Jeffrey Mezger - President, Chief Executive Officer and Director Jeff Kaminski - Executive Vice President and Chief Financial Officer William Hollinger - Senior Vice President and Chief Accounting Officer Thad Johnson - Senior Vice President and Treasurer.
Robert Wetenhall - RBC Capital Markets Mike Dahl - Credit Suisse Megan McGrath - MKM Partners Michael Rehaut - JPMorgan Alan Ratner - Zelman & Associates Susan Maklari - UBS Securities Trey Morrish - Barclays Capital Stephen Kim - Barclays Capital.
Good morning. My name is Latonia, and I will be your conference operator today. I would now like to welcome everyone to KB Home 2015 Third 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 line later for questions. KB Home’s discussion today may include forward-looking statements that reflect management’s current views and expectations of 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 the SEC filings, the company’s actual results could be materially different from those expressed and/or implied by forward-looking statements.
A reconciliation of 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 like to turn the call over to Jeff Mezger, President and CEO for KB Home.
Mr. Mezger, you may now begin..
Thank you, Latonia, and thank you everyone for joining us today for a review of our third 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 third quarter performance along with an update on some of 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 for your questions.
We’re very pleased with this quarter’s results as they reinforce the progress we continue to make within our business. Most notably, our results reflect across the board improvement in our four regions with respect to nearly all key financial and operational metrics.
Among our results for the quarter, we posted higher deliveries, higher revenues, higher pre-tax income, higher net orders and higher ending backlog. Our community count growth continues to be a primary driver for these improvements.
As we anticipated and shared on previous earnings calls this year, our results for the year are unfolding as the tail of two halves. In the first half, among other things, we expanded our community count, had a successful spring selling season and built a robust backlog that strategically position our operations for revenue and earnings growth.
In the second half, we have started realizing the benefits of our expanded platform as we’re converting this backlog into deliveries and revenues, improving our margins on a sequential basis as well as closing the gap on a year-over-year basis, and achieving greater economies of scale.
Our businesses are now operating with a nice healthy rhythm that is more predictable. We’re accelerating our profitability and believe we will sustain this momentum into 2016.
Our results for the third quarter met or exceeded our internal goals for community count, housing revenue, ASP, and the sequential improvement in our margin, SG&A ratio and earnings. In addition, we continued to generate substantial year-over-year growth in net orders, driven primarily by the increase in our community count.
Our net order performance for the quarter led to our quarter-end backlog value reaching the highest third quarter level we have seen since 2007.
This substantial backlog provides great visibility for significant revenue growth and accelerating profits in the fourth quarter of this year and supports our expectation for continued revenue growth and profits in 2016.
Turning to some financial highlights from the quarter, we delivered 25% more homes than in the year-earlier period, with increases in each of our four regions. Our housing revenues of $799 million were up 36% from a year ago. We have now posted year-over-year revenue growth in every quarter for the past four years.
We saw broad-based housing revenue increases from our operations across the country with increases ranging from 17% in Central region to 112% in the Southwest region. On a sequential basis, we improved our adjusted housing gross profit margin by 80 basis points to 21.1%.
We lowered our SG&A ratio by 110 basis points from the second quarter to 11.9%, and by 50 basis points from a year ago. Our pre-tax income increased 18% year-over-year to $34 million. This was our highest third quarter pre-tax income since 2006. We posted net income for the quarter of $23 million, or $0.23 per diluted share.
We also performed well with respect to leading indicators of our business. Our net order value increased 23% from a year ago to $773 million. Net orders for the quarter grew 19% to 2,167, marking the first time since 2009 that our third quarter net orders have exceeded 2,000 homes.
At the end of the quarter, we had 252 communities open for sales, representing an increase of 26% from a year ago with increases in all four regions. We finished the third quarter with a backlog value of $1.6 billion, up 44% from a year ago, marking the first time this metric has topped $1.5 billion in a third quarter since 2007.
Our results are being driven through our continued focus on our four key strategic initiatives. These initiatives are to grow our community count, drive higher revenue per community, increase our profitability per unit and to enhance our return on investment.
We are energized by the progress we have made this year in executing on these initiatives and generating measurable improvements across our operations. Since we have discussed our four initiatives in detail on previous calls, today I will comment briefly on just two of these initiatives, community count and profitability.
First, turning to community count, having achieved a significant ramp up thus far in 2015, we are now crossing over to a period where our community count growth will be at a more moderate year-over-year pace.
We continue to invest in our growth trajectory and at this time are well positioned as we own and control all of the lots required for our 2016 deliveries and the majority of the lots needed for 2017. We also continue to activate communities that were previously held for future development.
Year-to-date, we have now opened 12 such communities and are constantly evaluating our portfolio for additional opportunities. Moving onto profitability, we expect our housing gross margin to continue to improve in the fourth quarter, significantly narrowing the gap versus the prior year as a result of the following four factors.
First, we are taking actions to contain or reduce our cost to build. With the size of our backlog and consistency in starts, we’ve been able to manage through the labor shortages that have been featured in the media. However, in some cases, these shortages have put additional pressure on our cost to build.
As such, each of our division teams have an action plan in place to control or reduce their direct costs. Second, the higher margin we are capturing in our new communities will now be falling through in deliveries.
Third, the impact of the additional field overhead associated with the ramp up in communities during the first half of the year is diminishing as these communities are now starting to produce revenues. And finally, the added benefit of overall leverage from our accelerating revenue growth.
As I said, we plan to significantly close the year-over-year gap in our housing gross margin in the fourth quarter. Looking forward into 2016, we expect our housing gross margin to cross over to a favorable year-over-year comparison in our first quarter. With regard to profitability, we also plan to further enhance our SG&A performance.
We continue to do a good job of controlling overhead, while expanding our community count and driving higher revenues. Not only was our third quarter ratio of 50 basis points better than a year ago, it was 110 basis points than the second quarter.
Even with this significant sequential improvement in our third quarter ratio, we still expect a further sequential reduction of 100 basis points to 150 basis points in the fourth quarter. On a regional basis, we continue to experience steady demand. For the third consecutive quarter we’re reporting positive order growth across all four regions.
Let me provide some comments on net orders and other highlights by region. In California, net orders increased 7%, which is a softer positive comparable than reported in the past few quarters.
This was primarily the result of a transition period in the Bay Area where last year we had several community openings or new phase releases that drove a very strong result for the quarter. This year, we have replacement communities that have just opened or will open in the next few months that are just now starting to build momentum.
Overall, the Coastal markets of both Northern and Southern California continue to demonstrate strong demand. Our inland regions also generated positive net order comparables during the quarter as the shortages of supply on the coast pushes prices upward and consumers seek affordable alternatives in more inland locations.
Across the state, we have many large and strategic new openings on the horizon. One of the areas of our business that I’m most proud of is our leadership in sustainability. I’d like to thank all of our employees for their commitment to helping reduce our impact on the environment.
As everyone is aware, California has been dealing with severe drought conditions of the last few years.
As part of our leadership efforts to reduce water usage in this state, we successfully opened a community in San Diego County called Sea Cliff which features a great water recycling system that virtually eliminates the need for fresh water to irrigate landscape and dramatically reduces water usage per home.
This was the first community in California to offer this feature of standard and when combined with our WaterSense feature saves each homeowner an estimated 100,000 gallons of water per year.
Consumers and local municipalities are responding very positively and we’re looking to expand the availability of this system to other communities across our California footprint in the future.
In Sacramento, the long-standing moratorium on starts in the Natomas region was finally lifted and we were successful in pulling permits for models in a very desirable location that consists of a total of 585 lots and will feature overtime three product lines.
We have owned this asset since 2004 and look forward to once again taking advantage of this opportunity in a market that is recovering nicely. In our Southwest region, we reported 384 net orders, an increase of 94% over the prior year. We continue to perform well in Arizona and Las Vegas, with both markets demonstrating strong demand.
Phoenix, in particular, is demonstrating very favorable trends. As both the Las Vegas and Arizona markets continue to improve, we’re excited about the potential for this region to contribute a much larger share of our revenue and profit going forward.
Our Inspirada community in Las Vegas continues to be one of the top performers for our company and we’ll be introducing a townhome community that will be our fifth product line opened for sale in this very successful master plan.
The infrastructure and neighborhood parks are progressing as planned and there’s now a charter school in the community which opened with 700 students this fall that will create even greater value. Inspirada is truly a crown jewel for our company.
The Central region is currently our largest in terms of deliveries and we continue to experience steady demand across all major cities in which we operate. The region generated 10% year-over-year growth in net orders and a 25% increase in net order value.
There’s been lot of media coverage relative to the price of oil impacting the economy and housing in Houston. And we can report that our absorption rate per community was basically flat year-over-year. Due to the severe weather in this spring, we did delay openings in Houston into our fourth quarter as well.
We are seeing some softening at higher price points in Houston above 350,000. That being said, with an average price on deliveries year to date in Houston of $217,000, we’re well positioned to appeal to the strength in demand at these lower price points. While Texas continues to perform well, we’re also pleased with our growth in Denver.
We opened eight communities in the Metro area in preparation for the spring selling season. Demand in Denver remains very strong with low levels of inventory and we’re working with a seasoned management team to continue to take market share in this vibrant location.
In the Southeast, we also experienced steady demand with net orders increasing 13% and net order value up 15% from a year ago. As with the Southwest region, we are encouraged by our potential for growth in revenue and profits from this region going forward.
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 below normal and while there is still price appreciation occurring in most markets, it is at a more moderate and sustainable pace. Affordability levels are compelling, especially compared to rental rates which continue to climb.
We now have strong household formation once again creating demand, while at the same time the housing industry struggles to create adequate supply that meets current demand levels. It is the combination of all these factors that we believe supports a continued strengthening in the new home industry, providing growth opportunities for years to come.
In closing, we are pleased with our progress in the third quarter. We are particularly encouraged by the broad-based improvements across our regions. Our investment and product strategy is working as our new communities in all four regions are performing well and gaining strength in a housing market that is continuing to improve.
We have a nice rhythm to our business with a backlog in place that is driving more predictable results. We are now positioned for significantly higher deliveries, revenue growth and profitability in our fourth quarter.
We are entering the fourth quarter from a position of strength and 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. Now, I will hand the call over to Jeff Kaminski who will discuss our financial results in greater detail..
Thank you, Jeff, and good morning, everyone. Our strong operational execution continued to drive solid fundamental business performance in the third quarter and produced results that met or exceeded our second quarter guidance across virtually all key metrics.
We are continuing to realize the benefit of the strategic repositioning and expansion of our community count as we generated a significant year-over-year increase in third quarter revenues and sequential expansion of our operating margin.
Moreover, we ended the quarter with a strong backlog value which was 44% higher than a year ago and represented our highest third quarter level since 2007. This backlog supports our expectations for year-over-year revenue growth and higher profitability in the fourth quarter.
In the third quarter, our housing revenues of $799 million grew 36% from a year ago, extending our trend of year-over-year revenue growth to 16 consecutive quarters.
For the fourth quarter, we expect to generate housing revenues in the range of $1.04 billion to $1.10 billion as we convert our sizeable backlog into deliveries and realize continued improvement in our overall average selling price. Land sales produced $41.6 million of revenues and $1.3 million of gross profits in the third quarter of 2015.
We had no land sales in the year ago quarter. On a year-to-date basis, land sales generated revenues of $111 million, exceeding our $100 million target for the full year and produced profits of $7.1 million.
Consistent with our focus on enhancing asset efficiency, we plan to continue to execute on targeted opportunities to monetize certain land positions through either sales or reactivations. However, while we are in active negotiations on additional land sales, we do not anticipate that we will close any transactions during the fourth quarter.
Our overall average selling price of homes delivered grew 9% year-over-year to approximately $357,000, reflecting increases in all four of our regions.
We expect to generate an overall average selling price in the range of $374,000 million to $378,000 for the fourth quarter, representing an increase of approximately 6% to 8% versus the prior year quarter.
Our housing gross profit margin of 16.2% for the third quarter was up slightly on a sequential basis and was in line with our prior guidance, which assume no inventory impairment or land option contract abandonment charges.
Excluding the amortization of previously capitalized interest and housing inventory impairment and land option contract abandonment charges, our third quarter adjusted housing gross profit margin was 21.1% in 2015, representing a sequential increase of 80 basis points versus the second quarter.
We expect our housing gross profit margin to increase sequentially in the fourth quarter of 2015 as we increase the proportion of homes delivered from recently opened higher margin communities, gain on operating leverage through higher deliveries in the quarter and lessen the impact of start-up field cost as we convert orders to revenues in our newer communities.
Assuming no inventory impairment or land option contract abandonment charges, we are still forecasting a housing gross profit margin in excess of 18% in the 2015 fourth quarter, reflecting a continued narrowing of the gap versus the prior year quarter.
For the first quarter of 2016, we currently expect our housing gross profit margin to be in the mid-16% range, reflecting the typical seasonal decrease in operating leverage from lower revenues in the first quarter.
However, this performance would represent a favorable comparison to the prior year same quarter result and provide a strong start to the 2016 fiscal year, where we expect to generate a year-over-year improvement in housing gross profit margin for the full year.
Our selling, general and administrative expense ratio for the current quarter of 11.9% improved 110 basis points from the second quarter 2015.
As Jeff mentioned, we still expect to generate a sequential third to fourth quarter improvement in our SG&A expense ratio of 100 basis points to 150 basis points as we realize incremental revenues from our newer communities and continue to manage our overhead costs.
In the third quarter, our effective income tax rate of 31.5% reflected the positive impact of federal energy tax credits we earned from delivering high efficiency homes in prior years. For the fourth quarter, we do not anticipate additional tax credit impacts and are forecasting an effective income tax rate of approximately 38%.
Our third quarter average community count rose 30% year-over-year to 257 communities, which drove the increases in our net orders and net order value that Jeff summarized earlier. During the third quarter, we opened 10 new communities, including one community previously held for future development.
We also closed out of 19 communities during the quarter. Year-to-date through the end of the third quarter, we have opened a total of 84 new communities and closed out of 59. We ended the third quarter with 252 communities opened for sales, up 26% from the previous year.
Due to fewer close outs than expected, our quarter end count was higher than anticipated. As a result, we may have a slight sequential decline in our year end community count with potentially more communities closing out and opening in the fourth quarter.
We expect the percentage increase in our average community count for the fourth quarter in the mid-teens range as compared to the year ago quarter. For the full year, we anticipate that our average community count expansion will be in excess of 20% versus 2014, which exceeds our previous guidance.
Moving forward into the first half of 2016, we expect our year-over-year community count growth to moderate.
Nonetheless, through the combination of our anticipated strong year-end backlog and our projected community count and average selling price trajectories, we expect to generate an increase in full year 2016 housing revenues in a range of 10% to 25%.
For the past nine quarters, we have 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 $247 million in land and land development and we owned or controlled over 47,000 lots at quarter end. We anticipate investing an additional $300 million to $400 million in land and land development during the fourth quarter to support our near-term revenue growth objectives.
Turning now to our balance sheet, we retired the remaining $200 million of our June 2015 notes at their maturity date during the third quarter.
In August, as we previously announced, our unsecured revolving credit facility was amended to increase the committed amount from $200 million to $275 million at favorable terms and extend the maturity to August 2019. The credit facility also contains an uncommitted accordion feature under which its total capacity maybe increased up to $450 million.
We ended the quarter with unrestricted cash of $353 million and total liquidity in excess of $625 million, including the new revolver capacity. In conclusion, we are looking forward to a strong finish to our 2015 fiscal year and are entering next year with a higher backlog and community count versus the beginning of the current year.
Our expectations for revenue growth and operating margin expansion should position us for further improvements in bottom line profitability in 2016. Now, I will turn the call back over to Jeff for his concluding remarks..
Thanks, Jeff. With our plans for 2015 firmly in place, we are looking toward 2016 with optimism. We already have the land pipeline owned and controlled to meet our delivery goals for next year and we expect the financial improvements in our fourth quarter to carry into 2016.
There is a nice rhythm to our business and with our increased backlog position, we’re developing a more predictable business.
While it is still early to discuss detailed projections for next year, at a high level, we expect to see continued improvement in our major metrics, including deliveries, revenues, margins, SG&A ratio and earnings on a year-over-year basis. We look forward to sharing our continued progress with you in the future.
Now, we’ll open the call up to your questions.
Latonia?.
[Operator Instructions] Our first question comes from Bob Wetenhall with RBC Capital Markets..
First question, I just wanted to ask how should we think about the conversion rate both this quarter fourth quarter and into next year? And Jeff’s commentary gave a pretty wide range of guidance for homebuilding revenues next year, like 10% to 25%.
And what I’m getting at is are you guys taking more moderate view towards growth expectations, Jeff’s comments touched on predictability, are you slowing the pace down so you have better control, how should we think about that?.
Bob, let me make a couple of comments, then I’ll take it to Jeff for his methodology. We absolutely aren’t expecting to slow down our growth rate. We gave a broad range for next year because it’s going to be driven primarily by spring selling season and what’s going on in the world at that time. What we’re trying to message is we’re still growing.
And I mentioned we have a nice rhythm to our business. If you look at our backlog, our deliveries, our sales pace, where we’re headed, we’re going to end the year with a very strong backlog position that sets us up for a nice trajectory in the first half of next year.
So as we’re managing our communities, we’re holding to no more than four month on average, every community has its own strategy for how we optimize the returns and we’re still pushing to get our margins higher.
So we’re going to continue to elect to pull down sales pace in our stronger performers and get our margins up and in those that aren’t performing at the sales pace we need, we’ll continue to do things to get sales there as well.
But as we go forward, I would expect that you’ll continue to see our sales pace per community range like it has for a couple of years and will continue to drive our community count..
That’s really helpful.
Jeff?.
On the backlog conversion, Bob, as you know, in the current quarter we did about 47%. If you look at the midpoint of the range of our selling price guidance, average selling price guidance, and the midpoint of the range of our revenue guidance for the fourth quarter, I think that gives you a backlog conversion in the 60%, 61% range in that area.
Typically, our fourth quarter is our strongest backlog conversion quarter. And we expect it to probably settle back in around that 50% range that we’ve seen in the first three quarters of this year. It’s ranged from 47% to 55% over the first three quarters. And in fact going back into last year, we had two quarters in the 50%s as well.
So with the higher backlog and the expanded backlog count in virtually all of our – actually in all of our regions, that’s what we expect as far as conversion rates..
For a second question, just touching on KB’s focus on profitability, what are you seeing in land and labor costs? And for Jeff, from a SG&A perspective, I think you guys historically have told the Street that you’re running like $45 million in fixed cost per SG&A per quarter and 5.5% of revenues below that.
How do we think about the initiatives Jeff is touching on to manage land and labor and your fixed cost structure on the SG&A side?.
I’ll cover the SG&A side. Yeah, what we typically provide as guidance to help people with modeling is to about 5% to 6% incremental increase in SG&A per dollar of revenue increase and that’s when you look at it sequentially. That usually gets you pretty close to the mark. We do expect to see continued SG&A improvement as we go.
And like we mentioned during the prepared remarks, we’re expecting 100 basis point to 150 basis point improvement in the fourth quarter and we do expect continued gains next year as we continue to drive revenues and control costs..
As to the input cost side on land, every city has got a different story, whether the landmark is hard or moderate and we continue to acquire land based on current pricing, current absorptions and it has to hit our hurdle rate. So we’re staying disciplined in the more desirable areas as you would expect.
Land prices are up, but home prices are up with it and you just have to keep things in balance. I touched on the pressures we’ve seen on cost and I also shared that we’ve been able to moderate that due to the size of our backlog and our starts pace and that you can become a builder of choice in a city due to a consistent housing start activity.
And I think on average our costs are up 5% to 6%, build cost, year-over-year. So we’ve seen some pressure. We continue to challenge ourselves, while that’s our average, it was actually some cities that have gone in direct costs year-over-year. So every city has different pressure points and we’re constantly focused on containing and reducing costs. .
Our next question comes from Mike Dahl with Credit Suisse..
Jeff, I think in your opening remarks, you highlighted a number of things that met or exceeded your expectations for the quarter.
I noticed that orders was not part of that and just in light of a decline in absorption there, just curious to hear your thoughts on where orders were relative to your internal expectations for the quarter and what you think some of the drivers are?.
Mike, I’d start with our unit and value comp and our net orders were up 19% and our value was up 23%. And as we shared, it supports our business plan and our projections for the fourth quarter. So we were fine with our sales pace. You always want to get more sales, but the sales support the business plan.
And you have to put this in the right perspective. There’s a lot of variability on the community count, whether we try to do in average to smooth it out, but what month of the quarter did it open, what month did it close? If it opened in the last month of the quarter, you’re not going to see that much in sales.
If it closes out in the first month of the quarter, there’s a lot of things that drive the sales rate per community. Having said that, if you look at our absorption rates, we were less than one sale per community for the quarter. So it’s like a third of the sale a month across the system. And to me that’s almost a rounding there.
So we’re seeing strong demand everywhere; we have a nice pace; we’re selling as needed to support our plan. So we’re fine with our sales pace..
And then just around the comments for gross margin for next year, throughout the 1Q and then you expect year-over-year improvement for the full year. I think this year was a little more variable by quarter, it took the mix shifts in the community ramp.
How should we think about just from that 1Q margin should we expect a little less seasonality going forward through 2016 than we saw this year or any thoughts around magnitude?.
We really haven’t guided much out into next year on the gross margin. We did want to get the first quarter out there, because I think at times our first quarter gross margins are little misunderstood.
I don’t think people appreciate the level of leverage that we see, leverage loss that we see going from fourth quarter revenues on the top line to first quarter and we wanted to make sure that was understood.
And basically I also want to make sure it’s understood that’s basically all we’re forecasting right now is that loss of leverage would mean that we’re sort of in that [mid-2016] range.
So it’s relatively conservative, not really looking at any potential increases in underlying margins and in some cases we have to offset a little bit of a negative mix in the first quarter. So that’s why we pegged it there.
Typically and as we’ve been working very hard on gross margins throughout the year, throughout the past couple of year is that we do expect to see improvement in gross margin as the year goes and that should be evident by what we’re guiding as far as the full year increase for 2016 off a good start in the year with first quarter increase.
So we do expect margins to be up..
Our next question comes from Megan McGrath with MKM Partners..
Just a quick clarification, I might have just written this down wrong, but Jeff you just said mid-2016 range for the first quarter? I had written mid-2015, which is the right number?.
It’s 2016..
2016, okay. Thanks. I must have written it wrong down the first time.
So moving on to sort of the hot topic of the last couple of weeks which is input cost, labor and land, can you give us any color on the absolute value of percentage increases that you’re seeing? I know it’s sometimes hard to break out, but what are you seeing in terms of cost increases, if you could break out labor for materials that would be great or any kind of color there..
On the direct cost side, what we’re seeing, we’re actually seeing some favorability in a few of the material categories. I mean, lumber is down pretty significantly; oil cost, gasoline prices are down, that’s reducing travel and transportation for the materials et cetera in some of the other inputs. A lot of the commodities are down.
So most of the pressure has been on the labor side and I’d say the labor cost have offset a lot of the other base material cost.
Jeff gave some numbers on year-over-year increases what we’ve seen, we also look at direct cost on an index basis and we’ll index a few homes that start at the beginning of the year and we index those same homes in where the costs are as of the most recent quarter. And we’re seeing only about a 2% net increase in those index costs on that basis.
So material cost declines in many of the markets are offsetting, or at least partially offsetting a lot of the labor increases. But again, most of the pressure has been on the labor side..
And then I had a more bigger picture question. It’s certainly nice to see your margins, your gross margins going up again or talking about going up again year-over-year by the quarter. But you’re still a couple hundred basis points below where you’ve been underwriting to and I would assume where your goals are.
Aside from just kind of waiting for the market to recover or riding the recovery, is there a thought to doing looking at it from a more fundamental basis making some big changes at the company to make sure that in the future you can reach those 20% goals?.
I think we’re on our track, Megan. There’s a lot of things that go into your margin improvement. You can’t just flip a switch and go from 16% to 20% in 30, 60, 90 days, six months, nine months. It’s a progression.
And you touched on a couple of headwinds, we’ve been absorbing some cost increases along the way in our cost to build, that’s a headwind that we’re still covering with our ability to hit the margin guidance that we’re giving. So we remain committed to our gross margin percentage.
At the same time with our ASP movement, the gross profit dollars per unit will climb. And you can see how our SG&A ratio is continuing to drop. So on an operating margin basis, you’ll continue to see a very favorable trajectory on the operating margin.
And within the mix that I talked about, we’re reactivating communities which don’t hit our company average, but generate a lot of cash. They’re accretive to our business, but they’re going to pull your margin down a little bit.
As we continue to clear those out and they become less of our business mix as more of our new communities open at the same time, that’s another lift to the margin..
Our next question comes from Michael Rehaut with JPMorgan..
First question, I was just trying to get hopefully a little bit of clarity around your comments around community count growth, talking about obviously the great growth this year, but some moderation now expected into next year as you have done a lot of the heavy lifting over the last few quarters.
So just trying to get a sense for the degree of magnitude there, if you expect to end I think you said 4Q perhaps a little less than 3Q due to timing of closeouts.
What that might mean in terms of 4Q end of 2016 over 4Q end of 2015, any type of guidance in terms of a sequential cadence might be more similar to the type of sequential cadence we’ve had on an average basis of the last couple of quarters?.
Mike, I’ll comment a bit on that. As we’re looking at the community count right now, it’s flattening and it has flattened a little bit, in fact like we’ve guided to some potential sequential decline in the fourth quarter. When you look out into next year, we guided for the first half of moderation.
I think it’ll probably be up in a single digit range in the first quarter and that’s on a year-over-year average and flattish off a very difficult comp that we had this year’s second quarter. So we saw a very large spike in our community count this year in Q2 and coming off a comp would probably be in the flattish range for Q2 next year.
And I think you’ll see a little bit of that in the first half of the year before what we hope to see a continued build in the back half of the year..
And then just in terms of the sales pace, I appreciate the comments Jeff around Houston, I believe you said that actually I guess it was more broadly in the Central region that absorption was flattish year-over-year, and I think you also highlighted maybe some transition issues in the Bay Area, so maybe implying sales pace for California it sounds like a little bit down year-over-year.
Is that correct? And maybe you could just talk about regions where we’re calculating the average sales pace down about 9% and granted as you said that’s in some ways a little bit of a rounding error, but it’s still contrast to the first half of the year where it was up slightly.
So Central is flat, California down some, is that correct and maybe you could point to some of the other regions as well?.
You’re correct in part, Mike. On the flat absorption per community, I was referring to Houston, not Central. It is both, but Houston itself we were flat and we did experience some delays in openings due to the spring weather, where it kicked out development and models are getting completed.
As I shared, in California and you know our business, the infill nature of the Bay Area causes your community count to be very lumpy and the extremely land constrained, it’s not a large unit count and they can open and close in a quarter or two.
So you can – if you look at last year, we had some openings of some of these infill communities that performed extremely well and then they’re gone. This year, we’re running a little late and we have some very significant openings on the horizon.
We announced the Patterson Ranch acquisition previously and that’s finally coming online with multi products. And then we announced previously Communications Hill in San Jose, which is coming online in the next few months with multi products. So you’ll go from zero to eight or something like that just in those two locations in a 90-day period.
And if you look at the order count for California at 7%, we didn’t want you to think that California has slowed. It [was an odd transition] period in the Bay Area and we’re very bullish on our Bay Area business right now. I’d say the same in SoCal, the coastal area of SoCal is holding just fine.
And in our inland areas, demand is fine and sales are holding. So it was an extraordinary transition quarter, I’ll call it, in California.
And if you go up top and you look at our backlog position, I mentioned this nice rhythm to our business now, we’ve shared with you the strategy of averaging for a month, you can do the math on community count and backlog and see that we’re pacing our communities at a five to six month term and we’ll sell four in a month; we’ll start four in a month; and we’ll close four in a month.
And we’re not going to let them run harder than that until we can get our margins up to our standards. So you’ll see the movement in the unit count come from community count growth going forward. However, with our backlog and our improving ratios, you’ll see a lot of profit growth.
So it’s a nice position for our business, we feel we’re positioned from strength and looking forward to 2016..
Our next question comes from Alan Ratner with Zelman & Associates..
Jeff, I’m not sure which Jeff this is better for, but on the margin you had the big community count growth in the first half of the year. Probably haven’t seen a ton of deliveries from those communities yet.
But I was curious if you could give us any margin view on the margins you’re generating on those new community openings thus far as compared to legacy projects, because that is a big driver of the positive outlook going forward? So I think any performance metrics you could give thus far would be very helpful..
You’re right in a couple of things. The new community openings in the first half are just now starting to generate deliveries in the back half. In fact, our fourth quarter margin lift, about half of that margin lift is coming from higher margins in our newly opened communities than our old ones.
So it’s starting to have an impact and we expect it to have continuous impact as we move forward. In general, just like anything with our new communities, their ranging near our land book underwriting standards, sometimes slightly better, some worse.
But we’re seeing pretty good performance out of those both in terms of absorption pace as well as margin performance. So we’re pleased with the acquisition and we do believe that would provide us more of a growth engine as we go into next year..
Second question on cash, you actually generated quite a bit of cash flow this quarter. I guess part of that was probably from the land sale, but I would imagine fourth quarter is generally another positive cash flow quarter for you guys.
As you sit here today looking at the balance sheet, you paid off the debt at maturity and I think the next maturity is not until 2017. You’ve mentioned you’re comfortable operating with the lower cash balance.
So just curious what the various options you guys are throwing around as far as the balance sheet over the intermediate term and whether there’s any opportunities given where your stock is trading or other uses of cash aside from just holding it and waiting for some of that debt to mature?.
On the cash side, we’re trying to do a few things on the balance sheet. One is gain efficiency. We’ve been talking about that for a while. So one of the areas where we see an inefficient use of assets on the balance sheet is cash.
I mean, right now, it’s a non-producing, non-income producing asset and we’re looking to convert as much of that into producing assets as possible.
So our view right now is to use cash we have on the balance sheet, the extra firepower we have now sitting behind us with the enhanced revolving credit facility, but also some of the monetization activities that are taking place as far as some of the land sales that we’re making, the community reactivations to help fund the business.
We’re committed to not expanding the debt level of the company, you’re right in talking about our next maturity is not until late 2017. So we have a lot of runway.
We’ll judge based on business conditions and market conditions how much we want to invest back into land assets versus other uses of cash that could be more on the balance sheet side or as you mentioned on the shareholder side in the future.
But at this point, we see a lot of opportunities to expand the business and grow the business and a lot of investment opportunities to help the company extend our top line..
Our next question comes from Susan Maklari..
In terms of California, it sounds like you’re starting to see some improved demand in maybe some more inland areas.
Can you just talk about the kind of dynamics that you’re seeing, especially given some of the pricing that seems to be coming through on the coastal areas?.
It’s a fairly typical recovery pattern. As prices move up on the coast, people get as close to the coast as they can and buy where they can afford it.
So the western end of what we call the Inland Empire, the western side of Riverside and San Bernardino that commutes to work in LA or Orange County has stronger demand and less supply than the far eastern side of those two counties. And the same thing is going on up in the Bay Area.
I mentioned in my prepared comments we’re actually seeing Sacramento gaining momentum in their recovery and it’s not – that one is not necessarily a Bay Area commuter. They’re not going all the way to Sacramento, but you have a local economy that seems to be improving and demand building due to income growth and a lack of inventory.
So you have a combination of things going on. I think the underlying supply and demand in those markets is better and you’re seeing a little ripple come out from the coast..
And then something that we’ve got coming in about a week or so is the implementation of Tread.
Can you just talk a little bit about how you’re thinking that could potentially impact some upcoming closings and what you’re doing in anticipation of it?.
We’re trying to be proactive. The wrench in the works will be that you have to as a borrower you have to sign some documents and then you can’t close for three days.
So you have to get out ahead of it and we’ve been training our sales teams, partnering with Home Community Mortgage on the communication to our team and also to our customers and we’re hopeful it’s just an administrative snag, but doesn’t really gum the works up for deliveries this quarter. .
Our next question comes from Stephen Kim with Barclays..
This is actually Trey on for Steve. Thanks for taking my questions. So in the quarter, you had a lower backlog turn than we were expecting and as such a little bit less closings.
To what extent does the scarcity of labor impact closings on the quarter since we’ve been hearing that’s been somewhat of an issue in Texas and Colorado? And also could you give us a feel for what Austin feels like right now?.
On the closing side, the backlog side, we’re pretty much right where we expected as far as top line revenues and deliveries. We’re more or less in the top half of our range of guidance. We’d anticipated our build times and we have seen some extended build times throughout the business. That was anticipated in the guidance that we gave.
So our backlog conversion rate was in the neighborhood of what we expected for the quarter. I’d say, when we’re guiding revenues, that’s key for us, and that’s where we look at and what goes into it is the ASP, which typically we over-perform on a little bit and we take that into account as well. So from that side of it, we’re very pleased..
Because we’re primarily build to order, put it in a perspective, 75%, 80% of our WIP is sold and you have to be predictable with that customer to keep your customer satisfaction levels up. So we’re pretty tight with our customer and our build times and we track, what I call, the cycle time which is from contract to close.
So it’s not just the build time, it’s how long to take to get the customer through the studio and selection process, how long does it take from the final on the home to the actual closing. And year-over-year, when I was looking at it, I think we extended eight or nine day’s total.
So it’s taken eight or nine days longer than it did a year ago, but as long as you manage expectations and projections, you can operate within those conditions..
It’s Steve Kim, thanks for that. [I just have one or two more questions] but my second question was related to land spend, we have seen across the industry an interesting trend of somewhat reducing land spend relative to revenues.
With respect to your company, we’ve seen a little bit of that, but you’re still relatively elevated I’d say relative to your peers.
I was wondering if you could talk a little bit about what you’re seeing generally in terms of land prices as transactions for land have slowed a bit, are you finding that land prices are more frequently allowing you to hit your thresholds and so therefore you can pull the trigger on land deals [indiscernible] slowing down a little bit or if you could just talk a little bit about the dynamic would be helpful..
Steve, I already touched on it on one answer. You know this, you’re following us over the years, if you’re in an A+ location in the Bay Area, there’s a lot of pressure on land and you have to be very good at getting into the land and controlling it early in the entitlement process because if you try to buy it at market, it typically won’t work today.
Conversely, if you get out to a B- location, there is still finished lots and you can go buy what you want, there’s not a lot of pressure on price, but we don’t want to play in those type of dynamics today. I would say the land markets overall have softened a little bit.
We’ve actually had some sellers come back to us where we want a high bid and somebody won the bid and we stayed to our disciplines and they’ll now come back to us because the people that tied it up higher now are in closing.
And every year we see some real opportunities here in our fourth quarter to pick up some things that are quicker hit deals where others decided not to perform.
Through that, we stay disciplined and we’re holding to our hurdles and the numbers that Jeff guided are based on what we think we can invest and support our business and our growth going forward in the fourth quarter..
At this time, I would like to turn the call back over to management for closing comments..
Alright, thanks, Latonia. Thank you, everyone, for joining us on today’s call and we look forward to talking with all of you again very soon. Thank you. Have a great weekend..
Thank you. Ladies and gentlemen, this does conclude today’s teleconference. You may disconnect your lines at this time..