Lennar Corp (LEN) 2012 Q3 法說會逐字稿

Thank you for standing by.

And welcome to Lennar's third-quarter earnings conference call.

At this time, all participants are in a listen-only mode.

After the presentation, we will conduct a question-and-answer session.

Today's conference call is being recorded.

If you have any objections you may disconnect at this time.

I will now turn the call over to Mr. David Collins for the reading of the forward-looking statement.

Thank you.

Today's conference call may include forward-looking statements that are subject to risks and uncertainties relating to Lennar's future business and financial performance.

These forward-looking statements may include statements regarding Lennar's business, financial condition, results of operations, cash flows, strategies, and prospects.

Forward-looking statements represent only Lennar's estimates on the date of this conference call, and are not intended to give any assurance as to actual future results.

Because forward-looking statements relate to matters that have not yet occurred, these statements are inherently subject to risks and uncertainties.

Many factors could cause Lennar's actual activities or results to differ materially from the activities and results anticipated in forward-looking statements.

These factors include those described under the caption Risk Factors contained in Lennar's annual report on Form 10-K most recently filed with the SEC.

Please note that Lennar assumes no obligation to update any forward-looking statements.

I would like to introduce your conference host, Mr. Stuart Miller, CEO.

Sir, you may begin.

Great.

Thank you and good morning everyone.

Thank you, David.

Thanks, everyone, for joining us for our third-quarter 2012 update.

We're pleased to detail our results for you this morning.

As always, I'm joined this morning by Bruce Gross, our Chief Financial Officer, Diane Bessette, our Vice President and Treasurer, and Dave Collins, our Controller.

Additionally, Rick Beckwitt, our President, and Jeff Krasnoff, Chief Executive Officer of our Rialto segment are here to participate, as well.

Jon Jaffe, our Chief Operating Officer, will join us by conference line from California and also will participate.

I'm going to begin this morning with some brief opening remarks about the housing market in general and about our first-quarter results.

Rick and Jon will comment on specific aspects of Lennar's Homebuilding operations.

And Jeff will update performance in our Rialto segment.

And Bruce will conclude and add specifics with a financial review.

Simply put, the housing market is recovering.

Not only are sales, margins and backlogs improving, but the beginnings of a sense of visibility are coming back to underwriting land acquisitions and planning for the future.

The homebuilding business is beginning to revert to normal.

And that's positive for the US economy in general, which is, in turn, good for sustained recovery in the housing market.

Last quarter I noted various trends that were driving stabilization and recovery in housing.

Those trends have continued to define the path to recovery.

Briefly, those drivers are, one, home price value and interest rates driving affordability.

Two, for-sale monthly payments compare favorably to rentals.

Three, inventories of distressed homes and foreclosures are declining.

Four, consumer confidence is improving and consumers don't want to miss current prices and interest rates.

And five, the mortgage approval process is stabilizing and getting marginally better.

In fact, on this last trend, we see with QE3 that the government is focused on the home mortgage market and is working to keep rates low and to maintain an orderly flow of capital to the mortgage market.

To me at least, this is an important harbinger of future focus on nurturing a housing recovery.

Overall, demand has been improving and we've seen consistent sales pace at improving prices.

That is, prices that are reverting from over-corrected lows to normal throughout our third quarter.

Our steady traffic and sales pace indicate stronger demand trends as we have seen a material increase in our monthly sales per community from about 1.5 to 2 per month, to this quarter at 3.2 sales per community per month.

These improved results come with gross margins that are consistent with our current deliveries, indicating that we are not and have not been reaching for volume.

While I'm increasingly enthusiastic about the housing recovery, I don't want to overstate the case.

While the trend is decidedly positive, stabilization and recovery are still uneven across the country and even within markets.

As I've said before, the housing depression was a national phenomenon, while the recovery is very local.

We are continuing to see pockets of activity develop across the country that are recovering.

And these pockets are growing.

While still the broader market outside of these pockets often remains weak.

Additionally, demand trends continue to be constrained by mortgage qualification standards and processes that define today's mortgage market.

And remains over-corrected by the severity of the downturn.

But demand is growing, and more and more consumers continue to look for some loosening of credit standards.

With the market improving and driven by sound fundamentals, it's beginning to be interesting to be a home builder again.

Let me turn briefly to Lennar specifically as our management team will give additional color on our results.

In our third quarter, we saw continued improvement in all of the building blocks that define our Homebuilding and Financial Services operations.

While Rialto enhanced and expanded its bluechip operating platform.

Each of our operating segments remained profitable in the third quarter, as our associates across the country are really executing on all fronts.

On the Homebuilding front, each element of our business has continued to improve.

On a quarter over quarter basis, closings were up 28% versus 20% last quarter.

New orders increased 44% versus 40% last quarter.

Our backlog improved 79% versus 61% last quarter.

And gross margins of 23.2% versus 22.5% last quarter translated into our healthy operating margin of 11.2% versus 9.2% last quarter, as SG&A declined to 12% versus 13.2% last quarter.

We are clearly seeing the impact of the operating leverage that we expected as the market stabilized and as sales per community you have increased.

As we look ahead to future quarters, improved sales per community, together with increased community count, will be the engine that drives the SG&A operating leverage that will produce strong and sustainable bottom line earnings, even as construction costs do trend upward.

Our overall strategy of focusing on high margins in well-positioned communities has clearly paid off.

Lennar's Homebuilding operations are operating soundly and are defined by excellent hands-on management running the day-to-day activities, while excellent new communities are identified and added to each division.

Lennar Financial Services had another excellent quarter, as well, with operating earnings of $25.3 million.

Lennar Financial Services has continued to expand alongside of the core Homebuilding business, providing excellent service to our customers and leveraging increased volume.

Additionally, we've opportunistically added incremental volume by participating in the refinance market.

Rialto continued to play a central part in the improving Lennar story.

Rialto contributed $7.7 million of operating earnings.

While the Rialto connections and relationships have continued to help grow and expand our core Homebuilding business.

The synergy between our Rialto segment and our Homebuilding segment continues to exceed every expectation that we had when we began to grow this business.

Rialto results include the wind-down of our PPIP program that Jeff will discuss in just a few minutes.

But perhaps most noteworthy is the fact that capital invested the startup of Rialto is beginning to cycle back to Lennar and will enable us to aggressively grow our Homebuilding platform, while Rialto continues to invest third-party capital.

The Rialto franchise will continue to be a significant source of valuable homebuilding deals for some time to come.

While the base Rialto business continues to ramp its earnings.

As we look ahead, Rialto should continue to be a solid earnings contributor for Lennar, and will continue to return cash to corporate.

All in all, our third-quarter 2012 results mark an excellent steppingstone to strong future performance.

We are feeling more and more comfortable that the current trend is in fact the beginning of a new cycle for housing.

As I look ahead to the remainder of this year, and towards 2013, I'm increasingly optimistic that we are seeing a real recovery in housing and that we will continue to see improvement.

With national new home deliveries in 2012 expected in the 450,000 to 500,000 range, there's a lot of opportunity for expansion as the market normalizes over the next years to a normalized 1 million home plus.

Additionally, with smaller builders temporarily hamstrung by constrained capital markets, larger, well-capitalized builders like Lennar have a head start and can expect market share gains.

Assuming this market recovery is not derailed, expanding deliveries and fewer participants should provide us with some excellent opportunities.

Lennar is positioned with a strong balance sheet in the right markets, with an exceptional management team and a well-constructed strategy, to perform solidly as market conditions continue to improve.

All of the segments of our Company are performing well, and are extremely well-positioned, as you will now hear from our operating team.

Let me turn over to Jon now.

Good morning.

As Stuart noted, we saw continued improvement in our third-quarter results, with a post impairment 23.2% gross margin and an 11.2% net operating margin.

This bottom line profitability was driven by our focus on pricing strategies, product offerings, direct cost management, and by leveraging our operating structure.

We continued to see a normalized sales pace in the third quarter, with a rate of 3.2 sales per community per month, as compared to last year, with a 2.2 sales per month rate.

This level of activity produced 4,198 new orders.

And that's positioned us with a backlog of 4,513 homes.

Respectively, 44% and 79% year over year improvement.

In the context of these improving market conditions, many investors' questions have turned to the cost side of the equation.

Let me give you some color as to what we see going on in the field.

In the third quarter, we saw cost increases in all of our markets.

The level of these increases range from $2,000 to $3,000 per home.

And an average totaled about $2,400 per home or just over $1 per square foot.

This equates to about 10 basis points of our average sales price.

Many of these increases are not yet reflected in our closings, as the timing of the effective date on each contract will vary.

Cost increases range by product type and from region to region depending upon the local supply/demand balances.

The material categories that have increased the most over the last year are lumber, drywall and concrete.

Together, these categories are up year over year about $0.75 per square foot.

In some markets labor constraints are also contributing to the increasing costs.

This is most commonly seen in framing and drywall labor.

As an offset, we continue to implement cost reductions with the systems and controls we put in place during the downturn.

Through a nationally driven purchasing process, we have achieved savings that reduce the impact of these cost increases.

Through our process for analyzing field construction variances, we have reduced material quantities used in our homes saving about $0.18 per square foot year over year.

Another example of this is our value engineering review on hardware and beams that has saved us about $0.22 per square foot.

Cycle time is another topic where we receive questions from investors.

While to date our average cycle time has remained level, there are areas with shortages of labor supply that could drive cycle time a little higher.

Markets like Phoenix, parts of Florida and Texas have labor shortages in some trades.

While other markets like the Inland Empire, Dallas and Charlotte have labor pools that have been able to absorb the increase in activity.

Again, we believe that our strong management team will mitigate most of the impact of these labor shortages.

While construction costs are trending up as the market normalizes, we are finding the opportunity to improve our sales prices.

Sales pricing appears to be reverting back to normal market conditions.

Prices had over-corrected during the downturn, dropping by as much as 25% to 30%.

So the 4% year over year improvement in our average sales price represents a continuation of an adjustment.

Not back to peak conditions, but to a more normal market condition.

The opportunity to improve prices comes from a combination of reducing incentives and raising prices.

Our average incentives for the third quarter were down to 9.2%, a 280 basis point improvement.

Our average sales price was $258,000, an improvement of $11,000 over last year.

We expect as pricing returns to normal, we will be able to cover cost increases and deliver the high level of gross margin we achieved in the third quarter as we move forward.

With our increased volume, we continue to leverage our operating structure.

With deliveries up 28% year over year, our SG&A dropped to 12% of revenues, a 230 basis point improvement.

Again, the disciplines put in place during the downturn help us manage our overhead as conditions improve.

An example of this is our advertising spend where we reduced our total advertising costs by 25% year over year, and 12% sequentially.

This drop represents 70 basis points of the 230 basis point reduction in SG&A.

As market conditions improve, we're quick to address our advertising and other selling costs that were no longer necessary.

As we look forward, we believe our management team and the systems and controls we have in place from the reengineering of our Company during the downturn will work to provide industry-leading operating margins.

Thank you.

And I'd now like to turn it over to Rick.

Thanks, Jon.

We're really pleased with the operating results we had this quarter.

These results were driven by both the well-executed land acquisition strategy and a fine-tuned homebuilding machine.

As in prior quarters, I'm going to review our land activities and explain why Lennar's positioned to succeed in today's recovering market.

During the quarter, we continued to focus on acquiring or optioning new home sites that would have a positive impact on our bottom line.

This quarter we purchased approximately 8,300 home sites for $339 million, and we spent about $81 million on land development.

Combined, our land acquisition and land development spend was up about 67% over the prior-year period.

In addition, we signed contracts to acquire approximately 8,000 home sites.

From a geographic standpoint, approximately 55% of our land spend in the third quarter was located in the West, 14% in Florida, 13% in Texas, 7% in the Mid-Atlantic with the remaining 11% spread throughout our other markets.

The lion's share of our new land deals were sourced outside of the competitive bid environment and were relationship-based deals.

As in prior quarters, money was invested geographically in the markets we saw the best opportunities.

In Q3, we invested heavily in the West, particularly in California.

We also continued to invest in some unique, high-margin opportunities in Florida and Texas, two of our strongest markets.

You will continue to see quarter-to-quarter changes in the geographic mix of our land purchases, as we capitalize on the best opportunities out there.

While the land market has heated up, we found no shortage of great opportunities.

Strategically, we are still pursuing finished home site deals, which in today's market provide a higher return on investment in exchange for a somewhat lower gross margin.

The risk-reward associated with these deals is still very compelling, especially given the operating leverage we have today in our Company.

These deals can be brought online very quickly without any significant overhead.

And the profits fall right to the bottom line.

However, the better-located finished home site deals are getting harder to find because the land development and entitlement business shut down in the depth of the market decline.

Nonetheless, the deep-rooted relationships we formed with land sellers during the market turmoil positions us extremely well in locking up what is available.

Recognizing this inevitable shortage, for the past several years we have been aggressively tying up high-margin, low-cost deals where Lennar will develop the land internally.

Under the radar, while many of the other builders were focused solely on purchasing finished home sites, we have amassed some incredible properties across the country in A-plus locations where finished home sites are running scarce.

We started by acquiring large-scale busted development deals where much of the infrastructure was already in the ground.

In these deals the development costs are relatively modest, and finished home sites can be brought on and produced relatively quickly.

We then moved to early-stage raw land opportunities that required adjustments in zoning and other entitlements in order to work in today's market.

Many of these were in-fill locations.

In these deals we tied up the property and invested our intellectual capital by working with land sellers, towns and municipalities to create win-win programs.

In each case, these deals provide us with low-cost finished home sites in Class A locations where there will be very little new for-sale housing close by.

The good news is that many of these deals are coming online now and will continue to do so throughout 2013.

At August 31, 2012, we owned and controlled approximately 124,000 home sites, and had 444 active communities.

We should end the fiscal year with about 480 active communities, many of which will be coming online late in the fourth quarter.

Our community count by the end of 2013 should grow by approximately 15%, based on the deals we have in hand today.

We also expect that about 25% of these new communities will be legacy or mothballed communities where we already own the land and have waited for market values to recover.

We're excited to bring these inactive communities to the market.

As we move into 2013, while our focus to date has been on maintaining community count and increasing absorptions per community, our focus today has shifted to increasing both community count and absorptions.

We are operating very efficiently today.

And with the added fuel from our newer land deals, our operating leverage will be substantial.

We have been relentless in our pursuit of new opportunities.

And I'd like to thank our people for their hard work and dedication.

Simply put, they are in a league of their own.

Before I turn it over to Jeff, let me give you some final stats.

On a year over year basis, our inventory at the end of the third quarter increased by about $845 million to approximately $4.7 billion.

And this excludes consolidated inventory not owned.

Sequentially during the third quarter, our inventory increased about $276 million from the second quarter.

During the third quarter, approximately 51% of our deliveries came from communities purchased or put under contract during the last three years.

Our gross margin on the closings from these new communities has continued to exceed the Company average by about 200 basis points.

I'd like to turn it to Jeff.

Thanks, Rick.

And good morning, everyone.

During the current quarter, Rialto contributed $7.7 million of earnings to the Company.

While Bruce will walk you through in more detail the components of our contribution, the bulk of our earnings are from our growing investment management business, where we invest both our capital and that of third parties in funds and other vehicles.

We participate in our share of the income from our investments in these vehicles, as well as the fees and carried interest we receive related to managing those investments.

As an example, this quarter we effectively wrapped up the bulk of our first vehicle, our public-private investment fund in partnership with the US Department of Treasury.

During the 2.5 year life of our $4.6 billion PPIP fund, we had on average $61 million of our equity outstanding as an investor in the Fund that we helped to manage.

Effective today we've now recycled back in cash from interest income, capital gains, fees and carried interest almost $110 million.

While generating a 25% internal rate of return.

In addition, now that this very successful program has wrapped up, with almost $16 million of earnings this quarter, the volatility associated with mark-to-market accounting has been eliminated.

Similarly, our Rialto Real Estate Fund with $700 million of private equity commitments, including $75 million from us, had another strong quarter, contributing $10.6 million from our share of the Fund's underlying earnings, plus our fees and reimbursements.

All of our distressed debt investments since the Fund's first closing in late 2010 have been made through this vehicle.

We've now culled all of the Fund's original equity commitments to acquire in 44 separate transactions about $2 billion of assets based on unpaid principal balance and for less than $0.40 on the $1.

So far, we've done extremely well, exceeding our original underwriting and taking in over $275 million from asset resolutions, interest and property income, principal paydowns and financings.

These cash collections have allowed us to recycle equity into new fund investments beyond the original $700 million of commitments, even as we work on raising and closing our next real estate fund.

At the end of June, the net asset value for the Fund represented over a 27% net internal rate of return for our investors.

In addition, if we continue on this path on performance, we would expect to exceed the return hurdles set for our investors.

Which means that over time, carried interest would inure to Rialto as the manager of the Fund.

None of that potential value is represented in our earnings today.

Our pipeline of new investments also continues to be strong as the relationships we have built with sellers have put us in an advantageous position.

These relationships have also led to perhaps the most significant and unexpected contribution that Rialto has added to the Lennar enterprise.

As Stuart and Rick have already indicated, the invaluable access to lenders and distressed borrowers has helped to drive our primary Homebuilding business.

Together we've been able to add thousands of advantageously-priced home sites across dozens of new Lennar communities in multiple markets, and with more in the pipeline.

Our early on-balance sheet investments, however, continue to lag as the sluggish environment has slowed revenues.

In addition, broad government oversight and involvement has increased our cost to levels we had not anticipated.

We're finding that a number of borrowers and guarantors in our earlier deals, emboldened by the long delays available in the judicial system, and sympathetic legislatures, have been taking obstinate positions about repaying their personally-guaranteed loans.

Or electing not to perform after agreeing with us on restructured loan terms.

The related higher costs involved including those from owning and managing over $2 billion by principal balance of foreclosed properties must be expensed up-front.

While revenue recognition is delayed until resolutions or sales occur in future periods.

This extended timing and anticipated reduction in net collections, primarily in our FDIC portfolios, was reflected in a top-to-bottom review we just completed.

And is what drove the impairments we recognized this quarter, and which Bruce will also cover in more detail.

It's worth noting we're not seeing anything similar with our later investments, as we have recalibrated our newer purchases to this environment, have focused our efforts on buying directly from banks.

And purposely selected loans secured by vertical collateral, often with in-place operating cash flow, as compared with the significant land component in our earlier transactions.

Nonetheless, we remain very focused on these balance sheet investments to create long-term value and bring cash back to the Company to be recycled.

Overall, we've already collected over $700 million of cash from these investments to date.

The biggest component of that relates to the FDIC transactions where we have approximately $211 million left in net collection, in order to fully repay the original $627 million of seller financing.

After which we'd begin receiving cash distributions.

As we look forward, without the volatility from our PPIP investment, our future fund investment business should not only help to enhance the Company's returns and add more consistent cash flow and earnings, but also be an important building block for us to create a valuable investment management platform.

Our ability to add new sources of business in our already existing management base of over 200 professionals, our current position in the marketplace and the synergies with the rest of the Lennar operations, we expect in due course will be reflected in growing value for our shareholders.

We're excited about the future and look forward to reporting to you on our progress.

Thank you.

Bruce?

Thanks, Jeff, and good morning.

I'll provide a little more color to the results, starting with Homebuilding.

The Company's average sales price that increased 4% year over year to $258,000, I'd like to give a breakdown by region.

The East region was $245,000, up 11%.

Southeast Florida was $278,000, up 1%.

Central, $225,000, up 1%.

Houston, $236,000, up 3%.

West region, $299,000, down 1%.

Other, $358,000, down 5%.

Jon and Rick already highlighted the drivers of our strong gross margin performance and significant operating leverage during the quarter.

So I'm going of to turn to the Financial Services segment.

We had a good quarter in Financial Services, generating operating earnings of $25.3 million versus $8 million last year.

The third quarter is typically the strongest quarter of the year for the Financial Services segment.

And it was helped further this year with the strong refinance environment leading to higher volumes and strong operating leverage.

Mortgage pretax income increased to $22.3 million from $7.4 million in the prior year.

This quarter's mortgage originations increased by 72% to $1.3 billion.

Our in-house mortgage capture rate of Lennar home buyers was 75% this quarter.

Originations with non-Lennar home buyers increased 116% this quarter, primarily due to an increase in the number of refinance transactions.

Our title company had a $3.6 million profit in Q3.

And that compared with $1.3 million in the prior year.

This was driven by a 35% increase in revenues.

Our Rialto business segment that Jeff talked about generated operating earnings of $7.7 million.

And, again, this number is net of $13.4 million of net loss attributable to the non-controlling interest.

As you remember, we have to consolidate the FDIC transaction.

And this compares to $5.7 million in the prior year.

Let me go through the composition of Rialto's $7.7 million of operating earnings by type of investment.

Our PPIP investment contributed $16 million of earnings.

And this includes profits from interest income, sale of securities, and management promote fees.

Our first Rialto real estate fund contributed $6.2 million of earnings this quarter.

The FDIC transactions had a $7.8 million loss during the quarter.

The non-FDIC portfolios had a $0.5 million dollar loss.

And these amounts were reduced by approximately $6.2 million of general and administrative expenses and other, which is net of management fees and reimbursement of $6.7 million.

The $7.8 million FDIC loss was due to impairments during the quarter.

Each quarter we review all the cash flows in the FDIC deal.

And due to some changes in timing and reduction in cash flows, we recorded $20 million of impairments in the FDIC portfolios, with our share totaling approximately $8 million.

Rialto continues to generate strong cash flow.

At quarter end, the FDIC debt net of cash available in the [fee sense] account and in Rialto's cash account was $211 million.

As Stuart highlighted, we have been focusing on recycling capital invested in Rialto back to Lennar, And in the third quarter we returned approximately $70 million from the PPIP.

And this now reduces Lennar's total investment in Rialto to approximately $530 million.

Turning to taxes.

This quarter we reversed $44 million of the remaining $177 million deferred tax asset reserve.

And we continue to believe most of the remainder will reverse by the end of 2013.

We expect there will be enough reversal of the DTA reserve in Q4 to offset any tax expense.

Our balance sheet liquidity improved in the third quarter with $692 million of cash.

And no outstanding borrowings under our $525 million, three-year unsecured revolving credit facility.

The committed portion of the facility has been increased to $500 million subsequent to quarter end.

We continued our balance sheet strategy of pushing out debt maturities, while reducing our cost of capital, as we raised $400 million of 4.75% senior notes due 2017.

And simultaneously tendered for $205 million of 5.95% notes due 2013.

We took a charge of $6.5 million relating to the successful tender in the current quarter.

Let me turn it open for questions now.

(Operator Instructions).

Michael Rehaut of JPMC.

Thanks.

Good morning, everyone.

Great quarter.

First question on the margins.

They continue to surprise on the upside, the gross margins as well as the SG&A leverage.

You're at 11% roughly this quarter, bumping up against what you would consider normal versus the previous cycle.

I know you've discussed perhaps gross margins maybe moving into the mid-20%s over the next couple of years.

Is that still your view?

And how do you think about, quote-unquote, normalized operating margins in the next two, three years?

Mike, we're really holding short of looking too far ahead and projecting future sales deliveries and margins.

And I think that we certainly don't want to get ahead of ourselves or encourage anybody to get ahead of where we are.

What we are seeing is strength in our numbers.

We have an improving environment that is yielding increased pricing, but also increased costs.

We've made some very important strategic land acquisitions.

We have some mothballed communities coming back online.

There are a number of positives but we're still working through an uneven recovery.

So I don't want to answer the question by guiding to a gross margin range.

But as we sit here today, the outlook is fairly positive with increased volumes and a good strategic position.

All right.

I appreciate that.

Second question, (inaudible - technical difficulty), mortgage approval process has stabilized and even marginally has begun to get better.

We actually saw last week, we were with another builder that pointed to actually a new mortgage product out there, which is the first we've heard in some time.

I was wondering if you could elaborate on your remarks in terms of either if you're seeing either new mortgage products out there or the approval process.

Elaborate on how it's getting better, either from a paperwork standpoint, perhaps, or just standards overall.

Okay.

Let me take that, Mike.

As we highlighted, first of all, from the mortgage approval process, appraisers have been cooperating with the price increases that we've been seeing coming through.

So that's been helpful in the process in terms of the mortgage approval process for the full amount of what we're selling the homes for.

We're seeing people coming out of the penalty box, as far as some of the short sale and foreclosures where they were put aside until they eliminated that.

Income levels have been improving.

And in general we're seeing the trend positive in terms of approval percentages.

I don't know, Rick, if you want to add anything to that.

No, I think it's just been we're seeing quality buyers out there that really want to execute.

The process has gotten more streamlined of recent.

And things are going in the right direction.

So still tough, but definitely gotten much better over the last quarter or so.

Great.

Thank you.

Ivy Zelman, Zelman & Associates.

It's actually Alan on for Ivy.

Great quarter.

First question is just on the corporate G&A.

I know you highlighted in the press release that there was an increase there from some increase in share-based and variable comp.

Is there any color you can give us on how to think about that going forward?

I know you indicated it's about 2.9% of revenues.

Is that a good bogey to use or should we think about that maybe as a percentage of EBITDA or share price or some other way that we can model that going forward?

Sure, Alan.

This quarter, because of the success we had with the bottom line, that ties directly into the way that we're compensating our management team, which is bottom-line profitability.

So the variable compensation expense is what drove the majority of the core G&A increase.

And then we also, this quarter there were some shares that were issued, as well.

So that there was some share-based compensation expense that hit, as well.

I do want to tell you that there's still been tremendous focus on G&A at both the corporate and the field level.

And we think there's going to be leverage as our volume picks up.

But there is a component that's tied to the bottom line profitability with the variable comp expense.

As far as an exact percentage, we came from the low 1%s.

We're at 2.9% now.

I think over time, as volume picks up, that percentage should come down because a lot of that corporate G&A expense is not tied to volume increasing or profitability growing.

So I do think we'll get leverage.

I don't have an exact percentage to give you right now, but I think over time we'll continue to migrate down off of that 2.9% going forward.

Great.

That's helpful.

Thank you.

And on the Financial Service side on the mortgage business, can you give us any color on the composition or types of re-fi loans that you're doing today?

Where are those loans generally sourced from?

And does the composition in terms of split between FHA, GSEs, LTVs, are they similar to your purchase side on the Homebuilding business or is there any difference there?

There is a lower percentage of FHA/VA as you're looking at the re-fi business.

I don't have the exact percent on the re-fi business.

Our FHA percentage came down this quarter, if you look at a combined FHA/VA, down to about 53%.

And of that 53%, FHA was 37%, and VA was about 16%, of that 53% number.

So the sourcing of that business, it's being sourced by our loan consultants in the field.

As you remember, we had a company called Eagle Mortgage that we combined into Universal American Mortgage, and we have loan consultants around the country that are focused in driving that business.

And any difference in terms of LTVs or anything, FICO scores, credit quality?

No, I wouldn't say that there's a lot of difference, other than as far as LTV in a refinance you're going to have a lower LTV than you will, because you're going to have less FHA business, less purchase business.

So we're dealing with highly-qualified buyers.

FICO scores and credit quality remains high.

Those people that are able to refinance do have good credit today.

Okay.

Thanks a lot.

Stephen Kim of Barclays.

Good quarter.

Just wanted to ask you a question with respect to your pricing power that you're beginning to see.

Obviously, some of that is a broad statement about the market.

But also, you've done a number of things operationally that are Company-specific, as well.

Notably some of your product offerings are a bit different from your peers.

I was wondering if you've done an analysis on the degree to which you believe some of the shifts you've made, or the difference that exists in your product offering versus your peers -- think of things like NextGen and your Everything's Included and so forth -- to what degree that may have led you to enjoy better price appreciation than the broader market.

There's no question, good product sells for a higher price.

And we've been very successful in introducing new plans.

Our NextGen plans, the home within a home, has been selling incredibly well and commands a premium in the marketplace.

Our EI packages, our EI platform, is doing extremely well too, especially in an environment where you've got labor issues in order to get things built.

They're easier to build.

They're faster to build.

We take the confusion out of the selection process.

And as a result, we command very decent pricing for that.

We've instituted price increases across the board.

And the good news is they're sticking.

And we've been consistently pushing prices up really every month.

We don't want to kill the momentum out there, but at the same point in time we're very focused on the bottom line right now.

Just let me add to that.

The pricing side of the equation is not the only part that product is instrumental in driving.

Just as Rick was talking, relative to our EI platform, we've consistently said that EI enables not only an easier and more orderly program for construction, but it also helps us contain the natural trend upward in construction cost.

And so while pricing is reverting to normal and moving up, so too are costs.

And our EI platform, our product strategy is really helping us to contain that by keeping a simple program in the field and a consistent kind of SKU purchase that enables us to negotiate costs a little bit better.

Great.

Rick, I notice you didn't actually give me any numbers to work with, but that's 's all right.

We'll follow up later.

Following up, though, Stuart, on your comments there about efficiency.

That really touched on something that I think folks are going to be wrestling with over the next couple of years.

There's a general presumption in the market that homebuilding doesn't really lend itself to economies of scale.

And certainly all the things that you just talked about, would seem to argue that there are.

I think it's going to be one of the major determinants of just how high your operating margins can get this cycle.

In that regard, I've been thinking about the evolution of the business over the last 10 years or so.

And it seems to me that the business has seen the opportunity to extract economies of scale through the use of management technology and the information technology and information sharing across regions, in a way that didn't exist 15 years ago.

But at the peak of the market you guys were so frenzied that my sense is you really didn't have the opportunity to fully explore those opportunities.

So this upturn is really the first period where we're going to actually see the potential to extract economies of scale that have been made available through improvements in information sharing and so forth across regions.

Do you agree with that general view?

And if so, could you give us some sense, not just of what you're doing now, but what you are doing now that you couldn't do before at the peak of the cycle, to give us some sense of where operational efficiency may lead to higher margins?

This is Rick and then I'll flip it over to Jon.

Just a couple of examples, and maybe to back up.

During the depth of the market decline, it was a tough experience for all of us but it gave us an opportunity to completely restructure the way we do business.

We went from purchasing materials in every division to centrally locating our regional operating centers.

So right now we've got 3 instead of 27 or 30 purchasing centers.

And the visibility that we have across the country is just tremendous, Steve.

Another example of it is that during the downturn, we were able to debundle labor and materials.

We were purchasing things in the heat of the market on a turnkey basis and now we've separated those two things into different cost components.

Once you start doing that, it's tough for the trades to get back into a turnkey type of program.

But those are some examples of how things that we've done during the downturn, things we're focused on continuing today that give us an incredible amount of operating leverage as things start to grow.

Jon, any other thoughts?

Sure.

The unbundling point that Rick mentioned, tied together with software and technology that enables us to do take-offs and estimates of our plans much faster than we were able to before, really gives us a clarity into the details of purchasing that we didn't have before.

And when things are moving very fast it's hard to implement those.

When things were slower we were able to implement those.

I think as things continue to pick up, that will pay off from our ability to really track material usage and shift materials quickly when we need to.

And then on a pure technology side, today we have rolled out iPads in the field and our construction managers are able to communicate very quickly with architects and engineers, find solutions, communicate information.

Things that used to take a couple days perhaps can now get solved in a matter of minutes.

All those will add to our efficiency.

So direct answer, we're thinking as we look ahead that there will be economies of scale that reveal themselves in this recovery differently than we've seen in the past.

It is a combination of technology and the adjustments that we've made to our operating platform.

And all of this dovetails very well with our Everything's Included operating program.

Great.

Thanks a lot, guys.

Steve East, ISI Group.

Stuart, if we stay on the cost a little bit, could you just give us an idea of what type of inflation you're seeing right now coming through your income statement?

And just rank order between the material costs, the labor costs and the land inflation.

And then looking at the land what you're trying to buy now.

Rick, you talked a lot about it.

What type of inflation are you seeing in land on a year-over-year basis?

Okay.

Steve, Jon reviewed a couple of those construction concepts.

I'm going to toss it over to him and then Rick will come back on the land side.

When you look at what's happened with the material cost, you've seen the biggest increase in lumber where that represents about 7.5% of our construction spend.

And you've seen that go up anywhere in the 20%, 25% range.

And then you go down to other materials, most of them represent 2% or 3% of the total spend.

And in total, I think we've seen probably about a 5% increase.

And because that represents about 42% of our sales price, it doesn't have a big impact if any one item goes up on our margins.

Okay.

And then on the land side of that equation?

Steve, one thing to keep in mind as you look at us and you think about the land, a lot of the stuff that we're purchasing today was put under contract a year, two years, three years ago.

And so it's coming on balance sheet at prices that are sub where market is today.

The things we're contracting for today, if they're finished home sites, that's immediate -- that's a retail type of purchase, and we're still able to command 20% gross margins in that stuff.

Prices are up over a year or two ago, maybe 5% to 10% in various cases.

But you've got to keep in mind that those are high ROI deals that move very quickly.

So your operating leverage is tremendous if you can get good finished home sites.

As far as the raw land deals that we're doing right now, there's still a shortage of folks out there that are pursuing those because there's different philosophies as to whether you want to internally develop or buy from other folks.

We've been very aggressive in purchasing all throughout the continuum of the land curve.

I've said it before.

We are, I think, the best land company out there.

And you've seen some of the jobs we've brought on, Steve.

It's tremendous.

Okay.

I appreciate that.

That's helpful.

And then if we look at, Stuart, just looking at your segments and geographically the comparative nature of your business, what's going on and what you're seeing.

And then just an update on your second fund in Rialto, where you stand with it.

Relative to the second fund in Rialto, because we're in a quiet period relative to that fund, I really can't comment on that.

The one thing I will comment on in that regard is Fund I, as Jeff reported, is really performing at a very high level.

We have continued to generate an extraordinary pipeline of potential deals and that continues to enable us to invest very attractively the remaining funds in Fund I. And it leaves for us a nice backlog of opportunities that are already identified and in line to begin Fund II, as it is raised.

I really can't give any color beyond that.

And the first part of your question was?

Just looking at geographically and in maybe price point segment, what you're seeing across the country.

Okay.

I just want to highlight that that was a compound question with unrelated pieces.

We notice that.

I was trying to fit the Fund II in there.

Okay.

The shoehorn.

In any case, relative to, regionally, I've highlighted that the recovery of markets is pretty much across the country right now, but it's pocketed.

And we continue to see pockets of strength in all of the major markets across the country and it's expanding from there.

So I really wouldn't highlight one region versus another as outperforming.

We do see strength in places like Florida and some of the Eastern seaboard markets.

In California, some of the markets are coming back stronger than others.

In terms of price point, we still see a trend in favor of move-up purchasers.

The lower end is still a little bit more constrained.

But there is a recovery going on in a broad-based way across the country.

It's just very pocketed and very locally focused.

All right.

Thank you very much.

Ken Zener, KeyBanc.

I wonder if you could clarify, of the 124,000 owned controlled lots, what percent of those are owned.

I think last quarter it was 100,000.

And the breakdown of your finished lots versus your mothballed lots.

Sure.

Out of the 124,000, Ken, about 106,000 are owned.

And the rest are controlled.

And as far as the finished home sites you asked, finished home sites, let me give you a dollar amount because we don't typically break out the number as far as home sites go.

Finished home sites have been running about $540 million, as far as a pure finished home site.

If a home site is in progress, construction in progress, there will be a component of finished home sites included in our CIP, as well.

That's not broken out.

Right.

So what I find interesting is, I think, given your 8,000 purchases this quarter, if my math's right you've done about 48,500 lots in the last three years, which would be half of your owned inventory.

Can you describe, just to be clear, your community count of 444, does that include just owned or is that owned and optioned?

And how does that work out as you open up your mothballed communities next year?

What's the margin you're seeing on those?

Let me just highlight the way that we call an active community.

Any time a community has five or more homes to sell, and it's actively selling, we call it an active community.

And that's what makes up the 444 number that Rick gave you.

If we're not building in a community and don't have an ongoing sales presence, construction activity, it's not in our community count.

The second question was on the 25% of the --?

Right, what the incremental -- to the extent you're saying your new lots were coming in at 200 basis points above your benchmark, how are you seeing the mothballed component come on?

It's pretty much in that line.

The new things are about 200 basis points higher than the overall average for the Company.

As we bring in the legacy or inactive communities, it starts off a little slow because we want to build momentum, then generally we bring pricing back up.

You've got to keep in mind that we hung on to these communities for good reason, because we knew that the markets would come back.

We took appropriate value hits on the assets.

And we don't want to start selling them too cheap, so we're waiting for the appropriate time to bring them onboard.

What percent of the mothballed is represented in this new openings next year?

Thank you.

I don't have that with me right now.

Thank you.

Joshua Pollard, Goldman Sachs.

The first one was, in your prepared remarks you said that there was a little bit more visibility in planning your business.

Can you talk specifically about what you guys are expecting for next year in terms of community absorption rates?

I think it was 3.2 this quarter versus 2.2 last year.

You're talking about 40% growth just on that metric.

That's before you start getting into community count.

So could you talk a little bit about what you're expecting there?

And also what you guys are looking for in terms of price increases and whether or not the 8% in your backlog is a good precursor.

Josh, we knew that that remark might spur this kind of question.

We're really not ready to start going out and giving too much forward-looking guidance.

And we're still keeping our view fairly short, recognizing that we are in the initial stages of recovery.

What we're really seeing is a sense of consistency starting to present itself.

And so, as we look ahead, rather than that very rocky bottom that we endured for quite a long period of time, we're starting to see a lot of consistency in our quarter-over-quarter movements.

And are able to do some better planning around that, expecting that we're likely to see more consistency going forward and more stability in the way things look ahead rather than saying that we're going to get out over our skis and start projecting.

So we're not really giving guidance as we go ahead.

But we are saying that we do have a good sense that the market, as we look over the next quarters, is likely to show some consistent trends with what we've been seeing.

Stuart, that brings up an interesting question.

Back in '05 when I first picked up this group, the entire group used to give guidance.

What things do you guys need to see before you'll start feeling a level of confidence to give guidance to investors again?

Oh, boy.

I'm going to let Bruce answer that.

(Laughter) Sorry, Bruce, I was leaving that one for Stuart.

Look, as we go forward, I think we'll have to look at the environment as we go.

But we've given some guidance with gross margin as we've had stability.

We don't have the land impairments that we've had to deal with.

We're seeing the ability to raise prices.

So we've given some level of our thoughts on gross margin.

As far as activity going forward, I think when there's more clarity as to how many of the communities are actually coming out, and how much the sales pace might be changing, it will be a lot easier for us to give guidance because there's so much operating leverage.

The volume's going to drive a lot of what we might guide.

So I think we're going to look at this again very closely.

We're in the middle of our planning season.

And with the next quarterly conference call, after we come out of the planning season, we're going to be discussing what kind of metrics we could give for next year.

Okay.

Sounds good.

Last question around your gross margins.

You said 200 basis points spread between your newer land and your older land at 23.5.

That simply says 24.5 and 22.5.

But what I'm trying to understand is how low are you guys willing to go on high turnover, high returns land?

What are the gross margin metrics?

And how low are you guys willing to go on that metric?

And then I want to understand if your mothballed land, because of the write-downs, ends up at the higher end of that spectrum or the lower end, because I think it's somewhere in the middle.

Mothballed, you guys could have taken a lot of write-downs versus it being older land.

I'm not sure if mothballed land is something that we should be thinking of as additive to gross margins or a bit of a detractor.

Wow, that's a lot of questions within one.

I'm joining the crowd.

You tricky guy, you.

Okay.

With regard to the finished lots or finished home site opportunities that are high ROI and lower grosses, I don't want to really give you a number, for competitive reasons, as to where I would draw that threshold because that gets into overall strategy.

But what I can tell you is that depending on the number of communities, the proximity of that community to another community that we're operating in, Josh, we would be willing to work with a lower margin because the overhead, the incremental overhead is de minimis.

So if we're drawing that line from an underwriting standpoint at basically 20%, which is what the basic threshold is across the country today, it would be below that but not much.

With regard to the margin and the gross margins in our mothballed communities, I'd tell you that there would be some that are high and there would be some that are below.

All of them have been appropriately impaired.

But as you have some things that were mothballed, there could be some just A locations in there that we chose to not bring online, because we knew that the market would be really strong at some point down the road and we would be selling them too cheap.

Those would be infill locations that we just decided to sit on.

Thanks for your help, guys.

Steve Stelmach, FBR.

Just real quick, two questions.

One on the FDIC impairment.

I know earlier I inferred maybe you guys mentioned the political process slowing receipts in some of those issues.

The IG audit, I believe, was due in August.

Did that have any impact on that $20 million impairment or was that a completely, entirely separate evaluation on your part?

This is Jeff.

No impact.

Totally separate.

Okay.

Did you receive the results of that audit?

I know you guys have been strong partners with the FDIC.

And it seemed more politically-driven than FDIC-driven.

I personally have not seen the final report yet.

It may have been issued but I have not seen it yet.

I did see a draft.

Got it, okay.

And then the second question goes back to the economies of scale question.

When I think about your operating business, I think about it more, the operating leverage, more in terms of your land acquisition strategy, your balance sheet financing leverage.

Economies of scale, while positive and ncremental, is that more of a secondary and tertiary issue versus the others?

How should I think about that?

The operating scale is actually a very big issue.

To the extent that you bring on additional communities or you bring on additional sales per community, the incremental overhead that you have by bringing on a new community is basically the builder that you have in that community, the cost of the model in that community, and the variable sales commissions associated with the sale.

To the extent that you can add a community that will generate 100 closings in a year, that's a lot of money that pumps down to the bottom line.

So the revenue associated with that allows us to spread the overhead across all the units.

I think the metric that we think about is that when you add absorption per community, you're only adding about 4% of SG&A.

When you add a new community, an additional community, whether it's a retail developed home site community or otherwise, you're adding about an incremental 7% -- 7% to 8%.

and that compares to where we are right now, 12%.

So that's where you're seeing your operating leverage, is either in increasing absorption or increasing the number of communities within already existing divisions.

And it works in combination with all those other factors, sales price and otherwise.

Understood.

Great.

Thank you, guys.

Okay.

Great.

So that will wrap up our third-quarter conference call.

We look forward to reporting back as we close out our year-end and look forward to a continuation of recovery in the housing market.

Thank you.

This will conclude today's conference.

All parties may disconnect at this time.