KB Home (KBH) 2018 Q2 法說會逐字稿

Good afternoon. My name is Devon, and I will be your conference operator for today. I would like to welcome everyone to the KB Home 2018 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 5.

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

Thank you, Devon.

Good afternoon, everyone, and thank you for joining us today to review our results for the second quarter of fiscal 2018. With me are Jeff Mezger, Chairman, President and Chief Executive Officer; Jeff Kaminski, Executive Vice President and Chief Financial Officer; Matt Mandino, Executive Vice President and Chief Operating 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.

Before I get into the review of our business, I'd like to recognize Matt Mandino, whom we recently appointed as our Executive Vice President and Chief Operating Officer. Many of you met Matt at our 2016 investor conference as he was transitioning from Division President in Colorado to a Regional President position. Matt's new role, in a much broader capacity, reflects our rapid growth as we've more than doubled our revenues in just 4 years and our expected growth into the future, which Matt will help drive, as we expand beyond $5 billion in revenues.

Turning to our results for the quarter. We continued to considerably improve our key operating and financial performance metrics, a multiyear trend that reflects a larger and increasingly more profitable business. Looking at the specifics of the second quarter, we expanded total revenues by 10% to $1.1 billion and increased earnings per share by more than 70% to $0.57.

We've been on a steady path of producing year-over-year gross margin improvement as we rotate into higher-margin communities and begin to realize the benefit of lower interest amortization.

In the second quarter, we expanded our gross margin by 170 basis points to 17.7%, excluding inventory-related charges. Alongside our gross margin performance, we continued to control overhead costs while increasing our scale, holding our SG&A ratio flat. As a result, our operating income margin was also up 170 basis points.

Looking out our operating income on a per-unit basis, we generated more than $29,000 per delivery in the second quarter, an improvement of more than 35% as compared to the prior year quarter.

Demand for our build-to-order product remained strong, supporting our ability to maintain among the highest absorption rates in the industry even as we continued to capture price in the vast majority of our communities. Our net orders per community increased 15% in the second quarter to 5.5 per month, the highest [springtime] absorption pace we have seen in many years, off of an already high base of 4.8 per month in the year ago quarter.

Although our community count declined in the quarter, which I will speak to in a moment, our net orders increased 3%. We expanded our ending backlog value to $2.2 billion, our highest second quarter level in more than a decade. As we are now at the midpoint of our fiscal year, this sizable backlog provides solid visibility on our deliveries for the remainder of this year, giving us confidence that we will achieve our revenue and gross margin targets for 2018.

One of the key strengths of our returns-focused growth plan is our ability to generate a substantial amount of operating cash flow, which we can deploy simultaneously to invest in our future growth while also reducing our debt balance. Since implementing the plan 18 months ago, we have invested $2.4 billion in land acquisition and development, up 26% over the preceding 18-month period, and reduced our outstanding debt by roughly $600 million, including the recent payment of $300 million of senior notes this month. This combination of growing our active inventory while reducing our annual interest incurred by $46 million will enhance our future gross margins and returns.

With the meaningful level of operating cash flow that we expect to generate in the second half of this year and the balanced approach to deploying our capital, we are in a position to fuel continued growth and strengthen our balance sheet.

In addition, as noted in our earnings press release today, our Board of Directors recently increased our share repurchase authorization to 4 million shares, which gives us flexibility to be opportunistic in enhancing stockholder returns.

Community count growth remains a top priority. Our strong absorption rate in the first half of this year resulted in selling out of communities faster than we previously anticipated. However, we are planning on accelerating the pace of grand openings in the second half of this year versus the 47 openings we had in the first 6 months and still expect to slightly expand our year-end community count.

Equally as important, the makeup of our portfolio is better, comprised of higher-margin, higher-return communities which is already producing benefits. Looking forward, we foresee healthy community count growth in each quarter of next year, with planned openings in the first half of 2019 significantly higher year-over-year. This expectation is reinforced by the growth in our lot count in the second quarter, with the number of lots we own and control up by almost 4,500 lots year-over-year. We remain disciplined in our land acquisition efforts with respect to price point, location and product, consistent with our core KB2020 business strategy. In addition, we are taking positions that generally represent a 2- to 3-year supply, with an emphasis on deal structure and compressing time to first delivery, which will collectively benefit our inventory turns.

Market conditions remain robust with economic expansion, high consumer confidence, favorable demographics that reflect an increase in millennial household formation, plus job and wage growth supporting demand. Against this healthy backdrop, resell inventory is still near record-low levels and there remains an under-production of new homes to close the gap relative to demand.

The first-time buyer continues to fuel housing market activity, and with 53% of our deliveries this quarter to first-time buyers, we are strategically well positioned with the products that we offer, our ASPs and the locations of our communities. The factors that are driving demand appear to be outweighing the recent increase in interest rates. Although we are sensitive to the impact that rising rates or the anticipation of rate increases can have on home buyers.

While we continue to closely monitor shifts in the buying patterns of our customers, we have yet to see a change in behavior. Traffic levels and demand were solid in the second of the quarter, driver and absorption rate appreciably higher. Other key indicators remained steady with historical trends, including the square footage of homes sold and dollars spent in our design studios.

Our mortgage data was also consistent with prior quarters, with an average loan-to-value ratio of 88% and predominant use of a fixed-rate mortgage product. Our cancellation rate also declined year-over-year in the second quarter.

While we are mindful of changes in interest rates, the key internal measures that we track reflect the home buyer is willing and able to purchase a new home.

Moving on to the regional update. Demand remains solid in both the inland and coastal areas of California, driving our community absorption rate up 15% to 6.2 net orders per month in the second quarter. With market dynamics as strong as they are, we have sold out of communities faster than we've been able to open replacement communities as we managed through delays and municipal approvals and with the utility companies. As a result, we have a temporary shortfall in community count until our growth in the region resumes in the second half of this year.

As is often the case, timing can meaningfully impact comparables. To put this in perspective, at this time last year, we shared with you a very successful opening at our Hayden Community, a condominium building in the highly sought-after Playa Vista master plan in Los Angeles. This one community produced nearly 80 orders in last year's second quarter.

In addition, we experienced a mix shift in net orders as we have sold through many communities with ASPs in the range of $1.3 million to $1.7 million. This higher-priced band represented about 10% of our net orders in the region in the second quarter of '17 as compared to about 4% of our net orders this year. The combined effect of having fewer active communities and thawing out of many of our higher-ASP communities negatively impacted our net order comparisons in the second quarter of '18. As a result, the West Coast experienced a 13% decline in net order value on a 9% decline in net orders.

With that being said, we feel very good about our West Coast business today and we still expect our 2018 ending community count in California to be up roughly 15% year-over-year. We also anticipate the composition of that community count to reflect both higher-margin communities and a more balanced distribution of communities across the state. In addition, with our owned and controlled lots in California up about 20% year-over-year, we are also solidly positioned to extend our community count growth throughout 2019.

Moving on, our Southwest region produced an 8% increase in net order value on a 2% net order increase. Growth in our Arizona business led the region's performance as it continues to increase its scale. Our Las Vegas business remains very healthy, with the community absorption rate above 7 net orders per month, again, one of the highest across our company.

In the Central region, our largest region in terms of units, net order value increased 3% on a 6% increase in net orders. Market conditions remain favorable across the region. Our net order value was impacted by mix as we had a particularly strong net order comparison in San Antonio, one of our lowest ASP divisions in the region.

Elsewhere on the region, we're pleased to see the traction gain in our Dallas division over the past year. With 3 communities opened during the last 9 months and 3 more planned for the balance of 2018, the growth opportunity we envisioned in Dallas is beginning to materialize.

Wrapping up the regional updates, net order value increased 33% in the Southeast region on a 28% increase in net orders, with every division producing a positive net order comparison. While the region had a relatively easy comparison from the second quarter of last year, we've seen a steady acceleration of year-over-year net order growth in the Southeast in each of the past 3 quarters. Jacksonville was the largest contributor to the region's growth, increasing its community count as well as maintaining a high absorption rate. Both Orlando and Tampa's performance also improved, reflecting better execution internally and the economic growth of these markets. Our Southeast region is producing better and more consistent net orders, and we look forward to this trend continuing.

Before I wrap up, I'll provide an update on KBHS, our mortgage joint venture with Stearns Lending. This month marks the 1 year anniversary of KBHS becoming operational in each of our served markets. The JV has ramped up nicely during its startup year, providing a higher level of service to our customers. This performance contributed to us exceeding our expectation for deliveries in the second quarter and also to the year-over-year growth in the JV's income.

KBHS is also now offering a streamlined mortgage process called Stearns Digital. With this recently launched mobile and desktop app, the entire mortgage application can be completed digitally. The app can securely verify income, employment and assets electronically and home buyers can upload documents and receive real-time updates on the status of their loans. As a result, KBHS can compress the loan processing time and make the overall mortgage process an easier one.

As the execution in the KBHS business continues to mature, the JV is serving a higher number of our customers, resulting in even more predictability in deliveries and continued growth in the JV's income stream in the second half of this year.

In closing, we're pleased with the strength of our performance in the second quarter and the progress we continue to make on improving our key financial measures. With a backlog value of $2.2 billion, we are well positioned for the full year with healthy revenue growth and a gross margin at or approaching 18%. Market condition remains favorable, and with the consistent execution on our returns-focused growth plan, we expect to be within our 2019 target ranges by the end of 2018 on many of our key metrics, including operating income margin, returns and our leverage ratio on both the gross and the net basis.

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

Thank you, Jeff, and good afternoon.

We are very pleased that our continued strong operational execution on our KB2020 business model and returns-focused growth plan resulted in significant year-over-year improvement in our second quarter financial performance, including a 10% increase in total revenues, a 50% improvement in homebuilding operating income and a 73% rise in earnings per diluted share. We believe that in the second half of 2018, our operations will generate additional profitable growth, driving substantial operating cash flow to support further investments in land and development as we complete year 2 of our growth plan.

In the second quarter, our housing revenues grew 10% from a year ago to nearly $1.1 billion, reflecting a 5% increase in the number of homes delivered and a 4% increase in our overall average selling price of those homes. Three of our 4 homebuilding regions reported housing revenue increases, ranging from 6% in the Central region to 43% in the Southwest region. We ended the second quarter with a backlog value of $2.2 billion, which was up 3% from the year-earlier period and was our highest second quarter backlog value in 11 years.

Considering this quarter end backlog and expected future net orders, we currently anticipate third quarter housing revenues in the range of $1.23 billion to $1.29 billion. For the full year, we have narrowed our housing revenue range from our prior guidance to $4.6 billion to $4.8 billion.

In the second quarter, our overall average selling price of homes delivered increased 4% year-over-year to approximately $402,000, reflecting increases in 3 of our 4 homebuilding regions. Our average selling price in the Southeast region decreased due to the wind down of our Metro Washington, D.C. operations in 2017, which had the highest ASP in that region.

For the 2018 third quarter, we are projecting an overall average selling price in the range of $410,000 to $415,000. We still believe our average selling price for 2018 will be in the range of $400,000 to $410,000.

Homebuilding operating income increased 50% from the year-earlier quarter to $74 million. Excluding inventory-related charges of $6.5 million in the current quarter and $6 million in the prior year period, our second quarter homebuilding operating income margin increased 170 basis points to 7.3%, driven by continued measurable improvement in our housing gross profit margin.

For the third quarter, we expect our homebuilding operating income margin, excluding the impact of any inventory-related charges, will be in the range of 7.8% to 8.4%. For the full year 2018, we expect the same metric to be in the range of 7.7% to 8.2%, an increase versus our prior guidance.

Our housing gross profit margin for the second quarter improved 170 basis points on a year-over-year basis to 17.1%. Excluding the $6.5 million of inventory-related charges, our gross margin for the quarter was 17.7%, also a year-over-year improvement of 170 basis points, with 50 basis points in the improvement resulting from a reduction in the amortization of previously capitalized interest.

Our adjusted housing gross profit margin, which excludes inventory-related charges and the amortization of previously capitalized interest, was 22.2% for the second quarter, up 120 basis points compared to the same period of 2017. The year-over-year increase was primarily due to the same factors discussed during our first quarter call as we continue to drive margin improvement from community-specific action plans, including targeted home selling price increases calibrated with demand and the opening of new higher-margin communities, partly offset by increases in land, trade labor and material costs.

Assuming no inventory-related charges, we expect the year-over-year increase in our third quarter housing gross profit margin to a range of 17.6% to 18.0%.

Considering the continued strength of the housing market and the favorable community level results we experienced in the first half of 2018, we have increased our full year gross margin expectations, excluding inventory-related charges, to a range of 17.6% to 18.0%, which would represent an improvement of 70 to 110 basis points as compared to 2017.

Our selling, general and administrative expense ratio of 10.4% for the quarter was the same as the year-earlier period's second quarter record low. The positive variance in the SG&A ratio relative to our prior guidance was primarily due to improved leverage from higher housing revenues and favorable legal recoveries and settlements.

As we continue to make containment of overhead costs a high priority and expect to realize additional favorable leverage impacts from higher housing revenues, we are forecasting our third quarter SG&A expense ratio to be in the range of 9.3% to 9.8%. We anticipate that our full year 2018 SG&A expense ratio will be in the range of 9.6% and 9.9%, an improvement relative to prior guidance.

Our effective tax rate for the quarter of approximately 27% primarily reflected the favorable impact of the Tax Cuts and Jobs Act. We still expect our effective tax rate for the remaining 2 quarters of 2018 to be approximately 27%.

Overall, we reported net income for the second quarter of $57 million or $0.57 per diluted share, significantly up from the $32 million or $0.33 per diluted share reported in the second quarter of 2017.

As I mentioned during last quarter's call, for purposes of calculating earnings per diluted share for both the remaining quarters and the full year 2018, we expect to have approximately 101.5 million diluted shares outstanding.

Turning now to community count. Our second quarter average of 215 was down 10% from 238 in the same quarter of 2017. We ended the quarter with 210 communities, including 32 communities or 15% that were previously classified as land held for future development.

On a year-over-year basis, we anticipate our third quarter average community count will be down by approximately 10% as compared to the 234 communities in the third quarter of 2017. We expect our community count at the end of 2018 to be up slightly as compared to year end 2017.

We invested $379 million in land, land development and fees during the second quarter, with $136 million of the total representing new land acquisitions. Our year-to-date land-related investment of $844 million represents an increase of 19% versus the prior year period, and we expect this investment will drive future community openings and overall community count growth.

We ended the quarter with total liquidity of approximately $1.1 billion, including $670 million of cash and $463 million available under our unsecured revolving credit facility.

Earlier this month, we retired $300 million of our 7.25% senior notes after maturity using internally generated cash.

Since April 2017, we have received 3 rating agency upgrades, and in May 2018, Moody's Investors Service lifted our rating outlook from stable to positive.

The implementation of our returns-focused growth plan has generated significant cash from operations over the past 6 quarters, and we believe our expected revenue growth and margin expansion in 2018 will drive operating cash flow solidly above the 2017 level, excluding land-related investments from both periods.

Our land acquisitions have positioned us to grow our community count starting later this year, and the nearly $600 million reduction in our debt since early 2017 will result in an annualized decrease of approximately $46 million in both incurred interest and interest-capitalized inventory. This, combined with our increase in active inventory, will drive further future reductions in the amortization of capitalized interest on a per-unit basis, providing a tailwind for future gross margins and returns.

In summary, we delivered solid results in the second quarter, with 10% growth in revenues, 170 basis points of improvement in our housing gross profit margin and a lower tax rate, all contributing to an 80% increase in our net income versus the prior year quarter. We expect to generate additional improvements in our financial performance during the remainder of the year as we continue executing on our returns-focused growth plan and believe we will generate a return on equity in a range of 14% to 15% for 2018, excluding the first quarter noncash charge for the impact of the Tax Cuts and Jobs Act. As such, we believe we are well positioned to achieve our financial objectives for 2018 and expect to meet or exceed our growth plan targets for 2019.

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

(Operator Instructions) Our first question is from the line of Alan Ratner with Zelman and Associates.

So my question is -- obviously, really impressive gross margin improvement, and I know there's a lot of stuff going on, on a community-level basis as well as within the portfolio and the deleveraging that are certainly eating that number. I was curious if you could talk a little bit just about what you're seeing in terms of pricing power, how that's trending, if there's any markets or price points that you feel like maybe things are starting to hit a little bit of a wall, just given how much prices have gone up, up to this point as well as the increase in mortgage rates, and then maybe just compare and contrast that to what you're seeing on the cost inflation side. We heard from Lennar recently, they think that lumber might have peaked, but curious what you're experiencing on the cost side and what your views are for the go-forward view.

Alan, as I shared in the prepared comments, we were able to capture price in a vast majority of our communities in the quarter. And if you link the sales rate to our gross margin guidance, we've been able to keep prices ahead of any cost increase. There's still pressure on cost. Lumber did peak. It's come down a little bit in random lengths. That takes some time to flow through, but -- so there's pressure on cost, but so far, we've been able to raise price adequately to expand our margins some while covering the cost. We're pretty strategic with our price increases, right? I always refer to optimizing each asset and we'll balance the price and the pace, and we always take price where we can. And between the strength of our pace and the ability to raise price, it tells you the market is still out there to capture price. So I can't think of a single market we're in today where I would say that there are signs that the consumer can't afford it or that pricing has hit the wall. We're pretty optimistic about the market type dynamics right now.

Great. That's really encouraging. And then just turning to California little bit. Maybe just talk about what the community growth you're anticipating there. I think you mentioned maybe a little bit more of a balanced -- I think you used the word balanced when talking about the markets and where you expect these openings to occur. Can you talk a little bit about kind of just where you're seeing the demand today? I mean, you mentioned strong in both the coast and inland, but it looks like maybe you're starting to open up a few more communities inland. So are you seeing some migration inland just as the affordability, obviously, is getting more stretched in the coasts? Or is it really strength across the entire state, both inland and coastal?

I would say it's strength across the entire state. And as we've shared in the past, we'll take every deal we can in the Bay Area, or Orange County or San Diego County because there's so land constrained and you have to be pretty good to find communities and bring them to market. So our goal is to hold the scale there because it's land constrained. And as the state's housing markets have expanded inland, we're going to see a lot more opportunity in the more inland regions, both Central Valley around Sacramento and the Inland Empire. And if you look at the history of our state performance over the last several years, for a while, we were only investing in the coastal region because the inland areas weren't providing a return. So our coastal business grew, inland didn't go grow that much. Inland then started to open up as the market recovered, and you've got this -- the different pistons in the engine, if you will, are now working better in that the inland areas are offering a lot more opportunity. But as the year unfolds, the reason I said more distribution, we see growth in all the regions within the state.

Our next question is from the line of Stephen East with Wells Fargo.

Jeff, in the press release, you talked about a balanced manner as far as how you're going to deploy your cash flow. And so I'm just thinking about your current cash levels, what you think you can generate. And looking at your debt load, your land and development demands you think you have, and share repurchase going on in there, what's that balanced manner look like, if you will, over the next year or 2?

I can let Jeff talk to the specifics on the cash versus debt and whatnot, but our top priority right now is to continue to grow community count and grow the top line. And we've been successful, and we've proven it now that we can really throttle up our investment while at the same time delever. So we've been in a nice situation of being able to accommodate both. And that's why as the quarters go by, we don't always connect all the dots, but when you think of our ability to spend almost $2.5 billion over 18 months and take out $600 million of debt, it shows you the kind of cash that our current strategy is generating. So as we go forward, priority #1 will always be we got to grow the top line, and we're working diligently to do that. But at the same time, we're mindful of strengthening the balance sheet and looking at our returns. So we'll continue to address all of them. They're all tools in the toolbox right now.

Right. And a big part of that has been monetizing these legacy assets. You're well ahead of your plan like you were talking about. How many more years do you think you all have to monetize those legacy assets?

Well, we're on the downhill side, Stephen. I don't know that we've looked at it that way. But as a percent of our communities, you'll continue to see a decline going forward. We've been...

I could give a few numbers, if you let me help you out. I mean, I think we peaked the community count last year, in 2017. We had like in the low 40s -- 41, 42 reactivated communities for most of last year. In 2018, so far, first quarter, we ended the quarter, I think, 34. We ended the second quarter with 32. So it's definitely trending down, and we see it trending down further. But I'd tell you, it's a multi-step process. I mean, we have to activate the community, in many cases, we have to develop, open for sales and then sell-through it. And in a majority of the cases, we have other phases that are still in inactive status, so we have to work through it. We're proud of the progress so far. We cracked the $300 million level this quarter. We came in at $282 million of total land held for future developments, so we're now down to about 8% of our total inventory. So as you pointed out, we're making really great progress on this initiative, and we expect to continue to make good progress. But as the communities are rotating more towards newer land purchases and core communities, we're seeing additional benefits in higher ASPs and higher margins as well in those communities. So all really nice trends for the future.

Okay. So -- but the legacy, you do expect it will provide incremental cash flow, it sounds like, for at least a few more years then. Is that correct?

Yes, certainly. But I think we should really emphasize one point. The bulk of the company's cash flow is really coming from the core operation. I mean, our core communities and our core business are -- is generating the vast majority of the cash flow. But it is nice to have 2 additional levers, one with the lack of paying cash taxes, which is helping; and the second one is the monetization of the reactivated. So those to me are incremental, but the base core business has really been generating very, very nice cash flow for us in the past couple of years.

Our next question comes from the line of Michael Dahl with RBC Capital Markets.

Jeff, I wanted to follow up on that and just -- understanding there's a lot of moving pieces on the gross margin side over the next handful of quarters or so, but great progress so far. When you look at the combined impact of what you just talked about on the mothballed side starting to decline a bit mix-wise and the tailwind from the interest expense that you outlined, just ballpark, can you remind us kind of all else equal, what type of tailwind that supports the margins?

Sure, sure. So far on the -- interestingly, on the other reactivated side, it's been very, very consistent since we started reporting it and really getting into a lot of detail with The Street. I think this quarter was 90 basis points. And we've been saying all along, it's pretty much a full percentage point plus or minus every quarter. We've seen that pretty consistently. So until that really starts tailing off, probably second half next year, I think we'll see a little bit more of a tailwind from that. But right now, our margin improvement has really not come from a reduction in reactivated -- in the mix of reactivated deliveries. It's basically just come from improvement across the business and mainly in our core communities, so that's been good. On the interest amortization, we talked about last quarter that we expected 20 to 30 basis points of tailwind from reduced interest amortization in 2018 for the full year. This particular quarter I think will be a high point for the year. We saw about 50 basis points year-over-year coming from reduced amortization. But last year was -- in the second quarter was just a high-amortization quarter at 5%. So I think that 20 to 30, I might say now, closer to 30, maybe a little bit north of 30 for the full year of held and then additional incremental improvement next year. So that is starting to provide some tailwind for us, and I think there's a couple of years left of that, quite frankly, as right now, our interest capped and interest incurred is down significantly. And as that moves through the system, I think it will provide a tailwind for us for at least the next 2 years.

Okay, thanks, that's helpful. And shifting gears to some of the comments going back to community planning and rollouts across California, specifically. Look, we started to see that balance come through in the ASPs, as you've mentioned already. It sound like it's going to continue to shift towards this more balanced geographic position within California. Can you just help us ballpark, from an ASP standpoint specific to the West region, just how we should be thinking about trends going forward for the balance of the second half and into '19?

I think at the overall level, the guidance we provided is probably the best place to go to. For the full year, we think we'll be in that $400,000 to $410,000 range in ASP, and for the third quarter specifically, $410,000 to $415,000. That contemplates mix shifts within the region, both with -- between the West Coast region and the rest of the business as well within the West Coast region. We did -- as Jeff mentioned in some of his comments, we did have some very high dollar amount, ASP dollars of deliveries in California last year, and those have actually reduced this year, but it's basically just mix shift between communities is what we're seeing. So we've contemplated all that in the guidance that we provided.

Our next question is from the line of Nishu Sood with Deutsche Bank.

So thinking about the substantial investments you folks are obviously making in land and accelerating the community count growth. Jeff M., in your commentary, you talked about some tactics you might use to make it a little more capital efficient just in time. Obviously, I would imagine increased use of options as well. That would have been difficult, say, 4 or 5 years ago, given the state of the land market. And obviously, the land market moves incrementally over time. Does that tell us, as you're thinking about that, that the land market has eased quite a bit, that land developers are more active, better capitalized, able to get bank financing? How does the state of the market compare to -- or how has it evolved over the last couple of years?

I would say, the land markets are pretty rational right now. And it's always tough in the A locations because it's so land constrained and terms are difficult and you do your best. As the -- if you just take California, where the markets continue to recover inland, it's now a pretty active market where land is more readily available. So there's not as much of a land grab going on out there and that you've got more options. I also do agree with your comment that the land sellers that are developing lots and selling lots have the financial ability to do that and they'll try to get a higher return with their terms versus just a cash purchase because they don't have the balance sheets. But I think all those are going -- coming together right now.

Got it. And Jeff K., any -- you talked about cash flow, I think, before land spend being higher in '18 than in '17, I believe is what you said. Just -- can you give us some sense of what you're expecting operating cash flow to be for '18, now that you have a pretty good view of the back half of the year?

Right. We'd like to look at it on the basis of before land spend because it kind of levels that off. You can always drive a lot of cash flow by driving up your land spend, which we don't intend to do. So on a gross basis, if you look at last year for the 12 months, we generated about $500 million of cash flow on a net basis, and on a gross basis, it's about -- a little over $2 billion. We expect this year to be well north of the $2 billion, and already, for the first 6 months of the year, we're already on a favorable comp compared to last year, and we expect to drive more in the second half. So short of that, I don't really want to provide a point estimate on it, but suffice it to say, it will be extremely -- I think it will be meaningfully higher than last year and definitely sufficient to support our expanded land investment expectations for this year.

Our next question comes from the line of Michael Rehaut with JPMorgan.

First question, I just wanted to circle back to California, and Jeff, obviously, very encouraging results around the commentary and demand trends. And I think one of the areas of concern by investors has been some reports out pointing to some softening, particularly in California, maybe above normal levels of seasonality. It appears, obviously, that your business isn't showing that, and obviously, your sales pace broadly speaking is up year-over-year, and you had good sales pace in California, specifically. So I was just trying to reconcile, perhaps from maybe a broader market standpoint, if those areas of concern or those reports do strike any type of cord with you? Or if there's perhaps -- in the past what we've heard in Inland Empire is that the FHA demarcation point from a loan-to-value standpoint that anything above an FHA loan limit product didn't sell as well, or perhaps there's some areas within even coastal that, at points over the last year or 2, have been a little bit oversupplied at some price points in some areas. So just trying to get a sense -- obviously, your own business looks pretty solid, but if there's any type of element in the marketplace that you can reconcile with those reports.

Mike, I think in part it's because of the price points that we play at. Part of our strategy is to compete with the median resales in an area, and it's harder to do along the coast than it is inland. But these communities we referenced, where there are $1.3 million to $1.7 million, we're in -- last year, we're in Orange County and the Bay area where median retails were slightly below that. So they were high-priced submarkets and we were the affordable play, as sad as it is to say that, in California. We were the affordable play from $1.3 million to $1.7 million and sold very well. So as the inland areas have evolved, FHA is not as critical now because the demand is much stronger. You've heard those comments from the builders 3, 4, 5 years ago, and demand has lifted, so you have a lot more people out there that can qualify conventionally. And whether it's inland or along the coast, we typically will operate at a price point below a lot of our peers. We try to stay affordable and compete with resales, and I think that's one of the reasons that we've been able to hold the sales rates we have.

Okay. No, that's helpful, Jeff. Secondly, with regard to community count, I guess, you kind of outlined that you expect to be down about 10% year-over-year in the third quarter, but end the year still slightly positive as you accelerate the openings in the back half. To the extent, obviously, that you're looking at a faster sales pace, how does that impact the '19 numbers? I mean, obviously, you outlined that you expect year-over-year growth in every quarter, but if you're looking at a faster sales pace -- and I know you haven't really given guidance yet, but will that kind of perhaps, all else equal, mute the growth expectations maybe from, let's say, if you're previously looking at up mid-single digits for the full year on average, now it's down to low single digits? Or does this acceleration in openings kind of offset the sales pace impact for next year?

Mike, we'll give community count guidance for '19 at the end of this year. And what -- when I said we're selling faster than we previously expected, it was relative to our community count guidance going into the year. Markets have been very good. We've taken advantage of it, and we've sold out a little quicker than we had modeled, while at the same time, our new openings have been delayed more than we modeled. So we got pinched here, and we've now taken that hit and we -- you'll see us get back into a nice rhythm here in community count growth as we get out of '18 and certainly into '19. And if you look back at the reference I made to lots owned and controlled, we were up 4,500 in the quarter versus a year ago, and that's a meaningful increase in the lots that we're working hard to turn into open communities now.

Our next question comes of the line of Stephen Kim with Evercore ISI.

This is actually Trey on for Steve. So first question I had is on the strongest margin that you had in the quarter, you mentioned it was due in part to targeted home selling price increases, but at the same time, your ASP really was in the range that you guided for. So what other factors were in there that caused you to beat the high end of your guide by 50 basis points?

Right. Yes, there were several factors, like as always, in quarters and mix of deliveries, et cetera. If you look at the beat, we're about 70 basis points up from the midpoint of our guidance. About 20 basis points came from just higher leverage or increased leverage on higher revenues in the quarter than we expected. So that was a nice benefit from the delivery beat, the revenue beat. And the rest of it really came from favorable mix. We had spec sales and closings in the second quarter that we had to estimate -- provide estimates for upfront. It was about 18% of our total deliveries in the quarter. And those, quite frankly, came in at higher margins than we expected or had forecast. We also had a little bit of conservatism in the forecast, thinking that maybe we might see a little bit more cost inflation, a little more risk on the backlog margins that we were able to successfully avoid, which we're pleased on that side as well. So a little bit from several different factors, but all adding up to a nice quarter. And when I look at the quarter, for me, when you look at the revenue versus gross margin, it was kind of -- we achieved the trifecta, so to speak. I mean, we had a strong double-digit increase in absorption pace in the quarter, which is boding well for the future of the business the rest of this year. Our second quarter, as you pointed out, came in higher than expectations on gross margin, which is great. And due to the increased confidence and what we've seen now in our backlog, we were able to lift our back half guidance and our full year guidance on gross margin. So a really nice quarter. The sales pace and the pricing trade-off worked to our advantage this quarter, and we were able to do a bit of each and improve both of them, and we're very pleased on that side of it.

And then also, you clearly are making a point that demand in California is strong with absorptions up 15%. But you're talking about community selling out faster and then you're also seeing a gap in bringing communities on. So is there some type of issue of you pushing price little bit faster to slow the cadence of sales that are taking place in your active communities so a gap doesn't exist? Or would that potentially put your new communities at price points well above where you think they would sell?

Again, we optimize the assets, so if something's selling 5 a month, and your margins are not where you want them to be, you're going to push price. If you're selling 5 a month at extremely high margins and then there's plenty left to go on the community, you're not going to dribble it out because you want to get rid of the overhead. So I don't know that one place and the other. The comments we were making were more about our expectation going into the year and where we thought we would be. And we're set up now with a very strong backlog and very good margins to cover the second half of the year, and at the same time, we're moving quickly to open up a lot of communities and set up an even better '19.

Our next question comes from the line of Jay McCanless with Wedbush Securities.

First question I had just with the shortage of labor continuing to be a headline. Can you talk about where your cycle times are or contract close? I can't remember how you guys -- how that compares to where it was last year.

Jay, that's what we do, call the cycle time for contract to close so -- because we're so heavily build-to-order. We did compress it just -- pulling the base for you. We did successfully compress the time from the final on the home to closing. I think it's a reflection of the higher capture rate and the better performance with our mortgage JV. My general sense is our build times are holding. They're not really eroding. We're able to find the labor to get our homes built. We're having to pay a little bit more for it than a year ago, but I'm not hearing a lot of sub shortage as our issue today.

Yes, that's right. And I think, by way of numbers, sequentially, we actually came down a few days from the first quarter, which also added a little bit -- or was a factor on our revenue and delivery beat that we were able to bring that total cycle time down. We're up a few days compared to the same quarter of last year, and that trend has been generally continuing on an upward trend since the recovery started. And frankly, we've had -- it's almost inversely related to how well the company's doing overall as far as financial metrics. And the tight market and the pricing that we're seeing out in the market today is manifesting in tight labor conditions, but also, obviously, a reflection of a good market. And we've been able to take advantage of that. So it's not constraining the business right now. And I think as Jeff said, we're not seeing any pockets of trouble or anything else. We're dealing with a slightly extended, on a year-over-year basis, construction build times, but trying to reduce in the other areas, and again, the improvement over the first quarter was welcome.

Absolutely. And then just the second question I had. Touching on what you said earlier, Jeff K., about some of the cost in 2Q came in a little bit lower than you guys have anticipated in the guidance. Can you talk about which costs were lower than you thought, and are you seeing any of that in 3Q?

You're talking about SG&A?

Yes -- well, no. I thought you said on the build costs, maybe?

On the drags, on the drags. Yes, I think it was more just a factor of -- a hedge factor on the cost side. We've seen some labor cost inflation, and some of the material categories have been showing inflation on a pretty regular basis over the last year. So we thought maybe some of that pressure would bleed through, and we were able to avoid a lot of it. So it was a more general comment as far as specific commodity category.

Our next question comes the line of John Lovallo with Bank of America Merrill Lynch.

First question is it seems like your print should certainly help allay some of the market concerns about rates and demand, but just curious how orders kind of trended through the quarter. I mean, were there any air pockets at all or was it pretty steady?

It was pretty steady, John. We had good traffic, good demand all the way through from March to May.

Okay, that's great. And then in terms of the community count outlook for the third quarter, the average count being down I think about 10%, you said. I mean is it reasonable to think that third quarter orders could be, on a year-over-year basis, flattish maybe slightly down before rebounding pretty smartly in the fourth quarter and into 2019?

I mean, it really comes down to the absorption pace. We're starting a little bit disadvantaged as we did this quarter, we were down 10%. And current quarter community count still squeaked out a little bit of an increase on order, so it's really dependent on that absorption pace, which is difficult to predict. Last couple of quarters, we had double-digit increases in absorption on a year-over-year basis, and those are coming off pretty good quarters from last year, so we'll see where it goes. But what we see now is, on the community count trend, we've been managing through it. It's been a declining trend as we've gone through this year, and we've been able to manage through it and still drive top line revenue. And it will be very nice for the business and I think the future of the business and the financial metrics to see those communities and the community count increasing starting in the fourth quarter of this year. We're looking very much forward to that because it's a nice tailwind to have.

Our next question comes from the line of Susan Maklari with Crédit Suisse.

This is actually Chris on for Susan. So my first question was just on the Southeast region. Looks like orders came in strong for you this quarter on the back of somewhat softer ASPs. How does the operating environment here compare to the rest of the country? And are you approaching your strategy differently here relative to other markets?

I'm not -- when you say operating environment, are you referring to building and selling homes and how we execute?

Yes, like, is -- the pricing power, relative to other markets, how does that differ, how you're approaching that?

It's not like a coastal California environment, but it's certainly like inland California or Texas or Arizona. They're pretty typical because they're not that land constrained. The markets are good, and our teams are executing better. And we're -- have shown a stronger comp there because we weren't that strong last year. It's more of elevating our execution and opening new communities that are performing well. We think we have a lot of upside coming out of that region going forward.

Okay, got it. And just my second question's on your efforts to grow your local scale. Are there any regions that you're having more success in growing market share relative to other parts of the country and -- for some of your smaller markets, how aggressive are you in adding to your land position there?

We're open for business everywhere. We share this part of our business strategy and our returns-focused growth. We want to be top 5. I joke with the team here that top 5 is a yawner, if you can't be top 3, you're not doing as well as you could. So once we hit top 5, we're not done. Last time I checked, we were top 5 in a little over half and top 3 in many. So we have the same strategy in every city that we're in. We want to get to scale. There's a lot of benefits to it, and we're encouraging every management team to have a plan in place to get, if not top 5, top 3 and so on. And that's the same goal in every city that we operate in.

Our last question comes up the line of Alex Barrón with Housing Research Center.

I have a question regarding, I guess, the strategy going forward with regards to price point. I noticed a couple of the regions the ASP seemed to be lower year-over-year, so I was just wondering if you guys are emphasizing more entry-level communities, and specifically in California, if you can I guess, help us out with generally how you're think about your entry-level exposure?

Sure. Well, Alex, as I mentioned on another question, we really work hard to position our product so we're competitive with the medians and not floating way above the median. Specific to the Central region, our price point came down because the San Antonio portion of that region was very strong, and they were 1 of the lower price points, so we have a mix shift. But within all of our businesses, I am sensitive to the interest rate environment, affordability, what's going on. And we've been diligently working to rotate down a little bit in our assumptions on what footage homes to build, which ones to model, what price point to play at, and it's all part of our discipline to remain affordable to the median. In California, it's again a mix shift in that the inland areas, as they continue to strengthen, are becoming a higher percentage of our business. It's not that the coastal area, prices are down or that our sales for per community are down, it's just the way the mix is shifting around.

Ladies and gentlemen, this concludes our conference today. Thank you for your participation. You may now disconnect your lines.