Good afternoon. My name is Devon and I will be your conference operator today. I would like to welcome everyone to KB Home 2019 Second Quarter Earnings Conference Call. At this time, all participant lines are in a listen-only mode. Following the company’s opening remarks; we will open the line for questions.
Today's conference call is being recorded and will be available for replay at the company's website, kbhome.com, through July 26. Now, I will like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, thank you. 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 2019.
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 Investors 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. We continued to deliver solid performance in the second quarter under our Returns-Focused Growth Plan, which prioritizes the profitable growth of our business and greater productivity and efficiency of our assets.
Our execution on this plan has been consistent and strong since we launched it in 2016 and has produced measurable results. We have realized significant growth in our community count this year, which fueled a 15% year-over-year increase in our second quarter net orders.
In addition, by substantially reducing our debt while growing our active inventory, we expect to lower our annual interest incurred in 2019 by more than $40 million since the plan was introduced.
In the second quarter, we accelerated our community count growth by successfully opening 43 new communities, bringing our total openings over the last 12 months to 123, which had us well positioned for the spring selling season.
Our second quarter average community count was up 17% from a year ago, reflecting increases in all four regions, with three of our regions producing greater than 20% growth.
We expect to continue growing our average community count year-over-year over the next two quarters and remain committed to realizing a 10% to 15% increase for the year, which sets us up well as we look ahead to 2020. We generated just over $1 billion in total revenues in the second quarter and diluted earnings per share of $0.51.
Our housing gross profit margin, excluding the inventory-related charges, held even with our 2019 first quarter at 17.6%. While this result was lower year-over-year, we are encouraged by the composition of our $2.2 billion backlog, which we expect to drive gross margin improvement over the balance of the year, as Jeff will share with you shortly.
From a macro perspective, the combination of a decline in mortgage interest rates, along with steady economic growth, high consumer confidence and favorable demographics in particular household formation, continues to provide a healthy backdrop for our industry.
In addition, the buyer pause that the industry experienced in the latter part of 2018 has generally moderated home prices, which is positive for the market, given the significant levels of price appreciation over the past few years.
On the other side of the equation, supply remains insufficient to meet demand, stemming from the under production of new homes over multiple years and the shortage of existing home inventory, particularly at the price points where we operate.
These factors contributed to the solid market conditions that we saw in the early weeks of March, which we spoke of on our last earnings conference call. On a per-community basis, net orders were a healthy 5.4 per month, which closely tracked the prior year quarter's robust absorption pace.
Our business gained momentum as the second quarter progressed, fueled in large part by the significant number of new community openings that I discussed earlier, resulting in a 15% year-over-year increase in net orders. Each of our four regions produced a double-digit increase in the second quarter.
Net order value expanded by 13% in the second quarter to $1.5 billion. This result help bolster our backlog value to $2.2 billion, as I mentioned earlier. In terms of units, our backlog in the second quarter was up about 2% year-over-year.
Moving on to the regional commentary, our net orders were up 18% in our West Coast region, driven by an increase in average community count and a healthy pace of 5.7 net orders per community per month, compared to 6.2 net orders in the year-earlier quarter. In Northern and Central California, we experienced generally solid market conditions.
In the Bay Area, we expanded our average community count, contributing to net order growth of more than 20%, while achieving an absorption pace slightly ahead of our company average.
As we are now successfully rebuilding our Bay Area community count, the division's order result supports our expectation for a sequentially higher company ASP and gross margin in the second half of this year. In Southern California, our net order trends improved.
In both our Los Angeles and Inland Empire divisions net orders increased by roughly 25%, driven by community count growth in areas with healthy market conditions. We view these results positively, as we have been monitoring our Inland Empire business for any ripple effect from conditions along the coast.
Within our coastal business, the smallest of our California divisions in terms of units, while market conditions are softer than the Inland areas, the net order decline that we experienced was primarily due to the sellout of one community in San Diego that alone produced nearly 30% of this division's net orders in our 2018 second quarter.
Finally, in April, we were pleased to successfully open our first community in Seattle in Pierce County, a commuter market southeast of the city. When we started up our Seattle business, we identified an opportunity to offer affordable product in the high $300,000 to $400,000 price range, targeting first-time and first move-up buyers.
Our first community, Falling Water, is aligned with this market approach with an ASP starting at $385,000, as compared to a median new home price of $620,000 and a median existing home price of $465,000 across the three-county metro Seattle area.
We expect deliveries from this community by the end of the year and look forward to our second community in Seattle opening later this year as well. In our Central region, our largest in terms of units, net orders increased 11%, driven by our Houston and Colorado divisions.
In Houston, the combination of a strong economy, population growth and our positioning at affordable price points in desirable areas, resulted in the highest quarterly net sales for this division in over a decade.
The most active sales volume price band in Houston is between $200,000 and $300,000 and with our ASP of roughly $245,000, we are operating in the sweet spot of this market. Elsewhere in the region, our Colorado division opened five new communities in the second quarter.
The openings were well received in this supply constrained market contributing to a 45% increase in net orders. Demand in the Denver housing market is strong driven by positive in-migration and job growth.
We are well positioned to meet this demand with our ASP of approximately $485,000 in between, the median new home price of $525,000, a median resale price of $425,000 on point with our pricing strategy providing affordable product in attractive areas.
In addition to these specific market updates, I would also like to comment on KBHS, our mortgage joint venture with Stearns Lending. In the two years since becoming fully operational KBHS has provided high-quality level of service to our home buyers helping to drive our customer satisfaction scores higher.
In addition, the JV's consistent performance has supported our divisions as well, enabling more predictability in deliveries and contributing to our ability to successfully deliver homes to our buyers on time.
With a capture rate of nearly 70% in the second quarter, growing significantly from 52% in the year-ago quarter and our expectation for continued enhanced execution from KBHS, we anticipate a meaningful increase in the income contribution from our JV in the second half of this year.
In closing, with a backlog value of $2.2 billion, and a considerable number of new communities still to open this year, we are well positioned to deliver year-over-year growth in revenue and profitability by the fourth quarter of this year, and for momentum entering 2020.
With strong execution on our core business strategy to increase our scale, we have achieved a top five market share ranking in just over 70% of our divisions as compared to roughly 50% when we launched our plan.
We have a business model with our build-to-order approach that allows us the flexibility to move with demand and react quickly to market changes. This differentiates us and contributes to our growing share of first-time buyers, which increased to 55% of our business in the second quarter.
We are poised for a strong finish to 2019 and look forward to updating you on our progress moving forward. With that, I'll now turn the call over to Jeff for the financial review.
Jeff?.
Thank you, Jeff, and good afternoon everyone. I will now provide highlights of our financial results for the second quarter as well as our outlook for the third quarter and full year 2019.
We are very pleased with our second quarter performance, particularly our strong backlog conversion, which helped drive housing revenues, and the solid absorption pace in community count growth that led to a 15% year-over-year increase in net orders.
We believe we are well positioned for a strong second half of the year and expect to generate improvements in virtually all our key financial metrics.
In the second quarter, our housing revenues were just over $1 billion as compared to $1.1 billion in the prior year period reflecting an 8% decrease in our overall average selling price that was partially offset by a 2% increase in the number of homes delivered.
The primary drivers of the overall housing revenue decrease were a lower proportion of total deliveries from our West Coast region and a decline in our West Coast region average selling price that stem from both a mix shift towards deliveries in lower price inland markets, and the absence of certain communities with high average selling prices that closed out in prior quarters.
The 2,768 homes we delivered in the quarter represented a backlog conversion rate of 60%.
This strong performance reflected several factors including a sequential and year-over-year reduction in construction cycle time, an increase in closings financed by our mortgage joint venture, and a higher percentage of standing inventory that was both sold and closed within the quarter.
We ended the second quarter with over 5,900 homes in backlog, an increase of 2% versus the prior year. Our ending backlog value was $2.17 billion as compared to the year-earlier level of $2.24 billion, which represented our highest second quarter backlog value in 11 years.
Considering the quarter-end backlog and expected future net orders, we currently anticipate third quarter housing revenues in a range of $1.1 billion to $1.18 billion. For the full year, we believe our housing revenues will range from $4.45 billion to $4.6 billion.
In the second quarter, our overall average selling price of homes delivered decreased 8% year-over-year to approximately $368,000 due to the impact from our West Coast region that I previously mentioned and a mix shift in our Central region with the lower proportion of deliveries from our Colorado operations.
We believe the expected increase mix of West Coast region deliveries driven by the successful rebuilding of our California community count will result in higher average selling prices in the second half of the year.
For the 2019 third quarter, we are projecting an overall average selling price in the range of $395,000 to $400,000 and believe our ASP for the full year will be in a range of $385,000 to $395,000. Homebuilding operating income decreased from the year-earlier quarter to $52 million or 5.1% of revenues.
Excluding inventory-related charges of $4.3 million in the quarter and $6.5 million in the year-earlier quarter, this metric was 5.5% compared to 7.3%. For the third quarter, we expect our homebuilding operating income margin excluding the impact of any inventory-related charges will be in the range of 6.4% to 7.0%.
For the full year 2019, we expect this metric to be in the range of 6.7% to 7.3%. Our housing gross profit margin for the second quarter was 17.2% compared to 17.1% for the prior year period. Excluding inventory-related charges, our gross margin for the quarter was 17.6% compared to 17.7% for the 2018 second quarter.
The current year metric reflected favorable impacts from lower amortization of capitalized interest as well as the change in the classification of certain model complex cost, due to our adoption of the new revenue accounting standard ASC 606.
These favorable impacts were offset by pricing pressure on fourth quarter and first quarter orders, due to weaker marketing conditions during those periods, the effect of certain high ASP and high margin West Coast communities, having closed out in previous quarters and reduced operating leverage due to lower housing revenues and higher fixed community level expenses supporting community count growth.
Our adjusted housing gross profit margin, which excludes inventory-related charges as well as the amortization of previously capitalized interest, was 21.3% for the second quarter compared to 22.2% for the same period in 2018.
Assuming no inventory-related charges, we expect the sequential increase in our third quarter housing gross profit margin to a range of 17.9% to 18.5% and further improvement in the fourth quarter.
Considering this expected favorable trend, we believe our full year housing gross profit margin excluding inventory-related charges will be within the same range of 17.9% to 18.5%. Our selling, general and administrative expense ratio of 12.1% for the quarter was up as compared to the 2018 second quarter record low ratio of 10.4%.
The increase mainly reflected the ASC 606 impact mentioned earlier, reduced operating leverage due to lower housing revenues, increased marketing expenses to support new community openings, and the impact of legal recoveries and favorable legal settlements in the prior year period.
As we continue to prioritize containment of overhead costs and expect to realize favorable leverage impacts from higher housing revenues in the second half of the year, we are forecasting our third quarter SG&A expense ratio to be in the range of 11.3% to 11.9% and our full year 2019 ratio to be in the range of 11.0% to 11.6%.
Income tax expense for the quarter was $9.3 million, which reflected $5.2 million of favorable impacts from federal energy tax credits and benefits from stock-based compensation. Without these impacts, the effective tax rate for the quarter would have approximated 26%.
We expect our effective tax rate for the remaining quarters of 2019 to be approximately 26%, excluding potential impacts from stock-based compensation. Overall, we reported net income for the second quarter of $47.5 million, or $0.51 per diluted share.
For modeling purposes, diluted earnings per share for the remaining quarters of 2019 should be calculated using approximately 92.5 million shares, which reflects the 8.4 million reduction in our diluted share count due to first quarter repayment of our convertible senior notes.
Approximately 93.5 million shares should be used for the full year calculation, representing a year-over-year decrease of 7%. Turning now to community count. Our second quarter average of 252 was up 17% from 215 in the same quarter of 2018.
We ended the quarter with 255 communities, including 27 communities, or 11% that were previously classified as land held for future development.
As we continue to successfully implement our strategy of monetizing these inactive assets, and with less than $200 million in this inventory category at quarter end, we expect to see further declines in the number of reactivated communities in the future.
We invested $399 million in land, land development and fees during the second quarter with $132 million of the total representing new land acquisitions. Over the past 12 months, in addition to the capital allocated to pay down debt, we deployed over $1.8 billion into land-related investments and opened 123 new communities as Jeff mentioned earlier.
On a year-over-year basis, we anticipate our third quarter average community count will increase in the range of 15% to 18% as compared to the 2018 third quarter. We still expect our average community count for the 2019 full year to be up approximately 10% to 15% year-over-year.
We ended the second quarter with total liquidity of approximately $600 million, including $179 million of cash and $419 million available under our unsecured revolving credit facility.
Earlier in the year, we entered into a new $50 million unsecured letter of credit facility, separate from our existing $500 million unsecured revolving credit facility. Over time, we anticipate that most of our letters of credit will be transferred to or issued under this new line, which will free up capacity on the revolver and enhance liquidity.
At quarter end, our debt-to-capital ratio of 45.8% improved by 930 basis points as compared to the second quarter of last year, reflecting a $280 million increase in stockholders' equity combined with $500 million of debt reduction.
As we continue to drive improvements in our credit metrics, we have tightened once again our leverage objective from a 35% to 45% net debt-to-capital target to a debt-to-capital ratio within that same range.
While our quarter-end ratio was just above the upper limit of our revised target range, we expect our debt-to-capital ratio to be within this range by year-end.
Along with our return of capital to shareholders in the form of our quarterly dividend, our capital allocation priorities remain consistent with a focus on investment in land assets to grow the business and improve returns, and continue deleveraging the balance sheet to retain earnings growth enhanced by future debt reduction.
In summary, our second quarter highlights included a strong backlog conversion rate driving over $1 billion in housing revenues, a measurable increase in community count and a healthy sales pace per community contributing to a 15% year-over-year increase in net orders, a sequential expansion of our operating margin and a significant improvement in our debt-to-capital ratio to 45.8%.
We believe that our expanded community count and solid quarter-end backlog value position us to achieve growth in housing revenues and improvement in both our gross and operating margins during the second half of this year. We will now take your questions. Devon, please open the lines..
Thank you. At this time, we will conduct a question-and-answer session. [Operator Instructions] Our first question comes from the line of Alan Ratner with Zelman & Associates. Please proceed with your questions..
Hey, guys, good afternoon. Congrats, really great results. So, first question, I was hoping you might be able to talk a little bit about what you're seeing on the incentive environment. I think there's a lot of confusion out there right now on exactly what's going on.
I mean, you have a few builders talking about incentives coming down, but it sounds like they're still at fairly elevated levels across the industry. At the same time, I look at your absorption numbers and they're extremely strong, and it would seem like you should have some pricing power at that type of a sales pace.
So do you have an ability to push price now? Or are you kind of being a little bit conservative there just given how many communities you're opening up? And just any general commentary you could have on that front would be great..
So Alan thanks for the recognition on the quarter. As you know, our business model doesn't really focus much on incentives. We believe in offering the consumer the best value and price and then personalization in our Studios. So we don't have a heavy incentive business model.
We did -- there is some closing cost we pay in certain communities where the buyers may not have the cash to close without it. I think in the quarter, our sales incentives were up 30 bps, was it Jeff? Up 30 bps sequentially, so it's not a big mover for us. I think the markets are pretty rational.
I do think overall the industry is backing off of their incentives or pushing price. And as we look at our communities, we did raise price during the quarter in the majority of our communities, so we were able to take some price, while holding the fairly strong absorption rate..
Great.
And I assume that -- would that kind of continue through the quarter through May and into June? Or did you see kind of progressively that the pricing power improving through that period?.
Well, I don't want to talk June, because we're just closing the second quarter. But within our second quarter, I would say it was pretty consistent through the quarter. We manage each asset every week based on how our sales are going. And if we have an opportunity to take price, we'll take price.
If the community where sales are a little softer, we won't take price. I would say it was fairly consistent through the quarter. As we shared in our prepared remarks, we did see our sales strengthening sequentially from March to April to May..
Got it. That's very helpful. Second question if I could just for Jeff K. Thank you for the updated targets on the leverage and the goals there. You guys have been incredibly opportunistic through this cycle with buybacks especially when your stock is seemingly disconnected with reality.
And it would seem like, we're kind of entering one of those periods right now, stocks back below book value and in the face of what I perceive to be extremely strong results.
So can you talk about a little bit just the willingness or the opportunity there to maybe deviate a little bit from that target? If the stock remains at these low levels for an extended period of time, would you be willing to do a similar buyback like you've done in the past?.
Right. Well, let's first talk about the target level. I mean, it's a pretty wide range, right? It's 35% to 45%. We're just above the range right now at the end of the second quarter. And with just retained earnings growth alone by the end of the year, we could clearly see that to be well within it. It is a wide range for a reason.
It's there to allow us flexibility on capital allocation decisions as we go forward due to market conditions. But as you know, I think, you're using the right words with our stock buybacks in the past. They have been opportunistic buybacks. They're not -- it's not a scheduled program at this point.
We're still focused on our two main capital priorities, capital allocation priorities of growing the business and improving our returns as well as getting the leverage in place.
But we've been opportunistic in the past and with fairly modest buybacks at certain points in time and I'd say we'd still be open to that, but no prediction of where we're going with it at this point..
Great. And if I could just go back real quickly, just to clarify something that Jeff M. said on the incentives, I just want to clarify it. I think you mentioned incentives were up. I assume that's on closings, not on orders, so a little bit of a backward-looking data point there..
Correct..
Okay, got it. Thanks guys, good luck..
Our next question comes from the line of Stephen East with Wells Fargo. Please proceed with your question..
Hi, good afternoon guys. This is actually Truman Patterson on for Stephen. Nice quarter. Thanks for clearing up the incentive commentary. I realize, you guys don't use a lot of incentives, but you said the pricing was up in the majority of communities.
Is there any way you guys might be able to quantify the magnitude of that improvement from first quarter to second or maybe the percentage of the communities that you actually saw some base pricing power?.
Truman, it's very hard to quantify that because every asset is unique and it could be $1000 on a $500000 house or $5000 on a $300000 house. It just depends on how the community is pacing. And I think a part we're sharing, we expect margin improvement going forward and part of that is the price that we've been able to take..
Okay. Okay. Thanks. That actuallysegues nice into my follow-up. Just a little bit more clarity on the gross margin ramp in the back half of 2019, it seems like a little bit of that is just a little bit better pricing if you will.
But could you maybe walk us through the moving parts, because it seems like there's a pretty nice ramp in the back half of the year that hit your guidance, anyway you can just walk us through the moving parts to get investors comfortable?.
Sure. Yes. There are several things that are coming into play there. I mean the one -- and we should never lose sight of the mix impact that you see in all this. We have a fairly large change in our portfolio.
As I mentioned during the prepared remarks, I think Jeff mentioned as well, we opened 123 new communities since the end of the second quarter of last year. That was on a base of 210. So we ended the second quarter last year 210 communities opened 123 new and closeout of 78.
So there's been a pretty large churn in communities that we're selling out of right now that will provide third and fourth quarter deliveries. On top of that, when you look at some of the tailwinds that we have, we should continue to enjoy some year-over-year positives from the improvements that we've implemented in our capital structure.
So the lower interest incurred is now coming through in lower amortized interest and we expect to see more of that as we go through the rest of the year. And the new community openings themselves should be providing a higher uptick in gross margins in a lot of those communities.
And a lot of those communities are actually replacing reactivated communities at lower-margin levels. So we'll see some impact from that as well. So when you roll it all up, we do expect to see two quarters of sequential improvement and a full fiscal year that will be in that 17.9% to 18.5% range..
Our next question comes from the line of Nishu Sood with Deutsche Bank. Please proceed with your question..
Thank you. The absorption pace was really strong in the second quarter. And at the end of March, you had anticipated that it would be similar to 2017, the second quarter in 2017 which would imply kind of continued down double-digit pace as you saw and the housing market was weaker.
What changed so dramatically? I mean it implies a really serious ramp in April and May. Just wanted to understand the drivers of that where there successful grand openings? Jeff K, you were just mentioning how many communities you've opened.
Did that boost the absorptions? What changed so dramatically from the end of March?.
Well Nishu, I can make a couple of comments and then turn it to Jeff. At the time we guided on the absorption pace, we were early in the spring, so it's still unclear to us how strong the spring would be. And we also had the variable of so many communities yet to open and you wonder if the communities are going to hit as expected and as planned.
And for the most part the community openings hit and -- but I wouldn't just attribute it to that. Our overall sales rate around the system was pretty good. We target strategically to optimize our assets. We target about four a month on average.
You have to do better than four in your strongest selling part of the year which is right now, so that 5.4 is right on track for us to optimize the asset.
Anything else you want to add?.
Yes. Just, as we move through the quarter, we saw a pretty nice ramp. I mean when we were doing the call and at the time of the call, we were actually only up single digit over the prior year, so that was tracking about the 2017 consumption pace. And it just started picking up and getting progressively better as we enter the quarter.
As Jeff mentioned, the new communities performed very well. And importantly, a large proportion of them opened when they were supposed to open and we had a lot of openings in the quarter. I think, we said last call that we were expecting to open over 35 and we ended up opening 43 new communities, so that helped us well.
But I think just general market conditions, the way we had our product positioned, I think some of the changes we made in positioning and modifying the product has helped and we're right price point at the right place at the right time and we did really well on sales as a result..
Got it. No that's really encouraging. And I think -- I think I know you're not commenting on June in particular.
But as we think about some of the factors that you described, how should we think about the sustainability of some of those factors? Is there going to be a continued rate of new community openings which might impact it? Or say sequential trends, would you be able to expect them to continue? The third quarter of last year had a pretty nice absorption pace as well.
So I guess what it boils down to is would you expect to be able to sustain or meet that rate in the third quarter..
Nishu, you're correct. We don't want to talk about the third quarter. My expectation is that we'll see the normal seasonal trends that you typically see from Q2 to Q3. We don't see any storm clouds on the horizon in the housing markets because there's no inventory, rates are low and people out there looking and buying.
So I think you'll see the normal seasonal trends. We do have a lot of openings still coming at us here in the third quarter and we're hopeful that we produce nice sales numbers as the quarter rolls through..
Our next question comes from the line of Matthew Bouley with Barclays. Please proceed with your question..
Hi, this is actually Christina Chiu on for Matt. Thanks for taking the question. And just looking at California you had an 18% order growth. And I was wondering if you could elaborate and provide more color on what caused the strength there and what you're expecting regionally in the back half of the year..
Okay. Christina I can make a few comments and then Jeff can offer some more. As we shared in the prepared comments, Northern Cal overall did very well. And if you look at the inland areas I touched on our L.A. business Inland Empire, Central Valley, Sacramento, they're all very good right now. In the Bay Area, we're bridging through this.
We had a slowdown in community count as we've successfully sold through a lot of high-priced margin communities last year and it's taken some time to reload and get the new communities open. And that's what we started to see in our order results here in Q2. The expected openings hit.
And while it's higher priced on average than anywhere else we operate in the state it's still at a low price relative to the Bay Area and I think that's why you saw some strong sales. As we shared in the Bay Area, we're on the affordable side and there's such a shortage of housing up there. The price points are compelling.
When you move down to Southern Cal coastal is a small business for us. We want to grow it but it's still a little soft and it's the higher priced goods. The -- our view on that market is it held steady that sales rates are similar. We're not seeing pricing pressure. So, price is holding. It's just not as robust as the inland areas are.
And because prices are holding, it's continuing to fuel a lot of demand out in the more affordable inland areas of Southern Cal. So, overall we're pleased with what we're seeing in California right now..
Got it. Thanks.
And then given your lot position at this stage of the year nearly 55,000 lots, are you comfortable highlighting at least directionally what community count growth could look like beyond 2019?.
Not at this point. We really try not to get too far out ahead on things like that as far as guidance goes we're seeing obviously a really nice cadence this year. We've been very successful in opening communities. And I'll say actually relatively on time at least within the same quarters is what we plan.
And we're looking forward to the next couple of quarters of year-over-year growth. And we'll bubble up again later in the year and give you guys more guidance on what 2020 is going to look like..
Our next question comes from the line of Stephen Kim with Evercore ISI. Please proceed with your question..
Yes, thanks very much guys and thanks for all the color and good job in the quarter. Your guidance is really interesting obviously because it suggests a nice margin ramp and I want to talk about that for a sec. One of the things we get a lot is people wondering whether there's a lag effect from rates.
And as we think about that, your build-to-order business model which seemed to be well teed up to capture a drop in rates that happens maybe better than guys that do more spec building because the fellows who decide to sign on the dotted line and buy one of your homes little time goes by and all of a sudden they can afford more and they can cut back and maybe buy some more goodies to stick in the house.
And so I was curious as to just generally have you seen that? And is there any way that you can quantify the delta between the price that you initially sell the house at and what you ultimately are closing the house at? Is that a delta that you can monitor? Is that -- has it widened in the last few months? And do you project it to widen in the next several months?.
Well, Stephen, I guess, a few things just on the business model itself. We try to lock in all the option and choices before starting the house. And in fact we don't try to that's what we do do. So, we actually require the customers to lock in on their options before start.
So, you don't really see a creep in the price of the house once we're under construction. That's the one way we're able to really still build efficiently and not -- and stay away from the customization and more towards the personalization part of our strategy. So, that's one point.
The second I think when you look at what happens with the lower rate environment you certainly would see less cancellations. If rates were moving up, you could potentially see some cans coming out of the inability to still qualify for a loan at the new rate.
Our cancellations ticked down three points or so this quarter which I think was an indication partially of that anyway so that's a good thing. But I think overall the strength of the market and the build-to-order approach I think definitely has a lot to do with our strong sales base.
And you see it almost every quarter with our pace versus the rest of the industry; we're always one of the highest sales paces in the quarter. And I think a lot of that's a result of customers like the ability to personalize their homes and they like the business model.
So, I think that -- I'm not sure it gets right to the answer to your question or right to your question, but that's kind of what we're seeing right now in the market..
Yes. I guess the only difference would be if there's maybe a couple of weeks or maybe a three-week lag between when you take the order and when you actually start the house. I imagine it's not too great a period of time though, so that probably isn't a huge factor.
Could you talk a little bit then about what you're seeing in your margins as we look -- I'm drilling into this very nice ramp you seem to be forecasting for your gross margin into the fourth quarter implied through your year in the 3Q guide you've given? Can you talk a little bit about what you're seeing in terms of input costs that are informing your view on that -- your margin for the year relative to the 3Q margin that you talked about, particularly I'm thinking lumber.
Are you anticipating that you're going to see a benefit all the way through your fourth quarter before the spike in lumber futures that we've just seen maybe weighs on your 1Q of next year? Just trying to get a sense for input cost inflation movements..
Sure. Yes the input cost side is pretty good news for us. We just had our second consecutive quarter of decreases in the input cost. And we talked about it in a lot of conference calls in the past; we use an index approach to it.
We think it's probably the cleanest way to show it where you're taking out factors like square footage differences and things like that. So, we'll index the house. And we'll calculate what that indexed house will build for at a point in time and then we'll compare that index to the same house indexed at a later point in time.
So, if you can compare end of the second quarter to end of the year, we're actually down 1.1% in our budget for that indexed house. And I think where that's coming from is a couple factors.
One certainly the lumber cost decreases have been there and have helped that and they've also helped to offset what we view as somewhat moderate increases in other input costs. And we think there's been some moderation due to the market pause in the fourth quarter and the first quarter.
So, the one good part of the market pause is we felt that we've experienced some moderation in increases. On a year-over-year basis, our largest decreases or advantages favorable to margin came in obviously to the lumber category.
In the drywall category, net offset increases in a few of the other commodity categories like cement, roofing, and plumbing. On a year-over-year basis we're actually also down, less than 1% down, but still down on a year-over-year basis. So, the input story -- the input cost story for us has been pretty favorable. Obviously, there's a few watch-outs.
You have the whole tariff issue. That's a watch-out for us. And as you pointed out the increase in the lumber's futures is also a watch-out.
But because we are in look-back pricing and we obviously crossed out the house at the point in time when we frame it, we do think there's still more favorability coming from lumber before any potential downside that we could experience by the end of the year depending what the market does..
Our next question comes of the line of Mike Dahl with RBC Capital Markets. Please proceed with your question..
Hi, thanks for taking my questions and nice results. I wanted to start on the order side. And one of the things that you guys have been pretty vocal about and proactive about is kind of the shift to smaller floor plans and at least introducing smaller plan options into newer communities.
So I wanted to ask if even anecdotally you can give us any update or color on, how those smaller floor plans are performing or performed through the quarter. Presumably to get this type of order number, it had to be fairly broad-based, but just wondering if you could give us anything specific on the newer plan options..
Mike, as I shared in the comments, our sales were up double-digit in every region. So it definitely was broad-based in the strength of the sales. We've introduced smaller plans. We've modeled them in many locations. Coincident with that shift, we had a drop in interest rates. So I think it's tempered the need a little bit if you will.
We are seeing with a lower advertised price that we're drawn in a bigger pool of buyers, where they're coming in and may not have thought they could afford it. And then they get in and once they understand what they qualified for they'll move to a little bit larger home, so it is helping to expand our marketing and create a bigger pool.
Our sales in the quarter on the unstarted homes, so our presale square footage ticked down just incrementally. It could be just a function of mix by market. So I wouldn't call it a trend yet and we're certainly monitoring it. So it's helped us from a marketing standpoint. But with the rate decline people will move up to the biggest home they can afford.
And we are well positioned for when -- whenever rates do go back up we're already there..
Right. Okay. Yes. Helpful and that makes sense. And then second question just around margins. And Jeff K. I think you kind of alluded to a couple of different things helping you to kind of bridge to the year-end an implied 4Q margin which makes sense, but I wanted to follow up and try to get a little more quantification of two of the issues.
One, you've continued to benefit from the lower interest amortization, so any update on how to think about that delta as we move through the year? And then the second part, you mentioned reactivated communities that mix starting to kind of be reduced and help your margins by year-end. I thought of that as more of a 2020 occurrence.
Can you just help us -- how much is that starting to help by the end of this year and how to think about that potential support as that mix continues to decline of the reactivated communities?.
Right. Okay, let's -- we'll take the interest amortization first, because that's probably the simpler and more straightforward. We talked about during last quarter's call that we expected year-over-year benefit in interest amortization of between 80 and 100 basis points per quarter for the full year. In the first quarter, we were up 100.
This quarter we were 80. And we still expect to be within that same range the next two quarters, so 80 to 100 basis points per quarter year-over-year is still a good number.
On the reactivated communities, what you see there is, you definitely see a lag from the point in time when they enter community count or when the community count starts declining to when it's actually running through the revenues and impacting the overall gross margins.
In the quarter -- in the second quarter, we really didn't see any benefit from the prior year, because we had a fairly high revenue number coming from reactivated communities, partially because of the strong sales that we saw relative to last year in those communities. So it was pretty well even with the prior year.
We do expect to see some incremental improvement by the fourth quarter as the count continues to decline. But I would say, you are correct in saying that most of that improvement we'll see yet in 2020, which will be nice, because there'll be another tailwind or a continued tailwind for us as we get into the next fiscal year..
Our next question comes from the line of John Lovallo with Bank of America Merrill Lynch. Please proceed with your question..
Hey, guys, thank you for fitting me in here. First question, Jeff K., you brought up tariffs. I'm just curious, it seems like to me that that would be a pretty small impact. I mean, I think one of your competitors just laid out something like $500 per home.
I was wondering if you guys maybe had an estimate through List one, two, three and then maybe if -- on List four us as well?.
We -- I would say at this point, we're really not seeing any impact, any material impact at all on our cost. It may be being absorbed through the supply chain or we may be seeing certain increases here and there that are getting offset by others, but it hasn't been significant for us to even be all that focused on at this point..
Okay. Yes, that's encouraging. And then, clearly, demand is getting a little bit better here. And it's been I think it's been largely focused at lower price points.
Have you guys seen any improvement though at -- as we move up the price point spectrum, are you starting to see increasing demand like kind of the first maybe even second-time move-up?.
John, I think the comment that there's strong demand at the price points that we operate at; our first move-up communities are hitting their pro formas just like our entry level. We don't have as many first move-up and very little, if any second move-up even come to mind for me right now.
So we'll be -- we're watchful of what happens to pricing in the markets. My general sense is the higher-priced goods are a softer demand than the price points that we operate at. But our first move-up programs are selling well too..
Our next question comes from the line of Mike Rehaut with JPMorgan. Please proceed with your question..
Hi, good afternoon. Thanks for taking my question and congrats on the results. First question, I just wanted to circle back if I could to the sales pace. I think that was really one of the big upside surprises relative to your prior expectation. Again, that 2Q sales pace you had originally expected would match 2017 and instead it roughly matched 2018.
So in your prior answer, you talked about a few different factors, but it just seemed the answer itself that you gave was just more kind of generic in terms of yes things just overall performed a little bit better.
I guess, I just wanted to make sure from my perspective or maybe from investors' perspective, I think the initial reaction would be wow those new communities really did perform a lot better or -- and perhaps there was a -- between that and the combination of some conservatism that that was really the ultimate driver there.
And oftentimes, when you have new community openings, you really want these new communities to start off strong and they can be an outsized contribution to results.
So, I'm just trying to -- I just wanted to ask if I speaking about that correctly, or by contrast, was there some region or regions that really just kind of -- the switch flipped back on and you really just had some disproportionate strength from some regions recovering a lot better than you might have expected a few months ago?.
Mike, I can say a couple things. You're not totally correct on the it's just coming from the new communities. It's a frustrating statistic for me to share our average community count, because it could be open for one month two months three months or one day in the quarter.
And it's really a 90-day lag before the communities blend in and really start to gain strong momentum. So if it opened in March, it may have served a full quarter. But the communities we opened in mid-May didn't drive that absorption up.
And if you think of it from a math perspective, you got 255 communities and yet 43 openings and you still average the same as the year before that tells you that the existing communities that were already open performed well to hit that kind of an average.
If you look at it regionally, the one I would highlight is California, where we typically have a higher sales pace per community on average, because you have to turn a bigger asset base with the community count growth there and the sales rate that we saw in California that they again lifted our company average..
Yeah, Mike the other thing; I think Jeff was saying, we did see across-the-board improvement. It doesn't mean every single community in every market but it was pretty broad-based for the quarter. I think a lot of it is just the business model and where we're competing.
I mean, you read it all over the place with the industry news about the return of first-time buyer and the entry level picking up and being at the right price point is very important.
And the company stayed very disciplined over the last several years especially as we were rebuilding community count to make sure we were putting communities on the ground that met those parameters. And it's very natural for our company to operate in that space. It's been a strategy of the company for a long time.
So for me it was gratifying I guess to see the results at the end of the quarter, coming off some of the base communities that we've had in the ground for a long time as well as for the new communities. But Jeff said it right, I mean we opened 43 communities and there were not many of them that were opened for 13 weeks.
And they would average into the count at 21.5 because we're zero at the beginning and 43 at the end and two-point average, so that they certainly didn't drag us down. But I don't think that you could have point to that as saying that was a single point of focus.
But that said, we are pleased with how they're performing and hope the rest of the communities we open this year perform equally as well..
No that's great. I appreciate that. I guess, secondly shifting to the gross margins and obviously you reiterated your outlook for improvement there. As we think about 3Q and 4Q, I think the math would work more or less that you’d have perhaps even a little bit of a greater sequential improvement, it seems like.
If I'm kind of getting to the midpoints of your guidance ranges, let's see yeah maybe perhaps equal to or a little bit better of a sequential improvement in 4Q versus 3Q at least let's say a similar amount of improvement. So I'm just trying to get a sense -- yeah. So I'm just trying to get a sense -- okay. Good, good.
So I'm just trying to get a sense for as you look for the drivers of those improvements, would you say its equal parts revenue leverage and mix? Or I guess how would you rank order the drivers of that improvement as it relates to across let's say operating leverage if mix is a contributor and obviously input cost with lumbar and such?.
Sure. Let's start right up top right and let you guys know how we come up with our guidance ranges and how we actually estimate and forecast the rest of the year. And you could start with our backlog value.
I mean, we had about $2.2 billion in backlog at the end of the second quarter, which is a pretty high percentage of our expected third and fourth quarter revenues. So we've already priced that product. We already have budgets on the cost. We know the land cost.
We know about what the studio ad will be, some of those -- some of that backlog hasn't benched through the studio process yet.
But we know on average about what that takes and we basically just forecast out our deliveries on a community-by-community, division-by-division, region-by-region on a total company basis and roll off the margins coming off of that. We're getting, obviously, more confident in the ability to forecast.
This is the first time we've gone out to the full year. Because of the backlog and because of the quarter we just had and because of what we saw during the spring selling season, we definitely have a higher level of confidence in the guidance ranges that we have out there and what we're seeing.
As far as the gross margin specifically, certainly we always see better leverage in the back half of the year in the third and fourth quarters and this year is no exception. We do expect to see some pickup from higher top line revenues, leveraging the fixed cost that we have in cost of sales.
And the remainder of that, exactly as you outlined does come from mix. And not the least of which is we expect to see a higher West Coast mix later in the year where we typically do carry higher margins and we have some pretty high margin communities coming to market that will be delivering out in the fourth quarter, so all of that's helpful.
And we're pretty encouraged by the year and we like the progression. Certainly after some pretty tough market conditions in the fourth quarter in early first quarter, it was welcomed to see the market come back to us in the second quarter.
And to be able to build that level of backlog and have the visibility out for the rest of the year is important for our business model..
Our next question comes from the line of Scott Schrier with Citi. Please proceed with your question..
Hi, good afternoon. I wanted to ask a little bit more on the conversions to the smaller floor plans, understanding about the lower rates.
Does the lower number and the other math of costs, does that make it maybe a little more efficient to try to push more of the larger plans? How flexible are you in your communities to shift around the number of smaller plans that you had to -- as you alluded to earlier as more of a marketing tool to bring people in? And how do you think about keeping the smaller plan in the community versus potentially going back to the larger plans versus the smaller plan but possibly get more out of the design studio from both lower rates and then from your perspective the trend that you've seen in input cost and the efficiencies associated with that?.
Well, you bring up an interesting topic. And what we try to toggle, we use the term bracket to median income. We try to make our product attainable by the median income in that ZIP code. And we'll look at the median income and then how can we position the product to make the most money per lot that can be attainable for the median income.
So over here in the higher income area the smallest model may be 1,800 square feet. And over here it may be 1,200 square feet. And the beauty of this for us is that it's the buyer picking it, not us building it and then selling. So we constantly are tracking, which end of the footage spectrum the buyers are tilting to in a community.
If they're tilting up big, we'll push the price. We may introduce an even bigger home. If they're moving to the smaller products you push the price the best you can and everything in between. So it's pretty fluid each week in every community that's out there but we go to -- optimize how much money can we make on every lot..
Got it. And then on a year-to-date basis, it looks like your Southwest; your Southeast ASPs are up quite a bit year-on-year.
Can you talk about some of the drivers whether there's any granularity into the different mix or regional considerations or potentially on a like-for-like basis how much pricing you're able to get in some of those regions?.
Right. So you're speaking -- you said Southeast and Southwest, right? Yeah, they're both up. The -- there's a little bit of division mix particularly in the Southwest where our ASPs in the Vegas market are higher than our ASPs in the Arizona market.
And they've accelerated by a higher pace as well for the year, so most of that came out of the Vegas market in the Southwest. In the Southeast, you see it pretty much across Florida and even in the Carolinas in our business there where a lot of that is just replacement communities probably at a higher price point.
I don't think -- when you look at it, we couldn't say we got 6.4% price increase in the Southeast on a year-over-year basis but there's definitely some price in there along with community mix. Outside of that, I don't know if I could get any more granular detailed on -- than that high level for you..
Ladies and gentlemen, we have reached the end of our question-and-answer session as well as today’s teleconference. I would like to thank you for your participation. You may now disconnect your lines at this time and have a wonderful day..