Jill Peters - SVP, IR Jeff Mezger - Chairman, President, and CEO Jeff Kaminski - EVP and CFO Matt Mandino - EVP and COO Bill Hollinger - SVP and CAO Thad Johnson - SVP and Treasurer.
Alan Ratner - Zelman & Associates Stephen East - Wells Fargo Michael Dahl - RBC Capital Markets Nishu Sood - Deutsche Bank Michael Rehaut - JPMorgan Stephen Kim - Evercore ISI Jay McCanless - Wedbush Securities John Lovallo - Bank of America Merrill Lynch Susan Maklari - Credit Suisse Alex Barron - Housing Research Center.
Good afternoon. My name is Devon and I'll be your conference operator for today. I would like to welcome everyone to the KB Home 2018 Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Following the Company's opening remarks we will open the lines for questions.
Today's conference call is being recorded and will be available for replay at the Company's website, kbhome.com, through July 5th. I would now like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may begin..
Thank you, Devon. Good afternoon everyone and thank you for joining us today to review our results for the second quarter of fiscal 2018.
With me are Jeff Mezger, Chairman, President, and Chief Executive Officer; Jeff Kaminski, Executive Vice President and Chief Financial Officer; Matt Mandino, Executive Vice President and Chief Operating Officer; Bill Hollinger, Senior Vice President and Chief Accounting Officer; and Thad Johnson, Senior Vice President and Treasurer.
Before we begin, let me note that during this call, items will be discussed that are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future results and the Company does not undertake any obligation to update them.
Due to factors outside of the Company's control, including those detailed in today's press release and in filings with the Securities and Exchange Commission, actual results could be materially different from those stated or implied in the forward-looking statements.
In addition, a reconciliation of the non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in today's press release and/or on the Investor Relations page of our website at kbhome.com. And with that, I will turn the call over the Jeff Mezger..
Thank you, Jill, and good afternoon. Before I get into the review of our business, I would like to recognize Matt Mandino, whom we recently appointed as our Executive Vice President and Chief Operating Officer.
Many of you met Matt at our 2016 Investor Conference as he was transitioning from Division President in Colorado to a Regional President position.
Matt’s new role in a much broader capacity reflects our rapid growth as we’ve more than doubled our revenues in just four years, and our expected growth into the future which Matt will help drive as we expand beyond $5 billion in revenues.
Turning to our results for the quarter, we continue to considerably improve our key operating, and financial performance metrics, a multi-year trend, that reflects a larger and increasingly more profitable business.
Looking at the specifics of the second quarter, we expanded total revenues by 10% to 1.1 billion, and increased earnings-per-share by more than 70% to $0.57. We've been on a steady path of producing year-over-year gross margin improvement as we rotate into higher-margin communities and begin to realize the benefit of lower interest amortization.
In the second quarter, we expanded our gross margin by 170 basis points to 17.7% excluding inventory-related charges. Alongside, our gross margin performance, we continue to control overhead costs while increasing our scale, holding our SG&A ratio flat. As a result, our operating income margin was also up 170 basis points.
Looking at our operating income on a per unit basis, we generated more than $29,000 per delivery in the second quarter, an improvement of more than 35% as compared to the prior year quarter.
Demand for our built to order products remained strong, supporting our ability to maintain among the highest absorption rates in the industry, even as we continued to capture price in the vast majority of our communities.
Our net orders per community increased 15% in the second quarter, to 5.5 per month, the highest springs on absorption pace, we have seen in many years off of an already high base of 4.8 per month in the year ago quarter. Although, our community count declined in the quarter which I will speak to you in a moment, our net orders increased 3%.
We expanded our ending backlog value to 2.2 billion, our highest second quarter level in more than a decade. As we are now at the midpoint of our fiscal year, this sizable backlog provides solid visibility on our deliveries for the remainder of this year, given us confidence that we will achieve our revenue and gross margin targets for 2018.
One of the key strengths of our returns focused growth plan is our ability to generate a substantial amount of operating cash flow, which we can deploy simultaneously to invest in our future growth while also reducing our debt balance.
Since implementing the plan 18 months ago, we have invested 2.4 billion in land acquisition and development, up 26% over the preceding 18-month period and reduced our outstanding debt by roughly 600 million, including the recent payment of 300 million of senior notes this month.
This combination of growing our active inventory while reducing our annual interest incurred by $46 million will enhance our future gross margins and returns.
The meaningful level of operating flow that we expect to generate in the second half of this year and the balanced approach to deploying our capital, we are in a position to fuel continued growth and strengthen our balance sheet.
In addition, as noted in our earnings press release today, our Board of Directors recently increased our share repurchase authorization to 4 million shares, which gives us flexibility to be opportunistic in enhancing stockholder returns. Community count growth remains a top priority.
Our strong absorption rate in the first half of this year resulted in selling out of communities faster than we previously anticipated.
However, we are planning on accelerating the pace of grand openings in the second half of this year versus the 47 openings we had in the first six months and still expect to slightly expand our year-end community count.
Equally as important, the makeup of our portfolio is better comprised of higher margin, higher return communities which is already producing benefits. Looking forward, we foresee healthy community count growth in each quarter of next year with planned openings in the first half of 2019, significantly higher year-over-year.
This expectation is reinforced by the growth in our lot count in the second quarter with a number of lots we own and control up by almost 4500 lots year-over-year. We remain disciplined in our land acquisition efforts with respect to price point, location and product consistent with our core KB 2020 business strategy.
In addition, we are taking positions that generally represent a two to three year supply with an emphasis on deal structure and compressing time to first delivery which will collectively benefit our inventory turns.
Market conditions remain robust with economic expansion, high consumer confidence, favorable demographics that reflect an increase in millennial household formation, plus job and wage growth supporting demand.
Against this healthy backdrop, resale inventory is still new record low levels and there remains an under production of new homes to close the gap relative to demand.
The first-time buyer continues to fuel housing market activity and with 53% of our deliveries this quarter to first-time buyers, we are strategically well-positioned with the products that we offer, our ASPs, and the locations of our communities. The factors that are driving demand appear to be outweighing the recent increase in interest rates.
Although, we are sensitive to the impact of rising rates or the anticipation of rate increases can have on homebuyers. While we continue to closely monitor shifts in the buying patterns of our customers, we have yet to see a change in behavior. Traffic levels and demand were solid in the second quarter, driving an absorption rate appreciably higher.
Other key indicators remain study with historical trends including the square footage of homes sold and dollars spent in our design studio. Our mortgage data was also consistent with prior quarters with an average loan to value ratio of 88% and predominant use of a fixed rate mortgage product.
Our cancellation rates also declined year-over-year in the second quarter. While we are mindful of changes in interest rate, the key internal measures that we track reflect the home buyer is willing and able to purchase a new home.
Moving onto the regional updates, demand remained solid in both the inland and coastal areas of California, driving our community absorption rate up 15% to 6.2 net orders per month in the second quarter.
With market dynamics as strong as they are, we sold out of communities faster than we have been able to open replacement communities, as we managed through delays municipal approvals and with the utility companies. As a result, we have a temporary shortfall in community count until our growth in the region resume in the second half of this year.
As is often the case, timing can meaningfully impact comparable. To put this in perspective, at this time last year, we shared with you a very successful opening at our Hayden community, a condominium building in the highly thought after this is the master plan in Los Angeles. This one community produced nearly 80 orders in last year's second quarter.
In addition, we experience a mix shift in that orders as we have sold through many communities with ASPs in the range of $1.3 million to $1.7 million. This higher price band represented about 10% of our net orders in the region in the second quarter of '17 as compared to about 4% of our net orders this year.
The combined effect of having fewer active communities and find out of many of our higher ASP communities, negatively impacted our net order comparisons in the second quarter of '18. As a result, the West Coast experienced a 13% decline in net order value and 9% decline in net orders.
With that being said, we feel very good about our West Coast business today and we still expect our 2018 ending community count in California to be up roughly 15% year-over-year. We also anticipate the composition of that community count to reflect both higher margin communities and a more balanced distribution of communities across the state.
In addition, with our own and control lots in California up about 20% year-over-year, we also soundly positioned to expand our community count growth throughout 2019. Moving on our Southwest region produced an 8% increase in net order value and had 2% net order increase.
Growth in our Arizona business led the region's performance as it continues to increase its scale. Our Las Vegas business remains very healthy with the community absorption rate above seven net orders per month again one of the highest across our company.
In the central region, our largest region in terms of units, net order value increased 3% and a 6% increase in net orders. Market conditions remain favorable across the region. Our net order value was impacted by a mix as we had particularly strong net order comparison in San Antonio, one of our lowest ASP divisions in the region.
Elsewhere in the region, we are pleased to see the traction gain in our Dallas division over the past year. With three communities opened during the last nine months and three more planned for the balance of 2018, the growth opportunity we envisioned in Dallas is beginning to materialize.
Wrapping up the regional updates, net order value increased 33% in the Southeast region on a 28% increase in net orders with every division producing a positive net order comparison, while the region at a relatively easy comparison from the second quarter of last year, we've seen a steady acceleration of year-over-year net order growth in the Southeast in each of the past three quarters.
Jacksonville was the largest contributor to the region's growth increasing its community count as well as maintaining the high absorption rate. Both Orlando and Tampa's performance also improved, reflecting better execution internally and the economic growth of these markets.
Our Southeast region is producing better and more consistent and we look forward to this trend continuing. Before I wrap-up I'll provide an update on KBHS, our mortgage joint venture with Stearns Lending. This month marks the one-year anniversary of KBHS becoming operational in each of our served markets.
The JV has ramped up nicely during the start-up year, providing a higher level of service to our customers. This performance contributed to us exceeding our expectation for deliveries in the second quarter and also to the year-over-year growth in the JVs income. KBHS is also now offering a streamlined mortgage process called, Stearns Digital.
With this recently launched mobile and desktop app, the entire mortgage application to be completed digitally. The app can securely verify income, employment and assets electronically and homebuyers can upload documents and receive real-time updates on the status of their loan.
As a result, KBHS can compress the loan processing time and make the overall mortgage process an easier one. As the execution in the KBHS business continues to mature, the JV is serving a higher number of our customers resulting in even more predictability in deliveries and continued growth in the JVs income strength in the second half of this year.
In closing, we're pleased with the strength of our performance in the second quarter and the progress we continue to make on improving our key financial measures. With a backlog value of 2.2 billion, we are well-positioned for the full year, with healthy revenue growth and the gross margin at or approaching 18%.
Market condition remains favorable and with the consistent execution on our returns focused growth plan, we expect to be within our 2019 target ranges by the end of 2018 and many of our key metrics including operating income margin, return and our leverage ratio both the growth and net basis.
With that, I'll now turn the call over to Jeff for the financial review.
Jeff?.
Thank you, Jeff, and good afternoon.
We are very pleased that our continued strong operational execution on our KB 2020 business model and returns focused growth plan resulted in significant year-over-year improvement in our second quarter financial performance, including a 10% increase in total revenues, a 50% improvement in homebuilding operating income, and a 73% rise in earnings per diluted share.
We believe that in the second half of 2018, our operations will generate additional profitable growth driving substantial operating cash flow to support further investments in land and development as we complete year two of our growth plan.
In the second quarter, our housing revenues grew 10% from a year ago to nearly $1.1 billion reflecting a 5% increase in the number of homes delivered and a 4% increase in our overall average selling price of those homes.
Three of our four homebuilding regions reported housing revenue increases, ranging from 6% in the central region to 43% in the Southwest region. We ended the second quarter with a backlog value of $2.2 billion, which was up 3% from the year earlier period and was highest second quarter backlog value in 11 years.
Considering this quarter and backlog and expected future net orders, we currently anticipate third quarter housing revenues in the range of $1.23 billion and $1.29 billion. For the full year, we have narrowed our housing revenue range from our prior guidance to $4.6 billion to $4.8 billion.
In the second quarter, our overall average selling price of homes delivered increased 4% year-over-year to approximately $402,000, reflecting increases in three of our four homebuilding regions.
Our average selling price in the Southeast region decreased due to the wind down of our Metro Washington DC operations in 2017, which had the highest ASP in that region. For the 2018 third quarter, we are projecting an overall average selling price in a range of $410,000 to $415,000.
We still believe our average selling price for 2018 will be in the range of $400,000 to $410,000. Homebuilding operating income increased 50% from the year earlier quarter to $74 million, excluding inventory-related charges of $6.5 million in the current quarter and 6 million in the prior year period.
Our second quarter homebuilding operating income margin increased 170 basis points to 7.3%, driven by continued measurable improvements in our housing gross profit margins. For the third quarter, we expect our homebuilding operating income margin, including the impact of any inventory-related charges will be in a range of 7.8% to 8.4%.
For the full year 2018, we expect the same metric to be in the range of 7.7% to 8.2%, an increase versus our prior guidance. Our housing gross profit margin for the second quarter improved 170 basis points on a year-over-year basis to 17.1%.
Excluding the $6.5 million of inventory-related charges, our gross margin for the quarter was 17.7%, also year-over-year improvement of 170 basis points with 50 basis points of improvement resulting from a reduction in the amortization of previously capitalized interest.
Our adjusted housing gross profit margin, which excludes inventory-related charges and the amortization of previously capitalized interest, was 22.2% for the second quarter, up 120 basis points compared to the same period of 2017.
The year-over-year increase was primarily due to the same factors discussed during our first quarter call, as we continue to drive margin improvement from community specific action plans, including targeted home selling price increases calibrated with demand and the opening of new higher margin communities, partly offset by increases in land, trade labor and material costs.
Assuming no inventory-related charges, we expect the year-over-year increase in our third quarter housing gross profit margin for range of 17.6% to 18.0%.
Considering the strength the continued strength of the housing market and the favorable community level results we experienced in the first half of 2018, we have increased our full year gross margin expectations, excluding inventory-related charges for range of 17.6% to 18.0%, which would represent an improvement of 72 to 110 basis points as compared to 2017.
Our selling, general and administrative expense ratio of 10.4% for the quarter was the same as the year earlier period, second quarter record low. The positive variance in the SG&A ratio relative to our prior guidance was primarily due to improved leverage from higher housing revenues and favorable legal recoveries and settlements.
As we continue to make containment of overhead costs a high priority and expect to realize additional favorable leverage impacts from higher housing revenues, we are forecasting our third quarter SG&A expense ratio to be in the range of 9.3% to 9.8%.
We anticipate that our full year 2018 SG&A expense ratio will be in the range of 9.6% to 9.9%, an improvement relative to prior guidance. Our effective tax rate for the quarter was approximately 27%, primarily reflected the favorable impact of the Tax Cuts and Jobs Act.
We still expect our effective tax rate for the remaining quarters of 2018 to be approximately 27%. Overall, we reported net income for the second quarter of $57 million or $0.57 per diluted share, significantly up from 32 million or $0.33 per diluted share reported in the second quarter of 2017.
As I mentioned during last quarter’s call for purposes of calculating earnings per diluted share for both the remaining quarters and the full year 2018, we expect to have approximately 101.5 million diluted shares outstanding. Turning now to community count, our second quarter average of 215 was down 10% from 238 in the same quarter of 2017.
We ended the quarter with 210 communities, including 32 communities or 15% that were previously classified as land held for future development. On a year-over-year basis, we anticipate our third quarter average community count will be down by approximately 10% as compared to the 234 communities in the third quarter of 2017.
We expect our community count at the end of 2018 to be up slightly as compared to year-end 2017. We invested $379 million in land, land development, and fees during the second quarter with $136 million of the total representing new land acquisitions.
Our year-to-date land related investment of $844 million represents an increase of 19% versus the prior year period, and we expect this investment will drive future community openings and overall community count growth.
We ended the quarter with total liquidity of approximately $1.1 billion, including $670 million in cash and $463 million available under our unsecured revolving credit facility. Earlier this month, we retired $300 million of our 7.25% senior notes after maturity using internally generated cash.
Since April 2017, we’ve received three rating agency upgrades and in May 2018, Moody's Investors Service lifted our rating outlook from stable to positive.
The implementation of our returns focused growth plan has generated significant cash from operations over the past six quarters, and we believe our expected revenue growth and operating margin expansion in 2018 will drive operating cash flow solidly above the 2017 level, excluding land-related investments for both periods.
Our land acquisitions have positioned us to grow our community count starting later this year and the nearly $600 million reduction in our debt since early 2017 will result in an annualized decrease of approximately $46 million in both incurred interest and interest capitalized inventory.
This combined with our increase in active inventory will drive further future reductions in the amortization of capitalized interest on a per unit basis, providing a tailwind for future gross margins and returns.
In summary, we delivered solid results in the second quarter with 10% growth in revenues, 170 basis points of improvement in our housing gross profit margins and a lower tax rate all contributing to an 80% increase in our net income versus the prior year quarter.
We expect to generate additional improvements in our financial performance during the remainder of the year as we continue executing on our returns focused growth plan and believe we will generate return on equity in the range of 14% to 15% for 2018 excluding the first quarter non-cash charge for the impact of the Tax Cuts and Jobs Act.
As such, we believe we're well positioned to achieve our financial objectives for 2018 and expect to meet or exceed our growth plan targets for 2019. We will now take your questions. Devon, please open the lines..
At this time, we will be conducting a question-and-answer session. [Operator Instructions] Our first question is from the line of Alan Ratner with Zelman & Associates. Please proceed with your question..
So, my question is obviously really impressive gross margin improvement and I know there's a lot of stuff going on the community level basis as well as within the portfolio and the deleveraging that are certainly eating that number.
I was curious, if you could talk a little bit just about what you're seeing in terms of pricing power? And how that's trending, if there's any markets or price points that you feel like maybe things are starting to hit a little bit of a wall just given how much prices have gone up above to this point as well as the increase in mortgage rates? And then maybe just compare and contrast that to what you're seeing on the cost inflation side we heard from, one our recently they think that lumber might have peaked, but curious what you're experiencing on the cost side and what your views are for the go forward view?.
Alan, as I shared in the prepared comments, we were able to capture price in the vast majority of our communities in the quarter. And if you link the sales rate to our gross margin guidance, we've been able to keep prices ahead of any cost increase.
There's still pressure on cost, lumber did peak, it's come down a little bit and random lines that take some time to flow through. So, there's pressure on cost but so far we've been able to raise price adequately to expand our margins some while covering the cost. We're pretty strategic with our price increases.
I always refer to optimizing each asset and we'll balance the price and the pace, and we always take price where we can. And between the strength of our pace and the ability to raise price, it tells you the market is still out there to capture price.
So I can't think of a single market we're in today where I would say that there's signs that the consumer can afford it or the pricing hit the wall, we're pretty optimistic about the market dynamics right now..
And then just rolling in on California a little bit, maybe just talk about with the community growth you're anticipating there. I think you mentioned maybe little bit more of a balanced, I think you've used the word balanced when talking about the markets and where you expect these openings to occur.
Can you talk a little bit about just where you are seeing the demand today? I mean you mentioned strong in both the coast and inland, but looks like maybe you're starting to open up a few more communities inland.
So, are you seeing some migration inland just as the affordability obviously is getting more stretched in the coast? Or is it really strength across the entire state both inland and coastal?.
I would say its strength across the entire state, and as we have shared in the past, we will take every deal we can in the Bay Area, Orange County or San Diego County because there's so land constrained and we have two pretty good to fine communities and bring them to markets. So, our goal is to hold the scale there because of land constrained.
And as the state housing markets have expanded inland, we are feeling a lot more opportunity in the more inland regions, both Central Valley around Sacramento and the Inland Empire.
And if you read the history of our state performance over the last several years, for a while we were only investing in the coastal region because the inland areas weren’t providing the return. So, our coastal business grew, inland didn’t grow that much.
Inland started to open up this as the market recovered, and you have got this the different pistons in the engine if you will are now working better and that the inland areas are offering a lot more opportunity. But as the year unfolds, the reason I said more distribution, we see growth in all the regions within the state..
Our next question is from the line of Stephen East with Wells Fargo. Please proceed with your question..
Jeff, in the press release, you talked about a balanced manner as far as how you're going to deploy your cash flow. And so, I'm just thinking about your current cash levels, what you think you can generate? And looking at your debt load, your land and development demand you think you have and share repurchase stone in there.
What's that balance matter -- manner look like if you will over the next year or two?.
I can let Jeff talk to that and its specifics on the cash versus debt in one, not but -- our top priority right now with continue to grow community count and grow the top line, and we have been successful and we have proven it now that we can really straddle up our investment while at the same time de-lever.
So, we have been in a nice situation to be able to accommodate both and that’s why, as the quarters go by, we don't always connect all the dots, but when you think of our ability to spend almost 2.5 billion over 18 months and take out 600 million of debt, it shows you have kind of cash that are our current strategy is generating.
So, as we go forward, priority number one will always be we got to grow the top line and working diligently to do that but at the same time we are mindful of strengthen the balance sheet and looking at our returns. So, we will continue to address all of -- their all tools in tool box right..
And the big part of that has been monetizing these legacy assets. You are well ahead of your plan like you were talking about.
How many more years do you think you all have to monetize those legacy assets?.
We are on the downhill side Steve. I don’t know that we have looked at it that way, but as a person of our communities you will continue to see a decline going forward. I don’t know that if we even….
I could give you a few numbers maybe help you out. I think we take the community count last year in 2017, we had like in low 40s; 41, 42, we activated communities from most of last year. In 2018, so far first quarter, we ended the quarter I think 34. We had second quarter with 32.
So, it's definitely trending down we see it trending down further, but I think it's a multi-step process. I think we have to activate the community in many cases we have to developed, open for sales and then sell through it. And in a majority of the cases, we have other phases that are still in active status, so we have to work through it.
We're proud of the progress so far that we cracked the 300 million levels this quarter. It came in at 282 million of total land held for future developments, so that we're now down to about 8% of our total inventory. So as you've pointed out, we're making really great progress on this initiative and we expect to continue to make good progress.
But as the communities are rotating more towards newer land purchases in core communities, we're seeing additional benefits in higher ASPs and higher margins as well those communities, so all really nice trends for the future..
So, but the legacy, you do expect it to provide some of the incremental cash flow, it sounds like for at least a few more years and….
Yes, certainly. But I think we should really emphasize one point, the bulk of the Company's cash flow is really coming from the core operation.
I mean our core community and core business are -- is generating the vast majority of the cash flow, but it is nice to have two additional levers one with the lack of paying cash taxes which is helping and the second one is the monetization of the reactivated.
So those to me are incremental, but the based core business has really been generating a very, very nice cash flow for us in the past of couple years..
Our next question comes from the line of Michael Dahl with RBC Capital Markets. Please proceed with your question..
Jeff, I wanted to follow up on that and just understand there is a lot of moving pieces on the gross margin side over the next four quarters or so, but great progress so far.
When you look at the combined impact of what you just talked about on the mothballed side starting to decline a bit mix wise and the tailwind from the interest expense that you outlined.
Just ballpark can you remind us kind of all us equal what type of tailwind that supports the margins?.
So far on the interestingly on the reactivated side, it's been very, very consistent since we started reporting it and really getting into a lot of detail with the street.
I think this quarter was 90 basis points and we've been saying all along, this is pretty much a full percentage point plus or minus every quarter and we've seen that pretty consistently.
So until that's really starts tailing-off probably second half next year, I think we will see a little bit more of a tailwind from that, but right now our margin improvement has really not come from a reduction in reactivated in the mix of reactivated delivery especially just come from improvement across the business and mainly in our core communities.
So that's been good. On the interest amortization, we talked about last quarter that we expected 20 basis points to 30 basis points of the tailwind from the -- from reduced interest amortization in 2018 for the full year.
This particular quarter I think will be a high point for the year we saw about 50 basis points year-over-year coming from reduce amortization, but last year was in the second quarter it was just a high amortization quarter of 5%.
So, I think that 20 to 30, I might say now much closer to 30 maybe even a little bit north to 30 for the full year of held an than additional incremental improvement next year.
So that is starting to provide some tailwind for us and I think there's a couple years left of that, quite frankly, as right now in our interest capped and interesting part is down significantly that was for the system I think it will provide a tailwind for us for at least for next two years..
And shifting gears to some of the comments going back to community planning and rollouts across California specifically. We started to see that bounce come through in the ASPs as you’ve mentioned already. It sounds like it's going to continue to shift towards this more balanced geographic position within California.
Can you just help us ballpark, from an ASP standpoint specific to the West region, how we should be thinking about trends going forward for the balance of the second half and into ’19..
Well, I think the overall level of the guidance. We provided is probably the best place to go to.
For the full year we think we’ll be in that $400,000 to $410,000 range in ASP, and for the third quarter specifically, $410,000 to $415,000 and that contemplates the mix shift within the region, both between West Coast region and the rest of business as well as within the West Coast region.
So we did, as Chuck mentioned in some of his comments, we did have some very high dollar amount ASP dollars of deliveries in California last year and that actually reduced this year, but it’s basically just mix shift between communities as what we're seeing. And so we’ve contemplated all that in the guidance that we provided..
Our next question is from the line of Nishu Sood with Deutsche Bank. Please proceed with your question..
So thinking about the substantial investments you folks are obviously making it land and accelerating the community count growth. Jeff, in your commentary you talked about some tactics you might use to make it a little more capital efficient just-in-time. Obviously, I would imagine increased use of options as well.
That would have been difficult say four or five years ago, given the state of the land market. And obviously the land market moves incrementally overtime. Does that tell us as you’re thinking about that that the land market has ease quite a bit that land developers are more active, better capitalized, able to get the bank financing.
How does the state of the market compared to say, how does it evolved over the last couple of years?.
I would say the land markets are pretty rational right now. And it's always tops in the A locations because it’s the land constraint and turns are difficult and you do your best. As California where the market continues to recover, inland is now a pretty active market where land is more readily available.
So there's not as much of a land-grant going on out there and that you got more options. I also do agree with your comments that the land sellers that are developing lots and selling lots have the financial ability to do that.
And they will try to get a higher return with their terms versus just the cash purchase, because they don't have the balance sheet. So I think all of those are to coming together right now..
And Jeff, you talked about cash flow I think before land spend unit being higher in ‘18 than in ‘17, I believe is what you said. Just can you give us some sense of what you’re expecting operating cash flow to be for ’18? Now that you have a pretty good view of that back half of the year..
We’d like to look at it on the basis of before land spend, because we cannot level that off you could always drive a lot of cash flow by drawing up your land spend, which we don’t intend to do.
So on a gross basis if you look at last year for the 12 months, we generated about $500 million of cash flow, on a net basis and on a gross basis, little over $2 billion. We expect this year to be well north of the $2 billion.
And already for the first six months of the year, we’re already on a favorable comp compared to last year and we expect to drive more in the second half.
So shorter that I don’t really want to provide a point estimate on it, but suffice it to say it will be extremely, I think, it’ll be meaningfully higher than last year and definitely sufficient to support our expanded land investment expectations for this year..
Our next question comes from the line of Michael Rehaut with JPMorgan. Please proceed with your question..
First question, I just wanted to circle back to California. And Jeff, obviously, very encouraging results around commentary and demand trends. And I think one of the areas of concern by investors has been some reports out pointing to some softening, particularly in California, maybe above normal levels of seasonality.
It appears, obviously, that your business isn’t showing that and obviously, your sales pace, broadly speaking, is up year-over-year and you have good sales pace in California specifically.
So just trying to reconcile, perhaps from maybe a broader market standpoint, if those areas of concern or those reports, do strike any type of chord with you? Or if there’s perhaps, in the past what we've heard and Inland Empire is that FHA demarcation point, from a loan to value standpoint that anything above an FHA loan limit product didn't sell as well? Or perhaps there are some areas within even coastal, at points over the last year, to have been a little bit oversupplied at some price points in some areas.
So just trying to get a sense, obviously, your own business is pretty solid.
But if there's any type of element in the marketplace that you can reconcile with those reports?.
Mike, I think in part it's because of the price points that we play at. Part of our strategy is to compete with the median re-sales in an area, and it’s harder to do along the coast than it is inland.
But these communities we reference where there’re 1.3 million to 1.7 million were in, last year were in Orange County and the Bay Area where median re-sales were slightly below that.
So they were high-priced submarkets and we were the affordable play, sad as it is to say that in California, we were the affordable play from 1.3 million to 1.7 million and sold very well. So as the inland areas have evolved, FHA is not as critical now because the demand is much stronger.
You’ve heard those comments from the builders three, four, five years ago. And demand is lifted, so you have a lot more people out there that can qualify conventionally. And whether it's inland or along the coast, we typically will operate at a price point below a lot of our peers.
We try to stay affordable and complete with re-sales, and I think that's one of the reasons that we've been able to hold the sales rates we have..
Secondly with regard to community count, I guess you outlined that you expect to be down about 10% year-over-year in the third quarter but end the year still slightly positive as you accelerate the openings in the back half. To the extent obviously, that you're looking at a faster sales pace.
How does that impact the '19 numbers? I mean, obviously, you outlined that you expect year-over-year growth in every quarter. But if you're looking at a faster sales pace, and I know you haven't really given guidance yet.
But would that perhaps, all else equal, mute the growth expectations, maybe from let’s say if you're previously looking at up mid single digits for the full year on average. Now, it's down to low single digits.
Or does this acceleration in openings offset the sales pace impact for next year?.
Michael, we'll give community count guidance for '19 at the end of this year. And when I said we're selling faster than we previously expected, it was relative to our community count guidance going into the year.
Markets have been very good, we've taken advantage of it and we sold out a little quicker than we had modeled, while the same time our new openings have been delayed more than we modeled, so we got pinched there.
And we’ve now taken that hit, and you'll see us get back into nice rhythm here at community count growth as we get out of '18 and certainly into '19. And if you look back at the reference I made to lots owned and controlled, we were up 4,500 in the quarter versus a year ago.
And that's a meaningful increase in the lots that we're working hard to turn into open communities now..
Our next question comes from the line of Stephen Kim with Evercore ISI. Please proceed with your question..
This is actually Trey on for Steve, thanks for taking some time to chat. So first question I had is on the strong gross margin you had in the quarter. You mentioned it was due in part to targeted home selling price increases. But at the same time, your ASP really was in the range that you guided for.
So what other factors were in there that caused you to beat the high end of your guide by 50 basis points?.
There were several factors like always in quarters and mix of deliveries et cetera. If you look at the beat, we're about 70 basis points up from the midpoint of our guidance, about 20 basis points came from just higher leverage or increased leverage on higher revenues in the quarter than we expected.
So that was nice benefit from the delivery beat, the revenue beat. And the rest of it really came from favorable mix. We had spec sales and closings in the second quarter that we had to estimate, provide estimates for upfront. It was about 18% percent of our total deliveries in the quarter.
And those, quite frankly, came in at higher margins than expected or had forecast.
We also had little bit of conservatism in the forecast, thinking that maybe we might see a little bit more cost inflation, a little more risk on the backlog margins that we were able to successfully avoid, which we’re pleased on that side as well, so a little bit from several different factors, but all adding up to a nice quarter.
And when I look at the quarter, for me when you look at the revenue versus gross margin, it was we achieved the trifecta, so to speak. I mean, we had a strong double-digit increase in absorption pace in the quarter, which is floating well for the future of the business rest of this year.
Second quarter as you pointed out came in higher than expectations and gross margin which is great. And due to the increased confidence in what we see now on our backlog, we’re able to lift our back half guidance and our full year guidance on gross margin, so a really nice quarter.
The sales pace and the pricing trade-off worked our advantages quarter, and we are able to do a bit of each and improve both on them. And we’re very pleased on that side of it..
And then also, you clearly are making a point that demand in California is strong that absorption is up 15%. But you are talking about selling out faster and then you’re also seeing a gap in bringing communities on.
So is there some type of issue of pushing price a little bit faster to slow, the cadence of sales that are taking place in your active community so gap doesn't exist? Or would that potentially putting new communities at price points well above where you think they would sell?.
Again, we optimize the assets. So if something selling five a month and your margins are not where you want them to be, you’re going to push price. If you’re selling five a month of extremely high margins and there's plenty left to go in the community, you’re not going to dribble out, because you want to get rid of the overhead.
So I don’t know that one plays into the other. The comments we made were more about our expectations going into the year and where we thought we would be. And we’re set up now with a very strong backlog at very good margins to cover the second half for the year.
At the same time, we’re moving quickly to open up a lot of communities and set up and even better '19..
Our next question comes from the line of Jay McCanless with Wedbush Securities. Please proceed with your question..
First question I had just with shortage of labor continue to be a headline.
Can you talk about where your cycle times are or contract close, I can't remember how you guys -- how that compares to where it was last year?.
We do call the cycle time for contract close so because we’re so heavily built to order. We did compress just pulling the base for you. We did successfully compress the time from the final on the home to closing. I think it's a reflection of the higher capture rate and the better performance with our mortgage JV.
My general sense is our build times are holding, they’re not really eroding. We’re able to find the labor to get our homes built, we’re having to pay a little bit more for it than a year ago. But I’m not here in a lot of sub-shortage as our issue today..
And I think as by way of numbers. Sequentially, we actually came down a few days from the first quarter, which also added a little bit or was a factor on our revenue and delivery beat that we’re able to bring that total cycle time down.
We’re up a few days compared to the same quarter of last year and that trend has been generally continuing on an upward trend since the recovery started. And frankly, we have had -- it's almost inversely related to how well the company is doing overall as far as financial metrics.
And the tight market and the pricing that we're seeing out in the market today is manifesting in tight labor conditions, but also obviously, reflection of a good market and we've been able to take advantage of that. So it's not constraining the business right now.
And I think as Jeff said, we're not seeing any pockets of trouble or anything else, and we’re dealing with slightly extended on a year-over-year basis construction built-times but trying to reduce in the other areas and again, the improvement over the first quarter was welcome..
And then just the second question I had, touching on what you said earlier, Jeff K about some of the cost in 2Q came in a little bit lower than you guys have anticipated in the guidance.
Can you talk about which costs were lower than you thought, and are you seeing any of that in 3Q?.
You're talking about SG&A?.
Well, I thought you said on the build cost maybe….
On the direct, yes, I think. It was more just the factor of a hedge factor on the cost side. We've seen some labor costs inflation and some of the material categories have been showing inflation on a pretty regular basis over the last year. And we thought maybe some of that pressure would bleed through and we’re able to avoid a lot of it.
So it was more a general comment as far as specific commodity category..
Our next question comes from the line of John Lovallo with Bank of America Merrill Lynch. Please proceed with your question..
First question is it seems like your print should certainly help allay some of the market concerns about the rates and demand, but just curious how orders kind of trended through the quarter.
I mean were there any air pockets at all, or it was a pretty steady?.
It was pretty steady, John. We had good traffic, good demand all the way through from March to May..
And then in terms of the community count outlook for the third quarter, the average community count being down I think about 10% you said.
I mean, is it reasonable to think that third quarter orders could be, on a year-over-year basis, flattish maybe slightly down before rebounding pretty smartly in the fourth quarter and into 2019?.
I think it really comes down to the absorption pace. So we're starting a little bit disadvantaged as we did this quarter, we’re down 10%. And the current quarter community count is still squeaked out a little bit of an increase in orders, so it's really dependent on that absorption pace, which is difficult to predict.
Last couple of quarters, we had double-digit increases in absorption on a year-over-year basis. And those are coming off pretty good quarters from last year, so we’ll see where it goes. But what we see now is on the community count trend, we've been managing through it.
It's been a declining trend as we've gone through this year and we've been able to manage through it and still drive top line revenue. And it will be very nice for the business and I think the future of the business and the financial metrics to see those communities and the community count increasing, starting in the fourth quarter this year.
And we’re looking very much forward to that, because it's a nice tailwind to have..
Our next question comes from the line of Susan Maklari with Credit Suisse. Please proceed with your question..
This is actually Chris on for Susan, thanks for taking my question. So my first question is just on the southeast region, looks like orders came in strong for you this quarter on the back of somewhat softer ASPs.
How does the operating environment here compared to the rest of the country, and are you approaching your strategy differently here relative to other markets?.
When you say operating environment, are you referring to building and selling homes and how we execute….
Yes, like is the pricing power relative to other markets, how does that differ, how are you approaching that?.
It’s not like its coastal California environment, but it is certainly like inland California or Texas, or Arizona. They are pretty typical because they’re not that land constrained. The markets are good and our teams are executing better.
And we're -- have shown a stronger comp there because we weren’t that strong last year, it’s more of elevating our execution and opening new communities that are performing well. We think we have a lot of upside coming out of that region going forward..
And just my second question is on your efforts to grow your local scale.
Are there any regions that you're having more success in growing market share relative to other parts of the country? And for some of your smaller markets, how aggressive are you in adding to your land position there?.
We’re open for business everywhere, we shared as part of our business strategy and our returns focus growth, we want to be top five. I joke with the team here is that top five is a yawner if you can’t be top three, you're not doing as well as you could still. So once we hit top five, we’re not done.
Last time, I checked we were top five in a little over half and in top three in many. So we have the same strategy in every city that we’re in. We want to get to scale there is lot of benefits to it. And we’re encouraging every management team to have a plan in place to get, if not top five, top three and so on.
And that's the same goal in every city that we operate in..
Our last question comes from the line Alex Barron with Housing Research Center. Please proceed with your question..
I had a question regarding, I guess, the strategy going forward with regards to price point. I noticed a couple of the regions ASP seem to be lower year-over-year.
So I was just wondering if you guys are emphasizing more entry-level communities, and specifically in California, if you can just help us out generally how you’re thinking about your entry-level exposure?.
Alex, as I mentioned that another question, we really work hard to position our product, so we’re competitive with the medians and not floating way above the median. Specific to the central region, our price point came down, because of the San Antonio portion of that region was very strong, and they’re one of the lower price point.
So we had a mix shift. But within all of our business, I am sensitive to the interest rate environment, affordability and what's going on. And we've been diligently working to rotate down a little bit in our assumptions on what footage homes to build, which one is the model, what price point to play.
And it’s all part of our discipline to remain affordable to the median. In California, it’s again a mix shift and that the inland areas, as they continue to strengthen, are becoming a higher percentage of our business.
It's not that the coastal area prices are down or that our sales per community are down, it’s just the way the mix is shifting around..
Ladies and gentleman, this concludes our conference today. Thank you for your participation. You may now disconnect your lines..