Hovnanian Enterprises, Inc. (HOV) Q2 2018 Earnings Report, Transcript and Summary

Good morning and thank you for joining us today on the Hovnanian Enterprises Fiscal 2018 Second Quarter Earnings Conference Call. An archive of this webcast will be available after the completion of the call and run for 12 months. This conference is being recorded for a rebroadcast and all participants are currently in a listen-only mode. [Operator Instructions] Management will make some opening remarks about the second quarter results, and then open it up for questions. The company will also be webcasting a slide presentation along with the opening comments from management. The slides are available on the Investors Page of the company's website at www.khov.com. Those listeners who would like to follow along should log on to the Web site at this time. Before we begin, I would like to turn the call over to Jeff O'Keefe, Vice President, Investor Relations. Jeff, please go ahead.

Thank you, Kevin, and thank you all for participating in this morning's call to review the results for our second quarter, which ended April 30, 2018. All statements in this conference call that are not historical facts should be considered as forward-looking statements within the meaning of the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. Such forward-looking statements include, but are not limited to, statements related to the company's goals and expectations with respect to its financial results for future financial periods. Although, we believe that our plans, intentions and expectations reflected in or suggested by such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved. By their nature, forward-looking statements speak only as of the date they are made, are not guarantees of future performance or results and are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as a result of a variety of factors. Such risks, uncertainties and others are described in detail in the sections, entitled Risk Factors and Management's Discussion and Analysis, particularly the portion of MD&A entitled Safe Harbor statement in our annual report on Form 10-K for the fiscal year ended October 31, 2017, and subsequent filings with the Securities and Exchange Commission. Except as otherwise required by applicable security laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances or any other reason. Joining me today from the company are Ara Hovnanian, Chairman, President and CEO; Larry Sorsby, Executive Vice President and CFO; Brad O'Connor, Vice President, Chief Accounting Officer and Controller; and David Bachstetter, Vice President, Finance and Treasurer. I'll now turn the call over to Ara. Ara, go ahead.

Thanks Jeff. As is typical, I'm going to review the operating results for the second quarter. Larry will follow me with more detail on our progress in land acquisitions and discuss a few other items including our liquidity position and some multi-year targets on key metrics. At the risk of sounding like a broken record, I want to take a moment to remind you about the impact from our debt that matured from October 15 through May 16 because the high yield markets rapidly closed to all Triple C issuers back then we had to use $320 million of liquidity to retire this debt instead of investing in land for our future communities which had previously been our plan. The land we should have been controlling at that point in time would have resulted in communities that would be opening and delivering today. After working our way through those debt maturities we began to re-enter the land market again in the latter part of fiscal '16, but unfortunately it's not something we can just kick start right away. It takes time. We are however making progress on growing our land supply. The second quarter of 2018 was the second consecutive quarter that we had year-over-year increases in the consolidated lots that we control. However, because there is a lag effect between controlling land and opening a community for sale, our second quarter financial performance was still hampered by our lower community count, which caused the number of deliveries and our year-over-year revenues to decline. Turning to Slide 4, here you can see that our total revenues decreased during the second quarter of 2018 from $586 million last year. The improved sales per community slightly offset the drop in our community count. Now turning to Slide 5, in the top left-hand portion of the slide you can see that our gross margin of 17.7% for the second quarter of '18 improved 120 basis points from 16.5% in last year's second quarter. Despite increases in material and labor costs over the last few years, we have reported year-over-year increases in gross margin in five out of the last six quarters. In the upper right-hand portion of the slide, you can see that our total SG&A dollars were flat year-over-year. However, due to the decline in revenues our total SG&A as a percentage of total revenues was 12.3% in this year in the second quarter compared to 10.5% in last year's second quarter. Total interest was slightly higher on a dollar basis during the second quarter at $45 million compared to $43 million last year. And finally, in the lower right-hand portion of the slide, we show that our loss before income taxes, land related charges and loss on extinguishment of debt was slightly less this year at $5 million compared to $6 million last year. Growing the top-line is a critical component of our strategy to improving our financial performance. We believe we have to maintain our SG&A right now in order to grow our community count. Once we begin to grow our community count there will be a lag before we see the efficiency effect it has on lowering our SG&A ratio. This lag occurs because we incur the SG&A expenses for acquiring, planning and opening new communities well ahead of achieving deliveries or revenues from those communities. This is the position we find ourselves in today and is causing our SG&A ratio to be higher than our normal 10% range. Achieving community count growth will lead to revenue growth; will generate operating leverage and significant improvements to our future profitability. This next slide illustrates the power of growing the top-line. And Larry will demonstrate the power of revenue growth even further in his comments. Turning to Slide 6, we show a sequential comparison from the first quarter of 2018 to the second quarter of 2018 to illustrate the power of the growth in revenues. This slide shows that as we sequentially increased our top-line we leveraged our fixed costs. In the upper left-hand corner of the slide, you can see that our total revenues increased 20% from the first quarter of 2018 to the second quarter of 2018. This growth was primarily driven by a 19% increase sequentially in deliveries. Moving to the upper right-hand portion of the slide, our total SG&A as a percentage of total revenues improved sequentially by 260 basis points from 12.3% for the second quarter, excuse me to 12.3% for the second quarter from 14.9% in the first quarter. In the lower left- hand portion of the slide, you can also see that our total interest expense as a percentage of total revenues improved 90 basis points to 9% from 9.9% in the first quarter. The results of these improvements can be seen in the lower right-hand portion of the slide where we show the adjusted pre-tax loss decreased by $25 million for the second quarter. In summary, we saw the typical seasonal pick up in deliveries and in revenues from the first quarter to the second quarter and the result was a significant improvement in our financial performance. Now needless to say this is the right movement directionally, but we still need even more growth in order to secure a consistent quarterly growth in our profits. Assuming no changes in the current market conditions during the second half of fiscal '19, we expect to be reporting year-over-year growth in revenues. But we want to use this example to illustrate the operating leverage revenue growth can provide. In the interim, even with the lower current community count, we expect our fourth quarter of this year to be solidly profitable. While the results for the second quarter of fiscal '18 were in line with our expectations. We recognize the fact that we need to grow our top-line in order to improve our current levels of profitability. Our land acquisition teams are very busy around the company replenishing and is working hard to improve our land position. And Larry will talk a little bit more about that in a moment. But first let me take a moment to comment briefly on our sales activity. On Slide 7, we show our contracts per community on a monthly basis. Here we show the most recent months in blue and the same month a year ago in grey. For 11 of the past 12 months current contracts per community were equal to or better than the same month of the prior year. The 3.9 contracts per community we have for the months of April in both '18 and '17 were the most for any month since September of '07, which is before the great housing recession. The month of March was not far behind at 3.8 contracts per community. Our most recent month of May of '18 showed a continued positive trend with contracts per community of 3.6 compared to 3.4 in May of '17. I've already mentioned the declines in our community count, but if you turn to Slide 8, you can see the trend in our community count since the beginning of '16. Once again, primarily due to the steps we have to take in 2016 to retire $320 million of maturing debt, our community count decreased sequentially through '16 and '17. It does appear that we're now bouncing along the bottom and we continue to expect our community count to begin to improve sequentially during the first half fiscal '19. Needless to say the decline of community count trend has negatively impacted our total revenues and profitability. The fact that our contracts per community have been increasing over that same time period has partially offset the impact of the lower community count level. On top of each quarter of this slide, we show an arrow with year-over-year percentage increases in contracts per community for those same quarters. On the right-hand portion of the slide, we show our contract per community increased again during the second quarter of '18 rising 9% year-over-year. We reported increases in contracts per community for each of the ten quarters shown on this slide. While we continue to make steady year-over-year improvements contracts per community are still well below our normal levels. You can see this on Slide number 9. On the left, we show our annual contracts per community average 44 from '97 to '02, again the time that was neither boom or bust in the housing market. On the right-hand portion of the slide, you can clearly see the steady growth in contracts per community each year for the past several years. This includes the most recent 12-month period compared to the same period a year ago shown on the right-hand portion of the slide. We do anticipate that as demand returns to normal levels contract per community should also return to more normal levels. Ultimately combining contracts per community rising to normal levels with the growth in our community count will have powerful effects for our company. I will now turn it over to Larry Sorsby, our Executive Vice President and Chief Financial Officer.

Thanks Ara. I'll start by updating you on our efforts to control more land which foreshadows an increase in our community count. The first step is increasing our land control position year-over-year which we accomplished during both the first and second quarters of 2018. After we have the land under control except for cases -- for the cases where we control finished lots, we have to develop the raw land and build an open model homes for sale. So there's a normal lag time between contracting for a parcel land and opening a community for sale. We continue to believe the sustainable community count grow should begin to occur in the first half of 2019. Our land acquisition teams have been very busy throughout the country as we continue to work hard to replenish and grow our land supply. During the second quarter we spent $126 million on land and land development which is higher than the $100 million that we spent during the same quarter one year ago. On Slide 10, you can see that for the first half of fiscal 2018 we added 3637 newly controlled lots and delivered 2429 homes and lots resulting in an increase of 1208 controlled lots, further demonstrating the significance of our growing land position. Year-to-date our newly controlled lots equaled 150% of our year-to-date home deliveries. Throughout fiscal 2018, we've made good progress in rebuilding our land supply. We remain disciplined to our underwriting standards, underwriting assumptions use current home sales price, current sales pace, current cost. Historically during periods of a recovering housing market home sale prices increased more than cost. While we continue to believe that they occur further this cycle our budgets don't assume that benefit. There is a significant lag from the initial contract to the time when the community opens for sale and ultimately when we can deliver homes. This time lag vary from a few months in a market like Houston to three or five years in markets like California and New Jersey. Once our community count begins to grow delivery and revenue growth will follow a few quarters later. Based on our current land pipeline, during our third quarter, we expect to once again gain control of significantly more lots than expected third quarter home deliveries. While we're pleased to report an increase in our lot supply, we recognize there's still more work to do. We remain focused on replenishing our land supply even further so we can return to growing our community counts revenues and profitability. Many investors mistakenly believe that the majority of our land options are held by land banks which certainly is not the case. As of the end of the second quarter of fiscal 2018, we control 13,949 lots through option contracts. As you can see on Slide 11, only 7% of our auction lots are currently with land banks. Land banking for us peaked at 16% of our total lot options at the end of the third quarter of fiscal 2016 and compares to 10% at the end of last year second quarter. Although supply in terms for land banking transactions have been improving, we simply have not had the liquidity needs as of late to aggressively pursue them. As we find more acquisition opportunities to invest in land, we will likely begin to land bank some of the larger parcels. Looking at all of our consolidated communities in the aggregate including mothballed communities and the $79 million of inventory not owned, we have an inventory book value of $1 billion net of $280 million of impairments. We believe one of the key peer operating metrics for the homebuilding industry is EBIT inventory. This method neutralizes the impact of debt. On Slide 12, we show the trailing 12-month EBIT inventory for us and our peers. This ROI metric measures peer operating performance before interest expense. Despite our challenging community count, we remain in the top half when compared to our peers. We and the entire industry are still not at normalized ROI levels yet, but we believe this will improve as we get further into the recovery. One of the ways we were able to achieve this is maintaining our focus on inventory turns. Turning to Slide 13, compared to our peers, you see that we have the second highest inventory turnover rate over the trailing 12 months. Although we are below NVR's industry-leading turnover number, our turns are 58% higher than the next highest peer below us. This is a key component of our overall strategy. Another area for discussion is related to our deferred tax asset valuation allowance. Our deferred tax asset is very significant and not currently reflected on our balance sheet. We've taken numerous steps to protect it. At the end of the second quarter of fiscal 2018, our valuation allowance in the aggregate was $662 million. We will not have to pay cash federal income taxes on approximately $2.1 billion of future pre-tax earnings. On Slide 14, we show that we ended the second quarter with a total shareholders deficit of $500 million, if you add back our valuation allowance as we did on this slide then our shareholders equity will be a positive $162 million. Over time, we believe that we can repair our balance sheet and have no current intentions of issuing equity anytime soon. Now let me comment on our current liquidity position. As seen on Slide 15, we ended the second quarter with liquidity of $274 million which is in excess of our liquidity targets between $170 million and $245 million. Even without increasing our use of land banking and model sale leasebacks, we continue to have ample liquidity to increase our land spend. Before I move onto our maturity profile, let me update you on our recent GSO financing and the lawsuit filed by Solus against GSO and Hovnanian. On May 30th, we filed an 8-K announcing that Solus and GSO had entered into a settlement agreement and the Solus litigation against us was dismissed. As part of the settlement, we were allowed to make and we subsequently made the May interest payment to our wholly- owned subsidiary which owns $26 million of our 8% notes. The settlement agreement between GSO and Solus does not involve any payment from Hovnanian. Settlement payments were resolved between Solus and GSO only. Furthermore, the favorable financing and financing commitments to Hovnanian from GSO remain in place. I want to reiterate what we've consistently said since the beginning of these GSO transactions and that is, we are confident we acted properly at all times related to our financing transactions with GSO. We are grateful to GSO who has been a long-term and steadfast business partner for providing us with favorable financing terms last February and additional financial flexibility through financing commitments announced last December. Altogether, this is a very good outcome for Hovnanian and we are pleased with the resolution of this matter. On the top of Slide 16, we show our maturity profile as it look as of April 30, 2018, and on the bottom of the page, we show how it will look upon the funding of the remaining GSO financing commitments. Turning to Slide 17, in late May, we drew down approximately $70 million on the delayed draw portion of our 5% term loan to redeem all of the outstanding 8% notes other than the $26 million held by our wholly-owned subsidiary. The aggregate principle amount of the 8% notes redeemed was approximately $66 million. We have a commitment from GSO for a $125 million senior secured revolver term loan which we anticipate making the first draw in September 2018. We will use this to repay the $75 million super priority secured term loan due in 2019 and the facility provides us with $50 million of incremental liquidity we can reinvest in to land to grow our community counts. Additionally, GSO is committed to providing us in January 2019 with another $25 million of additional liquidity via a tack-on purchase at then current yield for our existing 10.5% senior secured notes due 2024, assuming no changes from yesterday's trading levels, the effective rate would be about 9.6%. We will continue to evaluate our capital structure and explore further ways to improve our financial position. I'm now going to spend the next few minutes discussing our multi-year key metrics targets to help you understand some of our longer term expectations. The targets which are presented in Slide 20 including the assumptions upon which they are based and our accompanying remarks and comments are integrally-related and intended to be presented and understood together given the forward-looking and longer term nature of these targets, you should keep in mind that the information we are showing you sets out our goals for future periods. But a wide range of outcomes is possible and our actual results may differ materially and adversely from our target results due to a variety of factors including those described on Slide 2 and in the section entitled Risk Factors and our most recent annual report on Form 10-K. We do not intend to update these targets and/or provide this type of longer term forward looking information on a regular basis and undertake no obligation to do so. The targets assume no changes in current market conditions and actual results may differ significantly depending on actual market conditions. We've been talking about our need to grow our community count, which in turn is expected to lead to growth in revenues, and then, ultimately growth in profitability. In just a moment, we will lay out what we believe are achievable multiyear key metric targets that we expect we can hit within the next several years provided there are no adverse changes in market conditions. Turning to Slide 18, we get into the multi-year forward looking targets. We wanted to review actual results for the same key metrics from 2013 and 2016 in order to illustrate the growth we can experience over a three year period. Keep in mind, this time period was before the full impact of the bond market becoming unavailable to us which ultimately negatively impacted our community count and financial performance. In just these three years, revenues grew from $1.85 billion to $2.75 billion, our SG&A declined from 11.9% to 9.2%, adjusted EBITDA improved from $180 million to $231 million, and average inventory grew from $833 million to $1.18 billion. Both adjusted EBITDA and pre-tax earnings that may have grown substantially more had we and the industry not run into gross margin headwinds due to significant labor and material cost increases during that time period. Furthermore, we believe if we had been able to refinance rather than retire maturity, the $320 million of debt beginning in October 2015 through May of 2016. The growth trend we were on would likely have continued making us a more profitable homebuilder with a much improved balance sheet today. Now turning to Slide 19, we had results for the trailing 12 months ended April 30, 2018, which reflect the impact of the debt reductions I just mentioned. The end result was an inability to reinvest as much as we planned in new land parcels causing declines in our community count which was the principal factor in revenues falling from about $500 million -- falling about $500 million from $2.75 billion in 2016 to $2.23 billion over the trailing 12 months. This also led to our SG&A ratio increasing from 9.2% in 2016 to 11.6% for the most recent four quarters and resulted in lower levels of EBITDA and pretax profitability. We would normally reduce our SG&A levels to be in line with our revenues. However, today we're confident we're going to be able to grow our revenues which will bring our SG&A ratio back in line with our normalized expectations. On the far right-hand portion of Slide 20, we show our multi-year key metric targets that we believe are achievable during the next few years assuming no improvements or deterioration from current market conditions. This plan is dependent on our ability to purchase additional land parcels and significantly grow our community count. While the market is competitive, we're having success in controlling additional lots as demonstrated by year-to-date controlling 150% more lots than home delivery. As we grow community count, we believe that this would lead to total revenues increasing to about $2.6 billion which is still $100 million lower than the revenues we achieved in 2016. Over time, we believe that our gross margin will approach 20% which for us is a normalized level. In five of the last six quarters, our gross margins have improved year-over-year despite increasing material and labor costs. Keep in mind that as recently as 2013 and 2014, we had reported gross margins of roughly 20% and we confidently believe that we can achieve that level once again. We also believe that over time as a result of increasing revenues, we can get our total SG&A ratio to a more normalized range of 10%. Frankly, as recently as 2016, we were even lower with our SG&A ratio approaching 9%. Up on hitting these targets, we believe that our adjusted EBITDA would be in the ballpark of $275 million and adjusted earnings would be about $100 million. On this slide, we also show that our inventory levels are expected to grow to approximately $1.25 billion. In order to grow to those levels, we plan to first fully invest our excess liquidity; second, invest the incremental financing we will receive from GSO; and lastly increase the utilization of our non-recourse bank financing and model sales leaseback opportunities. In addition, we plan to increase the use of land banking which helps increase our inventory turns. These steps will allow us to leverage our capital and grow our revenues more than we would otherwise be able to do. We also intend to remain focused on inventory turns, but as we're growing our inventory we expect these turns may come down somewhat from current levels. But even turns at 1.7x, which will show the key metric target that is a level still higher than all but one of our homebuilding peers as we showed earlier on Slide 13. Now, I want to turn it back to Ara for a brief closing remarks.

Thanks Larry. I just want to point out that these multi-year key metric targets are non-aggressive assumptions. The revenue growth from the trailing 12 months to the target is about 20% compared to about 50% growth in revenue from 13 to 16. Likewise, the gross margin percentage in total SG&A ratio targets or levels that we have hit in recent years. Furthermore, the inventory churn levels are lower than levels that we've been hitting. We're going to work hard to beat these targets, but we believe that these targets are achievable over the next several years. There's no question this has been a long hard road particularly due to our higher leverage position. We've lagged our peers in recovering from the great housing recession. However, the housing markets are still recovering and we believe our performance can substantially improve in the coming years including a solidly profitable fourth quarter this year. The combination of improving sales per community with more communities, normal gross margin and normal SG&A levels can be very powerful. We've worked hard to minimize any dilution for our shareholders. We believe everybody's patience will be rewarded in the near future. That concludes our formal remarks and we'd be happy to open it up for questions.

The company will now open for questions and answers. [Operator Instructions] Our first question comes from Megan McGrath with MKM Partners.

Good morning. Maybe one long- term question, one short- term question. Thanks for the long-term guidance, in terms of the margin expectations there, you made clear that you're not assuming any difference in market deterioration. So I assume that's also around pricing and input cost. So can you talk a little bit about that, it looks like roughly 200 basis point anticipated improvement in margin. How much of that is just volume leverage and what else is driving that?

Sure. I'll take that Megan. Well, first of all, just a reminder, 20% margin was the level we hit in both 13 and 14. Part of it is the fact that we are comfortable with the market pricing that's been going on. Part of it is the mix in our new land acquisitions. Our older acquisitions were affected by the increasing construction costs. As we purchased new properties, we factored in the then current construction costs and those would generally average about a 20% gross margin. Now, in theory construction costs could increase that would erode it, however, we feel like our home price increases should easily offset whatever construction cost increases we see in the future. That wasn't the case for a few years. Clearly from the bottom of the marketplace when we saw as an industry a big increase in activity there weren't enough vendors, they weren't able to handle those increases in volume. So prices really rose rapidly. We think the big price in cost increases are behind us and we think now it should be more in line with what we've seen historically. So we're comfortable looking forward and setting 20% as a target. And PS, just as a reminder, and this is far -- definitely not in our budgets, but during the peaks of the marketplace and happened in the last peak we had gross margins of 25% to 26%. So we certainly think a 20% is a reasonable target.

Okay. Thanks. That's helpful. And then, a little follow-up on the quarter in terms of the absorption pace. You had a pretty meaningful difference between the absorption pace on a fully consolidated basis and including the JV. So, I just wanted to get a little bit of color there, was that a regional difference, is there some thing specific happening with the JVs that is pushing that absorption pace a little higher. What about a little bit more color there?

I think Megan that's just a mix issue. We certainly don't put particular product types or particular geographies in JVs one way or the other, it's just a mix of where they are geographically and product type wise that led to that. I don't think there's anything you can -- any conclusion you can draw from it.

Okay. Thanks.

Our next question comes from Thomas Maguire with Zelman Associates.

Hey guys, nice job on incremental improvement in the quarter. On the land side, good to see a lot pipeline ramping and totally understand the eventual flow to the community count. But just wanted to square that with kind of a commitment to maintaining underwriting and recent increases in land costs. Have you guys found it challenging at all kind of to replenish that pipeline and just what you're seeing in terms of competition on the land side. And more broadly how you think about the ability to continue ramping your spend going forward?

It's a good question Tom. We have been staying strong to our discipline and the key underwriting metric for us is IRR. We choir to an unlevered 20% IRR. And frankly that discipline is part of the reason why we've been ending up with excess liquidity over the last many quarters. But generally speaking, while the market is competitive it's always competitive and we definitely have been seeing opportunities to replenish land at prices that absolutely make sense at the current market. So I think we demonstrated that over the last few quarters, certainly year-to-date when we required more than we've delivered. So we hope to continue to make progress that way and at this point we don't see obstacles in that happening.

Got it. Really good to hear. And then, just two quick ones on the corporate cost side. We saw sequential step down in the absolute level of spend this quarter. Was there anything in there with the litigation activity during the quarter or last quarter that we should expect to drop off moving forward with that behind us? And then, also I know there's a proposed transaction with the headquarters in the back half of last year, any thoughts on how that kind of flowing through, is it affecting the cost structure this year anything to keep in mind going forward on savings?

In the first quarter there were additional costs associated with preparing for the GSO transaction. So the first quarter was a higher run rate than to be expected. I think the second quarter is more, we'd expect to go going forward. Also in the first quarter as you mentioned we with the corporate building change we had rent on a sale leaseback of the building we were there in the first quarter that was more expensive than the go forward run rate. So those two things had the first quarter higher than what we'd expect going forward the second quarter is more typical.

Got it. That's really helpful. Have a great day guys.

Thank you.

Our next question comes from Arjun Chandar with JPMorgan.

Good morning guys. Just following up the community count cadence, if we look at the second half of '18 because you mentioned in the first half of '19 is when you expect to return to sustainable growth. What kind of expectations should we have around what that the trough community count could be -- could look like in the back half of '18? And what I'm kind of getting at there, do we expect a similar amount of decline in the third quarter to what we saw in the second quarter. Or should we expect that decline to taper a little bit as we head into the end of the year?

Community count is just a difficult number to give you a precise projections on because you can -- community pace continues to improve, we could sell-through communities faster than we would otherwise have done which is actually a good thing, but it would result in temporarily having less communities. You can have delays and opening and so on. So we're just not prepared to give you guidance on what's going to happen other than we expect to begin to see sequential improvements in the first half of '19 and continue thereafter. And then, you see for yourself what we're saying is possible over the next few years with the key metric targets in terms of the revenue growth. Obviously, you can't get to those kinds of revenue growth without having significant community count increases. So we're confident that we'll be able to achieve that.

Got you. That's great. And then, on gross margin again very good improvement year-over-year, as has been alluded to in previous questions and you mentioned the long-term targets as well getting back up to 20% gross margins. With some of the recent rhetoric around lumber inflation and rising materials costs and the potential pressure on pricing or as we move forward in the event that rates continue. Do you feel like there could be a little bit more of a longer time frame to realizing that that level of growth in gross margins and year-over-year increases on [indiscernible] sustainable into the back half of the year given your current base of inventory and factored toward the second half of the year?

I would say, one of the things you got to keep in mind is, some of the reasons that our margins are below normalized now, there was a time period over the prior two years give or take that labor material cost outstripped home price increases more recently and therefore land that we acquired prior to that. Obviously has to now absorb cost increases that are more than home price increases and results in lower margins. More recently, we've been underwriting our land deals at higher then current construction cost both on the labor and material front and on average that kind of equates for us even though we underwrite to an unleveraged IRR, and also happens to coincidentally average for us roughly a 20% gross margin. So a lot of the land that we have kind of in our backlog yet to be open, yet to be delivered we think is that the 20% number or better. And it's just kind of naturally migrate back towards that 20% level. Now, yes, going forward from today, home prices outstrip which is typical in a recovery period. Construction cost increases. Yes, we can get to that 20% level even faster and maybe even further than 20% as Ara talked about in his response. If on the other hand lumber prices and other construction cost outstrip our ability to raise prices. It makes it harder to get back to that 20% gross margin. So I can't predict the future. I don't think you can either. So our assumptions when we get there is just no change in current market conditions. But what we're really saying is that we believe that future home prices will at least equal any future construction cost increases.

Okay. I'll just add that the big material cost increase that we had was in lumber and that was driven by a sudden tariff on imports and that was very significant and definitely a while back quickly drove up lumber prices. Lumber prices have been moving a little more gradually recently and more in line with normal expectations. So we're feeling fairly comfortable that the numbers we have in our budgets are reasonable and any home -- any cost increases material or labor should be at least offset by home price increases. Remember that construction costs are somewhere from 30% to 50% of the home price. So if construction costs go up 3% all you need is a 1.5% increase in home prices to offset that. So we think that's reasonable and in the cards. And if we go back to many cycles in our 60-year history, typically at this stage in the cycle, margins are less under pressure and more likely to go in the other direction. I already mentioned what happened in the last couple of up cycles. We saw gross margins much higher than 20%. And there were construction cost increases that we had to bear at the same time.

Thank you. And then, finally, with regards to your balance sheet and future debt reduction strategies, what are your current expectations around the timeframe to focus on growth and continuing to build that lot count versus now that you have a little bit more of an extended runway. When would you potentially be looking at being more aggressive in terms of debt reduction with your current balance sheet and how does that play in when thinking about whether or not to reapproach the holders of the [10's of 22] [ph] about a consent to increase flexibility to repurchase unsecured debt in the future.

I'll take a shot at that one. I think that we need to return to substantial profitability kind of implied by our key metric targets so that we can generate profitability that would allow us to actually begin to self repair our balance sheet. We think that's a few years out. But at that point in time, I think it'd be appropriate to contemplate that that we would focus more on repairing the balance sheet rather than future growth. Yes, it's a little bit different question with respect to the 10's. Yes, I don't -- we don't have any current plans to go back to the 10's again and ask for relief on that covenant that restricts us to a $50 million basket of buyback any of our unsecured debt. I think it's more likely that as our performance continues to improve we're hopeful that those bonds will trade along with the 10.5 bonds will trade at more favorable yields and that will have a chance to refinance them that become available to refinance the summer of next year on the 10's and a year later on the 10.5. And we think that would be something that they were trading at favorable enough levels that's something we would consider doing.

Just from the broader level, we just want to comment on where we think we are in the cycle. If you look at single family home production and you compare it to averages over the last several decades. And by the way in spite of the big boom in '04 and '05, the decade average was about the same as the previous few decades incredibly close actually. We're well underneath that typical decade averages. Forget about the peaks. I'm not even talking about that. I'm talking about a full decade averages. So we think that we can remain aggressive right now. And just purely based on demographics and production that we're not under any immediate threat of market correction. I know there are some that say gee, it's been a long period but the prior growth cycle prior to this downturn was about a 15-year growth cycle and it ended with a years -- many years way above the averages for single family homes, we're way below the average. So we're comfortable maintaining our current strategy growing our land pipeline and with the growth in revenues self repairing the balance sheet. We'll play that out as the future unfolds. But at the moment we think we've got a good plan for self repairing the balance sheet over the next few years.

Great. Thank you for the answers. Appreciate it.

[Operator Instructions] Our next question comes from Sam McGovern with Credit Suisse.

Hi, guys. With regard to the reinvestment in the land strategy, can you talk about the specific markets or price points that you're targeting? Would there be any change or increase in your [indiscernible] strategy?

I'd say, first of all, we're really focused on virtually every market and a variety of price points and product types. Certainly one of our niches has been in the active adult arena with our Four Seasons brand. I'd say in general, we're working hard to increase that. It's an area that not every public builder is particularly proficient at. So we think it gives us a little bit of a competitive edge. We've been successful in the active adults throughout the country and we are planning to expand and are in fact expanding that footprint. The other end of it is very, very affordable basic entry level home. We've been doing entry level housing for a long part of our history. The new trend is being going extremely affordable and going furthest out to get to the lower rungs of household incomes. We have been doing that in Southern California and Northern California and Arizona recently with a product line that we call the Aspire. We've had good success with it and we're now planning to expand that part of the product line as well in a variety of areas. But the last thing, I'll mention is just a generic trend we're seeing and that is in non-age restricted communities. We're definitely seeing demand for single storey residences and master down residences. So in all of our normal acquisitions, we're striving to make certain that we have product in our lineup that some of the older baby boom buyers can gravitate to if they don't want an age restricted community but want a home that's more conducive to their current family or household situation than their two-storey four bedroom up center hall colonial. So we're working hard in that area as well.

Okay. And then, I think you also mentioned that part of the financing of this would be through an increase in land banking. Can you talk about current conditions for land banking; I believe there's been some new entrants there. Can you talk about any changes you guys are finding in terms of terms now versus a few years ago?

Yes. I think there are new entrants in land banking and some of the old entrants are having to respond to that competition in general as I mentioned in my prepared remarks. We're seeing more favorable terms on the land banking side of the equation. We just haven't had a need to use it because we had excess liquidity going forward especially as we find larger parcels. I think it's something that we're open to using again and planning to use again for our larger parcels. And the rates have come down a couple of percent give or take and some of the other terms have been somewhat more favorable as well. So it's moving in our direction.

Great. Thank you guys.

And I'm not showing any further questions at this time. I'd like to turn the call back over to Ara.

Great. Thank you very much. We'll continue to keep you updated. And again, we look forward to finishing the year with a strong fourth quarter. Thank you very much.