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Operator
Good morning, and welcome to the First Quarter 2018 Earnings Conference Call of D.R. Horton, America’s Builder, the largest builder in the United States.
(Operator Instructions) As a reminder, this conference is being recorded.
I will now turn the call over to Jessica Hansen, Vice President of Investor Relations for D.R. Horton.
Jessica Hansen - VP of IR & Communications
Thank you, Kevin, and good morning.
Welcome to our call to discuss the results for the first quarter fiscal 2018.
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 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, which is 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.
Please note that we have changed the presentation of our consolidated financials to present our homebuilding, Forestar land development, financial services and other operations on a combined basis.
The segment information following the consolidated financials in our press release include detailed financial information for all of our reporting segments.
And as a reminder after this call, we will post updated supplementary data at Investor Relations site on the Presentations section under News and Events for your reference.
The supplementary information includes data on our homebuilding return on inventory, home sales gross margin, change 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 V. Auld - President & CEO
Thank you, Jessica, and good morning.
In addition to Jessica, I am pleased to be joined on this call by Mike Murray, Executive Vice President and Chief Operating Officer; and Bill Wheat, our Executive Vice President and Chief Financial Officer.
The D.R. Horton team is off to a strong start in 2018.
In the first quarter, our consolidated pretax income increased 23% to $391.2 million on a 15% increase in revenue to $3.3 billion.
Our pretax profit margin improved 70 basis points to 11.7% and the value of our homes sold increased 17%.
These results reflect the strength of our operational teams and the diverse product offerings across our broad national footprint.
Our strategic focus is to produce double-digit annual growth in both revenue and pretax profits, while generating annual positive operating cash flows and increasing our returns.
For the trailing 12 months, our homebuilding return on inventory was 17%, an improvement of 110 basis points from 15.9% a year ago.
With 27,800 homes in inventory at the end of December and 259,000 lots owned and controlled, we are well positioned for spring selling season and further growth in 2018.
Mike?
Michael J. Murray - Executive VP & COO
Our consolidated pretax income for the quarter increased 23% to $391.2 million versus $318.1 million a year ago.
And homebuilding pretax income increased 27% to $373.8 million compared to $293.9 million.
Net income for the first quarter was $189.3 million or $0.49 per diluted share, compared to $206.9 million or $0.55 per diluted share in the prior year quarter.
Tax Cuts and Jobs Act enacted into law in December impacted our current quarter results with a onetime noncash charge to income tax expense of $108.7 million to reduce our deferred tax asset, which was partially offset by a $41.1 million reduction in current tax expense due to a lower federal rate -- lower federal tax rate applied to this quarter's income.
The net impact of the tax legislation was a $67.6 million reduction of net income for the quarter or $0.18 per diluted share.
Our backlog conversion rate for the first quarter was 88%.
As a result, our first quarter home sales revenues increased 14% to $3.2 billion on 10,788 homes closed, up from $2.8 billion on 9,404 homes closed in the prior year quarter.
Our average closing price for the quarter was $295,200, down 1% from the prior year quarter.
This quarter, entry-level homes marketed under our Express Homes brand accounted for 36% of homes closed and 29% of home sales revenue.
Our homes for higher-end move-up and luxury buyers priced greater than $500,000 were 6% of homes closed and 15% of home sales revenue.
Our active adult Freedom Homes brand is now being offered in 22 markets across 12 states and customer response to these affordable homes in communities offering a low maintenance lifestyle continues to be positive.
Freedom Homes accounted for 2% of homes closed and 1% of home sales revenue in the first quarter.
Bill W. Wheat - Executive VP & CFO
The value of our net sales orders in the first quarter increased 17% from the prior year quarter to $3.2 billion and homes sold increased 16% to 10,753 homes.
Our average number of active selling communities increased 1% from the prior year quarter.
Our average sales price on net sales orders in the first quarter was $299,700 and the 22% cancellation rate during the quarter was consistent with the first quarter last year.
The value of our backlog increased 11% a year ago to $3.8 billion with an average selling price per home of $306,200 and homes in backlog increased 9% to 12,294 homes.
Jessica?
Jessica Hansen - VP of IR & Communications
Our gross profit margin on home sales revenue in the first quarter was 20.8%, an improvement of 100 basis points from prior year quarter and 50 basis points sequentially from the fourth quarter.
Gross margin increased compared to both periods primarily due to lower litigation, warranty and interest costs.
And I apologize, but we're being told that the call is not coming through clearly and it's breaking up, so we're going to very quickly get (technical difficulty) the line and redial back in to see if that makes it better.
Our apologies for the inconvenience.
(technical difficulty)
Operator
Ladies and gentlemen, please stand by.
Ladies and gentlemen, please do not disconnect.
There will be silence in the meantime.
Now rejoining our speakers.
Jessica Hansen - VP of IR & Communications
Thank you, Kevin.
I'm going to continue with home sales gross margin.
Our home sales gross margin will be impacted by the strength of the spring selling season.
Based on our first quarter results and current market conditions, we expect our gross margin will be in the range of 20% to 21% for the full fiscal year, with quarterly fluctuations that may be outside of the range due to product and geographic mix as well as the relative impact of warranty, litigation and interest cost.
Bill?
Bill W. Wheat - Executive VP & CFO
In the first quarter, homebuilding SG&A expense as a percentage of revenues was 9.5%, unchanged from the prior year quarter.
This quarter's SG&A includes $5.3 million of transaction cost related to the Forestar acquisition.
We remain focused on controlling our SG&A while ensuring that our infrastructure adequately supports our growth.
Jessica?
Jessica Hansen - VP of IR & Communications
Financial services pretax income in the first quarter was $22.2 million compared to $26.5 million in the prior year quarter.
The decrease in profit was primarily from lower pricing on loan origination sales due to competitive pressures in the mortgage market.
96% 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 D.R. Horton home buyers.
FHA and VA loans accounted for 44% of the mortgage company's volume.
Borrowers originating loans with DHI Mortgage this quarter had an average FICO score of 719 and an average loan-to-value ratio of 88%.
First-time home buyers represented 43% of the closings handled by our mortgage company, consistent with the prior year quarter.
Mike?
Michael J. Murray - Executive VP & COO
We ended the first quarter with 27,800 homes in inventory.
15,500 of our total homes were unsold with 11,200 in various stages of construction and 4,300 completed.
Compared to a year ago, we have 13% more homes in inventory, putting us in a strong position for the spring selling season and the rest of fiscal 2018.
David?
David V. Auld - President & CEO
Our homebuilding investment in lots, land and development during the first quarter totaled $954 million, of which $573 million was for finished lots and land acquisition, and $381 million was for land development.
Our underwriting criteria and operational expectations for new communities remain consistent at a minimum 20% annual pretax return on inventory and a return of our initial cash investment within 24 months.
We expect our homebuilding operations to invest approximately $4 billion in the lots, land and development in 2018.
Bill?
Bill W. Wheat - Executive VP & CFO
At December 31, our homebuilding land and lot portfolio consisted of 259,000 lots, of which 126,000 or 49% were owned and 133,000 or 51% were controlled through option contracts.
98,000 of our total homebuilding lots were finished, of which 36,000 were owned and 62,000 were optioned.
3,100 of our option lots at December 31 were owned by Forestar.
We have increased our option lot position 42% from a year ago and we believe we can increase the option portion of our total land and lot pipeline to 60% over the next few years, while maintaining our number of owned lots relatively flat with the current level.
We plan to continue expanding our relationships with land developers across the country, as well as growing our majority-owned Forestar land development operations.
Our 259,000 homebuilding lot portfolio is a strong competitive advantage in the current housing market and sufficient to support our growth.
Mike?
Michael J. Murray - Executive VP & COO
On October 5, we acquired 75% of the outstanding shares of Forestar Group, a publicly traded residential land development company for $558 million in cash.
D.R. Horton's alignment with Forestar advances our strategy of expanding relationships with land developers across the country to increase our access to optioned land and lot positions and enhance operational efficiency and returns.
The interactions between D.R. Horton and Forestar have been very productive, and we continue to be excited about the value this relationship will create over the long term for both D.R. Horton and Forestar shareholders.
Forestar's operating results for the period subsequent to the acquisition date and as of December 31, 2017 are fully consolidated in our financial segments, with the 25% interest D.R. Horton does not own, reported as noncontrolling interest.
Forestar's assets and liabilities were recorded at fair value as of the acquisition date, including $402 million of cash, $345 million of land and lot inventories and $20 million of goodwill.
The segment information tables provided in our press release present Forestar's operating results as of December 31, 2017, on its historical cost basis and the impact of purchase accounting and other adjustments are presented separately.
Forestar currently has operations in 16 markets across 11 states.
Both D.R. Horton and Forestar are identifying land development opportunities to expand Forestar's platform.
Since the acquisition in October, Forestar has been evaluating approximately 22 opportunities primarily sourced by D.R. Horton and Forestar closed on 6 of those opportunities as of December 31.
All of the projects are located in high-demand markets that D.R. Horton currently serves.
These 22 communities are expected to yield approximately 11,000 finished lots, majority of which may be sold to D.R. Horton in accordance with the master supply agreement between the 2 companies.
We are also continuing to work with Forestar on plans for its existing projects to improve returns and accelerate cash flows on its legacy portfolio, which will provide capital for Forestar's future growth.
Jessica?
Jessica Hansen - VP of IR & Communications
Looking forward, during fiscal 2018, we expect Forestar to invest approximately $400 million in land acquisition and development, funded from both existing cash and the cash flows generated from its legacy portfolio.
Also in 2018, we expect Forestar to obtain a bank credit facility to help fund its working capital needs.
In fiscal 2019, we expect Forestar to access the public markets for additional growth capital.
And over the next 3 years, we expect Forestar's annual deliveries to grow to approximately 10,000 lots by fiscal 2020.
We do not expect Forestar to have a material impact on D.R. Horton's fiscal 2018 earnings, primarily due to the impact of purchase accounting adjustments and intersegment profit deferrals.
We will reference Forestar on future D.R. Horton earnings calls, and we expect to update our 2018 guidance for Forestar on our second quarter call in April.
As a public company, Forestar will continue to file quarterly and annual reports and other required public information, but will not host quarterly conference calls.
D.R. Horton will continue to handle Forestar's Investor Relations to allow the Forestar team to focus solely on operations.
Forestar has historically operated on a calendar year-end and will file its 2017 annual report by mid-March.
Forestar has announced that it is changing its fiscal year-end from December 31 to September 30 in 2018, which will align with D.R. Horton's fiscal year.
Bill?
Bill W. Wheat - Executive VP & CFO
At December 31, our homebuilding liquidity included $558 million of unrestricted homebuilding cash and $877 million of available capacity on our revolving credit facility.
Our homebuilding leverage ratio improved 270 basis points from a year ago to 25.9%.
During the quarter, we used $400 million -- we issued $400 million of 2.55% senior notes due in 2020 and repaid $400 million of 3.625% senior notes at par.
The balance of our homebuilding public notes outstanding at the end of the quarter was $2.4 billion, and we have no senior note maturities in the next 12 months.
During the first quarter, our consolidated cash used in operating activities was $75 million.
Excluding Forestar, we used $30.7 million of cash in operations as we increased our homes under construction in preparation for the spring selling season.
During the quarter, we paid cash dividends of $47 million to our shareholders and we repurchased 500,000 shares of our common stock for $25.4 million.
Our remaining stock repurchase authorization at December 31, 2017, was $174.6 million.
At December 31, our stockholders' equity was $7.9 billion and book value per share was $20.98, up 12% from a year ago.
We are also pleased that S&P recently upgraded D.R. Horton's investment grade corporate credit rating to BBB flat from BBB-.
David?
David V. Auld - President & CEO
Our balanced capital approach focuses on being flexible, opportunistic and disciplined.
Our balance sheet's strength, liquidity, consistent earnings growth and cash flow generation are increasing our flexibility and we plan to utilize our strong position to enhance the long-term value of the company.
Our top cash flow priorities are to consolidate market share by investing in our homebuilding business and strategic acquisitions, reduce or maintain debt levels and return capital to our shareholders through dividend and share repurchases.
After considering the impact of recent tax legislation, we now expect to generate at least $700 million of cash from operations in 2018, growing to over $1.25 billion annually in 2020, excluding Forestar.
Jessica?
Jessica Hansen - VP of IR & Communications
Looking forward, we are updating our expectations for 2018 based on current market conditions.
We now expect to generate a consolidated pretax margin of 11.8% to 12%.
We still expect consolidated revenues of between $15.5 billion and $16.3 billion and to close between 50,500 and 52,500 homes.
We anticipate our home sales gross margin for fiscal 2018 will be in the range of 20% to 21% with the potential for quarterly fluctuations outside of this range.
We estimate our annual homebuilding SG&A expense will be around 8.7%.
We expect our financial services operating margin for the year to be around 30%.
We are forecasting a fiscal 2018 income tax rate of approximately 26%, excluding the onetime deferred tax asset charge we took this quarter, and we expect our outstanding share count to increase by less than 1% this year.
And as David mentioned, we now expect to generate at least $700 million of positive cash from operations, excluding Forestar, in fiscal 2018.
Our results this year will be significantly impacted by the strength of the spring selling season, and we will update our expectations as necessary each quarter as visibility to the spring and the full year becomes clear.
For the second quarter of 2018, we expect our number of homes closed will approximate a beginning backlog conversion rate in the range of 97% to 100%.
We anticipate our second quarter home sales gross margin will be in the range of 20% to 21%, and we expect our homebuilding SG&A in the second quarter to be in the range of 9% to 9.2% of homebuilding revenues.
Over the longer term and as we generate increased cash flows, we expect to pay down debt and decrease our leverage, increase our dividend and repurchase shares to offset dilution with a target to keep our outstanding share count flat by 2020.
David?
David V. Auld - President & CEO
In closing, our first quarter's growth in sales, closings and profits is a result of the strength of our people and operating platform.
We are striving to be the leading builder in each of our markets and to continue to expand our industry-leading market share.
We remain focused on growing both our revenue and pretax profits at a double-digit annual pace, while continuing to generate annual positive operating cash flows and improved returns.
We are well positioned to do so with our solid balance sheet; broad geographic footprint; diversified product offering across our D.R. Horton, Emerald, Express and Freedom brands; attractive finished lot and land position; and most importantly, our outstanding team across the country.
We thank the entire D.R. Horton team for their continued focus and hard work, and we look forward to growing and improving our operations together in 2018 as we celebrate our 40th anniversary year.
This concludes the prepared remarks.
We will now host any questions.
Operator
(Operator Instructions) Our first question today is coming from Carl Reichardt from BTIG.
Carl Edwin Reichardt - MD
I wanted to ask a little bit about gross margin, which was better than what we expected and I know we'll see the numbers come out a little bit later.
But did you have any issues -- obviously, you've got spec up, but did you have any issues getting homes out of backlog this quarter?
And was there any significant mix impact from the higher-margin markets that helped you?
Bill W. Wheat - Executive VP & CFO
No, Carl.
It was just a solid quarter.
Backlog conversion was solid.
Our core margins throughout the business have been very stable, and really our outlook going forward is continuing very stable on a core margin basis.
We did see lower impact for litigation and warranty this quarter, I would say, back to a more normal level there.
We've had an elevated level the last several quarters, as well as we continue to see a steady decline in the interest component, the interest cost and our margin, which was a contribution this quarter as well.
But primarily, lower litigation, warranty and interest; and just solid, stable margins on a core basis.
And as we look forward, same outlook there.
Carl Edwin Reichardt - MD
Okay.
And then David, I'm interested in your perspective on some of the markets where you don't have as much penetration.
I know we expect you to continue to try to invest to consolidate share in the markets where you already have presence.
But markets like the Northeast, Mid-Atlantic, the Midwest, can you comment at all about your thought process there in terms of potential growth in those markets?
David V. Auld - President & CEO
Carl, we spent a lot of time the last 2 or 3 years looking at those markets, kind of repositioning within those markets.
And my personal belief is that those are going to be a big part of our company going forward.
There are markets, there are a lot of people there and there's no reason for us not to be #1 in those markets, just like we're #1 in Texas market.
Operator
Our next question is coming from John Lovallo from Bank of America Merrill Lynch.
John Lovallo - VP
The first one is on the comments around the intention for Forestar to access the capital markets in fiscal year '19.
I guess the question would be, any thoughts on whether this is going to be equity or debt?
And then is the goal, over time, to still kind of dilute that stake down to closer to 25% in accordance with the master supply agreement?
Michael J. Murray - Executive VP & COO
John, it's Mike.
We have not yet decided what makes the most sense between debt or equity right now, possibly a bit of a blend.
And yes, we do intend to drift down our ownership percentage over time.
But today, we're focused, first and foremost, on building and growing the platform.
John Lovallo - VP
Okay.
That's helpful.
And then, if I heard this correctly, did you guys comment on community count in the quarter being up about 1%?
And if that is the case, how comfortable are you with being able to continue to push absorption?
Jessica Hansen - VP of IR & Communications
Very comfortable with continuing to push absorption and that was the story, obviously, once again this quarter.
We were up 1% year-over-year.
Sequentially, we ticked down slightly, I believe, about 2%.
The details will be out in our supplementary data after the call, but we'd continue to expect our community count to be relatively flat to slightly up or down as we move throughout the year.
Bill W. Wheat - Executive VP & CFO
And John, our product diversity is really helping drive that absorption as we're introducing Freedom into some of our communities where we have other brands there as well.
That's helping us increase our absorption, and we really see the potential for that for the remainder of this year.
Operator
Our next question is coming from Stephen East from Wells Fargo.
Stephen F. East - Senior Analyst
Just to follow on, on Forestar and surprisingly here, you've identified about 22 deals.
You've brought on about 6. Could you talk about where they're located, first of all?
And then I have a couple of other questions on Forestar.
Michael J. Murray - Executive VP & COO
Our 22-deal portfolio right now is the Carolinas, Georgia, Florida, Texas and Washington State, yes.
Stephen F. East - Senior Analyst
All right.
Got you.
And then Mike, what's the limiting factor as you move through the year and into fiscal '19 as far as converting those 22 and whatever else you're seeing, converting those to going onto the balance sheet of Forestar?
And then, could you repeat for me how many lots you expect to use from Forestar in 2020?
I missed that.
Michael J. Murray - Executive VP & COO
In 2020, we expect to have around 10,000 lot deliveries coming out of Forestar.
So there's really -- the limiting factor is people, growing the team and the processes.
We feel like we've got adequate capital for the foreseeable future into '19 before we think about a capital raise, and feeling very good about our growth path and trajectory.
The additions to the teams we've made so far have been strong, and we think that's going to lead to more growth in the platform.
Stephen F. East - Senior Analyst
Okay.
And the limiting factor, I guess, on that growth -- and I guess if you're already looking at 11,000 lots to have only 10,000 in 2020, I guess, surprises me a little bit.
Michael J. Murray - Executive VP & COO
Well, the 11,000 would be the total inventory in the lots.
The 10,000 would be the annual delivery of (inaudible).
So they'll be holding on inventory of several years' supply and then -- but we expect them to be delivering 10,000 a year out of those deals as they finish development.
Operator
Our next question is from Alan Ratner from Zelman & Associates.
Alan S. Ratner - Director
So first question on the gross margin.
Really strong results this quarter and you're bumping the low end of the range that you've talked about, it seems like, forever, that 19% to 21% up 100 basis points.
The items you mentioned in the release that really drove the upside this quarter, the litigation, the warranty, they're certainly lumpy, but they seem a little bit more onetime in nature and they can move around a lot.
So I was hoping you could just expand a little bit upon like what you're seeing in the market that gives you the confidence to raise that low-end and maybe just expand a little bit on pricing power that you're seeing, especially in the face of rising rates that we've seen over the last month or 2?
Bill W. Wheat - Executive VP & CFO
Yes.
Alan, we're just seeing really stable, strong market out there, limited inventory.
Certainly, the ability to raise prices, obviously, in our more affordable product where we're very careful about the pace at which we raise price because we want to make sure we keep an affordable product out there, but the market's very solid, very strong.
Certainly, we expect to continue to see some cost increases, but our ability to either offset that through other categories or to offset that with some modest price increases, we believe, is still there.
So just overall market tone just feels very stable, very steady and our outlook for margin is solid for the year.
Jessica Hansen - VP of IR & Communications
We continue to see our purchasing teams across the country do a fantastic job on controlling cost.
We believe our business model plays very nicely into that, particularly with Express, but our revenues per square foot did outpace our stick and brick increase per square foot on a year-over-year basis again this quarter.
So more of the same.
We're still seeing labor cost pressures and material cost relatively net neutral.
Alan S. Ratner - Director
Great.
Good to hear.
And then the second question.
I know it's really early, but I'm hoping you could just give some rough parameters here.
When you look at the 22 opportunities you're looking at, at Forestar and even just if you want to drill more on the 6 that you've closed, can you give us a little bit of a sense of what type of margin underwriting we should think about for Horton as you actually deliver homes on those lots, as well as what Forestar will actually report on the development margin when they sell the lands to Horton?
Just trying to figure out how much different from the 20% to 21% you're talking about should we expect on those Forestar deals and what type of margin are you embedding for the developer.
Michael J. Murray - Executive VP & COO
Alan, we continue to focus on the returns of those projects as we look at it from both the Forestar side and the Horton side.
And we're looking at high teens, a very incremental -- incrementally positive returns to the Forestar portfolio and continuing to underwrite it to a 20% or plus return on inventory metric on the homebuilder side.
Those are the primary underwriting metrics that we're looking at.
And so that's where we're focusing and the margins will vary.
Operator
Our next question is coming from Ken Zener from KeyBanc Capital Markets.
Kenneth Robinson Zener - Director and Equity Research Analyst
So your guidance is up and gross margin's good.
Your orders hit seasonality.
My question is relative to your total units in inventory, your 27,300 versus 24,500 last year.
That low-teens growth is good, but I wonder why the spec component, the growth rate in the spec component has declined.
Is there something about your orders being stronger in terms of backlog or why did that component of units in inventory declined year-over-year when that's obviously a component that enables you to gain share by building spec ahead of other builders?
Jessica Hansen - VP of IR & Communications
Our spec count is actually up 16% year-over-year, Ken.
I don't know if that's part of what was cutting out on our call.
We do apologize for the in and out earlier.
Kenneth Robinson Zener - Director and Equity Research Analyst
Okay.
So your -- what is -- your total units in inventory is 27.3.
And what's your spec count?
Jessica Hansen - VP of IR & Communications
Our total units in inventory is 27,800 and our spec count is about 15,500.
Kenneth Robinson Zener - Director and Equity Research Analyst
Okay.
And is that -- the gross margin guidance there, I know you're obviously working on a lot of different things but you were the first company really to cut gross margins in order to get the pace up.
Is there something that you're doing to get this slight upward revision in gross margins?
I mean, is it -- if labor is there, material is there, why are you getting this upward tick?
Could you readdress that?
David V. Auld - President & CEO
We've been working very, very hard to improve efficiency, deliveries and the delivery of the product, take labor out of it.
I mean, if you look at our ASP on closed houses, we actually saw a slight dip this last quarter while we improved margins.
And that's just a culmination of a lot of really hard work and getting product positioned to be more competitive and drive a better return, which is now translating into -- it has been stable margins, but we saw a little uptick this last quarter.
Operator
Our next question is coming from Michael Rehaut from JPMorgan.
Michael Jason Rehaut - Senior Analyst
First question I just wanted to make sure I got the best feel for it, and I apologize if you answered this earlier.
It might have been when you were a little more staticky.
But the drivers of the gross margin increased for fiscal '18.
You highlighted that the -- kind of the upside or the higher end of the range in the first quarter was due to the litigation warranty, also a little bit of less interest cost and that, that has become more stable than previous years.
So am I to infer then that the raise for the full year is also driven by these 2 factors primarily?
And obviously, you continue to have good end markets and being able to roughly offset cost inflation, which are all very good positives.
But the lower litigation warranty and perhaps the less interest as a percent of revenue, those are the main drivers of the increase for the full year?
Bill W. Wheat - Executive VP & CFO
Yes, Mike.
That is the primary driver.
I would say it's the reason why we haven't been able to raise our margin guidance prior to this.
We were seeing a trend that was affecting our margin.
That trend has moderated.
We believe it's at a more stable level today, and we continue to see a very stable outlook in the core of our business.
Michael Jason Rehaut - Senior Analyst
Right.
Right.
Okay.
Great.
That's helpful.
And also then on Forestar, with the 10,000 deliveries that you expect the company to achieve in 2020, I guess that's a year ahead of the original slideshow presentation and expectations.
Also, you have -- now you talked about 22 deals that are being evaluated.
6 have already closed, and I believe in the original guidance, you were looking for 8 deals to be closed in the first year.
So is this -- are we to kind of conclude that maybe you would -- Forestar would be doing, perhaps, in the 10 to 15 range in the first year?
And that kind of as you look at further years out, if it's 10,000 in 2020, the 15,000 goal that you had, I believe, in 2022 could be something on the order of a 20 to 25 type number?
Michael J. Murray - Executive VP & COO
I think -- we indicated -- last quarter, we thought that we would be able to exceed those June projections that were out there, and we tried to update that a bit right now with the 2020 goal of 10,000 deliveries.
Been very pleased with the flow of projects and opportunities that Forestar has been able to evaluate, but we'll be updating our guidance for the balance of 2018 with some more details in April.
We'll be able to -- more comfortable, I think, to share a little more granularity into what we see in the interim periods.
Michael Jason Rehaut - Senior Analyst
Okay.
And just one last quick one, if I could.
The operating margin guidance being raised by 30 bps versus the gross margin guidance raised by 50 bps, what's the reconciliation there?
Jessica Hansen - VP of IR & Communications
We've reduced our financial services operating margin.
We have set 30% to 32%, and now we're seeing around 30%.
Their operating margin was only about 27.5% in the first quarter, and we are seeing competitive pressures in the mortgage market.
It's really reverting to what we would consider to be a normalized operating margin, whereas the last couple of years, they've seen outsized margins in their business.
Michael Jason Rehaut - Senior Analyst
Okay.
Perfect.
Yes.
I was thinking operating homebuilding margins, so thanks for that clarification.
Jessica Hansen - VP of IR & Communications
Yes.
That's why this was consolidated pretax margin of 11.8% to 12%.
Operator
Our next question is coming from Stephen Kim from Evercore ISI.
Stephen Kim - Senior MD, Head of Housing Research Team & Fundamental Research Analyst
My first question relates to the comment you made, David, about the importance of discipline.
And I think that's something that really has been a focus, I know, of yours and the company and the management teams over the last few years.
With respect to discipline, we were looking at your ROA across your regions recently, and I was kind of surprised to see just how wide the spread returns on assets were across your different reporting regions.
It was actually among the widest we've seen in our -- we see in the group.
And I was curious if you could just sort of comment on the degree -- why we're not seeing the discipline and the controls and the overall strength of Horton not also manifest itself in, perhaps, somewhat more similar returns across your regions if that's even a meaningful metric or goal or aspiration at all.
And if not, why not?
David V. Auld - President & CEO
Steve, every one of these markets are different, and we do operate with a very decentralized approach to what we're doing.
We think that gives us the ability to scale up and operate in markets profitably other people have a difficult time entering.
When I look at these operations and -- like the Northeast or Arizona a couple of years ago, I see opportunities get better.
And that's what we're striving to do is over time, get better.
If you look at the longevity of our people, you see that we, I think in a way, lead the industry and being able to keep the people in markets for the longest period of time.
That's very important to me.
So we don't have a top-down approach to it.
We don't have a quick trigger on changing people out.
We work with people striving to get better, and then build on their relationships within those markets to create long-term value for the shareholders.
And that's been the philosophy of Don Horton, Don Tomnitz and something I share.
Stephen Kim - Senior MD, Head of Housing Research Team & Fundamental Research Analyst
Great.
No.
I appreciate that.
If I could extend the question again a little bit in a slightly different way, talking about discipline.
We've also been very intrigued to note that this cycle is the first housing upcycle where we've seen 8 consecutive years of housing start increases.
That's never happened in the history of the country.
And so not -- so while housing may still be as cyclical as it ever was, it has been noticeably less volatile than in prior cycles.
And I was curious if you could talk about if you think housing demand is more likely -- is likely to become more volatile in the next couple of years in a potentially rising rate environment?
And how you think D.R. Horton's discipline in the market, particularly maybe with respect to your spec strategy and incentives, how that might be more visible or visible in a more volatile market, if we were to have one?
Bill W. Wheat - Executive VP & CFO
Steve, we've been expecting to see higher interest rates for quite a few years.
We feel it's very important to maintain an affordable product out there in any environment.
And that's really still the most underserved segment of the market today, is that the affordable end of the price range.
So as we go into a period where we're now -- interest rates are rising, we believe we're in a very good position to compete in that scenario.
Our decentralized operations also allow us to respond to individual market trends when changes in local economies affect the housing market.
But overall, we're very pleased with the position that we're in.
Michael J. Murray - Executive VP & COO
I'd also look at the recovery that it has been 8 years of increasing housing starts, but they're increasing from a very low level at a very slow trajectory relative to continued population growth household formations.
So the underbuilding, so to speak, that was occurring, we're still working out against that.
And there has been discipline in the industry with -- amongst the players in not being overbuilt.
David V. Auld - President & CEO
And I think the other contributing factor to what has extended this housing cycle has been the lack of financing for small builders and independent developers.
That -- typically, that's how the markets get oversupplied.
Lawyers become developers and doctors become owners.
And it's a -- they put product out there that there's no demand for.
And what you're not seeing -- and it's not just D.R. Horton.
It's all the builders, much more disciplined.
We all went through that downturn.
And we didn't enjoy it.
So we've got a great market working force today, and it's just a matter of positioning and execution and we do pretty well in that environment.
Operator
Our next question today is coming from Jack Micenko from Susquehanna.
Soham Jairaj Bhonsle - Associate
This is Soham on for Jack today.
My first question was on capital allocation, and just coming back to what you guys said in your opening comments on priorities going forward in the order of paying down debt, raising dividend and purchasing shares to offset dilution.
Just curious, you mentioned raising dividend, so just wondering what's driving the decision to favoring a dividend increase over share repurchase at this time.
Bill W. Wheat - Executive VP & CFO
We've always been a steady dividend payer.
That has typically been our preferred method of distribution to shareholders through the years and it continues to be.
We have more recently begun to fold in some level of repurchases of shares, and we expect that to now become part of our consistent distributions as well, but we've -- that's really been the -- our historical pattern on distributions to shareholders through dividends.
Michael J. Murray - Executive VP & COO
We went from no share repurchases in the year-ago quarter to 0.5 million shares repurchased in the most recent quarter.
So seeing an increase in return there.
And our focus would also be looking for opportunities to invest in the business, and continue to take advantage of market opportunities that we see as a high priority for our capital.
Soham Jairaj Bhonsle - Associate
Okay.
And then I guess on Forestar, as we think about gross margins and SG&A for that business, is 40% on the gross margin the right level to think about?
And then what does the SG&A percentage look like on the 10,000 lot bases that you guys just referred to?
Just trying to think through the longer term pretax profile for the business.
Michael J. Murray - Executive VP & COO
Right.
We're focused like we are at the homebuilder.
We're focused on the returns and the Forestar team is focused on the returns as the primary metrics that are guiding their decisions.
And we'll get back with some more updated guidance information after Forestar reports their full annual results in mid-March when we come back with our April call.
Operator
Our next question is coming from Nishu Sood from Deutsche Bank.
Nishu Sood - Director
First, thinking about the 60% optioned lot target, which you folks have mentioned again here and I you've been talking about that pretty consistently.
How do we think about the increment from here at 50% to 60% relative to Forestar?
The 10,000 lot deliveries by 2020 would seem to make up -- would seem to help make up most of that progress from 50% to 60%.
Is that roughly where that difference is going to come from?
Or am I not thinking about that correctly because of the consolidation of Forestar?
Michael J. Murray - Executive VP & COO
I think you're going to see it coming from both sources of third-party land developers as well as Forestar.
The exact mix between those 2, still kind of working that out.
But I do feel really good that both -- we will have both expanded relationships with developers, as well as certainly an increased supply from Forestar for our lot position.
Nishu Sood - Director
Got it.
Got it.
And in terms of mortgage rates, obviously, some concern about those having picked up.
Now you folks have been pretty consistent in describing that if rates are rising relative to a better growth pattern, that's fine.
But if there's a sharp move -- continued sharp move in rates during the spring selling season, what level on the third year would worry you?
Is it 4.5%, 5%?
How are you thinking about that heading into the spring selling season?
Jessica Hansen - VP of IR & Communications
There's no certain rate really, Nishu.
As you said, it really is based on how sharp they rise.
So if they do rise very sharply in a short period of time, we would expect some period of impact while buyers' mindset resets and adjusts to that higher rate.
But as long as we're offering affordable homes that people can afford, which we think we are doing today even with a decent rise in rates, we feel good about the overall spring selling season and really sales as we move throughout 2018.
David V. Auld - President & CEO
With the increase in rents that we've seen in the markets, a payment on the -- at 4%, 4.5% is -- even close to 5%, still going to be less than renting a house.
So it's -- these are great rates.
And what we have seen is that the uncertainty in rates is pushing people off the fence and is actually increasing demand right now.
So we're looking at each market individually and positioning within that market to meet our targets.
Feel pretty good about it.
Operator
Our next question is coming from Mike Dahl from Barclays.
Michael Glaser Dahl - Research Analyst
First question, just another high-level question around how to think about the impact of Forestar.
And I guess if we're thinking about these 10,000 lots or as you go out further clearly more, but these are deals that, by and large, would've otherwise been either sourced to other third-party partners or brought on your own books if I'm -- A would be, am I thinking about that correctly; and then B, if so, is it then more of an issue from an accounting standpoint of you'll capture the additional margin on having developed those lots through Forestar versus outsourcing them to a total third-party?
Or is it truly a -- so is it a margin gain or is it a top line gain in your view as far as the contributions from Forestar?
Bill W. Wheat - Executive VP & CFO
Well, the goal of Forestar is for them to be a large, well-capitalized national land developer that ultimately will not be on our balance sheet.
And so what we are in the process of doing right now is putting deals in place to build the pipeline to help them build that foundation and build that platform across the country.
Ultimately, what that will provide, when they are capitalized, when they -- the foundation is built, when they're across the country and they're off our balance sheet, the returns on D.R. Horton's side will grow because we will have a more efficient balance sheet.
There are profits to be made in the land development business and Forestar will make a solid profit, a solid return on the investments that they are making.
And we will earn our portion of the profits on the Forestar business.
But in the short run here for the next year or 2, we are in the process of building out that platform and putting them in position to deliver a more substantial portion of our lots down the line and to build a profitable strong returning business on a stand-alone basis.
Michael Glaser Dahl - Research Analyst
Got it.
Okay.
And the second question, I guess if you could just -- I know it's still a small piece of the business but in the midst of a, I think, a meaningful ramp over the course of this year and next, if we're looking at Freedom Homes, could you give us an update on how we should be thinking about that ramp over the course of '18?
And any details you can give us on what type of sales pace you're observing in those communities relative to your other brands?
David V. Auld - President & CEO
We've pushed us into 22 markets.
We're actively working on every market we've got introducing the Freedom.
It's a little bit different in that setup on the community.
The HOA documents are a little more restrictive than what would typically be a Horton community.
So it has been a situation where we're having to put lots on the ground to support that brand.
It's a huge buyer segment, buyer demographic, and they are much less interest rate-sensitive.
So we think it's going to be a significant impact to growth.
If not this year, next year, then certainly 3- to 5-year period.
Bill W. Wheat - Executive VP & CFO
Steady growth is the expectation.
Within a few quarters, it's now 2% of our overall mix.
We would expect to see steady growth going forward throughout '18 and '19.
David V. Auld - President & CEO
I can tell you where we have put those projects on the ground and executed well, they have outperformed.
And I'm very excited about it.
Operator
Our next question is coming from Dan Oppenheim from UBS.
Daniel Mark Oppenheim - Housing and Building Products Analyst
Was wondering about the issue of the specs and the rate environment to your -- wondering what you're seeing in terms of the consumer response.
Are you seeing that the fears of higher mortgage rates is actually increasing the attractiveness of specs in the shorter closing time?
And also wondering as others have talked about specs in terms of just the potential for lower margins, are you seeing that or you're seeing that these specs are coming through essentially the same margins as to be built homes?
Michael J. Murray - Executive VP & COO
Specs have consistently been a significant part of our business operations, and those margins that we see now reflect 70% to 80% spec home deliveries every quarter and have for a long, long time.
So we're not seeing anything but solid margin performance across our communities, and that's reflective of a lot of spec deliveries, which is very helpful as we compete with not just other new home sales, but with existing home sales as well.
David V. Auld - President & CEO
Our operators are very disciplined.
I mean, we're not just throwing inventory out there.
We plan our spec starts based upon demand within that community and position it to create the most efficiency we can building these houses through the -- on a month-to-month, week-to-week basis.
It's part of our overall program and I believe -- we believe that it is the reason we've been able to maintain such stable margins for the past 3, 4 years.
Jessica Hansen - VP of IR & Communications
And Dan, in terms of the rate environment, we haven't seen any impact to our traffic or our sales in January as a result of mortgage rates.
Actually, very pleased with our sales pace and in line with our business plan as we're finishing up the month here today.
Daniel Mark Oppenheim - Housing and Building Products Analyst
Right.
Jessica, actually meant more in terms of just does the -- into the spec actually, it served as an incentive and helped the conversion rate of traffic, so people can then close there.
Jessica Hansen - VP of IR & Communications
Yes.
If we're going...
David V. Auld - President & CEO
Absolutely.
Operator
Our next question today is coming from Jade Rahmani from KBW.
Jade Joseph Rahmani - Director
I was wondering if you could give your updated thoughts around integrated off-site solutions in terms of preconstruction of various aspects of the home.
How much potential do you see in this trend over several years?
Michael J. Murray - Executive VP & COO
We continue to look at different ways to be more efficient in the building process and we -- in various markets and we do panelization in other markets.
It's more of a stick-built process and it's in a lot of places.
It's a combination of both on-site, always looking for the most efficient way to deliver an affordable home.
But we continue to watch that.
And at this time, we don't really have any kind of a codified view on what impact that will have on D.R. Horton.
But with something -- rest assured that we're watching continually.
Jade Joseph Rahmani - Director
And can you also comment on labor availability and cost pressures related to labor constraints?
How are you managing that and where would you say the problem is most acute?
Michael J. Murray - Executive VP & COO
The problem really hasn't manifested itself for us broadly across the board.
We -- our spec strategy, our disciplined starting program of working to a given absorption in a community has allowed us to get the labor we need.
From a high level, we monitor overall build times to see if we're having issues delivering homes, and we've not seen any kind of elongation in our build cycle by our field production teams.
They've done a great job staying on top of the labor.
And then with the cost, we have seen increases in stick and brick cost, but it varies from quarter to quarter as to how it's manifesting itself.
But for the most part, we've been able to get the pricing power to cover any of the cost increases that have come through.
Operator
Our final question today is coming from Buck Horne from Raymond James.
Buck Horne - SVP, Equity Research
I had a question on labor, but that got answered as well.
So I'll ask a question that I get a lot from my clients just about the tax law changes and how you guys might internally be thinking about if this changes the standard deductions, state and local taxes, mortgage interest deductibility, do you think that has any meaningful effect on buyer behavior, maybe between certain states this year or even next?
Michael J. Murray - Executive VP & COO
Buck, with the -- the homes we're looking to deliver primarily affordable homes at whatever customer segment we're serving.
We're not expecting a significant negative impact at all from the tax rate changes.
In fact, we're hopeful with more money in people's pockets that they're more emboldened to be confident to make the decision to go ahead and buy that new home and to buy an affordable home from D.R. Horton.
David V. Auld - President & CEO
Buck, the alternative is rents.
And if you want to lock in your housing cost, you've pretty much got a home and build some form of equity over time.
So it's a strong economy, more money in their pockets.
Those are both wins for D.R. Horton.
Buck Horne - SVP, Equity Research
Okay.
And just a quick follow-up.
Have you guys given any thought to partnering or working with other single-family rental operators for product that may be built for rent if that type of opportunity presented itself?
David V. Auld - President & CEO
We get pitched a lot of things from a lot of different people.
Right now, we're very happy with the absorptions we're driving, selling to single-family homeowners.
And to me, you put too many renters in a community owned by 1 company, you can end up creating problems for the homeowners.
So if we -- if that was a way to drive absorption and we were looking to drive absorption, then we probably would think more about it.
But right now, today, we like the model we work under and feel like we're offering long-term value to our homeowners and that's a winning combination for us.
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.
David V. Auld - President & CEO
Thank you, Kevin.
And we appreciate everyone's time on the call today and look forward to speaking with you again in April to share our second quarter results.
And to the D.R. Horton team, thank you for a strong first quarter and an outstanding start to 2018.
We are proud to represent you up here.
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.