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Operator
Good morning and welcome to the third-quarter 2016 earnings conference call for D.R. Horton, America's builder, the largest builder in the United States.
(Operator Instructions) As a reminder, this conference is being recorded.
It is now my pleasure to turn the call over to Jessica Hansen, Vice President of Investor Relations for D.R. Horton.
Please go ahead.
Jessica Hansen - VP, IR
Thank you, Kevin, and good morning.
Welcome to our call to discuss our results for the third quarter of fiscal 2016.
Before we get started, today's call may include comments that 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 call, and D.R. Horton does not undertake any obligation to publicly update or revise any forward-looking statement.
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.
This morning's earnings release can be found on our website at investor.drhorton.com, and we plan to file our 10-Q next week.
After the conclusion of the call, we will post updated supplementary data to our investor relations site on the presentations section under news and events for your reference.
The supplementary information includes current and historical supporting data on our homebuilding return on inventory, gross margins, changes in active selling communities, product mix, and our mortgage operations.
Now I will turn the call over to David Auld, our President and CEO.
David Auld - President and CEO
Thank you, Jessica, and good morning.
In addition to Jessica, I am pleased to be joined on this call by Mike Murray, our Executive Vice President and Chief Operating Officer; and Bill Wheat, our Executive Vice President and Chief Financial Officer.
The D.R. Horton team delivered a strong third quarter.
Our consolidated pretax income increased to $379 million on $3.2 billion of revenue, and our pretax profit margin improved 40 basis points to 11.7%.
Our homes sold increased 13% compared to the third quarter of 2015 as we continue to see improvement and absorption per community.
These results reflect the consistent, solid performance of our core D.R. Horton communities and our Emerald Homes and Express Homes brands as we strive to be the leading builder in each of our markets.
Our focus is to produce double-digit annual growth in both our revenues and profits while generating positive cash flows and increasing returns.
During the nine months ended June, we generated $89 million of cash from operations, on track for our second consecutive year of positive cash flows.
For the trailing 12 months, our homebuilding return on inventory improved to 14.3%, up from 12.1% a year ago.
With a sales backlog of 14,670 homes at the end of June and a well-stocked supply of land, lots, and homes, we are well positioned for the fourth quarter and next year.
Mike?
Mike Murray - EVP and COO
Net income for the third quarter increased 13% to $250 million or $0.66 per diluted share compared to $221 million or $0.60 per diluted share in the prior-year quarter.
Our consolidated pretax income increased 13% to $379 million in the third quarter versus $334 million a year ago.
And homebuilding pretax income increased 16% to $349 million compared to $302 million.
Our third-quarter home sales revenues increased 9% to $3.1 billion on 10,739 homes closed, up from $2.9 billion on 9,856 homes closed in the prior-year quarter.
Our average closing price for the quarter was $290,400, essentially flat both sequentially and compared to last year.
This quarter, entry-level homes marketed under our Express Homes brand accounted for 28% of homes closed and 20% of home sales revenue.
Our homes for higher-end move-up and luxury buyers priced greater than $500,000 were 7% of our homes closed and 16% of our home sales revenue.
Bill?
Bill Wheat - EVP and CFO
The value of our net sales orders in the third quarter increased 14% from the prior-year quarter to $3.4 billion, and homes sold increased 13% to 11,714 homes on a slight decrease in our average active selling communities.
Our average sales price on net sales orders in the third quarter was $293,300.
The cancellation rate for the third quarter was 21%, consistent with the prior-year quarter.
The value of our backlog increased 17% from a year ago to $4.4 billion, with an average sales price per home of $298,600; and homes in backlog increased 15% to 14,670 homes.
Our backlog conversion rate for the third quarter was 78%, at the midpoint of the range we guided to on our second-quarter call.
Mike?
Mike Murray - EVP and COO
Our gross profit margin on home sales revenue in the third quarter was 20.3%, up 40 basis points from the second quarter.
The improvement in our margin this quarter was primarily due to controlling cost increases while also reducing incentives or raising prices in communities where we are achieving our targeted absorptions.
Our general gross margin expectations remain unchanged.
In the current housing market, we continue to expect our average home sale gross margin to be around 20%, with quarterly fluctuations that may range from 19% to 21% due to product and geographic mix and the relative impact of warranty and interest cost.
David?
David Auld - President and CEO
In the third quarter, homebuilding SG&A expense was $280 million compared to $258 million in the prior-year quarter.
As a percentage of homebuilding revenue, SG&A improved 10 basis points to 8.9% compared to 9% in the prior-year quarter.
For the nine months ended June, our SG&A improved 40 basis points to 9.5% compared to 9.9% in the same period in the prior year.
We remain focused on controlling our SG&A while ensuring our infrastructure adequately supports our current and expected growth.
Jessica?
Jessica Hansen - VP, IR
Financial services pretax income in the third quarter was $29.4 million compared to $31.7 million in the prior-year quarter.
92% of our mortgage company's loan originations during the quarter related to homes closed by our homebuilding operations, and our mortgage company handled the financing for 56% of our homebuyers.
FHA and VA loans accounted for 50% of the mortgage company's volume compared to 49% in the prior-year quarter.
Borrowers originating loans with our mortgage company this quarter had an average FICO score of 716 and an average loan-to-value ratio of 89%.
First-time homebuyers represented 45% of the closings handled by our mortgage company compared to 41% in the third quarter last year.
Bill?
Bill Wheat - EVP and CFO
At the end of June, we had 25,300 homes in inventory, of which 1,600 were models.
11,300 of our total homes were spec homes, with 8,200 in various stages of construction and 3,100 completed.
Our construction in progress in finished homes inventory increased by $218 million during the quarter due to seasonal construction activity.
Our third-quarter investments in lots, land, and development totaled $823 million, of which $586 million was to replenish finished lots of land and $237 million was for land development.
For the nine months ended June, our investments totaled $2 billion, an increase of 18% from the same period last year.
We expect a continued increase in our investments in land and development in the fourth quarter as compared to the prior year.
David?
David Auld - President and CEO
At June 30, 2016, our land and lot portfolio consisted of 202,000 total lots, of which 112,000 or 55% are owned and 90,000 or 45% are controlled through option contracts.
73,000 of our total lots are finished, of which 30,000 are owned and 43,000 are optioned.
Our 202,000 total lots owned and controlled provide us a strong competitive advantage with a sufficient lot supply to support solid growth in sales and closings in future periods.
Bill?
Bill Wheat - EVP and CFO
During the third quarter, we reported $2.9 million in land option charges for write-offs of earnest money deposits and due diligence costs for projects that we do not intend to pursue.
We also reported $5.2 million of inventory impairment charges, primarily due to an expected land sale in the East region.
We will continue to evaluate our inventories for potential impairment, which may result in future charges, but the timing and magnitude of these charges will fluctuate.
Our interactive land held for development of $156 million at the end of the quarter represents 9,100 lots, down 29% from a year ago.
We continue to work through each of our remaining inactive land parcels to improve cash flows and returns, and we expect that our land held for development will continue to decline.
Mike?
Mike Murray - EVP and COO
At June 30, our homebuilding liquidity included $863 million of unrestricted homebuilding cash and $882 million of available capacity on our revolving credit facility.
Our homebuilding leverage ratio improved 730 basis points from a year ago to 30%.
During the quarter we paid $373 million of senior notes at their maturity, and the balance of our public notes outstanding at June 30 was $2.8 billion.
We have $350 million of debt maturities in the next 12 months.
At June 30 our shareholders' equity was $6.5 billion, and book value per share was $17.50, up 14% from a year ago.
Jessica?
Jessica Hansen - VP, IR
Looking forward to the fourth quarter, we expect our homes closed to approximate a beginning backlog conversion rate in the range of 81% to 84% at an average sales price of around $290,000.
We anticipate our home sales gross margin in the fourth quarter will be around 20%, and we expect our fourth-quarter homebuilding SG&A to be in a range of 8.4% to 8.7% of homebuilding revenues.
We estimate that our fourth-quarter financial services operating margin will be around 35%.
We expect our tax rate in the fourth quarter to be around 35% and our fourth-quarter diluted share count to be approximately 377 million shares.
And we continue to expect $300 million to $500 million of positive cash flows from operations for the full year of fiscal 2016.
Our expectations are based on today's housing market conditions.
Our current preliminary expectations for fiscal 2017 are for our consolidated revenues to grow by approximately 10% to 15% and for our consolidated pretax margin to increase to a range of 11.2% to 11.5% for the full year.
We also expect to generate positive cash flows from operations for the third consecutive year in a range of approximately $300 million to $500 million.
We anticipate our tax rate for fiscal 2017 will be between 35% and 36%, and that our diluted share count next year will increase by approximately 1.5%.
David?
David Auld - President and CEO
In closing, our third-quarter growth in sales, closings, and profits and the improvement in our pretax profit margin are the result of the strength of our people and our operating platform.
We are striving to be the leading builder in each of our markets and continue to expand our industry-leading market share.
D.R. Horton has been the largest builder in the United States for 14 consecutive years.
And according to Builder Magazine's recent local leaders issue, in 2015 we were the number-one builder in 13 of the top 50 US housing markets and a top-five builder in 30 of the largest markets.
Since 2009, our market share has increased from 5% to 8%.
We remain focused on growing both our revenue and profit at a double-digit annual pace while continuing to generate positive cash flows and improved returns.
We are well positioned to do so with our solid balance sheet, industry-leading market share, broad geographic footprint (technical difficulty) country.
We'd like to thank the entire D.R. Horton team for their continued focus and hard work, and we're excited and looking forward to our opportunities ahead.
This concludes the prepared remarks.
We will now host questions.
Operator
(Operator Instructions) Stephen East, Wells Fargo.
Stephen East - Analyst
David, maybe I'll ask you a little bit.
Thanks for the guidance on all that.
That's very helpful.
And if I look at the cash flow for 2017, another year that looks a lot like this year, I guess a couple of things: what does that imply -- again, going back to your capital allocations that I always ask you -- but what does that imply for being able to grow your communities?
At what growth rate are you expecting?
Is it in that 10% to 15% range that you had for revenues?
And then as you look out, what's your next use there?
Are you seeing M&A out there?
Do you have more debt paydown, et cetera?
David Auld - President and CEO
You know, Stephen, I think right now we're looking at every opportunity that is out there.
You know, as we have talked before, our goal is to be consistent and kind of take advantage of situations as they appear in our market.
Community count growth -- you know, I would think we are probably going to take community count up single-digit, mid-single-digit maybe.
Certainly, paying down debt to me is always a good thing.
Deleveraging the balance sheet and creating opportunity for -- opportunities as they arise is something that we believe in.
And as far as the guidance for next year, I think it's just -- you know, we see a consistent, solid market out there.
And we're well positioned to take advantage of it.
And just going to continue to try to improve our execution and get better building, selling, closing houses every day.
Stephen East - Analyst
Okay.
And just going back to the M&A, what are you seeing out there from the privates?
And then, switching gears, it sounds like -- so for next year, you've got your absorption rate continuing to improve.
Is that really just being driven on the express side of the world?
Or what -- are you seeing anything else in the markets?
David Auld - President and CEO
Well, from the absorption rate, yes, the Express definitely drives higher absorption rates than even the core Horton brand.
And as we continue to expand that brand -- we're in 51 markets, I think, right now -- we're going to continue to push that brand into other markets.
And I think we will see added absorption on a developed -- on a division standpoint, improved absorption division by division, which drives the overall.
But I do think that we will see growth in communities next year.
Mike Murray - EVP and COO
Stephen, this is Mike.
On your M&A question, we continue to see various private builders across the country testing the waters.
We've been very fortunate with the acquisitions we've made.
We've been very selective, brought on a lot of good people, a lot of good teams.
And we'll continue to be selective.
We've set a high bar internally.
And, you know, we're looking for the best opportunities that either expand our geographic coverage or bring us new customers, new customer segments.
Stephen East - Analyst
All right, thanks a lot.
Operator
Alan Ratner, Zelman & Associates.
Alan Ratner - Analyst
Congrats on another strong quarter.
David Auld - President and CEO
Thanks, Alan.
Alan Ratner - Analyst
David, I think I might have asked you this last quarter, too, but the option lot count -- I mean, 90,000 now.
You are up almost 70% from a year ago, 45% of your total lots controlled option.
What are you seeing in the land market that you've been able to drive that success?
Because obviously that's going to be a huge positive for returns.
And it seems like you're not really anticipating those options having much of an impact on your margin, because you're still keeping the same language for roughly 20% gross margin.
So is it just that the land market is opening up, and developers have access to capital, and they're more willing to flip you these lots on options?
Or are you kind of going outside the box and doing something unusual?
Because none of your competitors seem to have had as much a success as you have.
David Auld - President and CEO
Well, we've got a huge advantage in that we've got a great big footprint.
And our absorption per community is something that developers that are putting lots on the ground look to.
So good market, bad market, we're going to build houses.
And I think our outreach to the development community -- we are a much friendlier buyer.
It's becoming -- you know, our goal is to really partner with these guys and to put their capital at play and avoid some of the longer-term negatives of owning as a builder as a public company.
So it's just focus, to be honest with you: focus and execution.
Our guys out there are -- have been asked to do it, and they're getting it done.
Alan Ratner - Analyst
And generally, you're able to underwrite these deals and keep a pretty similar gross margin as if you were to own that land outright?
Or is there a margin differential when you do this?
And just the final follow-up there: is it widespread across the country where you're having this success?
Or are there certain geographies where the majority of those optioned lots are located?
Thank you.
David Auld - President and CEO
As far as across the country, we've got option.
We've been able to create optioned lot situations in California.
And I can tell you, in the last market there was never a chance of doing that.
So it really is just focusing.
And as far as margin, yes, the margins may be a little bit lower, but the returns are significantly higher.
And that's -- to me, we value capital.
We want to maximize the return we get on capital.
And so trading a nominal amount of margin for a significantly higher return is a good way of helping our shareholders, maximizing the value of the shares.
Alan Ratner - Analyst
Thank you.
Good luck.
Jessica Hansen - VP, IR
Thanks.
Operator
Eric Bosshard, Cleveland Research.
Eric Bosshard - Analyst
Interested in Express from a competitive standpoint and also from a customer standpoint -- what you we're observing evolving as this product has continued to move forward.
Bill Wheat - EVP and CFO
Eric, this is Bill.
Certainly from a competitive standpoint, been very pleased with what we've seen with Express.
We are offering a great value, an affordable value for buyers out there.
And there's still very limited inventory and very limited supply of affordable product out there in the market.
So we're still seeing what we've been seeing as we have rolled it from market to market.
We've been introducing Express into some of our Western markets over the last couple of quarters, and we're seeing very positive responses there as well.
We've commented in prior quarters about -- in markets like Florida, where there are perhaps more retirees, we have seen a larger mix of older buyers buying the Express Homes, because they see the same value there.
And so that's been a nice observation as well and, I think, will serve us well going forward.
That's just another element of demand for that product line.
Eric Bosshard - Analyst
In terms of the runway with this product, both from a competitive standpoint and your ability to source land where the economics work for this product, and then as well as a percentage of your total business, where are we?
And what's the runway from here look like moving forward?
Jessica Hansen - VP, IR
We expect to continue to expand that footprint, as David mentioned earlier.
Today we are in 51 markets in 17 states.
It was 28% of our sales.
It was also 28% of our closings and 20% of our revenues.
If you recall, when we first introduced this and got the question about when this is rolled out, what does that look like, we generally talked about over time about 60% of our revenues coming from our core D.R. Horton brand; 20% from Emerald; 20% from Express -- which would infer probably closer to 30% in units on the Express side.
I think at this point, we would tell you that it looks like we will overshoot that during this cycle, because that's where the demand is right now.
And we want to cater to that demand in what we believe is still being underserved.
So we don't have any set targets on where it could go.
We'll continue to adjust our business based on what we see in the market to go capture as much market share as we can.
David Auld - President and CEO
You know, we're allocating capital based upon the highest returning projects.
And right now we have been pleasantly surprised with the demand for Express and have actually seen higher margins than we originally underwrote at higher absorption levels than we originally underwrote.
So it is a great way to improve returns for the shareholders.
Eric Bosshard - Analyst
Great.
Thank you.
Operator
Ken Zener, KeyBanc.
Ken Zener - Analyst
David, if you -- I mean, we talked a long time ago about the housing market prices.
Your Express Home -- obviously it's differentiated.
It's only 20% of revenue, but it's obviously contributing to your volumes.
So if you do that 28% of closings, 20% of revenue, you know, you're at a house at about $210,000 in terms of price point.
So what does it mean?
I mean, thanks for giving FY 2017 guidance.
Many other builders wouldn't do that.
What gives you the confidence?
I know you have your visibility into 1Q based on your units under construction, but what really gives you the confidence to be making the statements about the back half of 2017, A?
And then, B, it seems as though -- as you get this growth, could we be seeing flat to down pricing on your average sales, realizing turns are offsetting that?
Jessica Hansen - VP, IR
On the pricing front, right now we are anticipating it to stay essentially flat.
But yes, it could trend down with Express continuing to become a bigger mix.
What we are seeing, though, is the markets we're rolling Express out in today are the higher-priced markets.
So it's not as much of an incremental drag on our ASP as the initial rollout was.
David Auld - President and CEO
Right now, Ken, California is probably going to be, we think, a very successful Express market for us.
We are early in the process of rolling out there.
It's typical Express; only California is going to be over our average sales price right now.
Bill Wheat - EVP and CFO
And, Ken, when we look at fiscal 2017 and our visibility and our confidence level, it's simply a reflection, number one, of we do see a good market right now.
It's a good, stable, healthy market.
Certain variability market to market, certainly, but it's a relatively stable market.
But what we see the most is our positioning.
Across our divisions, our division operators are doing a tremendous job of positioning communities, positioning lots in front of those communities, and really executing well on our product offerings today.
And so as we begin to look forward to the next several quarters, the next 18 months or so, we really do have good visibility and confidence level to be able to deliver consistently at a double-digit pace on the revenue line, continue to drive some additional SG&A leverage to improve our operating margin and improve our returns.
So we felt it like it was appropriate to start to give some preliminary guidance for next year, as we did last year at this time for fiscal 2016.
And certainly we've been pleased that we've essentially delivered on that preliminary guidance thus far this year.
Ken Zener - Analyst
Right, no, I think it's obviously nice to have that early communication.
If I could go back to the gross margin, still on your guidance -- a builder reported today -- you know, modestly trimmed their guidance.
Another public builder talked about gross margin pressure.
So it seems as though the -- either construction cost or land inflation, given your roughly 20% gross margin, you feel that's defensible.
Is that because you're getting better pricing on these -- perhaps on these Express than you are on the other pieces, or is it just that you bought the land at a lower targeted gross margin?
You can't comment on other builders, but it seems as though you're not concerned about gross margin degradation next year.
Mike Murray - EVP and COO
We are always very focused on gross margin, Ken.
But what we've seen is that we have taken some lot costs as a percentage of revenue, taken some of those increases, and been able to offset them with reduced incentives and controlling some cost increases on the stick-and-brick side.
When we get our communities to the targeted absorption levels, at those points we are able to bring incentives down or take pricing up and protect the margin.
And overall, in the balance, the team has done a great job of enhancing the margin on a consolidated basis this quarter.
And we feel good about -- you know, with the range of the guidance we are giving on the margins, that that's a defensible position for us going forward as we continue to drive absorptions community by community.
Part of that has been Express and simplifying some of our operations behind the scene in that and delivering a house with fewer labor hours in it to get it built.
And part of it has been some of the great land positioning we've been doing over the past few years.
David Auld - President and CEO
Ken, we feel very good about next year.
What we're seeing in the markets -- you know, there's not a lot of lots being put on the ground that we're going to have to compete against.
There is still pent-up demand at the entry-level and first move-up price points.
You know, it just feels good right now.
Ken Zener - Analyst
Thank you.
Jessica Hansen - VP, IR
Thanks, Ken.
Operator
Bob Wetenhall, RBC Capital Markets.
Bob Wetenhall - Analyst
You guys are crushing it.
And I love the fact that you have that crystal ball somewhere in the office in Fort Worth into 2017.
Wanted to ask you -- when we're thinking about comments around 2017, it's kind of like flat ASP performance looking out.
How should we be thinking about the interplay between kind of like community absorption rates versus new community growth?
Because I think to get to your kind of range at 10% to 15% against flat pricing, you can either deliver faster, or you can open new communities.
What's the right way to think about that?
Jessica Hansen - VP, IR
Bob, we think in 2017 it will be a combination of driving further improvement in our absorption coupled with, at some point as we move throughout 2017, an increase in our community count.
Our community count on a year-over-year basis was down, which was not a surprise to us.
And we would expect over the next couple of quarters it to move up or down no more than a low to mid-single-digit range.
But at some point as we move throughout the year, we would expect an increase in that community count to help drive that 10% to 15% consolidated top-line growth.
David Auld - President and CEO
And Bob, we don't have a crystal ball, but Don Horton does tell us what it's going to be, and we go do it.
(laughter)
Bob Wetenhall - Analyst
That's quite helpful.
And you guys are speaking a lot about California.
And I was hoping you could kind of -- I always think that's the cash market, not an option market.
And I was hoping -- you know, it sounds like the torch is kind of being passed from really good growth in the Southeast to a very optimistic view of West Coast markets.
Could you just give us some flavor of what you're seeing in terms of land buying opportunity and your expectations for growth in both Northern California, Southern California, and the Phoenix market?
Thanks a lot.
David Auld - President and CEO
Bob, the growth we're looking at there is at a new price point that hasn't existed out there.
And we feel very optimistic based upon the land that we've been able to put in front of that program.
So do we feel more optimistic about California than the balance of the country?
Absolutely not.
I think Texas continues to be strong, and our Southeast area just continues to outperform.
Bill Wheat - EVP and CFO
And we're introducing Express in Phoenix and certainly expect it to do very well there, and expect to see some growth out of Phoenix as well.
But, really, the key is the affordable product we are offering.
David Auld - President and CEO
It just runs at a much higher absorption.
And developers typically -- when they see that, they feel more comfortable putting [lots] on the ground for us.
Bob Wetenhall - Analyst
Just to understand, are you saying they price point for what you're bringing to the California market's just going to be way below competing entry-level and first-time homebuyer product in the market?
David Auld - President and CEO
I'm not saying way below.
I'm saying that the value combination is going to be superior.
And we've been able to capture market share with that product offering.
Bob Wetenhall - Analyst
Makes sense.
Good luck.
David Auld - President and CEO
Thank you.
Operator
Nishu Sood, Deutsche Bank.
Nishu Sood - Analyst
Thanks.
And yes, just following up on the double-digit, I appreciate the guidance there and obviously the confidence that that shows.
So, so far in the Q&A, you've touched on obviously some low single-digit rate of community count growth; ASPs, selling prices continuing this kind of flattish trend that they've had this year, putting the burden, if you will, on absorptions.
And Jessica, you just mentioned that in the prior question.
How should we think about that?
Is that absorptions across the portfolio?
So on a same-store D.R. Horton-brand basis, we would see strong absorption growth there?
Or is this -- you know, with -- there's obviously a lot of community rotation.
Is this Express subbing in for other brands as its percentage grows, and naturally those are at higher absorptions, so that would drive the absorption?
How should we think about it in how you're thinking about it for next year?
Mike Murray - EVP and COO
Nishu, there's several pieces of it.
And I think you touched on a lot of them.
It's some of the Express communities rotating in.
Also, just within the core D.R. Horton communities, some of the communities that we are closing out may have been smaller communities, and what's been opening are communities with larger lot positions in front of them that are going to be running at higher absorption paces that are coming on line -- have been coming online over the past few quarters and will be coming online into the future.
So that's where we are seeing our double-digit growth within the existing community count.
And we do expect, as David mentioned, that we would probably be growing, you know, average selling community count slightly into 2017.
But the nature of the communities, each one producing a few more sales than the ones that they are replacing.
Nishu Sood - Analyst
Got it, got it.
That's really helpful.
And then also, consolidated pretax.
I believe that the -- you kind of got it to high 10s, you know, 10.7 to 11.2, I think you had said last quarter.
I don't think it's specifically laid out this quarter.
But then thinking about 2017, and Jessica, I think you mentioned low 11s for next year.
A lot of that, I imagine, is coming from continued SG&A leverage.
I was wondering if you could just provide some -- you know, some general color around that, or also the financial services profitability is part of the mix there as well; that's been pretty strong, consistent.
So I was just wondering if you could give us your thoughts on trends on both of those?
Jessica Hansen - VP, IR
You are correct, Nishu, that we do expect the majority of our operating margin improvement next year to come from SG&A leverage again, like it did this year.
So we have guided specifically to 11.2% to 11.5%.
And we would expect our gross margin to be right around 20% and to drive that better bottom line by further stretching our overhead structure, leveraging our overhead structure.
SG&A -- or in terms of the financial services business, they did see a step down in their margin this year, which we had been expecting.
They've had outsized gross margins for the last year or two.
They're still operating at a very good level.
We guided to Q4 for that to be around 35%.
They follow the homebuilder business seasonally.
So in fiscal 2017, we would expect them to have lower operating margins in the first six months of the year and then to pick up in the back half of the year like we saw in 2016.
We'd expect a similar trend in 2017.
Nishu Sood - Analyst
Great, thanks.
Appreciate the color.
Operator
Michael Rehaut, JPMorgan.
Michael Rehaut - Analyst
First question I had was on the East region.
I believe -- you know, you highlighted the impairment in the quarter was largely driven by a parcel sale or expected landfill there.
And I was curious if that was the same parcel that you took the impairment on in the second quarter?
And just more broadly, regarding the East, I think when we marketed a couple -- you know, did our MDR a couple of months ago, kind of talked to the East as an area of opportunity, maybe doing a little bit better gaining some share there; an area that, maybe relative to some of your other regions, there is still some share to be gained there.
So any just thoughts specifically on the impairment and, secondly, on the opportunity you see in the region over the next year or two?
Mike Murray - EVP and COO
Michael, this is Mike.
That is not the same project that we impaired.
We sold that project that we impaired in the second quarter.
That's no longer with us.
This project is a different project.
It had been an older project in land held for development.
We evaluated it, determined the best course of action for us was to pull the capital out of it and move forward, redeploy that capital.
And we do see opportunity for growth and improving our position in our East market, but that's not going to happen overnight.
We're working hard on it every day.
We've had some changes in the teams up there and very excited about the direction they are taking us and the opportunities they are putting in fronts of us.
But as with everything, nothing ever happens fast enough or quick enough for us.
But we are working very hard to get more lots on the ground in front of us, and get those communities opened, and drive more growth out of those.
Jessica Hansen - VP, IR
Our public East region, Mike, just for clarification, includes our Northeast markets, which are the ones Mike was referring to -- our Capital division and our New Jersey division.
But the East publicly reported region also does include the Carolinas, which -- those are firing on all cylinders and very strong markets for us today.
Mike Murray - EVP and COO
Right.
Michael Rehaut - Analyst
Great, and I appreciate that clarification.
I guess just second question on the gross margin: obviously, you're very clear in your guidance, but you did have a nice -- a little better-than-expected result this quarter, and you highlighted a couple of the drivers.
I was wondering if there was some particular element of mix that also helped this quarter?
And I guess, looking forward, do you still expect the gross margin to be in and around 20%?
And I was curious on that.
You know, you talked about Express coming in a little better than expected.
And obviously, as you do more Express and more Emerald, I would expect the efficiencies and experience to maybe result in a little bit better amount of profitability.
So, again, sorry for the two-parter for my second question, again, but mix on the quarter; and then some of those improved operational efficiencies or experience set benefiting the margin into next year?
Mike Murray - EVP and COO
Thanks, Mike.
This is Bill.
Nothing unusual on the margin this quarter, other than just continued focus on execution and controlling our costs.
You know, we've been absorbing labor cost increases, some materials cost increase over time.
And we've been working to offset those, and we are making some progress there, getting some traction on that, while we're still absorbing increasing land costs that are coming in.
So -- but we've done, I think, an improving job on controlling those costs and continuing to push price and then reduce incentives wherever we can.
So we did see a nice little pickup this quarter, nothing unusual in that number.
And it's really just in that normal range of around 20% we would expect to see, and a move of 30 or 40 basis points is not really unusual in and around 20%.
But certainly pleased to post a quarter at a little bit above 20%.
And hopefully we can -- we are always focused on doing everything we can to maintain and improve on that while driving better returns.
Michael Rehaut - Analyst
And just thoughts around some of the better efficiencies?
As you gain experience in Express and Emerald, could that the ultimately showing up as a potential positive lift?
Or is it just another element that allows you to combat, let's say, rising land costs and labor costs?
Bill Wheat - EVP and CFO
Certainly part of our strategy is to get better every day at what we do.
The margins that we see across the three brands are actually pretty closely clustered together around the Company average, and we do expect to get better in every community every day at what we do.
And we have seen that: we have seen our margins moving up, and we are held to a pretty high standard to expect to continue to see those margins -- making progress on them every day.
And in a market, Mike, that does continue to improve and grow, there will be cost increases that come along the way.
And these additional efficiencies that we are able to glean out of the business to help offset those other cost increases.
Michael Rehaut - Analyst
Great, thanks very much.
Operator
Jack Micenko, SIG.
Jack Micenko - Analyst
I wanted to understand the message on backlog conversion little bit better.
So 81%, 84% for the fourth quarter.
You did the midpoint of the range this quarter.
If I go 84%, I get to the midpoint of the range, which I guess would mean if you had a sort of similar result this quarter than last, you'd be in the sort of -- albeit, admittedly, it's a narrow range for the year on deliveries, but you'd be at the bottom half.
Is that the message?
Or is it conservatism on the guidance range?
How do we think about that?
And then on a broader basis, it's an 8-handle on the backlog conversions -- I mean, is that the new Horton norm, given the mix, the product mix?
Has that number sort of stepped up the last couple of years?
Jessica Hansen - VP, IR
Jack, there's a lot of fluctuation in our backlog conversion rate, and there's a lot of things that impact that each quarter.
But if you look at the last 4 to 5 years, on average, our Q3 to Q4 change in our backlog conversion has typically been about flat.
So we are saying that it's going to go up a little bit to that 81% to 84% compared to what we did this quarter.
I would not tell you there is a bunch of conservatism baked into that.
As you saw this quarter, we delivered at the midpoint of our range.
And in some of the headlines out there, it's being called a miss, even though we were right in the dead center of the guidance we provided.
So no conservatism on next quarter.
We feel good about delivering 81% to 84%, and it's a little bit better.
And we are focused every day on delivering the best we can.
And we would like to continue to see a backlog conversion rate in the 80% range, but there will be some quarters that are in the 70%s.
David Auld - President and CEO
You know, from an operational efficiency and getting better, that's something we look at and strive to improve, because that helps with the SG&A leverage; it helps with the inventory turn.
Conversion rate is a great metric to determine whether you're actually getting better or not.
So we're not going to guide optimistically, but it's a consistent market.
We've got a consistent, solid performance and expect to continue that.
Jack Micenko - Analyst
Okay, thank you.
And then your FHA mix from the mortgage company was up a bit year-over-year.
The rhetoric from some of the larger banks seems to suggest that they are moving away from that product somewhat with some of the inherent sort of legacy legal risks or tail risk to that program.
Are you seeing any shift from FHA to private mortgage insurance on your borrower base more granularly, or is it still pretty stable?
Jessica Hansen - VP, IR
I'd say it's pretty stable.
The difference for us is with Express becoming a bigger piece of our mix, their percentage usage for those buyers of FHA loans is higher than our Company average.
It's closer to the mid-40s.
So that's really the function there.
Jack Micenko - Analyst
Okay, all right.
Thank you.
Operator
Susan Maklari, UBS.
Susan Maklari - Analyst
You have mentioned the fact that you are seeing some more older buyers coming in to your Express communities.
And as we think about the evolution of Express and maybe some of the demographic trends that we expect to come through, is that something that we could see sort of further come along and perhaps maybe even evolved from a marketing or branding perspective down the line?
Mike Murray - EVP and COO
Yes, we are certainly focused on all the buyers that are responding to Express.
And we're seeing great acceptance of Express in Florida, as Jessica mentioned before -- some of the retiree buyers.
And we're going to look to meet those buyers' needs, and understand exactly what it is they want, and put a house on the ground for them at a great value.
People that are retiring on a fixed income are looking for value in a high quality, well-built home.
That's exactly in the wheelhouse of what we do.
And so I think you can expect to see that we're going to try to take advantage of every opportunity in front of us, including that buyer demographic.
Susan Maklari - Analyst
Okay.
And then, as we think about some of the labor issues that remain out there and the experience set builders in general are facing, do we expect any change outside of the normal seasonality in terms of your spec phase or your start phase as you go through in the next few quarters?
Mike Murray - EVP and COO
We are looking at our starts phase to just kind of continue as we go seasonally to build some inventory for the spring and to be prepared for a spring selling season next year -- hopefully as good or better as the one we just came out of.
And we're seeing -- certainly labor is always a challenging component; our market positioning, the scale we have in so many of our markets gives us a great advantage on a labor availability front.
And we watch very closely our build times and our cycle times.
And we are not seeing an elongation of that, so we feel like our team is doing a great job of managing their trade base.
David Auld - President and CEO
The absorption per community is a great deal to expand our optioned lot program, but it is also a great deal to secure and keep the labor force.
Because they come in, they start, and we build through the communities, instead of start, stop, start, stop.
And they are always out chasing new jobs -- job sites.
So there's a lot of benefits to what we're doing, and that's one of them.
Susan Maklari - Analyst
Okay, great.
Thank you.
Operator
John Lovallo, Merrill Lynch.
John Lovallo - Analyst
The first question is on Southeast conversions.
They've been a little bit light year-over-year in the first three quarters.
Was there anything in 2015 that made those exceptionally -- the conversion exceptionally strong?
Or is there something going on this year?
Bill Wheat - EVP and CFO
I wouldn't say there's anything unusual, John.
They did certainly see very strong absorptions last year.
That's moderated a little bit this year, but we are still seeing very strong growth and expect very strong growth going forward in the Southeast.
They are delivering right in line with our expectations.
John Lovallo - Analyst
Okay, moving on: valuations across the Group have risen in the past couple of weeks in particular.
In your conversations with the private builders, are you hearing a general expectation for higher prices on the private side as well on the M&A front?
Mike Murray - EVP and COO
We always probably have a bit of a valuation gap at the initial conversations.
It takes time, and that's why our bar is pretty high, and we're very selective in what we are doing.
And we're going to look to make the right acquisitions where it makes sense for us and the numbers work.
We're not going to push.
You know, fortunately we are in a position -- teams have done a great job in lots and product positioning -- that we don't feel the need that we have to push and drive on making a deal work that otherwise might not.
But we haven't seen any specific rise in the past couple of weeks.
I mean, that private builder market is not quite as liquid as the public side.
John Lovallo - Analyst
Great.
And one last one, if I may.
The 11.2% to 11.5% gross -- sorry, margin for 2017: is that a homebuilding margin or a consolidated pretax?
Jessica Hansen - VP, IR
That's consolidated pretax.
John Lovallo - Analyst
Great, thank you.
Operator
Mike Dahl, Credit Suisse.
Mike Dahl - Analyst
Wanted to ask first about longer-term thoughts on SG&A.
So it sounds like, based on the preliminary guide for fiscal 2017, you'll dip below 9%, which historically had kind of been the low-water mark.
And so, clearly, success at driving absorptions and some of the efficiencies have done wonders for that.
If you think about other structural ways to reduce SG&A beyond those levels -- we've heard some other builders talk about a couple of different things.
Just curious to get your thoughts on if there's anything else you are exploring outside of just continuing to drive absorptions.
Bill Wheat - EVP and CFO
No, the main driver, Mike, is absorptions.
Community by community, that's really where our expense structure resides.
And as we continue to work to improve our absorptions, then we are able to drive better leverage on our SG&A structure, both in the community and then all throughout our organization.
So that -- and each year we look at what our expectations are to improve on the top line, and then we assess how much we can leverage SG&A.
But as we expect to grow top line double-digit, we should expect to leverage SG&A further as well.
So, yes, this does imply we will get down below 9%, and there is not a magic floor there.
Each year, if we expect to grow, we would expect to continue to push some more SG&A leverage.
Certainly, some of the other things that have been talked about among other builders -- we are doing a lot of those things as well.
We're certainly taking advantage of technology wherever we can.
We're looking to be as -- to drive ways to be more efficient in all areas of our business.
But there is not one magic bullet.
We are looking to do -- get more efficient on every line of our financials.
And certainly those things are a part of it as well.
Mike Dahl - Analyst
Okay, thanks.
And then second question, just going back to some of the Express discussion, and so certainly appreciate that kind of first-mover advantage has been pretty powerful in terms of even out through next year; you don't have a lot of competition as far as things that are coming to market -- what about if we look at the land deals that you are looking at today that would be 2018 or 2019?
Obviously, people have taken notice of your success at the Express part of the market.
So are you showing up and seeing significantly more competition for those types of deals as you look out to the next couple of years?
David Auld - President and CEO
Mike, we have competition in every factor of everything we do.
And I believe ultimately it comes down to execution, and right now our people are out executing.
We are the Group that -- or the builder that I think makes the most sense to align with.
And so we're finding land deals we need to support the growth that we are seeking.
So do I think it's going to become more competitive?
You know, maybe.
But it's pretty competitive out there right now.
We've just got great people doing a great job.
Mike Dahl - Analyst
Okay, thank you.
Operator
Alex Barron, Housing Research Center.
Alex Barron - Analyst
Great job, guys.
Jessica Hansen - VP, IR
Thanks, Alex.
Alex Barron - Analyst
I was hoping maybe -- I don't know if I missed this, Jessica, if you mentioned the stats for Emerald Homes like the ones you mentioned for Express on closings, orders, revenues?
Jessica Hansen - VP, IR
Sure.
That will be in our supplementary data that we'll post at the end of the call.
What we did say during our scripted comments were our homes priced greater than $500,000 were 7% of our homes closed and 16% of our home sales revenue.
If you look at homes just marketed at Emerald, it stayed constant at about 4% of our homes closed.
But if you look at that in terms of units on a trailing 12-month basis year-over-year, Emerald has actually grown by over 50% for us.
Alex Barron - Analyst
Okay.
And the orders for that same group?
Jessica Hansen - VP, IR
The orders for Emerald were right at 4% as well.
Alex Barron - Analyst
Got it.
And then I guess as far as your outlook for what you guys are calling affordable homes or Express, I'm kind of curious to see what your outlook is going forward in terms of community count growth, in terms of just -- do you feel that that's where the biggest opportunity is at?
And, I guess, the second follow-up question: where do you guys generically think we are in the cycle at this point?
David Auld - President and CEO
You know, I don't know where we are in the cycle.
I can tell you, it feels very good right now.
And you look at the number of people in the country, you look at the housing formation, you look at job growth -- all of those things are positive.
So we feel very good.
And as far as -- you had asked about the Emerald brand; I can tell you that --.
Alex Barron - Analyst
Yes, but the Express was the one where I was interested in what your outlook is for that going forward.
David Auld - President and CEO
Yes, but your first question was Emerald, right?
Alex Barron - Analyst
Yes, yes, yes.
David Auld - President and CEO
Okay.
Well, as far as confidence for us, when we see that brand starting to accelerate along with how we're executing on the entry-level, I mean, that's -- that to me is a pretty positive sign of what 2017 could be.
Alex Barron - Analyst
Got it.
Okay.
David Auld - President and CEO
I wanted to answer my question, so I forgot yours.
(laughter) So go ahead and ask your question again.
Alex Barron - Analyst
Yes, I guess my question as it pertains to affordable homes and entry-level -- I feel like the entry-level market has kind of been missing in action for the last few years, and you guys were one of the first to, I guess, kind of put your toe in the water a few years ago through the Express brand.
And you've been growing it.
I'm just kind of curious if you guys feel as bullish or more bullish today than you did three years ago about that segment?
David Auld - President and CEO
You know, we are in 51 markets.
We've got another 20-plus markets we can push into.
We feel very good about the Express program.
And in the markets that we have been open and operating, are we going to continue to see the kind of growth we've had?
No, probably not.
But the demand is still -- even after three years, the demand is incredibly strong.
So it just feels good right now.
Alex Barron - Analyst
Okay.
Well, great.
Good job.
Mike Murray - EVP and COO
Thank you.
Operator
Jade Rahmani, KBW.
Jade Rahmani - Analyst
Just wanted to ask about M&A, and if you could share your thoughts on potential for a larger-size transaction than recent deals?
We noticed your leverage levels are extremely low, which creates some optionality.
And regarding leverage, is that based on conservatism on the cycle, or a change in longer-term view about optimal leverage?
Or is it to create this optionality around M&A?
Mike Murray - EVP and COO
Well, I think it's to create optionality around a lot of things: investing in the business, reducing debt -- having a lot of flexibility in the business is good.
With specific regards to M&A, you know we continue to look at a lot of potential transactions, and we pursue those that make the most sense for us, whether they are larger or smaller.
We're kind of neutral to the size of the transaction.
If it makes sense to have a small transaction, good team, good people, good positioning, we'll be interested.
If it's a larger transaction that fits well with us, and there's alignment in what makes sense with the other side, we would look at that as well.
We're not shutting either off at any point in time.
Jade Rahmani - Analyst
Thanks very much.
And just on your guidance in terms of the underlying economic expectations, are you assuming sort of a low to mid-single-digit growth rate in existing and new home sales?
Jessica Hansen - VP, IR
We're assuming kind of more of the same in 2017 as what we saw in 2016.
So when we say our expectations are based on today's housing market conditions, really just more of the same.
Jade Rahmani - Analyst
Thanks very much.
Operator
Will Randow, Citigroup.
Will Randow - Analyst
I know that you guys didn't want to comment on necessarily where you think we are in the cycle, which is definitely fair; but how do you believe you're positioning D.R. Horton within the cycle, given you've been generating free cash for this year and the prior year?
And also, how does that influence your view on potential incremental M&A or returning cash to shareholders, if you will?
Bill Wheat - EVP and CFO
Will, I think we're working to stay in a very balanced, flexible position.
We're putting ourselves in position to continue to grow while we continue to see the good, stable, healthy market conditions we see today.
But as we are utilizing our cash to further strengthen our balance sheet, that's giving us even more flexibility to be opportunistic when we see opportunities to invest in whatever form that may be.
And then, certainly, if things were not to continue as strong, we are in a very strong position there as well.
So really great position to take advantage of M&A opportunities, to invest further in our business.
Really, we're in a very good, flexible position at the moment.
Will Randow - Analyst
And just one follow-up that's unrelated.
In terms of demand pacing through the quarter, did you see any influence from a relatively hot June's inclement weather and a seasonally -- a relatively warm spring, if you will?
Bill Wheat - EVP and CFO
On the sales demand side, no, not necessarily; certainly on the construction side, when you have dry weather, there's no disruptions there.
So from that standpoint, that's always positive.
But the summer is always hot.
Will Randow - Analyst
Thanks, guys.
Great quarter.
Operator
Thank you, we have 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.
David Auld - President and CEO
Thank you, Kevin.
We appreciate everyone's time on the call today and look forward to speaking with you again in November to share our year-end results.
And to the D.R. Horton team, great quarter, great year-to-date performance.
Let's go finish this year and get started on 2017.
Thank you.
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.