Earnings Call Transcript - KBH Q1 2021

Operator, Operator

Good afternoon. My name is Devin and I will be your conference operator today. I would like to welcome everyone to KB Home’s 2021 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 line for questions. Today's conference call is being recorded and will be available for replay at the Company's website at kbhome.com through April 24th. Now, I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may begin.

Jill Peters, Senior Vice President, Investor Relations

Thank you, Devin. Good afternoon, everyone, and thank you for joining us today to review our results for the first quarter of fiscal 2021. On the call are Jeff Mezger, Chairman, President, and Chief Executive Officer; Matt Mandino, Executive Vice President and Chief Operating Officer; Jeff Kaminski, Executive Vice President and Chief Financial Officer; Bill Hollinger, Senior Vice President and Chief Accounting Officer; and Thad Johnson, Senior Vice President and Treasurer. Before we begin, let me note that during this call, items will be discussed that are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future results and the Company does not undertake any obligation to update them. Due to factors outside of the Company's control, including those detailed in today's press release and in filings with the Securities and Exchange Commission, actual results could be materially different from those stated or implied in the forward-looking statements. In addition, a reconciliation of the non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in today's press release and/or on the Investor Relations page of our website at kbhome.com. And with that, I will turn the call over to Jeff Mezger.

Jeff Mezger, Chairman, President, and CEO

Thank you, Jill. Good afternoon, everyone. We're off to a strong start in 2021 with solid execution in our first quarter that highlights our ability to strike an effective balance between capturing demand in this robust housing market and measurably increasing our margins. We are poised for profitable returns-focused growth this year, based on a number of factors, most notably our backlog, both its composition and size, the success of our newly opened communities, and a compelling lineup of planned openings for the remainder of the year. As to the details of the quarter, we generated total revenues of $1.14 billion and diluted earnings per share of $1.02, up 62% year-over-year. Our housing revenues were at the low end of our guidance range due to the weather disruption in Texas, which shifted some deliveries from our first quarter into our second quarter. Texas is our largest market by units, and the severe weather shut down our operations for roughly 10 days in mid-February. We resumed activity in our communities by the last week of the month, and nearly all of the impacted homes have already been delivered. Our profitability was substantially higher year-over-year with more than a 400 basis-point increase in our operating income margin to 10.4%, excluding inventory-related charges. This result was driven by several key factors: First, strong demand for our personalized products at affordable price points and our success in balancing pace and price; secondly, operating leverage from increasing our community absorption rate and the resulting higher revenues; third, the ongoing benefit from the cost containment efforts we put in place last spring; and finally, the continuing tailwind from lower interest amortization. Our profitability per unit grew meaningfully to over $41,000 in the first quarter, 73% higher than in the prior year period. These results are also generating a healthy level of operating cash flow to fuel the expansion of our scale. In the first quarter, we increased our land investments by 37% year-over-year to roughly $560 million. We grew our lot position by approximately 3,000 lots since year-end to nearly 70,000 lots owned and controlled, and maintained our option lots at 40% of our total. We own or control all the lots we need to support our growth target for 2022. And although we remain opportunistic in seeking additional lots that can provide deliveries next year, we're now primarily approving land acquisitions for deliveries in 2023 and beyond. We are achieving our objectives in growing our lot count with a higher quality portfolio of assets and increasing our returns all at the same time. A healthy tension exists within our division as they work to expand their business while staying on strategy. We have experienced land teams in our markets who have strong local relationships with land developers and sellers. And we continue to see good deal flow that meets our investment criteria. Although every acquisition is different, requiring a tailored set of assumptions regarding the sub-market, the number of lots, the type of product we plan to offer, and the price point, we're generally underwriting our deals to a monthly absorption of between 4 and 5. We're being prudent with our investments yet opportunistic with pace and price, based on market conditions once we open each community. Our longstanding approach has been to underwrite in today's dollars, and as such, our land deals reflect our current ASP as well as our current costs, and assume no future price appreciation or cost inflation. Geographically, we remain in close proximity to where we've been investing in land over the past couple of years, entering neighboring submarkets to grow our scale, but without moving to the more remote submarkets of each city. Our Las Vegas business provides a good example of this strategy. This division has increased its annual deliveries by almost 50% in the last three years and has achieved the number one ranking in the market. We have a large business in Henderson at Inspirada and we are well-established in Summerlin. To expand further, we are investing more heavily in the Northwest and Southwest areas adjacent to our existing submarkets, which still offer good schools, shopping, and amenities at more affordable prices. In terms of deal size, we continue to acquire lots that typically represent a one to two-year supply per community, consistent with our approach over the past several years. We remain on track with respect to our 2021 and 2022 community count goals that we shared with you in January, as we execute our growth plan. In the first quarter, we successfully opened 22 new communities out of the approximately 150 openings we anticipate for this year. As we look to the remainder of 2021, we continue to expect a sequential increase in our earnings count each quarter and year-over-year community count growth in the fourth quarter. We remain well positioned to extend this growth into 2022 and still expect year-over-year community count expansion of at least 10% next year. Our monthly absorption per community accelerated to 6.4 net orders during the first quarter, a year-over-year gain of 39%. We achieved this sales rate even as we raised prices in the vast majority of our communities and managed lot releases in order to balance pace, price, and starts as we optimize each asset. Municipalities have increased their capacity for processing permits, heightening our ability to accelerate our starts, which were up 40% year-over-year in the first quarter. Going forward, we expect to continue matching starts to our order rates. While we have remained sensitive to affordability levels throughout the past year, we have utilized price as our primary mechanism to manage our sales pace and to cover construction costs, which are under some pressure right now. That being said, our ASP expectation for this year reflects only mid-single-digit percentage growth year-over-year. This modest increase in our blended ASP reflects our effective approach to our community location and product positioning to help maintain affordability. By targeting the median household income in each submarket and with our built-to-order approach, we provide the consumer flexibility in floor plan size and price, enabling them to quickly adjust their purchase decision if interest rates increase further. We strive to position our communities below the new home median price and at a reasonable premium to an older resale home. Each of our divisions is aligned with this strategy, and in some cases we're finding that we're actually below median resale levels as well, given the steeper appreciation in price that the existing home market has experienced. We offer floor plans below 1,600 square feet in approximately 75% of our communities. However, the median square footage of our homes in backlog is almost 2,100 square feet, which is consistent with the median footage of homes we delivered in 2020. Buyers are not adjusting the size of the homes they are purchasing, nor have they reduced their spend in our design studios, which tells us that even with the uptick in rates, affordability remains favorable. As to overall market conditions, supply remains tight with existing home inventory down nearly 30% year-over-year. Resale home availability is sitting at record low levels, representing a two-month supply and further below that level in many of our markets. This, combined with the underproduction of new homes over the last decade, has resulted in supply being virtually nonexistent. In terms of demand, mortgage rates, while higher relative to where they were in January, are down year-over-year and remain attractive, generally around the low 3% range for a 30-year fixed-rate mortgage. Most notably, demographic trends are favorable, especially with respect to first-time buyers, as over 70 million millennials are in their prime home-buying years with an even larger Gen Z cohort right behind them now entering their home buying age. As a result of all these factors, but particularly the strong demographics, we believe demand will stay healthy for the foreseeable future. Net orders in the first quarter grew 23% year-over-year to nearly 4,300, a solid result given the strength in net orders that we experienced in the prior year's first quarter. Net orders increased as the quarter unfolded, reflecting typical seasonal trends and remained at high levels exiting the quarter. We produced double-digit growth in each of our four regions, as demand for our affordable price points remained robust across our footprint. We continue to observe trends in our underlying order data that are consistent with the patterns that emerged in the second half of last year. Buyers favored a personalized built-to-order home, and millennials represented our largest segment of buyers. The increasing presence of this cohort in our order activity is naturally translating into a higher percentage of deliveries to first-time buyers, with 65% of our deliveries in the first quarter, up 11 percentage points year-over-year. The pent-up demand among first-time buyers and their ease of mobility is an advantage for us, given our expertise in serving these buyers, along with our locations, products, and price points. We offer features in our homes that today's consumers value. A prime example of these features is our advanced energy efficiency, which helps to lower the total cost of homeownership. We lead the industry in building ENERGY STAR certified new homes, having delivered more than 150,000 of these homes to date, as well as over 11,000 solar-powered homes. As a result of our leadership, we were the only national homebuilder to be named to Newsweek's 2021 list of America's Most Responsible Companies in recognition of our leading ESG practices. We were the first national builder to publish an annual sustainability report. We are excited to share our latest achievements in the 14th edition of our report, which is scheduled for release in conjunction with Earth Day next month. Our backlog value grew substantially in the first quarter to $3.7 billion. The 9,200 homes we have in backlog, together with our first quarter deliveries, represent about 85% of the deliveries that were implied in our full-year outlook we provided in January. With housing market conditions still healthy, our ability to match starts with sales in reasonable build times, we are confident that we can exceed our original volume expectation for this year. This is driving our full-year revenue guidance higher, which Jeff will discuss momentarily. On the mortgage side, our joint venture, KBHS Home Loans, continued its strong execution for our customers. Our JV handled the financing for 79% of our deliveries in the first quarter, up 8 percentage points year-over-year, producing a significant increase in its income. Consistent with the past few years, conventional loans represented the majority of KBHS volume, and the credit profile of our buyers remained very healthy with an average down payment of about 13% and an average FICO score of 724, which is striking, considering our high percentage of first-time buyers. As we continue to accelerate our revenue growth over the balance of this year, we expect our income stream from the JV will grow as well. We are positioned for a remarkable 2021, achieving our objectives of expanding our scale and improving our profitability while driving a meaningfully higher return on equity, which we now anticipate will be above 18%. I'd like to take a moment to recognize the outstanding team of individuals that are producing our strong results. We were gratified to be recognized by Forbes in its 2021 list of America's Best Midsize Employers, again, the only national builder receiving this honor. In closing, we remain mindful that the pandemic is still present. However, we are encouraged by the progress we are making as a country to emerge from it. We are energized by how our year is shaping up and look forward to updating you on our progress. With that, I will now turn the call over to Jeff for the financial review. Jeff?

Jeff Kaminski, Executive Vice President and CFO

Thank you, Jeff, and good afternoon, everyone. I will now cover highlights of our 2021 first quarter financial performance as well as provide our second quarter and full year outlook. We are very pleased with our first quarter results, with higher housing revenues and considerable expansion in our operating margin, driving a 62% increase in our diluted earnings per share. In addition, strong net orders in the quarter combined with our substantial beginning backlog resulted in a 74% year-over-year increase in our quarter-end backlog value, supporting our raised revenue and margin outlook for 2021. In the first quarter, our housing revenues of $1.14 billion rose 6% from a year ago, reflecting increases in both homes delivered and the overall average selling price of those homes. Looking ahead to the 2021 second quarter, we expect to generate housing revenues in the range of $1.42 billion to $1.5 billion. For the full year, we are forecasting housing revenues in the range of $5.7 billion to $6.1 billion, up $150 million at the midpoint as compared to our prior guidance. We believe we are well positioned to achieve this top-line performance, supported by our first quarter ending backlog value of approximately $3.7 billion and our expectation of continued strong housing market conditions. In the first quarter, our overall average selling price of homes delivered increased 2% year-over-year to approximately $397,000, reflecting variances ranging from a 5% decline in our West Coast region to an 11% increase in our Southwest region. The West Coast decline was mainly attributable to product and geographic mix shifts of homes delivered. For the 2021 second quarter, we’re projecting an average selling price of approximately $405,000. We believe our overall average selling price for the full year will be in the range of $405,000 to $415,000, a relatively modest year-over-year increase and a result of our focus on offering affordable products across our footprint. Homebuilding operating income for the first quarter increased 90% to $114.1 million from $60.2 million for the year-earlier quarter. The current quarter included inventory-related charges of $4.1 million versus $5.7 million a year ago. Our homebuilding operating income margin improved to 10.0% compared to 5.6% for the 2020 first quarter. Excluding inventory-related charges, our operating margin for the current quarter increased 430 basis points year-over-year to 10.4%, reflecting improvements in both our gross margin and SG&A expense ratio, which I will cover in more detail in a moment. For the 2021 second quarter, we anticipate our homebuilding operating income margin, excluding the impact of any inventory-related charges, will be in a range of 10.0% to 10.5%. For the full year, we expect this metric to be in the range of 11.0% to 11.8%, which represents an improvement of 310 basis points at the midpoint as compared to the prior year. Our 2021 first quarter housing gross profit margin improved 340 basis points to 20.8%. Excluding inventory-related charges, our gross margin for the quarter increased to 21.1% from 17.9% for the prior year quarter. This improvement reflected the favorable impact of selling price increases outpacing construction cost inflation, increased operating leverage on fixed costs, and lower amortization of previously capitalized interest. Assuming no inventory-related charges, we are forecasting a housing gross profit margin for the 2021 second quarter in a range of 20.5% to 21.1%. We expect our full year gross margin, excluding inventory-related charges, to be in the range of 21% to 22%, an improvement of 70 basis points at the midpoint compared to our prior guidance and up 190 basis points year-over-year. Our selling, general, and administrative expense ratio of 10.7% for the first quarter reflected an improvement of 110 basis points from a year ago, mainly due to the continued containment of costs following overhead reductions implemented in the early stages of the COVID-19 pandemic, lower advertising costs, and increased operating leverage from higher housing revenues. We are forecasting our 2021 second quarter SG&A ratio to be in the range of 10.4% to 10.8%, a significant improvement compared to the pandemic impacted prior year period as we expect to realize favorable leverage impacts from an anticipated increase in housing revenues. We still expect that our full year SG&A expense ratio will be approximately 9.9% to 10.3%, which represents an improvement of 120 basis points at the midpoint compared to the prior year. Our income tax expense of $26.5 million for the first quarter represented an effective tax rate of approximately 21% and was favorably impacted by excess tax benefits from stock-based compensation and federal tax credits relating to current year deliveries of energy-efficient homes, the cornerstone of our industry-leading sustainability program. We currently expect our effective tax rate for both the 2021 second quarter and full year to be approximately 24%, including the impact of energy tax credit relating to current year deliveries. Overall, we reported net income of $97.1 million, or $1.02 per diluted share for the first quarter, compared to $59.7 million or $0.63 per diluted share for the prior year period. Turning now to community count. Our first quarter average of 223 was down 11% from the corresponding 2020 quarter, primarily due to strong net order activity driving accelerated community close-outs over the past 12 months. Consistent with our forecast, we ended the quarter with 209 communities, down 15% from a year ago. We believe our quarter-end community count represents the low point for the year as grand openings are expected to outpace close-outs during each of the remaining quarters. While we expect this dynamic to result in a sequential increase of 5 to 10 communities by the end of the second quarter, we anticipate our second quarter average community count will be down by a low to mid double-digit percentage on a year-over-year basis. We currently expect continued strong market conditions to drive an elevated number of community close-outs during the remainder of the year, resulting in a single-digit year-over-year percentage increase in our community count at year-end. However, we remain very focused on our goal meaningfully growing our community. Given our land pipeline and current scheduled community openings, we are confident that we will achieve at least a 10% increase in our 2022 community count to support further market share gains and growth in housing revenues. During the first quarter, to drive future community openings, we invested $556 million in land and land development, including a 43% year-over-year increase in land acquisition investments to $275 million. At quarter-end, total liquidity was approximately $1.4 billion, including $788 million of available capacity under our unsecured revolving credit facility. We had no borrowings under the credit facility in the 2021 first quarter. Our debt-to-capital ratio was 38.9% at quarter-end, and we expect continued improvement through the end of the year. We still expect strong operating cash flow in the current year to fund levels of land acquisition and development investment needed to support our targeted future growth in community count and housing revenues. Given our current community portfolio and backlog, along with expected ongoing strength in the housing market, we continue to expect significant year-over-year improvement in our revenues, profitability, credit, and return metrics in 2021. In summary, using the midpoint of our new guidance ranges, we expect a 42% year-over-year increase in housing revenues and significant expansion of our operating margin to 11.4%, driven by improvements in both gross margin and our SG&A expense ratio. In addition, achieving our new revenue and profitability expectations will drive a return on equity of over 18% for the year. These expected results reflect our view that continued emphasis on our returns-focused growth strategy will enable us to further enhance long-term stockholder value. We will now take your questions. Please open the lines.

Operator, Operator

Our first question comes from Truman Patterson with Wolfe Research. Please go ahead with your question.

Truman Patterson, Analyst

Hey. Good afternoon, everyone. Thanks for taking my questions. I appreciate it. First, Jeff, orders in the first quarter, I believe you all said were up about 44% in the first six weeks. It looks like they were basically flat in the final six weeks. Could you just really walk us through what's driving this? It sounds like internal initiatives driving pricing or maybe capping production and limiting lot sales. But on the flip side, if I heard you correctly, it doesn't sound like interest rates have had any real negative impact on demand yet. So, if you could just walk me through what's really driving that. And, I don't think I heard a March-to-date order update.

Jeff Mezger, Chairman, President, and CEO

Truman, I can talk to this. And Jeff, pile on. A couple of things are going on with the order comp. As we shared back in January with our year-end call, our January and February last year were very good. And yes, our comp was up 40% at that point in the quarter, but we knew it would come down because last year, frankly, February demand was as good as it is today and our orders were very strong. So, we had a much tougher comp. We had favorable numbers through the quarter. Demand remained strong through the quarter, no signs of slowing up. So, you had this mass on the comp while at the same time, we did take some steps in February, in particular, to slow down sales a bit and capture the price opportunity that's out there. We have a large backlog. We're balancing starts with our sales and our backlog. And we elected to go for more price and more margin opportunity and still generated a pretty significant orders per community for the quarter at 6.4. So, I think that answered your question on the comp. Actually, the comp ended up about where we guided in the first quarter call, because we thought it would come down. We didn't talk specifically to March, and as everyone on the call knows, we had a very disrupted Q2 last year, and for the quarter the comp’s going to be very large. But, it isn't really a reflection on what we're doing now. It's a reflection on the speed bump we had in orders last year. So, rather than give a distorted number, I just share that demand trends remain very strong right now. We're not seeing any impact from interest rates. Affordability is still favorable. And as you'll look at our Q2 from last year, the comp is going to be incredible.

Truman Patterson, Analyst

Okay. And maybe asked another way, you all did a little bit under 4,300 orders, and you're matching starts for orders. Is that a level that you're comfortable with?

Jeff Mezger, Chairman, President, and CEO

Yes. Our starts were up 40% in the first quarter, and we'll continue to keep our starts and our sales in line. If we can keep starts at pace, we will keep selling at that pace.

Truman Patterson, Analyst

Okay. And on your community count, I believe you said at the year-end of '21 up low to mid-single digits, and then in 2022, you're comfortable with 10% gross. Could you just run through what absorptions is included in that guidance? And could you just talk a little bit or characterize the health of the horizontal land developers and the municipalities’ regulatory process? Are you seeing any incremental tightness that might delay some community openings?

Jeff Mezger, Chairman, President, and CEO

Right. I could talk a little bit about the community count, and maybe Jeff, if you want to comment on the land development. But, as far as community numbers go, their largest variable, like always, has been close-outs. Our focus right now is on getting our openings up and running and driving count based on that. If we get to the end of the year and we have some variance in count up or down, it's just going to be a trade-off between the community count and our backlog numbers, frankly. So, if the pace continues at the current levels or even goes higher than what we've seen, we may close out a few more communities that those sales would obviously end up in backlog and not really impact either current year revenues or next year revenues. We think we'll still be around the same number. So, we're just driving towards that. As far as cadence goes, we do expect to see sequential improvement, and not only sequential improvement through the end of the year but out into 2022 as well. And as we're getting deeper into '21, we're starting to really shore up our plans for next year. We have a large number of grand openings on the docket again. And we do expect next year to see the close-outs moderate a little bit as we have some larger lot counts to start the year in some of those communities than we did this year, which will see, I thought, an abnormal number or level of close-outs in the current year. So as we try to forecast that and I guess get back to your original question, we try to consider current absorption pace in the numbers and take into account seasonality a bit in that and do the best job we can on forecasting those close-outs. But actually, the grand openings are much more impactful on the future of the business and the growth in the community count, and the close-outs, those will just be timing.

Operator, Operator

Our next question comes from line of Matthew Bouley with Barclays. Please proceed with your question.

Matthew Bouley, Analyst

Good afternoon. Congratulations on the quarter, and thank you for taking my questions. I want to revisit the sales pace of 6.4. You mentioned that the 10 days in Texas is affecting deliveries. Did it also impact the sales pace? Additionally, Jeff, you're talking about aligning starts to maintain this elevated pace, especially with the 40% this quarter. Has your capacity to initiate those starts changed at all compared to a couple of months ago, considering what's happening with labor and materials? I'm looking for your insights on sales pace in Texas and the starts pace. Thank you.

Jeff Mezger, Chairman, President, and CEO

Thank you, Matt. I’ll share a few thoughts and then I’ll let Matt provide additional insight on capacity. In Texas, the situation in February affected deliveries more than it affected sales. Sales tend to be queued up for some time and can largely happen online; people can complete the process from home or remotely. The challenge for us was with the last set of city finals and appraisals needed once a home is finished. I would say we experienced a small delay in deliveries, but we've successfully closed the majority of them in March. Whether we're discussing land developments or operations, I can confidently state that the industry and municipalities have adapted to navigate this post-COVID landscape. The setbacks we encountered were primarily last summer and fall, and we are now operating much more predictably. We're also actively looking for ways to streamline processes on land development, permitting, and construction, and currently, we're not experiencing any pressure on our capacity. Everything is operating smoothly, and our business is more predictable at this point. Matt, would you like to share some details about build times and our ongoing efforts?

Matt Mandino, Executive Vice President and COO

Sure. As Jeff mentioned, all our divisions are focused on increasing our overall capacity, which involves recruiting more trades and getting them on board. Additionally, as we move through the year, we expect a reduction in cycle time thanks to this added capacity. On the municipality side, as the economy opens up and city staffing improves, we anticipate a decrease in cycle times there as well. While we are facing challenges in this environment, we believe that as we progress, our cycle time, currently around seven months, can improve to our usual six months. We're not factoring in this improvement in our guidance, but we are optimistic about returning to our normal pace.

Matthew Bouley, Analyst

Perfect. No, thanks for the details, for hitting both parts of my question there. Second one on the gross margin, just thinking a little more near-term. The guide suggests a step lower in the second quarter. I'm just curious, to the extent that you're guiding deliveries higher sequentially, so perhaps some greater fixed leverage, clearly the pricing trends have been on the favorable side. Is the expectation that just cost has gotten that much worse, such that the price versus cost is a little less favorable in Q2 or is it more just mix? Any more color on that? Thank you.

Jeff Mezger, Chairman, President, and CEO

Right. Yes, the dynamic between Q1 and Q2 is mainly mix. We ended up beating the first quarter guide in our first quarter forecast by quite a bit. And a lot of that was just the units that were closed. So, we closed higher margin units in the first quarter. Obviously, those will not be closed now in the second quarter and some of the lower margin units will be. So, it's mainly mix. If you really look at the guide for the full year, the second half margin is going to be closer to 22% margin and the first half margin all together for the first six months would be closer to the 21%. And we are seeing improvements sequentially as we go from Q2 to Q3 to Q4. So, actually, the outlook is quite positive and quite favorable as far as continued strength in the margin side. We were quite pleased to be able to lift that guidance by 70 basis points this quarter, based on our backlog, what we’re seeing in the backlog, success of our new communities, and very importantly the pricing versus construction cost inflation dynamic that we've been experiencing and able to control quite effectively up to now.

Operator, Operator

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

Stephen Kim, Analyst

Yes, thank you. We've seen strong results, and I'd say the pricing and sales environment is as robust as it has ever been. Looking back, it seems you could likely sell every home you build. You mentioned that the pricing in the existing home market is rising quite significantly, which I found intriguing. My perspective is that every home sold in that market acts like an auction, whereas builders typically set an asking price and rarely sell above it. However, I've learned that some major builders, in certain communities, are actually taking bids for extra sales, and if a buyer is willing to pay a surcharge of tens of thousands of dollars, they will proceed with the sale. I'm interested to know if you are considering similar strategies or auctions and, if not, why that is the case.

Jeff Mezger, Chairman, President, and CEO

Stephen, that's a good question. For starters, what you're describing is not very customer-centric, and you can get more price on that sale, but you're going to lose brand over time. I'm very sensitive to that because we've got a great brand. What we will do is part of what I touched on with our metered sales releases. What we'll do is drop back to reservations where we can gauge the interest level at different price ranges and do some whisper pricing, if you will. And if we get strong enough interest, we open up for sale at a much higher price. And people are on our waiting list and they go through the waiting list right now. But, I'd rather keep the good relationships with the customer base and the realtor community and go through our process to capture our prices. It's not that we’re taking a lot of price right now. But it's in a controlled way to make sure we retain those relationships with the customers.

Stephen Kim, Analyst

Okay. Have you heard of what I'm describing happening, and is this something that you are actually competing against, or is this something that you have not heard of yet?

Jeff Mezger, Chairman, President, and CEO

To me, it's more of a one-off that was covered on another builder’s analyst coverage. But it's certainly not something we're seeing broad-based or that we would entertain.

Stephen Kim, Analyst

Great. Jeff Kaminski, you provided the guidance for Q2 gross margins. Gross margins seem to be rising unexpectedly fast, almost like trying to catch a balloon. I'm wondering if part of this could be attributed to increased sales in the design studio or other factors that come into play after a home sale, which may not be fully reflected in your methodology. Could that dynamic, which led to a nearly 100 basis-point improvement in gross margin in the first quarter compared to your expectations three months ago, potentially influence Q2 as well? Or do you believe that the unexpected increase we saw in Q1 is not likely to be repeated?

Jeff Kaminski, Executive Vice President and CFO

Right. Look, I'd never say doing better than what we say is not repeatable. There is always potential, which we kind of call on how we see it. We have a large backlog and a pretty consistent backlog that closes. Again, we did see some mix shift in the quarter, and the total units came in a little lower than what we had expected. So, that certainly had an impact. The other impact that we see every quarter is we do have a certain number of units that sell and close within the quarter. So, as you know, we're a built-to-order builder, but typically we'll have 70% built-to-order, about 30% inventory, and of the inventory, about a third of that sells and closes in the same quarter. So, we'll see some variability there. And typically, we'll forecast slightly lower margins on that. And frankly, in the first quarter, the environment was so strong. We didn't really take a haircut on those sales and closing. So, there's potential for that. But again, we call it like we see, and we only cushion that. We're showing up 70 basis points for the full year reflecting the strong sales that we saw in the quarter and the cost containment, everything else all together. So, we stand by our guidance for the second quarter and full year and join the more favorable outlook and more favorable forecast. It's driving not only margins but returns up quite significantly as well for the full year. So, we're happy about that.

Operator, Operator

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

Alan Ratner, Analyst

Hey, guys. Good afternoon, and congrats on the very strong results. Jeff, maybe first question kind of similar to the last one on margin. I was just curious, a few other builders have kind of talked to this idea that as communities close out, they generally generate the strongest gross margins over the life of that project for a multitude of reasons. You've got obviously price appreciation, but also kind of some true-ups of accruals over the course of the life of the project. And you guys are churning your communities quite a bit this year. You're closing out a lot, and you're also opening up quite a bit. And obviously, a lot of new openings probably won't be deliveries until next year. But, I was just hoping you could kind of talk through what impact, if any, that turnover in community count is potentially going to have on your gross margin over the next, call it 12 to 18 months?

Jeff Mezger, Chairman, President, and CEO

One of the deposits relates to the communities we are launching today. When these were underwritten, it was before the pandemic and the market surge, resulting in relatively modest average selling prices. Since then, we've experienced cost inflation, particularly affecting prices. However, the current performance is better than our original projections. Our existing community portfolio reflects similar trends. With improving market conditions, we are noticing enhanced margins. I'm optimistic about the performance of the new communities, as most are exceeding the land book values and contributing to the low-20s gross margins that we are currently achieving. I don't foresee any significant risks from the addition of new communities. Overall, the situation has been positive. Over the past few quarters, we've introduced and closed several communities, and the new ones are maintaining solid margins. The portfolio is strong and showing improvement. I'm pleased with the progress, and since many of our deliveries next year will derive from what I consider pre-pandemic land prices, this bodes well for the overall health of the community portfolio.

Alan Ratner, Analyst

That's very helpful, thank you. My second question is for Jeff. Your built-to-order model has buyers waiting in your backlog for a while, and interest rates have changed. I know you're not particularly worried about that, but I'm curious because your current rate is likely at historic lows. Have you noticed any increased inquiries or calls from buyers in the backlog asking about how to lock in rates or what they can do to secure their rates to avoid potential increases? Is there any indication that there's growing concern among them?

Jeff Mezger, Chairman, President, and CEO

I wouldn't call it a skittishness necessarily, Alan. They are coming in now and asking to lock their rates, which when rates are sliding, they don't like to do. And as soon as the rates are going up, they’ll lock. And the lock program we have covers the time to build the home. So, if they think rates are going up and they want to come in and lock, we accommodate that. Matt, any other color you want to give on that?

Matt Mandino, Executive Vice President and COO

Yes. Alan, taking a look at our pipeline of what we have currently, the percentage of buyers who have elected to lock is 10% to 15%. And that's very comparable to where we were a year ago. So, even with the headlines on the rates and the rate potentially moving up has not triggered our buyers to make an additional step. But, the good thing is we have a program in place; the buyer elects to do that. We can put them in that lot, but have not seen that happen yet, Alan.

Operator, Operator

And our next question comes from the line of Susan Maklari with Goldman Sachs. Please proceed with your question.

Susan Maklari, Analyst

Thank you. Good afternoon, everyone. My first question is, can you talk a little bit about the construction costs that you're seeing? How inflation kind of came through in the quarter? And how you're thinking about that as we look through the next couple of quarters?

Jeff Mezger, Chairman, President, and CEO

Do you want to talk to based on…

Jeff Kaminski, Executive Vice President and CFO

Sure. So, as far as construction costs go, the percentage of overall average selling price, it's remained incredibly steady and constant for quite some time now. So, what we've been saying and doing we continue to see, which is offsetting inflation on the construction cost side with selling prices, and that's working quite effectively. There are concerns, obviously, in a tight market and a hot market like we're seeing now. There's a lot of pressure on the supply chain, both in materials and certain commodity categories as well as in labor. And our pursuing folks are very, very busy right now trying to manage that. And they're doing a really good job. It's very challenging. It's a challenging environment, but they get paid to solve problems and they're solving the problem. So, I think what we're really seeing now is just our ability to just continue to align our long-term relationships, and whether they’re with some of the large national suppliers that we've had in partnership or that we've been in partnership with for a long time or some of the large local labor providers and subcontractors, we've just really gotten tight with the supply base and providing a lot of visibility. We have a big backlog built. So, it's a huge advantage for us. We know exactly what we're building, where we're building it. We share those backlog details with our suppliers so that they can plan accordingly. And it's a tough environment, but so far, so good. And it's a high-class problem. I might rather be facing this than trying to go out and get sales or anything else you could think of. And so far, the operations have been doing, I would say, an outstanding job managing through it, not only getting their deliveries and trying to compress their cycle times, but also controlling as much as possible the inflation on that side of it.

Susan Maklari, Analyst

That's very helpful information. My next question goes back to the topic of higher rates. We've heard that with the savings rate increasing significantly last year, the stimulus money coming in, and the overall rise in home prices, some people moving up or transitioning from one home to another are making larger down payments to counteract the effects of the higher rates. I know you mentioned that your average down payment is around 13%. Have you noticed any changes in that? Are people able to put down more? Is that aiding them in navigating the current rate environment while still accessing the options and upgrades they desire?

Jeff Mezger, Chairman, President, and CEO

Susan, I don't think the 13% has changed significantly in the last couple of years, maybe by a percentage point at most. However, considering that 65% of the buyers were first-time buyers this quarter, and our average selling price is around 400, they're putting down $50,000 on their home purchase. Typically, a first-time buyer would go FHA and put down the minimum since that's all they can afford. But these are financially stable first-time buyers, and we've been focusing on this segment for the last couple of years. Their FICO score is 724, enabling them to borrow more without difficulty. They aren't stressed during the qualification process, and I believe they have some liquidity remaining after closing. Matt, do you have any additional insights on this in relation to studio or...

Matt Mandino, Executive Vice President and COO

Just as you think about the loan product that they're selecting, a year ago, they were 55% conventional, and we're still seeing that. So, there just has not been a significant movement over the last six quarters, the loan that they're selecting. And as Jeff touched on in his comments, this is a high credit score. This is a buyer in a very strong position and ready to move forward. And is this the millennial who waited and has now been able to accumulate a very strong deposit and good credit score? That's what we're seeing.

Operator, Operator

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

John Lovallo, Analyst

Hey guys. Thank you for taking my questions tonight. Obviously, you're performing at a very high level, which is encouraging. I just have a question, just rounding out the affordability conversation here. If we think back to 2018, the economy was improving, home building demand was solid and also improving. Fiscal stimulus was expected to put more money in buyers' pockets and offset the effect of higher rates and ASPs. Everything felt pretty good from a homebuilding standpoint and then the music sort of stopped in the fall. So, I guess, the question is, what were some of the early signs, if you can recall, that things were kind of coming to a head and getting ready to pause, any thoughts around that?

Jeff Mezger, Chairman, President, and CEO

As we look back on it, John, there's a couple of things that are different. Back then, interest rates ticked up more than they have right now, and builders were pushing price. There's a couple of other things going on. One, there is literally no inventory. And back in '18 and '19, inventory was more plentiful and in balance. And I think the maturing of the millennials starting the family and saving the money, there's significantly more demographic demand today than there was back in '18 and '19. And we've shared the story when we saw the slowdown, I would say our traffic probably ticked down a little or people took a little longer to buy; you'll see things like that. But we quickly move to reposition our model parks to smaller homes that were lower priced, more affordable, where we would go from a 2,200-foot model down to a 1,700 or 1,800-foot model, put it into a model park, it would have a similar room count, albeit slightly smaller rooms, but would live the same, and we were ready for this affordability crunch, and the buyer came back after about 120 days. I think it was more the adjustment to the rate at the time because rates didn't come back down when our sales picked up again. And so, we were positioned for a tougher affordability environment. And the buyer came right back, rates then did come down, and we didn't need to take advantage of what we have done, and our average home size today is similar to what it was back in '18 and '19. But we're well positioned if it were to happen again because we still have the product out there and can move just as quickly. And we've actually done a lot of look-back research right now because this is so topical. And if you look at many of our markets, we took the same communities where we've moved price, but rates are lower. And in some cases, the payment right now year-over-year is up $30. I think the worst one I saw was up $180 in that community. So, this move with interest rates, while it's come up a little bit, it's still pretty compelling out there, and affordability is still, as I said in my comments, very favorable.

John Lovallo, Analyst

Okay. That's helpful, Jeff. And then, maybe one other one. I think you mentioned that your land purchases are pretty consistent with recent history at sort of one to two-year supply per community. One of the things that we've heard from folks in the field is that other builders may not be being quite as disciplined and are buying lots of greater size and paying up quite a bit for some of these lots. Are you seeing any of this kind of land grab in any of the markets that you're competing in?

Jeff Mezger, Chairman, President, and CEO

Well, we are seeing larger purchases occur, and if somebody wants to do that, that's their strategy. Hopefully, it works out for them. We like our approach. We like to be in the community, make your money being a homebuilder, turn the asset, move on. And we think over time, that's part of why our return on equity is increasing so well, where we're now up north of 18%, and we call it returns-focused growth. And if you can keep turning your assets, generate your profits, generate your cash, move on to the next one like we've effectively done, you can get to very nice returns along the way. We think our approach is the right one.

Operator, Operator

Our next question comes from the line of Michael Rehaut with JP Morgan.

Michael Rehaut, Analyst

Just a couple of questions here, maybe more clarifications. On the guidance, I was just curious about the raising of the revenues, which is obviously encouraging, given some of the timing issues in the first quarter, second quarter. But, at the same time, I found it interesting that you did not lower SG&A, which typically all else equal would have some operating leverage against that higher revenue. So, any comments around that would be helpful.

Jeff Mezger, Chairman, President, and CEO

The impact of the $150 million raise on leverage is not very significant. We are focused on preparing and scaling the company to a larger size. As we expand the business, we're also increasing our resources simultaneously. You may notice a rise in SG&A as the year progresses, especially with many new communities set to open. We plan to launch about 150 communities this year, which is roughly a 50% increase compared to last year. This represents a substantial escalation over the past two to three years, and it does require some additional upfront expenses. However, we are experiencing good leverage and anticipate a reduction in SG&A in the second quarter compared to the same period last year. Throughout the full year, we expect to make progress on the SG&A front as well, which we are pleased about. This is contributing to a strong operating margin as we advance through the year. We will keep looking for opportunities to manage costs in SG&A while our primary focus remains on scaling the operating model. We are committed to investing in this scaling process and are currently experiencing success, particularly on the order and construction sides, where our starts align with our sales pace. We aim to continue supporting this growth with company resources in the future.

Michael Rehaut, Analyst

That's great, Jeff. Thank you for that. Secondly, I wanted to focus on current demand trends. It's been discussed a lot during this call, and you've mentioned that you haven't really seen any impact from rates so far. Demand trends remain strong. Given that you achieved 6.4 orders per month per community in the first quarter, should we expect something similar or even slightly stronger as we typically see some improvement during the spring selling season? Is that a fair expectation? Clearly, you're aiming to align sales pace with starts, so maybe we're hitting a capacity limit on starts and can expect a similar sales pace. I'm trying to understand how we should approach the second quarter in this context because, as you've pointed out, demand remains strong, and you want to maintain the current starts pace. Logic suggests that you might be able to achieve a similar or slightly stronger sales pace due to the seasonal improvement.

Jeff Mezger, Chairman, President, and CEO

Michael, there's a couple of things to qualify that. If market conditions remain as they are today, we'll continue to be opportunistic and frankly take pace in price like we did in the first quarter. If you think of our business model and our stated blended absorption is 5 a month, and the spring is a stronger time a year, but average 5 a month for a year, you're going to be 6, 6.5 in our second quarter. So, I think, it's fair to assume similar absorption to what we saw in Q1. And at that level, we hit the starts everywhere, and we're in a nice balance and a nice rhythm to deliver on the year and set up growth for '22. I think that's a reasonable assumption.

Operator, Operator

And our final question comes from the line of Mike Dahl with RBC Capital Markets.

Mike Dahl, Analyst

Hey. Thanks for squeezing me in. And I appreciate the color so far. I guess, Jeff, just a quick follow-up on that. I wanted to ask about just how the kind of phasing of lot releases plays into the pace? And maybe if you could give any quantification around what percentage of your communities you've shifted to a phased release model? And anything around kind of what those phases or timing of those phases actually look like compared to, say, three or six months ago, if they're either shorter or longer periods in between when you release the next set of lots?

Jeff Mezger, Chairman, President, and CEO

Matt, do you want to take that?

Matt Mandino, Executive Vice President and COO

Sure. As we evaluate our business, we consider each community and the terms under which we structured each deal. We will adjust as we progress and occasionally limit some of the releases within a specific week. However, this varies by community and is subject to change. I don’t mean to be unclear, but in some instances, we may choose to continue at an increased pace if we acquire an additional community in the same submarket. If that community is advancing and will be established, we will proceed with the current community at a slightly faster pace. Therefore, this involves a weekly analysis and review of each community that I conduct with all our division presidents to manage it effectively while also ensuring that we are positioning ourselves for growth throughout the year. Mike, I'm not sure if that answered your question, so please feel free to ask for clarification if needed.

Mike Dahl, Analyst

Thank you, Matt. For my second question, I understand you have discussed extensively throughout the call about managing costs and pricing, particularly how your pricing exceeds costs based on the margin guidance. I would like to know more about your overall average selling price, which is expected to increase by 5% this year. There seems to be some mix impact involved. Could you provide any quantification on the underlying price trends per square foot, or any other methods to normalize that information to help us better understand the true core pricing power?

Jeff Mezger, Chairman, President, and CEO

The main factor driving costs has been lumber, as everyone is aware. Beyond that, there have been fluctuations in other commodity categories, including labor costs, but these haven't significantly impacted overall costs. The primary focus on cost has been on lumber, which is a commodity subject to future pricing. It's anticipated that lumber prices will decrease throughout the year, although the timing is uncertain. Our cost percentage relative to the average selling price is expected to remain stable throughout the quarters. However, there is significant variability with lumber prices. Ultimately, I believe the challenges with lumber will become a more favorable factor for the industry than we've seen so far, with potential limits on price increases. While I'm uncertain about that cap and the timing, I'm confident that prices will stabilize to more familiar levels, with potential upside to follow. For now, I’m satisfied with how we’ve managed costs amidst lumber pressures, allowing us to maintain construction operations. We're in a good position to control costs while expanding margins and mitigating cost inflation. Therefore, I am not overly concerned and have enough confidence to raise our margin guidance for the year. We are feeling more optimistic about profitability compared to three months ago.

Operator, Operator

And with that, this concludes today's question-and-answer session as well as today's conference call. You may now disconnect your lines at this time. Thank you for your participation. And have a wonderful day.