Jeffrey T. Mezger - President, Chief Executive Officer & Director Jeff J. Kaminski - Chief Financial Officer & Executive Vice President.

Megan McGrath - MKM Partners LLC Susan Marie Maklari - UBS Securities LLC Michael Jason Rehaut - JPMorgan Securities LLC Stephen S. Kim - Barclays Capital, Inc. Alan Ratner - Zelman & Associates Joel T. Locker - FBN Securities, Inc. Collin A. Verron - RBC Capital Markets LLC Nishu Sood - Deutsche Bank Securities, Inc.

Alex Barrón - Housing Research Center LLC Jack Micenko - SIG (Susquehanna) Susan Amy Berliner - JPMorgan Securities LLC.

Good morning. My name is Lattania, and I will be your conference operator today. I would like to welcome everyone to KB Home 2015 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Today's conference is being recorded and a live webcast is available on KB Home's website at kbhome.com.

Following the company's opening remarks, we will open the lines for questions. KB Home's discussion today may include forward-looking statements that reflect management's current views and expectations of the market conditions, future events, and the company's business performance.

These statements are not guarantees of future results and the company does not undertake any obligation to update them. Due to a number of factors outside of its control, including those identified in its SEC filings, the company's actual results could be materially different from those expressed and/or implied by the forward-looking statements.

A reconciliation of the non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in the company's earnings release issued earlier today, and/or on the Investor Relations page of the company's website. At this time, I would now turn the call over to Jeff Mezger, President and CEO of KB Home.

Mr. Mezger, you may begin..

Thank you, Lattania. Thank you, everyone, for joining us today for a review of our second quarter results. With me are 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 Corporate Treasurer.

This morning, I will start with a brief overview of our results for the quarter along with an update on our strategic initiatives. Then, Jeff Kaminski will provide additional detail on our financial results after which I will share a few closing remarks before opening the call up for your questions.

Our results for the second quarter reinforce the progress we are making with year-over-year revenue growth and sequential improvement across our key financial and operational metrics. As I mentioned on our first quarter earnings call, we view this year as a tale of two halves.

In the first half, among other things, we've expanded our community count and built a robust backlog that has strategically positioned our operations for revenue and earnings growth.

In the second half, we expect to realize the benefits of our expanded platform, as we convert our backlog into deliveries and revenues, improve our margins on a sequential basis and achieve greater economies of scale.

Our results for the second quarter met or exceeded the guidance provided on the first quarter earnings call, with respect to our community count, housing revenues and average selling prices, as well as the sequential improvement in our housing gross margin and SG&A ratio.

Most importantly, we achieved substantial year-over-year growth in net orders, driven primarily by significant increase in our community count.

With this net order performance, during the spring selling season, we now have a strong backlog position in place which sets us up for significant revenue growth and profit improvement for the second half of this year. I'd like to review some highlights from the quarter.

Our housing revenues of $605 million were up 8% from a year ago, marking our 15th consecutive quarter of year-over-year revenue growth. On a sequential basis, we improved our housing gross profit margin by 90 basis points to 16%. We also lowered our SG&A ratio by 50 basis points from the first quarter to 13%.

Net income for the quarter was $9.6 million or $0.10 per diluted share. We performed particularly well with respect to the leading indicators of our business. Our net order value increased 38% from a year ago to $1.1 billion.

Net orders for the quarter grew 33% year-over-year to 3,015, tracking closely with the 30% expansion in our average community count. We ended the quarter with 261 communities open for sale representing an increase of 35% from the prior year. On a sequential basis, our ending community count increased 11% from the first quarter.

Our ending backlog in units grew 39% to 4,733 and our backlog value rose 57% to $1.6 billion. This was our highest second quarter ending backlog value since 2007.

With this solid backlog position and our expectation for continued year-over-year community count growth over the balance of this year, we are now set up for accelerating revenue and profits and to enter next year with terrific momentum.

Our results are being driven through our continued focus on four key strategic initiatives, which are to grow our community count, drive higher revenue per community, increase our profitability per unit and to enhance our return on investment. As our results demonstrate, we've made tremendous strides in growing our community count.

So I'll move on to the actions we are taking to increase our revenue per community.

While we will always take price as the market allows, we're also working to increase revenue per community through our new locations and the types of homes and options we offer and by taking advantage of the many opportunities for revenue enhancements that are available in our unique build-to-order approach.

As we've shared in the past, we continue to balance price and pace in order to optimize each asset and are not looking to increase our overall sales per community until we achieve our margin goals.

Our second quarter results reflect this strategy, as our absorption rate per community held constant, while our average selling price grew 6% over the prior year, an increase of approximately $20,000 per home.

In order to increase our profitability per unit, we have programs in place to drive further improvement in both our gross margin and SG&A ratios. We expect our gross margins to continue to improve in the second half, as a result of four factors.

First, the actions we're taking across the system to drive price, while containing or lowering our cost to build. Second, the higher margins we are capturing in our new communities will be flowing through in deliveries.

Third, we've invested in field overhead to support our ramp-up in communities in the first half that we are now converting to revenue in the second half. And finally, the added benefit of leverage from our accelerating revenue growth.

We expect continued sequential improvement in gross margin over the balance of the year, and we'll significantly narrow the year-over-year gap by the fourth quarter. On the SG&A front, we continue to do a good job of controlling costs, while we ramp up our community count.

As an illustration of this point, even with the overhead and marketing costs of the additional communities we have opened this year, most of which have yet to generate revenue, our second quarter SG&A ratio was essentially flat year-over-year.

Our accelerating revenue growth in the second half of the year will drive solid sequential and year-over-year improvement in our SG&A ratio. Our fourth key strategic initiative is to enhance our return on invested capital.

While we continue to improve our profitability, we also feel we can support the investment necessary to achieve our growth targets, in part through improving our asset efficiency.

We will continue to generate cash through land sales, whether they're non-strategic assets we currently hold or a portion of a new acquisition that is not critical to our needs. Year-to-date, we've generated $69 million in land sales, and now expect to exceed our earlier guidance for full year land sales revenue of $100 million.

We're also continuing to activate communities that were previously held for future development. We'll take the cash we generate from both of these activities and reinvest in new communities that will generate higher returns. Turning now to the macroeconomic environment and housing.

The national economy is continuing to improve with sustained job growth now occurring across the country. This improving employment and economic environment is in turn contributing to increased consumer confidence, which is currently at one of the highest levels reported since 2007. Meanwhile, the housing market also continues its measured recovery.

Inventory levels remain well below normal, and while there is still price appreciation occurring in most markets, it is at a more moderate and sustainable pace. Even with the slight uptick in mortgage rates over the past week, affordability remains at compelling levels.

The most encouraging statistical trend that bodes very well for future housing demand is the dramatic increase now occurring in household formation.

Recent census reports put household formation at an annualized rate of almost 2 million, well above normalized historical levels and significantly higher than the 500,000 households we have averaged per year over the last eight years.

This data point suggests that we may be at a turning point in this housing recovery, as household formation has been the missing link. We are well positioned to move with this demand, as evidenced by the increase in our first time buyer percentage to 56% during the second quarter, even with the $20,000 increase in our average selling price.

With housing markets continuing to recover, we are experiencing high levels of demand as our product offerings and Built to Order approach resonate with consumers. For the second consecutive quarter, we're reporting solid order growth across all four regions.

In California, net orders increased 32%, with continued strength in the Bay Area and Coastal Southern California. During the quarter, we opened for pre-sales at our first urban mid-rise community, 72 Townsend, which is located in the South Beach area of San Francisco.

The condominiums are priced in the $1.3 million to $1.7 million range for the lower floors, and over $3 million for the upper floors with a view of the Bay and the initial demand has been very strong. Later this year, we'll be opening a community in the Lower Pacific Heights area of San Francisco with pricing starting around $1 million.

While many of you are familiar with the higher density podium products we have developed over the years in the suburban rings of the major California cities, these are our further developments in the urban core; they offer a great opportunity to expand our business presence and our logical extension of our California development expertise.

In our Southwest region, we reported 532 net orders, an increase over the prior year of 152% due to both a much higher community count and an accelerated sales pace per community.

While our Las Vegas business continues to perform well, for the first time in many years, our Arizona division was also a significant contributor to order growth for the region. This growth is being driven by both activations and investment in new communities.

As an example, in May, we successfully grand-opened a large planned community in a great infill Mesa location named Copper Crest. With 440 lots and three product lines, where we are offering price points from the low $200,000s to mid $300,000s that catered the first time, as well as first and second move-up buyers.

As both the Las Vegas and Arizona markets continue to improve, we are excited about the potential for this region to contribute a much larger share of our revenue and profit growth going forward. The Central region is currently our largest region in terms of units, and we continue to experience strong demand across all markets.

The region generated 8% growth in net orders and a 23% increase in net order value, off of a strong order comps from last year. This order growth was consistent with our community count growth in the region and the positive comp was generated in spite of the weather disruption in May.

While we remain cautious, we are still not seeing signs of a slowdown in demand in our communities as a result of the oil price decline. In the Southeast, we also saw strengthening demand, with a net order increase of 38%.

As with the Southwest region, we are encouraged with our potential for growth in revenue and profits from this region going forward. In closing, we're pleased with our progress during the quarter.

Our investment and product strategy is working as our new communities in all four regions are performing well and a housing market that is continuing to improve. We're growing our community count and backlog and are now positioned for significant revenue growth and improved profitability this year and sustained momentum heading into 2016.

Now, I'll hand the call over to Jeff Kaminski who'll discuss our financial results in greater detail.

Jeff?.

Thank you, Jeff, and good morning, everyone. We continue to successfully advance our key strategic initiatives during the second quarter. Our progress is evidenced in part by the substantial growth in our backlog and community count, which as Jeff said, reinforces our expectations for strong second half deliveries in revenues.

We anticipate that this accelerated top-line growth, combined with sequentially higher housing gross profit margins, will drive significant earnings improvement over the remainder of this year. In the second quarter, our housing revenues of $605 million grew 8% from the same quarter last year, extending our trend of year-over-year revenue growth.

We were pleased with our operational performance during the quarter, particularly as our Central region operations were faced with severe weather conditions.

Looking to the third quarter, we plan to generate housing revenues in the range of $770 million to $810 million, as we convert our sizeable backlog into deliveries and we realize continued improvement in our overall average selling price. For the full year, we are projecting housing revenues in the range of $2.95 billion to $3.1 billion.

Land sale revenues increased to $15.9 million in the second quarter from $2.6 million in the prior year quarter. These land sales produce essentially breakeven results in both periods.

So far this year, we've generated $69 million of land sale revenues and are on track to slightly exceed our goal of approximately $100 million for the full year, as we continue to execute on targeted opportunities to monetize certain land positions through either sales or reactivations as part of our focus on enhancing asset efficiencies.

During the second quarter, our overall average selling price of homes delivered grew 6% year-over-year, to approximately $339,000, reflecting increases in three of our four regions. We expect to continue to generate year-over-year increases in the mid-to-high single-digit range for the remaining quarters of 2015, as well as for the full year.

Our housing gross profit margin of 16% for the second quarter improved 90 basis points from the first quarter 2015.

Excluding the amortization of previously capitalized interest and land option contract abandonment charges, our second quarter adjusted housing gross profit margin was 20.3% in 2015, representing a sequential increase of 80 basis points versus the first quarter and a decrease of 230 basis points from the second quarter 2014.

As we expected, our gross margin performance for the second quarter improved sequentially from Q1. We anticipate additional sequential margin increases in the two remaining quarters of 2015, particularly as we gain operating leverage by delivering a higher number of homes and the increasing revenues from our expanded growth platform.

In the fourth quarter, we expect the sequential improvement to be even more pronounced due to an increased proportion of our deliveries coming from recently opened, higher margin communities and the impact of start-up field cost diminishing as we convert orders to revenues in these communities.

Consistent with the guidance provided during last quarter's earnings call and assuming no land option contract abandonment or impairment charges, we are forecasting a third quarter housing gross profit margin in the mid-16% range.

For our fourth quarter, we are slightly increasing the prior guidance and now anticipate a gross margin in excess of 18%, again assuming no abandonment or impairment charges.

Our selling, general and administrative expense ratio for the current quarter of 13% improved sequentially by 50 basis points as compared to the first quarter, but increased 20 basis points from a year ago.

On a year-over-year basis, this slightly higher ratio was primarily due to increases in staffing and other community-related expenditures to support both an anticipated uptick in third quarter and fourth quarter deliveries and our expanded community count. At May 31, 2015, we had 67 more communities open for sales than we had a year ago.

We expect to generate sequential improvements in our SG&A expense ratio in excess of 100 basis points for the third quarter and an additional 100 basis points to 150 basis points for the fourth quarter as we produce increased revenues from our newer communities and continue to manage our overhead costs.

In the second quarter, our effective tax rate of 24.5% reflected the positive impact of $1.7 million of federal energy tax credits we earned from delivering energy efficient homes. For the third and fourth quarters of this year, we are forecasting an effective tax rate of approximately 38% with tax credit impacts if any expected to be minimal.

Our second quarter average community count rose 30% year-over-year to 248, which helped drive a significant increase in our net orders and net order value that Jeff summarized earlier. During the second quarter, we opened 42 new communities, including four communities previously held for future development.

Year-to-date, we have opened 11 such communities as part of our asset efficiency initiative and we plan to continue to evaluate our land held for future development to identify additional communities for reactivation. We ended the quarter with 261 communities open for sales, up 35% from the previous year.

During the quarter, we closed out of 16 communities, which was fewer than we expected and will result in a somewhat higher than anticipated number of community closeouts in Q3. For the remainder of the year, we expect community closeouts to exceed openings.

As a result, we anticipate our community count would decrease sequentially in the third quarter and remain relatively flat in the fourth quarter. However, on a year-over-year basis, our average community count should increase in the mid-20% range for the third quarter and in the low double-digit range for Q4 against the higher 2014 comparison point.

For the full year, we anticipate that our average community count expansion will be in the range of 18% to 20% versus 2014, which is at the high end of our previous guidance.

For the past eight quarters, we've generated year-over-year increases in our average community count, reflecting the strong inventory pipeline we have built through our substantial investments in land and land development over the past few years.

During the quarter, we invested $253 million in land and land development of which more than 70% was related to land development. And we owned or controlled approximately 50,000 lots at quarter end.

We anticipate investing a total of $1.1 billion to $1.3 billion in land and land development in 2015, which we believe will support our community count and revenue growth objectives.

In conclusion, we are looking forward to a strong second half of 2015, as we continue to execute on our strategic initiatives aimed at accelerating growth in revenues and profits. With a strong backlog and expanded community count underpinning our expectations, we are confident in our ability to achieve these goals.

Now, I will turn the call back over to Jeff for his concluding remarks..

Thanks, Jeff. Before we conclude our prepared remarks, I would like to take a moment to thank the employees of KB Home who're driving our success on a daily basis. I sincerely appreciate all of your hard work.

We're entering the second half of the year from a position of strength with an expanded community count and a strong backlog supporting our revenue and delivery projections for the remainder of 2015. As we move ahead, we intend to continue to advance on our four strategic initiatives and to build on the momentum we have in our business today.

With our plans for 2015 firmly in place, we are looking toward 2016 with optimism. We already have the land pipeline in place to meet our delivery goals for next year. And we expect the financial improvements over the next two quarters to carry into 2016.

While it is still too early to discuss next year, our preliminary projection show that we will see improvement in our major metrics, including deliveries, revenues, gross profit margin, SG&A expense ratio and earnings on a year-over-year basis. Therefore, the future looks bright for KB Home. Now, we'll open the call up to your questions..

Thank you. We will now conduct a question-and-answer session. We ask that all callers limit themselves to one question and one follow-up. Our first question comes from Megan McGrath with MKM Partners. Please proceed with your question..

Good morning. So thanks for all the guidance and still working through it a little bit, but a couple of questions here. On the community count, you've talked in the past about having some issues opening communities and seeing some delays there. So you were able to get a fair amount opened in the quarter.

Did some of those delays and issues subside in the quarter?.

Megan, I've shared on past calls that that's been one of my biggest frustrations; as we've been reloading for growth, it's taking longer than we projected to get communities opened. And I think lot of the delays from last year and early this year, finally came through and culminated in the big jump in openings.

I think we're now – we're continuing to fight through delays with contractor base service city (25:12) processing and a little bit of weather right now. I don't know if it has gotten a lot better, but we've plateaued at a higher level now, because a lot of what was in the queue was pushed through.

So there's still some headwinds in getting them open, but I think we're a little further ahead of the game than we were in the past..

Okay. Thanks. And then just wanted to get a little bit more color on your ASP guidance and your confidence there. I look at your backlog ASP and it's about $340,000, (25.56) but your guidance at least for the 4Q looks like it's calling for a significantly higher number in the fourth quarter.

Is that just an expected mix, as you talked about, towards some of these newer communities? What's behind that confidence especially for 4Q?.

Right, yes. There are several things I think that are behind it. One, I think traditionally if you track it that way you'll notice that most cases our backlog trails a little bit from our future quarter ASPs. Part of it is a lot of the backlog hasn't been fully through the studio process at this point.

So while some of the backlog reflects studio orders or additions, it all doesn't reflect it. Part of it is certainly mix and part of it is still some sales to go in the next couple of months that will deliver out in the fourth quarter, particularly some of our higher priced ASP product in California..

Thank you. Our next question comes from Susan Maklari with UBS. Please proceed with your question..

Good morning..

Good morning, Susan..

My first question is that you noted in your comments that you expect to continue to generate cash and you actually could have some more land sales than had originally been expected.

How do you think about the uses of that cash, especially investing in the business relative to perhaps other shareholder return sort of oriented things?.

Right now, Susan, we're reinvesting to fuel growth. We're just now growing into the scale that we're capable of and it helps to carry the current debt load and our overhead structure and it's the best way to improve our returns..

Okay. And then my next question is, you also noted – you made a comment about household formation and how that seems to be improving more recently over the last few quarters.

How do you think that as that comes together, it breaks out between the rental versus buy decision? Are you seeing a lot more first-time buyers coming into your communities?.

I think the household formation will favor both rental and ownership on both sides. It's typically a first-time buyer that's created when a millennial moves out of the home, is fully employed, gets married, has a child, all the normal lifecycle things that have been delayed for a decade.

And as we shared in our prepared remarks, our first-time buyer percentage did move up a little bit in the quarter. We were up to 56% – couldn't tell you if that's a sustained trend or a coincidence of mix. But we saw an increase in three of the four regions during the quarter – a couple of points a region in first-time buyers.

So it's an encouraging sign and as I've shared, it's what's been missing to get a sustained housing recovery. We haven't had the first-time buyer demand and this household formation that's developing, that was very encouraging..

Thank you. Our next question comes from Michael Rehaut with JPMorgan Chase. Please proceed with your question..

Hi, thanks. Good morning, everyone. Just to go back to the first-time buyer for a moment, if you could give us what that percent was in the first quarter and also a year ago.

And I'm just trying to get a sense on a bigger picture, if you think that's being driven by any easing of credit conditions or underwriting standards that are out there or if it's more just this broader macroeconomic momentum that's in the backdrop in terms of employment and the economy continuing to go in the right way?.

Yeah. Mike, I'll speak to the macro trends and then Jeff can give you the numbers. If you think about it, over a 40-year period, the nation averaged 1.2 million household formations. From the period of 2008 to 2014, we averaged 500,000, well below normal.

So people that don't have a job, they're staying with their parents longer – everything we've talked about over the past few years. With the job growth that's occurring and the ageing of the millennials, they're getting to a point in their life where they're getting a job and moving on with their life.

So if you go from annualizing the 500,000 to 2 million, it creates demand, whether it's rental or for sale, there's a lot more people that are out there needing a roof over their household. So I think it's a combination of the pent-up demographics and an economy that's creating jobs..

In relation to your question on the percentages, Mike, as Jeff mentioned, 56% was the percentage for the most recent quarter, last quarter was at 50%. It had been trending sort of in the low to mid 50%s for the last six quarters or seven quarters. One year ago, it was 54%..

Great. And then just a couple clarification questions on the guidance, Jeff.

You mentioned you raised 4Q gross margin guidance a little bit from prior, if you could just remind us what that prior guidance was for 4Q? And also, when you talked about community count, up low double-digits in 4Q, just wanted to know if that was against – is that – when you say up low double-digits, is that against the year ago average or the year ago end of quarter number?.

Yes. Yeah. Good question, Mike. Starting with community count, it's the average against the fourth quarter average in the prior year, so fourth quarter 2014. On the guidance on the margins, if you kind of do the math and where we started from the first quarter and we kind of gave guidance sequentially as improvements in basis points, last quarter.

And if you kind of go through it, it gave us a range of 17.7% to 18.2% for the fourth quarter. And like I said, we're slightly increasing that, now saying that we believe, we'll be in excess of 18%. So we're kind of taking the 17% off the table for the fourth quarter..

Thank you. Our next question comes from Stephen Kim with Barclays. Please proceed with your question..

Yeah, thanks a lot, also appreciate all the granular guidance, it's helpful.

I wanted to first ask, I think Jeff Mezger, you mentioned in your opening remarks that it was your intention and you're going to continue your strategy of increasing your profitability first, before focusing on increasing absorptions, sales per community, I was curious if you could share with us, if you have a certain threshold in mind for overall profitability metrics that would allow you to sort of cross over into the next stage of focusing on absorptions or if there is some other way in which you're thinking about that internally that you could share? Thanks..

Sure. Sure, Stephen, what I – I didn't touch on profitability, I touched on gross profits that we're not going to move our sales pace up until our gross margins are achieved. I'd say that because you can also improve your profitability through inventory turns and just running a better business and that's part of our improvement in profitability.

As we analyze our communities, most of them have an optimal return in the three months to four months range. Depended on how much the initial investment is, it's larger in some states than others, but on average, it's three months or four months. So we'll toggle back and forth.

If something selling above the four months' range, we'll push price, and so, you move this one, and over here, this community may be a two a month, so you do things to get the sales pace up, because you're focused on the returns.

Over time, as we continue to toggle and work on everything we've shared, we continue to have a goal of a gross margin in excess of 20% and SG&A ratio around 10%, maybe a little lower than 10% now with the way we're headed and we'll be working between the two to get there, but in the meantime, you won't see our sales pace lift until we get our margins north of 20%..

Okay. That's very clear and very helpful. Thanks very much for that. I guess the next question relates to your average price mix.

So obviously, there's a lot of things that go into the average price metrics that we can calculate on our ends, but as you think about the distribution of your product that you're offering to various buyer types, over the last few years, KB has been engaged in the process of moving that upwards. And you started your project in San Fran for example.

Can you give us a sense for generally speaking, where you think – what inning you think we are in terms of making that migration, the deliberate migration, higher? Do you feel for example that by the time you get to the earlier part of next year that you will have essentially accomplished your goal or do you feel that this is still a multi-year process that you're going to be engaged in from here?.

I think it's a continuum, Stephen. We like to use the term that we move with demand and we've shared that we can have a product series at a certain width in a city that ranges from 1,200 square feet to 4,200 square feet and if the demand is evident in higher footages and price points, that's the product we'll put to market.

If the demand in that area moves to more first time, we'll go to the lower footage and maybe change the spec level and attack the lower price point out of the same product series.

So my hunch is, as these markets continue to normalize, we'll probably settle pretty close to the range we're in right now, first-time buyer range around 50% to 60%, our first or second move-up another 30% and then move-downs that are 10%.

Also, at the same time, I think if you go back to my comment, we're seeing price still around on the resale side, but it's moderating, and to me, it's part of a healthy recovery, inventory keeps clearing, and as prices normalize, I would expect year-over-year, you'll see our pricing track with the more normalized inflation rate and we'll follow demand in the different cities and that's what will drive our mix and price..

Thank you. Our next question comes from Alan Ratner with Zelman & Associates. Please proceed with your question..

Hey guys, and congrats on a solid quarter. The first question on Texas, Jeff you mentioned weather headwinds there. You did raise the low end of the revenue guidance for the full year.

I was curious just what you're hearing from your guys in this field about production delays and how you are thinking about that for your third quarter and fourth quarter revenue guidance, talking about the cycle times on Texas deliveries, any changes there and kind of how you're building in some conservatism?.

Well, we certainly took some hits with the weather in May. It's pretty incredible what's been occurring in an area that was suffering from a drought.

We lost some deliveries in the quarter, no question about that due to the weather and the way we're looking at it, you didn't just lose deliveries in the quarter, your framing slowed, your Sheetrock slowed, your finish slowed. So you have this roll, where I think just kind of extended out a quarter across the WIP.

So it's not like we lost deliveries and we see a big uptick in Q3, because we're going to go right back and get them, it moved out the whole production machine. Having said that, we took all that into consideration in the guidance that we have given here. While our WIP was impacted by the weather, it did impact our land development as well.

So we're trying to find ways to compress time now in areas where we couldn't grade or couldn't pave over the last 60 days..

Okay..

But I'm assuming it's going to stop raining one of these days in Houston while you're back..

We'll hope so. And just to follow-up on that, Jeff, when you ran through the 2016 metrics, you expect to show improvement. I think one thing I didn't hear was community count.

So I was just curious if you think that community count kind of plateaus here for a while or do you think that as you move into the out years, you could see additional growth?.

Right. Well, we did actually provide a little bit of commentary on the community count. Talking about the third quarter, as I said, our closeouts will exceed our openings for the remainder of the year. So we believe we will sequentially decrease decline in Q3 and stay relatively flat through the end of the year.

But despite that, when you look at it versus prior year, our third quarter estimate for average community count should be up in the mid-20% range versus the prior. And the fourth quarter should be up in the double-digit range versus the prior year, both on an average basis versus the same quarter of the prior year..

Thank you. Our next question comes from Joel Locker with FBN Securities. Please proceed with your question..

Hi guys.

Just curious about your community count in the Southwest region, what it was at the end of the quarter and versus a year ago, at the end of the second quarter?.

Well, the community count in Southwest was up quite significantly. On an average basis for the quarter, if you look at third quarter over the third quarter, we're up about 117% in community count between the operations there.

So we more than doubled and we're pretty pleased with the performance both in the ability to get new communities opening, in a way they're performing and particularly, also saw an absorption increase in the region. So we're quite pleased with how that's gone there..

Thanks. And then just a follow-up on SG&A.

Do you have a breakdown of the $78.5 million in the second quarter between commissions, marketing and corporate?.

I mean we do, but it's a little detailed. I don't have it right in front of me. I will make one comment on the SG&A for the quarter. In relation to our forecast, where we thought we come in, we came in pretty much spot on.

We were a little bit light on the percentage – or a little bit heavy on the percentage by about 10 basis points just due to some of the deliveries that we lost. But we did anticipate a sequential decline, which we had. We did not anticipate catching the prior year number, which we did not.

And the main driver of it is – as we talked about in the prepared remarks was that we knew with an expanded community count and setting up the second half of the year that we were going to have to absorb some additional investment in infrastructure and overhead cost in the second quarter, especially, those that are community related in order to drive strong second half revenue growth.

So for us, it was pretty much on expectation for performance in that area..

Thank you. Our next question comes from Robert Wetenhall with RBC Capital Markets. Please proceed with your question..

This is actually Collin filling in for Bob. Thank you for taking my questions. So during the first quarter earnings call, you guided toward a sequential increase of 50 basis points in your homebuilding gross margin.

What drove this beat versus your expectations?.

Right, yeah, there were several factors in there. The predominant – I guess, when we were forecasting, the 50 basis points predominantly came from leverage; increased revenues on some of our fixed costs are included in margin. What we also saw during the quarter was some pretty strong pricing trends.

So on our spec inventory, I believe we had slightly better margins than anticipated or anything that we sold and delivered in the same quarter. We had a real nice quarter of cost containment, on the cost side and in fact, probably one of the best six-month periods we've had in quite some time, from that point of view.

And we had, obviously, a little bit of favorable mix in the quarter. So it was a 40 basis point beat or so and is close to our expectations and we're pleased that it was a little bit above..

Great. And then a question on conversion ratios, given your guidance for the third quarter, I'm kind of forecasting that you've seen a decline year-over-year.

When do you expect this to tick up towards more normalized levels and what would you consider in the more normalized levels?.

Yeah, Collin, actually, it ticked up last year, because we were covering some inventory. As you look at our business model, if we're imbalance, a lot of your backlog hasn't started yet. In a Built to Order business, you wait more. Your backlog too sold and not started.

And if you think about our sequencing and the rhythm, it's a six-month cycle from contract close. You'll have about a third of your backlog that's either not started or just started and will close two quarters out, not next quarter. So over the years, when we're in balance, our backlog conversion is around 50% maybe 55%.

When you're growing, you're typically growing the unstarted backlog ahead of the started backlog. So it could be we're below 50%, I don't know, but it would be 1% or 2%. And as we continue to grow our backlog in our WIP, (43:30) you'll see us hang around 50% to 55%, but it'll be a very predictable 50% to 55%..

Thank you. Our next question comes from Mike Dahl with Credit Suisse. Please proceed with your question. Mike, your line is live..

Hi, Jeff and Jeff, this is Anthony (43:50) on for Mike. Thanks for taking my question and congrats on a solid quarter.

My first question has to do with, you talked about the goals to drive higher revenues per community and the way to do that was increased option use, so I was just wondering if you could talk about the pricing – when you think about increasing revenues, is it going to come from higher option pricing or are buyers increasing the amount of options as to their purposing or how you think about crafting this strategy going forward to drive higher revenues per community?.

Anthony (44:28), if you look at our previous calls and the transcripts, what we've shared is we're lifting our revenue by community with the types of products we're putting out there far more than pushing option revenue.

And I'd say that relative to communities we're opening maybe in a higher price area or a higher income area and you'll model a larger array of footage, and you'll get higher pricing on the same lot because you put a larger home on it, and that's where we'll move around with demand.

On the studio side, we use it first and foremost to sell homes, and along the way there's always incremental revenue opportunities. I don't know if you have the numbers, Jeff, on what our studio has been doing, but it roughly tracks about 10% of the base revenue. So as we push our base revenue, that buyer typically will spend about 10% in the studio.

The other parts of our Built to Order where we continue to mind pricing is in lot premiums, elevation premiums. You can evaluate over time what plan sells better than another because it's all built to order and you can move your pricing on the plan that's outselling the others to keep everything in balance.

So it's not just a studio, it's across the whole spectrum of the selling process..

Great. Thanks. And then my second question is obviously you guys know two of your competitors recently merged.

So I was just trying to get your take on how further industry consolidation is going to – how you think about that impacting your strategy in terms of land acquisition or how you go forward with your relationships with either construction or material suppliers.

So just your overall take on that?.

Yeah. Well, M&A has been a part of our industry for a long time. Certainly, I'm not going to comment on the transaction that was announced. I'll leave that one to the experts, but in our world, we've always seen our best returns come from organic growth and that's what we're working on right now and we're doing pretty well..

Thank you. Our next question comes from Nishu Sood with Deutsche Bank. Please proceed with your question..

Thanks. Wanted to ask about the cadence of demand that you've seen so far this year. I mean you mentioned that your markets have been strong and you've seen potentially some broadening out; you mentioned across all four of your regions demand was strong. So just wanted to get your sense of that.

Has demand overall and as you dig down into the regions, has it been accelerating anywhere or has it been mainly that this – simply this broadening out across the regions.

And as we look to the second half of the year, is there anything that gives you pause or reason for encouragement, because it seems like a lot of investors look at this space and they say housing demand just can't sustain into the second half of the year in a lot of years.

So I just want to hear your thoughts overall on what you've seen so far and what you expect?.

Nishu, good questions. Specific to our business, there is no question that our demand has broadened out, where some regions that weren't as larger contributor to our orders are stepping up quite a bit. So there is a broadening, but within the markets that we're in, we're seeing strength across the markets.

There is not – all of them are doing better at their own pace of improvement, but there is none that I can think of where I'd say that's a tough market today. It's a pretty broad-based strengthening going on and I think a lot of it's demographics.

This household formation you can't ignore the demand that gets created when those many people are moving from the roost..

Got it. Got it. And second question, I think you've been pretty clear that you want to use or capture this demand in pricing and margins versus trying to drive your absorption, so we appreciate the strategic clarity.

Where do we stand in terms of pricing? And the way I was thinking about this was if the current pace or the pricing power that you're seeing out there, is it enough that it would get you eventually to your 20% rough target that you're talking about or would we need more pricing power to emerge to balance out your pricing against the pace of cost increases you're seeing?.

I would say that we have the potential to get there in the current market conditions in that whenever markets have priced, the land sellers are smarter than we are. So land prices go up or your cost goes up, you need to lift your margins through your execution, your product mix, the submarkets that you're investing in.

And we think we've got a nice pipeline set up right now of new openings in the right submarkets where we make get more price, we don't count on that. If we do, we'll certainly take it. But we're trying to raise our margins without the benefit of price..

Thank you. Our next question comes from Alex Barrón with Housing Research Center. Please proceed with your question..

Thanks, guys, and good job. I wanted to ask about the entry level demand that you're seeing as well as the mothballed communities.

Are those mothballed communities, what type of consumer, I guess, are you trying to target? Is it entry level or move-up and how is this increase in the entry level demand shifting your strategy going forward?.

Couple of comments, Alex. Every community that we're activating is a different position in that submarket. So we've activated some that were more affordable play. And we've activated some that are first move-up play or even into a second move-up play. No different than new investments at the same time.

As long as we feel, we can get the right returns with the acquisition or the activation that – I've shared on the call that we're pretty nimble about moving with demand and within our current holdings or future holdings, we can move up or down in footage and spec level and price to where the demand is.

On the resale said, I think this household formation is going to help unlock what I call the food chain, where if there's more strength in the first-time buyer demand, people can sell their homes and move up to their next home now, which they may not have been able to do in the past.

So I think on the macro side, this household formation is really going to help; and within our company, we'll continue to navigate and target where the strength is in that location..

Okay.

And as far as the San Francisco project that you mentioned, are those – when do you expect first deliveries of those and are the margins there higher than your company average?.

The first one that I mentioned, Townsend, we're hopeful of delivery sometime around the end of the year range, we'll see. These are fairly complex products to build and whatever our optimistic completion date is, we're obviously going to miss them by a month or two months.

You have to run a higher margin in these in order to get your returns because they're more capital intensive than building a home on a lot in the suburbs. So when they do hit the market, typically it'll be a higher price and a higher margin, no different than our prior experience, which I believe you too heard last year out here, Alex (52:22).

And I share it because it's an extension of a business that we haven't done before and we stuck our toe in the water up in the Bay Area. The initial response has been very strong. And again, it's a natural extension of the things we do here in the States.

So we're looking to expand our penetration of this type of business on top of the other things we do..

Thank you. Our next question comes from Jack Micenko with Susquehanna International Group. Please proceed with your question..

Hi, good morning. Most of my questions have been answered, but I was looking at the option-owned mix and your option mix is down pretty fairly significantly. And just curious, obviously you've got a lot of development dollars in the land spend too.

I mean is it a strategic shift away from option, is the margin mostly in more raw land purchase here at this point or have seller preferences changed, just curious as to the mix owned versus option strategy here?.

Ideally we'd option every lot we could, Jack. In the A locations that are land constrained, pretty difficult to get an option.

We have done some and continued to, but Jeff can you give the color on how the numbers have moved, but I wouldn't read too much into that, but obviously we'll continue to turn and develop our owned, but you will see us tie up lots in the future on options where we can..

Yeah. In speaking on the numbers, I think Jeff said it right. I wouldn't read too much into it. It does vary quite a bit. You do have a tendency. From time to time, you go out and lock up some option lots, sometimes you let those options go and you never actually close on the lots. Other times they move into owned as time progresses.

So it's not, I'd say, a purposeful shifting that you see there; and like Jeff said in good locations with good returns and good margins, we love option lots because they're more capital friendly; however, right now we're seeing, I guess, a majority of development deals coming across..

Okay.

Great and then I think you mentioned the first time a little bit balancing margin and pace and getting that margin – getting close to those margin targets on one hand and then if you see more demand on the first time, should we think, look we're going to get to 20% (54:45) before we start really moving down to that true entry level where the margins are a bit less, but the pace is higher or are you going to stick with, look our buyer is built to order and it may be a higher income first-timer as it's been, who are going to stay with that, just thinking how that looks in the context of sort of your longer term strategy given the mix is a little bit different with that buyer profile?.

It's an interesting question in that, I was in Texas a month ago in Austin and we actually had a first-time buyer community I visit that's selling extremely well, margins above the company average at a high absorption rate, because we have a large lot position, so you let it run above the four.

And in the same town, we had opened up a first and second move-up product that was selling above local averages, probably three a month, at a much higher price, actually a little lower percentage, but higher dollars.

And actually as we're doing the math, driving around the returns, we're much higher on the first-time community than they were on the move-up community because you had above-average margin in a very strong pace.

I say that because people think your margins are going to be lower on first-time buyer product and they are if it's a play that's a volume play, but over time a lot of our communities that are the more well-healed first-time buyer, I'll say margins are above our company average just because the price is lower doesn't mean that the percentage margin has to be lower.

And your run rate's typically a little higher..

Thank you. Our last question will be from Susan Berliner with JPMorgan. Please proceed with your question..

Hi, thank you. Just one question to follow up.

I guess with regards to your cash position after the bond repayment, I apologize if I didn't hear this, I guess I was wondering with regards to cash flow over the next year or so and I guess your appetite for potentially raising new bonds?.

Right. I think the most important thing to kind of focus on right now with regards to cash is where the second half's forecasted to come in.

We'll have revenues in excess of $1.8 billion, ranging up to about $2 billion in the second half of the year, which will generate significant cash flow not only from improved profitability in the second half, but also from the return of the investment that's already in the land as we get that back.

So we're pretty comfortable right now with where things are heading. We've purposefully put more cash to work. We do plan and intend to run the company with a much lower cash balance, particularly with our revolver that we have standing behind it, giving us additional liquidity. So we're pretty comfortable with that.

The prior discussions we've had all still hold. We're still continuing to target the 40% to 50% leverage ratio as we move forward. And again, very comfortable with the liquidity and the cash position at this point in time..

Great. Thank you..

Thank you. At this time, I would like to turn the call back over to Mr. Jeff Mezger for closing comments. Please proceed..

Right. Thank you, Lattania. And thank you, everyone, for joining us on the call today. Look forward to speaking with you again in the very near future. Have a great weekend and Happy Father's Day..

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation..