KB Home (NYSE:KBH) Q1 2019 Earnings Conference Call March 26, 2019 5:00 PM ET

Company Participants

Jill Peters - Senior Vice President, Investor Relations
Jeff Mezger - Chairman, President, and Chief Executive Officer
Jeff Kaminski - Executive Vice President and Chief Financial Officer

Conference Call Participants

Stephen East - Wells Fargo Securities
Alan Ratner - Zelman & Associates
Timothy Daley - Deutsche Bank
Stephen Kim - Evercore ISI
Mike Dahl - RBC Capital Markets
Jack Micenko - SIG
John Lovallo - Bank of America Merrill Lynch
Michael Rehaut - JP Morgan
Scott Schrier - Citi Investment Research
Matthew Bouley - Barclays Capital

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 First Quarter Earnings Conference Call. At this time, all participants lines 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 April 26.

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 first quarter of fiscal 2019. 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 the Jeff Mezger.

Jeff Mezger

Thank you, Jill, and good afternoon. We had a solid start to 2019 with first quarter results that reflected continued execution on our returns focus growth plan, particularly in our balanced approach to allocating the significant cash flow we have generated to achieve our objectives. We made considerable progress in three key areas, continued to expand our gross profit margin, further strengthening our capital structure, and realizing growth in our community count.

Our capital allocation priorities have been very consistent since the start of our plan in 2016. Investing in our future growth and reducing our debt. In just over two years, while continuing to invest in land acquisition and development, we also repaid over $800 million of debt, which has meaningfully reduced the amount of interest incurred per home and created a tailwind to our gross margin. In the first quarter, this interest reduction benefited our gross margin by a full percentage point year-over-year.

During the quarter, we repaid the $230 million that was due on our convertible notes, decreasing our diluted share count by $8.4 million shares, which will benefit our earnings per share this year. Our debt-to-capital ratio in the first quarter was down about 500 basis points year-over-year, reflecting significant progress.

An additional highlight for the quarter was our community count growth. While we began to see year-over-year growth in our average community count in the 2018 fourth quarter, we anticipated a bigger step-up in 2019 first quarter and we achieved it. Our average community count growth of 10% reflected increases across each of our four regions and both our average and ending community counts were the highest they have been in several years.

Moving up from the quarter’s results, as we look at the health of the U.S. economy, it remains on solid footing. Consumer confidence is high, the unemployment level is low, and wages are growing as employers compete to fill the considerable number of job openings nationwide.

Household formation is another important indicator for us with over 50% of our deliveries to first time buyers. And it also continued to rise. Housing supply remains low due to both the multi-year production deficit of new homes and an insufficient inventory of existing homes, particularly at lower price points. Home prices have moderated recently and interest rates have eased back down improving affordability.

Last week’s announcement from the Federal Reserve signaling the likelihood of no further rate increases this year, should also help to sustain the favorable macro environment. Overall, the back drop for the home building industry is positive and we are optimistic about our ability to capture the demand for home ownership.

Our net orders for the first quarter, improved relative to the update we provided on our fourth quarter earnings call, progressing from a year-over-year decline of 15% for the month of December, to a 4% decrease for the quarter overall. We saw market conditions beginning to improve in January, with further improvement in February and we are encouraged to see the solid trends continuing in March.

On a per community basis, our net orders were 3.7 per month in the first quarter. A healthy pace that was more closely aligned with our 2017 first quarter, as compared to the outsize pace we achieved in the 2018 first quarter. Based on current market conditions, we expect that our 2019 second quarter absorption rate will track in the range of the 2017 second quarter.

Our net order value for the first quarter of $1 billion was impacted by two distinct mix-shifts. Within California, we had a larger percentage of net orders coming from Sacramento and the Central Valley, which were lower ASP markets. And among our regions the shift reflected a growing Southeast business. We view these mix-shift as short-term in nature and believe that as our community count expands and matures, we will revert back to a more normalized distribution of net orders.

Ending backlog was down 7% in units and our backlog value of $1.7 billion was down 16% year-over-year. As to community count, the 24 new communities we opened in the first quarter contributed to our growth in average community count, which as I mentioned earlier was up 10% year-over-year.

We have a large number of openings planned for the remainder of the year, particularly in the second quarter, which position us well to capture demand during the spring selling season. We continue to expect between 10% and 15% growth in our average community count for the full-year. And while having more communities is important, offering more affordable product within our communities is also key.

Our efforts to address affordability concerns, by expanding the choice of square footages available to home buyers are well underway and we expect to continue to introduce lower square footage plans in select communities in the months ahead. These smaller plans are incremental to, not in place of larger footage plans, and allow us to feature a lower starting price point in the community, widening the pool of interested and able buyers and driving traffic.

A good example is our new Autumn Winds community in Riverside County, California. We added 1,400 and 1,500 square foot plans to complement our initially planned product lineup for this community, which had ranged from 1,600 to 2,400 feet.

Since the opening, these two smaller plans have generated above 25% of this community’s net orders, with the community operating at an absorption pace and gross margin above our company averages. This is a good illustration of how our built to order model enables us to be proactive and quickly moving with demand, without compromising margins through the use of incentives.

With our business model, we can sell for affordability by introducing smaller plans at lower price points, while continuing to provide the choice and personalization that consumers value. versus staying with only with larger plans, which may require discounting.

Moving on to the regional commentary, our net orders were down 13% in the West Coast in the first quarter, primarily due to a decrease in net orders in the Bay area. In the first quarter of last year, we had a strong absorption rate in this division with a number of very successful close out communities, that generated about 45% of the Bay Area's net orders for that quarter, which is quite unusual.

In spite of the lower net order comparison, our absorption rate in the Bay Area, where we hold the top market share ranking remain strong at five per-month well above our company average. Products that are priced affordably in this market continue to sell well. As an example, two of our newest communities in Newark and Alameda County, contributed just over 50 net orders in the first quarter at ASPs of $1.3 million to $1.5 million, which is considered affordable for the area.

Elsewhere in the region, net orders in our Sacramento division where we have a top five ranking more than doubled with growth in both community count and absorption pace. This result reflects our product positioning and focus on affordable smaller square footage, traditional detached product.

Sacramento is a market with steady demand and one that is experiencing a shortage of affordable product. Our pricing strategy is working well with an ASP of just over $400,000, which is well below the median new home price of $490,000 and an appropriate premium to older less energy efficient resale homes, which have a median price of 355,000.

In Southern California, our coastal business, which includes Orange County and San Diego have experienced some weakness. This is due in part to reduced demand from foreign buyers, although market pricing has remained relatively stable. As one of our smaller divisions in the region, our combined Orange County and San Diego business has a more modest impact on our overall results.

However, we're watching the impact that market conditions along that coast have on our Inland Empire business. Our [closing] [ph] communities in the San Bernardino County adjacent to Los Angeles and Orange County continue to perform well, although we are seeing some softness as you move further inland.

While the California market overall has slowed relative to 2018. It remains a good market for us with an absorption rate in the first quarter, that was above our company average. Last week's announcement, that existing home sales for February in California increased at their highest rate of the past 6 months, underscores belief that this market continues to provide a solid opportunity for growth, especially at our lower price points.

We’re making strong progress increasing our average community count in West Coast region. With 10 community openings in the first quarter, and a higher number of communities slated to open in the second quarter, we except significant year-over-year growth in our West Coast region’s community count. In our Southeast region, net order value increased 27% and 25% growth in net orders.

For the fourth consecutive quarter every division in this region produced a positive net order comparison. We are pleased with the improved performance this region has been delivering and except it to more meaningfully contribute to our overall results going forward.

Before I wrap up, I’ll share a brief re-cap on our project house at Inspirada in Las Vegas, which many of you toured during the builder’s show in February. It was a great example of the innovation we can bring to own building, while primarily an R&D initiative, the project house contains certain elements that are currently available in select KB Home communities in California, including air quality, circadian lighting and water quality wellness features. And we except to offer these features in other communities later this year. In addition, we are offering the solar battery storage from Tesla in certain of our West Coast communities.

The project house also showcased on the KB Homes smart system, utilizing Google assistant can be integrated in the home. This system has been piloted in four of our markets, as a standard feature in two communities each and has an option in all the other communities. We’re tracking consumer preferences for standard features and options in this pilot as we work to expand availability across our foot print. We continued to believe there is a benefit to being an industry leader and offering sustainable intelligent homes.

In closing, we’re well positioned for the year. We except the first half of 2019 to reflect continued growth on our average community count and while we are still early in the spring selling season, we are encouraged by the trends we are seeing. As a result, we are poised to generate year-over-year revenue growth in the second half of the year, and cross over to year-over-year operating margin growth in the fourth quarter of this year, due to operating leverage and an increase in our gross profit margin. With our continued execution, we are achieving the results that our returns focus growth plan was designed to produce and look forward to updating you on our progress as we move through the year.

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

Jeff Kaminski

Thank you, Jeff, and good afternoon everyone. I will now review highlights of our financial performance for the 2019 first quarter as well as provide our outlook for the second quarter. While the year-over-year reduction in our net order and backlog values during the second half of last year, negatively impacted our first quarter housing revenues, SG&A expenses ratio, and operating income, we believe we are well positioned for the remainder of 2019.

We are anticipating several factors to positively impact the business in the second quarter, including opening over 35 new communities, attracting incremental home buyers with our additional offering of smaller floor plans designed to address affordability concerns, and generally stronger demand resulting from increased consumer confidence and steady interest rates.

In the first quarter, our housing revenues declined by 8% from year ago to $798 million, reflecting a 5% decrease in our overall average selling price and a 71 unit or 3% decline in homes delivered. The primary driver of these decreases was the lower first quarter unit deliveries in our West Coast region, along with specific community mix impacts within our Bay Area operation, particularly the absence of fixed communities with average selling prices of $1.1 million to $1.8 million that closed out in 2018.

We ended the first quarter with a backlog value of $1.66 billion, down 16% from the year earlier period, which was our highest first quarter backlog value in over a decade. The decline largely reflected the 14% year-over-year decrease in beginning backlog value, along with the impact from the close out to higher priced Bay Area communities that I just mentioned. We believe our backlog value supports second quarter housing revenues in the range of $900 million to $950 million.

In the first quarter, our overall average selling price of homes delivered decreased 5% from the year earlier quarter to approximately $371,000. This decline reflected increases of 7% in each of our Southwest and Southeast regions that were more than offset by the impacts of the high ASP community closeouts in the West Coast region and a mix shift within our Central region, with a lower proportion of deliveries from our Colorado operation.

We are projecting a sequential increase in our overall average selling price for the 2019 second quarter to a range of $375,000 million to $380,000. Homebuilding operating income decreased from the year earlier quarter to $31.3 million, or 3.9% of revenues.

Excluding inventory-related charges of $3.6 million in the current quarter and $5 million in the prior year period, our first quarter homebuilding operating margin decreased to 4.3% due to an increase in our selling, general and administrative expense ratio, partially offset by an improvement in our housing gross profit margin.

For the second quarter, we expect our homebuilding operating income margin, excluding the impact of any inventory-related charges, will be in the range of 4.2% to 5.2%.

Our housing gross profit margin for the first quarter improved 100 basis points on a year-over-year basis to 17.1%. Excluding inventory-related charges from both periods, our gross margin for the quarter was 17.6%, up 90 basis points, compared to 16.7% for the prior year period.

The year-over-year improvement primarily reflected lower amortization of previously capitalized interest and a change in the classification of certain model complex costs, due to our adoption of the new revenue accounting standard ASC 606.

The classification of these model complex costs changed from construction and land costs to SG&A expenses. These favorable margin impacts were partly offset by increases in fixed community-level expenses supporting community count growth and reduced operating leverage due to lower housing revenues.

Our adjusted housing gross profit margin, which excludes inventory-related charges, as well as the amortization of previously capitalized interest, was 21.3%, compared to 21.4% for the same period in 2018.

Due to regional and community mix impacts relating to our expected quarterly deliveries, we expect our second quarter housing gross profit margin to be in the range of 17% to 17.6%, assuming no inventory-related charges. Directionally, we expect measurable sequential gross margin improvement in both the third and fourth quarters.

Our selling, general and administrative expense ratio of 13.4% was up as compared to the first quarter record low ratio of 11% in 2018. The increase mainly reflected reduced leverage due to lower housing revenues, the ASC 606 impact mentioned earlier, increased marketing expenses to support new community openings and the absence of legal recoveries and favorable legal settlements we had in the 2018 first quarter.

As we continue to make a payment of overhead cost a high priority and expect to realize a favorable leverage impact from higher housing revenues, we are forecasting a sequential improvement in our second quarter SG&A expense ratio down to the range of 12.3% to 12.9%.

Income tax expense for the quarter was $4.5 million, as compared to $117.3 million in the prior year period, which reflected a non-cash charge of approximately $111 million related to the impact of the Tax Cuts and Jobs Act.

The tax provision for the current quarter included $5.3 million of favorable impacts from a deferred tax valuation allowance reversal and tax benefits from stock-based compensation, which were partly offset by other items. We expect our effective tax rate for the 2019 second quarter to be approximately 26%, excluding potential impact from stock-based compensation and/or energy tax credits.

In the first quarter, all of our remaining federal net operating losses were utilized contributing to the reduction in our deferred tax asset balance to $433 million at quarter-end. This balance is now comprised of approximately $128 million of federal energy tax credits, $100 million of refundable AMT credits, $97 million of state tax credits and NOLs net of valuation allowances and $108 million of temporary differences.

Except for the temporary differences, we expect the vast majority of our remaining deferred tax assets to be utilized or refunded within the next two years, providing substantial cash tax savings.

Net income for the quarter was $30 million, or $0.31 per diluted share. For modeling purposes, diluted earnings per share for the remaining quarters of 2019 should be calculated using approximately 92 million diluted shares outstanding, which reflects the $8.4 million reduction in our diluted share count due to the repayment of our convertible senior notes. Approximately, 93.5 million diluted shares outstanding should be used for the full-year calculation, representing a year-over-year decline of 7%.

Turning now to community count. Our first quarter average of 244 increased 10% from 222 in the same quarter of 2018. We ended the quarter with 248 communities, up 13% from a year ago.

On a year-over-year basis, we anticipate our second quarter average community count will be up 15% to 20%, as compared to the 215 communities in the 2018 second quarter. We still expect our average community count for the full-year 2019 to be up 10% to 15% year-over-year.

During the first quarter to drive future community openings, we invested $384 million in land, land development and fees, with $188 million, or 49% of the total representing new land acquisitions. We ended the quarter with total liquidity of nearly $1 billion, including $512 million of cash and $467 million available under our unsecured revolving credit facility.

During the quarter, we repaid all $230 million of convertible senior notes at maturity. We also issued new debt for the first time since early 2015, raising approximately $400 million in net proceeds from two concurrent public offerings with senior notes.

Subsequent to the end of the quarter on March 8, we used the net proceeds to retire at par value all $400 million of senior notes that were scheduled to mature on May 15, 2019. As a result of these transactions, we have already exceeded our $200 million debt reduction goal for the year.

At quarter-end, our debt-to-capital ratio was 50.9% and our net debt-to-capital ratio was 44.3%. On a pro forma basis, adjusting our quarter-end debt balance for the March 8 redemption, our debt-to-capital ratio of 45.9% improved by 380 basis points, as compared to year-end 2018.

Over the past two years, under our Returns-Focused Growth Plan, we have generated enough cash from our core operations and monetization of both our inactive inventory and deferred tax assets to retire over $800 million of debt, while investing nearly $3.8 billion in land, land development and fees to grow the business.

In summary, our first quarter highlights included a year-over-year increase in housing gross profit margin and improving order trend as we move through the quarter, a measurably higher community count, a decrease in diluted shares outstanding, and the successful completion of refinancing transactions. We expect to generate sequential improvements in our financial performance during the remainder of 2019, as we continue executing on our Returns-Focused Growth Plan.

We will now take your questions. Devon, please open the lines.

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Stephen East with Wells Fargo. Please proceed with your question.

Stephen East

Thank you, and good afternoon, guys. Congratulations on a good quarter in a very tough environment. And I guess, I'll start with that tough environment. As you all looked at, your gross margin was better than we expected. Your California orders were better than expected. As you look at the incentive environment, what are you all seeing in your primary markets? And I'm thinking more about California, but if there are other markets you need to talk about, go ahead? And then how are you all responding on that incentive front versus what your competitors are doing?

Jeffrey Mezger

Stephen, as you would expect, it's a mixed answer depending on where you are in our business and our footprint. But I would say at a high level, our incentives in November, December were pretty aggressive. A lot of builders were clear in their year-end inventory and whatnot.

We stayed out of that game. We held to our business model and worked on sales. And while our sales were off in the – in December, we elected to wait and see what January and February would bring to the business. And as – sometimes you're lucky, but the business showed right back up again in January and February. I think, it's a combination of the start of the spring selling. Interest rates came down. The consumer feels better, so demand came right back. And at the same time, I think, builders backed off of their incentives a little bit.

As we talk with our management in any given city, somebody is out there doing something to clear inventory, but it's not broad-based like it was in the fourth quarter. But we stay away for incentive payments. As you know, we're more focused on giving the best price and value, let them create their value in the studio and we've attracted more by offering lower footages and holding to our value proposition.

Stephen East

Okay, gotcha. And on the demand front and offering the lower square footages, it sounds like you're seeing a pretty good take there. As you look at the progression through the quarter and you gave us some good info there. As you got into March, it sounded like you were seeing the same acceleration. Is that a fair analysis of what you said? And do you think you all are starting to see any incremental acceleration from the rates – the recent drop in rates?

Jeffrey Mezger

As we shared in the comments, Stephen, January was better and then February accelerated again. I think, the acceleration that we saw in February is probably more than just a coincidence when the rates started to pick back down a little more quickly.

March is only three weeks into it, so I don't know that you can say that we got this trend we can talk to on a weekly progression or anything like that. But the dynamics in the market, our traffic levels, sales pace, what's going on is typical that March is a little better than February, and that's what we’re seeing it. I call it a pretty normal spring selling cycle right now.

Operator

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

Alan Ratner

Hey, guys, good afternoon. Thanks for taking the question, and nice quarter. So, first question just on the demand trends through the quarter, Jeff, obviously, there's a – there was a lot going on busy quarter for you guys opening communities. Is it possible to rank order the impacts of what really drove that better sales pace through the quarter on a year-over-year basis between strong reception to new communities that you opened up, some of the company specific things that you did on the product offerings versus just kind of a broader market strengthening as rates came down, and kind of the environment stabilized?

Jeffrey Mezger

I can try on that, that’s a tough one to answer. What we're seeing with our new openings and we've explained this before on these calls. Our community counts on average and if they’d opened the third week of February and opened to great success, it really doesn't help your absorption pace calculations for the quarter, because it's counted as a community. And even though it may have strong sales, it's only a couple of weeks of sales.

So, I would say, on the community count side I'm encouraged as the Q1 openings mature, they're performing very well. We have a lot of communities coming in the second quarter and depends on when they open and how they've seasoned and what that does to sales. But I wouldn't attribute our sales improvement necessarily to just grand openings.

And on the product side, we're just now getting on the ground. We're continuing to introduce the plans. We've had some models open up. They're selling well. It's incremental business for us. We don't see it as a broad-based driver, as I shared in the comments, get you more traffic. It may get you to a different buyer pool that couldn't otherwise afford that location and they want to live in that area.

So, we see it as incremental, but beneficial to our business. And while we are introducing those interest rates ticked down a little bit, so it took a little of the affordability pressure off. But we like the positioning for – if interest rates were to rise again, we're far better positioned than we were a year ago. So, I would then go to the economy and job growth interest rates coming down. And I would say, that's a real driver right now of what we’re seeing and selling for.

Alan Ratner

Very helpful. Thank you for that. And second question, if I could for Jeff K. Just on the gross margin guide for 2Q, you guys typically do have some seasonality in your margin. So, I think your guidance kind of implies flattish sequential margins, maybe down a touch, which is pretty unusual for the 2Q versus 1Q, and you kind of walk through the mix dynamics there.

I think, you mentioned you expect meaningful improvement in the back-half of the year. Just I know you're not giving official guidance, but should we think about your normal seasonal lift that you generally see as a pretty good guide to how we should think about that, or are there going to be other puts and takes to that?

Jeff Kaminski

No, I think that's the right way of thinking about it just from the point of view of the Q2 versus Q1, as well as the third and fourth quarter. It is a little unusual we're seeing in the second quarter. We did want to highlight that in the prepared remarks, that's why we added a little bit of color around the guidance and talking about just some community and regional mix factors impacting us.

But we do see that coming back in the third and fourth. And a lot of it is driven by what we're seeing on the California community count growth with relatively higher margins, particularly in the Bay Area at high ASPs, with delivery scheduled off in third and fourth quarters, so all that will be helpful. But I think, you're looking at the right way for sure.

Operator

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

Timothy Daley

Hi. This is actually Tim Daley on for Nishu. So, my first question is in regards to the land spend in the quarter. So, land spend was down around 17% year-over-year after around 25% growth that was put up last year. So, given the high-level of activity that we saw last year, how are you thinking about the budgeting for land investments in 2019? And should we kind of expect this trend of kind of maybe declines on a year-over-year basis to continue into the remaining quarters of the year?

Jeffrey Mezger

Well, I'll make a few comments on the land spend. First of all, the year-over-year decline was really specific to a couple of large deals that we acquired in the first quarter of last year as opposed to any change in strategy you’re scaling back or anything like that in the first quarter of this year. So, it was really just – literally just a couple of large deals that happened in the first quarter last year, they didn't repeat this year.

We will continue to use the same approach on our land spend as we move forward, and we evaluate market conditions. We also evaluate what we need to fill out our expected deliveries and top line revenues in future years and then drive really the whole company in order to acquire the right parcels and develop them and open up for sale that'll help us hit those top line revenues.

So, we don't really use a budget approach with any of our divisions. Although at the corporate level, we know what our cash flow capability is and we'll try to stay within that. And we did actually a couple of years back, really pulled back from specific guidance on land spend, because it really depends on the full projects. And we've – like I said, had consistent discipline around the projects, around approvals, and we will judge it more on that basis.

So, we're in a really good position right now with company liquidity and the cash flow we're generating from operations, where we don't feel really constrained at all on land spend side. But we do want to make sure we're investing in good solid deals that will drive returns in the future, and that's how we’ll continue to operate.

Timothy Daley

That's very helpful description there. So, I guess, the second question is more for Jeff M. You mentioned in your prepared remarks that you expect the Southeast to be a larger contributor to the overall company performance this year as kind of everything gets online growth community count. So that region's gross margin had been lagging relative to the overall company in others. I’m just curious, was – were you guys able to close that gap a bit in the first quarter of 2019? And maybe is that going to be contributing to a bit of the improvement that you're expecting in the gross margin in the second-half of the year?

Jeffrey Mezger

There was a little bit of growth in the first quarter, and we would expect the trend to continue. If you look at what I shared four quarters in a row, we've had order growth in every business. And you need to get orders before you get revenue, before you get scale, before you get margin, and this region has been challenged in that regard for many years, and is now finally coming out of the cloud.

We're opening more communities. We're executing well. We have great teams on the ground, and we expect more profitability and a lot of growth coming out of that region going forward. We think it can be a real tailwind for us.

Operator

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

Stephen Kim

Yes, thanks a lot guys. Jeff K I guess, I just want to make sure that we were hearing you clearly with respect to your comments on absorption and community count and the intersection in 2Q. Basically what I'm hearing you, if you get absorption rates in line or equal to what you did in 2Q 2017 was about 4.8 orders of community, your community count up about, I think, I believe you said 15% to 20 % in 2Q. That would imply a range of about 0% to 5% auto growth in 2Q and I just wanted to make sure that – that is basically what you're trying to lead us to?

Jeff Kaminski

Right. Your math is accurate.

Stephen Kim

Okay, great. Second question I had relates to the recent news about FHA making some tweaks to the scorecard, the announcements [indiscernible] suggested you have about 10% of your business with FHA higher than DTI, with DTI is higher than 50%. I was wondering whether or not you, what your view was on the willingness of the company to increase exposure to product with consumers that may be using high DTI's like that. And if that’s something that you’ve kicked around in the C suite with respect to this change that happened, and just to get some contacts from your perspective as to that recent change?

Jeff Kaminski

Stephen let me make a few comments, we didn't touch on this in our prepared comments, but we're really pleased with the progress that we’re seeing in our execution in our joint venture with Stearns, our capital rate, retention rate whatever you called in the quarter was the highest it's been, since we started, we’re up in the 64% range and it's growing by the quarter so we're having higher costumer service levels and more predictable deliveries, which is a good thing.

I wanted to reference the JV and that the underwriting is done by Stearns not KB. We have no influence whatsoever on the underwriting. If you look at our current book-of-business, our FHA is about 24% of our overall business and within that as we analyzed our backlog, less than 5% would have been kicked out to the manual underwriting instead of what they call the black box underwriting. So, it's 5% of 24%, it's really not much of a percentage of our overall business at all. So, we don't see that as a big mover for us or frankly the industry and the resale business relative to cutting of demand or taking underwriting. I don't think it's that big of a thing.

I think it is more FHA trying to balance out their risk and their portfolio. Having said that, what we are also seeing in our borrower profiles improving credit metrics. I was noticing this morning, our FICO scores are up, our LTV's are going down. The credit profile of our buyers actually been strengthening and we’re not displeased with our sales, you already like more sales. But we don’t see the need right now to go stretch anything on the underwriting we’re doing just fine with the current loan programs that are out there, that are conforming loans for the most part.

Operator

Our next question come on line of Mike Dahl with RBC Capital Markets. Please proceed with your question.

Mike Dahl

Hi, thanks for taking my questions. So, first question on the absorption environment, I think Steve just touched on it in terms of what it implies for 2Q specifically. But also, just wanted to ask again around kind of the demand environment. Jeff M, you talked about it being a pretty normal spring. And if I look at the sequential improvement in 2Q versus 1Q absorptions. Kind of looks that way as well compared to history. If we comp to 2017, think you guys were doing a little under four sales a month for the entire year. Do you think that's a reasonable way to think about the balance of this year, or do you think just based on the improvement that you have seen in March you have the potential to kind of accelerate through and potentially do better than normal seasonality in the back half?

Jeffrey Mezger

Well we continue with our strategy of balancing price and pace with every asset, over the last few years, we've kind of optimized that four a month and will take some more margin if we can above the four a month. As you look back and compare 2018 to 2019 for us, in 2018 pretty good market conditions and we actually built a bridge to revenue growth by running communities a little faster and the strategy was, we have to do that to keep growing revenue until we can achieve the community count growth that we have been chasing for a few years.

We’ve now done that here in the first quarter. I shared in my comments we have the highest community count, not for a quarter, for a whole year, in many years right now and we expect it to continue to grow. So, we have more communities to farm our sales growth from and I don’t think you'll see it necessarily go much above the four month an average for a year. May spike above at this quarter or be a little below that quarter but we will continue with our four-month targeted discipline and try to go for margin above that.

Mike Dahl

Okay. Got it. That's helpful and that’s certainly good thing on the community count. In terms of the second question shifting over to margin side, I guess a two-part question for Jeff K. Could you remind us, I think the guide have been – that this accounting shift would impact gross margins by 50 basis points and SG&A by 70 basis points in 1Q, I guess, first is that impact what the impact was? Second, how should we think about that? In the context of that 2Q guide and then, I guess this will be third part, the interest amortization obviously a huge benefit year-on-year in 1Q. I think you've talked about it being a little more modest for the full-year in the past, but just any update on how we should be thinking about cap interest for the year?

Jeff Kaminski

Sure. I'll take your three-part single question. No problem. So, as it relates to Q1. Yes, we did guide 50 and 70 and we were off a little bit on both of those. Actually, the margin impact was a little more favorable than we had anticipated and the margin impact was about 70 basis points. On the SG&A side, it was actually a little more negative than we anticipated. We thought it would be a 70-basis point hit to SG&A and it was actually about a 100-basis point. So, the net operating margin hit we took in the first quarter due to the accounting change is about 30 basis points and again just as a reminder, the reason for it is, the model expenses of now, with the new accounting converted from a variable cost through a fixed cost, so they get more impacted by top lines volume and that's what we saw in the first quarter.

The second quarter we think will be right around those same numbers that we saw in the first, 70 basis points on the gross and 100 basis points on the SG&A. And then we should see those turning in the third and fourth quarter, and basically what we think of the gross margin will stay relatively stable because it was a variable cost in the past. So, we think that’s 70 basis points or probably be about the impact for the full-year, but the SG&A with the higher revenues in the third and fourth quarter should reduce and impact so that by the end of the year full-year altogether we may see a slightly negative may be 10 basis points, may be 20 basis points negative to operating margin overall. Obviously over the medium term that goes to zero because the expense is the expense and it’s just a different way of accounting for it now. So, that’s really how we're looking at that side. That probably covers your question on the 606 change.

On interest amortization, good news on that as well. We kind of expecting about a 50-basis point uptick and we came in much more favorable than add up at a 100 basis points for the first quarter. And when we forecast out the year, it does look like we will have an impact of between 80 and 100 basis points in each of the quarters for the year. So, quite helpful and a big step down. In fact, I looked at the first quarter amortization number at 3.7%, and I was trying to find the first quarter where it was lower [than that]. I went all the way back to 2011, which was my first full year with the company and this was lowest interest amortization we’ve had in the first quarter since I started with the company.

So, the progress we made on the balance sheet and the leverage ratio and the – basically the recapitalization, it's really paying off now in forms of improved gross margin and lower expenses. The other fact point on that is, incurred interest from the point in time when we launched the returns focus growth plan to the full-year 2016, compared to the full-year 2019, incurred interest will be down by over $50 million. So, really significant impact from what we’ve done over the last few years.

Operator

Our next question come from the line of Jack Micenko with SIG. Please proceed with your question.

Jack Micenko

Hi. good afternoon. The land sales in the quarter were a little bit larger than you have seen, and I just want to draw on that a little bit, is that an acceleration of some of the monetization of some of the lower margin loss that are still left out there or is there something else and how do we think about that through the balance of the year?

Jeff Mezger

It was a bit unusual, I mean, I would say, you know they were ordinary course sales. We don’t have really that many ordinary course sales, and that came from acquiring a couple of parcels that had either more loss and we cared to try to work though on pace. Part of the parcel was actually built or entitled for an apartment building. So, we made that sales to an apartment builder. The other ones were just lot sales to reduce some exposure. So, it really wasn’t related to the re-activation strategy or the debt side of things at all, just normal cause it just happen to lumpy in this quarter.

Jack Micenko

Okay, okay and then you know the quarter really sounds like it was, maybe really the tail of two quarters in terms of the difference in activity from beginning to end, was it the pause in November, December, was that enough to meaningfully change the labor environment and pricing power, just curious, you know about any labor observations you guys have over the last 3 or 4 months since we last talked.

Jeff Mezger

It’s a little spotty depended on the market. We’re hearing anecdotally of more labor availability. I’ve actually in some market seen were apartments starts to weigh down that may have freed up some of the labor. Labor is still tight, but it seems to be easy in a bit. And one of the initiatives we’re on right now as a company is to expand our labor base and shrink back some of the build time we lost, with the labor pressure we saw over the last few years, but costs are still going up a little bit, but labor is a little loser that it was 6 months ago.

Operator

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

John Lovallo

Hi, guys, thank you for taking my questions. The first one here, you guys indicated that the second quarter gross margin will be flat to down slightly, then third quarter and fourth quarter would step up pretty nicely seasonally, is it fair to think that the seasonally step up in the third and fourth quarter could be more pronounced than usual given the amortization benefit that you talked about and also I think lumper should start flowing to at point as well.

Jeff Mezger

I don’t know how much detail we want to get into it. I mean, the reason we made the comment on the back half of the year was because it was a little unusual to a see a second quarter step down. We’re still not really providing full year guidance for a couple of different reasons. We’re not sure how the spring is going to finalize and they were still kind of right in the middle of it, beginning phase of it. And second, the third and fourth quarter deliveries, a lot of those deliveries are going to come from communities that had either just opened for sales or are going to open for sales in the very near future.

So, it is all pretty hypnotical right now. And we do except to see a big mix shift in communities between what we have opened this year and last year for no other reason just from the pretty large step-up in community count that we are seeing. So, I don’t know that would predict anything outside of the normal. At the moment, we’re not even really going that far. We just wanted to give some directional flavor or color around what we think will happen in the third and fourth quarter.

John Lovallo

Okay. Got it. And then second question is, the second half of the year you’re expecting year-over-year revenue growth and operating profit growth in the fourth quarter, I mean in terms of operation margin in the fourth quarter how should we think about it? I mean I know you are [indiscernible] but we could think that directionally that could actually be up on the year-over-year basis?

Jeff Mezger

Yes, that’s what we’re saying by that comment, operating margin.

John Lovallo

Perfect. Thank you.

Operator

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

Michael Rehaut

Thanks, good afternoon everyone. Thanks for taking my question and congrats on the quarter. First question I just had, you know Jeff I think referenced earlier in the call that as you had highlighted in your prior call, December orders were down 15% obviously you’ve seen some good sequential improvement throughout the quarter that you said continued into March. I was just hoping to get a sense of what January and February orders the months were as a year-over-year percentage and, you know – I’ll leave it at that and maybe just any color around the sales pace on a year-over-year basis as well.

Jeffrey Mezger

Mike as we shared in the comments, if you end the quarter down 4, and after a month, you’re down 15, you have to do better in the other two quarters. I hate to give monthly trends, because it depends on what a week cuts off and what holiday and what Super Bowl and all these other factors. But we shared that in January that we closed the gap and February was good. So that the momentum built through January and into February and the February momentum has continued here in March.

Michael Rehaut

Right. Right, now understood. I guess, I was just trying to get a little more granular, but obviously, also the color on the second quarter sales pace is very helpful as well. So, we appreciate that.

Secondly, just circling back to the gross margin cadence and you certainly appreciate the help there and how to think about it. When you mentioned the significant increase that you expect in gross margins in the back-half, which combined with revenue growth, you'd expect operating margin improvement in 4Q year-over-year.

I was just trying to get a sense, I think, most people would be kind of interested if that would be more driven by an improvement in gross margins year-over-year, or more SG&A, maybe reaching below 9% we did in 4Q 2018, or would it be a combination? How are you thinking about the bigger drivers of that operating margin improvement at this point?

Jeff Kaminski

Right. Well, let me just walk you through a few things relating to gross margins first, then I’ll talk a little bit about the SG&A side. When we look at the back-half of the year, we have a number of what we think are tailwinds that will see coming at us or behind us, I should say. We'll see increased leverage on our fixed costs. We'll see continued good news on a year-over-year basis from the 606 adjustments, that’s about 70 basis points a quarter.

I highlighted in detail about the interest amortization gains that we're expecting was the mix shift, both regionally and within communities that will go towards higher-margin communities in the back-half. And at least for the second and third quarter, we'll see some benefit, I believe even more benefit from the lumber cost reductions as we're on a look back cost on our lumber cost of the businesses.

So, as we're closing the homes, where the lumber cost was at the trough, we'll see some good news there. Who knows where it's going over the next few months, but at least for the next three, four, five months or whatever, we'll see some positives?

On a headwind side, the things we don't know right now, worse pricing power going to be added as we move through spring and through the back-half of the year. We think that's less of a risk now than it was maybe last quarter because of the recent rate moves, so that's a good thing.

We're seeing more or less normalized input cost inflation. So, it's not out of bounds there and particularly, when you combine it with the lumber cost decreases, that's really well controlled right now, although that is still potentially a headwind. And the largest unknown force right now is just how the new communities perform on opening. We know where we underwrote those communities.

Oftentimes, when you open, you’re a little bit under your underwriting standard as you're trying to get sales going and you're trying to get some activity going in those new communities and it comes up to average and then towards closeout your higher than average on the closeouts. So, that's a big unknown for us. But those are some of the tailwinds we have on the margin side.

On the SG&A expense side, I don't think last year's numbers are within range just simply because of the accounting reclass, with all the costs going down from cost of goods sold into the SG&A line. I think, that's going to be a tough one to overcome.

On the other side of that, however, what we're seeing early – in the earlier part of the year is, we’re making a lot of investment into the business to support this growth, both to get the communities open and then to market those new communities and everything that goes along with it.

So, there's a lot of investment for growth. We're seeing that in a big way in the first six months and we should see some of that payback in the back-half as we get better leverage of higher revenues. So, to answer your question, I guess, just really briefly on the operating margin in the fourth quarter, I think it'll be driven by improvements and definitely SG&A expense sequentially as we go through the year in gross margin on a year-over-year basis, so by the time it gets to the fourth quarter. So hopefully that helps.

Operator

Our next question comes from the line of Scott Schrier with Citi. Please proceed with your question.

Scott Schrier

Hi, good afternoon. I wanted to just ask a little bit if you could talk about the weather in California, weather from a community opening standpoint or traffic or activity. And if you've seen a rebound – and if any kind of weather has caused any issues in terms of the pace you expect to open communities in California in the balance of 2019?

Jeffrey Mezger

Weather – we stayed away from it, because we know it just sounds like an excuse. And everyone knows, we've had a lot of weather if you go back to last fall and hurricanes and all the rains and fires, we've had here. The snow in Colorado a couple of weeks ago had an impact on our communities there.

So, we've been taken the hits, if you will, on delays in getting communities open. And that's in part why we're a quarter or two behind in our community count ramp up and now it's finally here. The guidance that we've given you for where we're headed right now with the community growth and our revenue growth and all that is tied to our current assumptions on what is going to take to get communities open, when they reopen and how much will they drive revenue. So weather is out there. We're just continuing to fight it and manage through it as best we can.

Scott Schrier

Thanks. And then for my follow-up, I wanted to ask about your earlier comment on creating value in the design studios and taking into account lower base prices with respect to smaller plans. What are you seeing there? Are you seeing that, because maybe the base prices of the smaller plans are there that folks are maybe buying more in the design studios or conversely are, they still pulling back and just thinking about any kind of gross margin impact that you might extrapolate from those trends into some of the commentary you talked about for gross margins up going forward?

Jeffrey Mezger

It's a good question. We – as I shared, we’re early in the roll out of these plans. So, I don't know that we have enough data yet to tell any – to pick up on any trend. I shared that was – it's incremental business for us and it's helping with traffic and marketing. If it's 3% of our sales for the year, it’s not going to move the needle at all in the studios. If it's 10% of sales, it might a little bit.

But we're seeing the studio revenue as a company hold pretty standard. And I like to remind people, it's not just the price point you're at, it could be a 2,000 square foot home for $1 million, or 2,000 square foot home for 200 grand, and the carpet is the carpet in the home.

So, it doesn't necessarily go to the price point, it goes to what people want to put in a similar footage home around the country. But so far, over the last couple of years, our studio results have held pretty steady.

Operator

Our final question will come from the line of Matthew Bouley with Barclays. Please proceed with your question.

Matthew Bouley

Hey, thank you for taking my questions. I wanted to ask about the community repositioning, again. I think, Jeff M, you mentioned in the comments that there was that one community that's operating above company averages on gross margins and you're seeing some pace driven by the reduced square footage offerings. So, are you saying that those product offerings specifically are already generating higher than company average margins, or I guess, just what else can you say around what the margin impact has been?

Jeffrey Mezger

In that example, there's no question that those two floor plans are generating sales and the community is average enough to generate in a margin higher than our company average. Another one I can reference, because they're not all the same communities and the ones that we shared, we introduced the 1,400 or 1,500 square foot home below our community that was originally going to be 1,600 to 2,400.

We just opened a community in Mesa, where we introduced a smaller floor plan, albeit bigger than the example I used on the call in a community called Allred Ranch in Mesa. We introduced an 1,800 square foot model. And since we opened, it's been 60% of the sales in that community and, again, it's that margins and pace higher than our company average.

So, these aren't necessarily 900 square foot homes. They're smaller than what we were putting out there before, an 1,800-foot home can leverage a lot just like 2,200-foot home. It just – it brings you price point down and you sell more houses.

Matthew Bouley

Okay, that's really helpful. And then I was curious if you've potentially started to see any impact of the solar panel rule in California, that's going to take effect next year? And I guess, if not yet, how would you anticipate seeing that effect in ASPs or margins as we start to look towards the second-half of this year? Thank you.

Jeffrey Mezger

We're continuing to evaluate the roll out and what it means as a company, we're the largest builder of solar homes in California already. Probably close to half of our business is solar in the space, something in that area. So, as it rolls out, we actually think it'll move prices for that other half that don't have solar today. We’re evaluating LEED programs, which may not move the pricing at all, and we’re still trying to get our arms around on how to comply what does it mean. Today, it really hasn’t impacted anything other than what do in the normal course.

Operator

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