Earnings Call Transcript - KBH Q2 2021

Operator, Operator

Good afternoon. My name is Alex and I will be your conference operator today. I'd like to welcome everyone to the KB Home 2021 Second 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, kbhome.com through April 03. Now, I'd 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, Alex. Good afternoon, everyone, and thank you for joining us today to review our results for the second 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. 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. Before I turn the call over to Jeff, I will note that year-over-year comparisons should be considered in the context that our performance in the 2020 second quarter was significantly and negatively affected by the broad economic downturn and the extensive public safety measures put in place across the country beginning in March due to COVID-19 pandemic. And with that, here is Jeff Mezger.

Jeff Mezger, Chairman, President and Chief Executive Officer

Thank you, Jill, and good afternoon. We delivered healthy results in the second quarter marked by one of the strongest quarters for both operating and gross margin performance in some time. Operationally, our divisions are doing an excellent job of navigating this environment of demand strength and well-publicized supply chain constraints as we effectively balanced pace, price, and starts to optimize our assets and manage our production. With our full year coming into better view, we are poised for continued return-focused growth, expanding our scale to about $6 billion in revenue and generating a return on equity of roughly 20%. As for the details of the quarter, we produced total revenues of $1.44 billion and diluted earnings per share of $1.50, which is an operating income margin of 11.3% driven by several factors. In addition to strong market conditions, we're benefiting from solid performance in our newer community, operating leverage from both the increase in our community absorption rate as well as overall higher revenues, disciplined management of our SG&A costs, and the ongoing tailwind from lower interest amortization. Our profitability per unit grew meaningfully on a sequential basis to nearly $47,000. We achieved or surpassed our expectations across our financial metrics although deliveries were at the low end of our range as some of our deliveries shifted into the third quarter due to supply shortages and municipal delays. That said, with the benefit of local scale in most of our divisions, we are relying on our long-standing relationships with subcontractors and trade partners to mitigate delays. With the progression of our work-in-process and our success in accelerating starts, we are confident in our ability to achieve full year deliveries of between 14,000 and 14,500 homes. Our balance sheet is solid; as we work through the bulk of our inactive assets, our inventory is rotated into a higher quality portfolio of communities. We've grown our equity while reducing our debt resulting in a significantly lower leverage ratio which we expect will decline further by year-end. We recently completed a $390 million debt offering, the net proceeds from which together with a portion of our existing cash will be used to retire our '21 maturity in full. Ultimately, the offering will contribute to a reduction of our debt levels and lower our average borrowing rate providing an ongoing tailwind to our future margins. We continue to allocate the substantial cash we are generating in a consistent manner, prioritizing our future growth to drive greater earnings and returns. In addition, our balanced approach includes returning cash to stockholders primarily through our quarterly dividend which we raised in each of the past two years and reducing our debt as I just mentioned. In the second quarter, we invested $575 million in land acquisition and development, expanding our lot position sequentially by 7,800 lots to roughly 77,500 lots owned or controlled with 45% of the total optioned. This growth in active inventory together with improving margins should help to drive further improvement in our return on equity. As we discussed last quarter, we are assuming a lower monthly absorption in our underwriting as compared to our current pace and no inflation either in ASP or costs. In addition, we're pursuing moderately sized deals in our preferred sub-markets, averaging between 100 and 150 lots and staying on strategy and positioning these new communities to be attainable near the median household income for that submarket. We believe using a disciplined approach helps to manage our risk as we acquire land throughout a cycle. While we expect our near-term growth to come primarily from our existing markets as we work to gain market share and expand our scale, we are also selectively entering new markets. Along with our success in Seattle and recent re-entry into Charlotte, we're announcing today that we've started up a division in Boise, Idaho, a top 25 housing market. We see a meaningful opportunity in this fast-growing metro area to offer our personalized homes at affordable prices and we are excited about extending our market strategy to Boise. We now have over 900 lots under control and anticipate our first land parcel closing in the third quarter. We successfully opened 33 new communities in the second quarter. However, as a result of the heightened demand for our homes, we sold out of more communities than we had projected and also experienced slippage in some community openings. Jeff will provide more detail on our community count expectations for this year in a moment. Looking forward to 2022, with our strong lot pipeline, we remain on track for double-digit year-over-year community count growth. As we prepare for the significant acceleration of new community openings over the next six quarters, we've also stayed focused on building our backlog to drive our revenues for the balance of this year and into 2022. Our monthly absorption rate rose to seven net orders per community during the second quarter, even as we managed sales primarily through price increases and secondarily through lot releases in order to balance pace, price, and starts. We are sensitive to affordability as we work to stay with an appropriate range near the median household income of each submarket; our order ASPs climbed in the past three months reflecting a combination of mix as well as rising prices. Our largest sequential net order increase was in our West Coast region. Although this region carries our highest average selling price, it remains competitive with resales within our submarkets. Our Los Angeles Ventura business provides a good example. This division generated the strongest sequential order growth in the second quarter and although it operates at a higher ASP, it is still below the median resale price of homes in its submarkets which are as much as $100,000 higher and selling within a few weeks of being listed. Resale prices have moved significantly and our relative position has actually been enhanced. As to lot releases, our approach is similar to how we gauge interest in a new community. Homebuyers complete an application and go through their initial credit process to join a list of qualified buyers. We then work through that list as we release lots. We are typically raising prices in conjunction with each lot release and have not seen a decrease in the conversion of qualified buyers even as prices have risen. Our teams work hard to earn our place as the number one customer ranked national homebuilder in third-party customer satisfaction surveys by prioritizing service and the relationships we have with our buyers, and we're focused on continuing to do so during this time of limited supply. The metrics that we monitor internally for shifts in affordability are stable. Buyers are not adjusting the size of the homes they are purchasing to stay in the market. Although we offer floor plans below 1,600 square feet in over 75% of our communities, buyers are still selecting homes averaging 2,100 feet, which is consistent with their choices over the past couple of years. As is evident in our results, the desire for homeownership is strong, and we believe will remain so for the foreseeable future. There are two primary factors informing our view. The first is an acute shortage of supply stemming not only from limited resale inventory, but also from the underproduction of new homes over the past 15 years. This deficit will take many years to correct and until the inventory reverts to more normalized levels, the imbalance between supply and demand should continue to support new home sales. Another key factor is demographics. The size of the millennial population and the pent-up demand from this cohort together with the Gen Zs now reaching their homebuying years form a large and healthy pool of prospective buyers. These demographic groups value personalization and we believe we are well-positioned to capture increases in home sales, given our expertise in serving the first-time buyer which represents 64% of our deliveries this past quarter with our built-to-order approach. Net orders were 43,000, our best quarter since 2007 with strength throughout the quarter resulting in year-over-year growth of 145%. This compares to narrow at the end of May when we experienced a significant acceleration in order rate that has lasted for the past year. We are matching starts to sales, and in the first half of this year we have quickly scaled up our production to start over 8,500 homes. To put this in context, the homes we started in the past two quarters represent about 75% of the total homes we started for the full year 2020. Almost 95% of the homes in production are already sold and we remain committed to our build-to-order business model. We value the visibility that our even slow production provides and the flexibility that it affords in positioning our communities to move up demand. Offering a personalized home creates meaningful differentiation for our company, which we view as an advantage because buyers value choice. Nearly 80% of our orders in the second quarter were for personalized homes, which also creates an additional revenue stream from our design studios and with lot premiums. Our studio revenue per unit rose sequentially in the second quarter and continues to average about 9% of our higher base prices. We continually monitor the frequency of studio selections and have been raising prices on some products, enhancing an already accretive studio margin. As to lot premiums, we've found over time that clients can pick the home they want and build that home on a lot they choose; they are willing to pay for that choice, and we can generate additional revenue. Every incremental dollar lot premium has an additional dollar of margin. Between studio revenue and lot premiums, we are averaging about $40,000 per home today and believe there is opportunity to continue to grow this going forward. We entered the quarter with a robust backlog value of $4.3 billion, up 126% year-over-year, representing over 10,000 homes. As I referenced earlier, our backlog supports the higher revenues we anticipate this year and sets the stage for another year of revenue growth in 2022. KBH's Home Loans, our mortgage joint venture, continues to be a solid partner for our customers entering the financing for 75% of the homes we delivered in the second quarter. These buyers have a strong and consistent credit profile with an average down payment of about 13% or over $50,000 and an average FICO score that ends up at 727. The majority of our buyers are asking for conventional loans similar to the past few years. Switching gears, we published our 14th annual sustainability report in April, the longest-running report in our industry. We've been on this journey for over 15 years and the commitment we've made to sustainable homebuilding has resulted in KB Home being the industry leader in energy efficiency. We've built over 150,000 energy-star certified homes today more than any other builder and have the lowest published average home energy rating system or HERS index score among production homebuilders, and we are striving to be even better with an aggressive goal to further improve our average HERS score from 50 down to 45 by 2025, a level which translates into an estimated reduction in KB Home's carbon emissions of about 8% per year. In closing, we are poised for incredible year of expansion in revenues, margins, and return on equity as we execute on our ongoing plan to increase our scale while driving a higher ROE. Equally as important, we are positioned for a strong start to 2022 with the expected increase in our year-end backlog and projected community count growth next year. We're pleased with how this year is unfolding and look forward to updating you on our continued progress. I am appreciative of the hard work and commitment of the entire KB Home team, and I want to thank them for their efforts as we navigated through the challenges brought about by the pandemic while never wavering from delivering high levels of customer satisfaction throughout this past year. With that, I'll now turn the call over to Jeff for the financial review.

Jeff Kaminski, Executive Vice President and Chief Financial Officer

Thank you, Jeff, and good afternoon, everyone. I will now cover highlights of our financial performance for the 2021 second quarter and provide our current outlook for the third quarter and full-year. During the quarter, we generated improvements in all our key achieved profitability measures and continue to enhance our balance sheet strength and liquidity. With our operations performing well, we leveraged 58% growth in housing revenues to generate a 216% increase in operating income for the quarter. In addition, our net orders reached their highest second quarter level in 14 years. Based on our robust financial results and net order performance, we're once again raising our outlook for the remainder of 2021. Our housing revenues of $1.44 billion for the quarter increased from $910 million in the prior year period reflecting a 40% increase in homes delivered and a 13% increase in overall average selling price. Considering our current backlog and construction cycle times, we anticipate our 2021 third quarter housing revenues will be in the range of $1.5 billion to $1.58 billion. For the full year, we're projecting housing revenues in the range of $5.9 billion to $6.1 billion. We believe we are very well-positioned to achieve this topline performance due to our strong second quarter net orders and ending backlog of over 10,000 homes, representing nearly $4.3 billion in backlog value. In the second quarter, our overall average selling price of homes delivered increased to nearly $410,000, reflecting strong housing market conditions, which enabled us to raise prices in the vast majority of our communities, as well as product and geographic mix-shifts of homes delivered. For the 2021 third quarter, we're projecting an overall average selling price of $420,000. We believe our ASP for the full year will be in the range of $415,000 to $425,000. Homebuilding operating income significantly improved to $162.9 million as compared to $51.6 million in the year earlier quarter, reflecting an increase of 560 basis points in operating income margin to 11.3% due to meaningful improvements in both the housing gross profit margin and SG&A expense ratio. Excluding inventory-related charges of $0.5 million in the current quarter and $4.4 million of inventory-related charges and $6.7 million of severance charges in the year earlier quarter, this metric improved to 11.4% from 6.9%. We expect our homebuilding operating income margin, excluding the impact of any inventory-related charges, to further improve to a range of 11.7% to 12.1% for the 2021 third quarter. For the full year, we expect our operating margin excluding any inventory-related charges to be in the range of 11.5% to 12.0%. Our housing gross profit margin for the second quarter expanded to 21.4%, up 320 basis points from the prior year period. The current quarter metric reflected the favorable pricing environment over the past several quarters, when most of the orders relating to the second quarter deliveries were booked, increased operating leverage due to higher housing revenues, and lower amortization of previously capitalized interest. Excluding inventory-related charges, our gross margin for the quarter increased to 21.5% from 18.7% for the prior year period. Our adjusted housing gross profit margin, which excludes inventory-related charges as well as the amortization of previously capitalized interest, was 24.2% for the 2021 second quarter compared to 21.9% for the same 2020 period. Our continued gross margin improvement trend demonstrates that we have been successful in offsetting the input cost inflation with slight price increases. In addition, with our strategy of locking in material and labor costs at the time each home starts, we have largely mitigated the impact of cost inflation during the construction process. Assuming no inventory-related charges, we expect a sequential increase in our 2021 third quarter housing gross profit margin to approximately 21.7% and further improvement in the fourth quarter. Considering this expected favorable trend, we believe our full year housing gross profit margin, excluding inventory-related charges, will be within the range of 21.5% to 22.0%, representing a 215 basis points year-over-year increase at the mid-point. Our selling, general, administrative expense ratio of 10.1% for the quarter improved from 12.6% for the 2020 second quarter. The 250 basis point improvement reflected the continued benefit of overhead cost reductions implemented last year in the early stages of the pandemic, increased operating leverage from higher revenues, and the severance charges in the year earlier quarter. Considering anticipated increases in future revenues and our continuing actions to contain costs, we believe that our 2021 third quarter SG&A expense ratio will be approximately 9.8% and our full-year ratio will be in a range of 9.8% to 10.2%. Our income tax expense for the quarter of $30.3 million, which represented an effective tax rate of 17%, reflected the favorable impact of $14.8 million of federal energy tax credits recorded in the quarter, relating to qualifying energy-efficient homes. We expect our effective tax rate for the full year to be approximately 20%, including the expected favorable impact of additional federal energy tax credits in the third and fourth quarters. Overall, we produced net income for the second quarter of $143.4 million or $1.50 per diluted share compared to $52 million or $0.55 per diluted share for the prior year period. Turning now to community count, our second quarter average of 205 communities decreased 17% from the year earlier quarter. We ended the quarter with 200 communities as compared to 244 communities at the end of the 2020 second quarter. On a sequential basis, our average community count decreased 8% for the first quarter and ending community count was down 4%. The decreases were due to our strong absorption pace of seven monthly net orders per community during the quarter, which drove 42 close-outs, as well as community openings that were delayed to the third quarter. Over the past 12 months, our robust absorption pace has driven the closeout of over 150 selling communities. Although they will not generate additional net orders, we will continue to produce revenues and profits in future quarters associated with nearly 80% of the sold-out communities, as we work through the construction and delivery of the sold homes. The upside from our strong pace of orders is now reflected in our backlog, which will drive increased future housing revenues. Our expectation of continued strong net order activity will drive elevated models of community close-outs in the second half of this year. Our goal is to offset the impact of these close-outs by opening a higher number of new communities in both the third and fourth quarters to achieve sequential growth. We anticipate our 2021 third quarter ending community count will increase sequentially by approximately 5%, followed by another modest sequential improvement in the fourth quarter. With our significant year-over-year increase in lot supply and our focus on developing and opening new communities as quickly as possible in the next six quarters, we believe we can achieve sequential increases in our quarter-end community count over that period. We remain committed to our target of double digits year-over-year growth in community count for 2022. Favorable operating cash flow in the quarter, generated primarily from homes delivered, net of higher levels of land investment, resulted in quarter and total liquidity of approximately $1.4 billion, including $608 million of cash and $788 million available under our unsecured revolving credit facility. Earlier this month, we completed the $390 million issuance of 4%, 10-year senior notes, and used a portion of the proceeds to redeem approximately $270 million of tendered 7% notes that mature on December 15, 2021. We expect to realize the charge of approximately $5 million for this early extinguishment of debt in the third quarter. It is our intention to redeem the remaining $180 million of the 7% acknowledged at par value on September 15. Once completed, this redemption, partially offset by the new issuance will result in a net $60 million reduction in debt and an annualized interest savings of nearly $16 million contributing to our continuing trend of lowering the interest amortization included in future housing gross profit margins. In addition, we believe the $350 million of our maturity in 2022 of 7.5% senior notes represents another opportunity to reduce incurred interest and enhance future gross margins. In summary, given the size and composition of our quarter and backlog of over 10,000 homes, along with our expanded production capacity, we expect further improvements in our financial resolves and return metrics in 2021, as compared to our expectations at the time of our last earnings call. Using the mid-points of our new guidance ranges, we now expect a 45% year-over-year increase in housing revenues and further expansion in our operating margin to 11.75%. This profitability level should drive a return on average equity of approximately 20% for the full year. We believe our emphasis on return-focused growth will continue to drive improved financial results, increased scale, and higher returns to further enhance long-term stockholder value.

Operator, Operator

Our first question comes from Matthew Boulay with Barclays. Please go ahead with your question.

Matthew Boulay, Analyst

Hey, good afternoon. Congrats on the results. Thanks for taking the questions. First one on the pricing relative to resell at a market level, Jeff, you gave some great color there on the LA Ventura markets. Curious if you could expand a little bit on that point because I think it is an important point, but perhaps you could maybe walk around some of your markets, just any other interesting anecdotes or quantification on how your product is comparing versus resale in this clearly an environment where resell prices continue to move much higher? Thank you.

Jeff Mezger, Chairman, President and Chief Executive Officer

Sure. Well, thanks for the question and the comments, Matt. It's a different story in every sub-market as you know around the country, but the pricing on resale homes in most of the sub-markets we're in is moving pretty dramatically, primarily because there's no inventory on the resale side either, but a lot of the headline coverage of homebuilding has been talk about how much our prices have moved and they ignore how the resale pricing, which is our biggest competitor is moving as fast if not faster, and we're sensitive to affordability as I shared in my comments, and we're also always mindful of how we are positioned versus the resale market. Whatever our prices are up in the submarkets we operate in, the resales are up at a similar level, if not higher. In many cases, we're actually enhancing our position. So a specific city doesn't come to mind. I can tell you in general, every city we operate in, resale prices are moving as quickly, if not quicker than the new home side where builders are mindful of affordability and while we're opportunistic, we may not be as opportunistic as resales because we're mindful of that.

Matthew Boulay, Analyst

Wonderful. That's really great color there. The second one, obviously in an environment of production constraints, you talked about I believe you said 8,500 starts year to date. And correct me if I'm wrong, but if that equates to roughly six to seven starts per month per community, should we think of that as kind of your ongoing production capacity? And therefore, could you continue to sell at that pace if demand is there as you mentioned seven selling pace this past quarter or conversely, should we think of some more normal seasonality in general to demand perhaps rearing its head again this year? Thank you.

Jeff Mezger, Chairman, President and Chief Executive Officer

Yeah, Matt, it's an interesting topic and you've followed us for a while. And if you go back over the evolution of the past few years in our business, we worked hard to lift our margins and get our margins back up to normalized levels and we've now done that. There were years when we put a cap on how many we would sell and opted for just margin, until we could get our margins up, and when we did that, our construction machine had the capability to build more houses, but we were pushing on the price and the margin pedal a little harder. Over the last year, obviously, incredible demand and a strong selling environment and we've been letting out the string, if you will, on sales because our margins are strong and improving and we have the capability to build more. So I felt it was important to communicate in my comments that we're not selling out ahead of starts. We're selling and starting that up at a comparable level around the system. And my hunch is that everybody will have a different crystal ball; it wouldn't surprise me if the sales slow a little bit through the summer. I think we slowly revert back to a normal home sales environment. I don't know what we'll do each month of the third quarter, but we don’t need to do seven to hit our growth target, but if we're in a community where the market is strong and we have the ability to start that many homes a month and we're lifting our margins, we will take advantage of the opportunity. So to wrap that up, we may not sell at seven in this quarter; we'll see how the market conditions are and how things operate. But we have the capability to build at that level and again, I thought it was important to make sure every investor understands that our construction machine has more capacity than we had demonstrated in the last few years.

Operator, Operator

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

Stephen Kim, Analyst

Thank you very much. You mentioned that your production has ramped up to about 18.5%, which I assume corresponds to your initial output this quarter multiplied by four. You also indicated that your production is aligned with your sales pace. I want to clarify that it appears you are not planning to delay the timing of your home sales in relation to the construction cycle; you seem satisfied with the current approach. Can you clarify what that level is right now? At what stage of construction would you say you are selling your homes?

Jeff Mezger, Chairman, President and Chief Executive Officer

Yes, good question Stephen. The cycle time, as we call it, we're averaging today 45 to 60 days from contract to start and five months, a little over five months depending on the city for the build times. So it's a seven to 7.5 month cycle from contract to close. We continue to really prioritize, sell it, get the loan approved, let the buyer pick everything at the studio and then start the home, and that's our business model. And I believe over the long run that will prove out to be the best returns, the lowest risk; you can take the argument that while you can sell it more down the road if you hold off on releasing it, but we'd rather have certainty of close, visibility of margin, and keep the balance to our business. So we're continuing to sell them and then start them. And every city has got a different strategy on how far out you sell to set up your pipeline in your construction within that city.

Stephen Kim, Analyst

Great. Yes, that's really helpful. So just to clarify, you're definitely adopting a strategy where you do not want to emulate certain competitors in the market who are intentionally selling homes later in the construction process. You believe that while you might be underpricing the market in the short term, the risk-reward balance favors a consistent approach in the long run. I just want to ensure that I've expressed that correctly.

Jeff Mezger, Chairman, President and Chief Executive Officer

Yes, that is our view Stephen. I'd rather know when we start the home; we know what the margin is when we start the home, our costs are locked. So you have a little risk between the contract and the start is something weird happens on your cost structure. And you may give up a point or two in price versus down the road, but you're also not exposed to that nasty incentives word, if you get the home completed and it hasn't sold and we've seen that movie. So we like knowing when we start the home, it's going to close. And we know what the margin is, and it's predictable for our contractor base and it helps us in our forecasting.

Operator, Operator

Thank you. Our next question comes from Truman Patterson with Wolfe Research. Please proceed with your question.

Truman Patterson, Analyst

Hey, good afternoon, everyone. Just wanted to touch on some affordability, very strong margins, strong pricing. It looks like, as of the fourth quarter, you're getting more than enough pricing to cover all the spot costs today and lumber has come back in or at least lumber futures have come back in. If inflation levels are off in the back part of the year as you're attempting to bring on more communities, how should we think about pricing? Are you all going to step off the gas a little bit to try and maintain affordability or is it truly just kind of pricing the market without really concern for potentially rising interest rates?

Jeff Mezger, Chairman, President and Chief Executive Officer

Yes. When a community is open, Truman, we'll price it to the opportunity. Before we open a community, we create interest while we call and intend; we can figure out where demand is and where the price can be and if it's above your pro forma, you'll take the higher price and you'll run. And so we're opportunistic once we're open in that submarket. When it comes to the investment in the new community in a submarket, we're very mindful of affordability and household incomes and we need to be attainable and we can move around with lot size or the size of the homes that we offer in a model park to get close to that median income and then if you open up and demand is stronger, you take advantage of the opportunity. So it's per community and its pricing to market, not necessarily to cost. So if we can be opportunistic, we'll take it.

Truman Patterson, Analyst

And then I don't know if there is any way you can help us out with this to quantify how deep the buyer pool is. I know you all have interest lists or waitlists. Have you seen those change at all compared to maybe a few months ago? Are you seeing any buyer pushback or fatigue from recent price increases? Just trying to understand how deep that buyer pool is?

Jeff Mezger, Chairman, President and Chief Executive Officer

Yes. So I shared in the comments, Truman, the markets are very strong today, and we may spend two to three months developing an interest before we grand open a community, and within that two or three months period, you can get hundreds of people on a waiting list and the early entry to the waiting list then are going to see the prices move more than the later entries on the waiting list, and we've had some cases where somebody is pretty cloud and okay we opened for sale and they don't like the price and they say, never mind, I don't want it. But there is many people buying and saying, I'll take it, let's write it up today as the prices have increased, but as I shared in my comments, as we're releasing lots for sale today at the higher prices per phase release, we're not seeing a tapering in demand. It may be off a little bit from the strength that was in March, but in March, it was really, really strong and now it's just really, really strong. It's a very good market environment out there today.

Operator, Operator

Thank you. Our next question is from Alan Ratner with Zelman & Associates. Please proceed with your question.

Alan Ratner, Analyst

Hey guys, good afternoon. Thanks for taking my questions. Jeff, first question, I just want to clarify. So I think you made a comment earlier on that from the time you start the house you have kind of certainty of costs. And then you said afterwards that your typical timeline is about 45 to 60 days from contract to start. So am I thinking about that right where in that, call it 60-day window, if there are cost increases, like that's the variability on your margin? And I guess the follow-up to that is, I'm hearing some builders are starting to build in some like cost escalator clauses into sales contracts in case cost do go up a lot. So curious if you're doing that to protect yourself against any costs in that window?

Jeff Mezger, Chairman, President and Chief Executive Officer

We're not including escalators in our contracts with customers. Our division does account for contingency in their budgets when pricing products, allowing us to absorb some costs. The surge in lumber prices was more significant and rapid than anticipated, but it's now decreasing. In our larger operations, we effectively manage the transition from contract to start without notable margin erosion during that 45 to 60-day period. In smaller operations where we lack scale, there is a bit more vulnerability; however, as Jeff mentioned in our guidance, we have managed not only to cover those costs but also to raise our prices beyond those costs. We expect to continue expanding margins in the second half of the year based on our recent reports. Overall, we're in a solid position right now.

Alan Ratner, Analyst

Okay, that's helpful. Yes, I just wanted to understand the kind of the timeline there. Second question, you guys have been entering a handful of new markets lately and I think you mentioned Boise on the call today, and Boise is a fascinating market, it's probably one of the hottest, if not the hottest in the country at least in terms of price appreciation. So I'm curious as you enter these markets and maybe pick on Boise and specifically, how long have you been looking at that market and how do you get comfortable with kind of starting to buy land in a market that has seen the type of run-up in home prices, and I'm assuming land prices as well over the last 12 months or so?

Jeff Mezger, Chairman, President and Chief Executive Officer

Good question, Alan. I'd compare this to Seattle. If you look at what we did in Seattle, everybody said Seattle is very land constrained. You can't get scale and it's very expensive, and we have a very good team out there that is very seasoned in the Seattle land market with a lot of connections, and we were able to introduce a product that was priced well below where the new homes were offered and competitive with resale, and we quickly grew market share through our ability to penetrate the market in that approach. So we're well below the median new home price in Seattle today and running very strong margins. And as we look at Boise, the person that we've had there pursuing the land activity is a seasoned veteran in the market, been there a long time, and we're doing the same thing. We're targeting affordability and approaching it a little bit different than a lot of local builders who have moved up scale in their footage and moved up in their pricing and are chasing price. We're coming in underneath. So we think it's a good time and a real good opportunity for our business model to go into Boise where nobody really operates there lately.

Operator, Operator

Thank you. Our next question comes from Deepa Raghavan with Wells Fargo. Please proceed with your question.

Deepa Raghavan, Analyst

Hi, good evening, everyone. Thanks for taking my question. Jeff, can you comment on how much of your delivery has been delayed to Q3? You mentioned some timing issues and also referenced municipal delays and supply chain concerns. Could you provide more details on that?

Jeff Mezger, Chairman, President and Chief Executive Officer

Sure. As for deliveries, they were under 100. I don’t have the precise number, but it’s around that figure. In the second quarter, we presented to the Board about various factors that caused our build times to extend, and we have since adapted to those changes. Based on our current work in progress and our projections for completions, we are confident in the delivery numbers we provided. Regarding municipal delays, we’ve experienced issues as cities are ramping back up; inspectors are taking several days longer than expected to conduct final inspections, and utility companies are experiencing significant delays in setting meters and completing underground work. This situation can be likened to playing whack-a-mole in each city where we operate, as different issues arise—whether it’s lumber delivery, installation delays, inspector availability, or garage door shortages. Navigating through these challenges is essential in a building supply constrained environment. Our teams are managing well, and we remain confident in the numbers we communicated for the year.

Deepa Raghavan, Analyst

Okay, got it. Does that increase your cycle time compared to a few months ago, or is it still similar issues that you have been experiencing?

Jeff Mezger, Chairman, President and Chief Executive Officer

Different problems and added a few days to our build time. Nothing dramatic, just a few days here, a week over there in the city. But one, if you lose three days, it's more than 100 units at our scale. So you have to keep working to compress your build times.

Operator, Operator

Thank you. Our next question comes from Susan Maklari with Goldman Sachs. Please proceed with your question.

Susan Maklari, Analyst

Thank you. My first question is you mentioned in your comments that your studio options and your lot premiums are adding about $45,000 per home. Can you give us some sense of how that compares historically where that's been? And you mentioned that there is upside to that over time. Can you talk to how you think about where that can get to and the benefit that that can drive in margins over time?

Jeff Mezger, Chairman, President and Chief Executive Officer

Good question, Susan. The way we separate the two. And if you go to the studio, the primary focus for us with the studio is how to sell houses and give people choice and allow them to personalize that. That's job one. Job two, along the way, you can make additional profit and keep finding ways to make more money in the studio. What I wanted to make sure that in the comments was third, and you heard it, while our base pricing has gone up, the percent of base out of the studio has held steady. So if a year ago, our ASP was $370 or $380 and there was 9% of base and now we are $420, it's still 9% of base. So buyers are spending more in the studio. And it's a combination of what they're selecting and also with our frequencies we can gauge what's the strongest interest for the buyer, and if it's something that they can't go shop at Home Depot because it's custom for that floor plan, we can get a higher margin there, and that's what we're looking at now to mine more margin, which is resulting in a little more studio revenue. So I would expect that over time as if our base pricing continues to go up, there will still find ways to keep the studio at about 9% of base. So it's an increment. And on the lot premium side, we've found our company goal right now is 2.5% of base.

Susan Maklari, Analyst

I'm having trouble hearing you.

Jeff Mezger, Chairman, President and Chief Executive Officer

We have targeted 2.5% of the base for lot premiums, although in some years, we've been as low as 1.25% and had periods where we've reached 2.5%. Currently, we are not at 2.5%, but we believe we can achieve our goal and that is our focus.

Susan Maklari, Analyst

Okay, that's very helpful.

Jeff Mezger, Chairman, President and Chief Executive Officer

Yes. They're driving additional margin opportunity in the future for us.

Susan Maklari, Analyst

Yes. Okay, all right. And then, obviously, you've seen some delays in bringing some of these communities online. I know you mentioned that you still expect to grow your community count double-digit next year. But as we think about the puts and the takes sort of coming expect that there is actually maybe some upside to that 10% target that you've given us for 2022. How should we think about…

Jeff Mezger, Chairman, President and Chief Executive Officer

We definitely have the developments and communities planned that will allow us to achieve more than expected. We aim to exceed 10%, which could lead to better outcomes, although it's a challenging figure to predict. The pace at which we sell out varies based on location, pricing, and other factors, along with some delays in the second quarter. Most of these communities are set to open in June. While we did not meet our community number, it’s only a matter of weeks, and we anticipated reaching that goal. We didn’t hit it, but we are currently focused on it. If you assess our business and progress, we have seen a nice increase in our backlog, which supports our revenue guidance and positions us well for momentum into 2022, alongside growth in community count to ensure significant revenue growth for that year.

Operator, Operator

Thank you. Our next question comes from an unidentified analyst. Please proceed with your question.

Unidentified Analyst, Analyst

Hi. This is Maggie on for Mike. Question sense of how your sales pace trended sequentially. On an absolute basis could you give us month to month during the quarter and maybe any comments on what you've seen through the first three weeks?

Jeff Mezger, Chairman, President and Chief Executive Officer

I don't know that we have it by week or the trend through the month, Maggie, but during the whole quarter, we didn't see demand lighten up at all from March through May and you've seen demand is very good right now.

Unidentified Analyst, Analyst

Got it. And one more for 3Q; you're expecting gross margin of about 21.7% and to get to your full year step up into 4Q. So could you give us any puts and takes there? I mean, is that primarily volume price cost dynamics that you're foreseeing?

Jeff Kaminski, Executive Vice President and Chief Financial Officer

As we look at the remainder of the year, the market conditions we're experiencing as we move into our third and fourth quarters reflect the challenges we face with rising lumber prices impacting our deliveries. The third quarter will likely be the first to fully feel these price increases, and the fourth quarter will follow suit. This poses a challenge that we need to address to maintain our sequential growth. We've experienced five consecutive quarters of increasing gross margins and are confident in our guidance for two more, which would give us seven in total. We're pleased with that progress. Overall, we expect positive trends in our selling margins and our backlog. While the spike in lumber prices and annual starts will impact our third and fourth quarter deliveries, we believe we can manage these challenges through other factors. We anticipate ongoing positive results from amortized interest, which has been favorable for the past couple of years. We're optimistic about our margin trends supporting our goal of increasing returns. Our strategy focuses on scaling up and expanding gross margins, which we believe will help us achieve our return expansion targets. Therefore, we are pleased to revise our estimates for the current year to around 20% for return on equity and are optimistic about continuing this upward trajectory. Margins are crucial for us, and we are seeing encouraging trends that we expect to sustain well into the future.

Operator, Operator

Thank you. Our next question comes from Mike Dahl with RBC Capital Markets. Please proceed with your question.

Mike Dahl, Analyst

Thank you for taking my questions. I wanted to ask one more about affordability. Jeff, I believe you mentioned earlier that your internal tracking shows stability in the affordability metrics you are monitoring. I think you cited square footage as one of those metrics. Could you elaborate a bit more on what you're examining internally and the context of that stability?

Jeff Mezger, Chairman, President and Chief Executive Officer

The demand is significantly outpacing the available supply. For instance, in a 100-lot community with an interest list of 300 or 400, we see much higher demand upon opening than there is supply. Buyers are quickly committing to lots at the prices we set. It's noteworthy that 64% of our buyers are first-time purchasers, and our average borrower, who accounts for 75% of our sales, is putting down $50,000. Additionally, we’ve observed an increase in FICO scores this quarter, indicating a strong quality among our buyers. We haven’t encountered issues with qualification payments relative to income, and there are no signs of affordability stress at this time. If we do notice such a trend, we will adjust our offerings accordingly, as we've done previously. But for now, demand continues to far exceed supply.

Mike Dahl, Analyst

Okay. That's helpful. Thanks. My second question just relates to some of the new market entries and also I guess broader capital allocation. You've now entered three major markets organically which is kind of an interesting choice if you look at the history of what public builders often do, and it coincides with a period where just given the dynamics in the land market we would expect that some M&A activity would potentially pick up. Could you just talk about how you're evaluating the organic versus M&A decision when you're looking at these new markets? And is an M&A potential avenue for you as you look at additional ones?

Jeff Mezger, Chairman, President and Chief Executive Officer

While mergers and acquisitions are certainly an option, we continuously engage with potential sellers as opportunities arise. However, the premiums involved can be significant, and there's also the risk of integration. Currently, we are focused on our strong organic growth in existing markets, where we have not yet reached our full potential. This allows us to gradually expand into softer markets and let them develop over time. Our experience in Seattle demonstrated that it can take a few years to start generating substantial revenue and profits, which ultimately contributes to the overall profitability of the company. We see similar potential in markets like Charlotte and Boise. With our current growth trajectory, we can continue to develop these markets at a slower pace, thereby avoiding large premiums and related integration challenges, leading to a higher quality of entry. Although this approach may take a bit longer, we're also open to exploring mergers and acquisitions as a means to enhance our top line growth.

Operator, Operator

Thank you. Our next question comes from Alex Barron with Housing Research Center. Please proceed with your question.

Alex Barron, Analyst

Yeah. Thanks, guys, and good job on the quarter. I was just kind of curious as far as the sharp price increases we've seen so far this year, especially this year to date and how you guys are thinking about that, particularly like do you have a measure on what percentage of your buyers are coming in from other states that might be driving these prices up the way they have?

Jeff Mezger, Chairman, President and Chief Executive Officer

I don't have the specific data on that, Alex. I'm not sure how closely we track the percentage of buyers from California or New York or anywhere else. While I believe that plays a role, I think the main factor driving prices right now is the strong demand across all markets combined with the lack of supply. It's a classic case of supply shortages, and I expect it will take time to address that issue. The out-migration from California that you often hear about seems exaggerated. There's certainly some movement happening, but it has existed for several decades, with people relocating to Arizona, Texas, Nevada, and even Florida from New York. Ultimately, I believe the core demand in all the cities where we operate is a larger factor.

Alex Barron, Analyst

What do you think will happen if lumber costs decrease and supply chain problems improve? Do you believe that pricing will remain high and margins will increase, or do you think prices will eventually come down as builders begin to pass on some of the cost savings once they become available?

Jeff Mezger, Chairman, President and Chief Executive Officer

Yeah. But I think we'll be taking it to margin that it will depend on the competitive landscape in each city, and when I say the competition is not just new, it's used homes. But our hope and expectation is we'll take it to margin.

Operator, Operator

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

Jay McCanless, Analyst

Thanks for taking my questions. The first one I had with the land that you're out buying today, when do you anticipate that land will go into service? And maybe could you talk about what you're assuming for HPA as you move forward on land buying?

Jeff Mezger, Chairman, President and Chief Executive Officer

Is HPA home price appreciation, Jeff? Yeah, we don't assume any appreciation price. We take the view that it's got to work today and if prices go up, costs probably went up whether you're not going to get more margin over time, that's typically how it happens. So we don't underwrite with inflation. We own and control everything for '22 and a good chunk of '23, 80%, 85%, 90% of '23 today. So the things that we're looking at probably are late '23, if not into '24. So there are ways out. So the things we're bringing to market today we probably controlled two years ago for the most part.

Jay McCanless, Analyst

Okay, that's helpful. The other question I had is about your earlier comments, Jeff. You mentioned how KB is increasing the number of starts and the company's capacity to begin more home constructions. Can you explain how that relates to the decision to raise the lower end of the guidance without increasing it further? Does that mean you increased the starts to sustain the expected pace from the beginning of the year? I’m trying to understand how these two points connect.

Jeff Mezger, Chairman, President and Chief Executive Officer

Our build times for many of the starts in May are likely pushing into December deliveries. You will continue to see the benefits of our community absorptions not only in the fourth quarter but also in the first quarter of next year and beyond. We have been increasing our revenue guidance each quarter, I believe.

Jeff Kaminski, Executive Vice President and Chief Financial Officer

Yeah, the midpoint is up $100 million.

Jeff Mezger, Chairman, President and Chief Executive Officer

Yeah. So we are lessening as we go, Jay.

Operator, Operator

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