Beazer Homes USA Inc (BZH) 2013 Q2 法說會逐字稿

Good morning and welcome to the Beazer Homes Earnings Conference Call for the quarter ended March 31, 2013. Today's calling is being recorded and a replay will be available on the Company's website later today. In addition, PowerPoint slides intended to accompany this call are available on the Investor Relations section of the company's at www.beazer.com.

At this point I will now turn the call to have Carey Phelps, Director, Investor Relations. You may begin.

Thank you, Tanya. Good morning, and welcome to the Beazer Homes conference discussing our results for the second quarter of fiscal 2013.

Before we begin you should be aware that during this call we will be making forward-looking statements. Such statements involve known and unknown risks, uncertainties, and other factors which are described I think our SEC filings, including our Form 10-K, that may cause actual results to differ materially. Any forward-looking statement speaks only as of the date on which statement is made, and except as required by law, we do not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. New factors emerge from time to time, and it is not possible for management to predict all such factors.

Joining me today are Allan Merrill, our President and Chief Executive Officer, and Bob Salomon, our Executive Vice President and Chief Financial Officer. Following their prepared remarks we will take questions in the time remaining.

I will now turn the call over to Alan.

Thank you, Carey, and thank you for joining us.

We had a very productive second quarter. Our operational improvements and better market conditions, which began to emerge last fall, have continued into the start of our spring selling season. Traffic is encouraging and our efforts are delivering solid results.

Overall for the quarter adjusted EBITDA was $15 million an improvement of over $16 million from last year. We recorded 3.4 sales per community per months which exceeded our expectations. Despite a 20% decline in our average community count and an intense focus on increasing our margins, orders were up slightly year-over-year based on the stronger than anticipated performance.

Our cancellation rate declined 380 basis points to 18.7%. Closings were up 34%, wit and average sales price that was 13% higher than a year-ago. Gross margin improved to 19.1% with each closing contributing $48,000 in gross profit. Ending backlog was 12% higher in units and 26% higher in dollars than a year-ago. And finally we spent $63 million in land and land development during the quarter, entered into a $150 million land banking arrangement, and activated a $12 million asset out of land held for future development, all in support of our drive to return to profitability as soon as possible.

Last November we introduced target ranges for our four primary operational metrics, illustrating our path to profitability. There's progress to report on all four fronts.

First, taking a look at our sales per community. For the four quarters ended March 31, we averaged 2.7 sales per community per month, comfortably with within our target range of 2.5 to 2.75, and 87% of our qualified as performing with at least one sale per month. Both metrics reflect improvement were this time last year when we recorded two sales per community per month with 73% of our communities performing. I'm very proud of the 3.4 sales per month absorption rates achieved by our sales teams this spring even as they have embraced our priority to drive margin expansion. While we don't expect to repeat absorptions over three per month in another quarter this year, we are raising the top end of our target range to three sales per community per month measured on a trailing 12-month basis.

The second path to profitability strategy relates to our G&A costs. For the 12 months ended March 31, we reduced G&A as a percentage of revenues by 440 basis points from 13.9% last year to 9.5% this year, at the mid-point of our target range. As we continue to grow our topline, I anticipate staying within this band of 9% to 10%.

Our third path to profitability strategy is to drive higher gross profit dollars per closing. As we have discussed before, achieving this objective is a function of increasing both our margin percentage, which we hope to expand to at least 20% and realizing higher ASPs. With continued improvement in all three reporting segments, our gross margin percentage for the quarter was 19.1% compared with 17.5% last year. Despite continuing material and labor costs pressures, I anticipate positive year-over-year gross margin comparisons in each of the next two quarters.

Average sales prices are also notably improved over last year. For the second quarter, our ASP grew to $253,000, up $29,000, or 13% and our ASP in backlog at the end of the quarter was $264,000, up 12% over last year. Together, our improved margin percentage and increased ASPs are driving our gross profit dollars per closing higher. For the 12 months ended March 31, we recorded and average of $41,500 of gross profit per closing, up 16% from a year-ago and moving us closer to our target regular of $45,000 to $50,000 on a trailing 12 month basis.

On this slide you can see that our performance for the second quarter was even stronger with $48,000 of gross profit per closing. Because of this solid performance we are raising the top end of our target range to $55,000 per closing, stretching our goals to reflect our improving trends.

Moving now to the fourth strategy in our path to profitability plan. As we guided on our last call, our active community count has remained relatively stable as our 18 new community openings during the second quarter were offset by 20 community closeouts. At March 31, we had 148 active communities and our average for the quarter was 150, below our longer-term target range of 190 to 210. The good news is that with the improvements we've made in our other packet to profitability metrics, we'll be able to return to profitability well before we return to 190 communities. For that reason we have lowered the bottom end of our target range to 170 communities, which is an achievable target in the next 12 months.

We are making the investments necessary to grow community count next year, emphasizing investments in California, Florida, Texas, and the mid-Atlantic region. I will let Bob provide a few more details on these activities before he discuss our expectations for the remainder of the year.

Bob.

Thanks, Allan. We spent $62.6 million in land and land development during the quarter. Year-to-date we have spent $152.6 million, or 52% more, than we spent for the same six month period last year. While there is competition for the best sites, we are finding and aggressively pursuing those deals that meet our investment criteria to generate deliveries for gain in fiscal 2014 or 2015.

As Allan said, at March 31, we had 148 active communities. In addition, we also had 33 communities under development but not yet open, and 24 new communities approved for acquisition but had not yet closed. At the end of the quarter, our land committee approved and additional 11 communities for acquisition. These new communities will add to our average community count next year but will partially offset by community closeouts.

To further enhance our efforts to grow our community count at the end of March, we entered into $150 million land banking arrangement with GSO. This relationship has nothing to do with existing assets. Instead, it should enable us to open approximately 20 more communities than we had planned using our own capital and we're off to a fast start. We expect to have several land deals in the land bank by the end of the third quarter.

Based on our current pipeline I expect to spend in excess of $120 million on land and land development during the third quarter, and for the full year fiscal 2013 I expect our total land and land development spend to be in the $550 million range, of which $450 million or so will be from our own cash and at least $100 million will be part of the land banking arrangement.

At March 31, we controlled nearly 24,700 lots including 6500 that were immediately available for use and almost 12,000 lots that are under development or under option which are available in the near-term. During the quarter we activated a $12 million asset in Phoenix from land held for future development containing over 500 lots. When fully developed these lots will have a basis below current market prices for lots in this particular submarket.

We will likely activate additional communities in fiscal 2013 with more expected next year. There are several assets located in Sacramento, valued at approximately $80 million, that are impacted by levee repairs. These assets will remain in land held for future development until those repairs are complete.

Turning now to our balance sheet, we ended the quarter with $426 million of unrestricted cash and an undrawn $150 million revolver. With these available resources, and no significant debt maturities until fiscal 2016, we feel very good about our liquidity position, capital structure and ability to meet our path to profitability objectives.

Similar to most of our competitors, we have a very large deferred tax asset, which will allow us to avoid paying cash taxes on a significant amount of our net income in the future. We currently estimate the realizable savings to be on the order of $450 million, or $13 a share. This asset is subject to a valuation allowance not on our balance sheet until we return to sustainable profitability. Regardless of when we remove the valuation allowance, the ability to avoid cash takes he is represents an important financial attribute of the company.

Overall, I'm very pleased with our performance this quarter and the significant strides we are making to return the company to profitability. With that I will turn the call to Allan to go through our expectations for the rest of the year.

Thanks, Bob.

Across all of our markets, we are executing our path to profitability strategies. We have improved our sales per community even as we have successfully expanded our gross margins. Based on this progress, and our current backlog, we now expect to report positive net income for our fiscal fourth quarter, allowing us to be profitable for the second half of fiscal 2013. That would be the first time since 2006 that we were profitable from operations for any cumulative six month period.

At a more detailed level I'm pleased to announce that we have raised our expectations for adjusted EBITDA for this year. Based on our solid results to date, we now expect adjusted EBITDA of at least $70 million, up $20 million from our previous projection, and nearly $50 million higher than we reported last year. These improvements are driven by year-over-year growth in closings, increases in our ASP, improvements in our gross margin percentage and dollars and modest additional leverage of our overhead costs.

Year to date, our orders are up about 10% as a result of better than expected absorption rates. With the continuing headwinds of the smaller community count, for the second half of the year we'll be happy to simply match last year's orders, implying full year growth of about 5%. More precisely we expect Q3 orders to be below last year with a resumption of order growth in Q4.

As we have said many times, our top priority is to return to profitability as quickly as possible and, almost as often as we have said that, we have been asked when that objective will be achieved. Although it is still very early to make forecasts about next year, we now believe that full year profitability for fiscal 2014 is attainable. It's not layup, and a substantial downturn in-housing demand or home prices would clearly make it less likely, but if we sustain our path to profitability improvements, and success me launch our new communities, 2014 should be our first profitable year in almost a decade.

Thank you for your interest today. We look forward to sharing our continued progress in the quarters to come, and at this point we will be happy to take your questions in the time remaining. Operator.

Thank you. (Operator Instructions). Our first question comes from Ivy Zelman with Zelman Associates. Your line is now open.

Good morning. Congratulations, guys. Alan, that's a hell of a birthday present to have such a great quarter so you must be a happy guy.

I think what we would like to drill in first just to clarify your percentages increases in pricing how much of that is mix-related? And then, if you can just give us a sense -- I mean your goals and your path to profitability are clearly coming to fruition you're closing the gap. When you look at your 19% gross margin, the improvement is impressive, but recognizing that it's still below the 20% gross margins that you figure underwriting to, so what can we expect going forward that will be dependent upon price for gross margin improvement as opposed to just the operational improvements that you continue to obviously bring to the -- to the finish line, and how much more kinds of low hanging fruit is there? That's my first question.

Okay. Boy, that was a lot of questions. I will try and weave through some of that.

Let's talk about margins. There are a couple of things that we said this morning I think that are important. You know, we're very confident that we can drive additional gross margin percentages and dollars. It's why we've raised our target for where we want to get in -- in the next year or two and I think the $48,000 in this quarter was a clear function of both the percentage and the sales prices.

I think the other thing we said and this isn't really in your question, but I want to make sure I point it out. We've always cautioned folks against making sequential gross margin compares sons it's really why we focus on the year over year. As we look at our backlog, as we look at what we've been selling this spring, I'm very confident we're going to be up nicely year-over-year in both Q3 and Q4 in terms ever of gross margins. But I'm little cautious about the sequential trends just because in prior years in fact looking back three or four years our Q3 has been a little lower than our Q2.

So I think it's important to kind of keep context here. It isn't necessarily a hockey stick in a single direction. We're going to be pulling the LTM numbers up I think for some period of time, but we want to be careful about trying to perform unnatural acts in 90 day periods.

You know, in terms of what's driving margin I still think we have and awful lot of room on the operational side, and it's flies to have the price as well and I wish I could tell you a nice tidy sound bite about how much each component is, but of course in every market at each community, is a somewhat different answer. You know, it's clearly the case that feature levels in homes are moving up, and as we change feature levels as we meet customer demand more accurately, I think that's giving us a good margin enhancement opportunity.

If we look at the price side, what's really happened for us with prices is a couple of things. The mix of closings has been part of it, but we started raising prices last full and we are now seeing the benefit of that. So I don't think that mix is a huge part of it. One of the metrics I look at is the average house size our average house size I think is up about 100 square feet year-over-year so it isn't a mix change in that sense, but it may be a mix change that the features within the home are creeping up a little bit, and so that's where it gets very difficult to feel how much of it is feature price increase versus base price increase. So I don't know.

I probably hit about half your question there, Ivy.

No. I think it's helpful. I think that it would seem as if your conviction should be higher sequentially if there were knows operational improvements and the benefits of things that you have put in place and that you would see more of a hockey stick frankly.

You can comment but I will ask my second question first, which would be your community count growth -- obviously we see the challenges of this year, and with all of the benefit from your land bank initiative and further capital spend on more land parcels, can you give us an idea when do you resume to more of the double-digit growth rate with respect to order activity? Where is the inflection point going to come to fruition?

It's a great question. Let's talk about community count. So we're at 148 at the end of the quarter, we averaged 150. I think that will trough in Q4 a little bit below 150 and I think we will start to see good community count growth in the first quarter with -- at some points during fiscal 2014 we will clearly get through 170. Exactly the timing of that is challenging and I think -- I want to tie that back to the land spend.

I know that the amount of money that we spent in the second quarter was more or less than different people's estimates, but the fact is it's very difficult to just spend the money quickly and wisely and I feel very, very good about the 33 deals that Bob talked about that we have under development, the further 24 that we have contracted for but not yet closed, and then the 11 additional in April, all of which gives us pretty good confidence that this Q3 land spend, over $100 million, is real, and Q4 land spending will be even larger than that. And that's just our money in addition to the GSO money.

So I really feel pretty good about the fact that we can drive a community count growth from where it's going to trough a little below 150 above 170, but it's a bit of a fool's errand for me to guess exactly what that mix of community cap growth is going to be quarter by quarter by quarter, but I think all through fiscal 2014, we should see community count growth on a year over year basis.

In terms of conviction back on the margin question I feel pretty good about our margins, but I have to say being a little bit of a student of history I mean the fact is for four or five years in a row with Q3 margins at a little bit below Q2, even if we're up materially year over year, we could be flattish to this quarter and I feel very good about that, because the mix by geographies that we tend to see in the third quarter is a little different mix margin-wise than we see in Q2. So I -- I would certainly not want to leave you or anyone else with the impression that we don't have conviction in our ability both operationally and through price to drive margin.

We are headed in a single direction. It's just that I think the quarterly comparisons, particularly around a business that's as small as ours is right now, it's a little tricky. And I want to just argue for a bit of caution so folks don't make any linear kind of extrapolations and then feel disappointed.

I understand. Thanks very much. Again, happy birthday.

Thanks, Ivy.

Your next question comes from David Goldberg with UBS. Your line is open.

Good morning everybody. Nice quarter. And also, happy birthday, Allan.

Thanks, David.

Look, my first question is about the land banking arrangement, and I'm trying to get an idea on how you're thinking about the permanency of the land banking arrangement. Is this kind of a bridge to get you guys to the point where you get this group what you need to get back to, you do this for a couple of years, and then you go back to a model where you are controlling more of the land yourself? Or is this kind of a longer term, we think this is parts of the business and a way to defer some of the risk?

Yes. Thank you for asking, David, because it's something I wanted to comment on in a more public way since we announced that deal at the end of March, which was really in a period where we were in a quiet period and I couldn't talk much about it.

Here's how I think about it. I think there are regulatory issues that may change and, therefore, my view may change, but if we look back on our company or frankly any company in our industry over the last five 10, 15 years, all of us would have your sued some mix of owned assets and rolling-lot option type assets. We know the names of the companies that had more rolling lot options, we know the names of the companies that have less. These are history over a long period of time of being close to 50/50, 60/40, where rolling-lot options were a meaningful part of what the lot supply or the land use was.

Well, set aside for a moment the relatively attractiveness of that, and let's deal with the practical reality which is that bank capital to land developers to provide rolling lot options to home builders essentially doesn't exist. I have talked to a lot of land developers in the big markets and they will tell you what the banks are telling them the capital requirements for those kinds of loans, the liquidity reserves for those kinds of loans, the loan losses in the loan books for those kinds of loans, are still too recent.

So what I really look at the land bank as is a way to synthetically replace what would have been a portion of our business that was on rolling-lot options. But there are a couple of important improvements, actually. For one thing when you do rolling-lot option deals you can only option those lots that are available. So they pick where they are and we have to figure out a way to make them work. The one nice thing about the land bank is we identify the sites we want to acquire.

The other thing, and it's closely related, is that when you're optioning somebody else's lots, you're paying a retail price with some kind of a price inflator on it. When we do a deal in the land bank we're getting that wholesale cost basis, plus a cost of funds, for our partner. And I think when we look at what the effect on our lot costs is comparing the two kind of head-to-head, we're actually pretty happy with where the lot cost is. Now it's clearly higher than if we just owned it on our balance sheet, I think it's somewhat lower than what a traditional rolling-lot option would be.

Now, $150 million is a fraction of our total spend over any 12 month time period, and I think time will tell whether or not that facility or others like it become a meaningful part of our land acquisition strategy. But I think, optimistically, and frankly it is my perspective, that it is going to be very difficult for the land developers to get back into the bank market the way they used to. And as a result I think we and others are going to have to use these kinds of strategies we want a portion of our lots available to us other than wholly-owned.

So that's kind of how I look at it. I think it's a little bit more permanent and I have seen others trying to guess about the percentage that it might represent. For us right now, options are a relatively small part of our business, even with this $150 million fully deployed, it would be a relatively small percentage of our business. So I don't think it really changes the overall dynamics very much, but I think the margin is very helpful to have that source of capital for and increment of lots other than those that are wholly-owned.

Great. Thank you for the color.

My follow-up question I imagine you don't want to get too specific on it, but obviously, there's been some personnel changes over the last 12 to 18 months kind of getting the right teams in place, really good quarter this quarter. Do you feel like you have the right people in place now? Do you feel like the teams are right and we're not going to see a lot of changes at the division level? Or do you feel like there's still more to come?

We have changed such a high percentage of our divisional leadership I think it's very likely that we will have low turnover at the division level. And when I look at the core markets for us from an investment standpoint, when I talk about California, Texas, Florida, the mid-Atlantic region, I talk about Arizona and North Carolina as sort of in a second tier in terms of incremental capital, we have fantastic teams.

In fact, I think one of the things I'm most proud of and I think it sets us up well for this improving market, is there are a couple of very big market that we were essentially irrelevant in and not present. That's Dallas and Orlando. And if I look at where we are today because of the leadership teams that we have, the land deals that we have done over the last two years, I mean we're not recognizable to the company that was in those markets two or three years ago. So I think it's the people but I also think it's the land positions that we have taken core markets that are setting us up nicely for the next several years.

Thank you. Congrats again.

Next question comes from Michael Rehaut from JPMorgan. Your line is open.

Thanks. Good morning and nice quarter.

First question I had was on gross margins and I guess just to take at it another way -- if you could just remind us as now you're expecting, I guess as you said earlier, community count to trough out later this year and, eventually get to that higher target, with this new communities coming online I guess number one, can you give us a sense of by the time you get to that 170 number what percent of your overall communities would be purchased in the last 18 months? And what type of different margin profile those communities have versus your current mix? Thank you.

Okay. So that's a complicated questions. That's sort of speculation, and I don't mean that in a pejorative way, but trying to estimate exactly when the existing communities run out which is dependent on a sales basis prospectively so it's a bit tricky. I think if you look at the math, Bob talked about 33, 24 and 11. As 33 communities under construction but not yet open, 24 more and then 11, which gives us what, 67, 68. Those 68 are going to be active, I believe, next year at some point during the year. So just those communities -- forget what we did two and though quarters ago -- are going to represent a meaningful chunk of a number like 170 or greater. So I think that's maybe a context to think about it.

I will tell you from an underwriting standpoint with really very few exceptions. In fact, I'm not sure I can think of one off the top of my head, we're targeting gross margins above 20% in the new deals that we're buying on current pricing. It's challenging in some places, and in fact I think one of the great lies in our business is well, so and so bought a deal and they're going to settle for lower margins. And I looked at my team and said, "Hey look, guys we have not stellar margins compared to our peer group. So when we lose a deal it's not because they're dumb and they're going to settle for lower margins. What it really reflects is they were better dialed into what product for the particular buyer profile would maximize the value of that particular piece of dirt."

And so where we have got to be better and where we've got to be able to compete is do we have the ability to deliver the product to the buyer that allows us to get that kind of margin. And I feel like, the plan two years ago, the No Community Left Behind, which was, I admit, very hokey but kind of getting the ratio of communities that are performing working, that was an important learning lesson for us about what makes a community tick and how it fix product, and the people, and the promotion, not just the price.

So I feel pretty good that that skill set is translating into our land approval process so that we're not having to bid stupidly by accepting low margins to win deals, that we're having to be intelligent -- and I credit our peers for making us smarter to figure out what is it going to take to make a particular deal work and meet our margin targets. So I'm not worried that this community count growth has got a bias towards lower margins.

No. I mean I certainly wasn't implying that. I was -- I thought implying a positive impact, but just I guess second question this might be more for Bob. From a modeling perspective, the interest expense amortization -- how should that trend through the rest the year? I mean you've had -- it's been down $3 million, $4 million year over year for the first couple quarters. How should we think about that for 2014? And also any comments on D&A if that should be a kind of keep it at the same run rate, more or less?

Sure. Good morning, Michael. I think that when we talk about cap interest as we continue to add access we're going to continue to capitalize more interest. So the below the line interest obviously will decrease, and the run rate through COGS will probably be similar to what it's been the last couple quarters. I think as we look out.

On a dollar basis?

No. On a percentage of revenue basis. Because obviously as you relieve more assets your dollars that go through will be higher.

Okay. And then as we look into next year would the percent decline as you build up the inventory?

I think once you get to a point where your, let's call them qualified assets, are equal to your debt, then you're not going to have anything below the line. So then you will kind of shift some of that will you will start to relieve maybe a smaller a little bit higher percentage through COGS on a go-forward basis as you get all of your interest running through cost of sales, because you will get a points where everything that we incur will flow through COGS.

Okay. So it would kind of stay more similar on a percentage basis ostensibly in 2014 as you probably won't surpass your debt?

Yes. It's hard to predict when that time will crossover, but certainly once you get to that point in the model then you will probably flip to that a little bit.

Okay. Thank you.

Next question comes from Dan Oppenheim with Credit Suisse. Your line is open.

Thanks very much. I was wondering if you talk a little bit more I think there's been enough in terms of the margin questions, you but I guess just thinking about in terms of the sales ahead of expectations and what the community count where it is, it does sort of bring a question are you doing in terms of pushing pricing? And you're pretty clear in terms of talking about the geographic mix of closings is going to be different, and clearly I would expect to see different turnover of the land and margins in Texas versus some of the coastal markets.

But I guess trying to think about margins on a same house basis in terms of adjusting for that -- how do you look at that as we go forwards on a sequential basis here? Just trying to understand that in the context of the improvement of the market we're seeing now.

Yes. And, Dan, good morning. It's such a tricky thing. I mean we spend a lot of time trying to make sure that we can answer these kinds of questions. But really it's so difficult to split because you never really sell exactly the same house twice because the lot is different. There many a lot premium the feature level maybe a bit different. So you start peeling it down and say, "What was the margin on the Lexington model in this community a year ago? What is it today?"

Well maybe something's changed other than your input costs, and your base price has changed, or your features are higher. So it's tricky. I think the -- so I'm not really sure how to give you a numeric hand hold on that. I definitely do not believe that it is just geographic mix driving margin. We are seeing margin improvements in every single division. And so while the mix may accentuate or attenuate that, the fact is every division is seeing improvement in margin.

Okay. Thanks. And then I was wondering you talked about bringing on land in Phoenix, and then talked about some land in Sacramento that won't come on for a bit. But is there other land in California that you expect in terms of communities to bring on soon or as you go into fiscal 2014?

Yes. I think in that "land held" bucket there is other than the $80 million behind or affected by the levee work up in Sacramento, there are some other assets. And I think will have some of those California assets activated in the next several quarters.

Great. Thank you.

Next question comes from Adam Rudiger with Wells Fargo Securities. Your line is open.

Hi. Good morning. I wanted to ask about the back half of the year profitability in light of some of your commentary with Ivy's question about not expecting a linear kind of gross margin ramp. If I don't -- at least in the way I model it, if I don't take those gross margins up sequentially, I have a difficult time getting to that back half of the year profitability. So could you tell me what I might be missing maybe or what the other drivers of that might be?

Well, sales price is a big one. So you've got to make sure that you're thinking about that. The number of closings obviously is a big one. I do think as said, we're going to be up nicely year-over-year in each of those quarters. And frankly, it's within the realm of possible that we'll be up sequentially. I just want to be a bit cautious about that because the pattern has not been that we would be sequentially up.

I think G&A as a percentage may turn down just a little bit. We have talked about kind of staying in that 9% to 10% range, so I think specific we've got a bit of room there. But that mix of drivers gives us pretty good confidence in that fourth quarter which allows us, I think, to make the full back half GAAP profitable.

I guess maybe following up on that then, for the closing price, should we expect -- I'm not trying to, I guess I am asking specific items but not trying to -- but should we expect the kinds of ramp we have seen sequentially the last couple of quarters to continue on the average closing price?

Here's what I would recommend. Take a look at -- because it's not -- you can do the same thing that I can do, which is look at the relationship between closing ASPs in a quarter and the backlog ASP a quarter and two quarters earlier. And I think if you map that out a little bit, what you will see is the ability to predict within a decent range kind of where closing ASPs ought to be. It's not insignificant that the backlog ASP at $264,000 is $10,000 where it was as a closing ASP this quarter. So but it's not necessarily a next 90 day phenomenon, which is why I'm telling you go look one quarterback and two quarters back and sort of roll that and I think that will help you with your pricing modeling.

Great. The other question I had was one could argue that you guys might have more of a margin versus volume focus than some of your peers as now you have your orders in the desired range although I know you just took the range up and you have different community count trajectory. I was wondering what you in and out that might -- if you thought about that at all the in the context of market share and orders relative to competitors in existing markets.

Hmm.

Meaning if you have a greater focus on margins than peers, there might be more or less likely to raise prices as much as you and then you lose some orders.

Yes. That could happen. I think -- let me just reset back to summer of 2011, and a candid assessment would be that our sales per month per community were last, and our gross margins were last. Two years later our sales per month per community are near the top of the peer group and our gross margins are no longer last but we're not bragging about them. We have still got a lot of room for improvement. And I think that the importance of that sequencing from our perspective was learning how to compete, learning how to make the sale.

And having done that and seeing the benefit of that in the absorption rates now, I think that's given us the momentum. It's frankly given us something that is very powerful with home buyers which is sticks in the air. Sticks in the air is the one of the great things working for any builder in terms of driving activity and enthusiasm, creating a sense of urgency, which gives you some pricing power.

So I don't think that the rate of improvement in our sales per month per community is going to continue. In fact I said I don't think we'll do another quarter at 3.4. We weren't really trying to do 3.4 this most recent quarter. So yes, we will probably plateau out there a little bit. We could go back a little bit and I would still be very comfortable with where we are with respect to the range that we've given. We've got more work to do on the margin side. And to Ivy's question that is both a mix issue, a price issue and it's and operational execution issue. It's just being smarter about what we put in the home and how we merchandise.

So I don't know exactly how to put that in the context other builders. You spend more time than I do by far thinking about them, but I would tell you that I feel like getting competitive selling at an aggressive rate gives us the opportunity to now drive margin. I don't think that there are either/ors, I think that they play off of each other.

Okay, that makes sense. Thanks for taking my questions.

Sure.

Next question comes from Jay McCanless with Sterne, Agee. Your line is now open.

Good morning everyone. First question what are the reasons for the big increase in the east segment gross margins on a year-over-year basis?

You know, this is Bob. I think the biggest reason in the east to be honest is we have executed a lot better. We had some issues a year ago, our volumes were lower. And we have improved our teams out there over the last 12 months, and they have executed at a higher rate. And the mix of closings in that east segment have also trended a little bit more towards Maryland and Virginia, which nationally have higher ASPs and higher margins than maybe some of other markets in that segment. But they have operated at a much better rate.

Second question -- with the almost 400 basis point year over year decline in the cancellation rate, is there any read-through we can make to better availability for first-time buyers in terms of getting finance for a mortgage? Or is it just generally better mortgage availability out there? What can we take away from that?

We've been in a transition over the last year with our Mortgage Choice program where we went from having not a captive but an affiliated relationship, or a marketing relationship with a single lender, to a program now where we've got lenders literally competing for each prospect in every community. And that list of lenders is small, it's hand-selected, it's based on their ability to service buyers of that profile in that location.

And I have to say that I think the lower can rate is largely a function of the fact that those lenders are aggressive, they are working to earn the business of the customer. They're not feeling in any way compelled to try and do business that they don't want to do. So we've got some lenders that in a particular division are very aggressive for a particular buyer profile in one subdivision, and they're not on our list on another subdivision

And it's a little tougher for us to manage, but it sure gives the our buyer needs and what the buyer wants, I attribute a big part of our can rate reduction to that dynamic.

Okay. And if I could sneak one more in -- what do you think the mix of entry-level versus move-up customers was this quarter, and where do you expect it to go over the next couple quarters?

I don't know how to define those things anymore. You know, first time home buyers are older and wealthier than they ever have been, which is kinds of a part of the legacy of the depression in housing that we've had. So it's very hard for us to tell the difference between a move up home, or a first time buyer, and a repeat buyer. And there is some consequence to us of not having a mortgage company, because we're not dealing with their individual credit files and so a bit harder to extract that.

I don't think we tried to effect a change really in the profile that we've got. I will tell you that in our two markets where we have historically been an entry-level builder predominantly, the very lowest price points, we have built through those communities over the last two years, and they're simply not replaceable. It's not that we are too good to go and work in that price points, but we can't get the lots to be at that price point. So I think that that's one of the things that's affecting us. But I would say our business is still more heavily weighted to first time buyers, but that definition of a first time buyer has expanded materially over the last couple of years.

Okay. Great. Thank you.

Next question comes from David Williams with Williams Financial Group. Your line is open.

Thanks so much, and congratulations on a great quarter, guys.

I wanted to talk a little bit about the releasing or the activating of the communities out in Arizona and what that means maybe for the other submarkets and maybe -- are you beginning to take a closer look at some of the second-tier markets today thinking about where that transition is? Are you seeing anything in terms of buyers that are more willing today maybe move out away from those city centers or maybe into those second-tier markets? Just kind of your general thoughts there.

Well, the asset that we activated in Phoenix and the submarket that we're in is one that we have consistently been in. But the fact of the matter was over the last three or four years, we could buy distressed finished lots more cheaply than we could develop that land held asset. Market conditions have changed, finished lots at distressed prices or otherwise have been absorbed. And so that asset is still in the right location but it is now economically pretty attractive.

It requires land development dollars. Two or three years ago, if we could buy a finished lot at a lower all-in costs than what it would have been to develop those lots, I think we did the economically rational thing.

But it's not so much that the location of the piece of dirt changed. That piece of dirt in relation to what other opportunities existed -- that's what's changed. Does that make sense?

It does. Thanks so much for the color there. And then secondly what are you seeing in terms of cycle times and how those are holding up, thinking about the labor constraints during the market today? And are you seeing anything maybe on the development side as well as far as cycle times and how long it's take to go bring some of that land to market?

Well, I don't want to jinx this on the land development side so I will say I'm very weary of that. So far we haven't seen too much of an effect there. We've got some bigger deals and some more land development dollars over the next six months. So I will just predict now in advance of it happening we will have a few challenges there as others are ramping up their community counts as well but we haven't really seen it yet. On the construction side, there are clearly labor peaks and valleys and those availability peaks and valleys can affect cycle time.

I think in the bigger markets in the Southwest in particular, we have seen a week, ten days in -- at certain times of the year where we have had some cycle time expansion. I will say that that's after a concerted effort over the last two years to quite dramatically reduce cycle time. So we are still a lot better than we were even two years ago. But it's definitely widened out in a market like Phoenix or Las Vegas in the last five or six months.

Great. And one more if I could. Could you kind of quantify the incentives this quarter, and then maybe how the input costs were up, maybe on a square foot basis?

I don't have the incentive number at my fingertips, so I can't do that for you. I will tell you that they were down both sequentially and year-over-year. One of the big factors in our quarter, in the March quarter, is always February. Well, the reason it's a big factor is that for the last six years, we have been running and annual sales event in February. And I can tell you 2006 through 2012, that was a period where we sold a lot of homes but there was a significant amount of discounting. Initially it was moving that view finished specs, and frankly at the very trough of the market it was allowing us to recover our basis and land really more than profit from the home sales.

That was really different this year. So February for us was not a discounting opportunity. It was and enthusiasm and an urgency opportunity -- get the last lot on the lake, get the first lot against the open space, be the first owner of the new two story master down, those kinds of things as opposed to trying to discount. So I just know that our discounts and incentives are materially lower.

We've also, through our CMA process, gotten I think a bit smarter. I think we were a bit lazy about high prices and big incentives. On a net basis we were okay. That's a pretty bad way to compete And those gaps get very large, the incentives get very large, it undermines buyer confidence. So I think we've tightened up pricing over the last year as we've really used our CMA process, where we probably brought a lot of base prices down but then more than offset that we reductions in incentives.

So hopefully that gives you a little color. I'm sorry I can't be very authoritative on the percentage or the dollars. I just know it's less. I think on the build costs -- well, Bob can talk a little bit that. I think he's done some work on it.

I think there certainly has been some increases in materials and labor. Everybody knows that lumber has been up quite significantly over the last six months. We have seen increases in drywall and concrete and the labor associated with framing and drywall and plumbing. However, I think that the throughput rate as you can see by the margins that have risen is we've been able to capture that and then some with the lowering of incentives and increasing our house prices.

In our builds, we have seen a several dollar per square foot increase, but the challenge with that is the features have changed. And so the build costs are higher, but it's not apples-to-apples. So a couple bucks a foot I would say you would have a good guess of the net effect. But it is kind of a guess because even if the category level, if you're building a bonus room for somebody as an example your lumber package is higher. Well is your lumber package higher because it's more 2x4s or is your lumber package higher because each 2x4 was more.

And at a point polling that out house by house becomes challenging. That's why I say it's that several dollars per square foot, it's probably more on the order of $2 that really is associated just with material and labor increases.

Great. Thanks so much.

Our last question comes from Joel Locker with FBN Securities. Your line is open.

Hi, guys. Nice quarter. Just basically I wanted to check in on your backlog conversion rates. This I guess your finished specs being only about 5% of your back log is the lowest number possible or lowest number by a long shot in a while and just going forward if you look at the third and fourth quarter if that dynamic is going to slow backlog conversion a little bit?

I think what we said, Joel, in November is that we thought our backlog conversion rates would mirror pretty reasonably with what we converted in fiscal 2012. And I still believe that, and I think we've been pretty close to those numbers the first two quarters. We've got a much lower spec count today than we had even a year ago. Our to-be-built homes in backlog are about 80% so I continue to think that we will be pretty close to what last year's conversion rates were. And I can tell you that Q3 of fiscal 2012 was about 56%. We're about 66% in the fourth quarter a year ago.

Right. Alright. And then also on your -- just about California, if you were looking to maybe strategically diversify because some of your land is weighted in certain areas versus maybe sell pieces to other builders because the land price has gone up and maybe redeploy that asset to take some I guess risk offer the table and maybe diversify in other parts of California if that was a point?

Well, positions where we are actively building right now, I like a lot. We're very active in that I-10 corridor east of LA, and we've got a number of communities in that area really starting in as close as Fullerton and then going out I-10. And the things that we've got there, and we have some land-held assets that are in comparable submarkets. I think those are going to be excellent positions for us in the years ahead. So I'm not overwhelmed about changing anything there.

I think up north we'll keep our eye on the levee situation. Obviously it's very difficult to predict when that will be fully appropriated and constructed, and we will have to make a decision about that market. We happen to own what I believe is among the very best parcels else in Sacramento. We're at two of the four possible interchanges or quadrants at one of the busiest freeway intersections in the state. They're very significant positions. They're very valuable positions. We'll make a decision about what to do with them when we're a little closer to being able to put them into production.

Right. And then what about the land in Temecula? I know you've got a large piece there. I was just wondering if you --

Yes. We like that Temecula corridor. I mean, gosh, it's amazing what's happened to land prices down there. I saw something a couple of weeks ago when I was out there. An investor had paid X and had just laid them off at 3.5 times X in relatively short order. It made me feel very good about our French Valley, we call it French Valley, our French Valley assemblage.

Right. All right, thanks a lot guys.

Okay. Well, I think that was the last question. Thank you all for joining us this morning. We look forward to talking to you in about 90 days.

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