LGI Homes Inc (LGIH) 2017 Q4 法說會逐字稿

Welcome to the LGI Homes Fourth Quarter 2017 conference call. Today's call is being recorded, and a replay will be available on the company's website later today at www.lgihomes.com. We have allocated an hour for prepared remarks and Q&A. (Operator Instructions) At this time, I will turn the call over to Rachel Eaton, Chief Marketing Officer at LGI Homes. Ms. Eaton, you may begin.

Thank you. Welcome to the LGI Homes conference call discussing our results for the fourth quarter and full year of 2017. Today's conference call will contain forward-looking statements that include, among other things, statements regarding LGI's business strategy, outlook, plans, objectives and guidance for 2018. All such statements reflect current expectations. However, they do involve assumptions, estimates and other risks and uncertainties that could cause our expectations to prove to be incorrect. You should review our filings with the SEC, including our Risk Factors and Cautionary Statement about Forward-Looking Statements section for a discussion of the risks, uncertainties and other factors that could cause our actual results to differ materially from those anticipated in these forward-looking statements. These forward-looking statements are not guarantees of future performance. You should consider these forward-looking statements in light of the related risks, and you should not place undue reliance on these forward-looking statements, which speak only as of the date of this conference call. Additionally, adjusted gross margin and non-GAAP financial measure will be discussed on this conference call. The presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. A reconciliation of adjusted gross margin to gross margin, the most comparable measure prepared in accordance with GAAP, is included in the earnings press release that we issued this morning and in our annual report on Form 10-K for the fiscal year ended December 31, 2017, that we expect to file with the SEC later today. This filing will be accessible on the SEC's website and in the Investor section of our website at lgihomes.com. Joining me today are Eric Lipar, LGI Homes' Chief Executive Officer; and Charles Merdian, the company's Chief Financial Officer. With that, I will now turn the call over to Eric.

Thank you, Rachel, and welcome to everyone on this call. We appreciate your continued interest in LGI Homes. 2017 marked our fourth full year as a public company. Our primary objective when we went public in 2013 was to access the capital markets to fuel our growth by replicating our business model across the country. Over the past 4 years, we have more than tripled the size of our organization, and today, LGI Homes are signing across 11 states and 21 markets, and we have startup operations in 4 additional new markets, including Sacramento, Oklahoma City, Birmingham and Las Vegas. As we have continued to grow, we have maintained the LGI culture, demonstrating that our unique operating model is sustainable. Our employees are our most vital assets and continue to make the difference. It is through the dedication and outstanding performance of our employees that we are able to leverage our systems and processes to deliver exceptional customer service and, ultimately, sales and closings. So to all of our LGI employees, we appreciate and thank you for your commitments, loyalty and hard work, which have produced another year of record-setting results.

During today's call, I will summarize the highlights from the fourth quarter and our 2017 full year results, followed by Charles discussing our financial results in more detail. After he is done, we will conclude with comments on what we are seeing this quarter and our expectations for 2018 before we open the call for questions.

At the start of 2017, we provided guidance, announcing our expectations to deliver more than 4,700 home closings and to have between 75 to 80 active communities by the end of the year. In addition, we provided guidance that we would deliver basic earnings per share to our investors in the range of $4 to $4.50, all while maintaining our gross margin at or near industry-leading levels between 25% and 27% and adjusted gross margin between 26.5% and 28.5%. As reported during the year, we increased and refined our guidance for both closings and EPS. Today, I am pleased to announce that for 2017, we met or exceeded our guidance in all areas.

We ended 2017 with a record 5,845 closings, exceeding our initial guidance of more than 4,700 closings by more than 1,100. Driving this record performance for the year was our record-breaking fourth quarter of 1,844 closings, including 770 closings for the month of December. For the year, we averaged 6.7 closings per community per month company-wide. This is the highest level we have experienced on an annual basis since we became a public company.

2017 demonstrated our ability to produce strong absorption rates as we continued to expand into new markets. Our top market on a closings per community basis was Fort Myers at 9.7 closings per month, followed by Dallas/Fort Worth at 9.5, Houston at 8.2, and San Antonio at 8 closings per month. Of the markets we operated in, with at least 2 active communities during 2017, all 16 of these markets achieved closing velocities greater than 4 closings per community per month.

Company-wide, active communities at the end of 2017 increased to 78 from 63. 11 of the 15 active communities added during the year were outside of our Texas markets, contributing to the further geographic diversification of our business. During 2017, our Southeast Division added 6 communities, our Central Division added 4, our Northwest Division added 2, and our Southwest Florida and Midwest Divisions added 1 community each. Consistent with our stated strategy, we continue to gain ground and demonstrate success in our non-Texas markets. For the fiscal year, the share of our home closings and our markets outside of Texas increased from 49% of our home closings in 2016 to 58% in 2017. Although our community count growth has been primarily outside the state of Texas, home closings for our Texas markets increased by 22% in 2017. In Florida, where we only added one net community, closings increased by 70% year-over-year. And in the Northwest, closings increased by 466% from 53 in 2016 to 300 in 2017.

Due to continued momentum and solid performance during 2017, we raised our basic earnings per share guidance twice during the year. As a result of our very strong fourth quarter, we exceeded the top end of our guidance range, ending the year with basic earnings per share of $5.24, a 45% increase above our $3.61 basic earnings per share for 2016.

During 2017, we had a goal of achieving $1 billion in home sales revenues. I am proud to report that we generated home sales revenue of nearly $1.3 billion during 2017, nearly 50% more than our 2016 home sales revenues. This growth was driven by a 40.4% increase in home closings, combined with a 6.9% increase in average sales price for the year, in line with our guidance.

For more detailed financial results, I will now turn it over to our Chief Financial Officer, Charles Merdian.

Thanks, Eric. Home sales revenue for the quarter were $405 million based on 1,844 homes closed, which represents a 71% increase over the fourth quarter of 2016. As Eric mentioned, home sales revenues for the year totaled nearly $1.3 billion, a new record for LGI.

Our average sales price was $219,618 for the fourth quarter, a 5.6% year-over-year increase, and a 3.8% increase over the third quarter. The increase in average sales price year-over-year reflects changes in product mix, favorable pricing environment and new or replacement communities added during 2017 that have higher price points. Sales prices realized from homes closed during the fourth quarter range from the 150s to the 530s. This includes 43 homes in our Terrata communities which had an average net sales price of approximately $416,000. For the year, we closed 108 homes in our Terrata communities, representing less than 2% of our overall closings. And we expect closings from our Terrata communities to continue to be less than 5% of our overall business in 2018.

This past year, we closed 201 wholesale units, generating $40.8 million in revenues in our communities. For the full year, wholesale units reduced our gross margins by approximately 30 basis points. We believe that our wholesale business is accretive to the overall business as operating margins are similar. Our expectation is that wholesale closings will account for approximately 5% of our business in 2018. Gross margin was 24.4% this quarter compared to 25.1% in the previous quarter and 27.2% for the same quarter last year. Our adjusted gross margin was 25.8% this quarter compared to 26.5% in the previous quarter and 28.5% for the fourth quarter of 2016. Gross margins were impacted in the second half of 2017 by increased production levels, increase in labor and materials and community mix offset by increases in home prices. Increasing our production, in many cases, required us to hire additional subcontractors and trades, increasing our costs in order to meet the production demand.

For the year, gross margin was 25.5% compared to 26.4% for the full year of 2016, and adjusted gross margin was 26.9% compared to 27.8% for the full year of 2016. Adjusted gross margin for the fourth quarter excludes approximately $5.9 million of capitalized interest charged to cost of sales during the quarter, representing 145 basis points. And we expect this to remain in the range between 130 to 160 basis points for the upcoming year.

Combined selling, general and administrative expenses for the fourth quarter were 10.8% of revenues and 12% for the full year. As a percentage of revenues, we believe that for the full year of 2018, we will continue to achieve operating leverage in our existing markets, offset by initial operating costs in new markets. Overall, we expect that we will see positive leverage with up to 40 basis point decrease in SG&A as a percentage of revenue this year, given our previously published closing guidance range. SG&A will vary quarter-to-quarter based on home sales revenue. And we typically expect the first quarter to have the highest SG&A ratio as our first quarter generally results in the lowest closings on a per community basis during the year.

Selling expenses were $28.6 million or 7.1% of home sales revenue compared to $18 million or 7.6% of home sales revenues for the fourth quarter of 2016, a 50 basis point improvement. Selling expenses as a percentage of home sales revenues remained consistent from the previous quarter.

General and administrative expenses were 3.8% of home sales revenue compared to 5.1% of home sales revenue for the fourth quarter of 2016, a 130 basis point improvement and the lowest percentage of home sales revenues since our IPO.

Pretax income for the quarter was $55 million or 13.6% of home sales revenue, an increase of 120 basis points over the same quarter in 2016. Year-over-year, pretax income was consistent at 13.6% of home sales revenue.

Our effective tax rate for the fourth quarter was slightly higher than previous quarters at approximately 35% due to a $1.1 million impact related to recent tax reform that resulted in a reduction in the value of our deferred tax assets. The impact is our most reasonable estimate based on our understanding of the Tax Cuts and Jobs Act and may change as more information becomes available. We believe, based on the information available at this time, that our effective tax rate for 2018 will range between 24.5% and 26% for the full year.

We generated net income of $35.6 million or 8.8% of home sales revenue for the fourth quarter of 2017, which represents earnings per share of $1.65 per basic share and $1.43 per diluted share. For the year, we generated net income of $113.3 million or $5.24 basic earnings per share and $4.73 diluted earnings per share.

Weighted shares outstanding for calculating diluted earnings per share are impacted by our outstanding convertible notes and, to a lesser extent, our stock compensation. In the fourth quarter of 2017, our average stock price was approximately $63.50, exceeding the conversion price, and therefore, the convertible notes were determined to be dilutive. This resulted in an approximate 2.6 million share increase to the weighted average shares outstanding for the diluted EPS calculation for the quarter.

Fourth quarter gross orders were 1,897, and net orders were 1,332. Ending backlog for the year was 816 homes, an 83% increase over the prior year-end. The cancellation rate for the fourth quarter was 29.8%. And for the year, our cancellation rate was 25.4%. We ended the quarter with a portfolio of approximately 39,700 owned and controlled lots. And as of December 31, approximately 11,700 of our 21,000 owned lots were either raw or under development.

As of December 31, we had approximately $68 million in cash, $919 million of real estate inventory and total assets of over $1 billion. At December 31, we had $400 million outstanding under our revolving credit facility, and our borrowing capacity was approximately $161 million. In addition, we had $85 million in convertible notes outstanding, our gross debt to capitalization was approximately 49% and net debt to capitalization was approximately 45%. During the fourth quarter, we completed our $25 million ATM or at-the-market equity program that was initiated in 2016. Approximately 87,000 shares were sold under the ATM program in the fourth quarter, generating net proceeds of $5.5 million. For the year, we sold approximately 355,000 shares under our 2016 ATM program, resulting in net proceeds of approximately $15.5 million. We ended 2017 with 21.8 million shares outstanding.

During the fourth quarter, we received conversion notices from the holders of $15 million in principal amount of our convertible notes. The notes were settled in January and February of this year, resulting in the payment of the $15 million principal amount and the issuance of approximately 500,000 shares of our common stock. There are $70 million in convertible notes remaining outstanding. At this point, I would like to turn it back over to Eric.

Thanks, Charles. In summary, we had another impressive quarter and a phenomenal 2017. This past year, we continued to see robust demand for home ownership. In 2017, we increased our digital marketing initiatives, driving quality traffic to our communities. Our new social media campaigns generated over 83,000 leads for the year, making up 26% of our total lead volume. We also saw increased inquiries from realtors due to a wider listing base on MLS, Craigslist and Zillow. For the year, realtors represented 30% of our total closings, up from less than 5% at the time of our IPO. In addition, we continue to use extensive print advertising to attract potential buyers, which continues to perform well for us. As we grow, we continue to explore new marketing initiatives to create additional efficiencies in our advertising spend. Advertising expense as a percentage of total home sales revenue for the year was 1.2%, which marks our fourth consecutive year of decreases.

Now let me provide some guidance and thoughts on what we are seeing for the upcoming year. The first quarter of 2018 is off to a solid start, with 277 closings in January representing a year-over-year increase of 61%. February will also be a strong month of closings. We expect to end this month with approximately 360 closings, representing an increase of more than 60% from last February's total of 224 home closings. Based on our strong performance to date and assuming a continuation of today's housing market conditions for the remainder of this year, we offer the following guidance.

As we've previously announced, we expect to close between 6,000 and 7,000 homes in 2018. We also plan to expand into 4 new markets this year: Oklahoma City, Birmingham, Sacramento and Las Vegas. Because we are a systems-based company with proven processes in place, we believe our expansions into these new markets are well-positioned for success. Our goal is to simply duplicate what we have accomplished thus far in our current markets. Our expectation is that each of these markets will perform at a high level, produce results consistent with our existing communities and will be accretive to our operations. We expect all 4 of these markets to have closings in 2018. We believe our average sales price in 2018 will continue to increase, ending the year with an overall average sales price between $220,000 and $230,000. Guidance for gross margin will be between 24% and 26%. We expect adjusted gross margin, which excludes the effects of interest and purchase accounting, will continue to be strong, ending the year between 25.5% and 27.5%. Given our home closing guidance, along with an increase in average sales price, realized SG&A leverage and a lower effective corporate tax rate, we believe our basic earnings per share for the full year of 2018 will be between $6 and $7 per share.

In summary, we are very pleased with our results for the fourth quarter and the full year of 2017. We are poised to take advantage of continued growth opportunities in existing and new markets and believe we are well-positioned to continue to grow our revenues, community count and earnings, allowing LGI Homes to achieve our long-term goals and objectives of producing market-leading returns for our shareholders. Now we'll be happy to take your questions.

(Operator Instructions) And our first question comes from the line of Jay McCanless from Wedbush.

The first one I had relates to the guidance, gross margin guidance of 24% to 26% from '18 -- for '18. Just given the gross margin in your highest unit closing quarter was in the low 24s, can you walk us through some of the avenues or things that could happen to get you guys back up to the midpoint of the '18 guidance from where you were in the fourth quarter of '17?

Sure. Yes, Jay. This is Charles. I'll start, and then Eric can add. First of all, I think what we saw in the last half of 2017 was the impact of increased production. We started over 7,000 homes this year in both our existing and our newer markets. And so what that required us to do is to go out and get additional subcontractors and trades, which had a cost to it to get those additional subcontractors. We also saw increases as everyone else is seeing as well, in material and labor increase, putting additional pressure on costs. And what was a little bit different, I think, this year was that those increases tended to be a little bit more frequent, or at least the significance of the increases were more frequent than what we historically had seen. And then the third component would be our wholesale business. So as I mentioned earlier, this year, we had a 30 basis point impact related to wholesale. So included in our guidance for '18 is a 30 to 50 basis point reduction in overall guidance from previous years specifically related to the wholesale business.

Okay. So 30 to 50 basis point ahead in fiscal '18 for wholesale. And then I believe on the -- can you repeat the SG&A guidance that you gave? I think you said it was 40 basis points of deleverage into '18 due to the higher volumes?

Correct. Yes. So we -- so between the low end of 6,000 to the high end of 7,000, we think that's a little leverage up to 40 basis points leverage on SG&A.

Okay. And with the convertibles that you guys paid out this quarter, where does the share count stand now? And approximately, where should it be at quarter end on a diluted and a basic basis?

Sure. So we ended the year at 21.8 million shares. The 0.5 million shares will flip between the diluted calculation and into basic that we issued for the $15 million in convertible notes. We typically have, in the first quarter, an increase in basic shares related to stock compensation. So we should -- and somewhere in the mid-22 million, 22.4 million, 22.7 million basic shares. And then if the fourth quarter -- first quarter is similar to the fourth quarter in terms of the remaining dilutive effect, there was 2.6 million shares effect in the fourth quarter at a $63 average stock price. So take those 0.5 million shares out, so there would be about a 2.1 million share impact related to the convertible notes in the first quarter.

Got it. Okay. And then the last question I had is, in terms of pricing power, can you talk about maybe what percentage of your total communities you think you have pricing power right now? And how are those trends developing in early '18 as mortgage rates have started to move up?

Yes, Jay. This is Eric, I can handle that. I think with the cost going up, we're increasing prices in 100% of our communities. We just had a price increase effective the first of the year because of the cost that we're talking about on this call with the margins. So it's necessary to increase the sales prices because we can see cost continuing to go up, regardless of rates you're going to do. And then we're going to have another pretty significant price increase in April. Again, in 95% plus of our communities, we see that trend continuing.

And our next question comes from the line of Michael Rehaut from JPMorgan.

First question, I just wanted to make sure I understood on the gross margins, which I think is causing a little bit of reaction stock today in terms of the guidance. Obviously, still very strong and industry-leading, but a little bit of a different -- slightly lower than last year. Charles, you broke out the wholesale business, which is very helpful. Just want to make sure, when you say 30 to 50 bps headwind in '18, on an incremental basis, you're talking about 0 to 20, correct?

In terms of -- from year -- well, really referencing more so from our historical guidance range. So when we previously guided the 26.5% to 28.5% on an adjusted basis, we would take essentially up to 50 basis points off of that. So we reduced our guidance by 100 basis points total from our historic range to our current range. So 50 basis points of that is related to wholesale.

Right. 30 -- the 30 to 50. And then would the difference be some of the other factors in terms of bridging the gap between the 30 to 50 to the 100 basis point overall delta? Would it be some of the factors that impacted 4Q results as you mentioned, adding subcontractors and trades as well as some labor and material inflation?

Sure. No, we think -- we definitely see some pressure in the early part of 2018 on gross margins. But as we increase production, that really took effect kind of early to mid-part of last year. And now in a lot of our -- particularly, our newer markets, we've now established those trade relationships and have probably a little bit more leverage then maybe we did in the mid to late part of last year. So we would expect between that and a combination of raising prices that Eric mentioned, would be able to catch us back up, if you will, on the back half of the year.

Okay. So then what in your view is the remaining delta in terms of the 100 basis point reduction in the gross margin range in addition to the wholesale business?

Yes. So wholesale is 30 to 50, then the remainder is the combination of all of the above in terms of building our houses more efficiently, paying attention to bids and negotiating prices, working diligently on those areas, and then offsetting it with our being a little bit more aggressive in price increases in the short run.

Okay. So I guess, secondly, on the SG&A. You mentioned 40 bps of expected leverage for this year. But I thought you also referenced a range. I wasn't clear if the range is like 30 to 50, and 40 was at the midpoint. If you could just clarify there.

Sure. Yes, so the range is dependent on really the top line, the revenue line items. So the combination of the fixed versus the variable costs. So we think if the closing guidance that we gave ended up at the low end of the range, then obviously, there's going to be little to no operating leverage realized in SG&A. But if we end up at the high end of the range, then we think it's up to 40 basis points based on what we're seeing right now.

Okay. And then just one last one, if I could. With the closings guidance range of 6,000 to 7,000, and you're able to do almost 6,000 in fiscal -- in 2017, obviously, you're off to a strong start this year. It just feels like, all else equal, there's a little bit of conservatism, at least, at the low end of the range. What factors would result in coming in closer to the 6,000, which would be just a fairly low growth rate, significantly lower than what you've done in the past? Obviously, just considering that you're still expanding into new markets, et cetera, why the low end of that guidance?

Yes. Mike, this is Eric. I'll start on this one. Our community count guidance is up 9% to 15% year-over-year. So I think it really comes down to absorption rates per community and where our closing guidance was going to end up. And we thought it was prudent to come out with a wide range to start the year, and then we should narrow that as the year progresses. Like we talked about in the script, last year, 2017, we averaged 6.7 closings per community. And that was higher than our traditional 6 to 6.2 closings per community since we've been a public company. So a pleasant surprise and an unbelievable year in 2017 due to increased absorption as we've been hiring a whole lot new people, as we've been entering markets and as we've been increasing our average sales price. And we're very optimistic on 2018. We think that trend is going to continue. If we can average 6.7 closings per community per month, again, then our closing increase will be right in line with community count of about 10% to 15%. So it's just a question of where those closings come in. We'd like to be conservative. Every year as a public company, we've hit our annual guidance in every metric, and we want that trend to be continued -- to continue. So we think we should start off the year being conservative with a little bit wider range on our guidance.

And our next question comes from the line of Nishu Sood from Deutsche Bank.

I also wanted to just talk about the closings guidance for '18. I think a lot of investors might look at the tremendous growth you had in the second half of '17, as you were just talking about, Eric. The slowdown, obviously, in the rate of growth in January and February. Obviously, it was up a lot year-over-year, but there were the production issues last year, which depressed the comps. You're having to raise prices a lot, obviously, to match construction costs and rates, obviously, going up. So I mean, I think a lot of investors might look at that and see it as affordability is getting constrained. Interest rates are affecting your growth trajectory. So just I was wondering, if you could kind of address your guidance relative to that way of thinking about it.

Sure. Nishu, this is Eric again. Yes, and all good questions. I think my answer is similar to what I said with Michael. But when we put out the 6,000 to 7,000 closing guidance, that was right around the first of the year. So we've had a couple of months since then. We didn't feel it was necessary to change that guidance this early in the year because we still have long ways to go. But certainly, based on sales, particularly over the last 30 days, sales have been very positive. We're seeing it in the February closing numbers, but also February sales have been very strong. So we're looking forward to seeing strong closings coming through in March and April. And we've been selling -- everybody's watching the rates. Everybody knows the 10 year is up at 2.9%. And we're selling with higher rates over the last 30 days than we have been selling. Most of our customers are in the high 4s or low 5s, as far as the 30-year rates. And we're comfortable with that. And sales remain strong, and I think it's because rates are going up, but the economy is strong, consumer confidence is strong, supply is very low, jobs are being created. So we feel really good about where we are with rates. And we do assume that rates will continue to increase another 25 to 50 to 75 basis points. And as long as that goes along with the economy still strengthening, jobs getting created, wage inflation, customers making more money, I think that's going to be very positive for LGI as well. So we're feeling really good about the business, especially sales over the last 30 days.

Got it. Got it. No, that's helpful. 7,000 -- or I think, Charles, you said, over 7,000 starts in '17 versus the 5,800-ish closings. Part of that was probably in the first few months of the year, that kind of difference, as you kind of were catching up with the inventory shortages. But it also implies a pretty heavy lean into production towards the end of the year, probably because you exceeded your guidance by quite a bit. But even then, like 7,000 still is a massive number. How should we think about that? I mean, it's higher even than what you're contemplating for closings guidance for '18. So yes, maybe if you could just help us understand the context to that and how it might accelerate sales maybe at some point in the first half of '18?

Sure. So we started off the beginning of the year with about roughly 1,600 units, either in process or completed, and ended the year with about 2,900. So part of that, I think, was a little bit an ensuring to make sure we had enough available inventory for the first quarter given what happened to us in the first quarter of '17. So rather than tapering off production, which we typically historically had done in the fourth quarters, knowing that the first quarter might have a little bit of lower volume, we just kept production up and gave ourselves the opportunity to be able to even out or level out closings just a little bit better than maybe what we did in the first quarter of last year.

Got it. Got it. And inventory, is that holding up sales, do you think, so far in 1Q? Or is there sufficient inventory to kind of sell at the pace that your sales folks are seeing demand?

Yes. I think -- this is Charles again. I'll start. I mean, it's really community-specific, so it really depends on each individual community on where the current inventory balance is versus where the current pending list is or where the backlog is. So it's community-by-community-specific. But I think overall, we're just in a much better spot in terms of, if you will, for inventory available to close over the next few months.

And our next question comes from the line of the Stephen East from Wells Fargo.

This is Truman Patterson, on for Stephen East. Just wanted to touch on your gross margins again. I think you guys have talked about labor costs and construction cost-inflating. But I wanted to touch on the higher lot cost eating into gross margins. I think you guys mentioned that in the press release. Are you guys seeing any increased competition in your land markets? It appears that multiple peers are starting to rotate towards more of a kind of a true entry-level product. And how should we think about that flowing through the P&L in 2018? And also I don't know if you guys gave this or not, but what are your backlog gross margins looking like currently?

Truman, this is Eric. I'll start off. I would say, yes, we're seeing increased competition from a standpoint of everybody hears the same thing that we hear, that more builders are entering the entry-level space or more focused on the entry-level buyer. And we think that's positive. We don't think that's going to have a negative impact. Obviously, the results of '17 and the early results of 2018 would indicate that. We have seen land costs rise. All costs are increasing. I mean, that was a consistent theme through 2017, whether it's land development costs or the price of land or the price of material or the price of labor or the price of fees or doing business with the different municipalities. So we think that trend is going to continue, a little bit because of competition, but we think land prices are probably going to -- likely to continue to increase. We think the cost to develop a piece of property is going to continue to increase, and material and labors will continue to increase. And we need to offset that with aggressive price increases. And in a tight supply environment, we should be able to mitigate that extra cost. With our price point, a couple of other points on gross margin, our difference between the third quarter and the fourth quarter, in order to have consistent gross margins, we would have to increase our average price point by $1,200, or our average sales price. So we missed it by $1,200 as far as the price increase. We should have increased our prices a little bit more. And we missed on that. We didn't think cost would increase that much. The other thing we're seeing and Charles can comment on it more thoroughly, as far as we haven't taken on a lot of additional debt. And a lot of what has come through in acquisitions is a lot of buying of finished lots from developers. And when we underwrite a finished lot deal, we underwrite it a 25% margin, whereas if we're developing the property and taking on that development risk and that upfront capital necessary, we underwrite to a 28% margin. So a little bit of mix on how we're replacing these communities as well will have an effect on the overall gross margin.

Yes, Truman. I would just add to Eric's point there. I mean, over time, when we went public, our land cost as a percentage of our sales price were in the 13.5% to 14% range. So those -- our land cost now today are over 18%. So we've absorbed increases in land cost, to Eric's point, over the years. And that's how we design and make plan selections and underwrite accounts for that. But I think I would concur with Eric that we are seeing more finished lot deals and on balance that helps from a capital allocation standpoint, but can add a little bit of pressure to the gross margin, but certainly within the range that we expect for the full year. And then as far as the question on the backlog gross margins, I mean, these are first quarter closings, generally homes that we've released purchase orders in the fourth quarter. So it's a little early for us to see exactly, just with only January behind us in terms of closings and the month end. So we expect, really, at this point that, like I mentioned before, we may be on the lower end of the range or at or near or maybe below at the beginning of the year, but then expect that to increase over time throughout the year.

Okay. Okay. That's really helpful. And since we're on the topic of affordability and you guys pushing -- being able to push pricing. With rising interest rates as affordability becomes constrained, how long do you think it would take you to make product changes or value engineer to lower your price? And how long does that take to flow through your income statement? And jumping over to buyer demand and the interest rate hikes, are you guys seeing any change in buyer behavior in January, in February, such as a change in consumer floor plan selections or possibly any pull-forward in demand?

Truman, this is Eric. From a demand standpoint, demand is as strong as ever. We're not spending our complete advertising budget right now because demand is strong. So even though rates have increased for us over the last quarter or 2, demand is still there. And I think on your question as far as product changes, I think the first thing that would happen, and may be happening some today, is that the customer, because of rates, does not qualify or does not like the higher payment associated with a particular house, the first thing that's going to happen is they're just going to have to pick a smaller square footage floor plan in the same community. And certainly, we have limitations on that once you get to the smallest floor plan. As far as product changes, I think we're always keeping affordability in mind. With the fit and finish of a house, there's not that much you can do, taking out $1,000 or $2,000 in cost is not going to affect monthly payment that much, but we're certainly always looking at our costs. The big drivers for us and what we're looking at on new communities and new sections is square footages and keeping those as lean as we can. And also density, when it comes to new development and new sections to really drive that lot cost and keep it as affordable as we can.

And our next question comes from the line of Carl Reichardt from BTIG.

Just following up on Truman's question, have you seen, over the last 6 weeks, a shift to ARM product for any of your buyers in out of fixed?

No, no. We don't. Our preferred lenders don't offer any ARM products. So all fixed rates right now, still highly 4s, low 5s, 30-year fixed rate, which is still a great rate. So we haven't seen any ARM products at all.

Okay. And then you mentioned the 30%, I think, you said at your -- of your sales now driven by buyers' brokers. How -- is that affecting your margin? Do you expect that to change? I'm just a little surprised by that, just given the long-standing nature of your business model. What are you thinking about that on a go-forward basis and moving to new markets, a broker is more likely to be involved? Just curious how that impacts you.

Yes, sure. Great question, Carl. Yes, it's been very positive for our business, the addition of realtors, and you can see that coming through in our SG&A expense, that we're continuing to get leverage on it. We've always thought about it, as a company, is our budget to drive leads to our communities is 3% of revenue. And if we pay a realtor 3% for bringing our -- bringing up the customer, which is traditionally what we pay across the country or we spend that going directly to the consumer, makes no difference for us. We really like the realtor business. We think it's additive to all the other leads that we get, all the other 70% of our closings that come from other lead sources. So we're very positive about that. And we believe that's increased from less than 5% to 30% of our business over the last 5 years, primarily because of 2 things: One is, as our average sales price continues to go up and as we have expanded outside of Texas into more expensive markets, realtors, as a percentage of the business, has definitely increased. And also what we have heard from the realtors is there is such a low supply of finished houses out there. I mean, our niche is building houses in spec, so we get the supply out there. We tend to have more inventory available than most other homebuilders, and that's really appealing to the realtor community as well.

That makes a lot of sense. That helps a lot. Two other just real quick ones. Did your warranty expense as a percent of your revenue increase in Q4 versus Q4 last year? And obviously, it bumped some in Q3. And I'd just -- like just a little update on that. As you look at warranty and your historical expense there, are you seeing your need to book within your COGS growing?

Yes. So this is Charles. From -- I don't have last year's right in front of me, but certainly, as we have expanded outside of Texas and entered into some new markets, that that has increased slightly. But I don't think -- it's not increased very significantly. I mean, we still focus on building a quality home and our punch list items are relatively consistent across the country. So I just don't have the numbers right in front of me, but I don't believe it's increased significantly by very much.

Okay. And then sorry last question. Any thoughts -- obviously, again, you're financing the company to the line. We've talked before, I think, you and I about fixing the debt, or the thought about fixing the debt. As you look at rate moves now, what's your thinking on capital structure over the next year or 2?

Yes, sure. Great question. So we're constantly looking at all of the alternatives. Obviously, our credit facility, which renews every May, we're taking a look at working with our administrative agent, which is Wells Fargo. Kind of working with them, working with our other financial advisers to keep our pulse on what's happening in the high-yield market, evaluating that option as compared to the our credit facility. Like I mentioned, the notice of conversions that we received, so our convertible notes reduced by $15 million this year. The convertible notes mature at the end of 2019, so we've got an eye on that and making sure that if we receive other notices of conversion in between then, we'd be prepared for that. And then we also keep, possibly, another ATM program, which was very successful for us. We had a lot of success with that program to be able to ensure that we could balance out our leverage to kind of keep it in that 50% range. So that's really how we look at it.

(Operator Instructions) And our next question comes from the line of Michael Martin from Michael J. Martin & Associates.

We've been conditioned...

Are you there, Michael? We didn't catch that question.

And I'm showing no further questions over the phone lines at this time. I'd like to turn the call back over to Eric Lipar for closing remarks.

Thank you, and thanks, everyone, for participating on the call today and your interest in LGI Homes. We look forward to sharing our achievements and for 2018 throughout the year. Have a great day.

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program, and you may now disconnect. Everyone, have a great day.

Thank you.