KB Home (KBH) 2016 Q2 法說會逐字稿

Good morning. My name is Shay and I will be your conference operator today. I would like to welcome everyone to the KB Home 2016 second-quarter earnings conference call.

(Operator Instructions)

Today's conference call is being recorded and will be available for replay at the Company's website KBHome.com through July 21st.

Now I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may now begin.

Thank you, Shay. Good afternoon, everyone, and thank you for joining us today to review our second-quarter results.

With me are Jeff Mezger, President and Chief Executive Officer; 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.

Before we begin, let me note that during this call, items will be discussed that are considered forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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 the Company's control, including those detailed in today's press release and in its filings with the Securities and Exchange Commission, actual results could be materially different from those stated or implied in the forward-looking statements. In addition, a reconciliation of the non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in today's press release and/or on the investor relations page of our website KBHome.com.

With that, I will turn over the call to Jeff Mezger.

Thanks, Jill, and good afternoon, everyone.

I'm going to start with a brief overview of our second-quarter results followed by a business update. Then Jeff Kaminski will take you through our financial results in greater detail and discuss our guidance for the third quarter of 2016, as well as the full year, after which we will open the call for your questions.

Our performance in the second quarter was quite strong, with meaningful progress across a number of financial and operational measures, led by a 30% increase in total revenues to $811 million. We capitalized on our robust backlog position entering the second quarter to produce a substantial increase in deliveries, which were also up 30%, with each of our four regions generating delivery increases in excess of 20%. As a result of our top-line growth, significant improvement in operating margins, and lower interest expense, we grew net income, inclusive of all inventory-related charges, by 63% year over year to $15.6 million. In the second quarter, the value of our net orders increased 14% to $1.2 billion, a healthy level of growth, particularly in light of the 38% year-over-year growth in net-order value in the second quarter of last year.

On a seasonal basis, our net orders typically reach their highest point of the year in the second quarter. We had a successful spring selling season this year, with our highest second-quarter net-order performance in the past eight years. We generated 3,249 net orders, up 8% from a year ago. We grand-opened 24 communities and closed out of 23.

Our grand openings for the quarter were roughly half the number we had in the second quarter of last year, which resulted in our average community count decreasing about 2% from a year ago. Generally, the grand opening period drives the highest sales in the life of a community. So our ability to achieve solid net order growth with a slightly lower community count and fewer grand openings highlights the underlying strength of our sales.

There is no question that improving market conditions contributed to our favorable results in the second quarter. We were also successful improving net orders in our reactivated communities and in communities that were previously underperforming relative to their sales goals. As a result, we achieved average net orders of 4.5 per month per community for the first time in many years.

On a regional basis, the West Coast delivered the highest year-over-year order comparison at 29%, with net orders of nearly 1,000 homes, reflecting an increase in average community count of 15% and the highest sales per community of our four regions. This outcome is even more significant considering the West Coast produced a 32% sales comparison in the year-ago quarter.

While the coastal markets in California remain strong, higher prices in these areas push demand further inland, which is where the majority of our order growth came from during the quarter. As an example, net orders in our central California division more than doubled.

In the Bay Area, we continued to work through the transition of community openings relative to closeouts. Five of the six openings that we anticipated for the second quarter are now open, in addition to the four communities we opened in the first quarter. We did experience a delay in one community, which is now set to open for sales in the third quarter of this year. We expect the Bay Area will cross over to community-count growth in the third quarter.

Our Southwest region returned to a positive sales comparison in the second quarter, driven by ongoing strength in Las Vegas, which continued to generate one of the highest sales rates per community in the Company.

In our central region, our largest business in terms of units, we continued to see healthy results. Net orders were up in this region, in spite of severely inclement weather across Texas and in Colorado. In Houston, demand trends appear to be stabilizing, particularly at our price points. Our average community count in Houston was down 13% from a year ago, but our orders per community actually improved, and our total sales in Houston were down 7%.

Our Austin division was a particularly strong contributor to the region's overall performance. We are the second largest builder in this market, and continued to grow our market share with a sizable increase in net orders. Wrapping up the regional commentary, net sales per community were up in the Southeast, although total net orders were down due to a decline in community count.

In the Metro DC division, we closed out of four communities and ended the quarter with only three remaining open communities. As we announced last month, we are exiting the Metro DC market and expect to complete this process by mid 2017. While it's never an easy decision to exit a market, it is the right decision for the Company in order to optimize returns on invested capital and drive stockholder value over the long run.

Activating land that has been held for future development is also a key area of focus as we work to improve our returns. Since the beginning of 2015, we have successfully reactivated 24 communities, and with market conditions improving, we are continuing to evaluate additional communities for reactivation. These reactivated communities typically generate below Company average gross margins, which is offset by positive leverage on SG&A. And as a result, we can grow our top line while maintaining our operating margins, increase our earnings, and generate cash that we can then reinvest in opportunities that we expect will produce higher returns. As Jeff will discuss in a moment, we are increasing our revenue expectation for this year, reflecting the improved sales results from our reactivated and underperforming communities.

In closing, we expect the housing market to continue its measured recovery, with steady economic growth, along with increasing household formation, favorable demographics, low interest rates, and the attractiveness of owning versus rent fueling demand. We expect the convergence of healthy demand and low inventory levels to positively influence new home sales for some time.

With first-time buyers representing 52% of our deliveries in the second quarter, and keeping in mind that this segment has historically accounted for more than half of our deliveries, we are well positioned to continue to serve the re-emerging demand from this buyer segment. With a healthy backlog, or approximately $1.8 billion in place, sales momentum, and improved execution, we believe we are poised to continue achieving our performance objectives.

With that, I will now turn the call over to Jeff for the financial review. Jeff?

Thank you, Jeff, and good afternoon, everyone.

I will now review the financial highlights of our second-quarter performance, as well as our outlook for the third quarter and full year. In the quarter, housing revenues grew 33% from a year ago to $807 million, fueled by a 30% increase in homes delivered and a 2% rise in our overall average selling price. Each of our four regions generated a strong double-digit increase in homes delivered, which drove significant year-over-year improvements in our homebuilding operating income, operating margin, and bottom line for the quarter.

We were particularly pleased with the increase in our backlog conversion rate to 54%, which reflected improved performance by mortgage lenders, higher-than-anticipated sales and deliveries of standing inventory, and shorter construction cycle time. However, we are cautious about projecting similar cycle-time improvements for the second half of the year, given anticipated seasonally heightened demand for construction services and the tight supply of skilled trades in many markets.

For the third quarter, we expect to generate housing revenues in the range of $900 million to $960 million, and for the full year, we are raising our housing revenue guidance to a range of $3.45 billion to $3.7 billion based on our strong second-quarter net-order performance. Our overall average selling price of homes delivered in the quarter increased 2% year over year to approximately $347,000.

This increase was lower than anticipated, largely due to a mix shift within our West Coast region, as a greater proportion of deliveries were from communities with lower ASP's in our coastal market, and a higher proportion of overall regional deliveries came from our inland California market that produce very favorable delivery results relative to expectations for the quarter. As a result, the ASP for our West Coast region declined 2% year over year, while our other three regions combined posted an increase of nearly 7%. For the 2016 third quarter, we are projecting an overall average selling price in the range of $375,000 to $380,000. In light of the robust 29% net order growth in our West Coast region during the second quarter, we expect a mix shift towards higher priced deliveries for the balance of the year, supporting our expectation for a 4% to 6% year-over-year increase in our full-year ASP.

Before reviewing the remaining financial metrics, I will provide more specifics on the components of the inventory-related charges that impacted the quarter. The $11.7 million total included $6.8 million relating to the wind down of our Metro Washington, DC operations that we announced last month, and $4.9 million for four land option contract abandonments in other markets, and an impairment for a reactivated community in our West Coast region.

It is important to note that of the $11.7 million of total inventory-related charges affecting our homebuilding operating income, only $6.4 million impacted our housing gross profit margin. The remaining $5.3 million, which related to planned future land sales, was included in our land sale results. Our housing gross profit margin of 15.5% for the second quarter included the $6.4 million of inventory impairment and abandonment charges I just mentioned, which equated to an impact of 80 basis points. Without these inventory-related charges, our gross margin was 16.3%.

Excluding both the inventory-related charges and the amortization of previously capitalized interest, our adjusted housing gross profit margin was 20.7%, up 40 basis points from the 2015 second quarter. Our selling, general, and administrative expense ratio of 11.6% for the second quarter improved 140 basis points from the year earlier quarter, due to favorable leverage on the higher housing revenues in the quarter and our ongoing cost-containment initiatives. Homebuilding operating income margin for the quarter increased 30 basis points year over year to 3.2%.

In addition to the inventory-related charges, the second-quarter operating margin included the impact of approximately $600,000 for severance and increased employee incentive accruals relating to the Metro Washington, DC wind down. After excluding total inventory-related charges from both periods, this metric improved 170 basis points from the year earlier quarter to 4.7%

Turning now to our operating margin guidance, as a result of the increased orders and absorption pace at both our reactivated communities and other lower margin communities that were previously underperforming relative to their sales goals, we are tempering our housing gross margin expectations for the second half of the year. Assuming no inventory impairment or land option contract abandonment charges, we believe our third-quarter gross margin will improve on a sequential basis to approximately 16.5% and anticipate that we will be in the range of 16.7% to 16.9% for the full year.

We currently expect the improvement in operating leverage from the increased second-quarter order absorption pace to offset the expected impact on second-half consolidated gross margins. We also anticipate our third-quarter SG&A expense ratio to be approximately 10.8% and the full-year ratio to be just below 11%, an improvement relative to both our previous guidance and the prior-year result. Considering these offsetting impacts, we believe our full-year operating income margin, excluding inventory-related charges, will be in the range of 5.8% to 6.0%.

Income tax expense for the quarter represented an effective tax rate of 37.1% and included a favorable impact of $400,000 of federal energy tax credit. In the same quarter of 2015, we recognized $1.7 million of such tax credits on much lower pretax earnings, resulting in a 24.5% effective tax rate.

These energy credits are a direct result of our sustainability and energy efficiency initiatives. We expect to recognize a larger amount of these tax credits during the second half of 2016 and project an effective tax rate of approximately 31% for the third quarter, and in the range of 32% to 34% for the full year.

Our second-quarter average community count of 242 was down slightly from the 248 in the same quarter of 2015, which had increased 30% from the previous year. We ended the quarter with 242 communities, about flat sequentially, but down 7% from a year ago. Included in the 242 communities at quarter end were 37 communities previously classified as land held for future development.

As mentioned earlier, during the quarter, many of these communities realized accelerated order absorption rates. By activating these communities, we have reduced our land held for future development by approximately $100 million from the end of the 2015 second quarter. The community activations have also contributing to the decrease in our interest expense by expanding the qualifying asset base we use to determine capitalized interest. The monetization of these land positions is contributing to increased asset efficiency and improved return. We plan to continue to unlock our investments in these properties and redeploy the capital into assets with expected higher income producing potential.

We anticipate our average community count will decline by about 7% in the 2016 third quarter, as compared to the same quarter of 2015, which had increased 30% from the previous year. For the full year of 2016, we still expect our average community count to be relatively flat compared to 2015, which had expanded 22% from 2014.

Looking beyond the current year, we believe our planned openings will drive an increase in our community count beginning in the first quarter of 2017. During the second quarter, we invested approximately $317 million in land and land development, with $127 million, or 40% of the total, representing land acquisitions, and the remainder spent on development to convert owned land into new communities.

We ended the quarter with unrestricted cash of $275 million, compared to $440 million at the end of the second quarter of last year. As a reminder, we used approximately $200 million of that cash in June of 2015 to retire senior notes upon maturity, and approximately $86 million for common stock repurchases in the 2016 first quarter.

In conclusion, we are pleased with our strong second-quarter performance and are confident about our ability to achieve our goals and produce further improvements in the second half of the year.

We will now take your questions. Operator, please open the lines.

(Operator Instructions)

Susan Maklari, UBS.

Thank you. Good evening. Just to start out with, you talked a little bit about the real strength that you saw in the west, and it seems like that's perhaps counter to what we've been hearing from some peers and just the general in our channel check. Can you just talk a little bit about your success there, how you think about bringing those communities online? I know you mentioned that you expect the Bay Area to have some growth as we look at the second half of this year, but any color you can add?

Sure. Susan, you have followed us for a while, and I've told this story before about how the California market can ebb and flow. And what we're seeing right now is continued strength along the coast, both north and south, that's moved pricing up. And so it's an affordability challenge in the more expensive coastal areas, and it pushes demand further inland. And as we saw as the quarter unfolded, the inland areas sold well and had good momentum coming out of the quarter. So we're holding our scale in the Bay Area, as an example, where we're transitioning out of old communities, opening new, and we expect to have community count growth here in the third quarter once again.

The real pick up, though, came out of the central Cal division up there, whether it's Sacramento or Stockton and on down. A combination of local demand and also some of the commuters that will go out until they can find a home that meets their needs that they can afford, because they can't afford necessarily close into the Bay. But it's a fairly traditional housing recovery that picked up some steam for us in the quarter, both north and south.

Okay. And then, you obviously have talked about how you're getting this improvement that's coming through in entry-level or first time buyers. Can you talk a little bit about how you think about that buyer today and what they are looking for? And how you have positioned the product, relative to perhaps some past cycles, where the buyer profile was a bit different there?

We have been -- I think part of our success and the pickup in sales is repositioning some of our communities where we may build a new model and offer it that's smaller in footage. It will have a three bedroom or four bedroom count, but a little smaller home. We've lowered some of the spec levels down where the spec levels were higher.

And in our business model where it's a pre-sold start, the buyer goes to the studio and personalizes their home with what they find is important. And at a high level, I don't know that the consumer's really changed that much. If it's a first-time buyer in the lower priced areas, they want big kitchens, they want nice bathrooms, great rooms have been popular for a while. So I don't know that the way they live has necessarily changed that much. A little more technology and what we do with sustainability is very important for this consumer.

Michael Rehaut, JPMorgan.

Thanks, good afternoon, everyone. Just wanted to dive in a little bit more on California and some of the regions. I apologize if you hit this earlier in your prepared remarks; I jumped on a little bit late. But just wanted to get a sense, when you talk about the improved demand on the first time, and particularly as it's finally percolating from the coast to inland, wanted to get a sense also of just how much of that -- how much of the demand and the improved demand that you are seeing is more due to communities opening at a price point that's within the FHA loan limits and just allows you to capture, perhaps, a part of the market that might not be as well served as other parts of the market?

That's certainly part of it, Mike. When we position a community, one of the first questions we ask ourselves is what's the FHA loan limit in this region, and we try to position product that will fall within that. But interestingly, in both the Central Valley and Inland Empire, the sales are occurring above the FHA loan limits for the most part, because after they were lowered, it became a much smaller component of the business.

And what the trade-offs are in a conventional loan, you have to put 10% down. Buyers try to put 20% down to afford -- to avoid paying the mortgage insurance, but it's easier to qualify on the conventionals right now.

So the payment is actually a little, less because FHA has a higher mortgage insurance, and I don't know that we have the statistics specifically to California, but FHA is not the lion's share of the business. It's more stronger demand, and they are finding ways to acquire home with conventional loans.

Okay so just to make sure I understand --

I'm sorry, Mike. That's specific to California. In most of our other business, we're operating within FHA loan limits where we are seeing similar strength.

Okay. Thank you, Jeff. Just so I understand it right, are you seeing improved strength because of -- so you're saying that you are seeing improved strength more just from existing communities benefiting -- you getting better sales pace or better demand in existing communities that were also open in the first quarter, as opposed to a -- any type of opening of a group of communities this quarter that took with it some -- drove some of the results.

I would say that it -- in that context, that it would be more the reactivation. Jeff can give you the number on what we tracked our sales lift from reactivations, but we were successful in opening more communities in the quarter.

Yes, right. Just specifically, on the reactivated communities, it's about 15% of our total communities right now average open for the quarter. It was about 14% last year.

To put it in perspective, as far as the impact on the absorptions this year, those 14% of the communities that were open the same quarter last year generated about 10% of the total sales. So they were pacing pretty much well below Company average. This year, we were very successful in increasing the pace of those communities up to actually slightly better than the Company average, so that 15% of the communities generated about 16% of the sales in this year's second quarter. So we saw a nice lift on that.

As Jeff mentioned, the total Company was at about 4.5% per community per month in the quarter and it was pretty evenly split between the reactivated communities and the rest of the business. So it was nice to see that improvement.

Generally, those communities have been a big challenged, which is the reason why they were inactive for a while. And being able to improve the pace of those communities to the extent we were able to get it up to in the second quarter was very pleasing.

Okay. One last quick one, if I could, just on the gross margins, appreciate the updated thoughts there. But for the year in the second half, gross margin is a little less than we were looking for, positively, obviously more than offset by SG&A gains. But on the gross margin front, how should we think about the cadence or the amount of improvement potentially in 2017? I know you're not giving guidance for next year, but should we just work off of this lower base or are there temporary things that might just be impacting 2H16 that might not be as influential for next year?

Right. A lot will depend on what happens on the orders in the back half of the year, obviously. When you look at the adjustment we made on the gross margins in the back half, the expectation that we had for our base or our core communities came in about as planned for the second quarter as far as the order absorption pace and the deliveries that we think those will generate in the back half of the year.

The positive surprise was what we did with the reactivations, like we talked about earlier, and some of the other what we call lower margin communities that were pacing below our sales goals in the quarter. And by lifting those, we did add top-line revenue. It was incrementally negative to the gross margin percentage, but at the bottom line dollars, it's actually accretive and it was also offset by SG&A leverage. So on balance, a positive. And I think the overall balance or positive point on that is just what it will do returns over time as we continue to work that balance down.

In the back half of the year, we will see where those communities pace out at; we hope to continue to see them pacing strong. We do have more activations planned in the back half of the year, and we will track those as we go and help guide you guys on the first part of 2017 as we get through the next couple of quarters.

Right now, we remain focused on our goals for this year, and also very importantly, on increasing our operating margin and our returns. And we recognize a very important component of improving both of those is the gross margins, so we will continue to focus on it.

Dennis McGill, Zelman & Associates.

Hi Jeff, just to continue on that play on the gross margin. I want to make sure I understood the comment you made earlier on mix. You had negative mix in the second quarter from some of the strength on those inland markets, but you were still up year over year on gross margin including that. So relative to the expectations, margin would've looked even better have those communities not outperformed.

If I'm understanding that correctly, can you maybe walk through in the second half of the year how you are thinking about the change in margin between apples-to-apples pricing power mix similar to what you talked about there, and then anything that might be impacting it from a fixed-cost standpoint?

Right. Well in the back half of the year, what we normally see is improved leverage on the fixed cost that we have in cost of sales. So that's certainly a component we will see impacting it. It's offset slightly by what we are seeing as an increasing mix of these reactivated communities.

To put it in perspective, we have a range of margin on those communities that are mid single digit, call it 5% or 6%, to mid double digit, 15%, 16%. There's obviously a few communities trailing below that mark and obviously above, but overall, that's about where it's tracking at.

So with that group of communities and if the average is within the low double digits, to the extent we drive mix and increase absorption pace into those communities, it does affect the second-half margin. That's really the impact that we're seeing relative to prior guidance.

As far as consecutive quarters goes, we're seeing as we talked about -- or as I talked about in the prepared remarks, an estimate of about 16.5% in the third quarter and mid to high 17% in the fourth quarter, as we'll see more deliveries coming out of the West Coast relative to the rest of the business and even within the West Coast region, the coastal markets relative to the inland markets, we will see a bit of a shift of delivery mix occurring in that phase as well.

So it's been more on that side that we are seeing the changes in gross margin than pricing or cost or anything else. The cost -- our index cost so far year to date versus the beginning of the year is up about 1.6%. We believe we've offset most of that with pricing and really not seeing many other impacts other than just the mix that we see in our backlog right now.

Okay, that's helpful. And then second question would just be as it relates to the exit of DC, the Southeast region has been a trailing region from a margin perspective. Is there any way you could frame what the exit would do to that segment? Maybe talk to what pro forma 2015 would've looked like ex-DC or put some numbers around it?

The DC business is pretty small in the overall scheme of things for the Company, so it really doesn't move the needle much. It does incrementally improve the Southeast region's results. I think we will see that as we move into next year, but as far as moving the needle on the overall Company, it's just not significant enough.

Nishu Sood, Deutsche Bank.

This is actually Tim Daley on for Nishu. Thank you for taking my question. My first question relates to the reactivated communities. Thinking of it in the anecdote that you guys gave us about 15% of current communities are the reactivated projects and compared to about 14% last year. It seems that -- just correct me if I'm getting this wrong, that as you keep community count flat, it's more of a replacing closeouts with the reactivated communities. Is this correct? And if so, what percent of the apples-to-apples 15% that you gave us should we expect for two half 2016 and then 2017 going forward?

The percentage I gave you was on deliveries, and that has remained relatively constant; over the past year, it's been right about 85%, 15%. The large difference that we see in the back half of the year is just the absorption pace. So while it was, like I mentioned earlier, while it was about that same percentage of our total communities, the pace of those communities was trailing the Company average. So by the pickup in that, we will see I think a little more balanced mix.

We are opening a significant number of communities in the back half of the year that are new communities on new land that has been recently developed and they'll grand open. At the same time, we do have additional plans, and we hope to be able to reactivate additional communities in the back half of the year.

I think Jeff gave the number that over the past year and a half or so we activated and grand opened about 24 communities. We hope to grand open probably at least about 10 communities in the back half of the year. So I don't think it's going to change the mix much. I think it will remain relatively constant and some of those reactivations will replace other reactivated communities that will be closing out.

All right, understood.

But, Tim, as we head into 2017 and you will see our community count start to grow again, it is not an all or none. We are working to open communities in every city on newer acquisitions that we have made. And actually my hope would be that you see the new acquisitions grow faster than the reactivations. But they link back together because you take the cash from these as you monetize them and build through them, and it helps you with your growth trajectory from there too. But it's both.

Understood, understood. And then just quickly following up on that, so from an operating margin perspective obviously, am I to think that -- obviously the gross margins are a bit lower. But does that mean that you guys are getting a bit of help on the SG&A end from these communities? From an operating margin perspective, how would that look?

Yes, absolutely. In fact, the operating margin improvement, and this is coming both from the volume push that we've seen in the reactivated communities as well as our base business, as well as our underperforming communities. So we did see improvement in what would I call all three quarters of communities, but the leverage improvement is significant enough to offset the incremental downward movement in the gross margin.

So as we guided for the full year, this 5.8% to 6% operating margin for the full year should be pretty much right on top of the prior guidance that you guys had from last quarter.

Mike Dahl, Credit Suisse.

Thanks for all the color so far and taking my questions. Jeff, not to harp on the reactivations too much, but do have a couple more questions here. I just want to understand or be clear on the pace versus margin side. When you're talking about the pace in these communities having improved up to or above Company average, was this a function of something that you were intentionally doing on price or incentives to drive it? Or has the market just come to you from a geographic standpoint to the point where the absorption just organically picked up?

Mike, I think there's a few things at play, and you've touched on a couple of them. Certainly, the markets have improved where a lot of these communities are located, so that's helped with it. As I mentioned in a previous response, we've done a lot with product rotation where we're offering a new model that's a little bit smaller to lower the pricing in the community. We've lowered spec levels, which will lower the base pricing in the community. So we go there and make sure our product is aligned with that consumer and the household incomes in that area.

Then you had the market lift. And if we have a community that's not selling, we have to do something to get it going so we could end up taking some price. And we look at every community every week, and we have an optimal combination of margins and absorption that we target. And if it's hitting the sales pace, we will push price, and we did a lot of that too in the quarter. And if it's below, you'll have to do something to get back online.

Underneath it, what we're pleased with is the way the -- all these reactivations performed in the quarter relative to what they did a year ago. It's more meaningful part of our business going forward in a good way.

Got it. And then I think you mentioned that there was part of the $5 million charge this quarter outside of the DC exit was related to reactivation. Was that charge taken upon reactivation or was that an instance where you had to act to bring pace up?

That's part one of that question and then part two of it is, could you just help us size up --if you're bringing on 10 more -- or reactivating 10 more of these communities, how many are borderline or would be on some impairment watch list as they come on?

Right. Just addressing your first question, the asset was a legacy asset. It had been on the balance sheet for quite some time. It was reactivated and grand opened last year. And we really haven't seen -- did not see the pace in that community that we expected on the grand opening.

And as a result of that, if you grand open a community and you're close to the mark as far as an impairment, if you're not pacing it makes it worse, obviously, because your interest carry is going up and it could cause you just to go into an impairment situation just on that alone. And that's really what's happened; we haven't seen pace in the community. We took the impairment this quarter, and obviously, we expect to see it not only pacing but earning back some of that impairment dollars on the margin side as we go.

As far as the 10 communities in the second half, they're really community-by-community specific decisions that we make. We don't have a hard and fast right now on what will come online. We evaluate them as we go; the divisions propose them as part of our regular land committee process, and we evaluate them at that point.

I believe as we look forward -- well, let's look backward, just to put it in perspective. We've reactivated 26 communities -- or 24, excuse me, communities over the last year and a half. And we have had relatively modest impairment activity relating to those. So I'd expect much of the same with the next group that we activate.

John Lovallo, Merrill Lynch.

Hey guys, thanks for taking my call as well. I think in a recent conference call, you guys had indicated that the Inland Empire was still in the early innings of recovery, and we've seen some pretty meaningful pickup in the quarter here. And from some of your competitors we've heard, and I think this touches on Mike Rehaut's question. We've heard of FHA loan limits, some discounting to reach -- to keep things in the parameters there. Are you seeing that from competitors? Are you seeing discounting in the inland Empire? And if so, what is your reaction in terms of your existing communities?

I haven't heard, John, of a lot of heavy discounting at all out there in the Inland Empire. I think the builders a pretty disciplined and trying to max their margin. I did hear an anecdote of one situation where someone took steps to get below the FHA loan limit at the conference I was at. And my observation was those loan limits changed two years ago. So we've been operating with that restriction in place for a couple of years, and you figure out a way to navigate around it. So we're not seeing heavy discounting to get sales out there right now.

Okay, got you. And then depending on where your view is of where we are in the cycle, you guys are carrying some relatively high cost debt still on the balance sheet. Any thoughts on either trying to take some of this down or refinance this?

We've talked about it on prior calls, our next maturity is September of next year. It's the highest interest rate debt on our balance sheet, so we are very much looking forward to eliminating that off the balance sheet. We've made comments in the past of our ability to pay that down with cash and intention to delever to get into our midterm range or mid-goal range of 40% to 50% leverage. So those plans remain intact, and we will continue to address that as time goes.

Jack Micenko from SIG.

This is actually Soham Bosley on for Jack. My first question was on absorption. Absorptions were up 16% in this quarter on a 2% decrease in community count. Could you maybe talk about the monthly cadence of sales pace? In some of our groundwork, we saw March sales pace drop off from February and then pick back up in April. Did you see the same and then what about May?

Hold on a second. I thought we were up about 10%.

Just to correct, I think maybe some of your math, we were -- the community count was down about 2% in total. The net sales were up 8%. The absorption pace was up about 10%.

Okay. Thanks.

Sequentially as the quarter played out, we saw a fairly consistent market dynamic through the quarter. So March, April, May held pretty well throughout. I think it got a little bit stronger toward the end.

Okay. And then, I don't know if you guys disclosed this historically, but what was sales incentives as a percentage of revenue year over year?

Really wasn't much change year over year. We're a low-incentive Company anyway. Our business model is a low net price and not offer a lot of incentives. And we typically don't see much change or fluctuation in that either quarter to quarter, sequentially, or quarter to quarter or year over year, and we did not see it in this quarter.

Jade Rahmani, KBW.

Good afternoon, thanks for taking my question. Just wanted to ask as a follow up to the leverage question. Were you to repay that 2017 debt maturity with cash on hand, can you give a sense for the magnitude of benefit from reduced interest amortization that you would get on the gross margin side?

Right. Well, number one, it's 9% times the total debt; I think it's $265 million that's out. So on the incurred interested, it would be pretty significant. As far as interest amortization, it takes a while to work through the system. First it gets capitalized and the interest gets capitalized to projects as you open them for sales and you activate and have active inventory. And as it amortizes out the other side, it takes a while to work through.

So you reduce your debt levels first, then improve your leverage, and following that, it would be about a year or two, you would see some benefits on the margin side coming through.

Thanks for that. And just in terms of supply in your markets, I wanted to find out if you've seen any competition from single-family rentals.

Not really. They're -- actually, let me back up. If you're referring to people deciding whether to own or rent, there's a lot of single-family rentals out in the marketplace. So you would have to say as people are evaluating their choices, that that would be an alternative for them. We have not seen a lot of product hit the market where they are trying to monetize their holdings and portfolio. I think they're still trying to get their arms around that. They've been pretty disciplined in that area.

Robert [Lindenhall], RBC Capital Markets.

Good evening, it's actually Michael Eisen on for Robert tonight. Quick question for you guys on the strong delivery growth you guys have had for the past couple of quarters. Was there anything in specific regions that may imply there was some pull forward in the quarter that, in turn, would imply a slower pace of delivery growth in the back half of the year? Any additional color on that would be very helpful. Appreciate it.

Michael, one of the things that gives us confidence in the second half of the year is heading into our third quarter with $1.8 billion in backlog value. So we've already got a lot of the backlog in place to support the second-half revenues. I don't know that we would say there was a pull through in this region, and it's fairly typical and pretty broad based, I would think, on our closing performance.

Right, I may just add to that a little bit. As I went through the prepared remarks, I mentioned a few of the factors that gave us a higher conversion rate this quarter and actually higher than our own expectations and higher than guidance, which we were certainly pleased with.

I think your question\\48.11 is getting more to how do you peg the third and fourth quarters. And I would say, just revert back to the guidance that we provided for the third and for the full year and you can extrapolate the fourth quarter off the full-year guidance. And that will probably get you as close as we think, at this point in time, as you could get to it.

So we considered, obviously, the strength of the second-quarter revenues and delivery number in the guidance. We also considered the strength of the second-quarter net order growth and the mix shift slightly towards the West Coast region, which had very strong order growth in the quarter in those guidance numbers for both the third quarter and the full year.

Patrick Kealey, FBR.

Hi everyone, thanks for taking my question. I wanted to circle back actually to the reactivated communities, maybe thinking about it another way. What would you say the average life remaining in those communities would be, just thinking how long it's going to take from a gross margin perspective, but also maybe from a cash-free cycling perspective, maybe reallocating that into higher return projects?

As far as getting that specific on the communities, it's pretty hard to peg an average. We have a number of reactivated communities that are now open and operating that have other phases that are still in active status. So we'd obviously, need to work through the current phase in order to open the next phase or the phase after that of those communities, so it's a little bit of a mixed bag.

We've made tremendous progress on the reactivated, or mothballed communities over time. Like I mentioned in the prepared remarks, we're down $100 million from last year and we're down quite significantly, actually nearly $300 million from the peak of that. So it will be some time to work through it all, certainly, but we're very pleased to have made the progress we've achieved up to this point. And the more that we can get activated and sell through, I think the better it will be for returns and cash flow for the Company.

Okay, great. Thank you. And I appreciated the color you gave earlier just on monthly cadence within the quarter. Any update you can give us on maybe June trends and how they are tracking versus June 2015?

Patrick, we're two weeks into the quarter, so we typically don't give a lot of color on the current month activity. As I shared, May was probably a little bit stronger than March, but we had a nice progression through the quarter with pretty consistent demand. We were pleased with the results.

Alex Barron, Housing Research Center.

Thanks. Just wanted to go over your margin guidance. You said you expected 16.5 for the third quarter, and then you gave the full-year guidance a little bit higher in the fourth quarter. So what's the -- what's happening in the fourth quarter to cause the margins to go higher? Is it just mix from a certain market or product size? Can you elaborate a little bit on that?

Sure, yes. It's pretty straightforward. In the fourth quarter, we expect to have a higher mix out of our West Coast region, which carried higher margins, higher average margins that the rest of the business. Supported again by the strong net order performance in the second quarter, and to be honest, it's more or less just almost a normal seasonal trend that we see in our business where we have a higher mix of deliveries in West Coast late in the year.

And secondly, we do achieve a higher level of operating leverage on our gross margin because we do have some fixed costs, including gross margin, in our highest revenue quarter of the year, which is pretty much always our fourth quarter. So with the high revenues in the quarter, we will see that leverage come through with the positive mix shift. We will see that come through.

And then what I had mentioned as a third factor is we talked about a fair amount on last call -- on the last quarter's call, some of the new openings that we have happening in the West Coast region and have happened earlier in the year will produce what we expect to see nice margins coming out of those communities at high price points, which can really impact the overall Company's margins in a favorable way. So I'd determine those -- or say those three are the three main factors in the improvement.

Okay, great. And then as it pertained to the backlog conversion this quarter, I think you warned not to expect maybe the same for the third quarter, but what were some of the bigger factors you think that contributed to the pretty nice surprise there, especially like in the Texas market?

Right. It's like we were saying earlier. I would say there are three main factors that favorably impacted it. One was the improvement in construction cycle time. As a Company, in total, we saw about a 10-day improvement in construction cycle time during the quarter.

We did see better reliability and consistency with our mortgage partners for the quarter. So loans that we had expected to close closed, and I'd say we got quite a few over the line that were maybe in past quarters a little more questionable to get done in the quarter. So that was very helpful for us. And hand in hand, and almost interrelated to the two in terms of spec sales, or standing inventory, sales of standing inventory, we were able to -- our sales of standing inventory were fairly typical for us in the quarter as far as a blend. We're typically about 70%, 30% blend on that side, built-to-order versus standing inventory or spec.

But during the second quarter, we were able to close more of those sales that were actually made in the quarter than we typically expect to close. And again, the mortgage side helped on that, and in some cases, improved cycle time on construction helped in that one as well. So those were the three main things.

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