billion.

For the 2024 full year, we are forecasting housing revenues in a range of $6.4 billion-$6.8 billion, supported by our backlog of sold homes, projected net orders per community, reduced construction cycle time, and expected growth in community count. In the fourth quarter, our overall average selling price of homes delivered decreased to approximately $487,000, due to both mix shifts and the impact of pricing adjustments and other homebuyer concessions, such as mortgage rate locks and buydowns. We believe our 2024 first quarter average selling price will be approximately $477,000. For the full year, we are projecting an overall average selling price in a range of $480,000-$490,000.

Homebuilding operating income for the 2023 fourth quarter totaled $180.9 million, compared to $278.2 million for the year-earlier quarter. Our homebuilding operating income margin was 10.9%, compared to 14.4% in the 2022 fourth quarter. Excluding inventory-related charges of approximately $1.2 million in the 2023 period versus approximately $27.9 million a year ago, our operating margin was 10.9% compared to 15.8%. We anticipate our 2024 first quarter homebuilding operating income margin will be approximately 10.5%, and the full year metric to be approximately 11%.

Our 2023 fourth quarter housing gross profit margin declined 170 basis points from the year-earlier quarter to 20.7%. Excluding inventory-related charges, our margin for the quarter was 20.8%, down from 23.9% in the 2022 fourth quarter, mainly due to price decreases and other homebuyer concessions, along with higher construction costs. We are forecasting a housing gross profit margin for the 2024 first quarter and full year of approximately 21%. This gross margin outlook assumes the current improved market environment remains stable.

However, if the recent favorable economic trends continue through the spring selling season and beyond, we believe there is upside to our full year estimate as further declines in mortgage interest rates, combined with the pent-up demand for housing and continued tight retail inventory conditions, would provide an opportunity to reduce homebuyer concessions. Our selling, general, and administrative expense ratio for the 2023 fourth quarter increased 190 basis points from a year ago to 9.9%, mainly reflecting higher costs associated with certain performance-based employee compensation plans and sales commissions, as well as reduced operating leverage from lower housing revenues.

We are forecasting our 2024 first quarter SG&A ratio to be approximately 10.5%, up from 10.1% in the year-earlier quarter, mainly reflecting higher costs, including marketing and advertising expenses, associated with the planned increase in our community count during the year as we position our operations for growth. We expect that our 2024 full-year SG&A expense ratio will be approximately 10%. Our income tax expense of $49.3 million for the fourth quarter represented an effective tax rate of approximately 25%. The rate was favorably impacted by $5.8 million of federal energy tax credits, reflecting a benefit of our industry-leading sustainability initiatives.

However, these credits were lower than expected, largely due to the impact of recently issued IRS guidance that unexpectedly specified a higher energy standard for single-family homes built in California than for other states. We expect our effective tax rate for the 2024 first quarter and full year to be approximately 24%. Overall, we reported net income of $150.3 million or $1.85 per diluted share for the 2023 fourth quarter, compared to $216.4 million or $2.47 per diluted share for the prior year period, which were among the highest fourth quarter levels in our history.

Reflecting on the full year, we are very pleased with our operational execution in 2023, in which we overcame volatile housing market conditions and stiff headwinds from rising mortgage rates to perform significantly better than our original expectations for the year. Relative to the full-year guidance we provided during our 2023 first quarter earnings call in March, our full-year housing revenue of $6.37 billion exceeded the midpoint of our guidance range by over $800 million, or approximately 15%. In addition, our 11.3% operating income margin exceeded the midpoint of our guidance range by 80 basis points. Turning now to community count. Our fourth quarter average was essentially flat year-over-year at 236. We ended the year with 242 active communities, up 5% sequentially.

We expect to end the 2024 first quarter with approximately 240 communities, which would result in a year-over-year decrease in the average community count for the quarter in the low single-digit range. We expect our quarter-end community count to increase sequentially through the remainder of 2024, starting in the second quarter, as openings each quarter are expected to outpace sellouts. We anticipate ending the year with approximately 270 communities, an increase of 12% and higher compared to the expectations last quarter of 265 communities at year-end. We believe our full year average count will be up about 5%.

We invested $483 million in land, land development, and fees during the 2023 fourth quarter, up 9% compared to the $443 million from the year earlier period, with $136 million of the total representing new land acquisitions. We ended the quarter with a pipeline of approximately 56,000 lots owned or under contract, that we expect will drive significant new community openings and community count growth in 2024, as I noted earlier. During the fourth quarter, we repurchased approximately 3.6 million shares of our common stock at a total cost of $162 million. For the year, we repurchased 9.2 million shares at an average cost of 11% below our year-end book value per share.

With $164 million remaining under our current common stock repurchase authorization, we intend to continue to repurchase shares with the pace, volume, and timing based on considerations of our operating cash flow, liquidity outlook, land investment opportunities and needs, the market price of our shares, and the housing market in general economic environments. We generated nearly $1.1 billion of cash flows from operations in 2023, as compared to $183 million in 2022, which drove an increase of nearly $400 million in our year-end cash balance, while also funding $411 million of stock repurchases, $150 million of debt repayments, and $57 million of dividends, which included a 33% increase in the dividend rate effective in the third quarter.

At year-end, we had total liquidity of $1.81 billion, including $727 million of cash and $1.08 billion available under our unsecured revolving credit facility, with no cash borrowings outstanding. Regarding our financial leverage, we are very pleased with the steady progress and favorable trend over the past five years that resulted in a 19 percentage point improvement in our leverage ratio. Over the past year, our debt to capital ratio improved by 270 basis points to 30.7% at year-end 2023, compared to 33.4% at the end of the previous year. We have no debt maturities until our term loans 2026 expiration, with our next senior note maturity in June 2027.

In conclusion, we are pleased with our strong 2023 operational and financial performance, and remain optimistic about the outlook for the housing market, given the favorable fundamental demographic trends, constrained inventory of resale homes available for sale, and continued underproduction of new homes. In addition, we believe our strong financial position, including our liquidity profile and long runway for debt maturities, will allow us to continue to be opportunistic with capital deployment in 2024 and beyond. In 2024, we plan to execute on the core principles of our unique Built-to-Order business model and returns-focused growth strategy, carefully allocating capital with a focus on enhancing long-term stockholder value.

We believe we are well positioned to achieve our objectives, supported by the recent decline in mortgage interest rates, our solid portfolio of communities and anticipated expanding community count, improving cycle times, and healthy net order activity during the first five weeks of the new fiscal year ahead of the spring selling season. We will now take your questions. John, please open the lines.

Operator (participant)

Thank you, sir. We will now conduct the question and answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate that your line is in the queue. You may press star two to remove a question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. We ask that you please limit yourself to one question and one follow-up. Thank you. One moment please, while we poll for questions. The first question comes from the line of John Lovallo with UBS. Please proceed with your question.

John Lovallo (Managing Director, Senior Equity Analyst, Homebuilding & Building Products)

Hi, guys. Thank you for taking my questions. The first one is, you know, it appears that the sort of slight downshift in home sales revenue, the outlook from $6.5 billion-$7 billion to $6.4 billion-$6.8 billion, was driven by the lower 4Q orders. So the first question is, you know, is that, is that correct? And, you know, if that is correct, rates are down about 50 basis points from when you gave that initial guide. So is there not enough time, you know, in the first half of the year to sort of make up the 300-400 home delta, and sort of stay on that $6.5 billion-$7 billion trend?

Jeff Kaminski (EVP and CFO)

... Right. Yeah, I think I can take that. So yeah, thanks for the question. When we look at the change in the full year, it wasn't a terribly significant move. It was about 2% at the midpoint, or about $150. You are right in saying there was about $70 million of pull forward into the fourth quarter. And you know, what happened in the fourth quarter, we had higher deliveries than we expected, and those sales were a little bit lighter than what we were planning for. So our year-end backlog came down a little bit more than what we were anticipating when we provided that guide. But I would term it, John, mostly as just refinement of the full year guide. We do believe there is upside.

We're trying to forecast the year based on the improved conditions that we have today, not necessarily looking at continued improvement as we go through the year. We're very encouraged by the start of the year and the first five weeks of sales that we've seen and remain optimistic about our potential in 2024.

John Lovallo (Managing Director, Senior Equity Analyst, Homebuilding & Building Products)

Okay, that's helpful. Seems like a little bit of conservatism, maybe. All right. In terms of the gross margin, it's expected to be about 21% in the first quarter and then 21% for the full year. I mean, are you expecting a relatively flat gross margin in each quarter? And if so, what would drive that consistency versus the normal kind of second half step-up that we would expect?

Jeff Kaminski (EVP and CFO)

Right. Yeah, we had a relatively steady trend in 2023. A little less variability than what we normally see. You know, it's been a pretty choppy market, as you know, so we're trying to base everything off of sort of current sales rates and current backlog margins and what we're seeing embedded in the orders right now. Yeah, our current backlog margins are actually a little bit higher than our guide, but we always like to have a little bit of room there in case there's some contingencies relating to either quick moving units or a continued need for incentives or whatever. So yeah, I would expect to see a relatively consistent gross margin profile for the year at this point in time.

That said, you know, we still have a lot of sales to make for the back half of the year, and we'll have a better, better visibility of that as we get more into the spring selling season to see how that, variability can go, you know, on, on the gross margin side. But, you know, we like the favorable economic trends we're seeing, you know, mortgage rates coming down, solid employment, growing economy, pent-up demand for housing, the retail inventory tightness. All of those, to me, suggest opportunities to reduce concessions, which would be pretty much right to the, right to the gross margin line to the extent we're able to do that, if market conditions continue to improve.

Operator (participant)

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

Stephen Kim (Senior Managing Director, Head of Housing Research)

Great. Thanks a lot, guys. A lot to like here. You know, obviously, strong performance and, the market helped you out, but clearly, it's clear the market's helped you out here in the first five weeks, but you also executed very well. So congratulations on that. My first question relates to, just, the absorption rate, implied, you didn't really give a, you know, obviously an order number, but certainly sounds like, 2024, in terms of sales per community per month, is, yeah, I don't want to put words in your mouth, but it certainly seems like it's gonna be, based on your closings guide, but at least as good as what you saw in 2023 and maybe, and probably better.

In that regard, when we look at your historical absorption rate, you know, in the past, you were very comfortably, you know, in the 4+ range on average for the year. You know, you got as high as in the 6s, you know, in 2021. And I'm kind of curious as where you feel comfortable with where absorption rates can ultimately settle out. And the reason I'm curious about this is because if I look way back, you know, into the early 2000s, for example, your absorption rates were substantially higher, you know, like 7 per month and that kind of a thing. So just curious if you could give us some commentary about where you think a sort of sustainable level for absorptions is for your company, given the way it's configured today.

Jeff Kaminski (EVP and CFO)

Steve, I can start. First, thanks for the recognition on the job we did in Q4. Over the last 5 or 6 years, we've gone through kind of a whipsaw. We came out with returns-focused growth. We were working on lifting our margins, so we capped our absorptions at 4 until we got our margins higher. Now, our margins are higher, and we keep using the term optimize the asset, and every community is a different story, but I would expect that it's probably around 5 on average. And as we look at 2023, we were soft coming into the year, and then it picked up, then it softened again later in the year. So we fully expect our absorptions in 2024 will be higher than 2023 for the year.

So I would think, five a month. Market runs, we could go higher than that, but it's a per community analysis. How many lots do we have left? Is it easily replaceable? How do you run it? How big is the community? But I think five is probably a good number.

Stephen Kim (Senior Managing Director, Head of Housing Research)

All right. That's... Yeah, that's really helpful. I appreciate that. And then your commentary about the margins and the incentives and all that. You've talked about the fact that the first five weeks here have gotten off to a good start. And the way you're talking about the incentives or the concessions, it sounds like you have not really reduced those concessions yet.

... and you think you may, as you go forward, can you help us understand what it is that you think would be the trigger for reducing incentives? Would it be, in fact, absorptions, let's say, in the late 1Q, early 2Q, kind of getting to that 5 threshold in absorptions, or, you know, would it be something else?

Jeff Kaminski (EVP and CFO)

Yeah. Rob, you want to take that? You can walk through what we're doing and where we're trying to get to.

Rob McGibney (EVP and COO)

Yeah. So Steve, you're right. We haven't really done anything different than what we were doing in Q3, as far as concessions that we were offering. Obviously, you know, you heard from the prepared remarks, we've seen a big uptick in sales, so that is how we're going to manage it. We always talk about optimizing each asset, balancing pace, price, and margin. And if we, you know, as we go through Q1 or into Q2, and we start to see that at a community level get above what we think is optimal for that, we're going to. We're first going to reduce those incentives, take it to price. We're going to be looking to lift margins on all those communities where we're seeing that happen.

We're encouraged early by what we're seeing here in the first part of Q1, so that seems pretty, pretty realistic for us.

Operator (participant)

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

Alan Ratner (Managing Director, Equity Research)

Hey, guys. Happy New Year. Good afternoon, thanks for all the great detail, as always. Yeah, my first question, you know, in a similar vein on the incentives, you know, it doesn't sound like you really got, you know, kind of played that incentive game in the fourth quarter, and I think that makes a lot of sense, given your sales strategy and whatnot. But clearly, other builders did, which I think is, you know, perhaps maybe why orders were a bit lighter than you were expecting coming into the quarter. You've seen, you know, maybe more of the spec builders begin to dial back those incentives that they were offering into year-end, and if so, you know, any idea kind of how much net pricing has moved year to date from some of your competitors that did play that discounting game?

Jeff Kaminski (EVP and CFO)

Rob, you got any thoughts on that?

Rob McGibney (EVP and COO)

Yeah, I really haven't. I mean, we've seen some change in behavior. It's kind of hard to track, you know, what's going on with individual builders, and they'll have, you know, certain deal of the day, deal of the week type things. But we do expect to see incentives overall come down as we move forward, just based on the uptick in demand that we've seen. You know, we did do a little more in Q3, especially in Q4, towards the beginning, to generate some additional net orders. But as rates got to that, you know, 8% kind of threshold, we saw buyers really pull back, and it just didn't seem prudent to chase sales with that going on in the market.

You know, we continued to start homes, and we're happy as we look back on it now, that that's the approach that we took, because, you know, we're seeing better sales. Obviously, we didn't tank the margins, and sales are really picking up. So that's been our approach.

Alan Ratner (Managing Director, Equity Research)

Got it. Okay, makes sense. So maybe a little bit early, but more of the expectation into the spring that that should come down. Second question, you know, on the margin guide, and Jeff, I appreciate, you know, kind of the commentary there. Just curious, you know, what your underlying assumptions are on costs, because, you know, obviously, lumber was a big tailwind in 2023 versus 2022. You kind of mentioned some of the moving pieces there. I would imagine, you know, beginning of the year is kind of typically when you start to get some price increase announcements from your trades, and, you know, they're probably seeing and hearing the same things you guys are as far as lower rates.

So has that emboldened the suppliers, the trades, to try to push the envelope a little bit on cost yet? Or are they still kind of content at the current levels, and what's your expectation there for the year?

Jeff Kaminski (EVP and CFO)

Yeah, first of all, on the suppliers, I mean, we haven't seen any significant change in behavior from the supply base. So, you know, it's pretty early, I'd say, on the market recovery and the mortgage rate decline to see that. You know, as we forecast margin, you know, we generally look at current pricing, current costs as we go forward and assume current market conditions. So as things get better, you know, there's more upside. And, you know, we've just talked about concessions a little bit with the last couple of questions. You know, one of the other important things on the concessions is to the extent they're tied to mortgage rates, so we're buying a rate down to X%, for example, the lower the rates go, the less cost of that concession.

So even if we were to maintain some of those incentives out there, they'd be less costly to us on a... and less of a hit to gross margins, which is a real favorable. So, and anyway, coming back to the cost side, yeah, it’s, I think it’s still a little bit early on to see. Hopefully, hopefully, we won't see from some of our supply base, you know, aggressiveness on that. We did see costs come down quite nicely over the last 12 months, and to the extent those costs are baked into the backlog, those are already included in the forward guide, and just assuming kind of business as usual from there.

Operator (participant)

Thank you. And our next question comes from the line of Matthew Bouley with Barclays. Please proceed with your question.

Matthew Bouley (Director and Senior Equity Research Analyst)

Good afternoon, everyone. Thanks for taking the questions. So, you know, you guided your ending backlog, or you guided your deliveries, the ratio of ending backlog to deliveries of 40%, which, you know, is very normal versus pre-COVID times, as you mentioned. It's a lot better in the past couple of years, of course. So do cycle times where they stand today, kind of get you there, or would you still need some further improvement in cycle times, you know, in order to get to that number relative to where your backlog is today?

Jeff Kaminski (EVP and CFO)

We've built the year mix based on current cycle times. So if we can continue to compress, and Rob's got a lot of plans in play to do that, it could help us, but we're in steady state when we're making our projections for the year.

Matthew Bouley (Director and Senior Equity Research Analyst)

Yep, got it. Okay. Thank you. And then, so I think in terms of spec, I think you said 30% of your production was unsold. Correct me if I'm wrong, but I recall in years past that that may be a little higher. You know, you might have been closer to more like 20%. You know, today is a little higher than normal. Can you remind us if there is any margin differential and on kind of spec homes versus the Built-to-Order and, you know, how you're thinking about any margin impact from mix of higher spec in 2024?

Jeff Kaminski (EVP and CFO)

Yeah. Matt, we typically run about 25% unsold, and we're up at 30%. It's about 300 units, so it's not a crazy number. And, you know, as the year unfolds, we'll see how our orders are on the Built-to-Order, because we like the predictability of the delivery with a predictable margin, and we just think it's a far better business. Typically, our inventory sales are running 2-3 percentage points lower than the Built-to-Order, so we would much rather prefer to keep running our business the way we have for the last 15 years. But there's a certain pace of starts you have to maintain in order to have your scale and your franchise in that city with the contractor base. And we'll keep toggling.

We'll get all the dirt sales we can, the BTO sales, and if we have to fill in some inventory, we'll do that.

Operator (participant)

Thank you. And our next question comes from the line of Michael Rehaut with J.P. Morgan. Please proceed with your question.

Michael Rehaut (Managing Director, Senior Equity Analyst, Homebuilding & Building Products)

Hi, thanks. Good afternoon, and thanks for taking my questions. First, I just wanted to zero in a little bit again on the first quarter gross margin. You know, looking for a roughly flat or even, I guess, slightly up result, you know, or apologies, maybe roughly flattish result. You know, it's actually in a positive contrast to typically when you have, you know, first quarter lower revenues and you are expecting lower revenues sequentially, Q4 versus first quarter. You in the past have kind of pointed to some negative operating leverage, and we've seen a sequential contraction of gross margins anywhere of 100, 200 basis points at times over the last 5, 6, 7 years.

So I was wondering, you know, kind of what happened to that negative operating leverage? You know, if there had been any differences in mix or other drivers, because normally, I think we would have expected some type of sequential step down.

Jeff Kaminski (EVP and CFO)

Right. Yeah, that's a good question, Mike. A couple of things. One, you're not seeing quite the same magnitude of change between our fourth quarter and first quarter as we have in certain years. So, you know, I think it's about $200 million or so at the midpoint, which isn't a tremendous impact on the leverage, but there is some. You know, there is some leverage loss there, but fundamentally, it's just offset by other factors, you know, and where we see the backlog coming through with the mix of deliveries that we expect in the first quarter, they're at slightly higher margins than we've been tracking to.

We did think we'd hit an inflection point in the fourth quarter with a low point of margin, which we have seen, or we do expect, even though it's only up incrementally, still up, and hopefully we'll leave that in the rearview mirror for us. So those are really the two main factors, just a mix of the business. And, you know, I think the other thing is, we used to have a fairly large mix impact between fourth quarter and first quarter between West Coast and some of the other divisions. That's been moderated a bit as we've been trying to rebalance the business.

Frankly, some of the margins in the other regions have come up over the years quite nicely, where we're just not seeing that same type impact on the first quarter.

Michael Rehaut (Managing Director, Senior Equity Analyst, Homebuilding & Building Products)

Right. Okay. No, that's, that's helpful, Jeff. Appreciate that. I, I guess secondly, on the SG&A guide, looking for it to be about flattish or, you know, maybe up 10 basis points year-over-year. And that is, you know, against a revenue range that is flat to up 7%. So I'm just kind of curious, you know, let's, for argument's sake, and I know the midpoint is obviously maybe up 3%, 3.5%. Perhaps you're just, you know, kind of saying relatively modest revenue growth, you know, not a lot of operating leverage. But to the extent that, you know, we were to see the higher end of that range, up 7%, you know, would it be fair to assume or expect some level of modest, SG&A leverage on that scenario?

Or kind of are there other factors that are, you know, would kind of depress that for fiscal 2024?

Jeff Kaminski (EVP and CFO)

Sure. Yeah. So for, you know, for starters, we always estimate, you know, the leverage impacts on both the gross margin, the fixed costs included in the cost of sales, and the impact on gross margin, as well as our SG&A percentage. We always basically calculate those at the midpoint of the ranges. So as we, you know, have beats on the top line, you should be incrementally better on those two metrics, which is, which is the case. You know, as far as the uptick, you know, like, as I mentioned in prepared remarks, we're in a different situation this year in January than we were last year. You know, we were really facing the stiff headwinds of these mortgage rate increases… not quite sure how the year was going to sort out.

We did way better than we thought we were going to, you know, during the, let's say, February, March of last year and where the year ended up. We had a little different approach on expenses. You know, you always get a little more, you're tighter on expenses, you're a little slower in replacing openings, sometimes you freeze head count, regardless of what's happening, you know, with the underlying positions. This year, we're in more of a growth-minded mindset. You know, we anticipate growth in community count. We want to grow the business and continue to take share. We're really happy with what we've seen on cycle times and our ability to take customers from order to close in a much shorter period of time.

So we're just in a more optimistic environment internally, as we look at the market and we look at the company. And then also, you know, I mean, if you want to grow the business, you have to invest in the business. So we're putting a few more dollars into various areas in order to support that growth. So that's... I'd say at the high level, those are the drivers. When you really look at it, I mean, a lot of this, you're almost talking rounding. You know, it's 40 basis points, you know, $6 million or something at the midpoint, so it's not a huge, huge issue.

Like I was saying, on the growth mindset, you know, with the community count going up, we're going to have to spend some money on, particularly advertising and marketing, supporting those new openings. Our openings are up significantly as we plan them today. They're up about 50% over the prior year. We have a lot of work to do, and we want to support it with the right level of expense.

Operator (participant)

Thank you. Our next question comes from the line of Jay McCanless with Wedbush Securities. Please proceed with your question.

Jay McCanless (Managing Director, Equity Research)

Hey, good afternoon. Thanks for taking my question. The first one I had, it seems like you have more tailwinds this year between the cycle time getting better, and sounds like incentives may be coming off a little bit. But could you talk about why you're not expecting any improvement in the full year gross margin for 2024 versus 2023?

Jeff Kaminski (EVP and CFO)

Well, you know, like I said, we forecast it based on current costs, current conditions, and the current market. Even though it's an improved market, we didn't look forward and say, you know, "Let's assume, a large increase or a, you know, significant increase in margins in the third and fourth quarter," reflecting, for example, a reduction in concessions and customer incentives. We didn't want to take that type of an outlook into the forecast, based on a relatively short period of time of improvement. We do expect that improvement to happen. We do, we do, you know, anticipate that we'll see that improving market condition. But, you know, at this point in time, we just wanted to be a little bit cautious with baking that in the future guidance numbers and, you know, leave it up to you guys.

I mean, if you have a more bullish outlook, on the space and you're ready to make that stand right now, then, you know, you can adjust as you think appropriate. But right now, we're forecasting based on what we're seeing in the backlog, what we're seeing in the current sales rates, the type of incentives that we need today, to book our sales. And, you know, our visibility is only about 40% of the year right now with their backlogs. So, the spring selling season will tell us a lot.

I think next quarter's call, we'll be able to dial in on a lot of these metrics, you know, more precisely and hopefully, give you a little bit more detail on what's going on in the markets, and hopefully, talk a lot about the improvements that we're seeing, you know, continue, as we get through the first quarter in the spring selling season.

Jay McCanless (Managing Director, Equity Research)

Thanks. My second question: could you talk about how many communities you were able to raise price in during the quarter? And as part of that, as kind of a two-parter, was the price action in terms of competition from the other builders as frenetic as what you saw in 2022 or in the fall of 2022, or was it a little more well-behaved this year?

Jeff Kaminski (EVP and CFO)

Rob?

Rob McGibney (EVP and COO)

Yeah. So, you know, we didn't have as much pricing action during Q4 as what we talked about in Q3. I think we had 60%-65% of our communities with price increases. Because of mortgage rates going up the way that they did, you know, that just wasn't in the cards. The market wasn't there. We weren't... You know, as we optimize each community and asset, we weren't seeing the need to raise prices to slow down absorption. So, you know, we, I think price increases, maybe it was about 25% of our communities, fairly small increases in the range of $5,000-$6,000 during the quarter. You know, most of what we saw from other builders was incentive action, not necessarily price moves.

Operator (participant)

Thank you. The next question comes from the line of Susan Maklari with Goldman Sachs. Please proceed with your question.

Susan Maklari (Senior Equity Research Analyst)

Thank you. Good afternoon, everyone. Thanks for squeezing me in. My first question is, can you talk a bit about the, just the level of activity you're seeing in the design centers? Anything that's changed there as we've seen the move-in rates?

Jeff Kaminski (EVP and CFO)

Susan, I'm not sure I heard the end of your question. I heard you say design centers, and I didn't hear the rest of it.

Susan Maklari (Senior Equity Research Analyst)

Yeah, I'm sorry. I'm on a train, and so I don't... Can you hear me better now?

Jeff Kaminski (EVP and CFO)

Yes.

Susan Maklari (Senior Equity Research Analyst)

Okay. Yeah, so just wondering if there was any change in the sort of trends that you were seeing in the design centers through the quarter and even into the first couple of weeks of this year, just given the move-in rates?

Jeff Mezger (Chairman, President and CEO)

... Yeah, no, they're very similar to what we saw all of last year, and frankly, the last several years. The spend in the studio has been very consistent. It's moved to more, what I'll call value items, more permanent things, not necessarily finishes, but room layouts and optional islands and things like that. Less Jacuzzis and sizzle stuff, but the spend has been very consistent.

Susan Maklari (Senior Equity Research Analyst)

Okay. And then, I guess, any thoughts, just as we think about this year, availability on the buybacks in there, and just how you're thinking about that relative to perhaps land spend and some of the other larger buckets?

Jeff Mezger (Chairman, President and CEO)

Sure. Well, as you can tell from our balance sheet, Susan, we're in a very strong position right now. And first and foremost, we're always going to be growing the company, and that's where our first dollars would go. But what we saw as 2023 evolved was a lot of idle cash, I'll call it. Nice problem to have, but the cash that wasn't needed to fuel our growth and position us, and we were opportunistic and bought back a lot of our stock. And we've been somewhat programmatic about it for a few years now.

We intend to continue to be active, and the level will be determined based on all the factors Jeff rattled off in the prepared comments on how are we doing on land spend, and how's our liquidity position, how do we look, what's the stock price? And that will influence our behavior, but we do intend to stay in the market and continue to buy stock.

Operator (participant)

The next question comes from the line of Alex Barron with Housing Research Center. Please proceed with your question.

Alex Barron (President and Senior Research Analyst)

Thanks, guys. You know, in the last couple of years with the rising rates, a lot of builders moved more towards offering spec homes, and I guess it was understandable. But now that rates are going down, are you guys seeing more demand for build-to-order? Is there any way you can gauge or measure that?

Jeff Mezger (Chairman, President and CEO)

Well, Alex, we always tilt heavily to Built-to-Order, and it was certainly the case in our deliveries in the fourth quarter as well. It's kind of interesting to me that the debate rages on Built-to-Order versus spec. If you look at our delivery cadence and our revenues, one of the values of Built-to-Order with a backlog is consistency in your results. And if you look back over the last two to three years, our deliveries, quarter after quarter after quarter, are in a very narrow range. We've been 2,800 to 3,300-3,400, no broader than that from Q1 to Q4, from 2021 to 2022 to 2023. So it speaks to the consistency that we've been able to produce, irrespective of what people say about what's a better selling approach.

We still maintain that we get better margins, we have predictability, we can align our land development with our pace of sales and starts, and it's just a far better rhythm and a better way to run the business. So my expectation as you look forward into 2024, we have some inventory to sell, and we always will, but we'll tilt heavily at a 70% Built-to-Order.

Alex Barron (President and Senior Research Analyst)

Great. Well, best of luck. Thank you.

Operator (participant)

The next question comes from the line of Joe Ahlersmeyer with Deutsche Bank. Please proceed with your question.

Joe Ahlersmeyer (Equity Research Analyst)

Hey, thanks a lot, everybody, for the question. I'll actually just batch my questions into one here, given the time. The first one, on the percentage of your land that you own and put under control before land inflation, can you just speak to maybe the development cost inflation that may have come in after that or will continue to come in after inflation took hold in that part of the process? And then, two, if you could just maybe provide a little additional detail on this California tax credit surprise.

Jeff Mezger (Chairman, President and CEO)

Rob, you want to talk to the development cost? And then Jeff can go over tax.

Rob McGibney (EVP and COO)

Sure. Yeah. You know, on the development cost, the vintage of our lots, you know, we've got the majority of our lots going back to 2021 or before, so our land basis is solid. We have seen development cost increase, and, you know, there's been a lot of work, whether it's new home communities being built or the government work that's going on, that's spreading that trade base pretty thin. So there was some pretty significant increases, inflation and development costs. We think that that's settled down now, but it's kind of settled at a higher baseline. Although, you know, when we combine where we are, current development costs on those communities plus our land basis, you know, we're in really good shape for our portfolio of communities and how that all balances out.

Jeff Mezger (Chairman, President and CEO)

Okay, yeah. In relation to the tax credit, the energy credit, it was pretty specific. It was on the homes that had been built in California, really affected the 2023 energy credit relating to those homes. It came from, a little bit of clarification from the IRS in early fourth quarter, where they talked about... where they actually changed the standard for ENERGY STAR specific to California, to a higher standard than we see in other states. So we were assuming the national standard for all of our operations, including our California operations. But once this new guidance came out, we had to make the adjustment to the rate or to the energy credits, which kicked the rate up.

I think it was actually rounded up 1%, but it was less than 1% impact on the tax rate for the year.

Operator (participant)

Thank you. And our final question will come from the line from Jade Rahmani with KBW. Please proceed with your question.

Jade Rahmani (Managing Director, Equity Research Analyst)

Thank you very much. Could you provide any regional commentary on how demand is holding up, specifically on California, and if possible, also Phoenix and the Sun Belt markets? Thanks.

Jeff Mezger (Chairman, President and CEO)

Rob, you want to take that?

Rob McGibney (EVP and COO)

Sure, yeah. You know, since we've seen rates come down, really the pickup in demand has been pretty widespread across our portfolio. The West, California has remained strong, really. They've done really well. Don't have anybody that's a big, you know, concern as far as sales pace or demand out on the West Coast or California. You know, really across the whole portfolio, Texas, Florida, you know, the demand pickup that we've seen since rates started coming down has really influenced sales in a positive direction. So, no real outliers to speak of there, and optimistic about sales here as we progress throughout Q1.

Jade Rahmani (Managing Director, Equity Research Analyst)

Thank you. As a follow-up, the Sun Belt market has really high multifamily supply right now. Any concerns about competition with that, going into the spring selling season?

Rob McGibney (EVP and COO)

Hey, you want me to take that, Jeff?

Jeff Mezger (Chairman, President and CEO)

Yeah. Yeah, go.

Rob McGibney (EVP and COO)

Yeah, I mean, as far as you know, there are a lot of multifamily completions coming online. You know, we're seeing the starts of those multifamily units come down. I mean, they are a competitor to some extent, but we're primarily focused on, you know, resale. That's always our biggest competitor. While resales have been down somewhat, it's created an opportunity for us for new homes, especially on personalized homes. And, you know, we have to stay connected to what's going on with rents because that's an alternative, but we don't really see that as our primary competitor. We think people, you know, they want the American dream, they want to own a home, and we're trying to make those homes as affordable as we can for them to get them into a new one.

Operator (participant)

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