Interview: Jeff Mezger, CEO, KB Home

BB: Do you remember what your first day on the job at KB Home was like?

JM: My very first day? It's very interesting and I don't know how much you know about my background, but I left U.S. Home to go to work for KB. And the offices were literally a couple blocks apart. So, I went from my old job to my new job a couple blocks away. KB and U.S. Home had been pretty stiff competitors in the Antelope Valley of California [1993].

So I walked across from Brand X to a competitor and the management team was suspicious of me. And I was now there as a new leader. I had to have a staff meeting on the first day and reinforce my values and reinforce the respect I had for the job KB had done because it was like going to the enemy and now you're best friends with them. So my first day was I'll call it a settling down and a rules of engagement day, where we all got around the table, the management team, and talked about the business.

The weekend before I started, I actually toured all the KB communities [in the area]. I would have the sales people demonstrate the product and talk about all the strengths and weaknesses. And then at the end, I would introduce myself. By the third community, I was no longer stealth. [The sales people would call up other communities and say,] "If he pulls up in this car and he looks like this, that's your new boss." So, I went in stealth and came out [known]. July 15, 1993, a nice cool summer day in the Antelope Valley.

And I was already in the area so I knew the contractors and the city, so I didn't have to get acclimated to anything other than the team and shape the strategy and go from there.

BB: What exactly was the value proposition that you presented to your team that first day?

JM: I believe in the strength of the team. I put a lot of emphasis on people. Over the years in my former life at U.S. Home, I had built a very good team where things got done with or without me. That was my goal as I started with KB and moved up through the ranks; that's always been my goal. Certainly in this job, it's more critical because of the size we're at, you're only as good as the team and the people. And the more you communicate, the more you reinforce, the more you show the direction and then get out of the way and let the people go to work, the more effective you are and the better your results.

There have been times over the years in our industry where ego could get in the way. When you're down at the divisional level, you can have a national brand but you're only as good as the division locally. And there were times in my career where I had a boss who was the opposite end of the spectrum, a dictator manager ? and I vowed if I ever got into a position of authority and responsibility, I would be the opposite of that. And I felt that through my whole career.

U.S. Home was a great company and I had a great relationship with the CEO and the president, and I actually was with the company through the bankruptcy. And after they emerged from the bankruptcy, so I was with them through thick and think and we had a good business in central California. And we were competing with KB and headhunters started talking with me. I'd been with U.S. Home for 15 years. I had a good job, I had a good team, so everything was working well. It just started rattling in my mind I could either do this for years at US or I could go and take on a new opportunity.

Believe it or not, one of my commitments to myself back then was that I would never work in a corporate office. I was a people person and I loved to be out in the field, kick dirt and be creative. You know, corporate offices didn't symbolize that for me. And at the time, U.S. Home was less focused in more capital intensive markets so we didn't have the growth opportunities as then Kaufman & Broad, who headquartered in California, the biggest builder in California at the time, and I thought to myself I could either stay at U.S. Home and run the same size business in my comfort zone or I really want to cross the street and was managing a division twice as big that still had an appetite to do more. So, it was a more growth-oriented environment and that was really what drove me.

BB: What do you see as critical moments in KB history?

JM: Certainly the decision in the early 1990s to expand outside California. In late 1992 was when California was in a very difficult market. KB only built in California and Paris, France. And Paris also was in a very challenged housing environment. The only two markets KB was in were two of the worst housing markets in the world. The strategic decision was made to branch out. And I started with the company just as the branching out occurred. Within months after I started we entered Las Vegas, then we entered Phoenix and then entered Denver, so it was the start of geographic growth platform, being creative in the early 1990s.

And then the next significant event was when we acquired Rayco in 1996 in San Antonio, Texas-a great business, large market share, but most importantly a business model that we blended with ours. Rayco was great at manufacturing, the process, focus on the customer; KB was great at land development, marketing, branding, and focus on the customer. We took the best of those two business models, blended them together and came up with KB2000. After the year 2000, we had to change it to KBNext. It was really something that revolutionized our company. And as we continued to grow and expand into other markets, a lot of the growth was fueled by the implementation of our business model, which allowed us to create a large business in a hurry and effectively run it and take market share in new markets. So, it was a great one-two punch. You had an aggressive growth strategy and a great business model. It's really been the focus of the culture for the last 11 years.

BB: Can you explain more in detail how the operating model changed the company's culture?

JM: It took the head off, turned it around, and put it back on. Literally it revolutionized it. As you guys have watched the challenges in the market over the last year, a lot of builders are saying you can't pre-sell, you can only build inventory and then you have to dump it. We've maintained a large backlog of pre-sold buyers that then in turn wait for their homes to be completed. Even today I think we have the largest backlog in the industry. And when you're building the home they want on the lot they want, they will, they'll go to the studio, pick their options, and wait for you to build it for them.

In the past, KB was just one of the pack, where you will build it and hope they come. And if they weren't sold by sheetrock, you'd start incentivizing and they weren't sold when they were completed, you really incentivized. You were forcing your values onto the customer. You were building what you thought they wanted and if they didn't like it, you cut the price versus give them a standard home that's designed [to their tastes].

We know what people want in that price range in that submarket up to a point and then you go to the studio and pick out what you want and it's your home not our home. So, with that, in order to do that at a high volume, you have to be very good at the systems. Walking through that studio and that division builds about a thousand homes a year, so you have a thousand opportunities to disappoint a customer. With that kind of choice, it's very difficult to manage if you don't have good processes and good discipline.

BB: Where do you see the next big moments happening for KB?

JM: These are certainly interesting times. We've quickly moved over the past eight or nine months definitely out of growth mode and back to manage the balance sheet, generate cash. And part of that was to refocus on the core business that we've done well with over the years in better times. We branched out to take advantage of opportunities in higher priced product-not our business. It's very difficult to be good at the high end and good at the entry level and first time. It's a different mindset in terms of the pace, the returns, and the customer. I don't think you can be all things to all people.

We had strayed a little bit from our core business model. And when I say we strayed, when you couple the survey, the product, the studio, and the strategic price points that we like to play at, part of our theory is that we don't just compete with new homes, we compete with resales. A buyer looking at resales can pick from 20 homes, every one different, so they have more choice than [with] a builder with three, four plans in a community that does 20 spec homes. So, in order to compete with resales-you can charge a premium over resales, but it's only so much. (In normal times, it's about 10 percent for like footage in the same area. And that's where we like to hang, no higher than the 10 percent up from the resale median so you can compete with resales.) So, when the markets became pretty warm over the last couple years, we started moving up in product and moved away from the resale medians.

And when things contracted the way they did and are continuing to that's where we've had the biggest heartburn, you know we went into second-time move up and third-time, you know higher priced stuff that is a more discretionary buyer who, when things get tight, will go sit on the sideline until ? they don't have to sell their home. The first-time buyer and the first move-up will still buy because they got married, they got a job, they have a growing family, the move-down couple that's still going to move; you're accommodating the demographic turn versus the more subjective buyer. We got into some price points in some market I wish we wouldn't have.

We've moved quickly to get back to our core business. In fact, I think we're going down further. I think especially with the credit challenges the last couple weeks in the credit markets, we're moving quickly to get all of our product back to FHA price points or certainly conforming loan price points, because the exotic loans and the jumbos I think are going to be a little tougher to [obtain]. I think there are so many changes going on fundamentally while we're sitting in this room, from what I've seen the past couple weeks.

Builder pricing got so far away from the mass and its slowly coming back down. We need to understand what we did. If you take some of our California communities, where historically we build a 2,200sf three or four bedroom, two-car garage, two-story home [for] wife, husband, two kids, and a dog-middle-class America. As the markets heated up, we would take the same lot-and you know the land sellers are smarter than us-and the land prices were moving up with our prices. The lot goes from $100,000 to $150,000. Well, a 2,200 sf house won't work. We'll build 3,200 sf. So, you're adding 1,000sf at $50 a foot plus a margin so your price didn't go up incrementally; it went up $50,000 for the lot , $75,000 for the home. So now you're at a different price point. [But] now that we are up this high, now we have to make more features standard. And you push it up another $50,000. So prices didn't move 10 percent, they moved a bunch due to product.

And where we've done better is in markets where we didn't go up like that in size. We would go to higher densities, instead of four to the acre, we'd go find a parcel that was eight to the acre and keep the home size down. And even toda, in parts of California where we're priced around the median incomes, we're selling very well. People are saying, excuse me, I can't afford your home anymore.

You had the flipper frenzy and then you had the feeding frenzy, [the] "oh, no, I'm getting priced out, I better jump in" [mentality], and people started buying for the "investment," not to live in a home. That started to wane. The investor said, "This one's going to pop, I'm out." Right as they got out is when all the subprime came in. And it kept fueling it up. If we'd stayed focused on the fundamental housing demand, price points would be much lower. There's a huge demand that growing every day, but it's how do we get back down to it. It's a challenge.

BB: Any plans to expand into new geographic markets? Or with the market still soft will you be looking to retrench and exit some less profitable markets?

JM: There's no question that there's opportunity; it's just a question of timing. One of the things that's been interesting for us, if you look at us versus some of the other large builders, over the last five to six years, up to 2006, so it's actually a four-year period, we entered a bunch of markets. In 2002, we were only in 19 markets. Today we're in 37. So, we expanded our growth platform significantly. And in a lot of those markets we went in as a little start up. You get your team together, you get your feet on the ground, you develop a little sub[contractor] base, and you have this little beachhead of a business in a large market.

And then the market tightened up so we didn't push the growth envelope. And as a result, while a lot of our peer group had already been in these markets and was trying to win share, we did it through entering cities and then didn't ever hit a critical mass. So, in my mind, today, if you look at the makeup of our business, I think we have a 4 percent share in the markets we're in, which is nothing. We have cities where we have a 10 percent to 15 percent market share, so could you go to an 8 percent market share in certain markets? Absolutely. And a lot of people do it. So, in theory, you could double the size of our business in the current market segment.

BB: In theory, sure. But what about markets like Chicago where the fundamental economics are weak and getting weaker?

See, that's a great example. In Chicago this year, we'll do 250 homes. Could we go to 500 in a 35,000 start market? Sure you could. You have wait for it to settle. We're in no hurry. We have the lots to hold our current size. Chicago is the one market that we are in that is a little out of strategy to stay in the SunBelt, stay where all the jobs are. We call it the "smile." And a lot of the builders do. But while the long-term economics prospects for Arizona, Nevada, Texas, Florida and California are very favorable, Chicago's got this turn where it's a very large housing market, has some job growth, but nowhere near the population growth of the Sunbelt, but it's our smallest business. [Another example is] we're in Tampa today. You know Tampa's a tough market. We're doing 500 to 600 homes. Could we get to 1,000? Yeah. In a heart beat.

Tying back to your question, where do we go from here? We entered so many markets that we've now got this strategic national footprint, if we just organically grow 10 percent a year in every city that we're in, we could double our size from where we are today without having to enter new markets. We don't need to do acquisitions; we could just grow organically. That's really the perspective we have today. If in the process an acquisition came along at the right price that would really fuel our growth, then we'd take a look at it. But we're not actually [out looking]; we don't need to enter new markets.

BB: How do you feel about your land supply and lot location?

JM: As the markets have tightened up, there's definitely a flight to quality locations. And our current owned and controlled lot supply is around 95,000 lots, so a three- to four-year supply. Sixty percent of that is owned, roughly. So, 60,000 owned lots, 35,000 optioned. The "C" locations that we have-Atlanta is a good example-where geographically it sprawls forever and there's a lot of lots out there, you could get easy roller options in a C location even when the market was very good. And those are the options that we would walk away from. And we did starting last fall. In our focus on cash flow, why buy more lots in a C location? Just write off the $1,000 lot deposit and go find some lots in the "A" locations.

And that's what we are doing. We have been extremely aggressive in shrinking the lot count, owned and controlled. I want to say, it was in our last earnings call? I want to say that in the end of 2Q2006, we owned and controlled about 190,000 lots, something like that. So in a 12-month period, we dropped our lot count 100,000. We still have 95,000 lots. And it's a mixed bag. Some are great assets that are selling well today; we'll just run with them. Others are challenged, [so it's] ok, get the cash out, turn the inventory, and then reinvest when the markets stabilized because it's not on-point with the strategy of where we want to be today.

Through that, we've actually got some cities that we're in that we have to get out in the market for lots because we don't have enough lots today coming out of 2008. While you hear about how bad it is and what's going to happen, we have cities where we're actively out in the market to find lots. It has to be at the right price point, it has to be in the right submarket, and [it has to] be a strategic shift for that business. We're having some success finding those. And if history repeats itself, and I do believe it will, there will be a lot of opportunities whenever this thing stabilizes to pick up some lots off other builders or banks. So, not optimal today, but we have our 2008 plan in place and because of the cash position we have and the fact that we whittled down our lot count so quickly, we're very nimble to be opportunistic in the markets where we are in.

BB: Will you be taking the company in new directions?

JM: No question. That's the fun part from here, where do you go from here and where do you reinvest. If you were to segue into what are the challenges we have-a lot of our management teams have never been through a downturn. I spoke last week-every year we have an annual conference for a couple of days with all of our finance people from the organization and I was getting questions in the Q & A like, "Will it ever come back? Where do you see it headed?" And I finally stopped and said, "Give me a show of hands, how many of you have been in the business 15 years?" And it was like 15 percent. It was nothing.

If you think about it, we haven't really had a slowdown of any magnitude since the early 1990s, so our employee base doesn't always understand the need to change the scorecard, focus on cash, focus on the balance sheet, reposition, retool, and be strategic on the way back. And be thoughtful on staying on your strategy. So these divisions that are running out of lots coming out of 2008 are already feeling the pressure [of] "oh my goodness, we have to go find lots now," and I'm saying, "Keep your wallet in your pocket because in a couple months you're going to have better opportunities than today, trust me." Because I've seen this before. And we're starting to see some of it; it's a normal cycle.

BB: What do you have to do differently as a leader when 85 percent of your people aren't prepared for today's market?

JM: Well, first you have to swallow your ego and [understand] that you're old. But if you back up, the management team we have here has been together a long time and has been through a very successful run. To put it in this perspective, the guys running Vegas were with Lewis [Homes] and now with KB, in turn, since we bought Lewis in 1999. They've been in Vegas since the 1980s and have never seen a downturn. Vegas has not slowed since 1985 or 1986. A 20-year run. They've never seen this before. And Vegas has turned pretty hard. When you have a group like that for years and years, the scorecard has been growth rate and profit, growth rate and profits. And then all of a sudden, the scorecard is lot count reduction, inventory reduction, cash flow-it's a different scorecard. In either case, the part of the scorecard that was the same was focus on the customer, take care of the customer.

We had a [division] presidents meeting where we put the new scorecard up on the overhead [to say] this is what we're all about today. We normally every year have a competition within the divisions and they get into a performance club and we celebrate the success and it's tied to profits and growth. This year I called it "The 50th Anniversary Club." And they are getting ranked based on inventory turn, cash balance, taking care of the customer, delivering on their units. And I sat there in front of them and said, "Where does it say profits here? And where does it say growth rate here?" And you could see the understanding and the light bulbs go on.

[Now] over the long run, you have to focus on making a profit to get returns to the share holder, but in the short run, we have to change the scorecard. Now my communication to the team has been about reinforcing this new set of measures for the year. Coming out of this year, we'll transition to a new scorecard going into 2008. It may be tied to the community count coming out of 2008 or back to a pre-tax target, but you have to change the scorecard because they've only had one scorecard for years and years.

BB: So, when do you expect the industry to turn around?

JM: I already got hammered by a bunch of [my people] for being too negative in the media. [laughs] I told them the truth!

I think it's going to get a little tougher before it gets better. And I don't think it's a 2008 fix; I think it's 2009.

It's pretty interesting as you look through the dynamics, one of the things that has occurred for the large public builders is very solid balance sheets. In the previous cycles, you never heard the word impairment. You never saw the type of balance sheet adjustments that you're seeing because we all gave it back to the bank. The bank would impair it, and then the bank would sell it at a loss to the next builder in line. This time around we're much bigger, much better capitalized, much stronger balance sheet-and you know what? The significant impairments that have been taken [aside], most of the builders have very solid balance sheets with good equity and good enterprise value and cash flow. I think you'll see there'll be some builders that don't make it [but] I don't think it'll be the large builders. Some of the midsize privates, the 300- to 400-unit builder in a market, may not want to play in this arena because it's a tough environment and they've done well enough over the years that they may say, "You know what? I'm done. I've made all my money and I don't want to fight this."

I think the bubble that burst in pricing is healthy for the long term in the industry to get back to more affordable levels. The tightening of credit I think is healthy. It blows your mind to think that people could get an 80/20 loan by being on the phone and saying, "Sure I make $150,000 and my FICO scores are good." It's healthy for the industry and the mortgage sector to actually document that you have a job, document you have income, and it's good for the neighborhood. I think it's the normal cleansing of a cycle and I think in the long run those that are good operators and have solid balance sheets will have a better opportunity coming out of this than they had at the peak.

BB: How do see the KB Home buyer experience evolving in the future?

JM: We're very customer focused, whether it's the [buyer] surveys [we do] or the [design] studios or the product that we build. So, we'll continue to fine tune that and totally align our products with the customer.

One of the accomplishments that I'm most proud of around here over the past 10 years is the way we've elevated our customer service levels. And I'd say that for the industry, and I know the industry is getting a little bit of rap right now, but I think it's the exception not the rule. If you follow back to 1999 or 2000, so seven years ago, we would rationalize away J.D. Power. We had reasons why our score wasn't very good. Our own internal customer satisfaction levels were actually down around 70 percent. On our surveys, we were only 70 percent and today we're at 95. J.D. Power will have the scores here in September, but the overall customer experience has come a long way in the past six years for the industry and certainly for KB. We'll continue to push the envelope there, so whether its the quality of product or the quality of experience.

[When it comes to] the product, I think we'll continue to elevate the focus on the customer and how we can accommodate their needs. I think technology is going to play a lot more than it does today in homes.

I also think that as an industry we need to come up with some better ways to be more environmentally friendly than we are today-there are some things that we're working on right now. The industry does good things for the environment, and we're not good cheerleaders about what we are doing well. To get past that, I think we have to do a lot more for the environment. It's certainly important to our customer, [although it's] unclear whether they will pay for it unless there's an economic trade off. So we have to keep the balance of what do we owe the environment, what do we owe the customer, what do we owe the shareholder and what's our corporate obligation-that'll be a bigger part of our business going forward.

BB: How much opportunity is there to improve your costs per home if you exclude land costs? How much scale do you need to achieve those benefits?

JM: It's a great question because our cost to build has not come down as quick as it went up. And we have markets we're in where in the past three or four years, our cost to build up 60 percent to 70 percent. We haven't seen our costs come down 60 or 70 percent yet.

I think it's [because of] a combination of things. You touched on the right comment when you talked about scale. But the scale, I think, is a local scale. If you are doing 20,000 units, 30,000 units, 40,000 units, you can get a little discount from Whirlpool or Delta plumbing; there's money to be had there. But none of us yet have cracked the code on the supply chain to get the real scale and the components. ? How you get synergies on the labor side?

My saying around here is in fat times you get fat. Builders got a little fat. We're having to enhance execution and realign our overhead and get lean and mean like we were in the late 1990s. I think our subcontractors have to go through the same thing. We're doing some of that.

I don't know how much you guys know about this, [but] we're the only builder nationally that's certifying our subs through the NHQ program that the NAHB puts on. [As] part of that, not only do they audit the subcontractors-and we require our subs to be certified-they audit them not just for construction practices and safety of the site and the quality of the job, [but] they actually work with them on their financial modeling and how they run their businesses. And as we've gotten into it with certain subs, there's "ah-has" for them, and they're saying, "I never thought about running it that way." If you're a small framing contractor, you're not exposed to a lot of the thinking on the synergies that are out there, so it makes them a better contractor. And through that we get a better quality product and have seen some savings on the labor side. We have to continue to partner with them and find more ways [to do so].

In theory, other than whatever oil prices do to drive up the cost of the delivery of goods or the manufacturing of the components or whatever other commodity-those go up and down-in theory, other than the inflation factor of 3 percent or whatever it is over the years, you should be able to get back to where you were on the labor side. And I think we have to; it's a big push for the company. I'd say in 2006, we probably saved 5 percent. In 2007, another 5 percent. So, we went up 70 and we're back down 10, so there's a lot of opportunity to go.

As important an issue for us in most of the cities we're in is the fee structures with the cities; they went up just as quickly as land prices and as quickly as the cost to build. It doesn't get much attention, but we're working with municipalities-and when I say we, the industry is-there's places in California where your fees are $100,000, $150,000 a home. We've worked with the NAHB.

[As a side note,] there's a very interesting chart that the NAHB prepared that shows by market there's a median income and how many buyers in that city get knocked out for every $1,000 bucks in fees. It's for every metropolitan area of the country. I'll looked at that in ? I think it was San Antonio and for every $1,000, it was something like 3,200 buyers get knocked out. And fees in San Antonio are now $20,000 instead of $5,000. So, we have to keep things in balance on our obligations as cities grow, our obligation for infrastructure around the community, for schools, and everything that goes with it. We challenge the cities. This Warner Center-where you go in for entitlement for infill-in this case they turned down an apartment project; we were building condos. I think we were paying every impact fee you would if you were up in Palmdale at the end of the earth, adding streets and adding schools and everything else that's not there, where there's no infrastructure. This is a 50-year old neighborhood, fully built out, and we're paying $50,000, $70,000, $80,000 in fees. It's a killer. And the cities, they don't understand. It's how do we all partner in and get there.

BB: So, tell us a little more about your strategy to move closer to urban centers?

JM: If you look at urban SoCal, from San Diego to Santa Barbara, there's no land left until you get out to the exurbs. And strategically to have any kind of scale, these are the type of locales that you have to get to or you won't be in the urban areas where all the jobs are. So, it's a strategic push for us and it's in our backyard so it's easier to do, but I think whether it's Phoenix, Denver, Dallas, Houston, all these cities have just blown up. And people are saying, "I'm not compromising the quality of life in the commute just to have a yard." So, it's like a lot of Europe.

The land is out there. It's very fascinating because you have the anti-sprawl people [who say] there's too much traffic and how can you drive [so far for a commute]. Ok, fine, we're building Warner Center. And then the city says, "Ok, now, it's too congested here, we don't want you here." It's the not-in-my-backyard versus the I-don't-want-sprawl, and we're saying, "Just pick one and let us know which you'll let us do."

If you fly over LA, if you flew into LAX, and you see all the two-, four-, five-, six-acre parcels where it's an older house that's closed and needs to be torn down and redeveloped. As some of these jobs clusters have developed over time, there's a lot of opportunity. Entitlements do take longer and you have to be more strategic and further out versus buy a lot in Santa Clarita and build a model and go to work. It's a little different, but absolutely the deals are out there.

The biggest cost [in more urban areas] is not the land it's the building. The critical mass comes from how quickly you turn the inventory once you start construction. And you have to go to sale earlier and hold the buyers in. It's a little different process that being in a master plan.