KB Home (KBH) 2017 Q2 法說會逐字稿

Good afternoon. My name is Darren, and I will be your conference operator today. I would like to welcome everyone to the KB Home 2017 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 27. Now I would like to turn the call over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may begin.

Thank you. Good afternoon, everyone, and thank you for joining us today to review our second quarter results. With me are Jeff Mezger, Chairman, 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 factors outside of the company's control, including those detailed in today's press release and in our 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 at kbhome.com.

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

Thank you, Jill, and good afternoon, everyone. We delivered another quarter of strong results in the second quarter with 24% growth in total revenues, an expansion of our operating income margin, driving earnings per share of $0.33. Reviewing the specifics of our performance, we increased our housing revenues to just under $1 billion. We are realizing the benefits of investments we have made, especially in our West Coast region, as our mix is positively influencing our revenue growth. We delivered over 25,000 homes during the quarter, an 11% increase. We converted this revenue growth into higher profitability, substantially increasing our operating margin. This was largely accomplished for our continuing trend of driving greater leverage from our growing scale while simultaneously containing cost. The strength of both our top line performance and operating margin expansion was the primary factor in our increase in pretax income to over $50 million.

As we discussed on our last earnings call, with the backlog in place to support our revenue growth goals, along with favorable market conditions, our objective at the start of the spring selling season was to maintain our sales pace and capture more price. We were successful in executing this plan, producing an increase in net order value in the second quarter of 15% to $1.4 billion on a 5% increase in net orders. The majority of these orders will deliver during the fourth quarter, which we expect will positively benefit both revenues and gross margin for that quarter and for the full year.

Absorption was 7% in the second quarter to 4.8 net orders per community per month as demand for our Built To Order product remains strong. Homebuyers continue to demonstrate a preference for choice and personalization of their homes. We build the home the customer wants with features that they value. In our view, our Built To Order approach is the biggest factor in our ability to drive industry-leading absorption rates. On a regional basis, the majority of our markets are performing well with the most desirable areas of each city remaining strong with limited inventory. As a result, demand is moving out to adjacent and more affordable suburbs. The West Coast provides a good example of this ripple effect. Prices continue to move up along the coast, and demand is expanding further inland.

Our West Coast region, our largest in terms of revenue, generated a 23% increase in net order value on a 7% increase in net orders. These results are notable, considering this region’s strength in last year's second quarter when we reported a 31% increase in net order value on a 29% increase in net orders. We again held our pace at a healthy 5.4 net orders per community per month in this region while capturing price. The Bay Area, in particular, produced strong net order results. This is our most land-constrained market where we have a long tenured management team with the relationships essential to driving community comp growth. This was a key factor in driving net order growth in this division during the quarter.

In addition, here in Los Angeles, we had a very successful grand opening at our Hayden community in Playa Vista that contributed to our net order results as well. Our Southwest region produced a 19% increase in net order value on a 16% net order comparison, led by continued momentum in Arizona.

The performance in Las Vegas also remains solid, with an increase in absorption to over 6 per month. This division continues to produce one of the highest order rates for communities across our company.

Net order value in our Central region was up 12% on a 5% increase in net orders. For the past year, Houston has consistently produced positive net order comparisons each quarter and did so again in the second quarter. In Austin, we grand opened Northridge, a community in a great infill location that was made possible through the skill and experience of our local team in successfully getting the lots and titles despite numerous complexities. The community opened very successfully in the second quarter, helping to drive Austin's positive net order results. Colorado was also a solid contributor with net order growth driven by strong demand in a market that features one of the lowest resell inventory levels in the nation.

Wrapping up the regional updates, absorption per community in the Southeast region continued its improving trend in the second quarter despite net orders being down, primarily due to the wind-down of our Metro D.C. division. Orlando has demonstrated solid improvement in growing net orders over the past year, and Jacksonville produced another quarter of positive order comparisons.

With our growth in net order value in the second quarter and the 19% increase in ending backlog value to $2.2 billion on over 5,600 homes, we believe we are well positioned to achieve a higher revenue target this year. In addition to the visibility of future revenues, a larger backlog also allows for a higher volume of even flow production, which helps us manage our construction cost and build times.

During the second quarter, we held average build times versus the prior year at about 4 months. This is a positive outcome considering the labor shortages our industry has been facing and the rainy weather we experienced earlier this year. Our even flow production approach is attractive to our subcontractors in that we commit to a certain start space each week in a community or submarket, and this commitment in turn provides our subcontractors with a level of predictability that helps them manage their labor and materials.

In most of our divisions, we benefit from the long-standing relationships we've developed with our subcontractor base, and we've also realized benefits from actions we have taken to increase our qualified subcontractor base. As part of our effort to improve returns, our goal is to further compress build times, and we have focused on simplifying and standardizing areas of our business to positively influence build times going forward.

Over the past 18 months, we have streamlined our product series, reducing the number of plans in our core business by about 60% while retaining a broad array of the highest frequency plans. Similarly, beginning about 1 year ago, we reduced the number of SKUs in our Studio by roughly 50%, eliminating low preference options while preserving ample choice. This simplifies the decision-making process for our customer and allows us to negotiate better pricing from our suppliers on the options we continue to offer.

Looking ahead, we maintain our outlook for favorable housing market conditions with job growth increasing and first-time buyers, a segment that continues to comprise 1/2 of our deliveries during the second quarter, fueling demand for new homes. What remains especially striking is the extremely low levels of resale inventory available. At 4.2 months nationally, and while below that in many of our submarkets, resale inventory is insufficient to meet demand. It is one of the key factors underlying pricing power in most of our markets, and we plan to continue maintaining price -- or pace, sorry, continue maintaining pace while increasing price when appropriate. And while we will always opportunistically take price when market conditions allow, we are also driving price through the many revenue enhancements that our Built To Order approach provides on an ongoing basis through lot premiums, exterior elevations and structural options and Studio revenues. Although our ASP was up significantly in the second quarter, our product remains competitively priced relative to new and resale homes. This is true even in higher-priced markets such as California, where resale inventory is extremely low at 3.3 months' supply.

Before I wrap up my comments, a brief update on KBHS Home Loans, our mortgage joint venture with Stearns Lending. As planned, the JV is now operational in each of our divisions. Stearns executed well during the second quarter, which contributed to our ability to exceed the top end of our delivery range, and they posted a modest profit. As the KBHS business matures and execution continues to improve, we expect the JV to achieve higher levels of customer service for our homebuyers, resulting in a higher capture rate, more predictable deliveries and a growing income stream.

In closing, our second quarter results reflect the continuation of our strong and consistent performance and excellent progress on the returns-focused growth plan we shared at our investor conference last October. We are executing in each of the areas that form our road map: Increasing our scale within our current footprint, expanding our operating margin, monetizing our deferred tax asset and improving asset efficiency. As a result, our revenue base is strong and growing, our profitability and returns are increasing, and we're generating a healthy level of cash, all of which position us well for the future. Our second quarter results, favorable market conditions and substantial backlog support an increase in our outlook for this year, and we are raising our guidance for revenues in both operating and gross margins. This progression in our results puts us firmly on track toward our 2019 goals.

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

Thank you, Jeff, and good afternoon, everyone. As Jeff mentioned, we are pleased with the second quarter performance and the positive trends we are seeing in the business, resulting from consistent execution on our returns-focused growth plan. I will now review highlights of the measurable improvements we generated across our key financial metrics in the quarter and provide details of our improved outlook for the third quarter and full year.

In the second quarter, housing revenues grew 23% from a year ago to $996 million, reflecting increases of 11% in both homes delivered and the overall average selling price of those homes. The significant growth in our housing revenues was largely driven by a 25% higher beginning backlog value in the current quarter as compared to the same quarter of 2016 in combination with solid operational execution. 3 of our 4 home building regions generated double-digit year-over-year increases in housing revenues ranging from 13% in the Southwest to 39% in the West Coast. Housing revenues in the Southeast region declined, mainly due to the wind-down of our Metro Washington, D.C. operations that we announced last year. We ended the quarter with a backlog value of $2.2 billion, increased 19% from the year-earlier period. Based on the strong backlog value, we believe we are well positioned for accelerated top line growth in the second half of the year and are raising our full year housing revenue expectations.

For the full year, we expect housing revenues to range between $4.2 billion and $4.4 billion with the midpoint up $150 million as compared to our prior guidance and up 20% as compared to 2016. We currently anticipate third quarter housing revenues in a range of $1.08 billion to $1.15 billion. In the second quarter, the overall average selling price of homes delivered increased to approximately $386,000, driven by increases in all 4 of our homebuilding regions as well as an increased proportion of deliveries from our West Coast region.

For the 2017 third quarter, we are projecting an overall average selling price in the range of $405,000 to $410,000, a year-over-year increase of 11% to 12%. Reflecting the targeted pricing actions we implemented across the majority of our communities during the spring selling season and the strength of our West Coast region’s second quarter net order value, we have raised our full year overall average selling price forecast relative to prior guidance. We anticipate our overall average selling price for 2017 will be in the range of $390,000 to $400,000, representing a year-over-year increase of 7% to 10%. This is the result of the changing mix of communities within our regions and expected full year mix shift towards our West Coast region and the successful implementation of targeted plan-specific price increases.

Homebuilding operating income in the current quarter increased 91% from the year-earlier quarter to $49.6 million, including inventory-related charges of $6 million compared to $11.7 million in the prior year period. Excluding inventory-related charges from both periods, our second quarter homebuilding operating margin improved 90 basis points to 5.6%.

For the full year 2017, we are increasing our homebuilding operating income margin expectations to a range of 6.0% to 6.6%, excluding the impact of any inventory-related charges. Our housing gross profit margin was 16% for the second quarter, excluding $6 million or 60 basis points of inventory impairment and land option contract abandonment charges.

Excluding both inventory-related charges and the amortization of previously capitalized interest, our adjusted housing gross profit margin was 21%, up 30 basis points compared to the same period of 2016. We expect to continue to generate sequential gross margin expansion during the remainder of 2017 from multiple contributing factors, including improved leverage on fixed cost from higher quarterly housing revenues, deliveries from recently opened higher-margin communities, a favorable regional mix of deliveries and community-specific gross margin improvement action plans. Assuming no inventory-related charges, we expect our housing gross profit margin for the 2017 third quarter could improve to approximately 16.4% to 16.7%.

During the spring selling season, we successfully balanced absorption pace and price increases in our communities, driving a meaningful year-over-year increase in our anticipated gross margin for the fourth quarter in addition to the improved full year housing revenue outlook mentioned earlier. We now anticipate our fourth quarter gross margin will be in the range of 17.6% to 18%, up 50 basis points at the midpoint compared to our prior expectations. With the strength of our second quarter performance and higher expectations for each of the remaining 2 quarters, we are increasing our projected 2017 full year housing gross profit margin to a range of 16.3% to 16.7%.

Our selling, general and administrative expense ratio of 10.4% for the second quarter improved 120 basis points from the year-earlier quarter. This significant improvement reflects our ongoing cost control initiatives and the favorable leverage impact from higher housing revenues.

In the second quarter, our SG&A expenses were up only $10 million year-over-year on a $188 million increase in housing revenue. We believe there are opportunities for further progress and expect to extend the favorable year-over-year trend into our third quarter with a projected ratio of about 10.1%. We currently anticipate that our full year SG&A expense ratio will be in the range of 10.0% to 10.3%.

Income tax expense for the quarter of $20.2 million, which was a predominantly noncash charge against earnings due to our deferred tax asset, represented an effective tax rate of approximately 38.9%. We still expect our effective tax rate for the remaining 2 quarters of 2017 to be approximately 39%.

Turning now to community count. Our second quarter average of 238 was flat with the first quarter and down 2% from 242 in the same quarter of 2016. The year-over-year decrease in our overall average community count was attributable to a 26% decline in our Southeast region due to fewer community openings relative to closeouts and the wind-down of our Metro D.C. operation. Our other 3 homebuilding regions posted a higher average community count compared to the year-earlier quarter. We anticipate that both our third quarter and full year average community counts will be approximately flat as compared to the corresponding prior year periods.

During the second quarter, to drive future community openings, we invested $405 million in land, land development and fees, with $204 million of that amount representing new land acquisition. We continue to make progress in reducing our land held for future development or sale through community activations and land sales. At the end of the second quarter, we had a balance of $396 million in this inventory category, representing a decrease of $36 million or 8% from last quarter.

In the 2017 second quarter, approximately 12% of our housing revenues were generated from reactivated communities. We ended the second quarter with total liquidity of over $590 million, including $349 million of cash and $242 million available under our unsecured revolving credit facility. In addition, our net debt to capital ratio of 54.9% reflected 390 basis points of improvement versus May 31, 2016. We believe we are firmly on track to be within the range of our stated goal of 40% to 50% in the near to mid-term.

In summary, we delivered a strong second quarter financial performance, particularly the 24% year-over-year increase in total revenues, the 90 basis point improvement in homebuilding operating income margin and growth in diluted earnings per share to $0.33. We made measurable progress across our key financial metrics in the quarter as we continue to execute on our road map for returns-focused growth. Based on the successful community-level management of pace and price during the quarter, leading to a 15% year-over-year increase in our net order value and a robust quarter-end backlog of $2.2 billion, we have increased both our midpoint full year housing revenue forecast by approximately $150 million and our midpoint fourth quarter housing gross profit margin expectation by 50 basis points. In addition, at the midpoint of our forecasted guidance for the second half of the year, we estimate that our full year return on equity will reflect a year-over-year improvement of approximately 300 basis points. With our strong and consistent execution within our operating divisions and current favorable market conditions, we are confident that we can deliver improved results for the remainder of this year and maintain the strong momentum into 2018.

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

(Operator Instructions) Our first question comes from Alan Ratner of Zelman & Associates.

I was hoping to dig in a bit more to the pricing trends you guys are seeing, you know, the ASP growth both on closings and orders, very strong. I know there's a mix going on there, but at the same time, I know you guys are raising price and focused on driving the margin higher. So one of the questions or concerns we get from investors a lot relates to how far can pricing go before it starts to impact both affordability and also confidence. So I was curious if maybe you can parse out those price schemes and maybe give an indication of what actual apples-to-apples pricing is doing on a community basis. And within that, what type of feedback are you getting from the field as far as buyers' reaction to those price increases? Is there still a pretty decent runway to go before affordability becomes a constraint?

I'll try to hit most of those, Alan, and what I miss, I'll turn over to Jeff. For starters, we know we raised prices in the quarters in about 200 communities, so most of our communities did see a price increase. And what -- we're rotating through communities fairly quickly so it's very difficult to have apples-to-apples on a year-over-year basis. There's no question we have a mix shift going on where the West Coast is growing the revenue a little faster than the other regions, but even within the West Coast, closing a community in Sacramento and opening 1 up in San Jose can move your ASP pretty significantly. As we position our communities, we try to -- we call bracket in the median income. We stay very focused on a product that's affordable for the median income in that submarket or in that ZIP code or in that area. So when we open for sale, typically, it's a very compelling value. We get momentum and, from there, we will monitor price and pace to hold whatever our stated absorption rate is, and then take whatever price we can get above that and make sure we optimize the returns. With the limited inventory that's out in the marketplace today, there's incredible demand for the product we offer at our price point and, at the same time, you have job growth and wage growth going on. So demand is growing while inventory is shrinking, so it's a pretty typical -- it's not a balance. There's not enough supply to meet today's demand, and within each community, we're navigating to that kind of dynamic. (inaudible) numbers, you want to...

Yes. I mean, the only thing I'd add is, you know, we're very watchful on the absorption pace and we're making sure the sales keep progressing. We had a good quarter from point of view of pace, where we're up 7%. Overall, we're actually up 8% in our core communities during the quarter in absorptions. And in addition to that, we're able to work on some margin improvement and actually -- which we believe will manifest in the fourth quarter with our improved guidance on gross margin by 50 basis points. So we like the balance right now. As Jeff said, the resale inventory is in short supply and it does provide a little more pricing power on the new home side and we're taking advantage of that. But certainly, we don't think we're moving at out past what the market will bear, again, as evidenced by our improving absorption pace.

I appreciate that. And Jeff K., if I can -- just on the absorption commentary, just want to clarify. So it sounds like community count's going to be flat in the back half of the year. It's been maybe down 1 point or 2 so far, and I know you've been signaling this push on maybe price over driving absorption growth. So just to be clear, are you actually assuming absorptions flat line on a year-over-year basis as well and the growth on the order side will come more in the dollars in terms of price as opposed to units? Or do you still think you can drive the absorption rate a little bit higher similar to what we saw in the second quarter?

Yes, well typically -- I mean, we target to maintain pace, particularly off the strong counts on absorption increases last year. So we had some very outsized comp in absorption terms last year. But it doesn't mean we're not looking for upside. We had a similar target this quarter to sort of maintain price -- or maintain pace and work on price, and we ended up actually improving both. We hope to do the same in the third and fourth quarter, but we'll see where market conditions take us and everything else. We don't have very many weeks or days of data points so far in the third quarter to know anything more than that. We have no crystal ball on that side of it.

Our next question comes from Stephen East, Wells Fargo.

Actually, this is Paul Przybylski on for Stephen. I guess, first question, your incremental SG&A increased to 5.4 from 3.6 in the first quarter. What drove that sequential increase? And how should we look at that on a go-forward basis?

I think the incremental increase is pretty much right in line with what we talked about every quarter. We always say, somewhere between 5% and 6% of top line -- of the differential and top line revenue is what we expect to see there. I think it was well controlled in the second quarter, given the revenue jump both on a sequential basis as well as on a year-over-year basis, and we actually did much better than we thought we were going to on our guidance, in our internal forecast. So we're actually quite pleased with the leverage. That 5% to 6% number is what I'd -- what we'd continue to suggest people use in modeling, and it's typically where we come in at the first quarter. I don't recall exactly, but there may be some ups and downs to the other factors. A few million dollars one way or another on adjustments here and there can really change things, but I think going forward, that 5% to 6% is about the right number.

Okay, and then orders in the West were a little bit lower than what we were expecting, and plus, community count flat there and then if you could give any color amongst the region and what's the status of the international demand in Orange County and the Bay Area versus a year ago?

Yes, do you want to talk about state of demand? I can go (inaudible).

Yes, Paul, Orange County is very strong right now. It's very good for us. In fact, the whole coastal zone, North and South, there's very limited inventory and demand is very strong. So it's very good conditions right now.

And as far as community counts goes, as you know, we were down a couple of percent total company. We were up a little bit in the West, but not significantly. So more of it came from just the management that we put into the business during the quarter of trying to improve the margins, and we're successful doing that, so we were pleased with the performance in the West Coast. (inaudible)

Our next question comes from Mike Rehaut of JPMorgan.

First question I had was on gross margin guidance, the 50 bp raise, Jeff, that you alluded to, Jeff K., a couple of times, and obviously, it's very encouraging. I was wondering if you could kind of break that down, if possible, what the big drivers of that in terms of -- do you feel that it's more -- if you kind of think about it in 3 buckets of mix versus price versus you've alluded to other types of gross margin improvement initiatives that you have in place?

Yes, specifically, the lift that you're seeing now, the 50 basis points that we talked about this quarter is more related to what we saw going through the spring selling season on the pricing side as far as price outpacing cost increases. So if you recall from last quarter's conference call, we talked a fair amount and we were very optimistic about being able to expand our operating margin for the year, but we did say we wanted to see what the spring selling season was going to bring us and we wanted to watch the management of our communities on a pace, price basis as we went through spring to try to drive some of that improved operating margin and we were successful doing that. So the incremental change versus last quarter came mostly from that. When you look at it on a year-over-year basis or sequentially as we go through this year, there were other factors involved and those include better leverage on fixed cost that are included in cost of goods sold. You're seeing new communities that are performing very, very well, so we've been very pleased with some of our new community openings. And as we're getting those opened up in the first half of the year, we're getting visibility and what that means in the back half as far as margins go, and in fact, out into the first quarter next year as well. Regional mix is certainly helping us on the edges and as well as really in every single one of our communities, the company, in total, is focused on community-specific action plans to improve margin. We know that's a real key to the success of the business, not only for the remainder of '17, but as we enter into '18, and we want to enter with a strong momentum on operating margin improvement, and particularly on gross margin improvement as we get into next year. So it's really a combination of all those factors, Mike.

Right. But, Jeff, before I go into my second question, just to be clear, because you started talking about the 50 basis point improvement in guidance and then you started talking about the year-over-year improvement. I just want to be clear that the raising of the fourth quarter guidance from 17.8% to 17.3% that the driving of that raising of guidance, if I heard you right, is more because of price -- getting price even greater than your cost inflation. So I just wanted to clarify that, that was the driver of the guidance. It sounded like that's what you said just the spring selling season being better, being able to capture and more than offset even better than you expected price over cost inflations. So I just wanted to clarify that that's the case. And then my second question is on the SG&A side. There's been a couple of quarters in a row now where you, I believe, you had a nice upside relative to guidance. And notice that you essentially only -- you effectively reiterated your full year SG&A guidance, lowered the high end of the range only down by 10 bps. Is that something where there's still a bit more upside to go there? And I noticed that you're only looking for about 70 bps year-over-year leverage in the third quarter versus 120 in the second quarter. So again, just clarifying the raising of the 4Q gross margin guidance and then is there's still an element of conservatism in the full year for SG&A.

Sure, sure. Starting with the gross margin side, yes, one of the main drivers was the strength of the spring selling season, just as we talked about last quarter. We definitely have better visibility now because most of those sales are now in our backlog relating to the fourth quarter, so that's definitely helped us. But in addition to that, we were successful with the new community openings, which until you get them open, everything's on paper. Once you get them open, you start selling and start seeing your gross margins per sale, it's reassuring and adds confidence to the back half margin guidance. So those 2 factors and mix played a role in it as well. So I think you said it more or less right on that, adding those other couple of factors. On the SG&A side, we have been very successful. We had a very in-line quarter this quarter on SG&A. We have some ups and downs in there that basically netted out, so we didn't have, really, any unusual onetime positives or unusual onetime negatives. A few million dollars moves SG&A. We're always a little bit cautious on SG&A, partially for that reason. We like the trend that we're seeing and we like, basically, the acknowledgment a lot of people had about the cost control on that side of the business, but we want to stay -- we don't want to get out over our skis on the improvement side. I think we can continue to leverage it, we said that consistently probably for the past several years, and we have done that, and I think you'll continue to see good progress, and our forecast, right now, indicate that as well. Nice progress on the year-over-year on a sequential basis, so I think we'll stay with our guidance on that, and hopefully, we can be at the lower end of it.

Your next question comes from Nishu Sood of Deutsche Bank.

I wanted to follow up on the pricing question. And Jeff M., you mentioned 200 of your communities where you were able to raise prices. So focusing on this comment about taking a little bit more in price, a little bit less in absorptions, it seems that, that comment applies more to California than maybe the other regions. Is that the right way to think about it? I mean, the 200 is pretty broad. I just wanted to understand, specifically by region, how you are thinking about that dynamic.

I would say it's a very broad, Nishu. A comment we’ve used for years is optimize the asset, and there's a certain pace that's a minimum, and when you get above that minimum, we'll try to hold above that and take more price. So the market commentary I gave where I observed that the most desirable areas remained strong in every city and it's rippling to the adjacent submarkets holds across our footprint. So we have pricing power in the close-in locations. And at the same time, as it ripples out, we're seeing some price lift-out on the peripheral. So while we raised in, in 200, it wasn't just in California or the Southwest. It was broad-based.

Got it. And the -- I think Jeff K. you mentioned over -- just over $400 million in land spend in the quarter. That would mark a cycle high. Your lot count, on the other hand, I think, only increase by about 500-or-so keeping your -- you probably, actually, been dropping your year supply metric a little bit. How should we think about that? Maybe if you could give us the develop versus buy -- versus new acquisitions. Does that reflect a lot of these California projects coming through the pipeline where there's probably more intensity of dollars on land development spend? Or how should we think about that number? And as well as reflecting your ability to grow now that you've got a pretty nice gross margin trajectory, the SG&A is going well, your absorptions are improving as well. So sorry, 2 questions in there.

Yes, no worries. On the split, it was about 50-50. There was about $204 million was land acq and roughly $200-million-or-so was development and fees. You are right in talking about California. I mean, there's heavy development dollars in California and a lot of the deals. And also when you look at where we're investing, in California, land is a higher percentage of total revenues. So to the extent, as everyone who understands our business, where were -- have a high percentage of our revenues coming from our West Coast region, it drives a high percentage of land spend into that same region if you want to reinvest to grow the business. We were actually quite pleased with the investment level in the quarter as our goal is to continue to drive community count growth as we get out into '18, and we want to continue to reinvest in the business for growth in the top line. So we thought we had a pretty successful quarter in what we have done, and we hope to continue more of that as we travel through the year.

Our next question comes from Stephen Kim of Evercore ISI.

It's actually Trey on for Steve. So first one, talk a little bit about California. It's definitely been quite a nice tailwind for you guys so far and probably will be at least for the rest of the year, maybe going forward some more. But we're just wondering how much of a greater mix improvement can you guys really see out to your West Coast and into California? Because you can't really see within the West Coast itself what's going on in that division.

Trey, I can speak to that. If you look at our California business, the community development and opening is a little more lumpy in the coastal areas because of the time it takes to get things approved and it's tougher to mine the deals, get them entitled, develop and open them up. And in the second quarter, we had some nice momentum out of the Bay Area where we opened a few more communities that are close in. As the markets have strengthened and the demand has moved inland, it's now out to areas where there's more buildable land available and it doesn't take as much effort to identify, entitle, develop and get things open. And if you look at the Central region from Sacramento, south of Fresno or if you look at the Inland Empire, they're still running the 20% or 30% of normal volume levels, and a lot of those areas are just now starting to hit their stride. But we think, within the region that there's a lot of upside still in California where we'll hold our scale and, hopefully, grow it some on the coast, but it's so land constrained, and, therefore, our growth engine will move inland, and that's what you're seeing right now.

Got it. And then secondly, just taking a step back, thinking about your 2019 targets that you guys laid out late last year. Could you talk a little bit about how after raising guidance for the full year this year, 2 quarters in a row, how you're thinking incrementally about that longer-term outlook for the company?

Well as I stated in my comments, we feel we're right on track to hit the goals we laid out for 2019.

Our next question comes from Will Randow of Citigroup.

I guess, in terms of input cost inflation, as mentioned previously, you're more than able to cover that. Are you seeing the full impact of lumber inflation? And are there any other factors that we should be conscious of? Of course land, but any other cost pressures that we should be focused on?

There's always various commodities that are either hot or cold in prices. You may have seen the announcement today on the tariffs that came out of the Commerce Department that really has been priced into our products for 90 to 120 days. It actually was more of a confirmation of the range that have been set many months ago. So that's been priced into our lumber now for a while. And there's still pressure on lumber prices, but it's not significant. And as we shared, we're able -- right now, we're able to take more price than we are seeing our input costs go up. On the labor side, there's still -- there's hot pockets around the country where sheetrockers here may be tight or stucco people over here or painters. And in that city, you do what you have to, to keep your production going. But I think right now, I'd say that the cost side is very manageable. That's in part why we're raising our margin guidance for the year.

It makes sense. And then secondly, just in terms of your strong progress on pace and price, outside of just typical consumer confidence, is there anything you can specifically point to? Have you seen mortgage credit ease or any other factors that are notable?

Certainly there's been employment growth, and employment growth creates demand. And don't forget the millennials moving out of the parent's house. There's a lot of demand being generated right now as millennials move on with their life and get married and dual incomes and all those things. On the mortgage side, again, there was an announcement today out of Fannie on encouraging lenders to loosen up their guidelines a bit. We're seeing little bits around the edges but no major shift in the quality of the underwriting.

Our next question comes from Susan Maklari of Crédit Suisse.

First question is really around the Design Studios. It certainly sounds like you're seeing some pretty good pricing power out there. Are you seeing any changes in how people are approaching the options that they're choosing?

I would -- at a high level and it's anecdotal, I would say that our customers are still looking for a value in their product over sizzle. So it's give me a little bigger kitchen, give me more counter space and they'll take that or convert this open area to a bedroom as opposed to a Level 5 granite and Jacuzzi tubs. It's still a buyer that intends to live there a while, and they're staying with more functional options.

Okay. And then in terms of the new mortgage operations, would you say that there was any level of a backlog that you kind of came through this quarter, especially as Stearns really sort of -- this new kind of model came into place and was firmly in there?

We've been working with Stearns since last fall. They actually were quite helpful. We didn't have the JV up and running yet and when we wound down Home Community Mortgage, our previous JV, Stearns stepped in and helped us with our deliveries in the fourth quarter at a small pipeline. They maintained the loans in the first quarter. And then here in the second quarter, they started taking on apps as a JV as we turned it on. And now they're building their pipeline for future origination. So we see this as a real opportunity as the -- as go forward over the next couple of years to really capture a big percentage of our business and make deliveries more predictable and generate another income stream. They're doing a very good job right now.

Our next question comes from Mike Dahl of Barclays.

I had a couple of questions on the community count. I think, first one, there was comment around some of the churn just given, obviously, the absorptions been strong and the flip side of absorptions being strong as you kind of sell through some communities pretty quickly. So could you give us a sense of if we look at the full year guide for flat year-on-year, how many closeouts are you going to have versus opens?

Well, I mean, I don't really have that number in front of me, but, I mean, overall, the community count last year on average for the 5 quarters was at 238. We think we're going somewhere near that number this year. We have a number of openings scheduled, obviously, in the third and fourth quarter. Again, I don't have that number in front of me, but it's going to -- hopefully, we’ll have more openings than closeouts to be able to grow our community count between now and the end of the year and keep that number relatively flat year-over-year. And ultimately, as we get into '18, I mean, we'd like to continue to obviously grow top line, and we've done a great job the last couple of years with our top line housing revenue growth on very flat community counts. Right now, at the midpoint of our guidance, we’re up 20% year-over-year. Last year, housing revenues were up 23% year-over-year. And in both those 2 years, '16 and '17, while '17 sets expectations at this point, but '16 we were relatively flat as well. So we'd like to add that additional driver to top line revenue of improving community counts going forward. But again, guidance for this year is relatively flat for the full year on an average basis.

All right, got it. And I guess, as a second part to that question, have you -- is there any sort of math you can give us of, I think, pace was a little ahead, as you said, relative to your expectation, and so then it seems like maybe community count was a little bit light of where we and some others were thinking. So anything you can give us as far as kind of the algorithm if pace continues to run up 5% or 10%, what the impact on your community count would be?

It's really difficult when you get into that because it's really at the community-by-community level. It depends where the pace is up. I mean, if your pace is up and the community where you have 200 lots and 3 more phases to go through and everything else, it doesn't change your community count at all, if you end up selling out quicker -- a quicker sellout out of a community that maybe has 10 or 15 lots left, the impact is so -- it's still -- I mean, it's very, very difficult to tell. In this particular quarter, we came in a couple communities shy of where we thought we might end the quarter due to some stronger sales in the closeout communities and more closeouts, but you're talking about 3 or 4 communities. I mean, on a base of in excess of 200, it gets pretty finite when -- and detailed when you're trying to forecast down to that level. So overall, again, just to reemphasize, we were pleased with the absorption pace pickup in both our core communities and overall. And we're pleased with the management, particularly being able to lift our operating margin and gross margin guidance for the year. And so we saw that as all being pretty successful in the quarter but to get any more detail than that in the community count, it's really difficult.

Our next question comes from Jay McCanless of Wedbush.

The first one, I just want to follow on some more on the community count. Are you guys thinking about net community count growth for '18 versus '17? And if so, should we expect SG&A to flex higher either at the end of this year or as we move into the first half of '18?

Jay, we're definitely trying to grow our community count in '18, that's our goal and our strategy. I don't think you'll see a big spike in SG&A as we ramp up the community count. That occurred a few years ago when we aggressively ramped up. But I think at our scale, it would be less of an impact. We'll be able to manage through that.

Okay. And then just the second question, any commentary on June orders or traffic? What you're seeing so far this month?

Jay, we typically don't comment within the quarter because we're so early into it. We did in the first quarter because we do our earnings release halfway through the quarter, so we can give you the color, I can say, in general, that the trends remain good just like March, April and May. But nothing specific.

Our next question comes from Bob Wetenhall of RBC Capital Markets.

This is actually Edson Flores on for Bob. I'd like to go back to the -- to gross margin. What do you expect in terms of contribution from reactivated communities and think about deliveries? And how should we think about the impact of these communities on gross margin? You already gave us our -- you already gave us guidance for gross margin, but I was just curious on what your thoughts were on that.

Right. What we're seeing on the reactivated communities is actually a lot of stability in terms of percentage of total revenues. Last quarter, it spiked up a little bit, I think it was 15% of total revenues. But if you look back throughout 2016, look at the second quarter 2017 and really, our expectation for the rest of the year, it's right in there around the 12% level of our total. So it is a headwind -- it remains a headwind of the company but not an incremental headwind either on a year-over-year basis or getting progressively worse, sequentially, as we go through the year. We think we'll just continue to be maintaining at around the same level of revenue and it is a drag of up to a full basis point on our margin, depending on the quarter (inaudible) full percentage point, excuse me, you're right. But it's not something that was see a lot of variability or variation in as we look forward.

And as a follow-up, jumping to capital allocation. In the first half of the fiscal '17, your investments in land acquisition were around $700 million. How should we think about land spend and capital allocation in general for the second half of the year?

I think capital allocation in general is just in line with what we've been saying publicly for a while. I mean we want to reinvest in the business, so land investment and development of land already owned is very important to us to continue the acceleration of our top line revenues. That's first and foremost. We're looking to delever the business, and we've made some moves, some earlier in the year towards that with our paydown of debt. We have other maturities coming up, and we'll see where market conditions are in capital markets as well as housing market conditions are and make decisions on that. But those are our 2 primary -- basically, the focus areas for cap allocation, in addition to our regular dividend, which is relatively modest, but we obviously continue to plan to maintain that. So that's really where we're coming from. And at the same time, we're seeing positive cash flow coming out of the business despite some pretty good levels of investment back in as far as land investment goes. So that's a positive, and that allows us to do both, to grow the business through community count growth as well as to delever the business as we move forward. It's worked up to this point and we don't see any reason to believe that it won't continue to work until we could get, basically, our ratios in line with our medium-term goals and our community count and investment in land in line with our goals as well.

Our next question comes from John Lovallo of Bank of America.

The first question that I have is if you could just remind us of your exposure to Houston and maybe what you've seen -- what you're seeing there and if that has changed at all throughout the quarter given kind of the pullback in oil?

John, Houston is about 7% of our business. And as we keep sharing on the calls, we're priced at the lower price points for Houston, our ASP there today is around $230,000. I think when you get up in the $300,000s and definitely the $400,000s, there's some danger there, and that's the area that seeing a softening in demand. But when oil prices tracked down last time, we powered through it pretty well because of the price points that we played at, and we stuck to that discipline. So as I shared in the comments, Houston had a very good quarter, had a solid run all of last year and we expect good things from that business.

Okay. And then maybe on the labor front, we've heard from some other folks that they're seeing some incremental labor, green shoots of incremental labor coming back to the market, whether it's some other industries or maybe even from the multifamily side. Are you guys seeing any of that?

Definitely. Most definitely and it's a combination of things. In some of the cities, apartment starts are down and now labor is coming back to the for-sale residential side, so that's encouraging. And it's always the case in the law of supply and demand. We've taken some pretty big increases over the last few years in labor in some of our cities. And then finally, it gets to a point where it starts to attract more people coming back into the market. So I think you do have both those are going on right now.

Our next question comes from Buck Horne of Raymond James.

I've got a couple of quick ones because most of mine have been answered, but do you have the quarter ending spec home counts? And I guess my other question, just to throw it out there, have you worked with any of the single-family rental companies recently to build some -- built for-rent homes that they're targeting? There's a few of them that are trying to ramp that up, and I was wondering if you might be working with any of them in particular.

I can speak to the rentals, Buck, we're really not looking at that right now. We're pleased with taking our assets and working our for-sale business model. In fact, several years ago when we were trying to figure out what to do with some assets we explored it, and we always came back to we can create the best returns through building our products and selling our homes.

Yes, and as far as spec count goes, we have about 1.5 finished spec per community. We ended the quarter with 362 finished unsold.

Our final question comes from Jack Micenko of Susquehanna Financial Group.

Kind of a related question to Buck's question. I mean your revenue beat pretty big upside to your conversion rate, and looking at our math, it looks like that you're looking for further acceleration in the backlog conversion in 3Q and 4Q. So I guess the question is are you doing something strategically different going forward? I know your Built To Order and by definition, less spec, but I was just curious as to what's driving some of that improvement both in the quarter and then on a go forward.

I can take a crack at a couple of comments. One, we -- our cycle time in our company is from contract to close. And in a Built To Order business, that's 5.5, 6 to 6.5 months depending on the city. While I talked in my prepared comments about things we're doing to simplify the build side of things, we're also looking to compress what we call the paper side from contract to start and from completion to close, and one of the things that we're seeing already in our joint venture is a partner that is very good at pushing the paper, getting buyers prepared for their loan approval and sign off on their start and then compress time also after the homes completed to get it closed quicker with a better and more efficient paper process. So we're strengthening our cycle time from a year ago, and I also think we have a better distribution of WIP now, where our backlog’s bigger, our unstarted backlog is bigger and it's doing better, even flow production than a year ago. So it's less lumpy in the second quarter, in March, was a very good delivery month for us, which tells you that you have to have the right balance of WIP. You just don't dump it all on February, you build through and it's a more even flow spread. So we have better WIP distribution, and then we're also working on ways to compress the cycle time.

And as far as the numbers go, I mean, when you look at it year-over-year, our backlog conversion was the same, this year in the second quarter as last year, we're at 54%. At the midpoint of our guidance range, if you look at the midpoint of our revenue and the midpoint of our ASP, it implies a backlog conversion rate in the third quarter a little bit better than last year. I think it was 48% last year, and this implies about a 49% backlog conversion. And really what's happening there is in the third quarter, with your second quarter ending backlog, you have a higher percentage of sales that were made more recently because it's your spring selling season. And as a result of that, your conversion, typically for us, moves down a little bit in the third quarter just because of the strong spring, adding to the backlog and adding more recent sales to your backlog. So I think it's pretty much in line with the trends that we've had, and as Jeff had mentioned, we're pretty focused on it, looking for improvement as we move forward.

Okay, that's helpful. And then the 40 to 50 net-debt-to-cap target, Jeff K., does that contemplate -- you’ve got some high-cost money coming due in September. Does that contemplate redeeming that for cash? Or are you still undecided there?

We're still looking at market conditions and what we want to do both on the capital market side as well as in the housing market side, things like land investment and where we want to move the business. But it remains firmly a part of our 3-year plan to have the business back within that range as quickly as possible. We talked last fall about a delevering of at least $250 million over that period. So it's very much on the crosshairs for the business, but we don't like making too many decisions too far out ahead of time, especially publicly on capital structure. So we'll evaluate that as we go through the quarter and then make some decisions by the time we talk to you guys again during the third quarter call.

Ladies and gentlemen, this concludes today's teleconference. Thank you for your participation. You may now disconnect your lines.