KB Home (NYSE:KBH) Q1 2023 Earnings Conference Call March 22, 2023 5:00 PM ET

Company Participants

Jill Peters - Senior Vice President of Investor Relations

Jeffrey Mezger - Chairman, President and Chief Executive Officer

Robert McGibney - Executive Vice President and Chief Operating Officer

Jeff Kaminski - Executive Vice President and Chief Financial Officer

Conference Call Participants

Stephen Kim - Evercore ISI

Matthew Bouley - Barclays Bank PLC

Michael Dahl - RBC Capital Markets

John Lovallo - UBS

Alan Ratner - Zelman & Associates LLC

Rafe Jadrosich - Bank of America Merrill Lynch

Paul Przybylski - Wolfe Research LLC

Michael Rehaut - JPMorgan Chase & Co

Buck Horne - Raymond James & Associates, Inc.

Alex Barron - Housing Research Center

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 First 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 April, 22.

And now, I'd like to turn the call over to Jill Peters, Senior Vice President of 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 first 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. Good afternoon, everyone. We delivered solid financial results in the first quarter, which highlights the value of our built-to-order model. Working from a large backlog has provided stability in our deliveries at healthy margins, while we navigate turbulent selling conditions. We want to thank our entire team for their outstanding effort in serving our homebuyers and persevering through the challenges of a volatile housing market.

As to the details of our results, we generated total revenues of $1.4 billion and diluted earnings per share of $1.45. We held our earnings essentially even with the prior year quarter due to a strong gross margin of 21.8%, excluding inventory-related charges and an improvement in our SG&A expense ratio, which offset a slightly lower level of deliveries. Relative to the guidance we provided in January, we came in at the high-end of our revenue range and exceeded our guidance on both operating and gross margins. Our performance together with our ongoing share repurchases, drove our book value per share higher to $44.80, up 27% year-over-year.

Although KB Home is perceived to be a California builder, our business is becoming more diversified and we like the balance of our geographic footprint. Our Southeast region has grown into a larger business, approaching 20% of our revenues this year as compared to only 11% five years ago. This region has significantly improved its profitability and returns over this timeframe, and we look forward to its continued growth.

During the quarter, we achieved our first deliveries in Charlotte, which is a dynamic and growing top 10 housing market. We are currently selling homes in two communities in Charlotte, with four additional communities scheduled to open this year. We expect Charlotte to further enhance the growth we are achieving in our Southeast region.

We also produced our first deliveries in Boise during the quarter. Boise has been one of the fastest growing areas in the country, which created strong demand amid limited supply, and as a result, home prices appreciated rapidly. The market is now adjusting and we will remain selective with additional land investments until we see stability in pricing. Over time, we believe Boise will be a growth market for our company.

The long-term outlook for the housing market remains favorable. As we have said in the past, the demographics of the millennials and Gen Zs are advantageous for our business as our primary buyer segments are first-time and first move-up buyers. While these demographics are a strong underpinning for demand, we are also still facing low levels of inventory, especially at our price points.

Just yesterday, February resales were reported, representing the first sequential increase in activity in 13 months, leaving resale inventory levels at 2.6 months supply. At the same time, new home inventory continues to be limited. As to our orders, demand in the back half of our first quarter improved significantly with a sequential increase in net orders in both January and February. This was in line with the expectation we shared with you on our last earnings call. We generated net orders of 2,142 for the quarter, down 49% year-over-year as compared to our projected range of down between 50% and 60%.

As I did on our last call, let me discuss gross orders and cancellation separately. We have continuously worked to balance pace and price to optimize each asset. With a sensitivity to our large backlog in many communities, we held off on adjusting pricing until more of that backlog was delivered.

In the first quarter, we continued to convert our backlog to deliveries while now also reducing prices in many of our communities or offering other concessions. The timing for these actions was favorable given the seasonally stronger selling period. In addition, a more stable mortgage rate environment during January and February where rates had settled in to a low-to-mid 6% range was also beneficial in moving potential homebuyers off the sidelines. Buyers seem to be acknowledging that these higher rates are the new normal as they return to the market.

Our gross orders improved significantly on a sequential basis with January's orders increasing 64% relative to December and February increasing 58% versus January. For the quarter, our gross orders were 3,357, a year-over-year decline of 29%.

On a per community basis, our gross absorption pace reached 6.6 orders per month in February above our long-term average for that month, contributing to an overall monthly pace of 4.5 gross orders per community for the quarter. We had a number of divisions that outperform this average, including Inland Empire, Sacramento, Las Vegas, Phoenix, and Orlando.

For the quarter, our total cancellations moderated sequentially and generally homes and backlog are closing when they are completed. As we continue to deliver out the backlog of orders failed that were written last summer during a lower interest rate environment, our cancellation rate should decline further.

In the early weeks of March, our net orders have remained strong. For the first two and a half weeks of our 2023 second quarter, our net orders were down 24% against a very strong comparable prior year period. Although we do not typically provide an intra-quarter update on this call or a projected range for net orders because we are only a few weeks into the quarter, we believe it is helpful for investors due to the volatility in market conditions.

While interest rate and economic uncertainties pose a large risk to the near-term demand, we are encouraged with our recent order trends. Our strategic goal continues to be a monthly absorption pace of between four and five net orders per community, which we think we will achieve for the second quarter, resulting in a projected range of between three-thousand and thirty-seven hundred net orders. At the midpoint, this will represent a net order decline of 14% year-over-year.

Our backlog at the end of the first quarter stood at over 7,000 homes valued at over $3.3 billion. This position will continue to provide consistency in deliveries and margins and supports our revenue projection for the year. During the quarter, we started 1,500 homes and ended the quarter with roughly 7,400 homes in production of which 77% are sold. We are ramping up our starts in the second quarter, as we continue to balance starts with sales, and as we look ahead to year-end deliveries.

We are committed to our built-to-order model, which is defined by the choice that we offer to buyers, including the selection of the floor plan, lots, square footage and personalized finishes. An important compliment to this offering of choice is the availability of quick moving homes in each of our communities to serve the buyer who prioritizes a near-term move-in date over personalization. In this regard, we always have some inventory available in each community.

During the quarter, approximately 37% of our deliveries were from inventory sales, whether a speculative start, a rewrite of a cancellation or a model sale. At the end of the quarter, we had roughly 640 finished and unsold homes available, the majority of which we expect to sell and deliver in our second quarter. We know buyers value our built-to-order approach as we achieve high customer satisfaction scores and typically one of the highest absorption rates per community in the industry. At the same time, there are some key financial benefits to this approach as we can capture incremental lot premiums and studio revenues. As a result, our gross margins are higher on our built-to-order sales.

In the first quarter, we generated nearly $52,000 per delivery in lot premium and studio revenues consistent with our quarterly average in 2022, representing about 11% of our housing revenues.

With that, let me pause for a moment and ask Rob to provide some color with respect to our sales approach as well as an operational update. Rob?

Robert McGibney

Thank you, Jeff. We are encouraged by the improvement in both demand and our sales results since early January. The initiatives we are utilizing are working and potential buyers that have moved to the sidelines are returning to the market. On our last earnings call, we shared with you two different sales strategies that we had implemented based primarily on how many homes we had in backlog in a community. For our high backlog communities with more homes already sold than remaining to sell, the emphasis was on our interest rate buy-down and lock programs to support sales as opposed to cutting price and putting our backlog at risk.

For communities with either smaller backlogs or were only a small percentage of the backlog would be impacted, we adjusted prices to find the market. During the first quarter, we continue to utilize these strategies and reduce prices at about one half of our communities. At the same time, considering the results that previous pricing actions generated together with an improving demand environment, we increased prices in some of our other communities as they were selling at a faster than targeted pace. As Jeff spoke to earlier, buyers responded to our actions as we saw a sequential improvement in our orders in January and February.

As to build times, we continue to make progress on the front-end of the construction cycle, although we, along with most other new homebuilders, again, experienced delays in the latter stages of construction due to the large volume of homes in construction that are nearing completion in our served markets. As to our deliveries in the quarter, build times were up seven days sequentially, but for new starts during the quarter, our build times improved by over one month between slab start and hanging drywall. We anticipate the improvement we are seeing in the front half of the construction schedule to flow through to our deliveries by the end of this year as we work to return to historical levels.

Supply chain volatility continued to impact us in the later stages of construction. For example, appliance availability improved, but has not yet fully resolved. At the peak of the supply chain disruption, we had about 400 loaner appliances in place across our system due to back orders or delivery delays, and by the end of the first quarter, we had less than 20. In addition, ongoing municipal delays and the availability of transformers and electrical equipment contributed to delays in finalizing homes.

We have many completed homes with loan approved buyers waiting on transformers and estimate that over a 100 additional homes would likely have closed in our first quarter and transformers been installed, a situation that was exacerbated by the hurricanes in Florida.

While supply chain disruptions will likely continue at some level for the foreseeable future with ongoing shortages and flooring, heating and cooling materials and insulation, we are encouraged by the improvements we are seeing in many areas, which we believe will provide greater predictability for our business and for our customers.

Another critical area of focus of our operations is driving direct cost reductions. As we analyze the data, we continue to recognize savings on new starts, which are down relative to their peak last August by about $19,000 per unit, helping to offset the price decreases we took. Although we are working to reduce trade labor costs, they are proving to be sticky, and the market improvement in early 2023 is resulting in increasing starts across the industry that may slow our progress, but we remain committed to driving additional savings as we progress through the year.

While we negotiate lower costs on our existing product array, we continue to focus on offering smaller floor plans with simplified and value engineered elevations and interiors that live bigger for less, providing a more affordable product that meets the needs of our customers and leveraging our scale and consistency in starts.

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

Jeffrey Mezger

Thanks, Rob. Buyers were about 80% of the loans funded during the first quarter financed their homes through our mortgage joint venture, KBHS Home Loans and their credit profile continues to be strong. About 66% of these customers qualified for a conventional mortgage and the vast majority of KBHS customers are using fixed rate products. The average cash down payment was 15%, which equates to over $74,000.

At the income levels, the average household income of these buyers was over 130,000 and their FICO score was 733. While we target the median household income in our submarket, we continue to attract buyers above that income level with healthy credit who can qualify at higher mortgage rates and make a significant down payment.

As to our land investment activity during the quarter, we maintain our conservative approach with investments in new land purchases of only $50 million, down 86% year-over-year. We expect to stay highly selective with respect to additional land investments until markets settle and there's clarity in pricing to gain confidence in achieving our required returns. We continue to develop land that we already own, investing $317 million in development and related fees.

As part of a regular review of our land portfolio, we have been active in renegotiating land contracts to reduce purchase prices and extend closing timelines. We are also canceling contracts that no longer meet our financial criteria, including contracts of purchase approximately 3,800 lots during the first quarter.

Our lot position stands at 62,400 owned or controlled, down about 30% year-over-year, but still providing the lots we need to achieve our growth targets in 2024 and 2025. Approximately 46,000 of our lots are owned with roughly 18,000 finished. Of these finished lots, roughly 8,100 have a home under construction including models. We continue to balance our development phasing with our start pace to limit building up a large inventory of finish lots. In addition, we are generally developing lots on just-in-time basis, creating smaller phases and reducing our cash outlay.

We like our current land and lot position and believe we can afford to be patient waiting until the time is right to be opportunistic with our capital. With a healthy level of cash generated from our operations, we increased the amount of cash that we returned to shareholders during the quarter with repurchases of $75 million or 2% of our shares outstanding.

Over the past 24 months, we have now repurchased about 12% of our shares at an average price of $35.74, returning a total of over $515 million to shareholders, including our quarterly dividends. The repurchases are accretive to our earnings and book value per share and will support a higher return on equity in the future without compromising our growth.

We also announced today that our Board of Directors authorized the repurchase of up to $500 million of our common stock. This new authorization provides us with the flexibility to continue to repurchase our shares on an opportunistic basis. With our stock currently trading at a significant discount to our book value, the buybacks provide an extremely attractive return on the investment.

In closing, we are off to a solid start for the year, and although there are some key unknowns with respect to interest rates and the economy, we are confident in our ability to navigate market conditions. As a result, we've resumed providing guidance for the full-year highlighted by expected revenues of about $5.5 billion and a healthy gross margin of roughly 21%. We look forward to continuing to update you on the progress of our business as we move throughout the year.

With that, I'll 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 first quarter financial performance as well as provide our second quarter and full-year outlooks. Given the challenging housing market environment, we are pleased with our execution during the first quarter. With our revenues essentially even with the prior year period, our healthy gross profit margin and expense containment efforts produced over $125 million of net income, down only $9 million as compared to our strong result in the year earlier quarter. In addition, we are providing an expanded full-year outlook rather than the limited guidance we provided in January.

In the first quarter, our housing revenues of $1.38 billion were basically the same as a year-ago, as a 3% decrease in the number of homes delivered was mostly offset by a 2% increase in the overall average selling price of those homes. From a regional perspective, an 18% decline in our West Coast region's housing revenues was largely offset by double-digit growth in our other three regions with the Southeast region generating the largest increase of 23%.

Looking ahead to the 2023 second quarter, we expect to continue to successfully navigate the improving albeit still challenging supply chain conditions and generate housing revenues in the range of $1.35 billion to $1.5 billion. For the full-year, we are narrowing a range of expected housing revenues to $5.2 billion to $5.9 billion. We believe we are well positioned to achieve this topline performance supported by our first quarter ending backlog value of approximately $3.3 billion, our higher community count, and our assumption of current housing market conditions continuing for the remainder of the year along with expected improvement in supply chain performance and build times.

In the first quarter, our overall average selling price of homes delivered increased 2% year-over-year to approximately $495,000 as increases of 10% to 12% across three of our regions were mostly offset by a 5% decrease in our West Coast region due to 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 second quarter, we are projecting an average selling price of approximately $480,000 as we expect a mix shift composed of a lower proportion of deliveries in our higher priced West Coast region. We believe our overall average selling price for the full-year will be in a range of $480,000 to $490,000. Homebuilding operating income for the first quarter was $156.5 million compared to $169.6 million for the year earlier quarter. The current quarter included abandonment charges of $5.3 million versus $0.2 million a year-ago.

Our homebuilding operating income margin decreased to 11.4% compared to 12.2% for the 2022 first quarter, reflecting a lower gross margin, partly offset by a slight improvement in the SG&A expense ratio. Excluding inventory-related charges, our operating margin for the current quarter of 11.7% decreased 50 basis points year-over-year. For the 2023 second quarter, we anticipate our homebuilding operating income margin, excluding the impact of any inventory-related charges, will be in the range of 9.5% to 10.5%. For the full-year, we expect this metric to be in a range of 10% to 11%.

Our 2023 first quarter housing gross profit margin was 21.5% as compared to 22.4% in the year earlier quarter. Excluding inventory-related charges in both periods, our gross margin decreased by 60 basis points to 21.8%. The decline was mainly driven by slightly higher construction costs and an increase in homebuyer concessions. Assuming no inventory-related charges, we are forecasting a 2023 second quarter housing gross profit margin in a range of 20% to 21%. We anticipate quarterly gross margins will be relatively consistent sequentially for the last two quarters of the year, resulting in an expected full-year margin, excluding inventory-related charges in a range of 20.5% to 21.5%.

Our selling, general and administrative expense ratio of 10.1% for the first quarter improved 10 basis points from a year-ago, reflecting slightly lower expenses on approximately the same topline revenue. We are forecasting our 2023 second quarter SG&A ratio to be in the range of 10.3% to 10.8% and expect our full-year ratio will be approximately 10% to 11%.

Our income tax expense of $36.7 million for the first quarter represented an effective tax rate of approximately 23%, an improvement from roughly 25% in the year earlier quarter. We continue to expect our effective tax rate for both the 2023 second quarter and full-year to be approximately 24%. Overall, we generated net income of $125.5 million or $1.45 per diluted share for the first quarter compared to $134.3 million or $1.47 per diluted share for the prior year period. The stock repurchases over the past two years favorably impacted the first quarter earnings per share by approximately $0.15 or 10%.

Turning now to community count. Our first quarter average of 251 was up 18% from the corresponding 2022 quarter. In the current quarter, we opened 24 communities and had fewer sellouts as compared to the prior year. We ended the quarter with 256 communities, up 23% from a year-ago with increases in all four regions. We believe our second quarter average community count will be up in the range of 15% to 20% year-over-year, and the full-year average will be up in the low double-digit percentage range. This larger portfolio of active selling communities will help offset the impact of weaker housing market conditions as compared to last year.

Due to the soft market conditions in our healthy existing land pipeline, we continued to moderate our investments in land acquisitions and development during the first quarter with our total expenditures down 48% to $367 million. As Jeff mentioned, land acquisitions represented only $50 million of the total first quarter investment, an 86% decrease.

At quarter-end, our total liquidity was approximately $1.24 billion, including over $983 million of available capacity under our unsecured revolving credit facility and $260 million of cash. During the quarter, we repurchased nearly 2 million shares of our common stock at an average price of $38.16, which is 15% below our quarter-end book value per share.

With our Board's recent $500 million repurchase authorization, we intend to continue to repurchase shares with the pace, volume and timing based on considerations of our cash flow, liquidity outlook, land investment opportunities and needs, the market price of our shares in the housing market and general economic environment. Our quarter-end stakeholders’ equity was $3.7 billion, and our book value per share was up 27% year-over-year to $44.80.

In conclusion, we plan to continue to execute on our operational priorities throughout the remainder of the year, focusing on improving build times, reducing cost, driving net orders across our footprint and generating and deploying cash in line with our capital allocation strategy.

As I mentioned earlier, we plan to continue our measured approach to share repurchases supported by our strong balance sheet and expected operating cash flow. We expect this repurchase strategy to continue to generate a tailwind to our financial results incrementally improving our EPS book value per share and returns. Driven by our anticipated operating performance in 2023, we expect further accretion in our book value per share as well as a low double-digit return on equity for the year as we continue to focus on stockholder value creation.

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

Question-and-Answer Session

Operator

Thank you, sir. We will now be conducting a question-and-answer session. [Operator Instructions] And the first question comes from the line of Stephen Kim with Evercore ISI. Please proceed with your question.

Stephen Kim

Yes. Thanks a lot guys. Yes, really impressive job. Appreciate all of the guidance as well. So thanks for that. You gave a lot of really interesting stats. I'm sure my peers will clean up a lot of them. But the one that I wanted to focus in on was your commentary about built-to-order margins being better than the – I guess the QMIs or the spec margins or whatever. So – and then you also said that I think 37% of your deliveries were kind of previously started. So just with respect to those stats, could you give us a sense for how much higher your margins are on built-to-order? Has that relatively changed? And then the share that 37% of deliveries that are – were sort of not BTOs, what does that look like historically and what is assumed in your guide?

Jeffrey Mezger

Yes. A lot Stephen, we'll try. As I shared in the comments, we did deliver more inventory in the quarter, and in part it was due to the cancellation spike we experienced in Q3, Q4, and early Q1. So we had to cover those. We always have strategic specs we put in the ground, whether a multi-family product or the odd lot on a cul-de-sac we want to build out or if it's a strong performing community, we'll throw more starts in the ground. So we always have some strategic specs.

And then we have models which really don't talk about too much, but we view them as an inventory sale as well. Historically that's higher than our average. We like to maintain on the starts basis, 80% sold, 20% unsold. That's what we have been targeting over time. But as you think about that, you start 80% and then about 10% of a [can] over the life of the construction cycle, you're really 70-30 is our typical ratio over time. So if you break down that way not too far off from historical, but up a little bit and we're glad that we were able to move them and move on to Q2.

Our built-to-order margins right now are typically 2 to 3 percentage points higher, depends on the city and there's always a story on the community, but typically 2 to 3 percentage points higher. I touched on lot premiums and studio revenue. We have an inventory home, it's a lot harder to get a lot premium because that's the first thing that gets discounted on the selling floor if someone is making an offer on a spec. So we do better on lot premiums on our built-to-order. But also we don't have to incentivize the sale as much. And what we like to say is we’re – the buyers creating their own value versus us forcing a value through discounts and incentives.

So typically there's a little bit more incentives that convince our customer to go purchase a home that's already built. I know there's a lot of noise on this metric in the industry and everybody probably measures it a little different, but if you're predominantly a spec builder, I can see where your margins would be higher on a spec that's completed because why would somebody buy a spec at frame stage if their choice is a completed home. But in our case, our buyer is still tilt to the preference of personalization.

So in the quarter, it's a blended margin that we reported 21.8, our built-to-order was a little higher, inventory little lower, and it came out to the average. And with the selling mix that we're looking at going forward over the balance of the year, it all ends up summarized in the guidance that Jeff gave for the year. So I think I covered all questions. I don’t know if there's anything I missed.

Stephen Kim

No, that was really great and comprehensive, so I appreciate that. Next question I had related to your outlook. Jeff, you gave this as a lot of detail and what it looks like is you're certainly expecting to see some strong closing, some strong orders that you've already experienced thus far in March. And so your volumes are going to be pretty solid here in 2Q, which leaves for the back half of the year. It does seem that you're being pretty conservative here with your closings outlook if I assume that your orders per community remain in anywhere close to that four to five range, let's say in 3Q, it would look to me like I should be able to exceed your closings guide.

So I'm curious, is there something that I should be thinking about with respect to maybe your backlog turnover ratio or something in the third or fourth quarter? Is that going to sort of stay stubbornly kind of low? Because I would assume that that would move back kind of to the ranges that you had maybe pre-COVID or approaching that by the fourth quarter just because of some of the things that Rob McGibney was talking about with cycle times improving and things of that nature. So can you help me understand why the closing guidance seems kind of low there for the back half of the year?

Jeffrey Mezger

Yes. For starter, Steve, we still have an extended build time. So we have divisions that are pretty much started out for this year by the end of this month. So if we continue to see strong sales and we convert to strong starts in Q3, it'll be more of an early 2024 benefit than it will 2023. And I think what I was trying to message, if you think about it, our business model went through a whipsaw where interest rates spike. We had buyers that hadn't locked their loan, [can rates] goes way up. We're still protecting our backlog, so we're not doing things to get gross sales, we're getting hammered with cans and now we're coming out of that. Our can rate, we expect will continue to moderate back to historical levels. At the same time, we've taken steps to get our gross orders up. So the guide is reasonable for the year. We are projecting a little higher backlog conversion over the balance of the year, but if this – the current market conditions hold, it sets up a very good start to 2024.

Operator

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

Matthew Bouley

Hey. Good afternoon, everyone. Thanks for taking the questions. So just a question on the margin outlook and the sort of guidance you gave around kind of relatively consistent margins trending into the back half of the year. Just looking at the order ASP during the quarter, recognizing there was some mix in that. I think it was down. It could be wrong, maybe $50,000 to $60,000 sequentially. I think you also mentioned your starting homes was about $19,000 of cost reduction in there. So maybe part of the answer is going to be around mix, but just curious around, what else are you seeing and what kind of gives you confidence to say that that margin in the back half will be relatively flat given these price reductions that are occurring? Thank you.

Jeff Kaminski

Sure. Matt, I can respond to that. So as always, we have the advantage of looking at our backlog as we forecast margins and we're anticipating that backlog right now delivers out over the next three quarters we know specifically in that backlog, the pricing, the cost, et cetera. So I have a pretty good hand on the margin included in there. I would caution a little bit on the net order average selling price. There is a bit of noise in there, not only from the point of your community mix and different plans obviously that are in the back or in those numbers, but there's backlog adjustments and noise associated with those backlog adjustments that get flushed through the average selling price on net orders every quarter. So those are the couple of items why that may not [quite box] with some of your numbers.

But essentially at the end of the day as we look at it, we have obviously some pricing pressure in the market that we're forecasting. Some is already embedded in our backlog and then some of the cost savings that Rob pointed out, but many of those have hit fourth quarter early next year, and we have pretty good beat on the margins excluding any unforeseen events over the next few months.

Matthew Bouley

Got it. Okay. Super helpful. Thanks for that, Jeff. The second one, just kind of higher level, recognizing the stress in the banking environments and regional banks is evolving quickly here. I'm just curious of what you're seeing kind of on the margin in these past few weeks. Any kind of thoughts or what you're hearing around lending standards as well as just kind of impacts within your own mortgage business. How are you thinking about how this kind of rapidly evolving in environment on regional banking may impact your business? Thank you.

Jeffrey Mezger

Well, Matt, we're watchful like everyone on this call to see how this plays out. We're not hearing anything right now on tighter lending standards. We're not hearing buyers say this banking crisis is really influencing my confidence. It's pretty quiet, but it's a headline that you're – you have to be watchful of and that if the regional banks got really stressed, it has to impact the economies where those banks are located. So we're watchful of it, but to date, there's no change in underwriting, liquidity is out there. Certainly the big banks we do business with are all open and doing their things. So far it's been good. If anything it helps drop mortgage rates down and it helps the consumer, but we have to wait and see how it plays out.

Operator

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. I guess Jeff, just to follow-up on that last comment, what are the things that you're most watchful for? What are the things that you view as the most leading indicators, whether it's feedback from your customers or things that you're seeing in the market from various lenders in terms of kind of identifying if or when or where you would start to see some of these stresses play out and start to impact your business?

Jeff Kaminski

Yes. I think if you're asking from the point of view of the consumer, obviously the headline is the mortgage rate and as Jeff said, some of the recent actions [indiscernible] to moderate that a little bit. I think that's the number one concern on the consumer's mind. Lending standards as Jeff also mentioned, really haven't changed it as far as we could see up to this point. So those would be the two watchouts. Spring so far for us is has been pretty healthy and we've liked what we've seen on the sales side and consumer behavior and we hope that continues and this whole banking situation sells and we kind of move on. We are watchable of it and obviously concerned as everyone is on where this could lead, but so far so good as far as our business goes.

Michael Dahl

Got it. Okay. And my second question just – and it's – was somewhat related, but just thinking about 2Q and the expectation on orders. I think last quarter was understandable you had kind of five weeks under your belt for the quarter. And so you had a good taste of where things were and looking at the comps and what you were trying to do on the sales side where you thought you could drive pace, you're pretty early in the quarter and there is a lot of uncertainty out there that's pretty quickly emerged. So in terms of the level of confidence getting to the four to five pace for the full quarter, just wanted to probe a little bit more on what's driving it. Is it – you think you've kind of found your stride on kind of price incentive strategy where if the market dips, you can plug that or is it just a function of what you've seen in these past couple of weeks? Just maybe elaborate a little bit more on what's giving you the level of conviction to give that – to give that range for the second quarter?

Jeffrey Mezger

Sure. When I – I say we don't like giving a guide in March because it's only right now two and a half weeks and it's more the comparables can be odd when you're comparing two and a half weeks to two and a half weeks and may not represent what's really going on in your business. But the [sound environment], there's not like a switch that puts on March 1 and you're now in a new sound environment. As we shared in our prepared comments, February was very good for us. In fact, even with this elevated can rate that's moderating, we were at four and a half a month or a community in the month of February and March has continued at similar levels. But Rob, you want to give him some insight into our thinking on the sales projection?

Robert McGibney

Yes. I mean, I just echo what you had said. I mean, we're confident in it because we're seeing it today. Like Jeff said, we were hitting the four and a half a month in February to increase sequentially each month of Q1. And while it's early in March, we're seeing even more positive results on the sales side than what we saw in February. So barring any kind of unforeseen surprise on that, we don't really see a reason that we won't continue on the path that we've been on which – that’s what gave us the confidence to guide the way we did.

Operator

And our next question comes from the line of John Lovallo with UBS. Please proceed with your question.

John Lovallo

Hey guys. Thank you for taking my questions as well here. And maybe the first one just on the delivery ASP outlook of 480 to 490. It's pretty far above what's in the backlog ASP right now. And so I'm just curious, what's driving this? I mean, is it just mix of what's going to close? Or is there an expectation that the second quarter order ASP is going to be elevated and that's going to flow through the back half? Just any help there would be appreciated.

Jeff Kaminski

Yes. John, as you know, we have a pretty wide range of ASPs between our West Coast business and the rest of the business. So at times those numbers get a little skewed just due to that mix between regions. We do schedule out our deliveries one-by-one, believe it or not, by community, by division as we forecast out second to fourth quarter. So a lot of it is just very specific to what homes are actually scheduled to close and in what quarters do we expect it.

The differential between our go forward guidance and really the backlog, in my opinion isn't really that significant. And we often deal with that, the backlog is up to eight or nine months now backlog, and we're trying to forecast the first three months of those deliveries. So you often get a little bit of a disconnect, sometimes the next quarter's a little bit higher than the backlog, sometimes it's a little bit lower. The backlog also doesn't include all of the potential revenue in that, any of the units in backlog that haven't completely gone through the studio process are still under clubbed a little bit. So those are things that kind of bring it back more into line, but I think you'd find that we're normally pretty accurate on the ASP go forward forecast and we're pretty confident with this one, so don't see a lot of variability there.

John Lovallo

Okay. That's helpful. And then maybe just going back to the gross margins and sort of the sequential – flat sequential gross margins in the back half relative to the second quarter. What are you guys forecasting in terms of direct costs maybe in lumber? And then how does the sort of the ASP flow into this as well?

Jeff Kaminski

Right. So on the cost side, most of the costs are more or less baked. We have a – the vast majority of our starts for the whole year, as Jeff mentioned, it'll be started by the end of this month so that we don't see a lot of variability on the cost side. Anything that happens with lumber upward down would be more an issue a bit in the fourth quarter, but even more so of an issue in the first quarter or an opportunity, I should say, in the first quarter of next year. So there's not a lot of variability on the cost side. The prices are more or less locked because they're a large backlog.

And our expectations around what we do on quick moving units, kind of reflect what's already in the backlog and kind of going off pricing and costs off some of those units. So again, we have a lot more visibility this quarter than certainly than we had during our conference call earlier this year, which is one of the reasons why we wanted to go out for the full-year and provide some more details. And that's kind of how it's sorting out right now, fairly consistent margins and all the other guidance points that we've provided, we're pretty confident.

Operator

And the 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 all the color and guidance. Appreciated. First question, I'd love to drill down a little bit in terms of what you're seeing in the land market. I know you walked away from some additional option deals this quarter, and if I look at your lot count, it's down about 35% year-on-year. Obviously a lot of that's coming through option walkaways. But what we're hearing is the land market is remaining pretty sticky and with home prices having declined, pick your number 5%, 10%, 15% in some markets, we haven't necessarily seen that come out of the land market yet is what builders are talking about.

So on one hand, you can wait and wait for that capitulation or on the other hand, if you're kind of optimistic that the market is found a solid footing here, it would seem like you kind of have to make a decision to go out and start buying land again. So I'm curious, a) what are you seeing in terms of that capitulation; and b) you pulled back quite a bit this quarter. How close are you to re-engaging in the land market again?

Jeffrey Mezger

Well, Alan, I wouldn't say that we disengaged it all. We're just being more selective and cautious and you're right in what you hear, the land prices have been sticky out there and most of the landowners in the markets were in are pretty well healed, and they're also waiting to see how the market plays out before they do anything. So we have not seen a lot of downward movement in land prices.

And as I shared on my comments, we're owned and controlled through 2024 and into 2025. So we don't feel the pressure today that we have to do something, but we are encouraging the teams to go tie things up and tie it up with some money and work on entitlements and we'll make a call on the closing when it comes time to commit to the deal or not. But we're encouraging all our teams to go on a land search and go out there and fill in the queue. We're just not writing big checks unless we're confident that that asset is going to give us the returns. So I think you'll see this healthy tension. There's land available out there, we're not worried that we won't be able to support a growth trajectory beyond 2025, but we're going to stay watchful for a while.

Alan Ratner

That's helpful. I appreciate that. Second question, it seems like the incentive across the industry that's been having the most traction are mortgage rate buy downs and it's definitely something that the new home market has an advantage on over the resale market with kind of the in-house mortgage subs. Are you guys using rate buy downs a lot I mean, obviously with the build-to-order model? I would imagine it's more costly for you to do a buy down out of three, four, five, six months into the future compared to spec builder that could have certainty of delivery date in the near-term. But how often are you using those rate buy downs? And if so kind of what are you buying the rate down to and what does the cost look like?

Jeffrey Mezger

Okay. Rob, you want to take that?

Robert McGibney

Yes, sure. So, I would say on the – we are using the mortgage programs, we've got both lock longer term loans or shorter term loans and in some cases buy the rates down. But I would say we're seeing that become less as the market's improving and we've adjusted pricing to get right in the communities where we don't have a lot of backlog that gets impacted. So we are using it, it's selective, it's not every community, it's not every customer, we use it where we need to drive the sales.

And another benefit that we're seeing is the cost of those programs is becoming less as well with rates coming down are typical and we offer a couple of different programs, but are typical is buying the rate down to five and seven, eight, and with rates coming down, the cost to do that has fallen along with the cost of the long-term lock. We can go out 270 days on a BTO sale to lock that. So the cost of both of those is coming down as well as the frequency of needing to use them with the market improvement and overall demand getting better here in the spring selling season.

Operator

And the next question comes from the line of Rafe Jadrosich with Bank of America. Please proceed with your question.

Rafe Jadrosich

Hi. Good afternoon. Thanks for taking my question. I just wanted to follow-up on the second half kind of gross margin commentary. Understand your point that the ASP is locked as a built-to-order builder and the houses are customized. But when you think about some of those incentives flowing through, like what's the outlook for incentives in the second half of this year versus the first half? And then what are some of like the offsets that you would expect that to get to the flattish sequential gross margins?

Jeff Kaminski

Yes. I can take that. So on the incentive side, the assumptions on incentives are really baked into what's already been offered and in some cases what the division needs, or fields they need on a community-by-community basis maybe to incent some of the buyers to actually close on the home. So there is some conservatism baked into the cost side on the incentives whereby, we've included a bit more than actually is contracted at this point in those out quarters. So I feel like there's enough cushion in there to cover what we'll need to do to get the closings.

On the cost side of things, like we've mentioned a couple times, once the home starts, the cost of the home are pretty well baked in. So there's not a lot of offset there coming from any surprises. Most of it's just basically the cushion that we have involved there. The other side of this is the percentage that we have locked on current mortgages. It's a pretty high percent right now with our mortgage company. So we have a higher confidence in closings that'll occur, so with that less variability on gross margin out in the back half of the year.

The final point I guess I'd make is, as we progressed through last year, we did see some costs coming down and as we started those homes, those homes on the lower cost basis, will be hitting in the second, third quarters, fourth quarters a little bit up in here because of some of the starts, we haven't quite finalized for the fourth quarter, but for the most part we're seeing some of the cost savings already flowing through, but the bulk of what Rob talked about earlier will actually flow through in the early part of next year.

Rafe Jadrosich

That's really helpful. And just to clarify, going forward, are you assuming incentives are higher in your deliveries, like the second, third and fourth quarter than what was in the first quarter? Just trying to understand the timing of like when you offered those and when they'll actually start to flow through?

Jeff Kaminski

I don't think they're necessarily higher. One of the more difficult things we've had to contend with was the variability in the mortgage market and just buyer behavior. As rates were peaking and we were seeing a high level of cancellations coming through, we were having to get a little more aggressive on incentives to hold some of those buyers. I think the more stable we see rates and again with the high percentage of buyers that are currently locked on mortgage rate, we don't think we'll have to do quite as much. But despite that, we still have included a little bit of talk on the cost side just to compensate for whatever we do have to do in the back half. So that's kind of our outlook right now. I mean we had a nice beat on the first quarter. We forecasted basically the same way for the rest of the year as we just did for the first quarter. And we're hoping to be right within that range that we provided earlier for both the second quarter and the full-year.

Operator

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

Paul Przybylski

Thanks. It's actually Paul Przybylski. I was wondering, as your construction times normalize, what level of incremental capital do you think you pull out of – or cash you can pull out of working capital and the timing of that flowing through the financials?

Jeff Kaminski

Yes. We think there's a tremendous opportunity on that side, Paul. Thanks for pointing that out. It could be – not could be, it is in the hundreds of millions of dollar range. As far as timing goes, that's a difficult thing right now because it's really going to rely on supply chain conditions and actually achieving the build times that we're targeting. It has proven to be sticky and a large issue for not only us, but for the whole industry for quite a few quarters now. But eventually, we're going to get back to the type of performance that our company is used to in terms of both backlog conversion level with inventory out there and the dollars we have tied up in it, and we think it's a tremendous cash flow opportunity for us on a go forward basis.

Paul Przybylski

Okay. And I think you mentioned you were developing smaller phases in your newer communities, I would assume you're also doing that for phase extensions and legacy projects. How does that impact the cost structure and would that present any kind of margin headwind as we move into the 2024, since you're not “getting that volume discount?”

Jeffrey Mezger

Incremental, it's not significant. A lot of it you get right back in less carry, you'll have to pay for another move-in for the heavy equipment, 30, 40, 50 grand, whatever. But the development subs are getting hungry too. So they've been accommodating us as we go to smaller phases because they want to keep moving.

Operator

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

Michael Rehaut

Hey. Great. Thanks for fitting me in. Appreciate it. First question, I just wanted to circle back to the gross margin outlook and kind of understand, and I apologize if I've missed this. But what drove the upside relative to guidance if it was mixed or if it was better pricing and the backlog, et cetera, obviously different factors can influence that. And in the – expectation for 2Q to be reverting back to the 20 to 21, which I think was your original guidance for the first quarter. Just trying to understand also what are some of the drivers there from in terms of the current pricing environment and the cost backdrop?

Jeff Kaminski

Sure. Yes. Just starting with the quarter and the beat on the quarter, we talked about actually last quarter that we had a number of things that we thought was going to drive a sequential decrease. We included things such as the concessions and the mortgage rate buy downs, the construction costs that ticked up a little bit when those homes were started, mix shifts and a little bit lower operating leverage.

On the operating leverage side, we actually held pretty steady there. Our sales on a year-over-year basis, or sorry, our revenues on a year-over-year basis were pretty close, so we didn't lose anything there. So we picked up a bit there. Didn't see as much on incentives as we had baked in. We have to basically estimate what the incentives would be on quick moving homes and we just didn't see the need to do as much as what we had baked in there. Maybe the estimate was a little too conservative, I don't know, but it was helpful. So most of the variability was really on mix, lower incentives and then doing a little bit better on the spec home deliveries than we had anticipated.

Michael Rehaut

Okay. Thanks for that. I guess second question, I think Steve Kim talked about, maybe looking at some of your guidance metrics as conservative, I think around closings. The question I had was, I think it was part of his comments, it talked about this four to five pace maybe continuing through the rest of the year. It does seem from your comments and others that seasonality and some more positive trends have come back throughout so far this year. But alongside that perhaps you'd also expect seasonality to kick in both ways. And historically you look at 3Q orders, they're down anywhere from 20% to 30% sequentially on a sales pace basis versus 2Q and then 4Q historically they fall off another roughly 20%. So if seasonality is coming back to the business in a kind of a more normal quarter-to-quarter cadence, it does seem like you are obviously guiding to some return to normalcy. Is it fair to assume, and I'm not asking for quarterly guidance in 3Q, 4Q, but from a seasonality perspective, is that kind of the right way to think about it if we're kind of returning to plus or minus, a normal type of cadence throughout the year?

Jeffrey Mezger

Certainly, my expectation, Mike, that we're normalizing on the cadence. Our move from Q2 to 3Q and Q3 to 4Q is not as great as you just articulated. Our Q3 is typically down about 10% from Q2 and then Q4 is down 5% to 10% could be in parts because of the markets we're in are a little warmer climate and you get a lot of snow birds that come down in the winter and things like that. But in a normal year, we'll run 4, 5.5 in the second quarter and then it'll come down a little in the third quarter and come down a little in the fourth quarter and then over the year, you'll average between 4 and 5. So based on what we're seeing right now in a consumer behavior and we qualified it because there's a lot of unknowns out there, but based on what we're seeing, we think the markets are starting to normalize.

Operator

And the next question comes from the line of Buck Horne with Raymond James. Please proceed with your question.

Buck Horne

Hey. Thanks for the time. I appreciate it. Just stepping back from a higher level question for you. Have you guys started to see any shift in consumer preferences? Just thinking through like work from home trends and as more companies are trying to mandate some sort of return to office, as the year has progressed, I'm just wondering if you've seen any changes in terms of like community locations or the floor plans that your customers are choosing. Has there been any shift noticeable in your business in terms of shifting work from home preferences or I guess conversely, is there still a strong driver in terms of the need for home office space in the business?

Jeffrey Mezger

I don't know that we've seen any shift yet. But I do know that buyers are putting offices in there – they'll take the fourth or fifth bedroom and convert it to a home office of some kind. So as we looked at it back when that was a big topic, the work from home, most people were still buying houses that were within 30 to 45 minutes of their employer. So their view was, we can own a home here, drive a little further to work, but we're only having to go in the office a couple days. It's not like they would move to Kansas City while working in San Jose, they'd move to Stockton while working in San Jose. So I don't know, we’ve seen a big geographic shift and we're certainly not seeing a shift right now in the size of the home or what they're spending in our studios. It's been pretty static for the last 18 months.

Buck Horne

All right. That's real helpful. I appreciate that. And then my last one, just in terms of the cancellations and maybe the [mechanics] that you guys have absorbed so many cancellations over the past couple quarters. Are you guys keeping most of the customer's deposits on those cancellations? Or are you refunding some of that? Or what's the amount of – kind of the average amount of non-refundable/hard money that the customer has when they sign a new contract with you guys?

Jeffrey Mezger

Yes. On average around the system buckets about 2% and if they cancel and their – they had a loan approved and [final to start], we'll retain on the deposit.

Operator

And the next question comes from the line of Alex Barron with Housing Research Center. Please proceed with your question.

Alex Barron

Yes. Thanks guys. Yes, I wanted to ask a little bit about the two markets, I guess where the orders still haven't come back fully. I guess that was the Central and the Florida market or Southeast markets. Was that still somewhat intentional on your part, and not fully – still focusing on delivering the higher margin backlog before incentivizing sales? Or are those things largely behind us and then you expect orders to get back to normal next quarter?

Jeffrey Mezger

Rob, do you want to take that?

Robert McGibney

Yes. So I would say that it's – part of what you mentioned is, is a driver, we talked on our last quarter about our strategy with the backlog and the higher backlog communities. In the Central region, they have really high backlogs. So there have been communities where we didn't make the early price adjustments there, which were just starting to now or did during the quarter, and we're seeing those sales paces pick up. As far as the Southeast, they performed really well on the gross sales side, especially as we got towards the end of the quarter. So as some of the older sales that we have in backlog may have purchased when rates were lower, as those work through the system here over the next couple of months, I expect that the Southeast is going to bounce back pretty quickly.

Alex Barron

Got it. My second question had to do more with the balance sheet. So I believe you guys have some debt coming due next quarter about $350 million due in May. Just curious if the plan there is to pay those off with cash or to potentially raise debt and take advantage and maybe do more of the share buyback given the big discount or just thoughts around those two topics?

Jeff Kaminski

Right. Alex, we refi that debt actually last year. So our next maturity is actually our term loan, and it's not until 2026. So we have no near-term debt maturities at this point.

Operator

Thank you. At this time, we have reached the end of the question-and-answer session. And ladies and gentlemen, that does conclude today's teleconference. Thank you for your participation. You may now disconnect your lines.