KB Home (NYSE:KBH) Q2 2023 Earnings Conference Call June 21, 2023 5:00 PM ET

Company Participants

Jill Peters - SVP, IR

Jeffrey Mezger - Chairman, President & CEO

Robert McGibney - EVP & COO

Jeff Kaminski - EVP & CFO

Conference Call Participants

John Lovallo - UBS

Michael Dahl - RBC Capital Markets

Alan Ratner - Zelman & Associates

Stephen Kim - Evercore ISI

Matthew Bouley - Barclays Bank PLC

Michael Rehaut - JPMorgan

Joe Ahlersmeyer - Deutsche Bank

Truman Patterson - Wolfe Research

Charles Perron - Goldman Sachs

Operator

Good afternoon. My name is John, and I'll be your conference operator today. I would like to welcome everyone to the KB Home 2023 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the company's opening remarks, we will open the lines for questions. Today's conference call is being recorded and will be available for replay at the company's website, kbhome.com through July 21.

And now, I'd like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Thank you, Jill. You may begin.

Jill Peters

Thank you, John. Good afternoon, everyone, and thank you for joining us today to review our results for the second quarter of fiscal 2023. On the call are Jeff Mezger, Chairman, President and Chief Executive Officer; Rob McGibney, Executive Vice President and Chief Operating Officer; Jeff Kaminski, Executive Vice President and Chief Financial Officer; Bill Hollinger, Senior Vice President and Chief Accounting Officer; and Thad Johnson, Senior Vice President and Treasurer.

During this call, items will be discussed that are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future results and the company does not undertake any obligation to update them. Due to various factors, including those detailed in today's press release and in our 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 measure of adjusted housing gross profit margin, which excludes inventory related charges and any other non-GAAP measure referenced during today's discussion to its most directly comparable GAAP measure can be found in today's press release and/or on the Investor Relations page of our website at kbhome.com.

And with that, here is Jeff Mezger.

Jeffrey Mezger

Thank you, Jill, and good afternoon, everyone. We delivered strong results in our second quarter, including a significant sequential improvement in our net orders. Our divisions executed well, improved their cycle times, reduced build costs further on new starts, and opened new communities, all of which will benefit us in the quarters ahead. As for the details of our results, we exceeded the high end of the guidance we provided in March with total revenues of $1.8 billion and diluted earnings per share of $1.94.

Our backlog continues to provide stability and deliveries and revenues with 3,666 homes closed during the quarter. This was higher than our implied delivery guidance by about 700 homes, driven by improved build times, fewer cancellations and better conversion of our unsold inventory. A 11.7%, our homebuilding operating income margin excluding inventory related charges reflected a solid gross margin of over 21%, and a healthy SG&A expense ratio below 10%. This performance along with the cumulative benefit of several quarters of share repurchases drove our book value per share to $46.72, up 24% year-over-year.

The long term outlook for the housing market remains healthy. Market dynamics are characterized by low existing home inventory and limited availability of new homes at our price points as well as demographics that are particularly favorable for our business, given that we primarily serve the first time and affordable first move up segments.

With respect to demand, buyers are adjusting the higher mortgage rates and the continuation of a more stable rate environment is a positive factor. In addition, with the lack of resell inventory that I mentioned and market price is now starting to increase, buyers are demonstrating a higher sense of urgency than we saw earlier this year.

As we discussed on our first quarter call, we have begun to see a sequential improvement in demand in February, which continued throughout our second quarter. As a result, we generated net orders of 3,936, significantly above our guidance, reflecting a year-over-year increase in our gross orders and a cancellation rate that is moderate back toward historical levels.

On a per community basis, our absorption pace averaged 5.2 net orders per month, which is consistent with our historical second quarter average prior to the pandemic driven volatility. Our strategic goal continues to be optimizing each asset, which generally results in a monthly absorption pace of between four and five net orders per community and generating high inventory turns.

We typically experience a peak in absorption in our second quarter coinciding with the spring selling season, and then see a sequential decline in our third and fourth quarters. While we do not usually provide guidance on net orders, we recognize it is helpful to investors considering the soft comparison in last year's third quarter when interest rates have started the rapid increase.

Demand has remained strong in June and while our 2023 third quarter net orders could be influenced in either direction by an increase in resale inventory levels or move in interest rates, we project a range of between 3,000 and 3,500 net orders.

Our business spans geographic markets that were selected for their long-term growth potential. With the diversification provided by our ongoing expansion of our Southeast region, which we discussed on our earnings call in March, our footprint is more balanced today than it was just a few years ago. Much has been written about the California market and over the years building homes in this state has moved in and out of favor from the investor perception point of view.

I want to spend a moment sharing some facts with you and our thoughts about the opportunity we see here. While numbers differ depending on the source, some public policy firms peg the existing shortfall of housing production relative to the 40 million people living in California at more than 1 million homes.

For a number of reasons, including a challenging regulatory environment, the state is severely under-supplied and there are not enough new homes built each year to overcome the deficit, let alone achieve equilibrium between supply and demand. In addition to this shortage, California's housing stock is aging with approximately 75% having been built before 2000, higher than most of our markets.

According to a recent report from Moody's Analytics, the state is projected to have above-average job and income growth longer-term, which together with the factors that I just referenced point to a highly attractive market opportunity in California. Within the state, our business has become better balanced across our served markets with our Inland divisions benefiting from work-from-home trends and affordability, while our coastal price points are now more affordable as we have rotated out of most of our $1 million plus price communities.

We have long-tenured teams in California that are well versed in identifying and acquiring land that meets our return requirements, navigating the complex regulatory environment and running profitable businesses. From a regional standpoint, our West Coast business is now also augmented by our operations in Seattle and Boise, which provide further diversification and growth. We believe we are well positioned to leverage our scale and capture the sizable opportunity in our West region, while also continuing to expand across the remainder of our operating footprint.

Our backlog at the end of the second quarter stood at nearly 7,300 homes valued at approximately $3.5 billion. This marks the first sequential growth in our backlog in the past year. With our built-to-order model, we work from a large backlog and see value in the visibility and stability in deliveries that our backlog provides, particularly in times of challenging market conditions as we saw during the past year. With the improvement in our build times, which Rob will speak to in a moment, we expect to be able to convert our backlog to deliveries more quickly in the future than we've seen over the past two years.

During the quarter, we started 3,556 homes, aligning our starts with net orders and ended the quarter with more than 7,300 homes in production, of which over 75% are sold, consistent with our targeted split of build-to-order and inventory homes. We expect to ramp up our starts in the third quarter. And while we continue to prioritize our built-to-order model, we are supplementing our starts with additional inventory homes given market conditions and a lack of supply.

With that, let me pause for a moment and ask Rob to provide an operational update. Rob?

Robert McGibney

Thank you, Jeff. I'll start with some color on our net order results and then discuss the progress that we've made on build times and direct costs, followed by a supply chain update. As Jeff mentioned earlier, the sequential strengthening of our net orders month by month in our second quarter continued the trend that began in February. We focus on optimizing each asset on a community-by-community basis, balancing pace, price and margin.

In late 2022 and early 2023, as we converted more of our large community backlogs to deliveries, we were in a position to adjust pricing to stimulate sales and we took steps in most locations to lower pricing based on current market conditions. That trend reversed in our second quarter as demand improved and markets began to normalize, and we were able to raise prices in about two-three of our communities. The benefit of which we expect to see in early 2024, when these homes are delivered.

And the other one-third, pricing yield remained flat or was lowered with the latter representing only a handful of communities. We continued to use rate buydowns selectively such as when a buyer leads to qualify, which occurred in fewer communities than earlier in the year. As to build times, we drove a significant sequential improvement with a reduction of over 40 days in the second quarter from slab start to home completion.

At roughly seven months, our construction times are still running above our historical level of between four months and five months depending on the division, but we are making solid progress in returning to those levels. In addition to reducing our cost in the amount of cash we have tied up in our work in progress, faster build times should also help our selling efforts on our personalized homes.

The construction time improvement was driven by a normalizing supply chain and better trade labor availability, as well as our ongoing initiatives to simplify our product offerings, designed, CDO choices and structural options. We have reduced our SKUs by 43% over the past 18 months, retaining the studio options that are most frequently selected by our customers and those most readily available in the supply chain. These changes have created efficiencies for our teams, our trade partners, and our customers, while helping to lower our cost and time to build.

We shared with you on our last call in March that direct costs on homes started were down approximately $19,000 from the peak in August 2022. During the second quarter, we continue to make progress in this area with an additional reduction of roughly $4,000 on new starts. Specific to the supply chain, while some products remain in short supply with long lead times in several markets such as air conditioning and heating equipment, insulation and electrical products, including the switchgear and transformers, overall product availability continues to normalize.

With respect to trade labor, it is becoming more available contributing to our compression in build times. In most of our markets, we have developed long-term relationships with our trade partners, many over the course of multiple decades. The even flow production inherent in our built-to-order model is attractive to contractors who value the consistency of our starts as opposed to the peaks and valleys of a speculative business model. As we look forward, we plan to continue leveraging the improved cycle time, lower costs and normalizing supply chain to help drive future volume and margins.

And with that, I will turn the call back over to Jeff.

Jeffrey Mezger

Thanks, Rob. Moving onto our mortgage joint venture, KBHS Home Loans, about 80% of the mortgages funded during the quarter were financed through our JV and these buyers continue to have strong credit profiles. About 60% of KBHS customers utilize the conventional mortgage and roughly 90% use fixed rate products.

The average cash down payment held steady with the first quarter at 15%, equating to roughly $72,000. The average household income of these buyers was over $137,000, above the median household income in our submarkets and their FICO score was 736. We continue to attract buyers above our targeted income levels with healthy credit, who can qualify at higher mortgage rates and make a significant down payment.

During the quarter, we maintained our cautious approach to land investment, spending $81 million to acquire new land. While our divisions are diligently looking for land deals, we're being disciplined in our underwriting with respect to achieving our required returns. We have the flexibility to remain selective given our current lot position and healthy balance sheet. With demand improving, we expect our land acquisition activity to accelerate during the second half of 2023.

We continue to actively develop land that we already own, as we invested $316 million in development and related fees during the second quarter. As part of a continuous review of our land portfolio, we are renegotiating some land contracts to reduce purchase prices and extend closing time lines. We are also reengaging with sellers on certain deals we had previously abandoned, often buying that we are now able to get better terms or better pricing.

Our lot position stands at just under 58,000 lots owned or controlled, of which approximately 43,500 are owned, representing just over three years supply, which is consistent with our historical level. Generally, we continue to develop lots on adjusting time basis focused on smaller phases with a lower cash outlay, balancing our development phasing with our starts phase to manage our inventory of finished lots.

We are well positioned as we currently own or control the lots that we need to achieve our delivery growth targets over the next couple of years. We again increased the amount of capital that we returned to shareholders during the quarter, given the strong level of cash generated from our operations. Our repurchase totaled $92 million for nearly 3% of our shares outstanding.

Over the past 24 months, we have now repurchased about 15% of our outstanding shares at an average price of $36.81, returning approximately $610 million to shareholders, including our quarterly dividend. The repurchases have been accretive to our earnings and book value per share and enhanced our return on equity. Looking ahead, we will remain balanced in our capital allocation, reinvesting in our business and returning cash to shareholders.

In closing, I want to thank the entire KB Home team for their commitment to our customers and our company, which drove our strong results in the second quarter. While there are still uncertainties with respect to the economy in the second half of our fiscal year, we have a business model and balance sheet that will allow us to remain flexible in navigating market conditions.

We are well positioned to achieve our now higher guidance for 2023 of about $6 billion in revenue at the midpoint and a gross margin of approximately 21.2% based on the size and composition of our backlog. We look forward to continuing to update you on the progress of our business later this 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 cover highlights of our 2023 second quarter financial performance and provide our current outlook for the third quarter and full year. Amid steadily improving housing market conditions throughout the second quarter, our solid execution produced financial results that exceeded our expectations and guidance across all key metrics.

In addition, our strong operating cash flow allowed us to repurchase an additional 2.2 million shares of our common stock and eliminate outstanding borrowings under our revolving credit facility. Our housing revenues of $1.76 billion for the quarter rose from $1.71 billion for the prior year period, reflecting a 6% increase in the number of homes delivered, partially offset by a 3% decline in an overall average selling price.

Based on our current construction cycle times and backlog, we anticipate our 2023 third quarter housing revenues will be in the range of $1.35 billion to $1.5 billion. For the full year, we are increasing our range of expected housing revenues to $5.8 billion to $6.2 billion. We believe we are well positioned to achieve this top line full year forecast based on the construction status of homes in our second quarter ending backlog, current housing market conditions and anticipated continued improvement in our build times.

In the second quarter, our overall average selling price of homes delivered decreased to $480,000 from $494,000 in the prior year period, as increases of 2% to 11% across three of our regions were offset by a 5% decrease in our West Coast region, which has the highest ASP of our four regions. The decline in this region was, as in the 2023 first quarter, mainly the result of a community mix shift in our Southern California business where several communities with $1 million plus selling prices delivered out in 2022.

For the 2023 third quarter, we are projecting a sequential decline in the overall average selling price to approximately $470,000, and expect an increase in the fourth quarter due to a higher mix of deliveries from our West Coast region. We still believe our average selling price for the full year will be approximately $485,000.

Homebuilding operating income in the current quarter was $202.1 million as compared to $264.5 million in the year earlier quarter. The current quarter included abandonment charges of $4.3 million versus $0.7 million a year ago. Excluding inventory-related charges, our 11.7% operating margin for the current quarter decreased 380 basis points year-over-year.

We expect our 2023 third quarter homebuilding operating income margin, excluding the impact of any inventory-related charges to be in a range of 9.5% to 10.1%. For the full year, we expect our operating margin, excluding any inventory-related charges, to be about 11%.

Our 2023 second quarter housing gross profit margin was 21.1% as compared to 25.3% in the year earlier quarter. Excluding inventory related charges in both periods, our gross margin decreased by 390 basis points to 21.4%. The year-over-year decline was mainly driven by price decreases and other homebuyer concessions, together with increased construction costs and a shift in the mix of homes delivered. Assuming no inventory related charges, we are forecasting a 2023 third quarter housing gross profit margin in the range of 20.4% to 21.0% and a full year margin of approximately 21.2%.

Our selling, general and administrative expense ratio of 9.6% for the 2023 second quarter improved from 9.8% for the 2022 quarter. The slight improvement mainly reflected operating leverage from higher revenues in the current quarter. We believe our 2023 third quarter SG&A expense ratio will be approximately 10.6% to 11.2% and our full year ratio will be about 10.3%.

Our income tax expense for the second quarter of $50.5 million represented an effective tax rate of 24% compared to 26% for the prior year period. The 2 percentage point improvement was due to the favorable impacts of federal energy tax credits in the current quarter. We now expect our effective tax rate for the 2023 third quarter as well as the full year to be approximately 23%. Overall, we produced net income for the second quarter of $164.4 million, or $1.94 per diluted share compared to $210.7 million, or $2.32 per diluted share for the prior year period.

Turning now to community count. Our second quarter average of 253 increased 20% from the year earlier quarter. We ended the quarter with 249 communities, reflecting 20 openings and 27 sellouts during that period. We anticipate our average community count for the third quarter to be up approximately 10% year-over-year with a sequential decline in our quarter end community count, reflecting increased sellouts due to expected continued solid order trends and a higher proportion of communities with a relatively low number of remaining homes to sell.

We expect the full year average to be up about 10% year-over-year and the year-end count to be approximately flat as compared to the prior year. To drive continued new community openings, we invested $396 million in land and development during the second quarter and ended the quarter with a pipeline of nearly 58,000 lots owned or under contract.

In the 2023 first half we invested a total of $763 million in land and land development, of which approximately 83% with the land development. At quarter end, our total liquidity was over $1.6 billion, including nearly $1.1 billion of available capacity under our unsecured revolving credit facility with no cash borrowings outstanding and $557 million of cash.

During the quarter, we repurchased approximately 2.2 million shares of our common stock at an average price of $42.58, which is 9% below our quarter end book value per share. With over $400 million remaining under our current common stock repurchase authorization, we intend to continue to repurchase shares with the pace, volume and timing based on considerations of our operating cash flow, liquidity outlook, land investment opportunities and needs, the market price of our shares in the housing market and general economic environments.

Our quarter end stockholders' equity was $3.8 billion and our book value per share was up 24% year-over-year to $46.72, reflecting our financial performance coupled with common stock repurchases over the past several quarters.

In conclusion, we are very pleased with our solid second quarter financial performance and strong operational execution, key factors supporting our enhanced financial outlook for the remainder of the year. Given favorable trends in both cycle time and housing market conditions, we are optimistic about our improved full year forecast and expect to finish 2023 on a solid foundation for further improvements in 2024.

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

Question-and-Answer Session

Operator

Thank you, sir. At this time, we'll be conducting a question-and-answer session. [Operator Instructions] Thank you. And our first question comes from the line of John Lovallo with UBS. Please proceed with your question.

John Lovallo

Good afternoon, guys, and thank you for taking my questions. The first one is maybe on just the margin outlook for the third quarter on both gross and operating. It seems like a fairly wide range and down sequentially. The down sequentially part seems like it could be a function of timing and mix. But curious what you see as sort of the factors that may drive the higher and lower end of both of those margin ranges, please?

Jeffrey Mezger

Sure. Yeah. Let's -- just starting with the full year for a second. We've raised our guidance by 20 basis points for the full year midpoint to midpoint this quarter versus last quarter. So we are more optimistic than we were last quarter, obviously, and the full year number. We did have quite a mix shift in the pull forward of deliveries into the second quarter and we saw a nice leverage impact on the margins in the second quarter. So a lot of the upside and actually a lot of the beat in the second quarter is actually due to the higher leverage from the deliveries.

So I would say, overall, our margin progression is very similar to what we were expecting. We talked about during last quarter's call that we expect a relatively consistent gross margins in the back half of the year and are still varying right around that 21% range almost for the full year with a little bit up in the first half and a little bit lower in the second half. And the second half is really reflecting the time when a lot of those units were sold.

So if you look back to the third and fourth quarter of last year and the market dislocation and the pricing, et cetera., that went through along with the cost when those homes were started, you'll see uptick in -- you'll see that second half margin ticking down a little bit. But all that said, at this point, we'd expect the trough margin to be in the third quarter and see that starting to increase beginning in the fourth quarter modestly.

John Lovallo

That's helpful. And it sounds like the setup into 2024 is pretty good as well here. But I guess the next question would be, in the two-thirds of communities where you guys were able to take price up, help us maybe just kind of ballpark, what that price increase look like? And then, in the markets where you lowered prices, what markets were those and by how much order of magnitude did you lower prices, please?

Jeffrey Mezger

Rob, you want to take that?

Robert McGibney

Sure, Jeff. So backing up a little bit. We shared with you before that we had adjusted pricing down in late Q4 of '22 and on into early Q1 of '23 to find the market and get back to our minimum pace of one per week per community, especially in those communities we delivered out a large chunk of the high backlog levels we were carrying and those changes worked. They were effective. And then as the market weakening and picking up and strengthening in February and our pace improved, we started lifting price, which is just part of our ongoing strategy to optimize each asset, and that continued throughout the second quarter.

So on the first part of your question, the price increases we implemented in Q2, it was really broad based across our footprint. I mean, if we didn't have any divisions where we didn't have some lift in pricing, and I mentioned in the prepared remarks that hit about 70% of our communities that they spread out across the country. And the average increase was a little over $11,000. And then on the balance, there were less than 10% that received a price decrease. And I'm not exactly sure on the amount of price. It was less than what the increases were. I think it was around $8,000. And then the remainder of those, the other 20%, it was flat with no pricing change.

Operator

Thank you. And the next question comes from the line of Mike Dahl with RBC Capital Markets. Please proceed with your question.

Michael Dahl

Hi. Thanks for taking my questions. Just to start on the demand environment. It seems like you're saying, it's still pretty strong into June and I think your guidance when I look at the orders about the community count guide, it doesn't imply that pace. While it slipped sequentially, it's still better than normal seasonality. So maybe could you just add a little color on what you've seen more specifically as you've kind of exited the spring selling season and how you're seeing that shape up relative to what you'd normally expect?

Jeffrey Mezger

John -- I'm sorry, Mike. As I shared in my prepared comments, the demand has remained strong here in our third quarter. And what we see across the system, really, there is so little inventory available on the resale side that it's pushing buyers to pay the premium for new as compared to resale because there just isn't a lot out there that's desirable for them. And so I mentioned that we have this normal cyclicality to our sales pace and we typically see a drop down in the third quarter.

And if you look at the guide, we're not projecting as significant a decline as we typically would. And it's tied right back to, there is no inventory out there. So, if rates stay where they are right now and we continue to see that the market conditions we're seeing that's what leads us to a guide that's still -- based on that community count it’s still about little over four a month per community. So we're pretty pleased with the way the consumer is responding right now in these conditions.

Michael Dahl

Okay. That helps. Thanks. And my second question, Jeff, is just on some of the comments around land investment. It seems like there is probably some puts and takes as the markets rebounded pretty quickly, haven't really been that many distressed land opportunities that have emerged coming out of this cycle, the publics are all pretty well capitalized now that starts are ramping, maybe people are looking to get back in the land game.

The flip side is there is some -- there's probably some optimism that given some of the banking fallout, maybe your private competitors will be a little bit more sidelined. So could you just give us a little more color on this as you look to ramp back up your land acquisition while still staying disciplined? What are you seeing in terms of competitive dynamics? Where are some examples either geographic or otherwise of some successes that you're starting to see?

Jeffrey Mezger

Well, you touched on a lot of the topics that I would share with you in a response in that. In most of our markets, there's a lot of large, well-capitalized landowners and they were very patient through the softening in demand and pricing really didn't capitulate. And now as demand is improving and you can again underwrite to a pace in a submarket, numbers are tight, but you can figure out ways to make them work. We have been successful with some of the smaller sellers that aren't as well capitalized where we may have abandonment and they just sat on it for a while and now we're back engaged with them and we're getting better pricing or better terms and they now have certainty of close again.

So, our teams never stopped looking. We weren't as aggressive in our work in Q3 and Q4 as we would be today in pursuing land activity. And I think it's pretty balanced out there. We're not the only builder out chasing land, so it's competitive. But we have a good team and a good network in that city, there is deals to be had. And we'll continue to be a balance. I don't know, Rob, if you want to share any color on -- I can't think of a market that's any better or worse than the others. They are all pretty typical or maybe you're aware of something.

Robert McGibney

No. You got it there, Jeff. I think that's right.

Operator

Thank you. And our next question comes from the line of Alan Ratner with Zelman and Associates. Please proceed with your question.

Alan Ratner

Hey, guys. Good afternoon. Nice results and thanks for the time. First question, you kind of made a comment, which is similar to what we're hearing from pretty much everybody about ramping some spec starts in the near-term given the tightness in resale. And you guys are obviously a built-to-order builder at your core. So I'm curious if you could give some numbers behind that. What percentage of your starts right now are speculative? What -- where do you see that share going for your business? And anything we should think about as far as the mix differences on the spec homes, either from a price standpoint, margin standpoint, geography standpoint?

Jeffrey Mezger

Rob, you want to take that?

Robert McGibney

Yeah. Sure. So we don't really manage it to percentages. I mean it depends on what's going on in the specific community and the specific division. And first of all, we're committed to our built-to-order model. But in the short-term with the lack of inventory in the market, we're going to get more starts in the ground to take advantage of this current market condition with ultra-low inventory as we reload our pipeline with more BTO sales we'll reduce spec starts.

But just talking about what's going on out there, I mean there was an article released this morning and it was observing that there are fewer resale homes for sale in May than any other month on record. And we're running at just 1.8 months of supply and we've got, I think, it was 35%, 37% of the resales out there now selling above list price. So it's not straying from our overall strategy, just looking to take advantage of the current conditions with no inventory or low inventory.

As far as the product, we've got laboratories out there in each of our communities that kind of tell us which plans, which product, which price point with what features are most in demand. And those are the -- when we do start inventory, that's going to be our focus is to align with that.

Alan Ratner

Is the idea on these homes to sell then at various stages of construction and maybe still provide an opportunity for consumers to use your design studios or are these more kind of completed inventory homes that you're hoping to sell more for quick moving?

Robert McGibney

Well, up to a certain point we're coming off some pretty wild supply chain issues where we had to order early and get things done fast. But in the early stages, we will sell these homes at any point during the construction cycle. But if the buyer gets in early, there is an opportunity to have them personalized certain things, especially like finished materials. But we will allow it, but we're also not going to allow changes up to the point where it's going to slow down construction or cause a delay in completing that home.

Operator

Thank you. And our next question...

Jeffrey Mezger

Rob, I was going to say, Alan, to that point, we've had good success with inventory starts because it takes a few weeks to get a permit. You pick the floor plan, the elevation you're permitted. And it sells before the foundation support then buyer gets the full array in the studio. So it's not a -- it's an inventory start, but it's really just a pre-plotted start to compress the time because we're fighting the cycle times still, get more houses in the ground and the buyers are buying them in the early stages. So it's worked very well for us.

Operator

Thank you. And our next question comes from the line of Stephen Kim with Evercore ISI. Please proceed with your question.

Stephen Kim

Yeah. Thanks very much, guys. Congrats on the good results. It seems like from your comments that you're pretty much able to sell whatever it is that you can build. And so I wanted to ask you a question or so about your starts. I think you had indicated that you were planning to have starts in the third quarter, I think somewhere north of where your orders would be, correct? So I mean clarify that if you could. Are we talking about 3,500 starts or so?

And then that would be up year-over-year. But I think you said your community count would be kind of flat by year-end. And so I'm just kind of curious as to what we think is -- what do you think is a good run rate for starts as you look ahead? Is -- let's say it's 3,500 in the third quarter, is that -- can we annualize that? Can we take that times four and say that that's kind of a reasonable annualized rate that kind of a thing?

Jeffrey Mezger

Yeah. It's interesting, Steve. I'll let Rob fill in some of the color. But in general terms, we should start in the -- in the following quarter, you should start at least what your sales orders were previously. So if we sold 3,600 or whatever the number was in Q2, that would be your starts in Q3 because you're rolling over year built-to-order sales, but we're also covering inventory sales and we're building a bridge from the fits and starts we had in the second half of last year on sales and starts.

So, our desire would be to start all the built-to-order we can and then supplement it with additional inventory starts. If you think about it, these would be deliveries in Q1 or August starts on our current cycle time maybe even into March. And we want to make sure that we're ramping up our volume levels for 14. But Rob, do you have any other color you want to fill in?

Robert McGibney

I think you did a good job, Jeff. I’ll leave it at that.

Jeffrey Mezger

Thanks.

Stephen Kim

Okay. Great. So I guess you're sort of suggesting that we can sort of think about that starts pace in the quarter as being a good indicator of where your annualized run rate could be if you multiply it by four. I guess my next question is, if you have increased or changed your earnest money requirements on the part of your buyers. I was kind of surprised and pleasantly surprised to hear you talk about the strength of your buyers, the credit metrics and the down payments and so forth. And I was wondering whether or not you were seeing a greater ability to get more earnest money from your buyers when they make -- when they place an order?

Jeffrey Mezger

Stephen, it's definitely something that we had to work on when the downturn debt as we learned through that process that even though you have a buyer emotionally committed to the purchase, when rates ran up the way they did, the rational side of a payment outweighed the emotional side of the commitment. So we learned we didn't have large enough deposits and we were actively -- do you want to share, Rob, what we're doing in this?

Robert McGibney

Sure. Yeah. So Steve, we set a minimum at 2% or 2% of base price, many of our divisions. And it depends on the buyer profile and what the profile of the community is too. But we've got a minimum of 2% of the base price and then it goes up from there. We've got additional deposits for studio and things like that. So a minimum of 2% with several divisions that are ranging above that, which gives us a little more coverage and protection.

Operator

Thank you. And our next question comes from the line of Matthew Bouley with Barclays. Please proceed with your question.

Matthew Bouley

Hey. Good evening, guys. Thanks for taking the question. So it sounds like you're closing out of more communities than you're opening. I know you also just spoke about sort of ramping up starts. So I mean, is this a situation where you're starting to outright meter sales again or is there perhaps an opportunity to be a little more aggressive on the pricing side? Just any color on kind of the availability of communities as you roll through this year. Thank you.

Jeffrey Mezger

Matt, we'll continue. We use the term we optimize the assets and in that regard you don't slow it down if you're running out of lots unless it's irreplaceable. Then you may meter out sales. A lot of the community count cadence that we're going through if you think about it, we put a halt to a lot of land development in the third and fourth quarter last year, as we're trying to figure out how deep is the trough and do we need it, have a community down the street, let slow this one down. So we actually put a pause on land development and then reviewed it community by community by community.

And in some cases, communities were put on hold for six, seven, eight months that we've now reenergized and we're developing that caused the delay in openings. So we've got the sellouts accelerating again and as the market improves and you'll see our community openings come right back in Q1, 2 and 3 next year. So it's not a case of running out of things to do. We'll keep the pace up and keep optimizing each asset.

Matthew Bouley

Got it. Okay. Thank you for that, Jeff. And then second one, I'm curious if you can elaborate a little on I guess what portion of your sales are including a rate buy down? Is it as simple as to say the spec product largely carries these incentives whereas built-to-order product, there is a lot less of that? Really what I'm getting at is given your built-to-order model the degree to which you're actually able to kind of insulate homebuyers here from spot mortgage rate volatility. Thank you.

Jeffrey Mezger

Rob, that's right up your alley.

Robert McGibney

Yeah. So as far as the financing concessions or buy downs, we're no longer promoting a specific rate buy down program. We talked about getting our price right and we made those adjustments in the last half of -- back half of -- last part of '22 and into '23. So where we do use it and it's applied on an as needed basis for the most part for those buyers that needed to be able to make the purchase or qualify and it's just not that significant overall. Our Q2 sales averaged about 0.5 and financing concessions outside of the normal closing cost funds we provide in certain markets to cover items like title or escrow fees in.

And our goal is just to offer the best base price that we can and provide transparency on that price. So we're primarily using the financing rate buy downs on an as-needed basis versus artificially inflating the price of the home so it can be incentivized. And really, many of our buyers understand that they can refinance down the road when and if rates fall but you can never change the price that you paid for the home.

Operator

Thank you. And the next question comes from the line of Michael Rehaut with J.P. Morgan. Please proceed with your question.

Michael Rehaut

Hi. Thanks. Good afternoon. Thanks for taking my questions. First, I wanted to circle back to the order pace for the third quarter. And obviously, understanding you haven't given guidance for the fourth quarter, but you pointed to a moderation in sales pace, but something less than your normal level of seasonality and still within the four to five -- desired four to five sales per month.

So, without necessarily talking specifically to the fourth quarter, 4Q normal seasonality is about a 20% drop off in sales per month versus 3Q. Is it fair to kind of anticipate that given today's market where you're kind of still staying within your built-to-order disciplined, but maybe increasing a little bit of the inventory homes and that's what's helping that third quarter sequential decline being less than normal? Could we also -- assuming the market stays where it is, particularly from a supply standpoint, is it also fair to expect 4Q seasonality to also be a little bit more muted and perhaps even staying closer to the low-end of that four to five per month range that you've described?

Jeffrey Mezger

Mike, I think that's an appropriate theory. If market conditions stay like they are today with as little inventory as it's out there, we would expect that we would do better than historical in the fourth quarter. But only tweak to your comment is it's not because we have more inventory. It's just our sales pace impact in the second quarter sequentially each month of the quarter, we sold more built-to-order growth than we did inventory. I think it kept tilting that way and I think as our build times come down you'll see it tilt even more in that regard. So, it's not whether it's an inventory or somebody picking their lot, it's just general market conditions and the desire to be a homeowner.

Michael Rehaut

Okay. So -- yeah, I appreciate that clarification. I guess I had thought I heard you say earlier in the call that part of the orders that you're going to be taking is also maybe increasing the inventory homes a little bit to fill the need in the market. Is that no longer what you're saying? Are you saying that it's...

Jeffrey Mezger

Well, we're talking two different things because what I was referring to was starts. And a lot of the starts as to compress the cycle, while we're still getting our build times down so we'll release things as an inventory starts and then we sell it by the time the foundation’s board and the buyers still get to choose everything. But as we look over the balance of the year, the primary focus will be how do we get more built-to-order sales that continue to fuel our growth in '24.

Michael Rehaut

Right.

Operator

Thank you. And the next question comes from the line of Joe Ahlersmeyer with Deutsche Bank. Please proceed with your question.

Joe Ahlersmeyer

Hey. Good afternoon, everyone.

Jeffrey Mezger

Hey, Joe.

Joe Ahlersmeyer

Yeah. Just a quick on the starts -- coming back to -- yeah, coming back to the starts questions that we've got, we've had on the call so far. Is this also maybe part of two learnings, one, around your success having repriced and resold the cancellations you saw in 4Q and 1Q, but also learnings from this tight supply chain period of time where having a little bit more visibility on cost relative to what you're selling your homes at was actually constructive for margin? Is that part of -- are those two learnings playing in here with the decision to increase specs?

Jeffrey Mezger

I think we went through a pretty good whipsaw on demand in Q3 and Q4 and then turn the corner into Q1 and Q2. And with the high cancellation rate relative to our historical, we've built up more inventory that we had to cover and that is -- so you turn your focus to clear the inventory because you have to, and it has an impact on your built-to-order sales. And until you clear it, it slows down starts. And so we went through a period where we didn't start enough because we were having to clear out the inventory, which we've now done.

And as we look back on Q2, frankly, we were surprised that the strength in demand that we saw. And if we knew on March 1, how strong demand would be, we'd have started more houses in Q2 than we did. So now we're going to catch up here in the third quarter. Actually, over time, we haven't had a lot of cost surprises relative to what we sold it for and what we build it for. Our costs on homes are all locked when we started, and in a lot of cases are locked before we sell it. But we have a good idea of the costs. So it wasn't so much a margin control, it was more this whipsaw of demand and starts and how do we keep it all in balance. And as things are normalizing right now for us, we'll go back to pushing more starts.

Joe Ahlersmeyer

It's great. And maybe the second one is for -- more for Rob. There's been a lot of talk about perhaps increasing energy efficiency of homes through regulating the mortgage market, basically requiring that homes underwritten with -- a mortgage underwritten for FHA loans are backed by the GSEs would have to have been built to '21 energy efficiency code. Wondering how big of a lift that would be nationally for you guys to have to adhere to the '21 code just based on where your code compliance is nationally at this point?

Robert McGibney

I think, far less for us than probably some of our competitors. I mean we've been so focused on energy efficiency for such a long time here that I don't think we've got a lot of heavy lifting to do to get to that point. And it's something that we're still analyzing. Each of our markets are on different code cycles and all that to really understand what the impact is. But our HERS scores and the ratings that we've been building to I think are already very efficient. So I don't think it's a big leap for us to take the next step there.

Operator

Thank you. And our next question comes from the line of Truman Patterson with Wolfe Research. Please proceed with your question.

Truman Patterson

Hey. Good evening, guys. Thanks for taking my questions. First, I wanted to understand kind of the cadence of the construction -- the reduced construction costs. I believe in fiscal 1Q (ph), your construction cycle times were about eight months, fiscal 2Q they're about seven months. You mentioned last quarter that costs, direct construction costs were down about $19,000 from the peak. And I think you said they're down another $4,000 this quarter. To me, I would expect a lot of the cost savings to kind of flow through by the fourth quarter of this year but hoping you all can help us think through some of the timing of that.

Robert McGibney

Yeah. Well, we -- do you want me to take that or you, Jeff?

Jeffrey Mezger

Yeah. No, I was going to say, hey, Rob, why don't you take that.

Robert McGibney

Okay. So a lot of it depends on the timing. I mean, if you're talking about the peak and I believe it was August, we said last quarter we come down $19,000 from that. But we're also working through houses during that point in time that had -- it was a challenging market. So challenged on sales price and rate buy downs and things like that. As far as the additional incremental $4,000, that's actually where we ended up in May. So we'll see some benefit of that through the starts that we got in May. We'll see a bigger impact once we get into Q1 and Q2 of next year.

Truman Patterson

Okay. Got you.

Robert McGibney

Now cycle times accelerate more obviously we'll see it faster. We're focused on that. But if we can bring cycle times down another 30 days to 45 days, the better and bigger impact we'll have in Q4.

Truman Patterson

Okay. Perfect. And then, just wanted to follow up on your ending community count being roughly flat year-over-year, it's down a little bit from the second quarter levels rightfully so you guys pulled back on land investment given everything that's occurred over the past 12 months. But, Jeff, I believe you mentioned that community count should start to grow again sequentially in 1Q and 2Q. I'm just trying to understand, do you still expect actual growth throughout '24 year-over-year basis? Do you think some opportunity for a decline or a potential to refill your pipeline with some finished lot deals moving through the year to kind of backfill? I'm just trying to understand the puts and the takes here.

Jeffrey Mezger

One of the variables, Truman, as you know is how quickly things can sell out. And we have a community with six left to sell, okay, because what we count in the sold out if there is less than five to sell. And so you can move through communities that had six left to sell and get down to five and you write the community off. So that -- and that can move around from quarter to quarter from where we project versus where we end up. But what I was referring to on the opening side is we expect a ramp up in openings in '24. We haven't guided on community count, but we do expect to grow the business. We're positioned to grow the business and that's our goal, would be to grow the business in '24. But we'll get into that more in the -- typically, we give a first look at that on our next quarter call.

Operator

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

Charles Perron

Thank you. Good morning -- good afternoon, everyone. This is Charles Perron in for Susan, and congrats on the strong results as well. I guess my first question is going back to the capital allocation. You repurchased 2.2 million shares in the quarter on top of obviously the dividend. And your balance sheet is in probably the best shape it has been in a really long time. Can you maybe provide a sense of how you see capital allocation between replacing the land pipeline, investing in the communities versus returning money (ph) to shareholders as we look forward?

Robert McGibney

Sure. As we often talk, we view our capital allocation policy as being balanced. Ideally, we'd like to invest as much as possible back in the business and continue the growth and returns and everything else that does for you. And at the same time, we've been balancing that with returning cash to shareholders. Like I said in the prepared remarks, we base those purchases off on a number of factors and most of them have been very favorable for the past several quarters and allowed us to really jump in and buy some stock back. So we do intend to continue to buy shares. We mentioned a couple of times in the prepared remarks and we'll immediately amount and the timing of that based on all the other factors that we mentioned.

But as you said, we're really pleased with the current balance sheet. It's rock solid right now and we're very pleased with the amount of cash the business is paying off and on top of where we've been at on that. As these build times continue to compress, we see even further opportunity for cash and we intend to deploy that cash. We'll deploy it either in the form of -- through investing in the business or preference and at the same time, we believe we have the bandwidth to continue to buy shares at the same time.

Charles Perron

Got it. That's helpful. And Jeff, you've touched this in your prepared remarks a little bit. But can you talk through the progress you've made on some of the markets you recently reentered like Boise and Charlotte, but also at the same time, maybe if you can talk about the potential to enter new markets? How you see this approaching going forward versus further penetrating the existing locations you guys are in?

Jeffrey Mezger

Well, we've done a few bolt-ons as I call it over the last few years and I'd just start with Seattle where I believe we entered it five years ago. We're now a top five builder and growing. And it's very profitable and quite a success story for us in our West region. And we always look at opportunities out there, private builders, what can we do to grow through acquisition. At the same time, if you go into Novo, it's a little less expensive and you may have to learn some things along the way. But our business model is pretty plug-and-play and work.

So we entered Boise. Boise was one of the first markets to correct when interest rates ran up last year. It's now adjusted. We're selling well. We have two communities under development in addition to the one that's opened today and it's doing just fine. And in Charlotte, we've opened a couple of communities that are selling well. We have many more that are about to open and you touched on it. We were in Charlotte at one time, and we've got as large as 1,000 units a year in Charlotte. So it's a market we know and we like, and it's a nice complement to Lolly (ph). And those are both start-ups and we've been able to carry the overhead, still have solid SG&A, and have been able to cover the startup costs and now are positioned to be real contributors to our business.

As we look ahead, the best way to grow is in your served markets. And we have a growth target in every city for where we want to get to. And it's at least a top three builder once you're there, we want to get to the number one spot. And everybody has targets. And there isn't a single market we're in today where we think we've maximized our opportunities. So, our primary focus -- long-winded answer, but our primary focus going forward, for now, will be to continue to push the envelope in the 39 cities that we're in, where there's a lot of upside from our current scale. So we like the opportunities and how we're positioned and where we're headed.

Operator

Thank you, everyone. Ladies and gentlemen, that concludes the question-and-answer session and this also concludes today's teleconference. Thank you for your participation. You may now disconnect your lines.