KB Home (KBH) 2015 Q2 法說會逐字稿

Good morning. My name is LaTonya and I will be a conference operator today. I would like to welcome everyone to KB Home 2015 second-quarter earnings conference call.

(Operator Instructions)

Today's conference is being recorded and a live webcast is available on KB Home's website at kbhome.com. Following the Company's opening remarks we will open the line for questions.

KB Home's discussion today may include forward-looking statements that reflect management's current views and expectations of the market conditions, future events and the Company's business performance. These statements are not guarantees of future results and the Company does not undertake any obligation to update them. Due to a number of factors outside of its control, including those identified in its SEC filings, the Company's actual results could be materially different from those expressed and/or implied by the forward-looking statements.

A reconciliation of the non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in the Company's earnings release issued earlier today and/or on the Investor Relations page of the Company's website.

At this time I will now turn the call over to Jeff Mezger, President and CEO of KB Home. Mr. Mezger, you may begin.

Thank you LaTonya and thank you everyone for joining us today for a review of our second-quarter results. With me are Jeff Kaminski, Executive Vice President and Chief Financial Officer; Bill Hollinger, Senior Vice President and Chief Accounting Officer; and Thad Johnson, Senior Vice President and corporate Treasurer.

This morning I will start with a brief overview of our results for the quarter along with an update on our strategic initiatives. Then Jeff Kaminski will provide additional detail on our financial results after which I will share a few closing remarks before opening the call up for your questions.

Our results for the second quarter reinforced the progress we are making with year-over-year revenue growth and sequential improvement across our key financial and operational metrics. As I mentioned on our first-quarter earnings call, we view this year as a tale of two halves.

In the first half, among other things, we have expanded our community count and built a robust backlog that has strategically positioned our operations for revenue and earnings growth. In the second half, we expect to realize the benefits of our expanded platform as we convert our backlog into deliveries in revenues, improve our margins on a sequential basis and achieve greater economies of scale.

Our results for the second quarter met or exceeded the guidance provided on the first-quarter earnings call with respect to our community count, housing revenues and average selling prices as well as the sequential improvement in our housing gross margin and SG&A ratio. Most importantly, we achieved substantial year-over-year growth in net orders driven primarily by a significant increase in our community count. With this net order performance during the spring selling season, we now have a strong backlog position in place which sets us up for significant revenue growth and profit improvement for the second half of this year.

I'd like to review some highlights from the quarter. Our housing revenues of $605 million were up 8% from a year ago marking our 15th consecutive quarter of year-over-year revenue growth. On a sequential basis we improved our housing gross profit margin by 90 basis points to 16%.

We also lowered our SG&A ratio by 50 basis points from the first quarter to 13%. Net income for the quarter was $9.6 million, or $0.10 per diluted share.

We performed particularly well with respect to the leading indicators of our business. Our net order value increased 38% from a year ago to $1.1 billion.

Net orders for the quarter grew 33% year over year to 3015 tracking closely with the 30% expansion in our average community count. We ended the quarter with 261 communities open for sale, representing an increase of 35% from the prior year.

On a sequential basis our ending community count increased 11% from the first quarter. Our ending backlog in units grew 39% to 4,733 and our backlog value rose 57% to $1.6 billion. This was our highest second-quarter ending backlog value since 2007.

With the solid backlog position and our expectation for continued year-over-year community count growth over the balance of this year we are now set up for accelerating revenue and profits and to enter next year with terrific momentum. Our results are being driven through our continued focus on our four key strategic initiatives which are to grow our community count, drive higher revenue per community, increase our profitability per unit and to enhance our return on investment.

As our results demonstrate we've made tremendous strides in growing our community count, so I'll move on to the actions we're taking to increase our revenue per community. While we will always take price as the market allows we are also working to increase revenue per community through our new locations and the types of homes and options we offer and by taking advantage of the many opportunities for revenue enhancements that are available in our unique Built to Order approach.

As we've shared in the past we continue to balance price and pace in order to optimize each asset and are not looking to increase our overall sales per community until we achieve our margin goals. Our second-quarter results reflect this strategy as our absorption rate per community held constant while our average selling price grew 6% over the prior year, an increase of approximately $20,000 per home. In order to increase our profitability per unit we have programs in place to drive further improvement in both our gross margin and SG&A ratios.

We expect our gross margins to continue to improve in the second half as a result of four factors: first, the actions we're taking across the system to drive price while containing or lowering our cost to build; second, the higher margins we are capturing in our new communities will be flowing through in deliveries; third, we have invested in field overhead to support our ramp up in communities in the first half that we are now converting to revenue in the second half; and finally, the added benefit of leverage from our accelerating revenue growth. We expect continued sequential improvement in gross margin over the balance of the year and will significantly narrow the year-over-year gap by the fourth quarter.

On the SG&A front we continue to do a good job of controlling cost while we ramp up our community count. As an illustration of this point even with the overhead and marketing cost of the additional communities we have opened this year, most of which have yet to generate revenue, our second-quarter SG&A ratio was essentially flat year over year. Our accelerating revenue growth in the second half of the year will drive solid sequential and year-over-year improvement in our SG&A ratio.

Our fourth key strategic initiative is to enhance our return on invested capital. While we continue to improve our profitability we also feel we can support the investment necessary to achieve our growth targets in part through improving our asset efficiency. We will continue to generate cash through land sales whether they are nonstrategic assets we currently hold or a portion of a new acquisition that is not critical to our needs.

Year to date we have generated $69 million in land sales and now expect to exceed our earlier guidance for full-year land sales revenue of $100 million. We're also continuing to activate communities that were previously held for future development. We will take the cash we generate from both of these activities and reinvest in new communities to generate higher returns.

Turning now to the macroeconomic environment in housing. The national economy is continuing to improve with sustained job growth now occurring across the country. This improving employment and economic environment is in turn contributing to increased consumer confidence which is currently at one of the highest levels reported since 2007.

Meanwhile the housing market also continues its measured recovery. Inventory levels remain well below normal and while there is still price appreciation occurring in most markets it is at a more moderate and sustainable pace. Even with the slight uptick in mortgage rates over the past week affordability remains compelling levels.

The most encouraging statistical trend that bodes very well for future housing demand is the dramatic increase now occurring in household formation. Recent census reports put household formation at an annualized rate of almost 2 million, well above normalized historical levels and significantly higher than the 500,000 households we have averaged per year over the last eight years.

This data point suggests that we may be at a turning point in this housing recovery as household formation has been the missing link. We are well-positioned to move with this demand as evidenced by the increase in our first-time buyer percentage to 56% during the second quarter even with a $20,000 increase in our average selling price.

With housing markets continuing to recover we are experiencing high levels of demand as our product offerings and Built to Order approach resonate with consumers. For the second consecutive quarter we are reporting solid order growth across all four regions. In California net orders increased 32% with continued strength in the Bay Area and coastal Southern California.

During the quarter we opened for presales at our first urban midrise community, 72 Townsend, which is located in the South Beach area of San Francisco. The condominiums are priced in the $1.3 million to $1.7 million range for the lower floors and over $3 million for the upper floors with a view of the Bay and the initial demand has been very strong. Later this year we will be opening a community in the lower Pacific Heights area of San Francisco with pricing starting around $1 million.

While many of you are familiar with the higher density podium products we have developed over the years in the suburban rings of the major California cities these are our first developments in the urban core. They offer a great opportunity to expand our business presence and are a logical extension of our California development expertise.

In our Southwest region we reported 532 net orders, an increase over the prior year of 152% due to both a much higher community count and accelerated sales pace per community. While our Las Vegas business continues to perform well for the first time in many years our Arizona division was also a significant contributor to order growth for the region. This growth is being driven by both activations and investment in new communities.

As an example in May we successfully grand opened a large planned community in a great infill Mesa location named Copper Crest with 440 lots and three product lines where we are offering price points from the low $200,000 to mid-$300,000 that cater to first time as well as first and second move-up buyers. As both the Las Vegas and Arizona markets continue to improve we are excited about the potential for this region to contribute a much larger share of our revenue and profit growth going forward.

The Central region is currently our largest region in terms of units and we continue to experience strong demand across all markets. The region generated 8% growth in net orders and a 23% increase in net order value off of a strong order comp from last year. This order growth was consistent with our community count growth in the region and the positive comp was generated in spite of the weather disruption in May.

While we remain cautious we are still not seeing signs of a slowdown in demand in our communities as a result of the oil price decline. In the Southeast we also saw strengthening demand with a net order increase of 38%. As with the Southwest region we are encouraged with our potential for growth in revenue and profits from this region going forward.

In closing, we're pleased with our progress during the quarter. Our investment and product strategy is working as our new communities in all four regions are performing well in a housing market that is continuing to improve. We are growing our community count and backlog and are now positioned for significant revenue growth and improved profitability this year and sustained momentum heading into 2016.

Now I'll hand the call over to Jeff Kaminski who will discuss our financial results in greater detail. Jeff?

Thank you, Jeff, and good morning everyone. We continued to successfully advance our key strategic initiatives during the second quarter. Our progress was evidenced in part by the substantial growth in our backlog and community count which as Jeff said reinforces our expectations for strong second-half deliveries and revenues.

We anticipate that these accelerated top-line growth combined with sequentially higher housing gross profit margins will drive significant earnings improvement over the remainder of this year. In the second quarter our housing revenues of $605 million grew 8% from the same quarter last year extending our trend of year-over-year revenue growth. We were pleased with our operational performance during the quarter, particularly as our Central region operations were faced with severe weather conditions.

Looking to the third quarter we plan to generate housing revenues in a range of $770 million to $810 million as we convert our sizable backlog into deliveries and we realize continued improvement in our overall average selling price. For the full-year we are projecting housing revenues in the range of $2.95 billion to $3.1 billion.

Land sale revenues increased to $15.9 million in the second quarter from $2.6 million in the prior-year quarter. These lands sales produced essentially breakeven results in both periods. So far this year we have generated $69 million of land sale revenues and are on track to slightly exceed our goal of approximately $100 million for the full-year as we continue to execute on targeted opportunities to monetize certain land positions through either sales or re-activations as part of our focus on enhancing asset efficiency.

During the second quarter our overall average selling price of homes delivered grew 6% year over year to approximately $339,000 reflecting increases in three of our four regions. We expect to continue to generate year-over-year increases in the mid- to high single-digit range for the remaining quarters of 2015 as well as for the full-year.

Our housing gross profit margin of 16% for the second quarter improved 90 basis points from the first-quarter 2013. Excluding the amortization of previously capitalized interest and land option contract abandonment charges our second-quarter adjusted housing gross profit margin was 20.3% in 2015, representing a sequential increase of 80 basis points versus the first quarter and a decrease of 230 basis points from the second-quarter 2014.

As we expected our gross margin performance for the second quarter improved sequentially from Q1. We anticipate additional sequential margin increases in the two remaining quarters of 2015, particularly as we gain operating leverage by delivering a higher number of homes and increasing revenues from our expanded growth platform.

In the fourth quarter we expect a sequential improvement to be even more pronounced due to an increase proportion of our deliveries coming from recently opened, higher-margin communities and the impact of startup field cost diminishing as we convert orders to revenues in these communities. Consistent with the guidance provided during last quarter's earnings call and assuming no land option contract abandonment or impairment charges we are forecasting a third-quarter housing gross profit margin in the mid-16% range. For our fourth quarter we are slightly increasing our prior guidance and now anticipate a gross margin in excess of 18%, again assuming no abandonment or impairment charges.

Our selling, general and administrative expense ratio for the current quarter of 13% improved sequentially by 50 basis points as compared to the first quarter but increased 20 basis points from a year ago. On a year-over-year basis this slightly higher ratio was primarily due to increases in staffing and other community-related expenditures to support both an anticipated uptick in third- and fourth-quarter deliveries and our expanded community count.

At May 31, 2015 we had 67 more communities open for sale than we had a year ago. We expect to generate sequential improvement in our SG&A expense ratio in excess of 100 basis points for the third quarter and an additional 100 to 150 basis points for the fourth quarter as we produce increased revenues from our newer communities and continue to manage our overhead costs.

In the second quarter our effective tax rate of 24.5% reflected the positive impact of $1.7 million of federal energy tax credits we earned from delivering energy-efficient homes. For the third and fourth quarters of this year we are forecasting an effective tax rate of approximately 38% with tax credit impacts if any expected to be minimal.

Our second-quarter average community count rose 30% year over year to 248 which helped drive the significant increase in our net orders and net order value that Jeff summarized earlier. During the second quarter we opened 42 new communities including four communities previously held for future development. Year to date we have opened 11 such communities as part of our asset efficiency initiative and we plan to continue to evaluate our land held for future development to identify additional communities for reactivation.

We ended the quarter with 261 communities open for sales, up 35% from the previous year. During the quarter we closed out of 16 communities which was fewer than we expected and will result in a somewhat higher than anticipated number of community closeouts in Q3. For the remainder of the year we expect community closeouts to exceed openings.

As a result we anticipate our community count will decrease sequentially in the third quarter and remain relatively flat in the fourth quarter. However, on a year-over-year basis our average community count should increase in the mid-20% range for the third quarter and in the low double-digit range for Q4 against a higher 2014 comparison point.

For the full-year we anticipate that our average community count expansion will be in the range of 18% to 20% versus 2014 which is at the high-end of our previous guidance. For the past eight quarters we have generated year-over-year increases in our average community count, reflecting the strong inventory pipeline we have built through our substantial investments in land and land development over the past few years.

During the quarter we invested $253 million in land and land development of which more than 70% was related to land development and we owned or controlled approximately 50,000 lots at quarter end. We anticipate investing a total of $1.1 billion to $1.3 billion in land and land development in 2015 which we believe will support our community count and revenue growth objectives.

In conclusion we are looking forward to a strong second half of 2015 as we continue to execute on our strategic initiatives aimed at accelerating growth in revenues and profits. With a strong backlog and expanded community count underpinning our expectations we are confident in our ability to achieve these goals.

Now I will turn the call back over to Jeff for his concluding remarks.

Thanks Jeff. Before we conclude our prepared remarks I would like to take a moment to thank the employees of KB Home who are driving our success on a daily basis. I sincerely appreciate all of your hard work.

We are entering the second half of the year from a position of strength with an expanded community count and a strong backlog supporting our revenue and delivery projections for the remainder of 2015. As we move ahead we intend to continue to advance on our four strategic initiatives and to build on the momentum we have in our business today.

With our plans for 2015 firmly in place we are looking toward 2016 with optimism. We already have the land pipeline in place to meet our delivery goals for next year and we expect the financial improvements over the next two quarters to carry into 2016.

While it is still too early to discuss next year our preliminary projections show that we will see improvement in our major metrics including deliveries, revenues, gross profit margin, SG&A expense ratio and earnings on a year-over-year basis. Therefore, the future looks bright for KB Home.

Now we'll open the call up to your questions.

(Operator Instructions) Megan McGrath, MKM Partners.

Good morning. So thanks for all the guidance and still working through it a little bit but a couple of questions here.

On the community count you've talked in the past about having some issues opening communities and seeing some delays there. So you are able to get a fair amount open in the quarter. Did some of those delays and issues subside in the quarter?

Megan I've shared on past calls that that's been one of my biggest frustrations. As we've been reloading for growth it's taking longer than we projected to get communities open. I think a lot of the delays from last year and early this year finally came through and culminated in the big jump in openings.

I think we're now continuing to fight through delays with contractor base or the city's been processing and a little bit of weather right now. I don't know that it's gotten a lot better but we plateaued at a higher level now because a lot of what was in the queue was pushed through. So there's still some headwinds in getting them open but I think we're a little further ahead of the game than we were in the past.

Okay, thanks. Then I just wanted to get a little bit more color on your ASP guidance and your confidence they are.

I look at your backlog ASP and it's about 340 but your guidance at least for the 4Q looks like it's calling for a significantly higher number in the fourth quarter. Is that just an expected mix as you talked about toward some of these newer communities? What's behind that confidence especially for 4Q?

Right there are several things I think that are behind it. One I think traditionally if you track it that way you'll notice that in most cases our backlog trails a little bit from our future quarter ASPs. Part of it is a lot of the backlog hasn't been fully through the Studio process at this point.

So while some of the backlog reflects Studio orders or additions it all doesn't reflect it. Part of it is certainly mix and part of it is still some sales to go in the next couple of months that will deliver out in the fourth quarter, particularly some of our higher-priced ASP product in California.

Susan Maklari, UBS.

Good morning. My question is that you noted in your comments that you expect to generate cash and you actually have some more land fill than had originally been expected. How do you think about uses of that cash especially investing in the business relative to perhaps other shareholder returns-oriented things?

Right now, Susan we're reinvesting to fuel growth. We're just now growing into the scale that we're capable of. And it helps to carry the current debt load and our overhead structure and it's the best way to improve our returns.

And then my next question is you also noted, made a comment about household formation and how that seems to be improving more recently over the last few quarters. How do you think as that comes together it breaks out between the rental versus buy decision? Are you seeing a lot more first-time buyers coming into your communities?

I think the household formation will favor both rental and ownership on both sides. It's typically a first-time buyer that's created when a millennial moves out of the home, is fully employed, gets married, has a child, all the normal lifecycle things that have been delayed for a decade.

And as we shared in our prepared remarks our first-time buyer percentage did move up a little bit in the quarter. We were up to 56%.

I couldn't tell you if that is a sustained trend or a coincidence of mix. But we saw an increase, a in three of the four regions during the quarter couple of points a region in first-time buyers. So it's an encouraging sign.

And as I shared it's what has been missing to get a sustained housing recovery. We haven't had the first-time buyer demand and this household formation that's developing is very encouraging.

Michael Rehaut, JPMorgan Chase.

Hi, thanks. Good morning everyone.

Just to go back to the first-time buyer for a moment, if you could give us what that percent was in the first quarter and also a year ago? And just trying to get a sense on a bigger picture if you think that's being driven by any easing of credit conditions or underwriting standards that are out there or if it's more just this broader macroeconomic momentum that's in the backdrop in terms of employment and the economy continuing to going the right way?

Michael I will stick to the macro trends and then Jeff can give you the numbers. If you think about it over a 40-year period the nation averaged 1.2 million household formations.

From the period of 2008 to 2014 we averaged 500,000, well below normal. So people that don't have a job they are staying with their parents longer, everything we've talked about over the past few years.

With the job growth that's occurring and the aging of the millennials they are getting to a point in their life where they are getting the job and moving on with their life. So if you go from annualizing the 500,000 to 2 million it creates demand.

Whether it's rental or for sale there's a lot more people that are out there needing a roof over their household. So I think it's a combination of the pent-up demographics and an economy that's creating jobs.

And in relation to your question on the percentages, Mike, as Jeff mentioned 56% was the percentage of the most recent quarter. Last quarter was at 50%.

It had been trending sort of in the lower to mid 50s for the last six or seven quarters. One year ago it was 54%.

Great. And then just a couple of clarifications on the guidance.

You had mentioned you raised 4Q gross margin guidance a little bit from prior, if you could just remind us what that prior guidance was for 4Q? And also when you talked about community count up low double digits (technical difficulty), I just wanted to know is that was against -- is that when you say up low double digits is that against the year-ago average or the year-ago end-of-quarter number?

Yes, good question Mike. Starting with community count, it's the average against the fourth-quarter average in the prior year so forth-quarter 2014.

On the guidance on the margins if you do the math from where we started from the first quarter and we kind of gave guidance sequentially as improvement in basis points last quarter and if you kind of go through it it gave us a range of 17.7 to 18.2 for the fourth quarter. And like I said we're slightly increasingly that now saying we'll be in excess of 18. So we're kind of taking the 17s off the table for the fourth quarter.

Stephen Kim, Barclays.

Yes thanks a lot, also appreciate all the granular guidance. It's helpful. I wanted to first ask, I think Jeff Mezger you mentioned in your opening remarks that it was your intention and you're going to continue your strategy of increasing your profitability first before focusing on increasing absorptions, sales per community.

I was curious if you could share with us if you have a certain threshold in mind for overall profitability metrics that would allow you to cross over to the next stage of focusing on absorptions? Or if there's some other way in which you are thinking about that internally that you could share? Thanks.

I didn't touch on profitability, I touched on gross profits, that we're not going to move our sales pace up until our gross margins are achieved. I say that because you can also improve your profitability through inventory turns and just running a better business and that's part of our improvement in profitability.

As we analyze our communities most of them have an optimal return in the three to four months range. Depending on how much the initial investment is it's larger in some states than others but on average it's three or four a month.

So we'll toggle back and forth. If something is selling above the four month range we'll push price. And so you move this one and over here this community may be at two a month so you do things to get the sales pace up because you're focused on the returns.

Over time as we continue to toggle and work on everything we've shared we continue to have a goal of a gross margin in excess of 20 and SG&A ratio around 10, or maybe a little lower than 10 now with the way we're headed, and we'll be working between the two to get there. But in the meantime you won't see our sales pace lift until we get our margins north of 20.

Okay, that's very clear. And it very helpful. Thanks very much for that.

I guess the next question relates to your average price mix. So obviously there's a lot of things that go into the average price metrics that we can calculate on our ends but as you think about the distribution of your product that you're offering to various buyer types over the last few years KB has been engaged in a process of moving that upwards. And you cited your product in San Fran for example.

Can you give us a sense for generally speaking where you think what inning you think we are in terms of making that migration, that deliberate migration higher? Do you feel for example by the time you get to the earlier part of next year that you will have essentially accomplished your goal? Or do you feel that this is still a multiyear process that you're going to be engaged in from here?

I think it's a continuum, Stephen. We like to use the term that we move with demand. And we've shared that we can have a product series at a certain width in a city that ranges from 1,200 square feet to 4,200 square feet and if the demand is evident in the higher footages and price points that's the product we'll put to market.

If the demand in that area moves to more first-time we'll go to the lower footage and maybe change the spec level and attack a lower price point out of the same product series. So my hunch is as these markets continue to normalize we'll probably settle pretty close to the range we're in right now, a first-time buyer range around 50 to 60, a first or second move up another 30 and then move downs that are 10.

At the same time I think if you go back to my comment we're seeing price still around on the resale side but it's moderating. And to me it's part of a healthy recovery, inventory keeps clearing and as prices normalize I would expect year over year you'll see our pricing track with the more normalized inflation rate. And we'll follow demand in the different cities and that's will drive our mix in price.

Alan Ratner, Zelman & Associates.

Hey guys, congrats on the solid quarter. The first question on Texas, Jeff you mentioned the weather headwinds there. You did raise the low end of the revenue guidance for the full-year.

I was curious does what you're hearing from you guys in the field about production delays and how you're thinking about that for your third- and fourth-quarter revenue guidance? Talking about the cycle times on Texas deliveries any changes there and how you're building in some conservatism?

We certainly took some hits with the weather in May. It's pretty incredible what's been occurring in an area that was suffering from a drought.

We lost some deliveries in the quarter, no question about that, due to weather. And the way we're looking at it if you didn't just lose deliveries in the quarter, your framing slowed, your sheet rock slowed, your finish slowed. So you have this roll where everything just extended out a quarter across the width.

So it's not like we lost deliveries and we see a big uptick in Q3 because we're going to go right back and get them. It moved out the whole production machine. Having said that we took all that into consideration in the guidance that we have given here.

While we're -- while our WIP was impacted by the weather it did impact our land development as well. So we're trying to find ways to compress time now in areas where we couldn't grade or couldn't pave over the last 60 days. But I'm assuming it's going to stop raining one of these days in Houston and we'll get back to it.

Well, I hope so. And just to follow-up on that, Jeff when you run through the 2016 metrics you expect to show improvement. I think one thing I didn't hear was community count, so I was just curious if you think that community count plateaus here for a while or do you think that as you move into the out years you could see additional growth?

What we did actually provide a little bit of commentary on the community count. Talking about the third quarter, as I said our closeouts exceed our openings for the remainder of the year.

So we believe we will sequentially decrease, decline in Q3 and stay relatively flat through the end of the year. But despite that when you look at it versus prior year our third-quarter estimate for average community count should be up in the mid-20% range versus the prior and the fourth quarter should be up in the double-digit range versus the prior year both on an average basis versus the same quarter the prior year.

Joel Locker, FBN Securities.

Hi guys, just curious about your community count in the Southwest region what it was at the end of the quarter versus a year ago at the second quarter?

Well, the community count in Southwest was up quite significantly. On an average basis for the quarter if you look at third quarter, over the third quarter we were up about 150%, excuse me, 117% in community count between the operations there.

So we've more than doubled. And we were pretty pleased with the performance both in the ability to get new communities opening, in the way they are performing and particularly also saw an absorption increase in the region. So we're quite pleased with how that's gone there.

Thanks. And just a follow-up on SG&A, do you have a breakdown of the $78.5 million in the second quarter between commissions, marketing and corporate?

We do but it's a little detailed. I don't have it right in front of me. I will make one comment, though, on the SG&A for the quarter.

In relation to our forecast where we thought we'd come, we came in pretty much spot on. We were little bit light on the percentage, or a little bit heavy on the percentage by about 10 basis points just due to some of the deliveries that we lost. But we did anticipate a sequential decline which we had.

We did not anticipate catching the prior-year number which we did not. And the main driver of it as we talked about in the prepared remarks was that we knew with an expanded community count and setting up the second half of the year that we were going to have to absorb some additional investment in infrastructure and overhead cost in the second quarter, especially those that are community related in order to drive strong second-half revenue growth. So for us it was pretty much on expectation for performance in that area.

Robert Wetenhall, RBC Capital Markets.

This is actually Collin filling in for Bob. Thank you for taking my questions.

So during the first-quarter earnings call you guided toward a sequential increase of 50 basis points in your home building gross margin. What drove this beat versus your expectations?

There were several factors in there. The predominant, I guess when we were forecasting the 50 basis points predominantly came from leverage, increased revenues on some of our fixed cost that are included the margin.

What we also saw during the quarter was some pretty strong pricing trends. So on our spec inventory I believe we had slightly better margins than anticipated on anything that we sold and delivered in the same quarter.

We had a real nice quarter of cost containment. On the cost side in fact one of the best six-month periods we've had in quite some time from that point of view and we had obviously a little bit of favorable mix in the quarter. So it was a 40 basis point beat or so and it was closer to expectations and we were pleased that it was a little bit above.

Great. And then a question on the conversion ratio.

Given your guidance for the third quarter I'm forecasting that you've declined year over year. When do expect this to tick up towards more normalized levels and what would you consider a normalized level?

Collin, actually it ticked up last year because we recovered some inventory. As you look at our business model if we're in balance a lot of your backlog hasn't started yet.

In a Built to Order business you weight more of your backlog to sold and not started. If you think about the sequencing and the rhythm, if it's a six-month cycle from contract to close you'll have about a third of your backlog that's either not started or just started and will close two quarters out, not next quarter.

So over the years when we're in balance our backlog conversion is around 50%, maybe 55%. When you are growing you're typically growing the unstarted backlog ahead of the started backlog. So it could be we're below 50%, I don't know, but it will be a percent or two.

And as we continue to grow our backlog and our WIP you'll see us hang around 50% to 55%. But it will be a very predictable 50% to 55%.

Mike Dahl, Credit Suisse.

Hi Jeff and Jeff, this is Anthony on for Mike. Thanks for taking my question and congrats on the solid quarter.

My first question has to do with you talked about the goals to drive higher revenues per community and the way to do that was increased option use. So I was just wondering if you could talk about the pricing or when you think about increasing revenues is it going to come from higher option pricing or are buyers increasing the amount of options that they're purchasing or how you think about crafting this strategy going forward to drive higher revenues per community?

Anthony, if you look at our previous calls in the transcripts what we've shared is we're lifting our revenue community by community with the types of products we're putting out there far more than pushing option revenue. I say that relative to communities, we're opening maybe in a higher priced area or higher income area and you'll model a larger array of footage and you're at higher pricing on the same lot because you put a larger home on it. And that's where we'll move around with demand.

On the studio side we use of first and foremost to sell homes and along the way there's always increment of revenue opportunities. I don't know if you happen numbers, Jeff, on what our Studio has been doing but it roughly tracks about 10% of the base revenue. So as we push our base revenue that buyer will typically spend about 10% in the Studio.

The other parts of our Built to Order where we continue to mine pricing is in lot premiums, elevation premiums, you can evaluate over time what plan sells better than another because it's all Built to Order and you can move your pricing on the plan that's outselling the others to keep everything in balance. So it's not just the Studio, it's across the whole spectrum of the selling process.

Great, thanks. And then my second question is obviously you guys know two of your competitors recently merged, so I was just trying to get your take on how further industry consolidation is going to -- how you think about that impacting your strategy in terms of land acquisition or how you go forward with your relationships with either construction or materials suppliers, so just your overall take on that.

M&A has been a part of our industry for a long time. Certainly I'm not going to comment on the transaction that was announced.

I'll leave that one to the experts. But in our world we've always seen our best returns come from organic growth. And that's what we're working on right now and we're doing pretty well.

Nishu Sood, Deutsche Bank.

Thanks. I wanted to ask about the cadence of demand that you've seen so far this year. You mentioned that your markets have been strong and you've seen potentially some broadening out. You mentioned across all four of your regions demand was strong.

So I just wanted to get your sense of that. Has demand overall and as you dig down into the regions has it been accelerating anywhere or has it been mainly simply this broadening out across the regions?

And as we look to the second half of the year is there anything that gives you pause or reason for encouragement? Because it seems like a lot of investors look at this space and they say housing demand just can't sustain into the second half of the year in a lot of years. So I just want to hear your thoughts overall on what you've seen so far and what you expect.

Good question. Specific to our business there's no question that our demand has broadened out with some regions that weren't as large a contributor to our orders are stepping up quite a bit. So there's a broadening but within the markets that we're in we're seeing strength across the markets.

There's -- all of them are doing better at their own pace of improvement but there's none that I can think of where I'd say that's a tough market today. It's a pretty broad-based strengthening going on.

I think a lot of it is demographics. This household formation you can't ignore the demand that gets created when this many people are moving from the roost.

Got it. And a second question I think you've been pretty clear that you want to use or capture this demand in pricing and margins versus trying to drive your absorption. So we appreciate the strategic clarity.

Where do we stand in terms of pricing? And the way I was thinking about this was if the current pace or this pricing power that you're seeing out there, is it enough that it would get you eventually to your 20% rough target that you're talking about? Or would we need more pricing power to emerge to balance out your pricing against the paste of cost increases you're seeing?

I would say that we have the potential to get there in the current market conditions in that whenever markets have priced the land sellers are smarter than we are. So land prices go up or your cost goes up you need to lift your margin through your execution, your product mix, the submarkets that you're investing in. And we think we've got a nice pipeline set up right now with new openings in the right submarkets where we may get more price.

We don't count on that. If we do we'll certainly take it. But we're trying to raise our margins without the benefit of price.

Alex Barron, Housing Research Center.

Thanks guys and good job. I wanted to ask about the entry-level demand that you're seeing as well as the mothballed communities.

Are those mothballed communities -- what type of consumer I guess are you trying to target? Is it entry-level or move up and how is this increase in the entry-level demand shifting your strategy going forward?

A couple of comments Alex. Every community that we're activating is a different position in that submarket. So we've activated some that were more affordable play and we've activated some that are first move up play or even into a second move up play.

No different than new investments at the same time as long as we feel we can get the right returns with the acquisition or the activation. I've shared on the call that we're pretty nimble about moving with demand. And within our current holdings or our future holdings we can move up and down in footage and spec level and price to where the demand is.

On the resale cited think this household formation is going to help unlock what I call the food chain where if there is more strength in the first-time buyer demand people can sell their homes and move up to their next home now which they may not have been able to do in the past. So I think on the macro side this household formation is really going to help and within our Company we'll continue to navigate and target where the strength is in that location.

Okay. And as far as the San Francisco project that you mentioned are those -- when do expect first delivery of those and are the margins there higher than your Company average?

The first one that I mentioned, Townsend, we're hopeful of delivery sometime around the end of the year range. We'll see. These are fairly complex products to build and whatever our optimistic completion date is we obviously are going to miss them by a month or two.

You have to run a higher margin in these in order to get your returns because they are more capital intensive than building a home on a lot in the suburbs. So when they do hit the market typically it will be a higher price in a higher margin no different than our Playa experience which I believe you toured last year out here Alex. And I share it because it's an extension of a business that we haven't done before.

And we stuck our toe in the water in the Bay Area. The initial response has been very strong and again it's a natural extension of the things we do here in the state. So we're looking to expand our penetration of this type of business on top of the other things we do.

Jack Micenko, Susquehanna International Group.

Good morning. Most of my questions have been answered but I was looking at the option owned mix and your option mix is down pretty significantly and I'm just curious obviously you've got a lot of development dollars in the land spend too. Is it a strategic shift away from option as the margin mostly in more raw land purchase here at this point or have seller preferences changed? Just curious as to the mix owned versus option strategy here?

Ideally we'd option every lot we could. In the A locations that are land-constrained it's pretty difficult to get an option. We've done some and continue to.

But Jeff can give you the color on how the numbers have moved but I wouldn't read too much into that. Obviously we're continuing to turn and develop our own but you will see us tie up lots in the future on options where we can.

Yes, and speaking of the numbers I think Jeff said it right, I wouldn't read too much into it. It does vary quite a bit. You do have a tendency from time to time you go on lots, option lot, sometimes you let those options go and you never actually close on the lots, other times they move into owned as time progresses.

So it's not I'd say purposeful shifting that you see there. And like Jeff said in good locations with good returns a good margins we love option lots because they're more capital friendly. However, right now we're seeing I guess a majority of development deals coming across.

Okay. Great. And then getting back to the first time a little bit balancing margin and pace and getting that margin -- getting closer to those margin targets on the one hand and if we see more demand in the first time, should we think we're going to get to 20 before we start moving down to that true entry-level whether margins are a bit less but the pace is higher or are you going to stick with our buyer is built to order and it may be a higher income first-timer as it has been we're going to stay with that? Just thinking how that looks in the context of your longer-term strategy given the mix is a little bit different with that buyer profile?

It's an interesting question in that I was in Texas a month ago in Austin and we actually had a first-time buyer community I visited that's selling extremely well. Margins above the Company average at a high absorption rate because we have a large lot position so you let it run above the four. And in the same town we had opened up a first and second move up product that was selling above local averages probably three a month at a much higher price, actually a little lower percentage but higher dollars.

And actually as we're doing the math driving around the returns were much higher on the first-time community than they were on the move up community because you had above average margin and a very strong pace. I say that because people think your margins are going to be lower on first-time buyer product and they are if it's a play that's a volume play.

But over time a lot of our communities that are the more well-heeled first-time buyer I'd say margins are above our Company average. Just because the price is lower doesn't mean that the percentage margin have to be lower. And your run rate is typically a little higher.

Susan Berliner, JPMorgan.

Hi, thank you. Just one question to follow-up, I guess with regards to your cash position after the bond repayment, I apologize if I didn't hear this, I guess I was wondering with regards to cash flow over the next year or so and I guess your appetite for potentially raising new bonds.

Right. I think the most important thing to focus on right now with regards to cash is where the second half is forecasted to come in.

We'll have revenues in excess of $1.8 billion ranging up to about $2 billion in the second half of the year which will generate significant cash flow not only from improved profitability in the second half but also from the return of the investment that's already in the land as we get that back. So we're pretty comfortable right now with where things are heading.

We purposely put more cash to work. We do plan and intend to run the Company with a much lower cash balance, particularly with our revolver that we have standing behind it, giving us additional liquidity. So we're pretty comfortable with that.

The prior discussions we've had all still hold. We are still continuing to target the 40% to 50% leverage ratios as we move forward. And again very comfortable with the liquidity and the cash position at this point in time.

At this time I would like to turn the call back over to Mr. Jeff Mezger for closing comments. Please proceed.

Thanks LaTonya and thank you everyone for joining us on the call today. Look forward to speaking with you again in the very near future. Have a great weekend and happy Father's Day.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time and thank you for your participation.