霍頓房屋 (DHI) 2014 Q3 法說會逐字稿

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  • Operator

  • Greetings.

  • Welcome to D.R. Horton, America's builder, the largest builder in the United dates, third-quarter 2014 earnings call.

  • (Operator Instructions)

  • As a reminder, this conference is being recorded.

  • I would now like to turn the conference over to your host, Mr. Don Tomnitz, President and CEO of D.R. Horton.

  • Thank you, Mr. Thomas.

  • You may begin.

  • Don Tomnitz - President & CEO

  • Thank you, Kevin.

  • Thank you and good morning.

  • Joining me this morning are David Auld, Executive Vice President and Chief Operating Officer; Bill Wheat, Executive Vice President and Chief Financial Officer; Mike Murray, Senior Vice President of Business Development, and Jessica Hansen, Vice President of Communications.

  • Before we get started, Jessica?

  • Jessica Hansen - VP of Communications

  • Some comments made on this call may constitute forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995.

  • Although D.R. Horton believes any such statements are based on reasonable assumptions, there is no assurance that actual outcomes will not be materially different.

  • All forward-looking statements are based upon information available to D.R. Horton on the date of this conference will and D.R. Horton does not undertake any obligation to publicly update or revise any forward-looking statements.

  • Additional information about issues that could lead to material changes in performance is contained in D.R. Horton's annual report on Form 10-K and our most recent quarterly report on Form 10-Q, both of which are filed with the Securities and Exchange Commission.

  • Don?

  • Don Tomnitz - President & CEO

  • This spring demand for new homes remained relatively stable compared to last year across most of our markets.

  • And the D.R. Horton team leveraged our platform as the largest and most geographically diverse homebuilder to generate a 25% year-over-year increase in our third-quarter net sales orders.

  • Our increased community count and inventories of land, lots, and homes put us in a strong competitive position and our teams in the field executed our business plan superbly this quarter by focusing on achieving their targeted sales absorptions in each community every week.

  • D.R. Horton has been the leader in the US homebuilding industry for 12 consecutive years.

  • Our market share position today is the largest in our history, with 40% more homes closed than any other builder in the most recently reported 12-month period.

  • To diversify and strengthen our market share both nationally and at the old local level, we're actively expanding product offerings across all price points throughout D.R. Horton, Express Homes, and Emerald Homes brands.

  • The rollouts of our entry-level Express brand and our move-up and luxury Emerald brand are going well, and we will discuss our progress on both later in the call.

  • Our homebuilding of financial services operations generated another solid quarter of profitability with $226.5 million of operating income and a 10.6% operating margin, excluding impairment charges.

  • With our 11,365 homes in backlog and a year-over-year improvement we have seen in our sales during the first part of July, we expect strong home closings, revenues, and profits in our fourth fiscal quarter ending in September.

  • All of our efforts are part of our comprehensive return focus strategy, which we will explain in more detail throughout the call.

  • Our primary strategic goal is to leverage our strong competitive position to generate growth in revenues and profits at a double-digit pace while improving our cash flows and increasing our returns on invested capital.

  • Some of the operating actions we are taking to execute our return focus strategy resulted in some volatility in our financial metrics this quarter.

  • However, we believe our consistent focus on increasing our returns and cash flows while still growing our revenues and profits will greatly benefit our Company and most importantly our shareholders over the next few years.

  • Bill?

  • Bill Wheat - EVP & CFO

  • Net income for the third quarter was $113.1 million or $0.32 per diluted share compared to $146 million or $0.42 per diluted share in the year-ago quarter.

  • Our consolidated pretax income was $171.8 million in the third quarter compared to $205.1 million in the year-ago quarter.

  • And homebuilding pretax income was $158.6 million compared to $185.4 million in the prior-year quarter.

  • The decrease in our pretax income this quarter was caused by $54.7 million of inventory impairment charges primarily in our Chicago market where we are taking actions to reduce inventories to enable us to redeploy the capital to generate better returns.

  • We will discuss these actions later in the call.

  • Our third-quarter home sales revenues increased 28% to $2.1 billion on 7,676 homes closed, up from $1.6 billion on 6,464 homes closed in the year-ago quarter.

  • Our average closing price for the quarter was $272,300, up 8% compared to the prior year, largely driven by increases in average selling prices in our Southeast and West regions.

  • David?

  • David Auld - EVP & COO

  • The value of our net sales orders in the third quarter increased 32% from the year-ago quarter to $2.4 billion.

  • Homes sold increased 25% to 8,551 homes on an 11% increase in active selling communities.

  • Our average sales price increased 5% to $281,300.

  • The cancellation rate for the third quarter was 24%, consistent with the year-ago quarter.

  • The value of our backlog increased 26% from a year ago to $3.3 million, with an average sales price of $286,200.

  • Homes in backlog increased 15% to 11,365 homes.

  • Our backlog conversion rate for the third quarter was 74% excluding closings from Crown Communities subsequent to the acquisition date.

  • We expect our fourth-quarter backlog conversion rate to be around me 75%, consistent with our long-term average for the full quarter.

  • A key part of our return focus strategy is to consistently achieve our targeted sales absorptions in each community.

  • Community absorption targets vary depending on location, product type, lot supply, and market conditions at a local level.

  • Our operators proactively adjust product offerings, sales prices, and incentives to meet the market and effectively compete for new home demand with the goal of improving inventory turn and optimizing a return on our investments.

  • The best way to maximize returns and profits over the life of our communities is to sell and close at a consistent and planned pace.

  • As the spring unfolded, we adjusted and increased the level of incentives in many communities, which helped generate our strong sales result.

  • Overall, incentive levels were at extremely low levels in FY13 and early 2014 but are now returning to normal levels in many markets with significant variations across our communities.

  • Mike?

  • Mike Murray - SVP of Business Development

  • In early May, we acquired the homebuilding operations of Crown Communities for approximately $210 million in cash.

  • Crown operates in Georgia, South Carolina and Eastern Alabama.

  • We acquired approximately 640 homes in inventory, 2,350 lots, and control of an additional 3,400 lots through option contracts.

  • We also acquired a sales order backlog of 431 homes valued at $113.6 million.

  • Although the assets acquired were recorded at their estimated fair values and $53.6 million of goodwill was recorded as a result of the purchase.

  • Our home sales gross profit this quarter was reduced by $9 million of purchase accounting related to the acquisition, and we expect additional purchase accounting impact of $9 million on home sales gross profit over the next three quarters.

  • Our third-quarter results included 290 net sales and 254 closings from the Crown operations, and Crown increased our average active selling communities by 4% for the quarter.

  • The Crown team operates an efficient business with very strong returns, and we are pleased to have them on the D.R. Horton team.

  • Jessica?

  • Jessica Hansen - VP of Communications

  • We continue to experience strong growth and profitability in the heart of our business, our D.R. Horton branded communities, which accounted for the substantial majority of our sales and closings this quarter.

  • We are also pleased with the progress and performance of the rollouts of our Express Homes and Emerald Homes brand as we expand our product offering to it diversify and strengthen our market position, both nationally and at a local level.

  • This year, we introduced our Express Homes brand, which is targeted at the true entry-level buyer who is focused first and foremost on affordability, a segment we believe is currently underserved.

  • In October, we acquired Regent Homes, an entry-level builder in the Carolinas, as we began to refocus on that segment of the market.

  • Today and going forward, we will include Regent in our reported metrics for Express.

  • We are now offering Express in 22 markets in eight states with a significant majority of our sales and closings to date coming from Texas and the Carolinas.

  • Even though we are still in the early stages of the rollout, Express accounted for 7% of our homes old, 4% of our homes closed, and 2% of homes sold revenue in the third quarter.

  • The average closing price for an Express Home this quarter was $156,000.

  • Customer response to our affordable Express product offerings has been extremely positive.

  • In 2012, under the D.R. Horton brand, we began adding more communities and floor plans targeted toward move-up buyers.

  • Last year, we introduced Emerald Homes as our brand for the higher end move-up and luxury committees.

  • 6% of our homes closed this quarter were greater than $500,000 under both the Horton and Emerald brand, accounting for 16% of our home sales revenue, up from 3% in homes closed and 9% in revenues in the same quarter of last year.

  • We are now offering Emerald in 32 markets across 11 states.

  • Homes marketed under our Emerald Homes brand accounted for 2% of our homes sold and closed and 4% of our home sales revenue in the third quarter.

  • The average closing price of an Emerald Home this quarter was $655,000.

  • Consistent with our return focus strategy, our expectation for all three of our brands is a 20% minimum annual return on inventory, defined as pretax income divided by average inventory, and our underwriting criteria for all land and lot purchases reflects this ROI expectation.

  • In general, we expect our Emerald communities to generate higher than average gross margin at lower than average absorption, our Express communities to generate faster than average absorption at lower than average gross margin, and our Horton communities to continue to operate at our average margin and absorption.

  • Bill?

  • Bill Wheat - EVP & CFO

  • After significant improvement in our gross margins over the last several quarters, we expected further improvement in our margins to be challenging, and we expected revenue growth to become the strongest driver of our profit growth.

  • Our expectations were realized this quarter as home price appreciation is moderating, some costs are still rising, and incentives are increasing back to normal levels.

  • At the same time, we are focused on improving our returns on our inventory investments in each community by balancing our home prices, incentives, sales pace, and profit margins.

  • Our gross profit margin on home sales revenue in the third quarter was 20.7%, down 70 basis points from the year-ago quarter.

  • 60 basis points of the margin decrease was caused by higher relative costs for warranty and construction defect claims as a percentage of home sales revenue due to a large amount of cost reimbursements received in the prior-year quarter.

  • 40 basis points of the decrease related to the purchase accounting impact from the acquisitions of Crown Communities and Regent Homes.

  • These decreases were partially offset by 20 basis points from year-over-year increases in sales prices and by 10 basis points due to lower amortized interest and property tax costs as a the percentage of home sales revenue compared to the prior-year quarter.

  • Sequentially, our home sales gross margin decreased 180 basis points from the second quarter.

  • 90 basis points of the sequential margin decrease was due to the combined effect of higher levels of incentives and cost increases.

  • As we mentioned earlier, we adjusted and increased the level of incentives in many communities throughout the spring in an effort to improve sales absorptions and maximize returns and profit.

  • In general, incentives were at extremely low levels in FY13 and early 2014 and are now returning to more normal levels.

  • An additional 60 basis points of the sequential margin decrease was due to higher relative cost for warranty and construction defect claims, and the remaining 30 basis points related to the purchase accounting impact from the Crown acquisition.

  • Generally, in a stable housing environment, we expect our average gross margins to be around 20%, with quarterly fluctuations due to product and geographic mix and the relative impact warranty and construction defect and interest costs.

  • Mike?

  • Mike Murray - SVP of Business Development

  • Another important aspect of our return focused strategy is actively managing inactive or underperforming assets to improve returns in cash flows and redeploying the cash into more productive assets.

  • As market conditions have improved, we are activating development of many of our mothballed assets and will begin selling and closing homes in these communities over the next year.

  • As a result, our balance of land held for development declined over $100 million to $396 million at June 30, which corresponds to a 22% decrease in the number of lots to 17,000 lots from a year ago.

  • Our operators continue to develop their plans for each remaining held land parcel and we expect that land held for development will significantly decline over the upcoming year.

  • Our third-quarter results included $54.7 million of inventory impairment charges.

  • $48.8 million of the charges occurred in our Midwest region primarily related to large land positions in actively selling communities in Chicago acquired between 2004 and 2007 that had been previously impaired.

  • In contrast to most of our markets, the Chicago housing market remains very weak with sales absorptions and returns in these communities performing below our expectations relative to the size of our investments.

  • In response during the quarter, we reduced prices and identified land parcels we intend to sell in these communities in an effort to increase sales pace, reduce inventories, and approve cash flows and returns.

  • Based on current market conditions, we believe that we do not have another concentration of underperforming communities in an individual market that would result in impairment charges of the same magnitude as we incurred in Chicago this quarter.

  • However, as we execute our return focused strategy and take actions to optimize cash returns by modifying our product, pricing incentives, or plans to sell land in individual active communities, and land held for development, we could incur additional impairment charges in the future.

  • Don?

  • Don Tomnitz - President & CEO

  • Homebuilding SG&A expense for the quarter was $221.9 million compared to $167.5 million in the prior-year quarter.

  • As a percentage of homebuilding revenues, our SG&A was 10.8% this quarter compared to 10.2% in the prior-year quarter.

  • Fiscal year to date, SG&A as a percentage of home sales revenues was 10.9%, flat with last year.

  • We are actively investing in SG&A infrastructure to support our current and expected growth.

  • Additionally, the third quarter SG&A percentage included a 20 basis point impact due to the increased valuation in composition accruals which increased because of our higher stock prices this quarter.

  • And to correct myself, our SG&A expense for the quarter was 10.6%.

  • We expect SG&A as a percentage of home sales revenues to decrease sequentially in the fourth quarter on higher expected revenues.

  • Beyond FY2014, our ongoing annual target for SG&A as a percentage of homebuilding revenues is 10%.

  • Jessica?

  • Jessica Hansen - VP of Communications

  • Financial Services pretax income for the quarter was $13.2 million compared to $19.7 million in the year-ago quarter.

  • This quarter continued to reflect a more normal competitive pricing environment whereas the year-ago quarter benefited from unusually favorable market conditions which produced higher than normal gains on sale of mortgages.

  • 88% of our mortgage company's loan originations during the quarter related to homes closed by our homebuilding operation.

  • FHA and VA loans accounted for 43% of the mortgage company's volume, down from 47% in the year-ago quarter.

  • Borrowers originating loans with our mortgage company during the quarter had an average FICO score of 719 and an average loan-to-value ratio of 89%.

  • David?

  • David Auld - EVP & COO

  • At the end of June, we had 20,500 homes in inventory, of which 1,500 were models, 10,000 were speculative homes with 3,100 of the specs being completed.

  • Our construction in progress and finished homes inventory increased by $518 million during the quarter and now represents 46% of our inventory balance, the highest percentage in 10 years.

  • This component of our inventory is the fastest turning portion of the inventory investment.

  • At June 30, our lot portfolio consisted of 125,000 owned lots with an additional 54,000 lots controlled through option contracts.

  • 66,000 of our lots are finished with half owned and half optioned.

  • Our land held for development totaled 17,00 lots, down 22% from March.

  • As we continue to proactively work through the older inactive land to redeploy the capital and improve inventory turns, cash flow, and the overall return on investment.

  • With 179,000 total lots owned and controlled, we are in a strong position to compete in the current housing market with a sufficient lot supply to support strong growth in both sales and closings in the coming years.

  • In the third quarter, our investment in lots, land, and development totaled $665 million, of which $456 million was to replenish finished lots and land and $209 million was spent on land development.

  • Our investment in lots, land, and development for the first nine months of the year, excluding the Crown and Regent acquisitions totaled $1.7 billion, down from $2.1 billion last year.

  • Bill?

  • Bill Wheat - EVP & CFO

  • At June 30, our unrestricted homebuilding cash totaled $538.5 million, and we had available capacity on a revolving credit facility of $657 million with no cash borrowings outstanding.

  • Our homebuilding leverage ratio net of cash was 34 4% and our gross homebuilding leverage was 38.7%.

  • The balance of our public notes outstanding at June 30 was $3.1 billion.

  • $137.9 million of our senior notes mature in September and we have sufficient cash and revolver capacity to repay these notes.

  • During the quarter, the holders of our 2% convertible senior notes converted their notes into 38.6 million shares of common stock which added $500 million to paid in capital this quarter.

  • At June 30, our shareholders equity balance was $5 billion and book value per share was $13.63.

  • Based on our solid balance sheet, liquidity, and current and expected levels of profitability, our Board of Directors increased our quarterly cash dividend by 67% from the most recent dividend paid to $0.0625 per share.

  • The dividend is payable on August 18 to shareholders of record on August 8. Don?

  • Don Tomnitz - President & CEO

  • In closing, we are pleased we've maintained our position as the largest builder in the United States by volume for the 12th consecutive year.

  • We are growing our volume at a faster rate than the overall industry and continue to capture additional market share.

  • Based on the recent Local Leaders issue of Builder Magazine, ranking homebuilders market share in the top 50 new home markets in the United States, D.R. Horton is the number one builder in 4 of the top 10 markets, is a top five builder in 8 of the top 10 markets, has a double-digit percentage share in 10 markets and is a top five builder in half of the top 50 new home markets.

  • We also have a leading market share position in many markets outside of the top 50.

  • Our leading market share position nationally and in many of our local markets, provided the platform for us to produce very strong increases in the value of our sales, closings, and backlog of 32%, 28%, and 26% respectively.

  • As we generated another solid quarter of profitability with consolidated pretax income of $171.8 million on $2.1 billion of revenues.

  • We've also make good progress this year towards our long-term goal of producing profit cash flow from operations while still growing the business.

  • In the first nine months of FY14, our cash used in operating activities declined by $560 million as compared to the prior-year period.

  • We expect additional substantial progress in our cash flow performance over the next year.

  • We remain intently focused on growing our revenues at a double-digit pace with strong profits while improving our cash flows and increasing our returns on invested capital.

  • We are very well-positioned to do so with our solid balance sheet, industry leading market share, broad geographic footprint, diversified product offerings across our three brands, and attractive finished lot and land position, and most importantly, our tremendous operational team across the country.

  • DR and I would personally like to thank our employees for your continued hard work and accomplishments.

  • We want to specifically thank our sales people for focusing on achieving their budgeted net sales each week in each subdivision, a key element in improving our ROI and free cash flow.

  • Keep it up and let's finish our fiscal year out strong.

  • This concludes our prepared remarks.

  • We'll now host any questions.

  • Operator

  • (Operator Instructions)

  • David Goldberg, UBS.

  • David Goldberg - Analyst

  • My first question was about the level of incentives you guys are offering and what I am try to figure out is, are you finding that other builders are kind of coming out and matching you on these incentives?

  • And if so, is there an endgame where you say, look, this doesn't make sense anymore, we're not -- we might sell more homes for a short period of time but eventually it's just kind of a zero sum game?

  • Or do you find that the competition is a little bit more reluctant to come after you guys given that you probably have a better cost structure and can still make money, maybe at a little bit lower price.

  • Don Tomnitz - President & CEO

  • We really have not noticed the other builders coming after us, as you mentioned.

  • And I think that's reflective in their sales increases that most of them have reported so far compared to our sales increase.

  • So as a result, I don't believe that it's adversely affecting the market for other builders.

  • We're focused on our key strategy of hitting our minimum absorptions per community, per week so that we can generate a higher return on our inventory and generate free cash flow for our investors.

  • David Goldberg - Analyst

  • And then just as a follow-up on the warranty -- the change in the warranty.

  • Nothing specific happening there.

  • There wasn't anything underlying that, no change in terms of increased claims or anything like that.

  • Just kind of normal fluctuations or is there anything more to read into that?

  • Bill Wheat - EVP & CFO

  • Just normal fluctuations, nothing specific in the quarter that occurred, no specific charges.

  • The comparison to the prior-year period, we had received some more infrequent cash reimbursements than the prior-year quarter.

  • This quarter, we received no such reimbursements.

  • So it's just simply normal fluctuations.

  • David Goldberg - Analyst

  • Thank you, guys.

  • Operator

  • Stephen Kim, Barclays.

  • Stephen Kim - Analyst

  • Great job in the quarter.

  • Wanted to get some clarity, I guess.

  • You made the comment, I think you used the phrase stable demand earlier on in your prepared remarks, and obviously, the new home sales numbers just came out and it looked like it was a pretty squishy number.

  • I know that that's not the most reliable metric of all, but wanted to see if you could clarify that, particularly in the context of your commentary about discounting being up, and Bill's comment that I think you said generally you look for about a 20% gross margin, which is obviously lower than -- significantly lower than what you've kind of been doing if you make the adjustments for the one-time event.

  • So, was curious if you could just talk about what you mean by seeing stable demand in the context of your discounting and the comment on gross margins.

  • Thanks.

  • Bill Wheat - EVP & CFO

  • Well, in terms of our comment on stable demand, we saw a significant increase in demand in 2013.

  • And we saw a significant price appreciation in 2013.

  • And so the levels of demand a year ago had increased dramatically.

  • We all know that has moderated some since then and as we assess this spring, we would say on an overall basis the demand is relatively stable with where it was last year.

  • Obviously there's significant variations across our markets.

  • Some markets we're still seeing increasing demand.

  • Others are flatter.

  • Generally, in most markets we're seeing less price appreciation here this quarter.

  • Really from our perspective, settling into a more normal pattern, perhaps modest growth, modest price appreciation but not as dramatic as a year ago.

  • Same thing for our incentives.

  • A year ago, our incentive levels were very low, extremely low.

  • Now they're simply moving back to a more normal level and so reflectively then, we would expect our margins to return to a more normal level which is really around that 20% level.

  • The margins, when they get 1 point, 2 points, 2.5 points higher than that 20% level are really the exception rather than the rule, over the long term.

  • Don Tomnitz - President & CEO

  • And as we've said for years, Steve, we've said the normal margins in this industry are somewhere between 18% and 22% and our goal is to hit a 20% gross margin, 10% SG&A, and a 10% pretax operating margin.

  • So that's our focus, and it continues to be our focus.

  • Bill Wheat - EVP & CFO

  • And our number one focus is generating a 20% return on investment community by community.

  • And that requires us balancing our pace, our pricing, our incentives, and the margin against volume to maximize really the return.

  • And so yes, we'll give some incentive to achieve a 25% sales increase.

  • We'll take that trade.

  • Don Tomnitz - President & CEO

  • We're in a strong position if you take a look at our total lot inventory of 175,000 lots, and I've said after quarter after quarter after quarter, our people have done a great job of buying land and lots at a very early time in the recovery and what we're doing is taking those lots, putting home on them, and producing very good margins based upon our low costs and our land and lots.

  • Bill Wheat - EVP & CFO

  • Now important to realize this is community by community.

  • Every community has a different target depending on its own situation.

  • There are certain markets where our lot supplies are more strained, where we cannot replace the lots we have, where there is very limited housing inventory, and so in those markets, our target absorptions are lower and we will push prices more there because that is the path to a higher return in those communities.

  • Other communities, there's not such constraints and the best path is to drive volume at a consistent pace.

  • Stephen Kim - Analyst

  • That's very helpful.

  • Thanks very much.

  • Regarding the volume, we obviously have written about your plans across the price spectrum to grow pretty significantly, and it looks very intriguing.

  • One of the things that we've gotten as pushback from folks is the comment well, gee, it sounds like an incredibly bull market strategy in an environment that frankly doesn't sound so bullish.

  • My interpretation is that your strategy is not actually characterize -- cannot be categorized as a bull market strategy.

  • But I wondering if you could respond in your own words the proliferation of your communities planned openings in Emerald, Express, and D.R. Horton, and in the context of somebody saying well, that sounds like a bull market strategy.

  • Don Tomnitz - President & CEO

  • I think it's a very conservative strategy and if you look at our creation and our expansion of our Express model, that's creating a lot of a bullish scenario associated with our sales and we're in a limited number of markets now.

  • With our Express, we're only in 22 markets in 8 states and obviously we have 79 markets in 27 states in which to expand Express in.

  • But with an ASP of $156,000 this quarter on Express, we feel very bullish about the opportunity to continue to expand Express and I think that will contribute to our higher than industry level sales on a go forward basis simply because we have chosen a part of the market that we believe truly is underserved, and as I said last quarter, a portion of the market that we feel comfortable is going to grow at a higher rate than the other parts of the market and that's why we chose to leverage up ourselves and expand into Express.

  • Don Tomnitz - President & CEO

  • And as well, we clearly believe there is demand in that segment of the market that there is no supply for.

  • And so we don't believe that that's an aggressive strategy, that's just simply addressing a need in the market.

  • David Auld - EVP & COO

  • And they also -- they also state we're leveraging off existing profitable platforms.

  • So it's not like we're jumping into new markets that we don't have operating platforms in today.

  • To me, it's a very conservative way to take demand that's in the market today.

  • Don Tomnitz - President & CEO

  • We're not trying to do greenfields of markets that we don't know anything about.

  • We know a lot about the markets, we're just opening a new brand for which we feel like the market is being underserved.

  • Stephen Kim - Analyst

  • Makes a lot of sense.

  • Thanks a lot, guys.

  • Operator

  • Michael Rehaut, JPMorgan

  • Michael Rehaut - Analyst

  • Thanks.

  • Morning, everyone.

  • Had a question first off on the timing and the pattern of the incentives, if there's any way to give a little more detail there.

  • In terms of you mentioned that you want to get to a certain pace and incentives were particularly low and now you're taking it back to normal.

  • But I am curious if that occurred maybe towards the beginning of the second quarter or the late at the end of your fiscal first quarter or is it something that as the spring selling season didn't maybe fully materialize to your more hopeful expectations, you know, in the May, June timeframe, you kind of cranked it up then.

  • And also if the incentives were more prevalent in some markets versus others.

  • Don Tomnitz - President & CEO

  • Well actually, it occurred in March and we had our division presidents meeting in April.

  • And that's at which point in time we focused with our division presidents on hitting their pro forma absorption level on a community-by-community basis, because we felt like that if they did that then they would achieve the ROIs, return on inventories, that they had projected and the return on inventories that we wanted.

  • And again, the incentive levels will vary by community to community, as Bill said earlier, where there are a shortage of lots where we can't replace those lots with the cost basis we have in them, then we're going to maximize our gross margins and our absorptions are going to go at a little slower pace.

  • But as David said, where we have larger inventory of lots and we could easily replace those lots, then that's going to be the business model where we are focusing on higher options and lower gross margins.

  • I want to emphasize, though, if you look at our three product lines, Express, where we're going to have lower margins and higher absorptions, Emerald where going to have lower absorptions and higher margins, and both of those are going to blend right in to the D.R. Horton margins.

  • And once again, I don't want anybody to get confused, our overall Company goal is 20%, 10%, 10%.

  • 20% gross margin, 10% SG&A, and 10% at the PTI line.

  • Bill Wheat - EVP & CFO

  • With the 20% net ROI community by community.

  • Michael Rehaut - Analyst

  • So in the terms of that 20% goal, Don, last quarter I believe you said as a Company that you thought going forward gross margin in a range of the prior four quarters, which was in a kind of a 21% to 22% range was more sustainable, it seems like you're more kind of revising that more based towards something that you've said on a much longer basis that it's just again this 20%, 10%, 10%.

  • Is that fair?

  • Don Tomnitz - President & CEO

  • As I've mentioned to Steve, and I'll say it again and again, and I've said ever since we've been doing these conference calls, the normal gross margins in this industry go between -- range between 18% to 22%.

  • We believe a normalized gross margin for ourselves were somewhere right at the 20% level.

  • And we were very fortunate in the early stages of the recovery where we had a lot of pricing power.

  • There was a lot of increase in median prices of homes across the country because they had -- the market had overreacted in a lot of markets and prices that declined more than they probably should have, but normal margins for us are 20%, 10%, 10%, and as Bill says, a 20% ROI.

  • Bill Wheat - EVP & CFO

  • Don is speaking to the longer-term expectations which that is clearly specific to the guidance we gave last quarter.

  • That was targeted more towards the next few quarters.

  • And I believe the low end of that range would have been around 21.4%.

  • So our margins did come in below the low end of the range that we gave.

  • Specifically the causes for that would've been the purchase accounting impact and the fluctuation that we had in the warranty and construction defect claims.

  • Outside of those, we would have been within a range.

  • And then going forward, over the long term, we expect to fluctuate around the 20% but again, focusing on returns.

  • Don Tomnitz - President & CEO

  • But if you take a look at a very important metric, and we will do this all day long, we can get a 25% to 28% increase in sales quarter over quarter, and only have to give up 90 basis points on incentives.

  • That's a win-win for us and our shareholders.

  • Michael Rehaut - Analyst

  • I appreciate that, and thanks for the additional color, Bill.

  • I guess one last one.

  • The SG&A, I think you said that 20 bps was due to some of the stock comp related expense, but even without that SG&A was on a percentage basis roughly similar to a year ago on a 28% revenue growth.

  • So I would have expected maybe a little bit of leverage there on a percentage basis on a year-over-year basis.

  • Any thoughts around that?

  • Are there any other items that we're not taking into account?

  • Mike Murray - SVP of Business Development

  • I think we're going to continue to see further leverage in the SG&A.

  • Sales are still pacing at a pretty good level ahead of -- with revenues and ahead of revenues and we're still building some of the infrastructure to support that growth that we're seeing in the brand launches and the platforms across the country as we do that.

  • So I think we're going to see better leverage on our SG&A into the fourth quarter and then coming closer back to our historical target of 10% into next year with the leverage we'll attain on the SG&A.

  • Don Tomnitz - President & CEO

  • But we believe it's a good problem that we have and that is our SG&A is growing to support our extraordinary growth in sales and our backlog.

  • Michael Rehaut - Analyst

  • All right.

  • And the better leverage for 4Q would be on a year-over-year basis as well or just sequentially?

  • Mike Murray - SVP of Business Development

  • Certainly, sequentially.

  • Michael Rehaut - Analyst

  • Thanks very much.

  • Operator

  • Dan Oppenheim, Credit Suisse

  • Dan Oppenheim - Analyst

  • Thanks very much.

  • Good job in terms of responding to the market.

  • I think historically, you guys have always done well in terms of balancing the pace and price there.

  • Wondering -- talked about 90 basis points in terms of the second quarter margins.

  • Presumably some of the -- what you're doing with the incentives were to generate sales that will be closing, sorry, the second calendar quarter but third fiscal.

  • But if we think about the fourth fiscal quarter here, some of those will likely be coming through.

  • Should we expect more of a hit to margins in the coming quarter from this impact?

  • Bill Wheat - EVP & CFO

  • We're not necessarily giving specific guidance for next quarter or the next quarter in terms of margins.

  • We're going to continue to balance the incentives to what we see in the marketplace, and we still close a significant percentage of homes in the same quarter in which we sell them.

  • So there is some reflection of the current market in our closings each quarter, but our overall guidance is really the longer term.

  • We're going to fluctuate around 20%.

  • Some quarters we may be higher than that.

  • Some quarters we may not.

  • Dan Oppenheim - Analyst

  • Great.

  • Thanks very much.

  • Operator

  • Mike Roxland, Bank of America.

  • Mike Roxland - Analyst

  • Thanks very much.

  • Is there any way to quantify how much incentives have increased versus earlier in the year in 2013?

  • Jessica Hansen - VP of Communications

  • Mike, we really look at it in terms of the impact on our gross margin and so the biggest impact we've seen from incentives so far in 2014 would be this quarter with the 90 basis points.

  • There were also some cost increases associated with that 90 basis points but for the most part that is incentives.

  • So we'll continue to see how that falls out but we really just try to talk about it in terms of how it impacts our gross margin.

  • Mike Roxland - Analyst

  • Got you.

  • And then just -- when you look at the entire housing complex, what would you say is the biggest limiting fact there preventing a more robust housing recovery?

  • Is it credit?

  • Is it employment?

  • Is it labor availability?

  • Can trading the availability of builders to construct homes?

  • Don Tomnitz - President & CEO

  • I think the biggest impediment to the housing industry continues to be job growth.

  • I still say that we continue to create a lot of temporary jobs and part-time jobs.

  • My comment is, is that part-time workers are not looking for a house, they are looking for a full-time job.

  • I think combined the major thing that we can do to help the housing industry and all industries is to create permanent jobs and better paying jobs.

  • And secondly, to have a consumer confidence level where people can wake up in the morning and feel good about what's going on in the economy and in their life.

  • So those two factors continue to drive our business more than anything else but jobs, jobs, jobs is what grows our industry.

  • Mike Roxland - Analyst

  • Thanks.

  • Operator

  • Stephen East, ISI Group.

  • Stephen East - Analyst

  • Thanks.

  • Good morning, guys.

  • You talked about the gross margin expectations, et cetera, moving back to 20%, and I assume the overwhelming majority of that is going to be in your core D.R. Horton product.

  • But if you look at Express, where you are today with its volumes, where would you expect that to sort of run to over the next two or three years and how much of that would be driving this move back down to 20% gross margin?

  • Don Tomnitz - President & CEO

  • What we're underwriting, as Jessica said earlier in the conference call, we're underwriting our Express, as well as our D.R. Horton for a 20% gross margin return.

  • Excuse me, 20% return, which then basically implies that if we're turning our inventory a couple times a year that our gross margins, as we said, would be less than the 20% level.

  • Jessica Hansen - VP of Communications

  • Stephen, so what we're actually seeing so far I would say is better than expected margins on Express, and they're trending relatively close to that 20% range, just shy of that.

  • That may change as we go forward because as we've said multiple times throughout this call, we are focused first and foremost on that 20% ROI, and if we're turning the inventory quick enough, as Don said, we can work for a little bit less gross margin.

  • But in terms of our gross margin guidance, which really isn't guidance, but in terms of it being around that 20%, that's just a combination our day to day business and isn't really an expectation of Express becoming a bigger piece of our business.

  • It will become a bigger piece of our business but we think we can run all three brands combined and put out somewhere around a 20% gross margin over the long term.

  • Stephen East - Analyst

  • Okay.

  • Bill Wheat - EVP & CFO

  • You asked about how big it could be.

  • We haven't put necessarily specific targets on how big it could be.

  • We're still in the very early stages.

  • We do expect substantial growth in Express.

  • And Emerald, we expect it to continue to grow as well.

  • But we haven't necessarily put a specific target as far as percentage of the business.

  • And really, different times in the cycle, different economic conditions, the percentages of the business may fluctuate a bit.

  • But clearly right now, we expect substantial growth from where we are today.

  • Stephen East - Analyst

  • Okay.

  • Don Tomnitz - President & CEO

  • As Jessica said, right now Express is running about 20% gross margin even though we're underwriting it for less but we think that will probably decline some over the years.

  • Stephen East - Analyst

  • Sure.

  • I got you.

  • And then different subject.

  • If you just look at the order progression through the quarter, we've gotten noise that June absorption is much lower than the prior three months, et cetera.

  • One, what your progression looked like, did you see that and just any color on July.

  • Jessica Hansen - VP of Communications

  • Really, just on July what we said on the call was that we've continuing to see year-over-year improvement in our July sales and so I'd say we're pleased just like we were in Q2, thus far.

  • We're not finished with July but we're happy with what we've seen.

  • Bill Wheat - EVP & CFO

  • And really, we saw strong steady sales pace really through all three months of the quarter.

  • Typically when you get into June you start to see a little bit of seasonal slow down but we didn't see very much.

  • So overall, we would still say good consistent demand all three months.

  • Stephen East - Analyst

  • Okay.

  • Thank you.

  • Operator

  • Adam Rudiger, Wells Fargo Securities.

  • Adam Rudiger - Analyst

  • Thanks for my question.

  • I recognize this is all done at the community level, but if you look at the company-wide average, how were the absorptions now relative to the budgets?

  • I'm just getting at is there -- you think there's further need to tweak some things to get things going?

  • Or do you have the pace where you want it?

  • David Auld - EVP & COO

  • Adam, this is David.

  • What I experienced out in the field for 25 years is that nothing drives margins higher than consistent absorption.

  • And we are right now operating pretty much on our budget on a community-by-community basis without anything unusual from a concession standpoint than what would be a historical norm.

  • And part of what we believe is that as we drive consistent absorption in these communities, we will be able to maximize margin, not continue to or see a deterioration of margin.

  • Adam Rudiger - Analyst

  • Okay.

  • David Auld - EVP & COO

  • And right now, we are getting consistent absorptions throughout our communities.

  • Adam Rudiger - Analyst

  • Okay.

  • And then totally different topic.

  • The Crown acquisition.

  • Atlanta seemed like a market that in the past a lot of big builders had shied away from.

  • I think the general criticism of it had been the fragmentation of it.

  • So could you talk about what you saw in that opportunity and really what you liked about it?

  • Mike Murray - SVP of Business Development

  • What we liked about that opportunity was the geographic footprint within the Atlanta market itself that we were not serving well, that Crown had done a very good job of serving with a very efficient platform, great team of people, very happy to have those as part of our organization.

  • And Atlanta is a very large housing market in the country.

  • It is on the rebound and permits are growing there.

  • Job growth has been good in Atlanta and we are seeing very good demand in a broad range of the submarkets around Atlanta.

  • Don Tomnitz - President & CEO

  • And frankly, there are operating metrics as well as just their style of operations reminded us so much of our formative days when DR formed the Company and we were operating with very little capital and having to do rolling option contracts and churning our inventory more quickly, and so we think that we'll be able to take what they're doing now and transition that over into some of our other operations where perhaps we're not as entrepreneurly oriented as we used to be or they are.

  • So it's a great learning experience for us and they participated very well in our division president meeting that we had in April, and already beginning to transfer ideas from them to us and from us to them.

  • Adam Rudiger - Analyst

  • Okay.

  • Thanks for taking questions.

  • Operator

  • Eric Bosshard, Cleveland Research Company.

  • Eric Bosshard - Analyst

  • Thanks.

  • Two things.

  • First of all, on incentives.

  • I'm curious if you could give us some sense of the breadth and depth of where that is and the trend that we should expect moving forward.

  • Obviously you've stepped it up effectively this quarter.

  • But I'm trying to figure out if are you at a level now that you feel is effective enough or do you see a need to continue to increase the amount or the breadth of the incentive efforts.

  • Don Tomnitz - President & CEO

  • Well if you take a look at our net sales orders having increased 32% in value and our backlog having increased 26% in value, we believe we're at a really sweet spot, and we don't see the real need to increase it significantly over where it is today.

  • As a matter of fact, we might be able to decrease it some because obviously, we have industry-leading sales increases, closing increases, and backlog increases so we're far ahead of our competition at this stage.

  • Bill Wheat - EVP & CFO

  • And at the same time, it's very difficult to make general comments about it.

  • We can talk overall and overall we're very pleased with where we are and we're hitting our expectations but it's really managed community by community, so there will be communities where we can let off on incentives and raise prices and improve margins.

  • There will be others where we will have to increase.

  • But in general, the overall result of what we've done collectively across all our communities we're pleased with the pace that we're at.

  • And overall, wouldn't expect to have to increase it from here.

  • Eric Bosshard - Analyst

  • Great and then just within that, I know you commented that a component of those incentives were invested for the completions in this current quarter that would have showed up in these financials.

  • I'm just trying to get a sense of how much the incentive investment would have shown in the gross margin in this current quarter versus how much is yet to show in the closings that will come in the coming quarter.

  • Jessica Hansen - VP of Communications

  • Sure, Eric.

  • About 33% of the homes we sold this quarter were actually closed this quarter as well.

  • Sorry, I kind of said that backwards, but sold and closed in the same quarter was 33% of our closings.

  • Eric Bosshard - Analyst

  • And then the second question that -- interested in the strategic thinking at this point in the cycle with land purchases and how you're thinking about the desire, the demand to add more land to inventory.

  • I know that you continue to be active there but how are you thinking about that in terms of the magnitude and if the type of land that you're acquiring if that that's changing at all?

  • Don Tomnitz - President & CEO

  • Well as we said on the conference call, the vast majority of our spend was associated with just replacing lots that we have rolled through, rolled off over the course of the past two to three quarters, and the rest of it was actually on land development spend which was on developing lots that we had already purchased the land on.

  • So we believe again we have a total of 178,000 -- 175,000 total lots and that's about a 4.8 or 4.9 year supply based upon our trailing 12-month sales.

  • So we feel like that we're in a very, very strong position that we're not out there in the marketplace today paying a higher price for land.

  • We've got a great land inventory as we've said quarter after quarter with a very, very low cost basis in it.

  • So we're being very conservative on the land purchasing right now.

  • Eric Bosshard - Analyst

  • Perfect.

  • Thank you.

  • Operator

  • Ken Zener, KeyBanc.

  • Ken Zener - Analyst

  • So pretty exciting quarter here.

  • Your guys' results, obviously on a company basis, reflect your initiatives, whether it's Express or the numerous acquisitions.

  • Yet I wonder if you have an adjective, an early one, Don, for 2015 given -- I think income, lack of income is the big thing that's missing this time.

  • But if you're looking at 20% gross margin, I heard it a lot longer term, can you talk about how you're responding and Bill, I know you're doing it community by community, but I think they're outliers.

  • The markets like Sacramento and Phoenix where new sales are down, rising existing inventory, those are once distressed markets.

  • Could you talk about what's happening there from your perspective and contrast that with the new home sales number today that had the south, obviously Texas is a big number in there, where you're having down sales there which obviously you're having job growth and income growth, so do you really view that market more supply constrained and could you contrast it with the distressed market, please?

  • Thank you.

  • Don Tomnitz - President & CEO

  • Well, (laughter) first of all, I'm going to state that I'm not going to -- .

  • David Auld - EVP & COO

  • That was a good question.

  • (laughter)

  • Don Tomnitz - President & CEO

  • And I'm going to answer it the way I've been answering it for the last quarter, or actually the last four or five quarters, is that I do not want to get into specific markets and talk about the strengths or weaknesses in the individual market.

  • And yes, I've read the same things about Sacramento and Phoenix and those different markets and we're experiencing pretty much what everybody else is experiencing in those markets.

  • So they're both difficult markets.

  • Bill Wheat - EVP & CFO

  • But clearly in Texas, when you look at our south central region and the sales we're reporting, clearly we are not down in Texas.

  • Clearly we are up substantially in our sales in Texas.

  • So we would be -- that would be gaining market share in Texas.

  • Jessica Hansen - VP of Communications

  • We haven't had time to actually look at the new homes sold number since it came out the minute our call started (laughter) but that being said, Ken, we are baffled a lot of times when we see it because it doesn't necessarily look the same as what we are seeing in our internal results for those periods.

  • Ken Zener - Analyst

  • Okay.

  • That's fair.

  • I do understand.

  • It's just there's obviously several different markets occurring.

  • How about this then?

  • Given what you've talked about, and I appreciate the sequential breakdown in gross margin, with price flattening, costs going up, generically, to hold pace, can you talk about the spread this quarter and last quarter relative to units closed from backlog versus spec units which you guys drive a lot of volume through?

  • Thank you.

  • Don Tomnitz - President & CEO

  • Spec versus build jobs, as we've said the last couple of quarters, we're getting closer to our normal spread.

  • We're a little bit lower margins on specs than build jobs, but it's the gap is still tighter than it has been over the long term.

  • So really, no concerning trends there.

  • Jessica Hansen - VP of Communications

  • And same thing as usual for us, Ken.

  • But about 80% of the homes we closed this quarter were specs, so when you see our reported gross margin, that is essentially our spec gross margin.

  • Don Tomnitz - President & CEO

  • I don't want anyone to get confused.

  • We're trying to explain to you what the historical gross margins have been in the industry.

  • 18% to 22% and we're not saying our margins are going to 20% or whatever.

  • We're just basically trying to set a reasonable expectation out there right now because we believe that pricing has moderated over the last probably 9 to 12 months.

  • Costs are definitely increasing as our subcontractors and vendors continue to try to raise their prices given where they had to take their prices so low during the downturn.

  • So we're fighting increasing prices with moderating increases in sales prices, and we believe that the norm, as Bill said earlier, we're going to gravitate back to a more normal level.

  • Certainly 2013 was not a normal level in terms of gross margins and land supply and costs and everything else.

  • So we believe it's going to gravitate back to a more traditional level which is 20% gross margins.

  • Bill Wheat - EVP & CFO

  • But will not gravitate back, what will increase is our return on inventory.

  • A return on investment will increase.

  • And that is -- if you want to measure the progress of our strategy and how we execute our business, watch our increasing returns on investment, quarter to quarter to quarter over the next couple of years because our plan is for that to increase steadily.

  • And we believe that returns are much more important to our overall performance and the health of the Company than one element on the P&L than gross margin.

  • It's returns.

  • Ken Zener - Analyst

  • Thank you.

  • Operator

  • Jay McCanless, Stern Agee.

  • Jay McCanless - Analyst

  • Good morning, everyone.

  • First question I had with this focus on a 20% community level return, does that means that the 10,000 specs this quarter is probably the top for the cycle?

  • Bill Wheat - EVP & CFO

  • We're not calling anything on cycle.

  • But clearly we drive, as Jessica said, 80% of our closings come from specs so clearly we prepare for a volume level and our specs are an indicator of what our expectations are.

  • We don't believe we're at a peak in the cycle at all.

  • We're just out there competing in the market and responding market by market.

  • Don Tomnitz - President & CEO

  • As a matter of fact, we strongly believe that market will gradually grow and perhaps in a year or two, grow even faster simply because the part of the market that's underserved, and largely it's underserved because of the ASPs, the entry-level buyer, and also the mortgage underwriting standards are still high relative to where they have been in the past.

  • I expect mortgage underwriting standards to moderate, hopefully not back to the level they were back in, in 2004, 2005, and 2006, but we believe that the underwriting standards will be moderated some and by virtue of us being able to offer Express homes, $156,000 current ASP, and if we get any relief on the mortgage underwriting, we think the homebuilding business is ready to take off, especially as it applies to the entry-level buyer.

  • Jay McCanless - Analyst

  • Okay.

  • That kind of plays into my second question because I think this is the disconnect all of us are trying to get to because from the outside looking in, right now, you guys are cutting back on your land spending.

  • You are increasingly pushing up your absorptions.

  • You're trying to push them up even on mothballed land that may not be in the best markets right now but then you're coming back and saying that you think that there's growth ahead for the homebuilding industry.

  • It's that plus this change in language from the last conference call to this conference call where you're talking much more about return on inventory rather than stable gross margins, like you discussed last quarter.

  • There's a disconnect there that I think we're all trying to figure out what changed from the last conference call to now.

  • Bill Wheat - EVP & CFO

  • Jay, on your lands -- comment about land, we're not decreasing our land investment.

  • We're maintaining a higher --what we believe is an adequate substantial land investment, around 179,000 lots owned and controlled, 125,000 lots owned.

  • So we're replacing.

  • We bought early in the cycle.

  • We believe that that level will support double-digit growth on the top line, which is still our expectation.

  • We've always been focused on returns.

  • We've always been focused on balancing our volume and our pricing to optimize our returns.

  • As we've moved through the spring and we've adjusted incentives, the gross margin line has adjusted but at the same time we believe that's more than balanced our increase in volume.

  • So we're not pulling back.

  • There's really been no shift from that perspective.

  • We're just simply delivering stronger returns on the investments we've made.

  • Don Tomnitz - President & CEO

  • And I said earlier in the conference call and I said this for three or four quarters in a row, we have made really, really good land buys early in the market.

  • We have about a 4.7 years' supply of land and lots today, and we've got about a 2.4 years' supply of finished lots today, all based upon a trailing 12-month sales pace of about 27,000 units.

  • So we think that it's an incredibly strong statement to say that we don't have to be forcing ourselves on the land side like some of our competitors are and having to go out and buy land today.

  • We've got adequate land at great cost basis.

  • As to the return side of the business, we have looked at our business upside down and sideways, and there's one thing that we've concluded.

  • We concluded that a good gross margin is a good thing.

  • But if you're only generating one net sale per subdivision with a 25% gross margin, that's not nearly as well as generating a 16% gross margin with three sales per month in the subdivision.

  • So our focus is on how to do we improve our return on inventory because that's the bottom line.

  • That's the best way we can increase our shareholder value is to by consistently receiving a solid return on our inventory, not necessarily having an arbitrary gross margin level that has a very low return on it.

  • Jay McCanless - Analyst

  • Okay.

  • Thank you for the explanation.

  • Operator

  • Nishu Sood, Deutsche Bank.

  • Nishu Sood - Analyst

  • Good morning, guys.

  • I want to do a -- I wanted to dig into the incentive question here a little bit as well.

  • When you folks were thinking about this back in March, looking ahead to this quarter, I wanted to get an understanding of what you were seeing on the ground that led to changing your thinking at this point because obviously demand has been slow for about a year now.

  • You think about incentives, they are lowering price.

  • And I think you laid it out very well and clearly very successful with the amount of order growth you got.

  • If affordability is stretched then incentives or reducing price can obviously spur some sales.

  • If you have skittish buyers, then offering incentives can probably bring them in.

  • Or you know just diverting traffic from competitors or from the resale market, so what were you seeing on the ground thinking about it in those terms that led you to the correct conclusion that if we increase our incentives a little bit, we will be able to generate such a significant increase in sales like you did.

  • Don Tomnitz - President & CEO

  • Let's go back to one thing that really drove our incentives, and a lot of it had to do with David Ault coming up here and spending some time analyzing where we were and what we were doing.

  • But we've known for years that we needed to hit the absorption level that we had projected when we funded a land deal.

  • And we have been reluctant and sometimes reticent to drive those absorptions at that level they were projected to be because we're trying to hold to a specific gross margin.

  • And we concluded that having a specific gross margin in the subdivision and not being able to turn our inventory as frequently as we need to is not exactly the most optimum return on our money.

  • So what really drove our incentives, not necessarily the market, not necessarily what we saw in the market, what drove our incentives was we are committed to hitting our absorptions and we believe by hitting our absorptions that we can deliver a higher return on inventory and a better return for investors.

  • So that's what drove our incentives.

  • Jessica Hansen - VP of Communications

  • And so Nishu, whatever that takes on a community-by-community basis, it rolls up to it is what it is.

  • Because we're going to do what we need to do to hit that targeted ROI.

  • Nishu Sood - Analyst

  • No, I understand all that and you folks have expressed that pretty well.

  • I was trying to ask is to the -- like if I'm thinking from a buyer perspective, if it's a more of a unique luxury community than affordability is probably not the constraints, so an incentive doesn't work.

  • But if it's an entry-level community where there are four competitor communities or there are distressed properties perhaps to look at or single-family homes for rent, an incentive makes it more affordable maybe and gives a person more confidence.

  • So I was trying to understand what you saw on the ground from a buyer behavior perspective.

  • And you know, clearly you made the right call because your volumes increased so much so I was trying to understand from a little bit of a different angle.

  • Don Tomnitz - President & CEO

  • Well I'm not so sure that I agree with your comment that it doesn't -- the incentives don't drive the high end as much as it does the low end, because I can tell you when we're selling Emerald homes, or even our normal D.R. Horton and someone coming in looking at a $289,000 average sales price home or a $655,000 average sales rise Emerald home, they are looking for the best deal.

  • So as a result, incentives do drive that end of the market as well as driving incentives on the low end of the market.

  • Nishu Sood - Analyst

  • Okay.

  • Got it.

  • That's helpful.

  • The 20% return on inventory that you've been mentioning in then return on capital, I was wondering if you could -- it sounds like you're describing the internal metric and then you know the external metric.

  • I was wondering if you could just give us a little bit more detail on the return on inventory, the 20%, is that like the divisional metric that you're asking your divisional managers to focus on?

  • What's in that?

  • And then the kind of corporate level metric, how are you defining that?

  • Bill Wheat - EVP & CFO

  • Yes it is, at our division level, it's on an annual basis.

  • It's the pretax income that that division generates, divided by the average inventory balance.

  • And just to give you where we are currently today, we're sitting at around 13.5% is our run rate on our internal ROI and so the target is to get our guys, get our divisions up to 20% or better.

  • On a company-wide level, return on invested capital, obviously that's a very well-known calculation.

  • Obviously to the extent that we do a better job internally with our guys at ROI, our return on invested capital will be better for the Company.

  • But you could just as easily simply look at a return on inventory for us.

  • Look at pretax income divided by our average inventory for the Company as well.

  • It would be pretty similar.

  • Nishu Sood - Analyst

  • Okay.

  • Thanks.

  • Operator

  • Jade Rahmani, KBW.

  • Jade Rahmani - Analyst

  • Yes, I was wondering if you could talk about what kind of earnings growth you think -- the double-digit revenue growth that you mentioned will translate in?

  • Bill Wheat - EVP & CFO

  • We would hope to grow our profits faster than our revenue pace, and as we generate returns, faster returns, faster cash flows that we can redeploy into the business faster than we've been able to in the past, then we would expect that earnings growth to be able to continue to grow faster.

  • Jade Rahmani - Analyst

  • Okay, so just a follow-up on that.

  • Is the main driver of that earnings growth going to be lower SG&A then because the gross margins relative to where it's been is declining?

  • Bill Wheat - EVP & CFO

  • I'm sorry.

  • You cut out just a little bit there.

  • Jade Rahmani - Analyst

  • Sorry.

  • Just a follow-up, is the main driver of getting to that faster than the double-digit revenue growth in earnings, is the main driver going to be lower SG&A since the gross margin is a headwind going forward?

  • Bill Wheat - EVP & CFO

  • There would certainly be some leverage there as well, but as you turn your inventory faster and redeploy it faster then there's simply more capital available on an ongoing basis to generate growth and profits over the long term.

  • This is a long-term measurement that you'd be looking at.

  • Jade Rahmani - Analyst

  • Okay.

  • Are you willing to comment on what you would expect for operating and free cash flow in the fourth quarter?

  • Bill Wheat - EVP & CFO

  • We don't make specific quarter comments on that.

  • There's a lot -- can be volatility on a quarter-to-quarter basis, but what we would comment on is we expect our operating cash flow metrics to continue to improve from here and our returns to continue to improve, and our goal is to get to a point where we are both growing the Company, growing revenues at double-digit pace, while improving our returns and getting to a positive cash flow position.

  • Jade Rahmani - Analyst

  • And just to follow up, do you think the fourth-quarter operating and free cash flow are likely to be positive?

  • In other words, more cash flow generated from home sales than to replenish inventories?

  • Bill Wheat - EVP & CFO

  • Again, we're not going to comment on one quarter of cash flows, but it's certainly possible but it's that we're not going to comment on one quarter of cash flows metrics.

  • Don Tomnitz - President & CEO

  • Specifically, our goal is in fiscal year 2015 to have free cash flow and to have free cash flow at an increasing amount in every fiscal year thereafter.

  • That's our long-term goal.

  • Jade Rahmani - Analyst

  • Thank you.

  • And lastly, just a clarification on the 20% gross margin.

  • Is that inclusive of the purchase accounting charges for the next three quarters or that's before that?

  • Bill Wheat - EVP & CFO

  • Yes.

  • Inclusive.

  • Jade Rahmani - Analyst

  • Okay.

  • Thanks a lot.

  • Operator

  • Bob Wetenhall, RBC Capital Markets.

  • Bob Wetenhall - Analyst

  • Hello, good morning.

  • Good ASP performance, you're hitting tough comps in the back half of the year.

  • What's your thoughts on pricing?

  • How should we think of ASP performance going forward?

  • Bill Wheat - EVP & CFO

  • Stable to slight improvement in general.

  • Again, we're in what we believe is a relatively stable environment.

  • It's going to depend on geographic mix and product mix, obviously, but we're not seeing dramatic price decreases at all so we would expect a relatively stable environment.

  • Bob Wetenhall - Analyst

  • Would you qualify that as mid single digit, high single digit, or low single digit?

  • Jessica Hansen - VP of Communications

  • You know, that's a hard one, Bob, just because we have three different product types now in terms of our brands and we don't know what the market's going to deliver so we're going to stay with just similar to slightly up.

  • Bob Wetenhall - Analyst

  • Cool.

  • Understood.

  • 13.5% on the way to 20%.

  • What in your mind is the trajectory for that to happen?

  • What has to fall into place to close the gap?

  • Thanks.

  • Don Tomnitz - President & CEO

  • We need to continue to hit our unit absorptions on a week-by-week basis in each subdivision, and that's the best way we can get to -- because currently it's around 13% to 14%.

  • Our goal is 20%, and that will probably take a two- to three-year time period for us to achieve that, but it's hitting those absorptions net per week, per subdivision, on a consistent basis, as David said.

  • Operator

  • Buck Horne, Raymond James

  • Buck Horne - Analyst

  • I apologize for the late question going over.

  • A quick clarification.

  • I just want to be sure that we're clear that the order count, the 25% growth in the order count reported, does that include the 431 homes acquired from Crown in the quarter?

  • Bill Wheat - EVP & CFO

  • No, no -- their opening backlog is not included in the 25% order growth.

  • Buck Horne - Analyst

  • Were any of those sales from Crown included in the 25%, I guess.

  • Mike Murray - SVP of Business Development

  • The sales we made post the acquisition through the end of the quarter, 296 sales I believe, were included in that 25% order growth.

  • Buck Horne - Analyst

  • Okay, but otherwise it's clean, the 25%.

  • Jessica Hansen - VP of Communications

  • Yes.

  • Buck Horne - Analyst

  • And what was the community count ex the Crown acquisition, or the active community count?

  • Jessica Hansen - VP of Communications

  • We were up 7% on a year-over-year basis without Crown.

  • Operator

  • Jim Krapfel, Morningstar.

  • Jim Krapfel - Analyst

  • Hello.

  • Thanks for taking my question.

  • How much were costs per square foot up in the quarter?

  • Jessica Hansen - VP of Communications

  • Our cost per square foot were up year over year, I have that somewhere.

  • Sorry.

  • 8.3%.

  • Jim Krapfel - Analyst

  • Okay, and then what's your forward outlook on labor.

  • Do you expect some moderation in labor inflation there?

  • And then also in terms of land, if you look out maybe a year or two years based on where you've underwritten land, holding all else equal, how much would you expect there to be a gross margin decrement just from that higher priced land flowing through cost of goods sold?

  • Thanks.

  • Jessica Hansen - VP of Communications

  • Right now, we're seeing more of an impact I'd say on the labor side and our land still continues to be a benefit because we were early movers.

  • And in terms of our stick and brick costs, we are seeing some pressure on the material side but more so on the labor side.

  • Specifically, in those local markets where we've seen pretty good growth in volumes.

  • Don Tomnitz - President & CEO

  • One of the things we think will moderate our labor costs is clearly, we're 40% larger than the second builder and we believe those kinds of volumes are going to help control our costs much better than our competition.

  • Operator

  • Joel Locker, FBN Securities.

  • Joel Locker - Analyst

  • Hi, guys.

  • Just commenting on the community count.

  • If you include Crown just at the quarter end, what was your community count up year-over-year, third quarter over third quarter last year, and then sequentially also?

  • Jessica Hansen - VP of Communications

  • Sure, Joel we were up about 11% including Crown, and sequentially we were flat.

  • Joel Locker - Analyst

  • You were flat.

  • And that was the quarter and community count, not the average community count?

  • Jessica Hansen - VP of Communications

  • We always talk about it in terms of our average just to give a good representation, and let me correct myself with Crown sequentially we were up 4%.

  • Joel Locker - Analyst

  • You were up 4%, and 11% year over year.

  • Jessica Hansen - VP of Communications

  • Yes.

  • Joel Locker - Analyst

  • And then on just the last question on what was your dollar amount of customer deposits you had at third quarter end?

  • Jessica Hansen - VP of Communications

  • Give us one second.

  • About $53 million.

  • Joel Locker - Analyst

  • $53 million.

  • All right.

  • Thanks a lot, guys.

  • Operator

  • Alex Barron, Housing Research Center.

  • Alex Barron - Analyst

  • Good morning, guys.

  • Good job on the orders.

  • Don Tomnitz - President & CEO

  • Thank you.

  • Alex Barron - Analyst

  • Wanted to ask you -- I guess if you could kind of discuss a little bit more your rationale for doing acquisitions at this point in time, and how you view them I guess in the future.

  • Do you think the industry needs more consolidation to be more rational?

  • Don Tomnitz - President & CEO

  • Well frankly, the way we -- I'll let Mike speak specifically as to the acquisitions, but generally speaking, we're looking for builders who fit well within our business model, who have very efficient operations, and also some people who we can learn something from.

  • And just because we're the largest builder doesn't obviously -- we don't have all the answers and a lot of these entrepreneurial builders that Mike Murray's been working with truly have some unique ideas or certainly some ideas to remind us of the way we used to be.

  • So as a result, I think that we're looking at being supplementing our existing markets in a number of situations and continuing to grow our market share in each one of these markets, as we continue to grow our market share in each one of our markets like we are in Atlanta.

  • We get better costs, both on the labor side as well as on the material slide, and most importantly on the land side going forward.

  • Mike Murray - SVP of Business Development

  • Alex, we looked builder by builder at different opportunities and looked for different geographies, different customer segments that were different capabilities to add to our existing pipeline, looking all the time for a good cultural fit.

  • There's no set recipe or formula for what works and the motivation of the seller is also a big factor in whether we'll have a successful transaction or not, but it's not something we're driven or compelled to do but it's a good opportunity that we can take advantage of.

  • It's going to make sense for us to do those.

  • Alex Barron - Analyst

  • Got it.

  • And then I guess a separate question was maybe for Jessica.

  • Do you have some type of community count or percentage of your overall communities that are in Emerald and Express as a percentage of total or just some absolute numbers?

  • Jessica Hansen - VP of Communications

  • No, Alex.

  • We haven't disclosed our community count and right now we're just talking about how many markets we're offering Emerald and Express in.

  • Operator

  • We've reached the end of our question-and-answer session.

  • I'd like to turn the floor back over to Management for any further or closing comments.

  • Don Tomnitz - President & CEO

  • Thank you.

  • I want to remind all of our D.R. Horton employees and especially our salespeople that we do not need to be deterred from our mission.

  • We have a revised business model that is going to be very accretive and additive to our shareholders and we need to continue to focus on our mission.

  • We're currently in the trailing 12 months.

  • We've closed 40% more homes than the second largest builder.

  • We want to continue to dominate our markets and to be as profitable as we can in each one of our markets but most importantly, what you can do for us, as you know, is hit your absorptions on a community-by-community basis so that we can get our return on inventory from its current 13% to 14% up to 20% because that's the best thing we can do for ourselves and our shareholders, so we thank you very much.

  • Let's kick tail on the rest of the year.

  • Operator

  • Thank you.

  • That does conclude today's teleconference.

  • You may disconnect your lines at this time and have a wonderful day.

  • We thank you for your participation today.