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Edited Transcript of KBH earnings conference call or presentation 9-Jan-19 10:00pm GMT

Q4 2018 KB Home Earnings Call

LOS ANGELES Jan 16, 2019 (Thomson StreetEvents) -- Edited Transcript of KB Home earnings conference call or presentation Wednesday, January 9, 2019 at 10:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jeff J. Kaminski

KB Home - Executive VP & CFO

* Jeffrey T. Mezger

KB Home - Chairman, President & CEO

* Jill S. Peters

KB Home - SVP of IR

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Conference Call Participants

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* Alan S. Ratner

Zelman & Associates LLC - Director

* Christopher John Shook

Evercore ISI Institutional Equities, Research Division - Analyst

* Jade Joseph Rahmani

Keefe, Bruyette, & Woods, Inc., Research Division - Director

* James C McCanless

Wedbush Securities Inc., Research Division - SVP of Equity Research

* John Lovallo

BofA Merrill Lynch, Research Division - VP

* Matthew Adrien Bouley

Barclays Bank PLC, Research Division - VP

* Michael Glaser Dahl

RBC Capital Markets, LLC, Research Division - Analyst

* Michael Jason Rehaut

JP Morgan Chase & Co, Research Division - Senior Analyst

* Nishu Sood

Deutsche Bank AG, Research Division - Director

* Soham Jairaj Bhonsle

Susquehanna Financial Group, LLLP, Research Division - Associate

* Stephen F. East

Wells Fargo Securities, LLC, Research Division - Senior Analyst

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Presentation

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Operator [1]

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Good afternoon. My name is Devon, and I'll be your conference operator today. I would like to welcome everyone to the KB Home 2018 Fourth Quarter Earnings Conference Call. (Operator Instructions) Today's conference call is being recorded and will be available for replay on 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.

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Jill S. Peters, KB Home - SVP of IR [2]

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Thank you, Devon. Good afternoon, everyone, and thank you for joining us today to review our results for the fourth quarter fiscal 2018. With me are Jeff Mezger, Chairman, President and Chief Executive Officer; Jeff Kaminski, Executive Vice President and Chief Financial Officer; Matt Mandino, Executive Vice President and Chief Operating 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.

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [3]

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Thank you, Jill. Good afternoon, and happy new year to all of you. We produced solid results in 2018 as we continued to increase our scale, expanding total revenues to over $4.5 billion. We also significantly improved our profitability. We grew our operating margin by 120 basis points to 8.3% within our Returns-Focused Growth Plan's 2019 target range, and expanded our gross margin to just above 18%, excluding inventory related charges for each metric. As a result, we increased our pretax income by 27% to nearly $370 million and, excluding the accounting charges related to the federal tax legislation, we delivered return on equity of 14.4%, a 440 basis point improvement as compared to the prior year. As we review our results relative to the guidance we provided prior to the start of our 2018 fiscal year, we finished the year stronger across most of our key financial metrics, including both operating and gross margin, SG&A, ROIC and ROE. Overall, this past year reflected solid execution on our 3-year Returns-Focused Growth Plan in achieving or exceeding most of our targets under the plan by the end of year 2.

Specific to the fourth quarter, our results were consistent with the update we provided on November 14, with some lift in operating and gross margins. During the quarter, we grew our earnings per share by 14% to $0.96 on revenues of $1.3 billion. With our increased profitability in 2018, along with more efficient utilization of our assets and monetization of our deferred tax assets, we generated significant cash from operations. We continued our balanced approach to allocating capital, investing approximately $1.9 billion in land acquisition and development, retiring $300 million of our senior notes and repurchasing $35 million of our common stock, representing 1.8 million shares in late November. And we still ended the year with a healthy cash balance of roughly $575 million and over $1 billion in total liquidity.

With respect to our share repurchases, we took an opportunistic approach to buying back our stock with our equity at that time trading roughly 20% below our book value of $24 per share. Overall, the strong cash flow our business produced drove a significant decrease in our net debt-to-capital ratio to 41.6%, solidly within our recently reduced target range of 35% to 45%.

From a macro perspective, the favorable factors supporting housing demand remain in place. The economy is expanding, consumer confidence is high, employment is strong, wages are growing and household formation is increasing. Alongside these positive factors, the supply of existing homes remains low at 3.9 months nationally and below that level in many of our markets, and single-family housing starts for 2018 will once again be well under the long-term annual average. Taken together, these dynamics give us reason to remain encouraged even as heightened affordability pressures, which we are working to address, are contributing to the pause by consumers on purchasing homes.

Our net orders improved a little relative to the mid-quarter update we provided on November 14, ending the quarter down 12%. Our net orders were impacted by the timing of community openings with more than 60% of our openings occurring in November, a point in the year where we don't typically see strong sales activity accompanying a grand opening. That said, we continue to see a solid level of interest in homeownership as traffic levels in our communities in the fourth quarter held steady year-over-year. We're seeing buyers taking their time with the process, making multiple visits before committing to a purchase.

On a per community basis, our net orders were 2.9 per month in the fourth quarter. For the full year 2018, our average absorption pace increased to 4.1 per month as compared to 3.9 per month in the prior year. Our net order value for the fourth quarter of $738 million was influenced by both a mix shift away from the West Coast and within this region, a geographic shift to the lower priced inland markets. As a result, while our earning backlog was down 7% in units, our backlog value of $1.4 billion was down 14% year-over-year.

Heading into the new fiscal year, traffic levels in our communities remain steady. However, our net orders were off to a slower start in the month of December, down 97 units or 15% year-over-year. December is typically our slowest selling month, and this year, it is also one of our most difficult comparisons given the unseasonably strong net order activity we generated in the prior-year period. In light of this continued market uncertainty, we are only providing guidance for the first quarter of 2019 today, which Jeff will address in a moment. As to community count, with a sequential increase in our ending count in the fourth quarter, we reached a turning point in our average count, which was up slightly year-over-year. This, together with our planned openings in the first half of 2019, have us well-positioned as the spring selling season begins. We continue to expect between 10% and 15% growth in our average community count for the full year.

In an effort to address affordability pressures, we've taken proactive steps to reposition our product offerings in many of our open communities as well as our 2019 grand openings. The flexibility of our business model is an advantage as it allows us to move with demand at a fairly rapid pace in order to have the most compelling products in place for the spring. We are adding smaller square footage plans selected from our existing plan series in most of our communities and repositioning numerous model parts to demonstrate these more affordable homes. In addition, we're also lowering the specification levels for our standard features within many of our communities. These spec-level changes don't necessarily require modifications in the models. Instead, we can utilize our design studios to showcase both standard and optional items. Our repositioning efforts expand the choices available to buyers in moving across the square footage band, and in selecting options in our design studios that they value most and can afford. Although we expect these shifts to moderate our ASP, we believe that we are making the appropriate adjustments to respond to home buyers' needs and preferences.

Moving onto the market updates. In the West Coast region, where our net orders were down 21%, the inland areas held up relatively well as we produced favorable net order comparisons in both the Inland Empire and Central California. However, their growth was more than offset by a net order decline in the Bay Area, which accounted for the majority of our company's fourth quarter decrease in net orders. We continue to experience delays in getting new communities opened in the Bay Area, and as a result, this division was impacted by a significant reduction in average community count of more than 40% year-over-year, down to only 8 active communities at the end of the fourth quarter. In addition, with the Bay Area having sold through most of its higher ASP communities in the range of $1.3 million to $1.8 million earlier in the year, we experienced a decline in the Bay Area net order ASP to $800,000 from $931,000 in the year-ago period. While this business is well positioned for today's market environment, the combined effect of having fewer open communities and lower ASPs in those communities impacted our net order comparisons for the West Coast region. It is worth noting that we saw year-over-year price appreciation in the Bay Area communities that were [started] in the fourth quarter of both years, an indication that there continues to be strong demand at the lower price points.

Looking ahead to the first half of 2019, we are anticipating a sizable increase in grand openings in the Bay Area, significantly enhancing its community count by the second quarter of this year relative to year-end 2018.

In our Southwest region, Las Vegas continues to be a solid market for us, with an absorption pace per community in the fourth quarter of just under 5 per month, the highest rate companywide. In 2018, this division grew into our largest in terms of annual deliveries, and it is an increasingly important contributor to our overall results given its profitability. At Inspirada, our master plan in Henderson, we are selling 5 different product lines, which, combined, generated nearly 500 deliveries last year. This community is also the site of our KB ProjeKt concept home, which we unveiled this week in conjunction with the consumer electronics show. The full-scale concept home has already received significant media attention for its innovation in showcasing how smart and sustainable technology can be used to offer convenience and wellness features to home buyers. And while the ProjeKt Home is future-oriented, we are planning to offer certain wellness features from this home as options in select communities in California later this year.

In Phoenix, while we were impacted by a sizable decrease in community count in the fourth quarter, demand was solid, driving an increase in absorption pace. With close to 10% of our company's grand openings this year planned for Phoenix, we're looking forward to expanding our business in this market, one that has experienced healthy population and job growth.

In our Central region, our net order shortfall was primarily driven by our Colorado division, which was impacted by the timing of new openings during the fourth quarter and by a decline in community count. However, we expect to see meaningful growth in community count in this division by the end of 2019.

Colorado is a market that has experienced significant price appreciation with a median new home price of roughly $480,000 and a median resale price of $415,000. Our product offerings in this market are well positioned, given our ASP of about $470,000, below median new home prices, and at a reasonable premium to an older less-sufficient resale home. We expect our ASP in Colorado to move down in 2019 as we open new communities at lower price points, reflecting our product shifts.

Wrapping up the market updates, net order value grew 20% in the Southeast region, on a 10% expansion in net orders, with every division producing a positive net order comparison. A solid end to a year of improving performance in this region. We look forward to continuing to increase our scale and profitability in the Southeast.

In closing, we believe we are well positioned for 2019. The impact of our Returns-Focused Growth Plan is now clear, as we have significantly expanded the scale and profitability of our company while strengthening our balance sheet. We have a growing community count, featuring product that is positioned to maximize affordability for the consumer, and we have a talented team of employees that continues to execute our plan. In addition, with the recent decline in mortgage rates, we remain optimistic for the spring and the year ahead. We look forward to updating you on our progress as the year unfolds.

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

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Jeff J. Kaminski, KB Home - Executive VP & CFO [4]

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Thank you, Jeff, and good afternoon, everyone. We're pleased with our solid 2018 performance, as we generated improvement in virtually all of our key financial profitability metrics, along with a meaningful strengthening of our balance sheet. I will now review highlights of our financial and operational performance for the 2018 fourth quarter and full year as well as provide our outlook for the 2019 first quarter.

Given the current volatility and market conditions ahead of the critical spring selling season, we are not reaffirming or providing 2019 full year guidance at this time.

In the fourth quarter, our housing revenues were down 4% from a year ago to $1.3 billion, reflecting a 1% increase in homes delivered and a 5% decline in the overall average selling price of those homes. As we mentioned during our November conference call, our fourth quarter housing revenues reflected headwinds from the historic rains experienced in Texas and fewer-than-anticipated spec sales and deliveries in the quarter. However, despite these fourth quarter headwinds, our full year housing revenues of $4.5 billion were up 4% year-over-year, primarily due to a 4% increase in homes delivered. Looking to the 2019 first quarter, we expect to generate housing revenues in the range of $800 million to $860 million.

In the fourth quarter, our overall average selling price of homes delivered declined 5% to approximately $395,000. This decrease was primarily due to a shift in geographic mix, with a smaller proportion of deliveries coming from our higher priced West Coast region. For the 2019 first quarter, we are projecting our overall average selling price to be in the range of $375,000 to $385,000.

Homebuilding operating income for the fourth quarter totaled $121.9 million compared to $131.9 million for the year earlier quarter, including total inventory related charges of $9.1 million in the 2018 quarter and $7.1 million a year ago. Excluding inventory related charges from both periods, our operating margin was 9.7% for the current quarter and 9.9% for the year earlier quarter. For the 2019 first quarter, we anticipate our homebuilding operating income margin, excluding the impact of any inventory-related charges, will be in the range of 3.4% to 4.4%. Our 2018 fourth quarter housing gross profit margin was 18.1%, including the $9.1 million of inventory related charges. Excluding the impact from these charges, our gross margin for the quarter was 18.7% compared to 18.6% for the same quarter the prior year. As a result of reducing our outstanding debt and growing our unit deliveries, we have steadily decreased the level of incurred interest per delivery over the past several years to just $13,000 -- $13,200 per unit delivered, or 3% of housing revenues in 2018. In churns, the lower levels of prior period incurred interest combined with a widening spread between active inventory and total debt have reduced our amortization of previously capitalized interest, generating improvement in our housing gross profit margin of 80 basis points for the 2018 fourth quarter. Assuming no inventory related charges, we are forecasting a housing gross profit margin for the 2019 first quarter in a range of 16.6% to 17.2%, reflecting the typical seasonal first quarter decrease in operating leverage from lower revenues, partially offset by lower amortization of capitalized interest. This first quarter range also now reflects the anticipated impact from the implementation of ASC 606, which will result in the reclassification of certain expenses previously included in construction and land costs to selling, general and administrative expenses.

Our selling, general and administrative expense ratio of 9% for the fourth quarter, was up 30 basis points from last year's record low fourth quarter result, reflecting increased marketing expenses to support new community openings that are driving our expected community count expansion in 2019. We expect our 2019 first quarter SG&A ratio to be in the range of 12.7% to 13.5%, reflecting the decrease in operating leverage from lower revenues, additional marketing expenses and the ASC 606 reclassification mentioned earlier.

Moving on to taxes. Our income tax expense of $32 million for the fourth quarter was predominantly a noncash expense due to our deferred tax assets and represented an effective tax rate of approximately 25%. We currently expect our expected tax rate for the 2019 first quarter to be approximately 27%.

Turning now to community count. Our fourth quarter average of 232 was up slightly from 228 in the same quarter of 2017. We ended the year with 240 communities, up 7% from a year ago. Of the 240 communities, 34 communities or 14% were previously classified as land held for future development compared to 41 or 18% at the end of 2017. On a year-over-year basis, we anticipate our 2019 first quarter average community count will be up in the range of 6% to 10%. For full year 2019, we continue to expect growth in our average community count in a range of 10% to 15%.

During the fourth quarter, to drive future community openings, we invested $443 million in land, land development and fees, with $184 million or 42% of the total, representing new land acquisitions. We ended the year with $574 million of cash and total liquidity of just over $1 billion, including availability under our unsecured revolving credit facility. We generated $222 million of net operating cash flow in 2018 after investments of nearly $1.9 billion in land acquisitions and development. Our investments in 2018 improved our land pipeline to nearly 54,000 lots, driving expected community count growth in 2019 while we reduced our inactive inventory by nearly $140 million to $238 million at year-end or 7% of our total inventory. In addition, we used internally generated cash to opportunistically repurchase $35 million of common stock in the fourth quarter and retire all $300 million of our 7.25% senior notes earlier in the year. Our current year profitability and deleveraging activities resulted in a 500 basis point year-over-year improvement in our year-end debt-to-capital ratio to 49.7%, the first time that we have been sub-50% since 2005. In addition, we ended the year with a net debt-to-capital ratio of 41.6%, representing a 380 basis point improvement and our lowest year-end net leverage ratio since 2007. These metrics reflect the achievement of one of the key components of our Returns-Focused Growth Plan, using significant cash flow generated from core operations along with monetizing our deferred tax assets and inactive inventory to reduce debt and at the same time, increase land investment to drive future growth. We plan to continue with this approach and are targeting a minimum of $200 million of debt reduction in connection with the 2019 maturities of our convertible notes and 4.75% senior notes in the first half of the year.

Reflecting on 2018, we made significant progress in our Returns-Focused Growth Plan objectives. For the full year, we increased our total revenues to over $4.5 billion and grew our housing revenues and deliveries by 4% with an average community count that was 4% lower than in 2017. We also expanded our operating income margin and significantly improved our credit metrics, reflecting both our increased profitability and our debt reduction using internally generated cash. In addition, excluding the noncash charge for the impact of the new tax act, our return on invested capital expanded by 300 basis points to 10.4%, and our return on equity improved by 440 basis points to 14.4%.

In 2019, we plan to continue executing on our roadmap for Returns-Focused Growth as we navigate market conditions. Our long-term objectives remain the same, with a focus on increasing our scale, improving our profitability, increasing returns and reducing our leverage.

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

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from the line of Alan Ratner with Zelman & Associates.

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Alan S. Ratner, Zelman & Associates LLC - Director [2]

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First question, I was hoping to dig in a little bit on some of the initiatives you're taking on the product offering to try to drive down the ASP there. I was curious if you might be able to quantify at all what impact that could have either on margins, on price, on sales pace. I mean, how impactful should we anticipate this being obviously just given the 1Q guidance, but is this something that's going to drastically change kind of the way the year and even beyond unfolds?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [3]

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Alan, I wouldn't say it's going to drastically change anything. That's -- to me, that's too tough a word. What we're doing is reacting to some of the affordability pressures that are out there. Order of magnitude, I just -- I'll give you a generic example. If we had a Model Park, where the product out there was 1,800 to 2,400 feet. We'll introduce a model in the 1,400, 1,500, 1,600-foot range. So you're dropping your base sales price $10,000, $12,000. Depending on where it is in the system, it may have no impact at all on margin because it's an area where the lot costs us a smaller percentage than directs, you're just lowering your directs and in turn, lowering your sales price. If it's an area where the lot cost is a much bigger percentage, it could have a minor influence on the margin, but we're not doing it in an effort to compress margins. We think it's a way to hold, if not increase, our sales pace, which should in turn help you on the capitalized interest side. So there's a lot of different levers that you pull in doing this, but we just see it as normal course in our business.

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Alan S. Ratner, Zelman & Associates LLC - Director [4]

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Got it. That's very helpful. Second question, I was hoping you could just comment a little bit on what you're seeing in the incentive environment. We heard from one of your peers earlier that indicated they got a little bit more aggressive in their quarter and kind of alluded to the fact that they might continue to be aggressive if demand doesn't pick up in the spring. You guys are not a big spec builder. So on that front, it's not like you've got a lot of inventory you want to clear and you've been very focused on rebuilding that margin. But how do you think about the push and pull on incentives and volume and margin at this point?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [5]

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As you know, Alan, in our business model, we focus on the best value to the -- for the customer in the price. So we are not an incentive-heavy business. I think our incentives did tick up in the quarter 30 bps year-over-year, so not a material move at all. Doesn't mean that we've may not have changed our pricing structure when we open the community to a more aggressive price band when we opened it, but we try to stay out of the incentive game and give people the best price per foot for the home and let them go build their own value in the studio.

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Operator [6]

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Our next question comes from the line of Stephen East with Wells Fargo.

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Stephen F. East, Wells Fargo Securities, LLC, Research Division - Senior Analyst [7]

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Jeff, maybe you can -- in your prepared remarks, you talked a lot about the community growth that you've got coming along. I guess, for me, this is always the toughest thing to forecast is will they get open or not. When you sit here and look at your risks on getting these communities open, can you handicap a little bit where you are in your comfort level in getting all these open on time?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [8]

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Right. Steve, I'll take that one. Yes. I think we're -- we've been pretty accurate on the community count forecast as we've gone over the past number of years, actually. So we have a pretty good beat on it. The land is all controlled, obviously, the ones we're planning and opening especially in the first part of the year, development's well along the path in some of those communities, it's just a matter of opening -- building the models and opening the communities. So we're pretty confident with the community count numbers. The largest variability we usually find is on the closeouts. So a stronger pace, more closeouts, lower community count, weaker pace, you have fewer closeouts. So there's more variability on that side we find than on the grand openings. Occasionally, you'll see some push back due to weather or other external influences, but we normally get them opened. So we're pretty confident on the ranges we gave for the quarter and for the year on that one.

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Stephen F. East, Wells Fargo Securities, LLC, Research Division - Senior Analyst [9]

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Okay, all right. And then you talked a lot about the demand and traffic geographically and all that. It sounded like to me, Jeff, your biggest issue was your community count in the Bay Area. I guess, I was wondering this morning with Lennar, we heard a little different, probably not as optimistic. And could you talk a little bit about what was happening in Southern California and Orange County? And they had sort of indicated that they thought it was -- that slowdown was filtering into the Inland Empire. And so there's a compare/contrast here, I guess. I'm just really interested in a little bit more detail on what you think you all are seeing in the market.

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [10]

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Well, the Orange County market for us, Steve, is a much smaller business. So we spend more time on the Bay Area because that's where we've got a very good scale. And I would say that in Orange County, we did see softening. I think, our average price there is in the -- it's not out quite $1 million, but it's close, and we did see some softening in Orange County. You have to assume that if it's soften on the coast, it will soften a little inland. We really didn't see it in the fourth quarter. We had a positive sales comp in both the Inland Empire and Central Cal, Central Cal/Sacramento. It could be due to the price points that we operate in the Inland areas because we stay focused in those areas on being affordable for that area, not just affordable relative to the coast. So we'll keep an eye on it and the reason that I -- if you go up north, the reason I spent the time I did on the Bay Area is our -- when you sell out of a community that's selling well at $1.5 million or $1.7 million and you open up a townhome community at $800,000 to replace it, I didn't want people to think that there's been this big price drop or some big shift in the Bay Area marketplace because we're not seeing it. But -- and I would say that at affordable price points. When you get up to the high price points, I think, throughout the system, you're seeing some softening right now.

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Operator [11]

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Our next question comes from the line of Nishu Sood with Deutsche Bank.

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Nishu Sood, Deutsche Bank AG, Research Division - Director [12]

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I wanted to ask about the share repurchases first. You folks have had some pretty opportunistic well timed share repurchases in recent years as you've been executing your return strategy. Should we think of the 4Q share repurchases as another such opportunistic purchase? Or is it something that might continue? Or would the priority with the uncertainty in the market be more towards debt repayment in '19?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [13]

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I would say it was definitely opportunistic, Nishu, as we shared in our comments, when you're trading at such a discount to book. At the time, it was one of our best returns on investments we could make for our shareholders. Our balanced approach that we've been doing for years will continue in '19 where we will have a capital allocation strategy that is primarily focused on growing our business, growing our scale, growing our profitability, how do we support all that, and at the same time, continuing to strengthen the balance sheet so that we -- the good news for us is we have the capacity to do all those things now. And as Jeff shared in his comment, we're expecting that will be reducing that $200 million here this year as part of that approach. But we'll stay balanced and whatever is the right thing to do for our shareholders.

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Nishu Sood, Deutsche Bank AG, Research Division - Director [14]

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Got it. Second thing, ASC 606. It looks like it took some out of SG&A and -- I'm sorry, out of the COGS line, and put it into the SG&A line so it boosted gross margins and probably increased SG&A. Does that accounting effect just happen inter-quarter? Or can it spread expenses across quarters? In other words, is it -- would it have more of an effect later in the year? Or is it fairly equal quarter by quarter?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [15]

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Yes, it's a good question. I mean, there are few dynamics related to it, and right now, obviously, it involves all forecasting because we haven't reported an actual quarter yet. But you're effectively taking its model expense for the most part that's the bulk of the reclassification for us. So you're taking model expenses that, in the past, would have been expensed on a per unit basis, right? Part of your cost of sales buy on a unit basis. And now, you're moving those to basically fixed cost within SG&A, and they follow more of an amortization schedule. So there's 2 things that will happen. In a low volume quarter, you'll tend to see a little more negative on the SG&A line than you do a pick up on the gross margin side. For the year in total, they should more or less balance out. So on the first quarter, where it's a lower volume quarter for us typically, we're expecting to potentially see a little bit of that impact, maybe 10 or 20 bps of negative on balance. But we think that should more or less net out for the year and it'll become mostly geography. Over time, as we renew communities and open new communities under the new methodology, we'll lose a little bit of that comparability to what it was before and what it is in the future. But for now, that's kind of what we're seeing. Your observation was correct. I mean, that was a big driver of the lift in the gross margin and the -- also the higher SG&A cost in our first quarter guidance.

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Operator [16]

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Our next question comes from the line of Stephen Kim with Evercore ISI.

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Christopher John Shook, Evercore ISI Institutional Equities, Research Division - Analyst [17]

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This is actually Chris Shook on for Steve. So during the quarter, you increased your land spend 13% year-over-year. Was this number pared back compared to what you're initially thinking? And also, what kind of level of land spend should we think about directionally this year?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [18]

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I mean, just like the rest of the full year, we really stopped guiding on full year land spend, I think, a couple years ago now because what we do as an alternative is we review deals on an item by adding basis. Every single deal gets reviewed and we know where our cash flow capability is and what we have coming in on the operating side and then we make decisions on that basis. So you see typical variability in our land spend, it mostly just relates to deal timing, when the deals are improved, when they're ready to close. A lot of the deals that we tie up have contingent closings on certain things that the seller has to do either entitlement related or, in some cases, development related before we close. So it's more a function of just timing than anything.

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Christopher John Shook, Evercore ISI Institutional Equities, Research Division - Analyst [19]

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Okay. But is it still within the kind of 1- to 2-year lifespan that you previously cited?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [20]

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Yes. So I mean, what we'd like to do is we'd like to see all of our deals actually come to market and start producing revenues within 1 year, if possible. Some of the development deals may go out a little further than that, but we try to keep that pretty tight. It tends to drive the best returns when you can do that.

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Christopher John Shook, Evercore ISI Institutional Equities, Research Division - Analyst [21]

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Got it. And given the recent softening, have you seen any kind of degradation with Inland prices or are people still out there bidding?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [22]

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It's a mixed bag, depending on what city you're in. We've seen a little bit of softening, nothing significant yet. Land sellers are pretty patient right now, and we're being patient with them. We have all the lots we need for '19 and most of '20, so we can take our time and only do deals that make sense and hit our strategy and hit our return.

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Operator [23]

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Our next question comes from the line of John Lovallo with Bank of America Merrill Lynch.

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John Lovallo, BofA Merrill Lynch, Research Division - VP [24]

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The first one is, Jeff, I think you mentioned that orders -- Jeff Mezger, I think you mentioned that orders in December were down 15% year-over-year off of the toughest comp. Can you just remind us what December, January, February comps were?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [25]

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Yes, I don't -- look, we really typically don't go out with monthly numbers. I mean, we just provide quarterly. Jeff wanted to provide a little bit of color on December to give a feel for the comp we were up against last year, but I don't know if you want to comment any further on January.

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [26]

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We started December because we have a full month. It is the softest time of the year, so the comps to me really don't suggest anything on market trends because the numbers are so small. But as I shared in the prepared remarks, the traffic levels held steady and people are out there looking for homes, and we're -- January, we're just barely into one weekend too, and it's a holiday week, so you don't want to get into that battle because it -- again, it's distorted. But so far, we're encouraged with what's going on in January with our traffic and where the market is headed.

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John Lovallo, BofA Merrill Lynch, Research Division - VP [27]

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Okay. And then maybe just dovetailing off of that in terms of the traffic being pretty steady. I mean, have you seen maybe the quality of that traffic improving more recently?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [28]

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I don't know if we can say that. Again, it's anecdotal. I think, our traffic was solid in December, and it was solid in the fourth quarter, and it's a good quality payer. They're just kind of pausing to see if prices are going up, going down or rates going up or going down. If it's a good time to buy a home or not, and they just paused a bit. So we're hopeful here as we head into the new year, and interest rates have come down. If they see it's a great time to buy a house and they make their decisions quicker.

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Operator [29]

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Our next question comes from the line of Mike Dahl with RBC Capital Markets.

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Michael Glaser Dahl, RBC Capital Markets, LLC, Research Division - Analyst [30]

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Jeff, I had a follow-up to Nishu's question on the reclassification. Can you -- is there a way for you to give us on your 2018 results if you had applied this change, what that would have done to gross margins and SG&A?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [31]

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I guess, I'd rather talk about the first quarter because we've done a little bit more work on the first quarter, and obviously, on the full year, which we won't talk about. But roundabout right now, you could look at the gross margin line and say, I think it's going to be at least a 50 basis point uptick for the first quarter on the gross margin line, and probably closer to 70 basis points in the SG&A line. And that's as near as we can tell right now. And we could provide you guys more detail on that as the actual results come in. But like I said earlier, we will lose a little bit of visibility to it particularly on the gross margin side as we go deeper into the year because we'll know the reclassification into SG&A, but it disappears, right, out of the cost of sales. And every time you open a new community, you don't go and recalc what would it have been on the cost of sales side. But I think, in round numbers, that probably gets you pretty close. I don't think 2018 probably varies much from that.

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Michael Glaser Dahl, RBC Capital Markets, LLC, Research Division - Analyst [32]

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Okay. Asked a slightly different way than just specific to 1Q. Is that the only part that changed in your gross margin guide versus the 16 to 16.6?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [33]

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I think we lifted it 60 bps, so there was a little bit of mix and other factors maybe to the extent of 10 basis points-or-so. But yes, that was the bulk of the rise.

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Michael Glaser Dahl, RBC Capital Markets, LLC, Research Division - Analyst [34]

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Okay. My second question is also circling back to, I think, kind of around what Alan and Steve were asking about earlier on some of the repositionings but also the community count, and I forget if this came up in November. But when you're going to introduce these new smaller models, I think you called it existing floor plans, are these plans that have already been permitted for these communities? Or are there instances where you're having to kind of push out a community opening because you have to go through any sort of repermitting activities?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [35]

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It's a little bit of both, Mike. We have a product series that will have a broad range of footage. We get all the plans designed and introduced for that community and we'll get the plan check done on the whole series. But to go back in and get a permit, depending on the city, may take a couple days or it could take a couple months depending on where you're at. We actually have delayed a couple of openings to retool, where we decided well let's rethink the product here and it may have been a month or 2 delay. And that's out, we've already absorbed that, and we're off and running. And as I was walking through it in the comments part of the message is this product is already done. We didn't have to go recreate anything. We can take it from our system, we move it from one city to another. We already know the take offs, we already know what the buyers like and don't like, and it's a plug-and-play environment. So we were able to move pretty quickly, and our goal is to have everything out there, here in the first quarter.

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Operator [36]

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

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Michael Jason Rehaut, JP Morgan Chase & Co, Research Division - Senior Analyst [37]

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First question, I just wanted to -- without trying to beat a dead horse on the slowest month of the year, there's obviously a lot of focus earlier in the day around your competitors' comments around trends in December. If I heard you right, you basically were saying traffic was steady in December, in other words, no real change relative to November. And I presume that there was also no change in incentives as a result. So I'm just trying to get a sense. Obviously, every company is different, but the optimism around the earlier statements was that the decline in interest rates that kind of occurred throughout the month did have some type of impact. Are you surprised that it didn't show up in at least the traffic numbers that you saw during the quarter? Or were there any other kind of signs that perhaps the tone did change. Or if it didn't, why you think it might not have.

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [38]

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Mike, let me correct something for you. The traffic I was referring to was year-over-year. So our December year-over-year was as solid as it was in both years and same in the fourth quarter. Our overall traffic levels are lower in December than they are in November, stands to reason with the holiday period. And December for us, we're open for business, we'll take every sale we can. We're not going to go chase the business. So if somebody across the street throws out incentives or whatever, we're not going to react in December, because it's a very inelastic time of the year. So our sales -- or our sales and I don't -- I always use December, it's really not a reflection on the market. You like the sales you get but it's December. So as we come into January, it's more critical to us, especially now as the sales rates starts picking up week over week and you get into the selling season. It's a far better gauge of what's really going on out there. And I think, this interest rate tick down was late in December, so I don't know if it would've influenced your December traffic anyway. In January, as I shared, we're encouraged with what we've seen, but it's only a 6- or 7-day period because you had the New Year's holiday in there. So we're encouraged and hopeful and we like our position as things light up here in January.

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Michael Jason Rehaut, JP Morgan Chase & Co, Research Division - Senior Analyst [39]

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Fair enough, Jeff. I appreciate that. I guess, secondly, just a point of clarification. You had mentioned that in the Inland Empire, sales were up year-over-year. I just wanted to make sure, was that just overall orders or also sales per community for the quarter?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [40]

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(technical difficulty)

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Operator [41]

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Our next question comes from the line of Jack Micenko with SIG.

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Soham Jairaj Bhonsle, Susquehanna Financial Group, LLLP, Research Division - Associate [42]

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This is Soham Bhonsle on for Jack today. My first question is on gross margin, and I know you're not providing guidance there. But maybe can you just talk through if your views have changed in any way on the organic levers that you guys can pull to drive that higher year-over-year? And maybe just comment on the better lumber pricing, when does that flow into gross margin this year?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [43]

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Yes. I can give you some pluses and minuses, I guess, for the year as we look at it. I'll start on the negative side so I could end on the positive side. On the headwind side, it's the typical headwinds we've been seeing. I mean, you have potential material and contracted labor cost increases. So the inflation side is a bit unknown right now and it's been a headwind for several years now, offset by pricing. That still get us out there. We have and expect to see a little bit of mix shift in the first quarter that could go a bit negative on us as we're trying to rebuild community count, particularly in our Northern California business. We do believe that will correct and restabilize as we get later in the year and get some of those communities open. But that will likely be a headwind early on and we didn't incorporate that into our first quarter guidance, of course. And then there's a question mark on pricing power. Typically, you see pretty strong pricing power. At least we have seen it over the past several years, particularly during the spring selling season. If conditions remained choppy, we'll see what we can take out of that, if they strengthen and if the mortgage rate environment and the buyers come back strong, that could turn a potential headwind into a tailwind for us. So that one's kind of an in-betweener. On the positive side, absolutely right on the lumber pricing. We've seen lumber prices come down pretty dramatically. We don't think we'll see much of that in the first quarter because we had most of those homes framed while we were still on our 13-week look back because we do average pricing on lumber. But that is a potential tailwind for us later in the year. Two other pretty significant tailwinds for us: one is a reclass, obviously, the 606, it's a tailwind to margin and offset, for the most part, in the SG&A line. So that will be a factor on our overall GAAP gross margins in 2019. And then finally, fairly significantly, we expect to continue to enjoy the benefit from our balance sheet strengthening and -- in the form of lower interest amortization. We're expecting a pickup of a minimum of 50 basis points for the full year and lower interest amortization and the impact that will have on margins. So that's there for us as well. On balance, those are sort of the pluses and minuses and things to consider, I think, as you look at our full year.

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Soham Jairaj Bhonsle, Susquehanna Financial Group, LLLP, Research Division - Associate [44]

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So I just wanted to see in the prior guidance that you guys provided, did you bake in any level of incentives? Or was that just all organic?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [45]

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To the extent, again, we're not a big incentive company. I mean, our incentives are typically less than a point. So you know, they fluctuated -- probably this is the largest fluctuations we've seen in a quarter, which is 30 basis points in the fourth quarter. So I would say there probably wasn't much of that baked in, in the upcoming year. [Cost, price hike] yes, right. No price increase either, right?

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Operator [46]

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Our next question comes from the line of Jay McCanless with Wedbush Securities.

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James C McCanless, Wedbush Securities Inc., Research Division - SVP of Equity Research [47]

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The first one I had, if we look back at '18, the average backlog price declined fairly steadily each quarter through the year, but your average closing price, held in at a pretty tight range. And I know you all basically, I think, maintained the ASP at the average closing price guidance for 1Q '19. But at some point, with you all going to a lower mix shift, with your average backlog price coming down, should we expect a gap down in prices? And if so, is it a 1 quarter event, 2 quarter event? How are you all thinking about that?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [48]

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Yes, as you were tracking it through the backlog for last year, the largest impact on that was really community count in some of the high-priced markets, particularly the Bay Area. That was the #1 driver on the decline. So again, we baked it into the guidance for the first quarter and we contemplated for the full year. We don't think we'll see ASP increase to the extent -- I mean, look, the strategy of going smaller square footage and some of the mix shift that we have going on in the business, we think ASP growth that we've seen in prior years is probably not in the cards at the same level as we've seen in the past but a several year reflection of base market price.

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [49]

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Jay, let me make a couple of clarifying comments on that. I gave you that generic example of 1,800 to 2,400, now we come in with a 1,400- or 1,500-foot model -- or plan. It doesn't mean that the old plans aren't still available, and we call it moving with demand. If interest rates were to tick up and that's all a buyer can afford, they may shift to a smaller plan. And if they do, you also have movement in how much they spend in the studio. So they may shift to a smaller plan but spend more in the studio and your ASP can actually end up flat. We don't know. So it's an insurance policy for us, but it's not like we're moving -- we've taken away these other plans. So if interest rates stay down, the buyer comes back like they were last year. They can still go right back to the larger plan and spend whatever they can afford in the studio. But we're sharing it because it's a strategic move to insulate ourselves better if interest rates tick up.

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James C McCanless, Wedbush Securities Inc., Research Division - SVP of Equity Research [50]

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Understood. And then on my second question. I'm encouraged to hear that the community count is going to be moving up in several markets. But given the timing that you guys have talked about, can we expect any of these newer community openings to be a real earnings tailwind for '19, or is this mostly just going to help out on the order side with most of the earnings growth coming in '20?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [51]

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No, I think to the extent, we have a pretty good chunk of openings in the first half of the year, we should see definite earnings coming off those communities in the back half. Typically, first quarter openings are producing some revenue in the second quarter, but pretty solid revenues in the third and fourth quarter for sure. So yes, we'll see some of it in '19.

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Operator [52]

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Our next question comes the line of Matthew Bouley with Barclays.

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Matthew Adrien Bouley, Barclays Bank PLC, Research Division - VP [53]

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I wanted to ask about the reactivated communities. So just given what we're seeing in the market, kind of the deceleration in the broader market. Does that perhaps kind of change any thoughts around the reactivated communities? Is there any, I guess, additional sensitivity to what you'd be seeing in the market in these particular communities that would manifest in margins or sales pace? And if so, would there be, I guess, any flexibility around future openings of these communities?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [54]

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In what direction are you thinking? Opening more, or opening less?

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Matthew Adrien Bouley, Barclays Bank PLC, Research Division - VP [55]

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I'll leave that up to you.

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Jeff J. Kaminski, KB Home - Executive VP & CFO [56]

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Okay. Yes, I would say we're staying consistent in our strategy around the inactive assets. We're fairly aggressively opening communities. I mean, the fact right now is that within our inactive inventory, the bulk of it, we already have communities opened, and they're basically next phases of currently open communities. So to the extent the market continues and we continue to sell and deliver out of those communities, we'll just naturally move into future phases of those communities. And the handful of communities that have yet to be opened or where we've never opened a single phase, we continue to work in some of those communities on reentitlement efforts, in some of those communities, in development efforts, and we continue -- we expect to continue with the strategy. I mean, we were very successful in 2018 in reducing our inactive inventory by $140 million, and have had a very significant impact on the company, mainly in the form of cash flow and incremental margin. So we like the results of the strategy and we'll continue it as long as the market is there to support it. Everything is subject to market conditions, but we don't, at this point, see anything in the market conditions that would suggest that we change that strategy.

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Matthew Adrien Bouley, Barclays Bank PLC, Research Division - VP [57]

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Okay. I appreciate that color. And then secondly, just following up on the questions around the repositioning, maybe asked a bit of a different way. Have you actually made these square footage offerings on a meaningful scale in any of your existing communities? And if so, could you provide, I guess, so far, what, if any, impact you've seen, any kind of tangible effects on sales pace with those products or perhaps on the margin side thus far?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [58]

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Matthew, we're still -- we're early in the rollout. We have introduced the product as a finished and decorated model in communities, different footages in different cities. They are selling well. And if you think about it, it's -- part of the challenge is in smaller footage offer the same livability, 3 bedroom to 3 bedroom, great room, great room, nook, nook, size of the kitchen and we work hard in the smaller footages to get rid of dead space and wasted space so they live as well. And we are seeing the consumer respond to it, so it's early still and we like the initiative and we think we can really help our business there.

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Operator [59]

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Our final question comes from the line of Jade Rahmani with KBW.

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Jade Joseph Rahmani, Keefe, Bruyette, & Woods, Inc., Research Division - Director [60]

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Just in terms of land spend, can you give any color on what you're spending on average per lot currently? Or otherwise, since it varies by market, maybe indicate what the percentage is of ASP and if that's changed at all from a year ago.

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Jeff J. Kaminski, KB Home - Executive VP & CFO [61]

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Yes, I don't have those stats right on hand. But I mean, you can calc them. You can see our lot change, particularly when the 10-K comes out, you can see the change in lots and the spend on new communities. There are new land acquisition. But yes, I apologize, I don't have those numbers on hand here.

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Jade Joseph Rahmani, Keefe, Bruyette, & Woods, Inc., Research Division - Director [62]

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Do you have any color on what drove the impairment in the quarter?

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Jeff J. Kaminski, KB Home - Executive VP & CFO [63]

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There was a small handful of communities. There was part of the total inventory-related charge, almost $1 million that was just abandonments of land deals that we had in the pipeline that we decided wouldn't even meet our hurdle requirements or there were other risk factors associated with it. I think we had 10 abandonments that were booked in the community in the quarter and we had about 5 impairments kind of spread across the business.

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Jade Joseph Rahmani, Keefe, Bruyette, & Woods, Inc., Research Division - Director [64]

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Okay. And just lastly, are you contemplating any change in spec strategy?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [65]

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Respective of inventory?

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Jade Joseph Rahmani, Keefe, Bruyette, & Woods, Inc., Research Division - Director [66]

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Yes. Do you plan to build more specs in order to drive volume?

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Jeffrey T. Mezger, KB Home - Chairman, President & CEO [67]

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No. Our inventory homes are the toughest homes for us to sell. We believe in build-to-order, we've done it for 20 years. We think it's the right way to go, and we'll continue to reinforce those values.

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Operator [68]

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