KB Home (KBH) Q3 2016 Earnings Report, Transcript and Summary

Good afternoon. My name is Shay [ph] and I'll be your conference operator today. I would like to welcome everyone to the KB Home 2016 Third Quarter Earnings Conference Call. [Operator Instructions] Today's conference call is being recorded and will be available for replay at the Company's website kbhomes.com through October 20. Now I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may begin.

Good afternoon everyone and thank you for joining us today to review our third quarter results. With me are Jeff Mezger, Chairman, President and Chief Executive Officer; Jeff Kaminski, Executive Vice President and Chief Financial Officer; Bill Hollinger, Senior Vice President and Chief Accounting Officer; and Thad Johnson, Senior Vice President and Corporate Treasurer. 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 a number of factors outside of the Company's control, including those detailed in today's press release and in its filings with the Securities and Exchange Commission, actual results could be materially different from those stated or implied in the forward-looking statements. In addition, a reconciliation of the non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in today's press release and/or on the Investor Relations page of our website at kbhomes.com. With that, I will turn the call over to Jeff Mezger.

Thank you, Jill, and good afternoon everyone. I'm going to start with a brief overview of our third quarter results followed by a business update. Then Jeff Kaminski will take you through our financial results in greater detail and discuss our guidance for the fourth quarter of 2016, after which we will open the call for your questions. We're pleased with the progress we continue to make as we pursue a balanced approach to achieving growth in revenue and earnings, as well as managing our business to drive higher returns. Building on our results in the first half of the year, we accomplished another quarter of steadily improving financial performance with gains across key operational and financial measures. We made particular progress in a few areas during the third quarter that I want to highlight, beginning with a 14% increase in housing revenues driven by an 11% increase in deliveries. Second, we continue to drive significant improvement in our operating margin through a reduction in our SG&A expense ratio of 110 basis points as we leveraged our expanding revenue base while continuing to contain cost. And third, as a result of our inventory investment and increase in community reactivation, we had adequately inventoried and capitalized 100% of the interests incurred in the third quarter. These three factors were the primary contributors to a 57% increase in pretax income to $53 million inclusive of inventory related charges. Our earnings per share grew 83% to $0.42. In the third quarter, the value of our net orders increased 20% to $930 million, which is significant considering the 23% year-over-year growth in net order value we reported for the third quarter of last year. As a result of the strong performance, the value of our backlog expanded 17% to $1.8 billion, with the West Coast region up 24%, supporting continued revenue growth for our fourth quarter and into 2017. On a net order basis and building on a successful spring selling season, our net orders in the third quarter increased 16% from a year ago to 2,508. During the quarter we opened 13 communities and closed out of 28. As a result, our ending community count was down about 10%. Our ability to achieve solid net order growth in spite of a lower community count illustrates the underlying appeal of the value proposition we offer, the combination of location, product offerings and affordability and how well customers are responding. During the quarter we achieved 3.6 net orders per community per month, an increase of 27% year over year, as we continue to drive one of the highest order rates per community in the industry. Our results from the third quarter also reflect a continued upswing in demand driven by rising household formation, favorable demographics, job and income growth, and further easing of mortgage restrictions. We have seen increasing activity emerge in the more affordable sub-markets of each city, primarily from first time and first move-up buyers, a trend that creates significant opportunity given our expertise in serving these buyers. On a regional basis, the West Coast again delivered the highest year-over-year order comparison in the third quarter at 37%, reflecting the highest sales per community of our four regions. The dynamics of the California real estate market continue to reflect ongoing strength along the coast, with rising prices in those areas driving higher demand to the inland areas as buyers seek affordable alternatives. California is a large and diverse economy, one that is showing an accelerating recovery. Last week the Labor Department released the August job numbers, with California posting 65,000 additional jobs, over 40% of the nation's job growth for the month. Our business in California is benefiting from this, with each of our divisions posting greater than 20% growth in net orders, with the largest order growth occurring in Central California and the Inland Empire. In the Bay Area we've opened 10 new communities year to date and overall they're pacing well with solid margins. While our business in the Bay Area continues to perform well, we did miss deliveries for the third quarter in our two condominium projects in the City of San Francisco. At the district, in Lower Pacific Heights, we were unable to gain occupancy approvals as expected from the city and it shifted deliveries with average selling prices of $1.2 million to $1.5 million into our fourth quarter. At 72 Townsend, a midrise in the south of market area, which features slightly higher prices on the district, we've experienced some softening in the market and we did not sell and close within the quarter the number of homes we were projecting. 72 Townsend is a valuable asset in a prime location, we've decided to sell through the remaining 25 units at a more measured pace to optimize revenue. The slippage in deliveries from these two high ASP communities impacted our average selling price in the third quarter by approximately $15,000. In our Southwest region, we once again produced a positive order comparison in the third quarter, driven by ongoing strong performance in Las Vegas, which continued to generate one of the highest sales rates per community in the Company. We're also pleased with an improved performance in Arizona as we reported net order growth in that division as well. While the Arizona market did pause earlier in the year, it is now showing signs of regaining momentum. Central is our largest region in terms of units and it continues to produce consistent results. Our net orders were up solidly in the third quarter, with each division posting a positive comparison. Our Austin division in particular generated a significant increase in net orders as we continue to gain share in this market. In Houston, as we discussed, we pulled back on our investment in early 2015 until we had more clarity on the impact on demand from falling oil prices, and our community count is now lower as a result. We are now seeing the market stabilize with demand solid at price points below $250,000. We are well-positioned today in Houston with an average selling price of about $230,000 and our net order growth for the quarter returned to positive territory in spite of fewer opened communities. Wrapping up the regional commentary, net orders per community were up in the Southeast, although total net orders were down due to a decline in community count. We've been more conservative in our new investment in the Southeast over the past few years as the region continues to improve its executions and works to restore profitability. One of our key areas of focus is improving our asset efficiency and generating higher returns. As such, we continue to evaluate additional communities for reactivation. Many of the areas hit hardest during the recession are now recovering at a faster rate and these more suburban locations are where much of our inactive inventory resides. With market conditions in these areas showing ongoing improvement, we will continue the activation of these idle assets. Although deliveries from these activations have a dilutive effect on gross margin, they're accretive to earnings and generate significant cash that we can then reinvest for higher returns. Before I wrap up, I want to make a few comments about our financial services business. We are winding down our home community mortgage joint venture with Nationstar Mortgage. Stearns Lending is in the process of acquiring the assets of HCM, hiring HCM's employees and purchasing the loans in process. Stearns is one of the largest mortgage lenders in the U.S., originating roughly $30 billion in loans each year, predominantly purchase originations. Stearns is now offering mortgage banking services to our home buyers and we are working with Stearns to establish a new relationship. In closing, we feel good about the significant progress on our results and we are confident in our ability to sustain this positive momentum. Economic indicators continue to show general improvement and we remain encouraged by the housing market's steady recovery. Interest rates remain low and credit availability is expanding, contributing to healthy demand. And with existing home inventory limited and new home starts well below normalized levels, the new home industry is positioned to benefit for the foreseeable future. As we enter the final months of our fiscal year, we expect 2016 will mark another consecutive year of growing revenues, accelerating profitability, and improving returns. And with our backlog sitting at $1.8 billion, we are positioned for both a strong conclusion to 2016 as well as poised to continue delivering revenue and earnings growth next year. As we look ahead to 2017 and beyond, having achieved our goal of establishing the scale that allows us to generate solid profits, we are focused on continuing to drive further improvement in our profitability per unit. With this growing profitability, the monetization of our deferred tax assets and the reactivation of additional communities, we are well-positioned to not only fuel our growth through internally generated cash flow but to also take steps towards achieving our midterm leverage ratio goal of 40% to 50%. At our Investor Conference next month, we plan to talk with you in detail about our strategy and roadmap to achieve a balance between growth and returns and look forward to the opportunity to share our thoughts with you. 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 review key components of our financial and operational performance for the third quarter, as well as provide our outlook for the fourth quarter. In the third quarter, housing revenues grew 14% from a year ago to $910 million, reflecting an 11% increase in homes delivered and a 2% rise in our overall average selling price. However, West Coast and Central regions generated double-digit year-over-year increases in housing revenues, with our Southwest and Southeast regions roughly on par with the corresponding year-earlier results despite lower community counts in the current period. While our third quarter housing revenues were at the lower end of our guidance range, we are pleased that we exceeded our bottom line expectations with a solid operating margin performance, the capitalization of all interest incurred in the quarter, and the favorable impact of tax credits from building energy-efficient homes. For the fourth quarter we expect to generate housing revenues in the range of $1.1 billion to $1.2 billion. Our overall average selling price of homes delivered in the third quarter increased year over year to approximately $366,000. This increase is lower than anticipated, primarily due to 38 delayed high ASP deliveries from the two San Francisco condo projects that Jeff discussed earlier, which negatively impacted housing revenues for the quarter by approximately $50 million. Despite the delayed deliveries, all four of our home-building regions posted year-over-year increases in the average selling price, with the Central region reflecting the strongest improvement of over 6%. For the fourth quarter we are projecting our overall average selling price to be in the range of $385,000 to $390,000. Our housing gross profit margin of 16.4% for the third quarter included $3.1 million of inventory impairment and land option contract abandonment charges. Without these charges, our gross margin was 16.8%. Excluding both the inventory-related charges and the amortization of previously capitalized interests, our adjusted housing gross profit margin was 21.2% up 50 basis points sequentially from the second quarter and up 10 basis points as compared to the 2015 third quarter. For the full year we expect our housing gross profit margin to be at the lower end of our previous guidance range of approximately 16.7%, excluding inventory related charges, which reflects a sequential improvement in our fourth quarter gross profit margin to the low 17% range. The lower expectation for the fourth quarter relative to prior guidance is mainly due to price impacts on a handful of high ASP communities, including the two condominium projects in San Francisco, the pull forward of some higher margin deliveries into the third quarter, and higher than previously expected subcontractor labor costs in some markets. Our selling, general and administrative expense ratio of 10.8% for the third quarter improved 110 basis points from the year-earlier quarter, due to favorable leverage on the higher housing revenues in the quarter and our ongoing cost containment initiatives. We expect to extend the favorable trend of improvement we have achieved over the past few years into the fourth quarter with an SG&A expense ratio in the low to mid 9% range. For the full year we anticipate an expense ratio of just below 11%, in line with our previous guidance. Home building operating income for the quarter rose 43% from the year-earlier quarter to $51.5 million and operating margin improved 140 basis points to 5.7%. On a sequential basis, our operating margin improved 250 basis points. Excluding inventory related charges from both periods and land sale profits of $1.3 million in 2015, our third quarter home building operating margin increased 120 basis points from the year-earlier quarter to 6%. In the third quarter of 2016 we capitalized 100% of our interest incurred due to the average amount of our inventories qualifying for interest capitalization, exceeding our average debt level for the period. The expansion of our qualifying asset base in 2016 used to determine interest capitalization reflects both our inventory investments and activations of land previously held for future development. We expect our inventory levels to continue to support capitalization of all our interests incurred in the fourth quarter. Income tax expense for the quarter of $14.1 million, which is a predominantly non-cash charge against earnings due to our deferred tax asset represented an effective tax rate of 26.4% and included a favorable impact of $6.7 million of federal energy tax credits. In the same quarter of 2015, we recognized $2.5 million of such tax credits. These energy credits are a direct result of our dedicated sustainability and energy efficiency initiatives. We were able to realize the benefit from these credits of about $3 million more than we anticipated during the current year quarter due to additional prior-year tax credits that were recognized. As we expect the impact to these tax credits to decrease in the fourth quarter, we are projecting a quarterly effective tax rate of approximately 36%. Overall we showed solid year-over-year improvement in the quarter with net income of $39 million, up 69%, and diluted earnings per share of $0.42, up 83%. Turning to community count. Our third quarter average of 235 was down 9% from 257 in the same quarter of 2015, which had increased 30% from the previous year. We ended the quarter with 227 communities, down 10% from the year ago. Included in the 227 communities at quarter-end were 38 communities previously classified as land held for future development. The majority of the year-over-year decline in our average community count as within our Southeast region which was down by 15 communities or 24% due to both the wind-down of our Metro DC division as well as fewer community openings in the region in the first three quarters of 2016 as compared to the same period of 2015. Average community count was about flat in both our West Coast and Central regions versus the same quarter the prior year and our Southwest region was down 12%. As a result of additional community activations during the third quarter, we reduced our land held for future development by over $40 million. Our activations this quarter were comprised of both idle assets where market conditions have improved and subsequent phases of existing communities. Most of these activations occurred in our West Coast and Southwest regions. The monetization of these land positions is contributing to increased asset efficiency, improved returns, incremental cash flow, and accelerated usage of our deferred tax assets. We plan to continue to unlock our investment in these properties and redeploy the capital into assets with expected higher income producing potential. We currently expect a small sequential increase in our yearend community count as compared to the 227 communities at the end of the third quarter, and we believe our planned openings will drive continued sequential community count increases into 2017. On a year-over-year basis we anticipate our fourth quarter average community count will decline by about 8% as compared to the same quarter of 2015. During the third quarter, to fuel future community count growth, we invested approximately $360 million in land, land development and fees, with $171 million or 47% of the total representing new land acquisitions. As Jeff mentioned, we have begun the process of winding down our mortgage banking joint venture, Home Community Mortgage, and developing a new relationship with Stearns Lending. We anticipate the transition will extend over one or two quarters. We believe our share of the HCM joint venture will generate a loss in the range of $1 million to $3 million in the fourth quarter as a result of the wind-down. Overall we are pleased with the third quarter performance and the trajectory of our business into the fourth quarter and 2017 and are looking forward to talking more about our strategic plans and objectives at our investor conference in a few weeks. We will now take your questions. Operator, please open the lines.

[Operator Instructions] Our first question comes from Alan Ratner from Zelman & Associates.

Hey guys. Good afternoon and congrats on the strong quarter. Jeff, I was just curious maybe just to kind of dig in a little bit to the price versus volume equation you guys are looking at right now, because I know if we went back a year ago when you were very focused on rebuilding the gross margin, you kind of highlighted at that time that you wouldn't really expect to see much absorption improvement, that you're already kind of taking above an average level for the industry, and yet this quarter, absorption is up almost 30%, it's obviously a great result, but curious if, with that strong absorption growth, you expect that to ultimately filter through to continued improvement in gross margin in 2017 because I know you talked down the guidance a little bit in 4Q or at least to the lower end of the range. So, are you now focusing more on volume over the pricing margin or do you expect this strong absorption growth to ultimately filter through to a continued improvement in margin? Thank you.

Okay. Thanks, Alan. A couple of comments. First off, it's not - 3.6 orders per month per community, that's still within range of our strategic objective of 4. We find that we optimize the assets around 4 a month. And if we're exceeding 4 a month, we'll push price; if we're at 2 a month, we'll do something to increase in general terms. So that the increase really is because our third quarter last year was not that strong of a quarter in sales per community. I shared we were up 27%, it's more a reflection that last year was softer. If you reflect a year ago, we had just opened a lot of communities; our community count had really surged. I think we were absorbing and getting them open, whereas right now we have a more mature community profile with things selling at a normal pace. And as I also shared in my prepared comments, we're continuing to work on ways to improve our profitability per unit and one of those is to continue to drive a higher gross profit. So we have not come off of our strategy of balancing the optimal price and pace and you'll see us continue to run around somewhere around 4 a month, 3.5, 4 a month.

Got it. That's very helpful. And second, just when you think about the improving demand at the first time buyer segment, I think we've been hearing that a lot from builders, and you guys have always been very well-positioned in that segment of the market, and I know earlier on you were indicating that, even though you had a lower ASP than some of your peers, you weren't necessarily looking to buy land, kind of in more those B, B-minus type locations that maybe you operated in in the prior cycle. Curious if that thought process has changed a little bit here now that other builders have had some success in those submarkets and just kind of how you're thinking about continuing to serve that entry level buyer going forward. Thank you.

Okay. As you know having covered us for quite some time now, Alan, it is a sweet spot for us the first time in the first move-up consumer, and we are seeing strengthening demand in what I'll call the B submarkets. We're really not looking at the Cs yet, don't know that we ever will, as long as there's opportunity in the B. So we're, within each city, we have a strategy. We'll target the median income and that submarket. We try to get to the most desirable submarkets with the best balance of demand supply and a median income that can get a mortgage, and that's where we'll spend our attention. So we hug the coast in California but we are seeing more business in the inland areas as they recover.

Thank you. Our next question comes from Michael Rehaut from JPMorgan.

Thanks. Good afternoon everyone. I wanted to, with my first question, just kind of, you know, dive in a little bit more to, you know, around the sales pace improvement and appreciate, Jeff, that you kind of pointed to last year being a tough comp - an easy comp rather, with the communities now a little more mature. But at the same time, you kind of looked at what your absorption pace has done on a year-over-year basis being flattish in the first quarter, up about 10% in the second, now up over 25% in the third. So my question, easier comp notwithstanding, there does seem to be a little bit something going on perhaps with the trend, and wanted to get a sense if that's being driven by a particular market or two. Obviously there's a lot of strength right now that you're seeing from an order perspective in the West Coast, in the California business, or if there's any type of community mix shift going on also with perhaps even more first time oriented communities that turn faster.

Again, Michael, as I shared in my prepared comments, our two biggest order growth areas were Inland Empire and Central Cal. So the inland area is the more affordable place, typically more first time buyer or more affordable first move-up demand in those regions, and that's what we're seeing. It's also where we, in a year ago, had more what I'll call underperforming communities, whether reactivations or things that just weren't working that well. So we're, if you want to say there's a mix shift going on, I think there is because we're holding our business in the coastal zones of California, and lifting it inland. And I'd say the same thing in a few of our markets where we had underperforming communities that are now hitting the - a more normalized pace, albeit at a lesser margin. But it's a mix shift because we're holding in the desirable areas and lifting our business in those that weren't performing so well in the past.

No, that's helpful, Jeff, I appreciate you pointing back to that, those earlier comments. I guess secondly, again kind of continuing on this line of questioning around first time and obviously highlighting inland and central, as - I'm just trying to get a sense I guess of what percent of your business currently is first time versus let's say a year ago, and if that's, you know, some of that again continued improvement in that ratio is also kind of what's driving on a bigger picture, that - I think it's the second quarter in a row where you slightly reduced your gross margin guidance for the full year. I know Jeff Kaminski, you cited a few drivers of that. But I was just curious about that trend and if you'd expect that to have an impact, if at all, as we think about fiscal 2017.

Okay. Our product mix, Mike, has basically 75% right now first time, first move-up, and it'll flex up or down a couple of points either way between the two. In the third quarter we're at 52% first time. There is a lag to this because we're primarily built to order. So if we sell now, it delivers four, five, six months from now. So it would not surprise me if you see our first time buyer mix tick up a little bit from the 52%. I don't know that you'll see the overall mix move that much from the 75%. First time buyer may move down a little bit. I say that in that, with intent, we're modeling smaller homes, probably lower features than we would have a couple of years ago, and we're working to keep our price points in the B submarkets more attainable by the median incomes out there. I wouldn't tie that necessarily to lower margins though, because typically our first time buyer product has a comparable percentage margin. It's just smaller dollars. So I wouldn't connect it, if the first time buyer comes back, our margins get dragged down. That won't be the case. We have a lot of plans in place continuing to raise our margin.

Thank you. Our next question comes from Nishu Sood from Deutsche Bank.

Thank you. First, I wanted to ask about your comment, Jeff, about mortgage lending standards. Certainly the trend in recent years has been positive, supportive in terms of gradually expanding mortgage credit access. But in calling it out, was there something specific that you're seeing in the field that led you to call that out?

Well, if you look at credit profiles of Fannie Mae bonds being sold, the FICO score continues to move down a little bit. So you're seeing they're still well above the regulations and guidelines but they are coming down from where they were a year ago or certainly two or three years ago. I think as more submarkets get into a position where more of the homeowners and loans have equity, that the banks are feeling more comfortable in getting back to more normalized underwriting as well. But I would start by looking at the Fannie and Freddie bonds that are being sold because the credit profile is migrating more towards normal underwriting.

Got it, got it. Appreciate that. Second question, also revisiting the comment, which is very encouraging, about improved demand in some of the outlying areas, certainly as was mentioned earlier, something we've heard from some of the other builders, but in your case also, on mothballing some assets, shifting the focus to returns a little bit versus margins, so, maybe you, you know, those forces would have helped you to find some of that demand as well. So, to the extent that you could just give us just broad-brush strokes, how much do you think was, you know, that improved demand you've been seeing is driven by what's going on in the market versus what you have been doing specifically at KB in finding that demand?

You want to give them the community mix or what?

Sure. I mean, I think there's a couple of things behind it, Nishu. I think there's definitely improvements at the market. There's no doubt about that, so we're enjoying that. But I think also importantly, we did start a pretty intense program I'd say earlier this year within the Company to work on absorption pays at our underperforming communities. So if we have communities that were performing at one or two a month, we put a lot of emphasis and a lot of pressure on that division to pick that up. And that's, I'd say, that's been the single largest determining factor in improving pace as we've seen as we traveled through the year. And that, you know, was an initiative that I think was - has been very successful quite frankly and it's really helping the Company to improve returns and improve turns and inventory in certain communities that we're really not pacing appropriate in the past.

Thank you. Our next question comes from Bob Wettenhall from RBC Capital.

Hey, good afternoon. Nice quarter. Love that you guys are in between the guidance that you've outlined, which is very encouraging. A lot of data coming at us and I hope one of the Jeffs could clarify. You guys had terrific absorption, and I'm trying to think through, does this pace continue into the next quarter?

Bob, we're still early in the quarter, we're not going to give you a commentary on where we think we're headed in sales. We'll deal with that and share some at our investor conference and certainly share it again at our yearend call. The color on the quarter that just finished is pretty consistent through the quarter. We saw solid demand, we saw good traffic levels. And as you could tell by our comments, across the Company, our sales per community were better than they were a year ago. So it's encouraging, but we'll speak to the fourth quarter later this year.

Okay. So I'll take that as being a bit premature. San Francisco market, you have some very high ASP projects which are profitable. It sounds like there's some delay and some deliveries are getting pushed into the next quarter just due to timing. But GM guidance was at the low end of the range. There might be a lot going on and I was hoping you guys could kind of untangle that and just give us a view if more generically if you think like the better level of profitability that you're grinding towards is kind of like the new normal for KBH. Thanks.

Okay. Bob, as you mentioned, there's a lot going on every quarter, but certainly this quarter specific to the Bay Area, and you have to split my comments between the two kind of projects. On the one hand, the district, we couldn't get our occupancies due to some technical things on the inside elevators, and until you get the inside elevators signed off, you can't take down the outside elevators and the staff fleet [ph]. So if you can imagine for the whole quarter, we had a bunch of scaffolding outside the building and a temporary elevator, and I say that because it didn't just affect deliveries, we are open for sale in a remote location nearby, but it also affects your selling effort, because you can't even get into the building to sell a lifestyle which is pretty critical when it's $1.5 million condo unit in San Francisco. So it didn't just delay deliveries, it took a little steam out of our selling effort. And the scaffolding is now down and we're already seeing improved interest and traffic, and we'll go right back at it like we normally do. In the case of Townsend, which is higher priced, we have seen some softening in the higher-end condo market in the City of San Francisco. And I'd say in the city because we have comparable-priced traditional suburban product out in San Jose, Santa Clara County, or up in the East Bay that continues to sell very well. So it's -- I think it's specific to a condo project, as I shared, has 25 left to sell. So it's not a big issue for the Company. Meanwhile, out in the suburbs, the margins are strong, the sales are strong, and we have a very nice business in the Bay Area. So I certainly wouldn't take -- actually one other thing I wanted to share, there's a mix -- there's a mix shift within the mix shift in that, within the condos, in the case of 72 Townsend, there's a bunch of affordable, below-market units that we have to deliver as part of the development agreement that come in at no margin and a much lower price, and those are delivery here in the fourth quarter. So it pulls the margin down from what you'll see over the balance of the community, certainly pulls the revenue down, versus the balance of the community. So, just a little run-through I gave you on those two buildings, you have a lot of things that can influence price, pace, margin, and the ASPs are so high, in a quarter it can move our expectation, and it did in the third quarter. I would not take our current level of profitability per unit and say that's a proxy for KB's profit equation. We continue to work to lower our SG&A further and did so in the third quarter, and we've got a lot of actions in place to fight the headwinds and keep lifting our gross margin at the same time.

Thank you. Our next question comes from John Lovallo from Bank of America.

Hi guys. Thanks for taking my call as well. The first question, Jeff, if I heard you correctly, I think that you had mentioned pressure, there's some pressure on the divisions to pick up the absorption pace. Just wondering, what, you know, how much incentives may have played into that equation.

John, let me change Jeff's words a little bit because that's the CFO hammer in [inaudible]. We try to - I call it optimizing the asset. There's a pace and a price and a margin for every asset that you can toggle for what will give you the highest returns in that community, and we review those on a week basis. So if something is not selling at the optimal pace and price, it's not just hammering price or throwing incentives out. We've actually retooled product, we'll introduce new models, up or down in price, up or down in footage. We'll do other things, in order to change the spec level, what options and what's standard and all that. So we do a lot of things. Typically we stay away from an incentive game. We'd rather give the customer the best price for the home, let them go to the studio, create their own value, as opposed to build the spec and then dump incentives. So, even third quarter with that sales pace, I don't know we had a material increase in incentives.

Okay, that's helpful. And then I think last quarter you had mentioned that the gross margin on the reactivated communities were similar from the 6% to 14% range. Would that be similar this current quarter?

Yeah. It's right around 10% give or take, that's what we're seeing every quarter. And I'm glad you did bring that up because there's a couple of very key things that's happening with that mix and we talked a lot about it last quarter as far as forward-looking. But when you look at the mix of business, and keeping in mind the initiative this year to improve the underperforming communities and a lot of those were reactivated communities, what we saw in the third quarter was a delivery mix this year of about 15% of our deliveries were reactivated coming from reactivated communities. Last year same quarter, that number is about 11%. That mix shift caused about a 25% decrease in the Company's total gross margin increment year over year. In other words, we would have done, instead of a 10-basis-point improvement, we would have done closer to 35-basis-point improvement year over year. On a standalone basis, if you just look at the third quarter of 2016, if you took out the reactivated deliveries, it had a - it was a headwind of about 80 basis points on the total consolidated gross margin. So it's having a pretty large impact on the Company and we think it's important for investors to understand what's going on there so that there's not a misconception that the companies-based business or that the Company's new land investments aren't working or that there's an issue with the Company's gross margin. When we're seeing those mix shifts like that, we do want people to understand that it's part of a strategy of monetizing efforts that will lead to higher returns and allow us to generate cash to reinvest in better-performing assets in the future. So I think all that's important and we'd like to continue to emphasize that and point it out and be transparent on some of those numbers as we move forward.

Thank you. Our next question comes from Susan Maklari from UBS.

Thank you. In your comments you noted that you've seen some higher labor costs in some of your markets. Can you just give us a little bit more color there, perhaps, you know, any impact from that as we move forward?

Right. What we're seeing across most of the markets, there's been very tight labor conditions across the country in most of the markets, particularly in framing labor category and dry wall I guess secondarily. And as the demand ticks up for those services, as we get later in the year, we're seeing more and more pressure on that side. And we've had instances in some of our divisions where some contractors are coming back to us and basically saying they're going to have to work over time with their folks or that they're going to need to see some price increases in order to stay on the job. It's been a very competitive environment out there and we're trying to hold our build times and obviously complete our homes and deliver those for our expectations. So those are and they have been continuing to be headwinds for us for quite some time. You know, if you look at the business on a year-over-year basis, in total we've been dealing with that pretty much every quarter since this time last year and as you remember last year in the fourth quarter it was very, very tight on labor and we're doing what we can to hold our sub-base and basically hold people on our jobs and complete our homes in time.

Okay. And then part of the activation of some of these assets is also obviously generating a lot of this cash. Can you just talk a little bit to how you think about some of the uses of that cash, what is your appetite for land deals perhaps going forward and perhaps other opportunities, deleveraging or those types of things that you consider.

Right. We see the strategy as being very effective for the Company in the longer term. As we're spinning out of some of these inactive assets and generating cash from those assets, first and foremost, we want to reinvest in the business, in fact in the core assets. But at the same time, as we've been talking about for several quarters, we have our eyes firmly set on attaining that 40% to 50% leverage ratio. And as a result of that, we do believe that we will deploy part of that cash in order to help with those efforts. So those will be our two primary uses, of course dividends and regular dividends will continue as well as the third use on the capital side. But primarily it'll be towards delevering and towards growing the core business into the future.

Thank you. Our next question comes --

Well, I was going to add to that and go back to my prepared comments. There's more going on on cash generation than just activation, that we're growing our profits. So we're getting cash out of the profits. We're not paying taxes because of our deferred tax assets. You're getting cash from the monetization of that as well. That's why we now feel we're in a position where our balanced approach is keep fueling our growth while also taken some steps that we shared to start to get toward our leverage goal.

Thank you. Our next question comes from Mark Weintraub from Buckingham Research.

Thank you. Following up on the split with the reactivated communities. So, about 15% in the most recent period. As you look forward, do you anticipate that number is going to remain relatively constant and/or increase? And when does it begin to wind down?

Right. Right now, I mean it's being driven really off the community count mix. If you look at the average community count, in the second quarter this year it's at 16%, was reactivated communities in the third quarter this year on an average basis again, 16% of our communities were reactivated communities. So the mix of deliveries is really being driven off that. And in this particular quarter we had a very similar absorption pace between the reactivated communities and the core communities so it's kind of maintaining that 85-15 or so split. Part of that will be dependent of course on growth in core communities and what's happening with close-outs and growth and grand openings of reactivated communities going forward, but at this point in time, given the second and third quarter percentages and knowing that we're predominantly a build-to-order business, I think for the next couple of quarters that percentage will hold relatively constant.

How many communities do you have yet to be reactivated?

There's roughly 60 additional communities outside of the ones that are currently open. And some of the count in the 60 is really counting as a community, the next phase of an open community that was activated in the past, but the total count is about 60.

Thank you. Our next question comes from Jay McCanless from Wedbush.

Hi, good afternoon guys. First question, the guidance on financial service and the wind-down with Nationstar. Did I understand it correctly it's going to be a $1 million to $3 million in 4Q16 but that that loss might be spread over two quarters?

No, you misunderstood that slightly. The $1 million to $3 million is our estimate for the fourth quarter net on that specific line item of the joint venture within financial services. It's not guidance for the whole financial services line item, it's just for the joint venture. The comment on the couple of quarters was the transition timing. So in order to transition to a new arrangement into the future, we expect that it may take one or two quarters to get there.

Okay. And then the second question I had, last conference call you had talked about how probably fiscal 1Q17, the community count should be up on a year-over-year basis, but this time I think you said that it's going to be more of a sequential growth through the year. Could you maybe give us a little more color on that? Where do you think based on current land [inaudible] in 2017?

In 2017? Yeah, we're not guiding out beyond the fourth quarter at this point. But last conference call we talked the same way, that it would be a sequential increase from third quarter to fourth quarter. So our expectations on community count going into the fourth quarter and then into early 2017 really have not changed, and that's we're expecting to see sequential increases in both the fourth - and in the fourth, it's going to be a very small increase. We expect to be up only a few communities but we think we'll reverse the trend of a downward trend in the fourth quarter and then more significant up in the first quarter. In the fourth quarter, despite the increase in ending count, we still believe our average count will be down about 8%. And that's an important metric because the average is really what drives the sales number, the order number on a year-over-year basis, so, just a little caution on that as well.

Thank you. Our next question comes from Stephen Kim from Evercore ISI.

Hey guys. Thanks for taking my question. I guess first question I had, just to clarify on the mothballed community conversation. I think you'd indicated 60 mothballed communities left to open. I guess, I just want to clarify, are you not opening these yet due to the fact that they're not able to generate any sufficient returns or are there any practical considerations? If you can just help us understand how many of those aren't really yet able to generate a suitable feasibility.

Sure. All right. Another area we'll dive into in a lot more detail during the investor conference in a few weeks, but just at a high level, there's a couple of primary factors on those. One is there's a pretty large population of those that are in fact just next phases of currently open communities. And in certain cases what we'll do is we'll open a phase, we'll unmark a phase, we'll go to market, we'll see how it ends up, so we'll see how it goes, we'll build models, we'll go to market, we'll sell, and we'll build the homes. And if it goes as expected, we'll go and unmark for the next phase and then the next phase after that. So there's a population of communities that are just simply in the normal course of business I would say are sitting idle at the moment because to open them or to unlock those assets right now, you know, will just be capping interest to them and have a large asset when we already have lots in front of it to work through. So that's one piece of it. Certainly the other assets, we have been waiting for market conditions to improve such that it made sense to open. And as we mentioned during the prepared remarks, some of the communities that have opened have fallen into that category, where we're seeing improved market conditions that allow us to get open and sell through the community.

That's helpful. And then --

Stephen, a couple of other comments. There's two other influencers. We're continuing to create value in some of these assets through re-entitling, where it may have been a larger lot and it's in a price point area of a city where you have to go to a smaller lot to get your prices down, and that takes time. We've been working on that. And another influencer is some of these assets are replacement communities for one that we're now working through. And if you invested the money to develop the lots and open it, you're just diluting your own effort a mile or two down the road. So as Jeff mentioned, we'll give you more color at the investor conference on the specifics, but we have a strategy in place for each one of these assets and we'll continue to work through them. We're making good progress.

Yeah. And I guess just to pile on one more time on that one, yeah, when you start talking about progress, our peak percentage, we have 43% of our total inventory assets at the end of 2011 that were in land held for future development. And right now, as of the most recent quarter, we're down to 12%, and that's over $300 million taken out in excess of $100 million over the last year or so. So it's accelerating and the pace of improvement is accelerating and the pace of activation is accelerating, which we're pretty excited about.

Right. Yeah. No, it's helpful. Regarding the first time product, I think you had mentioned, in addition to talking about the fact that that segment of the market is showing some signs of strength, which is great, I think you had also indicated that one of your strategies in targeting that market or that buyer type was to offer some homes that allow you to sort of maybe hit a price point, in other words you're probably taking out some of the amenity level or taking down the amenity level and that kind of thing, which is fine and very reasonable. The question I guess is, do you believe that, at a certain lower price point, it no longer makes as much sense to do a build-to-order business? Is, in your view, is there any relationship between the level of amenities and the products you're building and the advantage to build-to-order or not?

Stephen, I don't. And the reason I don't is a buyer can only afford so much house and we could have a -- it's not just spec level, it's the footage and the size of the home. So in a typical suburban community, a year ago our models may have been 2,000 feet and 2,800 feet. And it could be, if that's our strategy, we could model 1,500 and 1,800 and offer 1,200. And if you design the floor plans the right way, the 1,200 will live larger and the buyer may only want 1,200. So in a build-to-order, we let the buyer pick what size home they want, that's the biggest driver. And then in turn, whatever they desire on the finish level or can afford, they'll load in. But we actually see on a percentage basis percent of the price of the home, our first time buyer communities perform similar to the move-up in the studio process. So this is about getting the best value you can on the footage of a home.

Thank you. Our next question comes from Jack Micenko from SIG.

Hi, good afternoon. Wanted to think about ASP at a higher level. Obviously you've got the step-up in the fourth quarter with the higher margin, higher price count that's coming on. But with remix, I guess inland remix down first time a bit more, I guess up to 365 ASP, is it possible in 2017 ASPs drop below where we're at now or do you think that the mix continues to drive ASP higher absent the move we're going to see in the fourth quarter?

That's our crystal ball question.

It's broken this afternoon I guess.

Yeah, and it depends on where our mix goes even within the inland areas because on the closer in inland areas, the ASP can be 200 grand higher than the same home on the other side of that submarket. So if Texas keeps doing as well as it is, it's going to pull our ASP down. And if California keeps doing as well as it is, it'll pull our ASP up. Those will be far bigger drivers than a condo building in Orange County or the Bay Area though. It'll be the mix in the affordable areas. And it could be we're just flat next year, who - we don't know.

Okay, great. And then what's the motivation behind winding down the JV? Was the contract up? Was there quality issues? Seem to remember you've had a couple of iterations on the mortgage side, and then do you think there's any risk of disruption moving over to Stearns over the next couple of quarters?

Yeah. We made the decision to change because we weren't getting it done in the current JV. I'd say we weren't getting it done, Nationstar is a good company. It was a new business for them, and we weren't able to get the service levels up to a level that generate a high enough capture rate or generated profits and took care of our customers. All the way around we just -- we weren't hitting the service standards that you need to run our mortgage company the right way. In moving to Stearns, I think the biggest difference is Stearns, as I said in my comments, is wired as an originator, that's how they do. Nationstar's business is primarily servicing a loan portfolio with a small origination site. All Stearns does is originate. They're headquartered in California so they're more familiar with the jumbo products out here. I think they'll help in that regard. And their origination platform is far more efficient than the one that Nationstar had. So ideally we'll see increased service levels, better loan products and better execution and turnover time, hopefully a higher capture rate on our backlog. That was really the drivers.

Thank you. Our last question comes from Jade Rahmani from KBW.

Hi. This is actually Ryan Tomasello on for Jade. Thanks for taking my questions. Regarding the reactivated communities, can you say if these had been focused on certain regions in particular and how do you balance reactivating old communities versus deploying incremental capital into new land acquisitions?

Yeah, very good question. The recent reactivations I think in the current quarter were mainly in the West Coast and the Southwest regions. We'll, you know, it's not a region specific strategy, it's one when the markets are ready and when conditions are ready, we'll go ahead and reactivate. So that's part of it. The other I think issue on the regional is our central region has very few mothballed communities so you really don't see the reactivations there for obvious reasons. As far as the decision process on when to invest in new or when to reactivate, I'll tell you, as we're looking at the reactivations and we're looking at it on a sub-cost basis and looking at new dollars coming in as investment, the returns are extremely high on the reactivation. So where market conditions are right and where we're assured and have good visibility that we'll be able to sell homes at the right price and make some profit, those are really homerun decisions for us to be able to get those assets off the books and monetized and the incremental investment is a really good use of capital in those cases, and that's really the focus that we'd been on for a couple of years now in fact as the markets have started to heal.

And then regarding the leverage target of 40% to 50%, does management have a target timeframe to hit these levels and how do you balance the tradeoff between debt repayment versus share repurchases?

Right. I think on the first point, as far as timing, we kind of consider the midrange goal, which in our way of thinking is approximately three years. As far as the balance between share repurchases and the delevering, our stated capital priority is really towards delevering. The share buyback we did in the first quarter was very opportunistic. We saw the stock trading down at a very deep discount to book and we thought it was a great use of capital to go in and buy those shares in the first quarter. So it's not really a standard program where we have a standard buyback mindset at this point in time, and really the focus is more on the delevering.

Thank you. Ladies and gentlemen, this concludes today's teleconference. Thank you for your participation. You may now disconnect your lines.