Kb Home (KBH) Q3 2022 Earnings Call Transcript

This article was originally published on Alpha Street

Kb Home  (NYSE: KBH) Q3 2022 Earnings call dated Sep. 21, 2022

Corporate Participants:

Jill Peters — Senior Vice President, Investor Relations

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Rob McGibney — Executive Vice President and Chief Operating Officer

Jeff Kaminski — Executive Vice President and Chief Financial Officer

Analysts:

John Lovallo — UBS — Analyst

Stephen Kim — Evercore ISI — Analyst

Matthew Bouley — Barclays — Analyst

Alan Ratner — Zelman and Associates — Analyst

Michael Rehaut — J.P. Morgan — Analyst

Susan Maklari — Goldman Sachs — Analyst

Mike Dahl — RBC Capital Markets — Analyst

Truman Patterson — Wolfe Research — Analyst

Deepa Raghavan — Wells Fargo Securities — Analyst

Presentation:

Operator

Good afternoon, my name is Alex and I will be your conference operator today. I would like to welcome everyone to the KB Home 2022 Third Quarter Earnings Conference Call. [Operator Instructions]. oday’s conference call is being recorded and will be available for replay at the company’s website kbhome.com through October 21. Now, I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may begin.

Jill Peters — Senior Vice President, Investor Relations

Thank you, Alex. Good afternoon everyone and thank you for joining us today to review our results for the third quarter of fiscal 2022. On the call are Jeffrey 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 measures referenced during today’s discussion to their most directly comparable GAAP measures can be found in today’s press release and or on the Investor Relations page of our website at kbhome.com and with that, here’s Jeffrey Mezger.

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Thank you, Joe, and good afternoon everyone. We delivered another quarter of strong financial results, with meaningful year-over-year growth in most of our key metrics, highlighted by more than 600 basis points of expansion in our homebuilding operating income margin to approximately 18%. These results reflect the strength of our company, our larger scale and the size and composition of our backlog. At the end of our third quarter, our backlog stood at over 10,700 homes, valued at more than $5.2 billion, placing us in a good position with respect to deliveries in our 2022 fourth quarter and into the first half of 2023.

Approximately two thirds of our buyers are either locked on their mortgage rate or paying in cash and for the most part, these buyers are closing when homes are completed. Our buyers tend to have an emotional attachment to their purchases that comes from creating their personalized homes on a lot they have selected with features and finishes they have chosen.

As for the details of the quarter, we produced total revenues of $1.84 billion, up 26% as compared to the prior year period and diluted earnings per share of $2.86, which grew almost 80% year-over-year. While we achieved the low end of our revenue guidance, we experienced an extension in build times due to ongoing supply chain issues, which affected deliveries in the quarter. Rob will provide more detail on cycle times and the supply chain shortly.

Our gross margin of 27% is a particular highlight in the quarter, demonstrating the impact of our internal initiatives, along with our effective management of pace, price, and start, to optimize each asset during the robust demand environment earlier in our fiscal year. In addition, we successfully managed cost, driving our SG&A expense ratio down 100 basis points year-over-year. We remain committed to balancing our overhead, with our revenues as we continue to open additional new communities.

The factors supporting demand for homeownership remains strong, including favorable demographics, population and job growth in our served markets and rising rental rates, coupled with a limited supply of homes during the industry’s under production of new homes and low levels of existing home inventory, particularly at the more affordable price points. Although the long-term outlook remains positive, many prospective buyers have paused and move to the sideline amid higher mortgage rates along with ongoing inflation and a range of macroeconomic and geopolitical concerns.

As we manage through these uncertain times, we remain committed to our build to order approach. Our focus is to provide the best value to customers based on their budget and the features that are most important to them and not to offer the best incentive on a standing inventory home. Homebuyers were making the largest investment of their lifetime, and many desire a personalized home, with the ability to select their lot, floor plan, included or upgraded interior finishes and exterior elevations. This flexibility is also important to our customers if affordability is a constraint as our buyers can select a smaller square footage home at a lower price, with the same number of rooms and functionality and also reduce their spend in our studios.

We believe our approach is compelling and can make the difference on whether a customer is able to purchase a home. By outsizing choice and personalization, as well as the partnership our community teams offer, we provide an important service to our buyers. We think that is a key driver in our consistent achievement of the highest customer satisfaction ratings among production homebuilders.

Net orders of 2,040 were down relative to a strong 4,085 in the year ago third quarter. Let me discuss the components of our net orders by first providing some color on our gross orders with a separate discussion of cancellations. At the start of the third quarter, given the size of our backlog and with only 69 finished homes available for sale, we made the decision not to chase sales. The quarter unfolded with June’s average weekly gross orders coming in softer than May. July’s gross orders held consistent with June’s and we then experienced an acceleration in gross orders in August.

We had taken steps in July with respect to pricing in some underperforming communities, while at the same time, mortgage rates have declined slightly since June. We were pleased with the activity in August, but following Labor Day, interest rates have again risen, and we have experienced a softening orders trend. We will continue to monitor market dynamics and individual community performance and we’ll adjust pricing as necessary to maintain the balance between preserving our backlog and achieving minimum absorption rates to optimize each asset.

Over the years and throughout the cycle, we have typically generated one of the highest sales rate per community in the industry and that remains our objective going forward. With respect to cancellations, due to the unusually low level of gross orders and large beginning backlog of 12,300 homes, we believe looking at cancellation relative to backlog is a better way to understand the dynamics during the quarter. At 9%, our cancellation rate on beginning backlog did increase sequentially, but it was still well below historical levels. The number one reason for cancellation was buyer’s remorse. It was not necessarily that the buyers did not qualify. They did not feel comfortable moving ahead with the purchase.

We ended the quarter with only 12% of our homes in production unsold, consistent with our second quarter level, and with less than one finished and unsold home per community. We expanded our community count in the third quarter due to fewer community-selling out, partially offset by some deferred openings. In this market environment, we are not opening communities for sale until models are 100% completed to optimize the selling effort, which contrasts with the past 12 months during which we opened for presales while models were still being constructed.

We expect a modest sequential increase in our ending count in the fourth quarter and year-over-year growth in 2023. This will be an important contributor to our future net orders given the moderation and absorption rates. The credit profile of buyers that use our mortgage joint venture KBHS Home Loans remains strong and consistent sequentially. For loans funded during the third quarter, 67% of these customers qualified for a conventional mortgage and nearly all use fixed rate products. The average loan to value ratio was 84%, translating to our cash down payment of over $80,000. The average household income of these buyers was $130,000 and their FICO score was 7.34.

While we target the median household income in our submarkets, we are attracting buyers above that income level, with healthy credit that are able to qualify at higher mortgage interest rates. With that, let me pause for a moment and ask Rob to provide an operational update. Rob.

Rob McGibney — Executive Vice President and Chief Operating Officer

Thank you, Jeff. We continue to face difficulties in completing and delivering homes in the third quarter and as a result we were short about 160 deliveries or 4% relative to the midpoint of the guidance that we provided in June. While we had seen build times improved modestly in May, which we shared with you on our last earnings call, they extended significantly from that point, illustrating the larger industry-wide challenge in finding a consistent footing in build times. During the third quarter, build times for our homes under construction expanded by 11 days from the framing stage to completion. This drove the delivery miss in the quarter and is also having an impact on our fourth quarter delivery projection, which we have reduced.

There were several factors that contributed to this extension. Building material shortages continue to delay the completion of homes. We are seeing improvement in the availability of some products such as appliances, garage doors, installation, and HVAC flex duct, while other areas are still challenging, including electrical materials, cabinets, HVAC equipment, and flooring products. As to trade labor, the dynamics are mixed, with availability on the front end of the construction cycle improving, although continuing to be more difficult in the back end.

The homebuilding industry has been dealing with power infrastructure issues for quite some time and this is intensified. We had completed homes that we could not deliver in the third quarter because our utility providers could not get transformers and electric meters and many of our divisions that build attached products experienced delays in obtaining switchgear and wire.

In Houston, there were 77 homes across three communities that were completed and scheduled to close in the third quarter, but were postponed due to the lack of transformers. In addition, we continue to experience delays with Citi inspections in most of our markets due to municipal staffing shortages and elevated production levels in the back end of construction. We are factoring the longer municipal lead times, ongoing supply chain issues and labor shortages we experienced in the third quarter into our future delivery projections.

Our teams are working relentlessly through the challenges and finding ways to progress homes through the construction cycle. We are focused on what we can control and we are optimistic it would start slowly in most of our markets and our greater scale, we can transition back to our historical build times, although this will take time to achieve. The lower level of starts is also providing us with an opportunity to reduce our cost to build as we renegotiate them where possible.

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

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Thanks, Rob. Last quarter, we shared with you our expectation of reducing our land investments in light of current market conditions and then redeploying this cash to our stockholders. In the third quarter, we did just that with the year-over-year reduction in land acquisition and development spend of almost 30%. With near-term visibility limited as to the direction of the economy and its impact on homebuyers, we expect to continue at a lower level of land spend for the foreseeable future. We have been renegotiating land contracts to reduce prices and extend closing timelines. In certain cases, where we are no longer comfortable that we can achieve our required returns on the investment, we have terminated the contract. In the third quarter, we canceled contracts to purchase nearly 8,800 lots.

Our lot position stand at just under 80,000, lots owned or controlled. Of these, 51,000 are owned and only about 18,300 are finished lots with 11,000 of these having house under construction. We are balancing our development phasing with our starts pace so as not to build up a large inventory of finished lots, which supports higher inventory turns. Relative to the vintage of our own lots, we contracted approximately 40% of these lots in 2019 or prior and another 40% were tied up during 2020. As a result, the vast majority of our owned lots were underwritten before the run-up in average selling prices, which we believe supports our ability to sustain solid gross margins. The balanced approach we take towards capital allocation has resulted in $100 million of stock repurchases in the past two quarters, driving a 5% year-over-year reduction in our diluted share count in the third quarter. With strong profitability and healthy cash flow expected in our fourth quarter and ongoing caution in land investments, we expect to be in a position to redeploy additional capital to our stockholders before the end of this year. In closing, I would like to recognize and thank our entire KB Home team for their hard work and ongoing commitment to serving our homebuyers. We believe the differentiation we offer in our build to order approach, providing the choice and flexibility that creates an emotional connection between buyers and their personalized homes has contributed to our leading absorption rates in the industry over many years.

We are focused on preserving our backlog and achieving our minimum net order targets as we navigate current market conditions. All of the homes that we need to complete a strong 2022 fiscal year are already in our backlog, although we acknowledge the longer build times and ongoing supply chain disruptions have impacted the timing of some of our deliveries.

With about $7 billion of revenue expected for this year, reflecting over 20% year-over-year growth and a gross margin of 25%. We anticipate that we will generate a return on equity of about 26%, representing meaningful returns focused growth. With that, I’ll now turn the call over to Jeff for the financial review. Jeff.

Jeff Kaminski — Executive Vice President and Chief Financial Officer

Thank you, Jeff, and good afternoon, everyone. I will now review highlights of our financial performance for the 2022 third quarter and discuss our current outlook for the fourth quarter. In the third quarter, we produced measurable year-over-year improvements in most of our key financial metrics, including a 26% increase in our housing revenues, a 610 basis point expansion of our operating margin, and a 79% rise in our diluted earnings per share. We also completed several significant transactions to improve our capital structure and strengthen our balance sheet, which I will detail shortly.

Our housing revenues grew $1.84 billion compared to $1.46 billion dollars for the prior year quarter. This improvement reflected a 6% increase in the number of homes delivered and a 19% rise in their overall average selling price. As Rob discussed, our current quarter deliveries were tempered by extended build times in most of our served markets, driven by building material shortages, trade labor challenges, power infrastructure, delayed city inspections.

We have moderated our fourth quarter revenue outlook to reflect anticipated continuation of these industry challenges. Considering our quarter-end backlog of $5.3 billion, the status of homes under construction, and expected construction cycle times, we anticipate our fourth quarter housing revenues will be in a range of $1.95 billion to $2.05 billion. Our overall average selling price of homes delivered in the quarter rose to $509,000 from $427,000. Average selling prices were higher in each of our four regions, with year-over-year increases ranging from 12% in our West Coast region to 26% in our Central region.

For the fourth quarter, we are projecting an overall average selling price of approximately $503,000, which would represent a year-over-year increase of 12%. Our homebuilding operating income improved to $325.1 million as compared to $169.9 million in the year earlier quarter. Operating income margin increased 610 basis points to 17.7% due to meaningful improvements in both our gross profit margin and SG&A expense ratio. Excluding inventory related charges of $8.5 million in the current quarter and $6.7 million in the year-earlier quarter, our operating income margin was up 600 basis points year-over-year to 18.1%.

The current period inventory related charges were comprised of $5.9 million of abandonment charges associated with our housing operations and a $2.6 million impairment charge relating to a planned future land sale. We expect our fourth quarter homebuilding operating income margin excluding the impact of any inventory related charges will be approximately 16.7% compared to 12.9% in the year-earlier quarter. Our housing gross profit margin was 26.7%, up 520 basis points from 21.5% for the prior year quarter. This margin expansion mainly reflected the favorable selling price environment, supported by healthy housing market dynamics when most buyers contracted to purchase these homes. Excluding the $5.9 million of current quarter abandonment charges and $6.7 million of inventory related charges in the prior year quarter, our gross margin was up 500 basis points year-over-year to 27%.

Assuming no inventory related charges, we believe our fourth quarter housing gross profit margin will be in the range of 25% to 26%, which is lower than our prior expectation, due mainly to the anticipated impact of selling price adjustments in response to the softening housing market conditions and a loss of leverage on lower expected housing revenues. At the midpoint, our fourth quarter gross profit expectation represents a 310 basis point improvement as compared to the prior year period.

Our selling, general and administrative expense ratio of 8.9% improved by 100 basis points as compared to 9.9% from the 2021 third quarter, primarily due to a 70 basis point decrease in external sales commissions and increased operating leverage from higher revenues in the current quarter. Considering an anticipated increase in revenues and our continuing actions to contain and reduce costs, we believe our fourth quarter SG&A expense ratio will be approximately 8.8%, a 100 basis point improvement as compared to the year-earlier quarter.

Our effective tax rate was approximately 22%, reflecting $70.9 million of income tax expense, net of 15.3 million of federal energy tax credits we earned from building energy efficient homes. We were able to recognize the tax credits largely due to recently enacted legislation. We expect our effective tax rate for the fourth quarter to be approximately 24%, including an expected favorable impact from additional energy tax credits. Overall, we reported net income of $255.3 million or $2.86 per diluted share compared to $150.1 million or $1.60 per diluted share for the prior year quarter.

Turning now to community count, our third quarter average of 221 increased 8% from the year-earlier quarter. We ended with 227 communities open for sales as compared to 210 communities at the end of the 2021 third quarter. On a sequential basis, we were up 13 communities. We expect another sequential increase in the fourth quarter and believe our 2022 year-end community count will be in the range of 235 to 250. Using the midpoint, this would represent a 10% year-over-year rise in our fourth quarter average community count.

Our forecasted [Indecipherable] count is lower than our prior expectation as we anticipate fewer fourth quarter openings due to many of the same challenges that affected our third quarter deliveries. We invested $556 million in land, land development and fees during the third quarter, with only $135 million of the total representing new land acquisitions as compared to $467 million in the prior year period. The 71% year-over-year decline in land acquisitions reflects a pivot toward a more selective land investment strategy in response to the softening housing market conditions and our ability to develop land positions already owned or controlled to drive future new community openings.

In addition to being more selective on new land acquisitions, we abandoned approximately 8,800 previously controlled lots during the quarter. At quarter end, we had total liquidity of approximately $928 million including approximately $195 million of cash and $733 million available under our unsecured revolving credit facility. During the quarter, we issued $350 million of 7.25% eight-year senior notes and used the net proceeds together with cash on hand to redeem $350 million of 7.5% senior notes prior to the September 15, 2022 maturity, recognizing a $3.6 million loss on this early redemption of debt. In August, we entered into a senior unsecured term loan with $310 million of lender commitments. We are pursuing additional lender commitments and can draw up to the total committed amount at any time through November 23, 2022. We intend to use the proceeds of the term loan to redeem our 7.58% senior notes due May 15, 2023, which have a prior call date six months in advance of the maturity. After retiring the May 2023 notes, our next senior note maturity will be in June 2027.

During the quarter, we repurchased approximately 1.6 million shares of common stock at a total cost of $50 million. Year-to-date, we have deployed $100 million of cash to repurchase approximately 3.1 million shares, leaving $200 million available for repurchases under our current Board of Directors’ authorization. We ended the quarter with a book value per share of $40.79, a year-over-year increase of 26%.

In summary, while current housing market and supply chain conditions have negatively impacted our expectations for the fourth quarter, our outlook for the 2022 full year reflects significant year-over-year improvements across most of our key financial metrics with notable increases in our scale, housing gross margin, operating margin and returns.

We believe we will generate a full year return on equity based on our fourth quarter expectations of around 26%. It’s compared to 19.9% for 2021. In addition, during the fourth quarter, we plan to complete the refinancing of our May 2023 senior notes and continue measured common stock repurchases. We intend to carefully manage our business through the current housing market conditions and believe we are well positioned to achieve solid returns and drive book value accretion in the fourth quarter and into 2023.

We will now take your questions. Alex, please open the line.

Questions and Answers:

Operator

Thank you. [Operator Instructions]. Our first question comes from the line of John Lovallo with UBS. Please proceed with your question,

John Lovallo — UBS — Analyst

Hey, guys. Thank you for taking my question. First one is, I guess, maybe could you help us think about maybe quantify the incentive activity on a sequential and year-over-year basis? What type of incentives are you using or buyers responding? And then along the same lines, on the fourth quarter gross margin being now down sequentially, does that imply that incentives were used in the backlog as well.

Jill Peters — Senior Vice President, Investor Relations

John, I can make a few comments on it and I’ll kick it Jeff for the specifics on the slide moving to growth. As I shared in my prepared comments, we really don’t focus on incentives suite. We look at providing the buyer with the best value which to us is the most square footage for the best price and then let him personalized at the studio. And as a result of that, the buyer builds up their own value versus us building a home and then pushing incentives on and to force value. And therefore, we don’t really use a lot of incentives. We may move pricing in a community if it’s not selling. And we’ll take some stuff to pick up our sales rate, but I think in the quarter if I’m not mistaken, Jeff, our incentives are less than a percent, like a 0.5%, which is what they typically have run over the years.

So for us, the incentives, closing costs and kind of mortgage financing freebies here in there are less than 1% and that would hold true for our fourth quarter deliveries as well. You want to talk about the sequential?

Jeff Kaminski — Executive Vice President and Chief Financial Officer

Sure, John. Yeah, I mean sequential gross margin guide, I think first of all, it’s important to point out with our guide at 25% to 6% at the midpoint, it’s up 310 basis points year-over-year, which is a phenomenal level of improvement on a year-over-year basis. So first of all, we’re really pleased with our gross margin progression and what we’ve seen there. There have been a few impacts that had changed that outlook a bit from what we were expecting at the end of last quarter. A couple of them relate to pricing. One is we took a more cautious approach reflecting current market conditions on pricing expectations relating to any quick move in homes and also the homes either sold in the third quarter or in the fourth quarter for fourth quarter delivery. So, that had some impact.

We did include some potential selective price adjustments that may be required for some of our customers in backlog. In certain cases, some of our communities now had pricing a bit below where some of the customers of locked in. And with current market conditions, we wanted to make sure we had some provision in there to cover that in the event we need it. We’ve also lost some leverage on the lower fourth quarter revenue expectation and we explain that a little bit with what we’re seeing in the supply chain for the most part for that. We had a small impact as well on our fourth quarter gross margin. And then finally, we did see some mix impacts. We beat the third quarter guide by over 100 basis points at the midpoint of the guide and as a result — part of the driver of that was closing higher margin deliveries in the third quarter that we expected to close in the four. So, we saw some mix impact also coming into play there.

John Lovallo — UBS — Analyst

That’s really helpful. Thank you. And then the order cadence you provided with June being worse than expected; July I think down and then August you actually firming up and being positive relative to July, I guess the question is, was this gross orders or net orders? And then with September softening again, are you getting any sense that people are adjusting to a higher interest rate environment or is it still in the works?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

John, I’d call it a stair-step process. The rates ran up, then actually softened a bit in August. At that time, the buyers seemed to have digested the higher rate. They were okay and they moved ahead and we were encouraged with the activity that we saw in August. When you look at September, I want to qualify a little bit is 15 days in September and it includes the Labor Day weekend, which there’s always a little noise with that and there is no question, the market is softer than it was last September. We saw it turned down a bit. In August, if you go back to that point in time, we had also taken some steps in some communities that weren’t hitting their sales rates and we think that’s helped. And as we go forward, if things get sluggish, we will take some steps to further generate sales. But since I made my prepared comments, since I sum them over the last week, rates have run up again and with the Fed comments today, we think they will move a little more.

What’s interesting is that I can share also and we didn’t include it in our mortgage comment that we have some great and compelling interest rates on adjustable-rate mortgages where it’s a 10-year fixed. And if I were a buyer, I would take that in a minute. And those are couple of hundred basis points lower than the 30-year fixed and nobody is taking so far. It’s a very limited number of people that have shifted to arms yet. And if you take that dynamic and pair it up with the buyer profile I’ve shared, I don’t know that they need the arms yet. They’re just — everyone is just kind of paused. They are, as I said, they’ve moved the sideline and they’re waiting to see how things play out. Whether it’s our interest rates were going up more or our inflation concerns, all these thing that you’re hearing about in the media. So, the buyers just put in on pause. They haven’t gone away. They’re just not buying at the level that works.

Operator

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

Stephen Kim — Evercore ISI — Analyst

Thanks very much guys. And Jeff, yeah, thanks for that commentary about the nature of the slowdown in demand. It certainly sounds like the issue is more and more mental than math and so that’s encouraging. I did want to pick up though, Jeff K., on the comment about the gross margin outlook, and I believe you mentioned that in anticipating that you’re going to maybe do some more discounting or something to move your quick move in homes was a part of that and so regarding that, one of the interesting thing that we have been hearing recently is that quick move in homes are actually in greater demand by the buyers because they like to consummate the deal quickly. And so, I was curious, are you generating lower gross margins currently on your quick move in homes than on your BTOs? And then tied to that, you don’t have a lot of standing inventory, so, I’m curious are you — It seems like you’re maybe selling your QMIs or your quick move in homes pretty quickly. So again, are you generating a lower margin because you’re selling them pretty quickly? There seems to be a lot of demand for it, that kind of thing.

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

My comments really, Steve, were relative to where we were at a quarter ago. So, you know what’s our expectations on pricing a quarter ago versus today. Obviously, those expectations have come down a little. So, it wasn’t meant to imply that we’re having a deeply discount quick move ins or anything else. Most of our quick move ins are coming from cancellations as you know. So it’s just the dynamic between what was written down as a BTO order and where we ended up transacting at on a QMI. But overall, it was really more of a relative comment third quarter versus fourth quarter as far as our expectations.

Stephen Kim — Evercore ISI — Analyst

Okay, that’s good. So it doesn’t sound like QMI — quick move in homes are particularly a problem for you at this point.

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

No, not at all.

Stephen Kim — Evercore ISI — Analyst

Yeah, and you already talked about the fact that the can rate on backlog was only 9%, which isn’t very much either. So, then sort of a follow-up here, I wanted to talk about Investor buyers and basically landlords, would you consider selling more QMIS or more quick move in homes to investor-buyers if higher mortgage rates were to slow retail demand to the point where you do have more standing inventory than you would like? And is it your expectations that sales to landlords would come at a line average margin or better on an operating basis?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Steve, I want to make a few comments on that. First off, on your previous question, I wouldn’t say that buyers prefer spec over built order. We offer the customer nine-month lock. So, they get today’s rates not going on up them. I shared the percentage of our buyers who are locked or cash and they still value the ability to personalize their home. So I wouldn’t take the position that people prefer a spec home. We really limit or try to get away from any investor sale activity. And one of the things that I’m sensitive to is having a bunch of renter churn, I’ll call it, mixed into our community. So, we’re not a company that would go sell a bucket of inventory and put rental investors next to our customers on a broad-based approach. Maybe a householder here or householder there go to an investors purchasing and renting, but when we may consider it and we’ve looked at it, we haven’t penciled yet, but we may do it if we have a larger land holding and there is a distinct part of loss that you could identify a single-family rental and they have their own streets in and out and they aren’t mingled in with our purchasers, then we may look at something like that.

I would think on a bulk basis even though we’re not doing it, I would think that the bulk purchaser is going to expect some type of discount due to buying bulk. I can’t believe they’re going to just pay market right pricing right now.

Operator

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

Matthew Bouley — Barclays — Analyst

Good evening, everyone. Thanks for taking the questions. So, on the topic of ASPs, I know you mentioned making some price adjustments in underperforming communities. I think the order ASP overall was maybe down 12% sequentially. And if I’m doing the math right, it looks like on the West Coast, it might have been down more than 20% sequentially. Are you finding that these price adjustments are, I guess, reinvigorating sales pace in those communities or should we expect to see perhaps more reductions and I guess just given the magnitude of that, due to owned land impairment starts becoming more realistic given that move in pricing? Thank you.

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Matt, I’ll talk through the price move and Jeff can deliver the impairment thoughts.

California is primarily totally mix. We had several communities that sold extremely well in the second quarter and either sold out or approached sell out where the ASP was 1.5 million, 1.7 million up to 2 million. And when you get a few of those communities in our coastal business and they sell out and you replace them with townhomes for 600,000 in Anaheim. Iy can really move your ASP down and that’s what happened in California. That’s not price cuts. That’s a mix shift. So when we looked at it of the change in ASP, about two thirds of it was the California mix shift. And then the rest may have been adjustments or further mix within the other regions. But I’ll look at that as a pure price cut because that’s not what happen in our business. Jeff, you want to give any other thoughts.

Jeff Kaminski — Executive Vice President and Chief Financial Officer

Yeah. In relation to the impairment question, just spend a little bit of time during the prepared remarks talking about the vintage of our lots and when those lots are locked in as far as pricing goes, and we’re pretty proud of our inventory right now and our lot position in our communities. Exiting the year, as we guided in the mid 20s from a gross margin point of view, puts us in my tenure with the company at about the safest point we’ve had with the most room between where we’re currently selling homes at and what would even start to cross the line of impairment. So it’s not high on the list right now of concerns for us at the moment. Obviously, we will continue to carefully monitor what we’re doing with land in particularly with new investments, but it’s not a particular concern right now with those type of margins.

Matthew Bouley — Barclays — Analyst

Got it, okay. That’s really helpful. Thanks for that clarification, particularly on the mix side there. I guess, second one, you mentioned at the top, I think Rob spoke about the potential to begin renegotiating with certain construction materials, if I heard you correctly around the decline in housing starts. Just curious if you could, I guess, expand a little bit on that and sort of where you see the opportunities to maybe reduce some of your input costs there.

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Rob, you want to take that.

Rob McGibney — Executive Vice President and Chief Operating Officer

Sure. Yeah, on the direct, we’re starting to see some relief on the front end and I think that’s how we would all expect it to happen because this start slow down — the houses that are moving through the fronts front end of the construction cycle, there’s just not as much — there’s not as much out there. So the trades in the suppliers get hungrier so and that’s what we’re attacking right now and we’ll be working to drive the cost out of the business. We haven’t seen the same success and I wouldn’t expect to until we get probably through this year on the back end, because there’s a lot of production volume out there in all of the markets that we operate in on the new home side.

So the trade base and the products associated with the homes that are say, dry wall and beyond, is still pretty tough, but that’s going to flow through some of the slowdown we’re seeing and start to first get relief on slab and then framing that moves on to the system. So that’s really the way that our teams are approaching it and attacking it today.

Operator

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

Alan Ratner — Zelman and Associates — Analyst

Hey guys, good afternoon. Thanks for taking my questions. First one, would love to get a little bit more color on the roughly 9,000 lots you guys walked away from in the quarter. I’m curious, was there an attempt to renegotiate those deals and the sellers for one reason or another just didn’t want to play ball or those lots that just based on your kind of view of where the market is going just didn’t make sense to move forward on either at any price or any kind of take down schedule that you could have potentially renegotiated?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Hi, Alan, I think it would be across the board. You answered some of it. In some cases, the land sellers are sticky and they are not willing to reduce price and they’re not extending because they think they got other people in the wings that will come in and take your position. We say, okay fine, but we’re not comfortable and you walk. Then there is others where that the price point or in that city and what was going on around it, we decided we just don’t — we can’t support the returns. And as we look at our land activity now, it starts with the underwriting on the price and the pace and unless that sub-market has stabilized and we have demonstrated pace of a similar or less or similar price point, we can’t get comfortable. It’s not — going to get a little tougher out there. So, but it’s a full mix of things. We’re doing everything and anything to preserve these positions. But if it doesn’t make sense, we are prepared to walk.

Alan Ratner — Zelman and Associates — Analyst

Got it. And just in terms of the kind of vintage or duration on these deals, were these primarily lots that would have been community count growth in call it 2024 and beyond or are these deals that you were kind of on the edge of potentially taking down that could have contributed for more near term community count growth?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

There might have been one or two where its 2023 deal, late in 2023 would also, but for the most part is beyond. And finally, we’ve got a very successful run at filling a very good lot pipeline over the years here and if you look at the last count [Indecipherable], we don’t have the urgency to go tie up more right now to have a growth trajectory. We have a nice position, softer trajectory than we thought two or three years ago, but still a very favorable growth trajectory. So, we don’t have any urgency right now. We can afford to be particular.

Alan Ratner — Zelman and Associates — Analyst

Got it. That makes lot of sense. And Jeff, you brought up the underwriting and I remember earlier in the year, you answered a question of mine related to some of those assumptions on your underwriting and I recall at that time you said on land underwriting you were generally assuming monthly absorption rates in the four to six range and that was when your sales pace was obviously much higher. Today, it’s lower and to point in time, of course. But, should we think about your current sales base at three where four to six is really that desired pace you guys want to be at and until you get there, price is probably going to be a lever that you’re pulling maybe more significantly than you did this quarter or have you changed that view or all are you more comfortable in this maybe three to four range for the time being.

Jeff Kaminski — Executive Vice President and Chief Financial Officer

I’d say three to five. If I said four to six, it would be three to five now and every — it depends on how many lots and is it replaceable and what’s the price point and all those things we always talk about. But at three to five, we can make very good profits and very good returns at kind of margins we can run.

Operator

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

Michael Rehaut — J.P. Morgan — Analyst

Thanks, good afternoon and thanks for taking my questions. First, I just wanted to circle back and clarify from an earlier question around margins on spec or quick move in. It was cited as a driver. Reduced pricing expectations on quick moving in or spec, I guess, in the fourth quarter. So, it would suggest that that margin on spec is a lower margin than your homes in backlog, at least I would presume. I just wanted to get that right. And number two, Jeff K., I think you mentioned four drivers to the reduced gross margin expectations and I think versus your prior guidance is about 250 bps, you cited four different drivers. And I’m just trying to get a sense of the degree of magnitude of what each of those drivers represent on the guidance reduction.

Jeff Kaminski — Executive Vice President and Chief Financial Officer

Sure. Yeah, I’ll try to address both those. So first of all the QMI again, it was relational. It was related to where we were at a quarter ago versus any type of comparison between QMI homes and build to order homes or anything else. We’ve done very, very well with anything that we have needed to sell on a spec basis, particularly over the last couple of years and there hasn’t been much. Our spec homes in delivery has been pretty small. So that’s really actually pretty small impact on the fourth quarter gross margin but it is one of the factors.

When you look at order of magnitude, I mentioned four things. The mix and leverage probably being on the lower end of things. The QMI impact probably being on the lower end and probably the largest impact was just provisions that we made in the event that potential selective price adjustments are required on the backlog. So, and it was judgmental bit and we don’t know yet where that will land for the fourth quarter but we wanted to be prudent and a bit conservative on that piece of it in the event that conditions keep deteriorating. So that’s how we see it today. The mix impact also was somewhat impactful when you look at the over performance in Q3 and those homes were in backlog.

These home, these lower margin homes will be closing in the fourth quarter and some of the higher margin homes actually closed in the third. So there’s a little bit of a trade-off there as well. That’s how we see it right now. Every time we kind of redo a forecast, we don’t go through community by community, home by home, and quantify all of the differences but those are the main drivers as we see it.

Michael Rehaut — J.P. Morgan — Analyst

Right. Okay. No, I appreciate that, Jeff. And maybe just to drill down a little further on your answer I guess. When you say that the bigger portion of the 4Q gross margin guidance reduction is from this — an assumption around selective price adjustments, so if I’m hearing that right, it sounds like you’re saying you haven’t made those adjustments yet. These are assumptions of what you might need to do through the end of November. And to me that’s little surprising in that you have another 10 weeks to go. Obviously, that’s a decent amount of time, but you’re talked about a large number of closings. So, I was little surprised to hear that I would have thought that those price adjustments would have already been made. Just curious if that assumption is based on some price adjustments that you’ve already had to do in the last month or two and you’re kind of projecting out a run rate on that or is it something where these are kind of active and ongoing and maybe you haven’t hit the finish line yet, but it’s certainly in progress.

Jeff Kaminski — Executive Vice President and Chief Financial Officer

No price adjustments on homes in our backlog, Mike, are generally made very close to the closing date so that if you decrease prices below some of the contracted price, but later increase price slightly beyond that, you’re not hitting lowest common denominator. So, it’s always pretty close to the close date. Yeah, there is definitely a lot of extrapolation that’s in the numbers right now because we just don’t know what that environment will look like over the next couple of months and how many buyers we may need to offer encouragement to get their homes closed.

Operator

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

Susan Maklari — Goldman Sachs — Analyst

Thank you. Good afternoon, everyone. My first question is, can you talk a little bit about the studio sales and how are your buyers thinking about some of the options and the features that they’re putting into the homes and any changes there that you’re seeing?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

It’s interesting, Susan. We start with the recognition on the lag between contract and close. So, a lot of our Q3 closings actually were sold in December, January, February and in the March. But, the spend in the studio actually went up year-over-year and I didn’t really get into the guts of it. I don’t know whether we — it was — I don’t think it’s the buyer preferences changed. I think our studio pricing changed because of the costs were going up. But the type of items they were choosing and the spending went up with type of items were pretty much the same as prior year. So, we haven’t seen a shift there yet. The other interesting thing to me, the size of our homes have not changed. While interest rates have gone up and pricing moves and everything, the footage and deliveries were similar to a year ago and the footage on orders was almost identical. So buyers are not changing their preference yet.

I think in part, the profile of the buyers we’re catering to can afford all this still and so it may shift if rates keep going up moving ahead. But so far, we haven’t seen anything change. Okay, that’s helpful color. My second question is, I know you mentioned that despite the fact that you are offering 10 year arms and some other alternatives that are several basis points lower than a fixed rate mortgage now. You’re seeing that people are really just choosing to kind of pause the overall spend decision — buy decision. I guess how are you thinking about the buyer psychology? What are they waiting for in order to decide to make that decision and how are they weighing the rent versus buy decision today especially considering that rents are also still moving higher? Yeah, I just heard a report today, driving into work that — observed that on average single family rental payments are up 12% year-over-year. It’s a pretty big move. And I think that continues to be a compelling reason to be a homeowner and lock in the the value and build up equity over time. I think the buyer is primarily — I mean just confidence in the state of play out there — whether it’s inflation and whether it’s interest rates when they hear the news coverage on the FED today or what’s going on in the Ukraine war and all these things are weighing on the consumer today. They’re not going away and I’m joking with somebody yesterday on how each month there is millions more Gen Zs now in their home buying years, and they’re not going away. So they, they have to make a decision to own versus rent and there is arguments for both, but I think people want to be a homeowner. And right now, they’re just, they’ve taken a pause and we keep monitoring it and that’s part of why we elected not to start out chasing sales when we didn’t need them as we did not have any inventory and we already have the backlog for several quarters of deliveries and two, I think the buyers are inelastic right now. If they just lockdowns down, so I’m not going to do anything in the short run, you’re not going to get them off the fence by throwing more. So, we thought we’d just pause and see how it all plays out, but the buyers are still out there. That has not changed.

Operator

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

Mike Dahl — RBC Capital Markets — Analyst

Hi, thanks for taking my questions and the color so far. I wanted to ask a little bit more about the comments on monthly cadence and obviously with orders down 50%, net gross down 35, there can be moving pieces from month to month. Could you just give us a sense of, on a year-on-year basis, the order trends through the quarter? And then when you talk about the softening in September, maybe what pace or what type of year-on-year decline should we really be thinking about that you’re tracking to?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Tracking year-over-year.

Mike Dahl — RBC Capital Markets — Analyst

Not for two weeks.

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Mike, I don’t know if we can even give you any color on that. It’s a 2-week period in September. So don’t — I couldn’t tell you what we did last year in the first two weeks. I just know it’s a little softer than August.

Mike Dahl — RBC Capital Markets — Analyst

Okay. While I guess can you can at least speak to the kind of June, July, August trends more specifically either sales pace in each month or the year-on-year decline in net orders in each month and then I guess with respect to September, even if there is something on, well, at this weekly sales pace. It’s down ex versus August, anything like that?

Jeff Kaminski — Executive Vice President and Chief Financial Officer

I do not have numbers.

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

I mean, Jeff went through a little bit on the quarterly trending during the prepared remarks and talked about August. So, I’m not sure it’s terribly relevant right now with the rate moves we’ve seen since August. I mean one of the things that happened in August was we saw overall a little relief on the rates and little bit of, I don’t know if you call it relief rally or whatever. Same with the market, — the stock market had some signs of life as well during the month. So that may have had some impact on buyer behavior.

But as far as trying to get too detailed on this in a short period in September, we just — we don’t bother and probably won’t do again in this call either Okay, fair enough. Maybe I’ll ask I guess slightly clearly different way. I think Jeff, you also mentioned that kind of new targets three to five on pace. I’m not sure if that was kind of underwriting when you’re thinking about your land deals or if you’re thinking about that as a current selling pace, but given seasonality in the latter part of the calendar year, things like that, things like what you’re seeing with this step up in in rates. I mean should we be thinking that we see seasonality in terms of seasonally lower versus the pace that you saw in 3Q or could you potentially be a little more stable to that as you’ve adjusted prices? If you assume, just say four to five. When I was talking about four on the previous question, on the three to five and yet, but it was relative to land packages and go forward underwriting. But if we’re going to operate our community, just say, four to five or 4.5, so if you’re going to run a 4.5 through a year in a typical year, you’ll be at 5.5 through March, April, May and June in that period. And then in the fourth quarter, you’ll drop down under four and that would be a pretty typical seasonal trajectory for us. If you’re trying to model where our sales are heading, you’re going to do less in the fourth quarter than you did in the third quarter than you did in the second quarter due to seasonality and I do think we’re returning to more normalized seasonal pattern.

Operator

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

Truman Patterson — Wolfe Research — Analyst

Hey, good afternoon, everyone. First, I just wanted to follow up on one of Matt’s questions and look for a little bit of clarity. Jeff, I believe you said that two thirds of the decline in order ASP sequentially of that 12% was purely a function of product to mix shift, implying that based pricing is the remaining third or down about 4% quarter-over-quarter. Making sure that I heard that correctly and if so, that’s kind of a direct four point headwind to gross margin kind of all else equal and Jeff K., on your fourth quarter gross margin guidance, you ran through some of the items, reasons why it’s down quarter-over-quarter, but are you all seeing any benefit from lower lumber costs that will be hitting the P&L in the fourth quarter sequentially. I believe the lumber pricing kind of peaked in February, March timeframe.

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Yeah, the lumber. We expected the lumber to be peaking sort of third, fourth quarter. So, we’ll see some relief I think going forward on that. I think certainly we’ll see — lumber has come back, kind of, within range as I call it should see some nice benefit since it’s a large cost factor. Not just on the lumber, I think as the market softens, we’re working pretty hard on the suppliers and subcontractors and everything else in terms of pricing. There is usually some pricing benefits that help or cost benefits offset any pricing issues that we’ve seen. And then the other question is on the..

Jeff Kaminski — Executive Vice President and Chief Financial Officer

Yeah, to determine the two thirds, I was referring to the California mix shift only. It’s hard to say prices are down yet because you have ins and outs every month and every quarter, whether it’s open something in Denver and you close something in Tampa and the prices are different, but two thirds of the price shift was directly tied to all the high price goods that we sold through in coastal California North and South.

Truman Patterson — Wolfe Research — Analyst

Yeah, I’m just trying to understand because the whilst ASP following 21% in the quarter. I realized mix shift can impact that, but I was assuming that there’s price concessions included in that as well.

Jeff Kaminski — Executive Vice President and Chief Financial Officer

Go back to the order price growth in the second quarter was significantly higher than any price we’ve guided on delivery. It was just — it was a blip because of the mix.

Truman Patterson — Wolfe Research — Analyst

Right, got you, okay. Okay. And similar for I believe to the other three regions, the order ASP also kind of declined. Anyways, I think what everybody is trying to understand is what level of base price [Indecipherable] you all have been seeing nationwide. But I’ll leave it alone. On the new community, the new communities that you all have coming online, we’ve heard of builders, maybe not cutting price across all of their existing communities. They’re more adjusting pricing on the new communities coming online. Wanting to understand if that’s your strategy and maybe any sort of magnitude relative to new communities versus existing communities that you have down the road. And are you seeing consumers respond to these new communities? Are they hitting your absorption targets?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Yeah, for the most part openings are working very well. And what I would reshape the answer Truman in that, as I shared in the prepared comments, a lot of these assets have been tied up at a price from thre, four years ago, five years ago even. And therefore, the margins that we would plan on are much higher than our underwriting margins because of the market list. So now if prices come down, we adjust and may have a reservation process that helps us focus in on what the right price points are in the community. So [Indecipherable] come down to ensure a successful opening, but you’re still well above the margins that they were underwritten at, but we want to make sure that the communities a successful openings. You can only open once and if they aren’t successful, it gets painful. So we like to set the pricing worthy to community works out of the Dayton and typically good markets or bad, new openings were in a lot of excitement and energy and you generate a lot of sales. So, [Indecipherable] are working pretty well.

Operator

Thank you. Our final question comes from the line of Deepa Raghavan with Wells Fargo Securities.

Deepa Raghavan — Wells Fargo Securities — Analyst

Hey, good evening. Thanks for squeezing me in. Jeff, appreciating that your backlog cancellation rate is 19% versus the overall 35% cancellation rate. Can you talk through the risk to the backlog you have? I mean have you scrubbed the backlogs fully again for a higher qualification rate, maybe had conversations with those buyers again? I mean what can you proactively do to ensure the backlogs are resilient?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

Well, we’re constantly scrubbing the backlog, Deepa. The last thing we would want to say about a name on a home, that’s under construction. That isn’t prepared to close when the home is completed. So all those processes are intact and we have a quality backlog. What we’re seeing to some degree, we’ve had buyers that their loan was approved. Their loan was locked. The home gets completed. And then they say I just don’t feel good about going forward with this purchase even though their interest rates that they locked at is in the threes and they have 20, 30, 40 ground of equity in the home, they still say, I’m done. There is too much noise in the world and I don’t feel comfortable with this and we really can’t control that.

But if you look within the quarter at our deliveries, the can did not really impact our deliveries at all and they didn’t impact our percent of what this unfolded. The same level at the end of the third quarter it was at the end of the second quarter and as I shared in my comments, for the most part, these buyers are closing when home is completed. It’s still been very predictable.

Deepa Raghavan — Wells Fargo Securities — Analyst

Okay, that’s helpful. A bigger picture question. If rates stay in the 6 to 6.5 going to flinch, is that potential we can see a normalized spring selling season or is it too late to expect demand recovery given just how September positive playing out with these higher interest rates?

Jeffrey T. Mezger — Chairman of the Board, President and Chief Executive Officer

It depends on what’s going on with the economy, jobs, interest rates, inflation, everything else that drives consumer confidence, but I think if rates held where they were and if the consumer digested and they still qualify like our buyers do, I think you could see a more normalized spring. So I wouldn’t suggest for the couple of weak trend right now with everything going on is a precursor for what would happen next spring. It’s way too early to say that.

Operator

[Operator Closing Remarks]

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