Hovnanian Enterprises Inc (HOVNP) 2017 Q2 法說會逐字稿

Good morning, and thank you for joining us today for the Hovnanian Enterprises Fiscal 2017 Second Quarter Earnings Conference Call. An archive of the webcast will be available after the completion of the call and run for 12 months. This conference is being recorded for rebroadcast. (Operator Instructions) Management will make some opening remarks about the second quarter results and then open the line up for questions.

The company will also be webcasting a slide presentation along with opening comments from management. These slides are available on the Investors page of the company's website at www.khov.com. Those listeners who would like to follow along should go onto the website at this time.

Before we begin, I would like to turn the call over to Jeff O'Keefe, Vice President, Investor Relations. Jeff, please go ahead.

Thank you, Nicole, and thank you all for participating this morning in our call to review the results for our second quarter, which ended April 30, 2017.

All statements in this conference call that are not historical facts should be considered as forward-looking statements within the meanings of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995.

Such statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements of the company to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements.

Such forward-looking statements include, but are not limited to, statements related to the company's goals and expectations with respect to its financial results for future periods.

Although we believe that our plans, intentions and expectations reflected and/or suggested by such forward-looking statements are reasonable, we can give no assurance that such plans, intentions or expectations will be achieved.

By their nature, forward-looking statements speak only as of the date they are made, are not guarantees of future performance or results and are subject to risks, uncertainties and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as a result of a variety of factors.

Such risks, uncertainties and other factors are described in detail in the section entitled Risk Factors and Management's Discussion and Analysis, particularly the portion of MD&A entitled Safe Harbor Statement in our Annual Report on Form 10-K for the fiscal year ended October 31, 2016, and subsequent filings with the Securities and Exchange Commission.

Except as otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, change in circumstances or any other reason.

Joining me today from the company are Ara Hovnanian, Chairman, President and CEO; Larry Sorsby, Executive Vice President and CFO; Brad O'Connor, Vice President, Chief Accounting Officer and Controller; and David Bachstetter, Vice President, Finance, and Treasurer.

I'll now turn the call over to Ara. Ara, go ahead.

Thanks, Jeff. I'm going to review the operating results for the second quarter and discuss our current sales environment. Larry is going to follow me with a little more detail and discuss a few other items, including our liquidity position.

We've experienced a strong spring selling season and have seen our sales per community continue to improve. However, many of our 2017 year-over-year comparisons remained challenging for a couple of reasons. First, we generated 28% revenue growth in 2016, which makes for some pretty tough comparisons. Second, although we initially anticipated growing in 2017 and beyond, during late 2015 and throughout 2016, as oil plunged, the high-yield capital markets threw a kink in our plans. And as a result of the capital markets closing on us, instead of positioning the company for further growth last year, we temporarily reduced our land spend, we converted 13 wholly owned communities into joint ventures and we exited 4 underperforming markets, and finally, paid off $320 million of debt. The cumulative effect of these actions has led to decreases in community counts, contracts, deliveries and revenues this year.

By the end of last year, we had strengthened our liquidity position, had the debt behind us, and were once again working hard to replenish our land position so that we could generate growth in the future. Given these limitations, our second quarter results were in line with our previous guidance.

Starting in the upper left-hand corner of Slide 3, we show that, for the second quarter of 2017, total revenues decreased 11% to $586 million from last year. A portion of this decline is a shift in deliveries from wholly owned communities to joint ventures.

We don't report joint venture revenues in our consolidated reports. However, as an indication of size and trend that we're running, since we manage both consolidated communities and unconsolidated joint venture communities, if you were to combine the joint venture revenues with our consolidated revenues for the second quarter and for the first 6 months of 2017, they were roughly the same as last year. Considering the exit of 4 markets and the drop in community count, we're satisfied with that performance.

In the upper right-hand portion of the slide, you can see that our gross margins increased in the second quarter to 16.5%, up from 16.1% in last year's second quarter.

Moving down to the lower left-hand quadrant, our SG&A expenses decreased 11% during the quarter from $69 million to $62 million. However, given the reduction in our wholly owned revenues, the ratio was unchanged during the second quarter this year at 10.5%.

In the lower right-hand corner of the slide, we show that we had a pretax loss of $8 million for the second quarter, an improvement of $10 million compared with a pretax loss of $18 million in last year's second quarter.

Although loss was less than last year, it's obviously not where we want to be, and we're definitely focused on further improving our operating results and replenishing our land supply, improving our gross margins, opening new communities and continuing to reduce our debt and interest costs over the longer term.

While our gross margin increased year-over-year in both the first quarter and the second quarter of '17, it's still well below our 20% normalized level, which we achieved as recently as 2013 and 2014.

We've talked in the past several quarters about 3 factors that have been a headwind for more meaningful gross margin improvements. The good news is that 2 of these factors appear to be waning. First, we continue to burn through some of the higher-cost land that we purchased in '13 and '14, so this is going to have less and less of an impact on margins as we move forward.

The other factor that is having less of an impact is concessions and incentives. Excluding 44 communities in Houston, which are not entirely on our system just yet, only 19 of our communities had price decreases, while we were able to raise prices in 89 of our communities in the last 13 weeks.

We've been making small incremental increases to pricing, usually $1,000 to $2,000 at a time. And when sales remain strong after the price increases, we adjust prices again. Historically, during periods when the homebuilding industry is recovering from a downturn, both we and the industry were able to raise home prices more than enough to offset labor and material cost increases.

Unfortunately, while we've been able to do that in some locations, on average, that has not been the case this cycle so far. I'm sure that's going to change as the market forces hit the inflection point of supply versus demand, as it always does in a cyclical industry.

Construction costs are the area that continue to negatively impact our gross margin. On the positive side, anecdotally, the rate at which labor prices have increased has abated somewhat in the last 6 months in many markets. The supply of labor definitely remains tight, and there's still some cost pressure, but again, not quite as great. However, we're now beginning to feel the impact of rising material costs.

The biggest impact is coming from labor -- framing lumber and OSB, which I'm sure you read about, and unfortunately happens to be one of the raw materials that has the biggest impact on our costs. Although, in many of our markets, we lock in lumber prices over the short term, typically 90 days, the lumber market doesn't currently offer an efficient way to lock in lumber prices over the longer term.

Keep in mind that prices can fluctuate pretty dramatically. In order to illustrate the variability on Slide 4, we show a 10-year history of the framing lumber composite.

As of the end of April, the composite increased 24% from a year ago. Here, you can see the spike in January of '17 when the previous trade agreement with Canada expired. This put upward pressure on lumber prices as the potential impact from tariffs was assumed.

To put these increases into perspective, over the past year, the average costs for lumber increased roughly $2,000 for a 2,500-square-foot home. These are pretty significant increases that are factored in when we are underwriting new land parcels, but they were not factored in on land that we closed prior to the January price spike. Therefore, these lumber price increases will continue to have some pressure on both our gross margin as well as the gross margins of the overall industry.

On Slide 5, we show the trailing 12-month gross margin for 14 of our peers plus our own. 12 of our peers reported year-over-year declines in gross margin. Hovnanian and one other builder reported flat year-over-year margins, and one builder had a year-over-year increase.

If you turn to Slide 6, you can see our consolidated and unconsolidated community count on the left-hand portion of the slide. This decline is primarily a result of the steps that we took in 2016 to pay off the $320 million of our maturing debt, again, including the decision to reduce our land spend, do more with the JV structure and exit 4 underperforming markets. Our community count decreased sequentially each quarter throughout '16 and into the first half of '17.

Since we announced the decision to exit 4 underperforming markets, our community count in those markets is down from 23 at the end of last year's first quarter to 2 communities at the end of this year's second quarter. The falloff in community count from the steps we took last year makes year-over-year comparisons pretty difficult for '17, especially given the top line growth that we experienced last year.

The decline in community count was not part of our original plan a year-plus ago, but the capital markets last year required the steps we took, as I discussed.

After paying off $320 million last year, we ended fiscal '16 with about $350 million in liquidity, virtually all of which was in cash. This allowed us to invest $190 million in land and land development in the first quarter of '17, our largest land spend in 5 quarters. We followed this up with $100 million of land and land development spend in the second quarter.

We were able to increase the number of lots we control this quarter to 31,511 despite spending less on land and land development than the first quarter. We accomplished this by optioning more lots and purchasing fewer lots. This is consistent with our continued focus on high inventory turns and return on capital.

Growth in controlled lots is the first step in growing community count. Unfortunately, there is a significant time lag from the initial contracting of lots or land to the time when a community opens for sale. This time line can vary significantly from a few months in a market like Houston to a few years in a market like New Jersey.

Given the mix of land that we control today and the land we anticipate controlling in the future, we're not expecting community count to begin growing again until the second half of fiscal '18. As our community count grows, delivery and revenue growth will follow a few quarters later.

On the right-hand portion of the slide, we show that our consolidated contracts per community increased 18% from 9.2 in last year's second quarter to 10.9 during the second quarter of this year. This is the second highest level of -- excuse me, this is the highest level of contracts per community in a quarter that we've seen for many years. This increase in net contracts per community partially offsets the 26% decline in community count, and that resulted in only a 12% decrease in net contracts in the quarter -- in the second quarter of '17.

As we'll show you in a moment, the sales trend got even stronger in the month of May.

On Slide 7, we show net contracts per community by our geographic segments. While the tables in our press release, which only give absolute number, give you the impression that the sales environment was off in each of our segments, this slide shows contracts per community were actually up year-over-year in every 1 of our 6 segments. Leading the way with impressive improvements were our Midwest and West segments with a 47% and 41% increase, respectively.

Our Southeast segment also had strong year-over-year growth at 22%. This kind of improvement lessens the impact of a declining community count on our revenues. It allows us to increase our operating leverage because we get those benefits of the extra deliveries from existing communities without having to add much, if any, SG&A cost, and you saw that as we reduced actual SG&A spend in dollars last quarter. That certainly is a positive step toward improving both our operating efficiencies and profitability.

On Slide 9 (sic) [Slide 8], we show contracts per community for the past several years as well as for the trailing 12 months. On this graph, you can see our historical norm of 44 contracts per community. We chose a period between '97 and '02 because these were neither boom nor bust years. You can see the steady progress of contracts per community increasing for the last 2 years and through the first half of '17. We're definitely feeling the positive momentum, but there's a long way to go before we get back to historical norms.

Slide 9 shows our contracts per community -- excuse me, our consolidated contracts per community on a monthly basis. Here, we show the most recent month in blue and the same month a year ago in gray. For 10 of the last 12 months, contracts per community were equal to or better than the same month of the prior year. Here, you can also see that May was a very strong month. Net contracts per community were up 24% in May. In fact, despite an 18% decline in community count and exiting 4 underperforming markets, the absolute level of net contracts was basically flat. Additionally, there were only 4 Sundays in May this year compared to 5 Sundays last year. So we're feeling pretty good about the market condition.

Whether you look at contracts per community on a monthly basis or on a quarterly basis, our results reflect a very strong spring selling season. Of course, some markets are doing better than others. Looking across our markets, our strongest markets are Houston, Phoenix and Sacramento.

I'm now going to turn it over to Larry Sorsby, our Executive Vice President and Chief Financial Officer.

Thanks, Ara.

On Slide 10, we provide an update on Houston. Despite the fact that we have had over 2 years of significantly lower oil prices, our Houston operations continue to post solid results.

During the second quarter of 2017, we saw the absolute number of net contracts in Houston increase by 4% year-over-year and net contracts per community increase 13% year-over-year from 7.7 contracts per community to 8.7.

As I've said on prior calls, there are 3 things that set our Houston operations apart from many of the builders we compete against in that market. Number one, we focus on a lower average price point. Our average home prices on homes delivered for the second quarter of 2017 in Houston was approximately $288,000, which is slightly lower than it has been in recent quarters and lower than most of our competitors. Number two, we do not build in any of the highly competitive master-planned communities. And number three, we have less exposure to communities in the energy corridor in Houston than our peers.

We commend our local Houston management team who have worked diligently to successfully deliver solid results in extremely difficult local market conditions.

Despite continued success for our Houston operations, we will keep a close eye on the market, and we are prepared to take appropriate actions should circumstances change.

Turning to Slide 11. You will see our owned and optioned land position broken out by our publicly reported market segments. During fiscal 2016, our land spend was almost exclusively spent on parcels that we previously tied up under option agreements. Due to paying off $320 million of debt maturities, we did not have sufficient liquidity in 2016 to also invest in purchasing or option newly identified land parcels. We are now in the process of reloading our land position. We are encouraged that, for the first time in the past year, our total lots controlled increased sequentially this quarter. Continuing this trend will ultimately lead to an increased community count in the future.

At the end of the second quarter, we controlled 13,299 lots through optioned contracts. Many investors mistakenly believe that the majority of our land options are held by land bankers, which certainly is not the case. At the end of last year's third quarter, our land bank lots peaked at 16% of our total lot options and has steadily declined to only 10% of our lot options by the end of April 2017.

Our investment in land option deposits was $53 million as of April 31, 2017. Additionally, we have another $8 million invested in predevelopment expenses.

Turning to Slide 12, we show that we have mothballed almost 2,000 lots in the past 2 years. Every quarter, we review each of our mothballed communities to see if they are ready to be put back into production or sold.

About 3,000 of our 4,000 remaining mothballed lots are in California, a market that has been strengthening as of late.

If the market improvements continue, we will un-mothball more communities in the future.

Looking at all of our consolidated communities in the aggregate, including mothballed communities and the $150 million of inventory not owned, we have an inventory book value of $1.2 billion net of $392 million of impairments.

We believe one of the key pure operating metrics for the homebuilding industry is EBIT-to-inventory. This metric neutralizes the impact of debt.

On Slide 13, we show the trailing 12-month adjusted homebuilding EBIT-to-inventory for us and our peers. This ROI metric measures pure operating performance before interest expense, and we are in the top quartile when compared to our peers. We and the entire industry are still not at normalized ROI levels yet, but this will improve as we get further into the recovery.

We realize that even after paying off $320 million of debt maturities between October 2015 and May 2016, our leverage and interest expense levels still remain high. However, we are committed to further lowering both over time.

The combination of deleveraging along with a return to more normalized EBIT-to-inventory levels will improve our future pretax results dramatically.

One of the ways we're able to achieve this is with a focus on inventory turns. On Slide 14, you can see that we have the second highest inventory turnover over the trailing 12 months compared to our peers. We are behind NVR and substantially above the ones below us.

You can see on Slide 15 how our inventory turns have improved from 6 years ago at 1.1x to 3 years ago at 1.5x to the most recent trailing 12 months at 2x. We are focused on improving or maintaining our inventory turnover right further.

Another area for discussion for the quarter is related to our deferred tax asset valuation allowance. At the end of the second quarter of fiscal 2017, our valuation allowance in the aggregate was $628 million. The remaining valuation allowance is a very significant asset not currently reflected on our balance sheet, and we've taken numerous steps to protect it. We will not have to pay cash federal income taxes on approximately $2 billion of future pretax earnings.

On Slide 16, we show that we ended the second quarter with a total shareholders' deficit of $134 million. If you add back the remaining valuation allowance as we did on this slide, then our shareholders' equity would be a positive $494 million.

If you look at this on a per-share basis, it's $3.35 per share, which means that at yesterday's closing stock price of $2.51 per share, our stock is trading at a 25% discount to our adjusted book value per share. Over time, we believe that we can repair our balance sheet and have no current intentions of issuing equity anytime soon.

Turning to Slide 17. You can see that our total interest expense for the second quarter of fiscal 2017 decreased by 6% to $43 million compared to the same quarter a year ago. Furthermore, the amount of our interest incurred decreased 11% to $39 million during the second quarter of fiscal 2017. Interest incurred would have decreased even further to $37 million were it not for a change in GAAP adopted this fiscal year that requires the amortization of prepaid debt cost to be included in interest instead of as an operating expense. Our interest incurred declined primarily due to us paying off, at maturity, $320 million of debt between October 2015 and May 2016.

Highlighted on Slide 18, we continued to show improvement in some of our credit statistics. On the left-hand portion of the slide, we show that our adjusted EBITDA as a percentage of total revenues increased from 6.1% in last year's second quarter to 6.5% during the second quarter of 2017.

On the right-hand side of the slide, we show that our adjusted EBITDA to interest incurred increased to 0.98x compared to 0.9x in last year's second quarter.

As we look at our maturity ladder on Slide 19, we are running the business today as if we want to pay [off] with cash the $57 million of notes due in December of '17 and the $52 million drawn on our revolver as well as $15 million [to] replace letters of credit under the revolver due June of 2018. However, we are constantly reviewing the capital markets for refinancing opportunities. One such option we are exploring currently is the possibility of pushing out the maturity of our $577 million, 7 1/4% first-lien notes that come due in 2020. These bonds are trading in large volumes and currently priced close to par.

Slide 20 shows a list of the many liquidity levers we have used in the past and remain at our disposal today. Lately, we have been using fewer of these levers because of our increased liquidity position.

As I mentioned earlier, land-banked options as a percent of total options is down from a peak of 16% at the end of last year's third quarter to only 10% this quarter. We have not entered into any new joint ventures this quarter, but we do have more joint venture communities today than we did 1 year ago. We expect that our JVs will begin to contribute to our earnings as we get to the end of this year or beginning of next year.

Additionally, we have lowered our nonrecourse loan balance by almost $16 million this year alone. Should we decide to increase our use of these liquidity levers in the future, we have strong relationships and continue to develop new relationships with alternative capital sources, including land banking, project-specific nonrecourse debt, joint ventures and model sale leaseback financing.

As seen on Slide 21, after spending $100 million on land and land development in the second quarter, which brings our 6-month spend to just under $300 million, we ended the second quarter with a liquidity position of $284 million, which is in excess of our liquidity target between $170 million and $245 million.

Assuming no changes in market conditions, and excluding the impact of land-related charges and gains and losses on extinguishment of debt, as we said on our first quarter conference call, we continue to expect total deliveries, including deliveries from unconsolidated joint ventures for all of 2017, to be down approximately 10% compared to fiscal 2016 total deliveries on the same basis.

Additionally, we continue to expect our gross margin for all of fiscal 2017 to be similar to what it was for all of fiscal 2016, and we expect to be able to keep our SG&A ratio around a normalized 10% level.

While we expect lower interest expense dollars in fiscal 2017, we also anticipate a decline in consolidated revenues. As such, we do not expect to make progress in reducing our interest expense as a percentage of total revenues this year.

While we have the capital to invest in new land deals and we continue to strive for growth in 2018, it's been a challenge to find land deals with meaningful deliveries in 2018. As a result, we now expect growth in deliveries and revenues to occur in 2019 rather than in 2018.

Sales pace per community continues to improve and is partially offsetting the decline in deliveries resulting from a lower community count. However, we still expect our consolidated deliveries and revenues to be down during the third quarter of fiscal 2017 compared to last year's third quarter. Further, we expect our gross margin for the third quarter to be similar to the gross margin in the same quarter of the previous year.

While our SG&A and interest expense dollars should decline year-over-year, we expect our SG&A and expense -- and interest expense ratios to be similar to last year's third quarter. The end result is we expect our pretax profit for the 2017 third quarter to be slightly less than last year's third quarter and just below breakeven.

I'll now turn the call back to Ara for his closing comments.

Thanks, Larry. I just want to take a step backwards and once again put our recent performance into perspective.

At the peak of the last cycle, we built a little over 20,000 homes annually. We had a market cap of about $4.5 billion. We were not only one of the top performers in the homebuilding industry, but we are ranked #2 in the Fortune 500 for all industries for return-to-shareholder value in -- for 2 years in a row.

In hindsight, in conjunction with our strong performance, we are obviously overly aggressive in '04 and '05 from a company acquisition and a land acquisition point of view.

When the Great Recession of housing came along, our debt-to-capital ratio of 50% proved to be too much for the severity of the downturn and made for a more challenging downturn as well as a more challenging recovery.

As we mentioned, debt that we recently -- we did mention debt that we recently paid off, but if you turn to Slide 22, you can get a longer-term perspective and you can see that we've made good progress over the longer term. From the end of fiscal '08 to the end of our second quarter, we've reduced our debt by almost $1 billion. Debt reduction has been a focus of ours for a while.

Instead of diluting our shareholders, our plan was to grow our top line and return to higher levels of profitability.

On Slide 23, we show annual revenues for '15 and '16. We grew our total revenues by 28% in fiscal '16 or about $600 million of growth in 1 year. It's obviously a fairly significant growth rate for us.

When we set out on this growth path, we anticipated some continued growth of critical mass in fiscal '17 and beyond where we can attain certain economies of scale. However, the high-yield market changed rapidly coincident with the plunging oil prices, which required a dramatic and quick change in our strategy. We needed to rapidly prepare to pay off $320 million of debt maturing between October of '15 and May of '16 instead of refinancing, which is what we had been planning.

We temporarily reduced our land spend, converted 13 wholly owned communities to JVs, and we exited 4 underperforming markets. This resulted in decreases in our community count, contracts, deliveries and revenues. We successfully paid off $320 million of maturities, and we still ended fiscal '16 with about $350 million of liquidity, primarily in cash, which is in excess of our liquidity target, and we've talked about that for the last several years.

With these maturities behind us, we began to aggressively replenish our land in the first quarter of '17 in order to once again prepare to grow our community count, deliveries and revenue in the future.

All along, we've remained focused on solid returns on investment. On Slide 24, we show our adjusted homebuilding to EBIT -- homebuilding EBIT to inventory. We think this is a pure homebuilding operating metric and neutralizes the impact of debt and shows the returns that each builder gets based on operating metrics and in terms of investments on -- in inventories.

As you can see, we're in the top quartile based on this metric. However, the entire industry, including ourselves, is well below historical norms.

It's frustrating, but we think it's temporary, and the market will eventually reach that inflection point, as I talked about before. In what's been a challenging high-yield market, we've worked hard to preserve shareholder value while making improvements to our capital structure.

Because of the speed in which the high-yield market closed on us during the oil plunge, we were required to adjust and make significant changes in our plan regarding growth, overhead efficiency, et cetera. Fortunately, as Larry mentioned and as I mentioned, the high-yield market has been improving recently.

We're analyzing alternative steps that we could take in today's high-yield market. We believe this could give us more long-term visibility rather than the seesaw growth planning of the last few years when we were dependent on the volatility of capital availability, which has been challenging at best.

We feel positive about the housing market and believe we are headed in the right direction. We're bolstered by the 24% increase in contracts per community during the month of May. I look forward giving you updates on our continued progress in the future quarters. And thanks. This concludes our formal remarks, and we'd be happy to turn it over for questions.

(Operator Instructions) Our first question comes from the line of Arjun Chandar of JPMorgan.

With regards to your liquidity position, can you comment a little bit around the sequential improvement in liquidity as it relates to the sequential decline in owned inventory? You mentioned around $100 million of land spend. How should we think about the evolution of working capital going forward in the back half of fiscal '17?

We are -- our land teams have been busy scouting out deals. The pipeline has grown, and we don't typically project a specific dollar amount of land spend, but I believe that you will see an increase in land spend compared to the second quarter and the third and fourth quarter.

Yes, well, we definitely plan on operating at least within our capital liquidity targets. We've often been operating in excess of them. And as Larry mentioned earlier, we'd really love to do even more with options. We're the second highest in inventory turnover. We're working to even increase that, and that will allow us to do more without spending as much in land. But we're budgeting and planning for more land spend as we go. As we mentioned earlier, it -- there's a big time lag between spending the money for land, tying up options and when we can increase communities open for sale. It's frustrating, but we're plugging away with it and anxious to get our community count growth back again.

And then my follow-up question is just on quantifying the liquidity lever. So how should we think about quantifying the liquidity levers that you mentioned, additional land bankings, JVs, increased use of nonrecourse, project-specific loans, as it relates to managing near-term liabilities?

I think, as we have excess liquidity, we will pull less on the levers. And if the capital markets remain open and we're able to push out some of our debt, it obviously relieves some pressure, and we would use the levers less. And if the capital markets aren't open, then we have to pay off more debt in a short-term basis similar to what we did from October of '15 to 2016, we were able to raise significant liquidity to pay off over $320 million of debt. So we could certainly do the same playbook again. We don't expect that, that will happen, but that playbook remains open.

As we mentioned, we've ended the last few quarters in excess of our liquidity target. Frankly, we would rather put all the money to work, but we are working hard to be disciplined in our new land acquisitions. We want more land growth. We've got the capital for it. We're hungry for it, but we don't need deals that don't work. So right now, we've got excess liquidity we're looking to put back to work. If we find more opportunities than we're comfortable with, as we keep the priority of managing our liquidity, and as Larry mentioned, we have the opportunity to pull a lot of the liquidity levers. We've not been doing that because we've just had excess liquidity, but we have that flexibility if we see the opportunities.

Our next question comes from the line of James Finnerty of Citi.

So just touching base on the land spend again. So for full year '17 relative to '16, are you thinking of growth? And can you give us some idea of magnitude?

Yes, we've not made a public projection. I still stand by what I just reiterated to the last question is that I think you'll see an increase in land spend. I mean, we're happy to tie up land by options. It's more important to us as to how many new lots that we actually control than how much we actually have to spend to control them. Having said that, I still expect that our spend is going to increase in the third and fourth quarter.

And that's sequentially or is that year-over-year? Or both?

Yes. Certainly sequentially.

Yes.

Sequentially.

Okay, great. And then in terms of the absorptions and the increased absorptions, which seem really impressive, what do you sort of think is driving that? Is that related to sort of macro conditions, really healthy markets? Or is there a change in strategy that you're using to drive the absorptions higher?

No, there's not a change in strategy. As you know, our company's been around for about 60 years. We've gone through a lot of cycles. And there's a point in all the cycles, as you recover, market starts to increase in velocity. We've been increasing. We're still nowhere near normal, but we've definitely been increasing, and we think there's upside to go. What's going to be important is that not only velocity increases, but as you get past this inflection point of supply and demand, we want, and I'm sure we're going to see, pricing power and margin power. We're not budgeting it internally, but having been through so many of these cycles, this one's obviously the doozy of all cycles, but what falls down often will go up in our cyclical industry. So right now, I'd say it's nothing more than the cyclical recovery, and we're nearing that inflection point, I think, in the supply of -- supply versus demand of housing.

(Operator Instructions) Our next question comes from the line of Sam McGovern of Crédit Suisse.

Can you talk to what kind of IRRs you guys are targeting on the land purchases? And related to that, with regard to the buybacks you guys did earlier this year, how do you guys think about the IRRs on buybacks of debt versus reinvestment in the business?

Sure. It's always a delicate balance, but our internal target on unlevered IRR, without factoring in corporate overhead, is in excess of 20%. Typically, if we're able to get finished lot takedowns, it's well in excess of 20%. All-cash purchases where we do the land development, they -- those typically have a higher margin but are on the lower spectrum of IRR. Regarding -- Larry maybe can fill in on this more, but regarding that opportunity versus buying back bonds, over the last couple of quarters, we were aggressive in buying back our bonds because yields were pretty high. Those yields have been coming down pretty significantly. And as we mentioned, the first-lien and secured debt has been trading down to par, like 7%, so we're certainly more focused right now on investing in land.

Okay, great. And then just following up to some of your prepared remarks with regard to the land that you guys purchased in 2013 and 2014, but when do you expect that to cycle out of inventory? And also, what percent of inventory does that currently represent?

It's in -- go ahead, Larry.

I don't think we've publicly given data on what percentage of the inventory, but it's a lesser and lesser percentage. It's not the major mover anymore As Ara kind of commented in our remarks. I mean, what's happened is it's been -- that issue's been overtaken by the increases that we both saw in labor and, more recently, in material. So any land that we bought, whether it be '13, '14, '15 or '16, has seen increases in labor and material since we've underwrote those deals, and that's a margin pressure we in the industry continue to see.

Our next question comes from the line of Megan McGrath of MKM partners.

This is Kevin DaCruz on for Megan. So sorry if I missed this, but I was just wondering what next-quarter gross margins would be and the puts and takes for that guidance.

I believe what I said, it's going to be similar to last year's third quarter.

Okay. And then you had absorptions up around 20% year-over-year. Could you give some sense, geographically, where you're seeing strength, where you're seeing weaknesses?

Yes, you might have missed that point, but our strongest markets continue to be Houston. It's very strong in Northern California for us and Sacramento, and it's strong -- very strong in Phoenix as well. Some of the tougher -- by the way, it's also strong, it's not a huge market, but Delaware has been a very nice market for us. In terms of velocity, Chicago remained strong and margin has been -- excuse me, yes, velocity, Chicago is strong; margin, it's been tougher. Maryland has been a little more challenging. Interestingly, though, Virginia, on the other side of D.C., that market seems to be strengthening.

You might want to look at Slide 7 in our deck because it has the change in absorption pace by publicly reported segments. So it gives you pretty good color.

Our next question comes from the line of James Finnerty of Citi.

Yes, you mentioned in your prepared comments specifically looking to push out the 2020 maturity. How does that relate to the unsecured maturities coming due in '19? Is it sort of a one-step fashion that you're thinking about pushing out the secured?

Yes, I think if we push out the -- if we are able to successfully push out the tower, I think that's really what's been the overhang on the trading of the unsecured. So I would suspect that, if we pushed out the first-lien tower, that the unsecured would trade better and ultimately lead to our ability to refinance those at a more attractive rate than we could do so today.

And just 2 years ago, our unsecureds were around a 7% yield. Obviously, that changed dramatically as oil plunged and the high-yield markets really fell apart. We're hoping it gets a lot stronger. I think our results are supporting lower yields, and the moves we're contemplating in the capital markets should help as well.

And just as a follow-up to that, the H/2 Capital debt, how does -- how would that play into refinancing of the 2020 maturity? Would that be sort of included in that step in theory?

The H/2 Capital, I'm not sure that they're linked at all. So I mean, we're looking at all different kinds of alternatives and proposals. But right now, the only thing that we've kind of publicly commented on is we think that it might make sense to push the tower of 7 1/4% notes, and that's about all I can say on that.

And at this time, I'm showing no further questions. I'd like to hand the call back over to Ara for any closing remarks.

Great. Well, we're making progress. The market's getting stronger. We will definitely look forward to giving you some more updates about our success as the quarters roll on. Thank you very much.

Ladies and gentlemen, thank you for participating on today's conference. That does conclude today's program. You may all disconnect. Everyone, have a great day.