KB Home (KBH) CEO Jeff Mezger on Q4 2019 – Earnings Call Transcript No ratings yet.

KB Home (NYSE:KBH) Q4 2019 Earnings Conference Call January 9, 2019 5:00 PM ET

Company Participants

Jill Peters – SVP, IR

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 – SVP and Chief Accounting Officer

Thad Johnson – SVP and Treasurer

Conference Call Participants

Alan Ratner – Zelman & Associates

Truman Patterson – Wells Fargo

Stephen Kim – Evercore ISI

Mike Dahl – RBC Capital Markets

Christina Chiu – Barclays

Michael Rehaut – JPMorgan

Susan Maklari – Goldman Sachs

Jay McCanless – Wedbush

Operator

Good afternoon. My name is Devon, and I will be your conference operator today. I would like to welcome everyone to the KB Home 2019 Fourth Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the company’s opening remarks, we will open the lines for questions. Today’s conference call is being recorded and will be available for replay at the Company’s website kbhome.com through February 9.

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

Jill Peters

Thank you, Devon. Good afternoon, everyone and thank you for joining us today to review our results for the fourth quarter of fiscal 2019.

With me 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

Thank you, Jill. Good afternoon everyone and Happy New Year.

We finished 2019 strong with fourth quarter results that reflected solid demand for our products as home buyers continued to prioritize choice and personalization in their home buying decisions. In addition, our performance under our returns focused growth plans produced measurable results, most notably, in the year-over-year expansion of our housing gross profit margin.

With the conclusion of the third year of this plan, there are several achievements to highlight. First, at roughly $270 million, our net income in 2019 is up by over 150% relative to 2016 when we launched the plan. This helps drive our return on equity to 12.2% nearly doubling its 2016 level to a point that was solidly within the plan’s target range.

Next, the significant cash from operations that we generated in the past three years enabled us to invest over $5 billion in land acquisition and development as well as returned $73 million in capital to shareholders through dividends and share repurchases while also repaying about $850 million in debt.

As a result, we worked our debt-to-capital ratio down considerably to 42.3% from 60.5%, also achieving our tightest target goal and reduced our interest incurred meaningfully benefiting our gross margins. With the success of our plan, we are a larger, higher margin, more profitable and less leveraged company.

Going forward, our strategy will remain consistent with a continued focus on profitably expanding our scale while increasing return. Specific to the quarter, we produced total revenues of $1.6 billion and diluted earnings per share of $1.31.

Housing revenues were up 15% year-over-year despite falling a bit short of our anticipated range as some of deliveries in the Bay area were delayed due to the fires and power shutdowns which impacted our ability to get utilities installed. Nonetheless, we leveraged the higher revenue base to meaningfully expand our operating income margin, which was up a four percentage point year-over-year to 10.7% excluding inventory-related charges.

This translated to an increase in profitability per unit of approximately 10% over 42,000 in operating income per home. The key driver of our operating margin growth was our robust gross margin which we expanded 120 basis points as compared to the prior year to just shy of 20%. We opened 23 new communities during the quarter contributing to 9% growth in our average community count.

In 2020, we continued to anticipate another step-up in our average community count with nearly all of the openings coming from higher margin core communities. The composition of our portfolio continues to strengthen with core communities expected to represent more than 90% of our average count this year.

From a macro perspective, mortgage interest rates remain low continuing to support favorable market conditions characterized by steady economic expansion, solid job growth, high consumer confidence, and positive demographic trends. While these factors build strong demand, supply continued to be insufficient to meet home buyers’ needs with resale inventory declining to 3.7 months supply in November and even lower at affordable price points where we operate.

In the quarter, our absorption pace accelerated to 3.7 monthly net orders per community. This was our highest fourth quarter pace in more than a decade in spite of increasing prices in about 65% of our communities during the quarter, a seasonally significant level of pricing power.

Taken together, our community count growth and increased absorption pace, as well as a soft comparison in last year’s fourth quarter, all contributed to producing a 38% gain in our net orders. Net order value expanded by 43% in the fourth quarter to $1.1 billion contributing to a 26% rise in our yearend backlog value to $1.8 billion.

In terms of units, our backlog grew to over 5,000 homes, our highest fourth quarter level in a number of years. We continue to strategically invest in land and position our profit offering to be attainable for the median household income and each sub-market.

As a result, we cater primarily to first time, as well as first move up buyers. In the fourth quarter, our deliveries to first time buyers rose to 56% of our total, the highest share of this segment that we have generated in many years. Our ability to increase our profitability at the lower first time buyer price points is both a core competency and competitive strength that has been the foundation of our more than six decades in homebuilding.

We’ve been consistent in our approach and as housing markets continue their measured recovery, fueled by first time buyer demand, we believe we are solidly positioned in the sweet spot of the market. While we continue to capitalize on this demand, underlying the progression in our financial metrics is a stronger and more efficient business.

Our build times were down 12 days year-over-year in the fourth quarter, an 8% improvement to 131 days. Our implementation of our build-to-order model is highly efficient as working from a large backlog of homes enables cost synergies and an even flow of production process. We also like the flexibility the build-to-order provides.

A year ago, as interest rates and home prices were rising challenging affordability, we rotated lower in square footage in most cases using standard plans from our product series. We enhanced our product lineup thereby expanding the choices available to buyers by offering smaller homes with similar livability and room count and reposition our model parts to reflect these changes where possible.

While the subsequent fall in interest rates moderated affordability pressures, we believe we are well positioned for the future regardless of the rate environment. Moreover, we found that the steps we took were aligned with consumers’ preferences as our square footage on built-to-order homes is down about 100 feet year-over-year in the fourth quarter.

At the same time, our studio revenue per home was higher as buyers opted for less square footage without compromising the features they value. Our initiative was successful in widening our demand pool without sacrificing gross margins.

In addition to the efficiency in our homebuilding operation, our mortgage banking joint venture, KBHS continues to mature with a capture rate growing sequentially throughout each quarter of 2019, ending at 74% in the fourth quarter. KBHS originated 70% of our home buyers’ mortgages for the full year. As a result, our deliveries were more predictable with higher customer satisfaction and the JV produced a 67% increase in income versus the prior year.

We expect the capture rate to improve further in 2020, which should result in greater customer satisfaction and an increase in our JV income.

With respect to the market updates, I will now highlight a couple of regions beginning with the West Coast. This region continued to demonstrate momentum in the fourth quarter producing a 54% increase in net orders with a positive comparison in every California division. Growth of both community count and absorption pace contributed to the region’s results as market conditions were generally favorable across the state.

Our Bay Area communities delivered a particularly robust comparison reflecting in parts of softness from the prior year’s quarter, as well as our ongoing and intentional stir up to more affordable price points. Looking ahead, we expect our West Coast region to further expand its community count in 2020.

Our central region produced its highest fourth quarter net orders in more than a decade at over 1,000 a year-over-year increase of 41%. Market conditions in Austin were especially strong fueled by significant in-migration in response to job growth and home price affordability. We opened five new communities in the second half of 2019 in our Austin division in premier locations accessible to key employers, transportation routes and lifestyle amenities in the area.

These openings contributed to the division’s near doubling of its net orders year-over-year. One community in particular, Villa Trace, produced outstanding net order results at well above company average margin. The success of this community rests in providing an appealing product in the prime North Austin tech corridor that is affordably priced with respect to the area’s median household income in alignment with our company’s strategy.

Of note, many of our buyers already rented in the area and the opening of this community allow them to remain in their preferred location while now becoming homeowner. With an ASP in Austin of $295,000, we are competitively well positioned relative to the $315,000 median price of a resale home. Strong market conditions has continued in December and early January sustaining solid demand for our products.

While we typically provide an update on quarter-to-date net orders on this call, the comparison is skewed during this period due to the softer market conditions across our industry during the same period a year ago. As a result, we will instead provide our net order outlook for our first quarter of 2020. We believe a reasonable range is net order growth between 15% and 25% on community count growth of roughly 5%.

In closing, we ended 2019 strong and are off to a productive start in this New Year with a $1.8 billion backlog and an improving community mix, we are poised for double-digit growth in our revenue this year. Also, in anticipating higher profitability, we see further opportunity for expansion of our return on equity which we expect to grow meaningfully in 2020.

Given our favorable positioning, and health market conditions, we are anticipating a solid year ahead and we look forward to updating you as the year unfolds.

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

Jeff Kaminski

Thank you, Jeff, and good afternoon, everyone.

I will now cover highlights of our financial and operational performance for the 2019 fourth quarter, as well as provide our outlook for the 2020 first quarter and full year.

We are very pleased with our strong fourth quarter performance. We generated improvements in virtually all of our key profitability measures, and achieved solid absorptions and community count growth, which contributed to a significant year-over-year increase in backlog value. During the quarter, we also increased the borrowing capacity of our unsecured revolving credit facility and successfully refinanced our March 2020 senior note maturity.

In the fourth quarter, our housing revenues were up 15% from a year ago to $1.5 billion due to 16% increase in homes delivered that was partially offset by a slight decline in their overall average selling price.

Looking to the 2020 first quarter, we expect to generate housing revenues in a range of $910 million to $917 million, up 18% at the midpoint over the same period of 2019. For the 2020 full year, we still anticipate housing revenues in a range of $4.9 billion to $5.3 billion. Having ended our 2019 fiscal year with a backlog value of approximately $1.8 billion, up 26% from a year ago, we believe we are well positioned to achieve these expectations.

In the fourth quarter, our overall average selling price of homes delivered declined slightly to 392,500, primarily due to a shift in mix in our West Coast region towards lower price communities within our Bay area operation. For the 2020 first quarter, we are projecting an overall average selling price of approximately $375,000.

We believe our overall average selling price for the 2020 full year will be in a range of $380,000 to $400,000. Homebuilding operating income for the fourth quarter increased 33% to $152.5 million, compared to $121.9 million for the year earlier quarter including total inventory-related charges of $4.1 million in the 2019 quarter and $9.1 million a year ago.

Our homebuilding operating income margin was 10.5%, up 140 basis points from the 2018 fourth quarter. Excluding inventory-related charges for both periods, our operating margin was 10.7% for the current quarter and 9.7% for the year earlier quarter.

For the 2020 first quarter, we anticipate our homebuilding operating income margin excluding the impact of any inventory-related charges will be in a range of 4.9% to 5.3%, up 80 basis points at the midpoint over the same period of the prior year.

For the 2020 full year, we expect this metric to be in the range of 7.9% to 8.5%, an improvement of 50 basis points at the midpoint over the prior year. Our 2019 fourth quarter housing gross profit margin improved 150 basis points to 19.6% including inventory-related charges. Excluding the impact of these charges, our gross margin for the quarter increased by 120 basis points to 19.9%, compared to 18.7% for the prior year quarter.

This improvement reflected the continued reduction in our outstanding debt along with growth in our unit deliveries enabling us to further lower our incurred interest per delivery in the fourth quarter to under 3% of housing revenues.

With the lower levels of higher period incurred interest and the widening values between our active inventory and total debt, we have measurably reduced our amortization of previously capitalized interest, which favorably impacted our housing gross profit margin by 90 basis points in the 2019 fourth quarter.

In addition to the year-over-year improvement generated from the lower amortization of interest, our housing gross margin was favorably impacted by both our adoption of ASC 606 and the reduced headwind of deliveries from reactivated communities, partially offset by a mix shift of homes delivered from certain West Coast region communities with relatively high average selling prices and gross margins.

Assuming no inventory-related charges, we are forecasting a housing gross profit margin for the 2020 first quarter in a range of 17.8% to 18.2%, up 40 basis points at the midpoint over the same period of the prior year.

Compared to our fourth quarter results, this range reflects the anticipated seasonal first quarter decrease in operating leverage from lower revenues. We expect our 2020 full year gross margin excluding inventory-related charges to be in a range of 18.7% to 19.3%, an improvement of 30 basis points at the midpoint over the prior year.

Our selling, general and administrative expense ratio of 9.1% for the fourth quarter was up 10 basis points from last year’s fourth quarter ratio, mainly as a result of the unfavorable impact of the adoption of ASC 606, partly offset by improved operating leverage from higher housing revenues.

We are forecasting our 2020 first quarter SG&A expense ratio to be in a range of 12.7% to 13.1% as we continue to prioritize containment of overhead cost and expect to realize favorable leverage impacts from higher housing revenues in the current year period.

We also anticipate that our 2020 full year SG&A expense ratio will be in a range of 10.5% to 11.1%. Our income tax expense of $41.8 million for the fourth quarter was essentially a non-cash expense due to our deferred tax assets and represented an effective tax rate of approximately 25%. Our deferred tax asset balance of $364 million at year end was down more than $77 million from the prior year.

We currently expect our effective tax rate for the 2020 first quarter to be approximately 20% and for the full year to be approximately 23%. Due to our remaining deferred tax assets, we anticipate that for both periods, this will continue to represent a non-cash expense.

In December, Federal legislation was enacted which among other things expanded the availability of energy tax credits for building energy-efficient homes through December 31, 2020 reflective of our industry leadership and sustainable homebuilding and energy efficiency, the extension of the tax credits will favorably impact our 2020 effective tax rate.

The estimated favorable impacts from this recently enacted legislation is included in the first quarter as full year tax rate estimate. Including a charge for the early extinguishment of debt, our net income for the quarter was up 27% year-over-year to $123 million and diluted earnings per share increased to $1.31, up 36% as compared to the year earlier quarter.

This strong level of fourth quarter net income contributed to a 12.2% return on equity for the full year. We expect to realize an improvement in excess of 100 basis points in this metric in 2020. We ended the year with stockholders’ equity of $2.38 billion as compared to $2.09 billion at the end of the prior year and our book value per share increased by 11% to $26.60.

Turning now to community count, our fourth quarter average of 253 was up 9% from 252 in the corresponding 2018 quarter, primarily reflecting a 28% increase in our West Coast region. We ended the year with 251 communities, up 5% from a year ago. Of the 251 communities, 25 communities or 10% were previously classified as land held for future development, compared to 34 or 14% at the end of 2018. On a year-over-year basis, we anticipate our 2020 first quarter average community count will be up in the mid-single-digit range.

For the 2020 full year, we expect growth in our average community count in the low to mid-single-digit range. More importantly, in addition to this positive trajectory, we anticipate continued improvement in the quality of our community portfolio in 2020. We expect growth in our core community count to drive a lower percentage mix of communities previously classified as land held for future development, which we believe will provide a tailwind for future gross margins improvement.

During the fourth quarter, to drive future community openings, we invested $399 million in land and land development with $147 million or 37% of the total representing land acquisitions.

Moving onto our balance sheet, there are several areas of continued improvement that clearly reflect the successful implementation of our returns focused growth plan and achieving our capital allocation and efficiency objectives. These include measurably growing our total inventory investment while reducing our inactive inventory substantially deleveraging our capital structure and meaningfully expanding the borrowing capacity under our revolving credit facility.

I will now cover these achievements in more detail. In 2019, we invested $1.6 billion in land acquisitions and development and generated $251 million of net operating cash flow. We also reduced our inactive inventory to $150 million at year end or just 4% of our total inventory. Starting this quarter, we have elected to include lots under contract with refundable deposits in our total lot count.

As of yearend, 59% of the approximately 65,000 lots in our pipeline were owned and 41% were under contract including about 9200 lots under contract with refundable deposits. Our own lots at the end of the year represented about a 3.2 year supply based on homes delivered in 2019.

During the quarter, we raised approximately $300 million from a public offering of 4.8% senior notes maturing in 2029 and use the net proceeds along with available cash to retire all $350 million of our 8% senior notes that were scheduled to mature on March 15, 2020.

This early extinguishment of debt resulted in a fourth quarter charge of $6.8 million. Due to the impacts of the lower interest rate and decreased amount of debt outstanding, the successful fourth quarter completion of these transactions will lower interest incurred in 2020 by nearly $14 million.

In addition, these transactions extended the weighted average life of our senior notes from 2.2 to 4.9 years. Earlier in the year, we repaid all $230 million of convertible senior notes at the maturity in February resulting in an 8.4 million reduction in our diluted share count and contributing to a reduction of more than $300 million and our total outstanding debt at year end as compared to the prior year.

Our deleveraging activities over the past 12 months, combined with the increase in our equities from strong 2019 earnings drove a 740 basis point improvement in our year end debt-to-capital ratio to 42.3%. We expect further improvement resulting from stockholders’ equity accretion in 2020 and forecast our debt-to-capital ratio to be below 40% by the end of the year.

During the quarter, as part of our efforts to improve our capital efficiency and enhanced liquidity, we completed an amendment to our unsecured revolving credit facility, increasing its borrowing capacity to $800 million from $500 million and extending its maturity by more than two years to October 2023.

We ended the year with $454 million of cash and total liquidity of over $1.2 billion including availability under our unsecured revolving credit facility. We had no outstanding borrowings under our revolver at the end of the year.

In 2020, we plan to further execute on the principles of our returns focused growth strategy. Our priorities remain expanding our revenues within our served markets, improving our operating margin, monetizing our deferred tax assets, reducing our leverage, increasing returns, and enhancing long-term stockholder value.

We will now take your questions. Please open the lines.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Alan Ratner with Zelman & Associates. Please proceed with your questions.

Alan Ratner

Hey guys, good afternoon. Congrats on another very strong quarter and good end to the year. I think, obvious to the order number very impressive we’ve been seeing some big numbers recently out of the other builders as well. And I am just curious as we head here into the spring selling season, how does the supply side of the business seem right now?

Just thinking about all the various things that have been constrained to various points in the cycle, labor, land, it doesn’t seem like there is too much concern out there as far as an ability to get these homes built and delivered and kind of maintain a strong absorption pace for 2020. But I am just curious what you guys are seeing on the ground related to all of those various inputs?

Jeff Mezger

Alan, a few things. Very own and control all the lots for 2020 and we are very deep into 2021 and working on that. As Jeff has guided, we expect revenue growth this year. So we own the lots that support a nice growth trajectory in 2020 and we are working on 2021. But that’s in terms of input cost, the land is tight out there but it’s rational and we are able to invest just like we did in the fourth quarter to support our goal.

On the direct side, it’s pretty flat right now for us lumber came way down. Labor is fairly rational. We are working on growing our scale in our markets to retain all the great relationships we have with our trade partners on the ground. So, direct cost flat. Land is tight but we are finding it and we are pretty comfortable being able to support our growth goals.

Alan Ratner

Great. Now that’s really good to hearing. Helpful. The second – thank you for providing the order guide for 1Q. Obviously, that helps with the modeling off of a tough comp period from a year ago. As you move past the first quarter and just thinking about the interplay between community count and absorption right now, right now it seems like everything is kind of clicking on all cylinders. You’ve got margin lift.

You’ve got absorption growth, but how much from here is it reasonable to expect your ability to drive absorption higher? I mean, right now, you guys are probably the highest in the industry from an absolute standpoint.

So, is there in expectation that maybe absorptions flat line a little bit once you get past the easy comps and maybe more of the upside might be on price and margin or should I think about that more even in terms of where that upside might come from if the market stays strong?

Jeff Mezger

Good question. And it’s one we spend time on every week in here, Alan. As we shared in our comments, our fourth quarter pace was the highest we’ve seen for fourth quarter in over a decade. So, sales pace is strong and demand is strong. We continue to toggle it in every community every week where we are optimizing the pace versus price to get the highest return on the assets.

It wouldn’t surprise me if sales ticks up incrementally because of the strong market conditions, but our focus is going to be more on getting margin as opposed to pushing a higher sales pace in the short run, so we get to our margin goal. We get to our margin goals and you’d see us pull back for more pace. But for now, it’d be build rates to maybe go up a little and focus more on lifting our margin.

Operator

Our next question comes from the line of Truman Patterson with Wells Fargo. Please proceed with your questions.

Truman Patterson

Hi, good evening guys. Nice results. First, just wanted to talk about your capital structure and the potential tailwinds of the lower interest expense. Your net debt-to-total capital has declined nicely the past couple years. It’s in that kind of 35%. How do you think about your correct capital structure going into kind of 2020, 2021? Any chance that you actually work that down kind of below 30%?

Jeff Kaminski

What we have a target out there relating to our gross debt-to-capital is 35% to 45% and I would say that the target remains relevant for us and something we are focused on. We had forecasted at the end of the third quarter that we got these down within that range by the end of this year which we have accomplished.

We do believe that we’ll be to able to see below 40% by the end of 2020 and comfortably within that range and I’d say our capital priorities remain the same as they have been with the only slight differences in 2020 we believe more of that improvement on the leverage ratio comes from equity accretion as opposed to debt reduction.

We are really focused on growing the business and reinvesting in the business as a primary use of capital that will continue to maintain our now higher level of dividend and we’ll opportunistically work that leverage ratio as we have chances to do so.

Truman Patterson

Okay, okay. And then a couple questions on California. Very strong demand, but have you actually seen the higher price point coastal areas really start to heal or improve at all? And then, California’s 2020 solar mandate, could you give us an update on that whether you’ll eat some of the cost and it possibly impacts margins. Do you see this possibly stalling the construction cycle given potential installation labor constraints? Anything you can really discuss about the solar initiative.

Jeff Mezger

Sure. Truman, first on the markets we are seeing the minor improvement, I would say that the higher price points along the coast. The lower price points are showing strong demand, higher up to get in price the softer it gets, it’s better than it was in the fall.

But it’s still not back, if you go to the OC houses in $2.5 million, $3 million aren’t the still low cost out there. But overall, there are more affordable price points. The demand is very strong right now in the state which is impart why we rotated down again in our product positioning to cater to where the demand is.

Relative to solar, it’s a good question and it’s still playing out and the industry is trying to get its arms around it. As a company, not sure if this group is aware of it, but we’ve been the largest provider of solar homes in the state. We’ve now delivered over 10,000 solar homes. So we get it and we know how to do it and there is a different story in every community. In some communities we’re grandfather to other communities.

We have permits. We have already have in place to avoid the solar mandates where you get past those types of nuances though that consumer has a choice you can either lease the system or we can include it in the price. Order of magnitude if they lease it the payment is around 50 bucks a month. That’s not a crazy number. You can’t say with certainty it’s not going affect demand in some way because it is 50 bucks.

You could otherwise put toward a house payment. But as we get our arms around, we think it’s more of an incremental thing than some significant shift in demand or supply out there. No concerns right now on our ability to install the solar, because we’ve been doing it for so long and we have great partners out there.

Operator

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

Stephen Kim

Yes, thanks very much guys and again, let me add my congratulations for the quarter. I wanted to ask you about the land spend in the quarter if I could. This quarter your land spend was pretty modest and your yearly spend declined, I believe on a year-over-year basis. And so I was curious as to, given the growth outlook that you’ve laid out for 2020, what kind of land spend do you think we should expect in 2020?

Do you think you could see yet another decline? Or do you think that you are going to see in order to sort of maintain the growth that you’ve outlined here you are going to need to see your land spend pick up in dollars?

Jeff Mezger

Stephen, a good news as we have the dry powder to do whatever we want to pursue our growth. We were down a little bit in 2019 versus 2018. But if you get into the numbers, the down can be one or two deals in California.

It’s not a broad base decline in land spend and some of it’s timing, some of it’s structure. We are working toward controlling more, owning less that influenced the number a little bit. But our plan right now and our hope is that for 2020 we’d spend more than we did in 2019, because we want to fuel our growth trajectory. And that’s the way our plan is laid out right now.

Stephen Kim

Got it. Okay. That’s helpful. And last quarter, I believe you said two things and I wanted to sort of see whether or not your thoughts have changed or if things have changed at all in the last three months. Last quarter I believe you said your raised prices in 90% of your communities. How do that looks this quarter?

And then I think you also mentioned that you really weren’t interested in the built to rent model and that’s one of those themes that seems to be continuing to track a lot of folks. So, curious to see whether or not your thoughts have evolved there?

Jeff Mezger

Stephen, I shared in the prepared comments that we raised prices about 35% of our communities which, for a fourth quarter is pretty good.

Stephen Kim

Yes.

Jeff Mezger

So, there was purchasing power in the quarter, 6.5.

Stephen Kim

Okay. Got it.

Jeff Mezger

And then, on the for rent, our view right now as we are homebuilders, anytime we’d analyze this we get a better return on the assets a homebuilders than we would as a landlord. And until we get to a growth trajectory that we are struggling with, I think we’ll stay focused on what we do well.

It doesn’t mean we’ll look at it and if there could be an opportunity if we have a multi-product asset, we want to acquire where a portion of it to be for rent and lease, we’d figure it out. But it’s not a primary initiative for us at this time.

Operator

Our next question comes from the line of Mike Dahl with RBC Capital Markets. Please proceed with your questions.

Mike Dahl

Hi, thanks for taking my questions. I had a two-part question related to gross margins first and as Jeff K just on the amortized interest and also the percentage of deliveries expected from reactivated communities in 2020 versus 2019, could you provide us an update on how you are looking at those two metrics with respect to the 2020 numbers?

Jeff Kaminski

Sure, Mike. We believe both of those will remain tailwinds to our gross margin next year. Perhaps it is slightly reduced level, I mean, in 2019, we had 90 basis points of improvement coming from interest amortization and I do believe it will be less than that. Same thing with the reactivated headwinds that should reduce, but probably not by as much as what we’ve been seeing in the – for example in the fourth quarter, we were down 50 basis points year-over-year in the reactivated.

But there – we were kind of getting to the end of the story on that. I think we saw some upside coming from continuing to sell-out and close out those communities. But there is probably less opportunity. But still both nice tailwinds for us on gross margin next year. Both are included in our guidance metrics in addition to all the change in mix et cetera at our community portfolio for next year and I think more good news to come from both those areas.

Mike Dahl

Okay. That’s helpful. Thank you and then the second question is, related as well, which is those seem to be tailwinds and your margin guidance, midpoint is up 30 basis points. With those as tailwinds on the market conditions that you are speaking to, it seems like that’s a kind of conservative number to be up 30 basis points at the midpoint on gross margin.

So, maybe you could give us some of the other puts and takes that you are thinking about whether it’s mix-related or labor inflation or directs. Any additional color will be helpful. Thanks.

Jeff Kaminski

Sure. The largest impact and largest factor for us in 2020 will just be this community mix change. We closed over a 100 communities out. In 2019, it was over 40% of our beginning community count. So, the community portfolio is quite a bit different. As we go into next year, we are trying to forecast gross margins coming off those communities, many of which have not been opened yet.

So we have a lot of openings to occur still in the first half of 2020 that will generate revenues and margins in the back half of the year. So, we are trying to do the best job we can anticipating and forecasting where those margins will be.

At this point, we have pretty good visibility as, I think most people are aware with our large backlog to the first half of the year and very critical spring selling season that’s coming up where we’ll be refining our estimates and expectations for the full year.

In speaking to the spring, I mean, we are pretty excited about it. We think we are really well positioned as a company. Probably best positioned we’ve been in quite some time relative to the market and combined with very strong market conditions right now, we are really optimistic about the spring and we’ll be updating those gross margin metrics and expectations as we go through the year like we always do every quarter.

But right now, right at the midpoint, we are at about a 19% for the year up and our operating margins were up about 50 basis points year-over-year at the midpoint of our operating margin guidance. So, pretty nice improvement on a base of right around $5 billion of top-line revenue. So, we are excited about what that will do to the bottom-line.

Operator

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

Christina Chiu

Hi, this is actually Christina Chiu on for Matt. My first question is just on your community count growth expectations for 2020, specifically, geographically. Are there any markets or price points that you are specifically focused on in 2020?

Matt Mandino

Well, what we try to do with community count is, we try to grow the business throughout. We don’t constrain our divisions. We don’t constrain our regions at all with budgets and saying you can only spend so much on land. If they are hitting our hurdles, and they are bringing good land deals to the table, that’s how we go forward with it.

What we saw in 2019, which will impact 2020 revenues since we saw an outsize increase in our West Coast region for their community count growth, as well as our Southwest region, which has been a very strong market for us, and little more modest improvement, flattish actually in central, little more modest improvement in Southeast.

So those factors will impact 2020 top-line a lot more than what we do with the 2020 count. But as always, we’ll try to focus on opening as many communities as we can that they are hitting our hurdle rates. We are staying very disciplined on the hurdle rate side.

We will continue with the company’s strategy of focus on first time and first move of buyers and also happen to be really quite a bit of a strength in the market in that area right now. So we are right in the sweet spot and intend to continue to manage the business in that fashion.

Christina Chiu

Okay, got it. And then, can you quantify or maybe give a timing update of how you are expecting SG&A leverage in 2020 in light of accelerating revenue growth and coupled with moderating community count growth?

Matt Mandino

Right. Basically, on the SG&A side, I mean, we always hit kind of a high point is, it’s at a negative, but a high SG&A ratio in the first quarter as our revenues are typically lowest in the first quarter and it progresses as we go through the year usually hitting out a low point in the fourth quarter and we expect pretty much the same trend that we see in the prior years in 2020.

Christina Chiu

Great. Thank you.

Operator

Our next question comes from the line of Michael Rehaut with JPMorgan. Please proceed with your questions.

Michael Rehaut

Yes, hi. Thanks very much. I wanted to spend the first question just on the gross margin. Just trying to dig in a little better and maybe kind of rephrase or ask around some of Mike’s earlier questions in terms of fiscal 2020 guidance. You had, as you said, 90 BPS of interest expense amortization improvement in 2019. You expect further improvement in 2020 although at a lesser rate.

So even if it that’s a half of that amount, you could still be looking at your core gross margins excluding interest flat to down a little bit. So, just want to understand why you’d save that if I think you kind of pointed earlier towards actually a continuing improvement of mix of your community from a gross margin standpoint, you are coming off of an easier comp at least in the first half from, perhaps higher incentives in the marketplace from the back half of 2018.

And by contrast, also I mean, you’ve – I think what people are just trying to understand is, is there just a basic level of cushion or conservatism that you are baking in, given you are four quarters now averaging 50, 60, 70 BPS higher gross margins than at least our estimates and I am sure many on the street in terms what you’ve been able to beat. So just trying to also reconcile and connect the dots or the drivers after next year.

Jeff Kaminski

The basis of our guidance is really a rollup right from the community level to the division level, from the division level to the region and region to the company. So, it’s very much a detailed forecast. The mix impact is huge.

Like I mentioned earlier, over 40% of our communities are changing on a year-over-year basis you don’t have the same communities that you are selling out of, you are dealing with things like land cost inflation and trying to offset that with some of your new land parcels and we basically forecast based on what we know today.

So, we base our forecast on our backlog gross margins, as well as our selling gross margins in anticipating what those buying gross margins would be later in the year. As I mentioned earlier, we are not even to this critical spring selling season yet. So we don’t have anything on the books really for the third and fourth quarters.

So it’s all on paper right now and I’d say our best estimate as we see it. And I think what’s underappreciated generally by folks outside of the industry or trying – folks like you guys trying to come up with your own guidance there, or your own estimates for companies is, the impact that mix can have and how much community changeover can impact the numbers that it’s not just simple math of price up, cost down and there is certainly other.

It’s different store count, it’s different stores, it’s different markets and the mix has a big piece of it. So, at this point in time, we are – that midpoint guidance number of 19% is kind of what we are seeing. We do believe with the right market conditions in the spring that we could potentially do better than that.

That’s why we have a range around and right now we will stick with the guidance numbers and update you as we go through the year.

Michael Rehaut

Thanks, Jeff. I appreciate that and obviously, as you said to your point, mix can be a pretty big driver in terms of variation. Maybe just flipping to this past fourth quarter in an effort maybe to better understand guidance versus actual results. Your gross margin for the fourth quarter came in 40 BPS above the high-end of your guidance range, 70 BPS above the midpoint. So, I was just curious if you had a sense of what drove that difference relative to your expectations relative to the guidance range?

Jeff Kaminski

All right. The two largest items are really – we did a little bit better in the amortization than we thought. We were expecting something more similar to the third quarter. We will have 20 basis ahead of the third quarter in our amortization and really one of the largest drivers was the reactivated headwind was much lower than it’s been pretty much in for years.

I think, we picked up 50 basis points relative to the third quarter and reduced headwind from our reactivated communities and that was a function of two things. One, revenues were a lower percentage of the total, but also I think importantly, the reactivated communities actually had a pretty strong gross margin performance in the quarter and lifted the gross margin.

As Jeff had mentioned, we increased prices in about two-thirds of our communities during the quarter and the other thing that’s usually outside of our guidance is we have a certain percentage of spec sales and deliveries within the quarter which obviously don’t start off in our backlog and we end up forecasting those and to the extent you could take price in the quarter and we have to take less of a discount on our spec sales, that was also a positive. So those three factors are probably the main things on behind the margin beat.

Operator

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

Susan Maklari

Thank you. Good afternoon. My first question is just on – you noted in your commentary that you’ve seen buyers increase their spend in the design centers even as the size of the home has come down modestly. I guess, can you just give us a little more color on what you are seeing there? And maybe how you are thinking about that coming through? And especially maybe in the margin and in some of that mix as we think about 2020?

Jeff Mezger

Susan, to understand you’d asked to look what each buyer is picking. One buyer will pick up higher level of upgrade cabinet, and a different buyer will pick some more cabinet option or a den option or structural option. It really – when you look at the data, it really reinforces how personalized the homes are that we produce, because there are no two that are the same.

What’s interesting for me is the studio spend goes up while the home goes down and a lot of the cost in the studio are tied to the size of the home. So it tells you the – even the buyer that was buying a larger home had the ability to put things in their house and chose not to and with a little bit smaller home apparently they are choosing to put more in the studio.

So, we priced in the studio, it’s accretive to margin to a degree. It’s not a big lift to margin. It’s just more revenue at our normalized margin for the most part. So, as we model, we have a margin analysis per community that includes studio revenue based on our experience at that community or with that price point in that city. So, it’s all baked into our guidance. We don’t look to the studio right now as another upside for the year. It’s just part of the ASP and the revenue that we guided.

Susan Maklari

Yes, I know, sure. I was just trying to get a sense of, are you seeing more of a lift as the size of the house has shrunk, and should – is that something that generally could kind of continue as you get this move to more smaller homes?

Jeff Mezger

It could, it could, I bet. Literally, and you’ve been to our studios. Every buyer is different and some want a big home with less amenities and others want a smaller home and load everything in it and everything in between and that’s as part of why we sell so well, because we can cater to everybody.

Operator

Our next question comes from the line of Jade Rahmani with KBW. Please proceed with your questions. Our next question comes from the line of Jay McCanless and he will be our final question from Wedbush. Please proceed with your question.

Jay McCanless

Hey, good afternoon. Thank you for fitting me on. First question I had, a small decline in orders in the southeast this quarter. Could you talk about what was going on there, because that part of the world has had a pretty good run in the past few quarters in terms of order growth? Hello?

Jeff Mezger

No, no, we are looking at the notes, Jay. One of the things that happened last year in the fourth quarter, we had acquired that builder in Jacksonville Landon and had a bunch of inventory that we sold through. So there was a spike in sales in Jacksonville that didn’t replicate because this is getting out of old product that we weren’t going forward with.

So that’s probably the sum of it. The number is not that big. Our business in the major cities is very good. The Orlando, Jacks, Tampa, and Raleigh, we are seeing good demand in all of them. So I think it was just the timing of that acquisition.

Jay McCanless

And then the other question I had, could you all quantify how many closings were pushed because of the fire? I am sorry to hear that you were affected by the fire, but how many closings were pushed and are those pushed closings having any impact on your assumptions for the 1Q 2020 gross margins?

Jeff Mezger

No, it’s a pretty modest impact. It was well under a hundred units, but they are high ASPs. So it had a bit more of an impact on the revenues, but it wasn’t terribly significant and it held our full year revenues in about the same range as we were at the end of last quarters. So not a huge effect.

Operator

Ladies and gentlemen, this concludes the question-and-answer session, as well as today’s call. You may now disconnect your lines at this time. Thank you for your participation and have a wonderful day.

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