普爾特房屋 (PHM) 2016 Q4 法說會逐字稿

Good day, and welcome to the Q4 2016 PulteGroup Incorporated quarterly earnings call.

Today's conference is being recorded.

At this time, I would like to turn the conference over to Jim Zeumer.

Please go ahead, sir.

Great, thank you, Eric, and good morning.

I want to welcome you to PulteGroup's conference call to discuss our fourth quarter financial results for the three months ended December 31, 2016.

Joining me on today's call are Ryan Marshall, President and CEO; Bob O'Shaughnessy, Executive Vice President and CFO; Jim Ossowski, Vice President, Finance and Controller.

A copy of this morning's earnings release and the presentation slides that accompany today's call have been posted to our corporate website at putlegroupinc.com.

We will also post an audio replay of today's call a little later today.

Before we begin the discussion, I want to alert all participants that today's presentation may include forward-looking statements about PulteGroup's future performance.

Actual results could differ materially from those suggested by our comments made today.

The most significant risk factors that could affect future results are summarized as part of today's earnings release and within the accompanying presentation slides.

These risk factors and other key information are detailed in our SEC filings, including our annual and quarterly reports.

With that said, now let me turn the call over to Ryan Marshall.

Ryan?

Thanks, Jim, and good morning.

I am extremely pleased to speak with you this morning about PulteGroup's strong operating and financial results for the fourth quarter and full-year 2016.

At the outset of the housing recovery, we explained our focus on improving the Company's fundamental business performance and overall returns on invested capital.

As our business and financial metrics improved, we then discussed the opportunity to systematically increase our land investment which we did beginning later in 2013.

Then headed into 2016, we talked about the year being an inflection point for the Company as our increased land investment would begin delivering higher growth.

As our financial results indicate, 2016 was indeed that inflection point as we realized a meaningful expansion of our business.

On a year-over-year basis, PulteGroup reported 13% growth in unit sign-ups to 20,326 homes, while closing volumes increased 16% to just shy of 20,000 homes.

Benefiting from a 10% increase in ASP for the year, home sale revenues increased 29% to 7.5% billion, and perhaps most importantly, our reported earnings increased 29% to $1.75 per share.

While growth is important, it is worth highlighting that consistent with our focus on creating value for our shareholders the significant growth in our business was achieved while continuing to deliver high returns on invested capital and equity.

Clearly, 2016 was a year of exceptional performance and progress for the Company and has us well-positioned for continued success in 2017 and beyond.

While 2016 was an inflection point in the growth trajectory and performance of our business, we expect 2017 to be another outstanding year as we continue to realize benefits from prior-year investments.

Is important to remember, though, that we are seeking to build a business that consistently generates high returns on invested capital over the housing cycle.

As such, we will continue to stress running a balanced business.

As I explained on our last earnings call, I see opportunities for us to realize a better balance across the buyer groups we serve.

In 2016, roughly 43% of our deliveries were to move-up buyers which reflects increased investment in that segment in prior years.

Going forward, there may be opportunities for us to diversify and expand our business among first-time and active adult buyers where the huge bookend generations of the Millennials and Boomers will influence demand for years to come.

Our emphasis on building for the move-up buyer has served us extremely well during the initial leg of the housing recovery, but we want to make sure we aren't missing opportunities that would allow us to further broaden and grow our business while diversifying risk.

Consistent with this idea of being balanced, our goal is to drive high rates of return by properly managing the key inputs of sales pace, margin, and inventory turns.

We have done a tremendous job improving our margins since 2011.

Now we have to make sure we are effectively turning our assets in support of delivering high returns by maintaining the right sales and construction pace.

Critical to delivering high returns is that we remain disciplined in our land investment practices and work to be increasingly efficient in managing our land inventories.

We have talked often about the 13-point risk weighting criteria that we used to underwrite every deal.

By consistently underwriting projects with returns in excess of 20%, as measured by this scale, we can further improve returns and lower our overall risk profile.

This risk-based approach is now deeply embedded in our operating philosophy and we will continue to adhere to these underwriting guidelines in the future.

As we think about delivering consistent long-term returns, it is not just about what projects we are investing in, but how we are investing in those projects.

We are actively looking for opportunities to control more land via option.

In 2016, 42% of the lots we approved were initially controlled under some form of option agreement, allowing us to be more efficient with our capital while helping to lower overall risks.

Beyond the what and the how of the projects we invest in is the how much capital we choose to invest.

We have talked about previously several years of 30%-plus compound annual growth in our land spend has meaningfully improved our land pipeline.

As such, we were able to materially slow the growth of investment going forward while still expanding our business.

We currently expect land acquisition spend in 2017 to be approximately $1.1 billion which is comparable to our 2016 investment ex-John Wieland.

Given our prior investments, we are in a position to deliver additional volume growth in 2017.

We also expect to realize even higher returns on invested capital given plans to moderate the rate of land spend, increase the use of land options where possible, and accelerate our inventory turns.

In 2017, I also expect to take additional steps in our work to raise the bar on construction quality and customer experience even higher.

Though it can be difficult to quantify, I believe improving the products and experience we deliver can over time enhance sales, improve revenues, and decrease future warranty costs.

As such it is an opportunity that we continue to pursue.

Now let me turn the call over to Bob for a detailed review of our fourth quarter results.

Bob?

Thanks, Ryan, and good morning.

Our Q4 results represent the completion of an outstanding year for the Company as we realized significant gains throughout our business and resulting financial performance.

Consistent with Ryan's comments of 2016 being an inflection year in terms of realizing higher growth, our fourth quarter home sales revenues increased 21% to $2.4 billion.

The higher revenue in the quarter reflects a 9% increase in closings to 6,197 homes, along with an 11% increase in average selling price to $391,000.

Our Q4 conversion rate of 66% was slightly above last year and our prior guidance for the quarter.

Our ability to close additional homes reflect a number of factors including our decision to selectively start more spec production earlier in the year, the efforts we've made to strengthen our trade base, and perhaps most importantly, the hard work of all of our employees.

We're certainly pleased with the steady progress made toward being more efficient in converting our construction pipeline in 2016, but labor resources are still tight across many of our markets.

As such, we will continue our strategy of selectively including spec units as we plan our production pipeline so as to help develop a more even construction cadence.

With all of this in mind, we currently expect our first quarter conversion rate to be comparable to Q1 of last year.

Looking at the mix of our fourth quarter closings, 30% was first time, 43% was move-up, and 27% was active adult.

This is consistent with last year when the closing breakdown was 31% first time, 40% move-up, and 29% active adult.

As I mentioned, our revenue also benefited from the 11% increase in our average sales price this quarter.

The higher average sales price reflects the ongoing shift in the mix of homes we are building, coupled with higher prices realized in each of our buyer groups.

In fact, our ASPs were up 20% to $301,000 for our first-time buyers, up 9% to $464,000 for our move-up buyers, and up 6% to $374,000 for our active adult buyers.

The large increase in average sales price for first-time buyers was driven primarily by mix as we realized a large increase in homes closed in California which, as you would expect, carry much higher prices relative to the rest of the country.

With our backlog ASP up 8% over last year to $396,000, and given the mix of communities we plan to open over the course of 2017, we expect our ASP will continue to move higher through 2017 and is likely the average above $400,000 for the full year.

Before I address our gross margins, I would like to cover a change in the way we are classifying sales commissions.

As we highlighted in our press release, we've elected to reclassify both internal and external sales commissions from home sale cost of revenues to SG&A.

This adjustment makes our income statement presentation more consistent with the majority of our home building peers and we believe it is responsive to some of the questions and feedback we've received over the years.

So to assist in your analysis, we are posting three years of financial results to our website.

Each is adjusted to reflect the new classifications.

Having said that, our reported home sale gross margin for the fourth quarter was 24.8%.

The comparable prior-year fourth quarter gross margin was 27.1%.

Consistent with comments we've made on prior earnings calls, margins continue to be impacted by higher land costs as we are turning over almost one-third of our communities each year, as well as labor costs which are continuing to increase across many of our markets.

Looking at the year ahead, we continue to target full-year 2017 gross margins of 24% to 24.5%, likely still the highest in the industry, as we continue to benefit from operational changes we made as part of our value creation work.

Just to be clear, this range is the same as the guidance we gave previously related to 2017 margins, simply adjusted to reflect our reclassification of commissions at the SG&A.

That being said, given our current estimate for house costs to increase by 1.5% to 2%, as well as potential impacts related to affordability due to rising interest rates, we anticipate being towards the low end of guidance range.

Depending on the demographic and geographic mix of homes closed in a given period, reported quarterly gross margin could range from 23.5% to 25% with Q1 expected to be the low quarter of the year.

Our gross margins continue to be supported by our focus on maximizing lot premiums and option revenues.

In fact, total option revenues and lot premiums gained 7% over last year to approximately $73,000 per closing.

However, sales discounts of 3.2%, or $12,500 per home, while still modest did increase 40 basis points sequentially and 90 basis points over the fourth quarter of last year.

Our reported fourth quarter SG&A, including commissions, totaled $208 million or 8.6% of home sale revenues.

This includes the benefit of $55 million relating to the reversal of construction-related reserves realized in the quarter.

Comparable prior year SG&A spend was $210 million, or 10.5% home sale revenues, which included a $30 million benefit from a similar reversal of construction-related insurance reserves.

Adjusting for the reclassification of commissions and consistent with our prior guidance, we expect our full-year 2017 SG&A to be approximately 12.5% of revenues.

As a result, we continue to expect our full-year 2017 operating margin to be in the range of 11.5% to 12%.

Turning to our financial services businesses, we reported pre-tax income of $25 million in the fourth quarter as the operations benefited from the increase in homebuilder closing volumes.

This compares to $29 million last year, which included a benefit of $12 million resulting a reversal of mortgage repurchase reserves.

Mortgage capture rate for the quarter was 82% compared with 83% last year.

In the aggregate, we reported fourth quarter pre-tax income of $414 million, an increase of 11% over the prior year.

For the quarter, the Company reported $141 million of income tax expense representing an effective tax rate of 34%.

The Company's effective tax rate for the quarter was lower than its previous guidance of 38% due to the recognition of energy efficient home credits, as well as a deferred tax benefit related to a legal entity restructuring.

While we're on the topic of taxes, I would like to note that we currently expect to fully utilize our remaining federal net operating loss and tax credit carry-forwards in 2017.

As a result, we expect to become a federal cash taxpayer on a portion of our taxable earnings in 2017.

As we become a cash tax payer, we can take advantage of Section 199 manufacturing deduction which we expect will decrease our effective 2017 tax rate by approximately 1.5%.

As a result, we expect our 2017 full-year tax rate to be approximately 36.5%.

It is important to note that everything we have outlined for 2017 assumes that no corporate tax reform takes place.

Like all taxpayers, we're paying close attention to dialogue related to possible changes to the federal tax laws.

The timing and specific language associated with any tax form is critical to calculating the potential impacts on our cash flows and the value of our deferred tax assets.

As such, we have to wait to see actual legislative language before determining any future impacts.

Closing out the review of our income statement, net income for the quarter was $273 million, or $0.83 per share, which includes $0.16 per share of insurance and tax benefits realized in the quarter.

Fourth quarter earnings per share were calculated using approximately 328 million shares, which is a decrease of approximately 7% from 2015 resulting primarily from share repurchase activities.

Moving to our balance sheet, we finished the quarter with $723 million of cash.

During the quarter, we spent $252 million to repurchase 13.2 million shares at an average price of $19.07 per share.

For the full year, the Company spent $600 million to repurchase 30.9 million shares, or 8.8% of its outstanding shares.

As previously announced, the Company plans to repurchase an additional $1 billion of its common shares in 2017.

The timing of planned repurchases will be driven in part by the normal seasonal cash flows of the business and subject to overall business and financial market conditions.

Our year end debt to cap was 40%, which is within the 30% to 40% in which we seek to operate.

Depending upon the timing of future share repurchases, we may move above 40%, but expect future earnings should work to quickly delever our overall cash flow structure.

Let me finish with a few details on our homebuilding operations.

At the end of the quarter, we had a total of 7,486 homes under construction, which is an increase of 15% over last year.

Consistent with our strategy to use specs to better maintain our production levels, specs were 31% of year-end homes under construction which is consistent with last year.

We ended the quarter with 645 finished specs as we continue to average less than one finished spec per community.

For the fourth quarter, we generated 4,202 sign-ups which is an increase of 15% over Q4 of last year.

On a dollar basis, sign-ups were up 22% to $1.7 billion.

Breaking down sign-ups by buyer group, sales to first-time buyers gained 12% to 1,116 homes, while sign-ups to move-up buyers increased 27% to 1,985 homes.

Sign-ups to active adult buyers were up 1% from last year and totaled 1,101 homes.

Our community count was up 17% in the fourth quarter to 726.

Our community count growth was slightly ahead of our guidance due to the slower closeout of a few communities.

As we did in 2016, we again expect to turn over roughly one-third of our communities in 2017 and anticipate overall community count growth in the range of 5% to 10% for the year.

Year-over-year growth in communities should be fairly consistent between the front and back halves of the year.

Supporting this growth, the Company continued to invest in the business, approving roughly 6,000 lots for purchase during the quarter including a replacement Del Webb community in Southern California.

Excluding the 1,000 lots associated with this Del Webb position, our average deal size includes just over 100 lots that we expect to have a duration of roughly 2.5 years from the time we open for sales.

Consistent with the trends we have seen for the past several years, most of these lots will require development.

However, we were pleased to see that over a third of the deals were option transactions allowing us to improve asset efficiency and reduce potential market risk.

For the full-year in 2016, we spent approximately $1.1 billion on land acquisition excluding the assets we purchased from John Wieland.

As Ryan mentioned, we expect our 2017 land acquisition spend to be approximately $1.1 billion, and we expect to increase our land development spend by approximately 10% to $1.6 billion.

At year end, we owned approximately 99,000 lots while controlling another 44,000 lots via option.

Basin on our trailing 12-month closing volumes, we've lowered our owned lot supply to less than five years.

Our goal is to continue to shorten the duration of our land pipeline by continuing to focus our investment on smaller, faster turning communities, while continuing to work down our large legacy Del Webb communities.

We ended 2016 with a strong lot land pipeline that can support ongoing growth in 2017.

While we have a lot of work ahead of us as we seek to open upwards of 250 new communities in 2017, we have the required land and are optimistic about our opportunities heading into the selling season.

Now let me turn the call over to Ryan for some final comments on market efficiency.

Ryan?

Thanks, Bob.

Fourth quarter and full-year 2016 results for PulteGroup and the overall US housing market point to continued growth in housing demand.

After several years of strong job formations and low unemployment, supported by favorable demographics, there are signs that housing demand is now being bolstered by an improving economy and recent gains in consumer sentiment.

Against this increasingly positive background, we are mindful that interest rates have been rising over the past couple months.

However, coming off such a low starting point, it is certainly reasonable to expect that housing demand can continue to expand, especially if the rise in rates truly reflects increased expansion of the US economy.

We are fortunate that the initial increase in rates took place during the seasonal slow point for housing sales.

Buyer expectations have had time to adjust to these new market conditions, so expectations can be properly set as we head into the spring selling season.

While it is challenging to assess buyer sentiment during the slower winter months, we believe that higher rates have so far had minimal impact on demand.

We will, obviously, have a better read on the buyer as we move through the first two quarters of the year, but based on Q4 results, we are optimistic heading into 2017.

Specific to the fourth quarter, market conditions were generally consistent, albeit at seasonably lower volumes with the trends experienced earlier in the year.

In the East, demand conditions in Florida and up through the Southeast generally remain positive.

Demand in Florida remains strong, although our results for the quarter were a little choppy given the timing of community closeouts and openings.

I would add that our results showed consistent improvement as the quarter progressed.

We realized improved year-over-year sales volumes in the mid-Atlantic and Northeast markets, but still view these as very competitive where we have had to battle for each sale, particularly in DC.

Demand in the middle third of the country remains strong in the quarter, as our Midwest and Texas operations both posted year-over-year sign-up increases exceeding 20%.

Houston was particularly strong in the quarter, and given recent gains in the price of oil, 2017 could see a sustained recovery in demand.

And finally, looking out West, demand conditions were favorable, although we experienced some volatility as moved from week-to-week in the quarter.

Arizona got stronger as we moved through the quarter, while Northern California slowed a little.

That being said, our divisions have a positive view heading into 2017.

While we are only a few weeks into the new year, we are pleased with the overall demand conditions which suggest that higher rates are not dampening buyer interest, and that 2017 can be another year of growth for the industry.

Given the good start we are seeing, we are excited to get into the spring selling season.

Let me close by thanking all the employees of PulteGroup.

You helped grow the business the right way in 2016 by remaining focused on building a great home and delivering an outstanding customer experience.

Together we can look forward to an even bigger and better 2017.

Now let me turn the call back to Jim Zeumer.

Jim?

Great, thank you, Ryan.

Just reinforcing Bob's message, you can find the historical financial results on our website in the financial information section under the Investor Relations tab.

With that said, we will open the call for questions.

So that we can speak with as many participants as possible during the remaining time on the call, we ask that you limit yourselves to one question and one follow-up.

Eric, if you will explain the process we will get started with Q&A.

(Operator Instructions)

Nishu Sood with Deutsche Bank.

Thank you and nice quarter.

I wanted to ask first about the impressive ASP growth.

Certainly ahead of your peers in the past couple quarters and, Bob, you were talking about how we should expect that to continue in 2017.

You talked about the entry level, the mix shift to California?

I just wanted to get sense of, and how that affected the fourth quarter.

I just want to understand the drivers of the ASP growth across the divisions or maybe even regionally.

What is going to drive it to stay above $400,000 in 2017?

Yes, Nishu, I think it is a couple of things.

Mix matters geographically, so certainly in the fourth quarter of this year, what drove some of the increase was a heavier concentration of California closes where prices are higher.

In terms of going forward, it is a continued mix shift to some degree.

We, obviously, over the last three or four years invested a great deal in the move-up space.

That has a higher average sales price.

As we mentioned, in the fourth quarter it was $464,000.

So as you see more of those communities opening, you will see the price mix higher and, again, as you saw this year sort of a sequential increase quarter over quarter our expectation is you will see the same thing in 2017.

Got it.

Okay, and on the share buybacks, you have the $250 million a quarter.

Obviously, you have been on track with that for 3Q and 4Q.

As we look out across 2017, now that's coming into a little bit clearer view, how do you expect that to impact the balance sheet?

You mentioned that you should be able to deleverage.

Are these share repurchases as you continue with this aggressive pace at $250 million -- is it going to be mostly internally funded?

Now you have laid out for expectations for $2.7 billion in land spend.

What should the debt to cap roughly look like by the end of the year and how is it going to be funded?

Mostly internally or will there need to be some additional debt raises?

Nishu, it is Bob.

I think what we've highlighted is we would like to stay at or near that 40% rate.

It is our belief that we can stay there.

We've talked about needing maybe to go outside that a little bit.

As much a function of buying down the equity makes the percentage just naturally accrete higher.

But in terms of the cash flows of the business, we like many in the industry have typically outflows in the first half of the year as we build house and develop lots that we will deliver later in the year.

So the cash flow is skewed more heavily towards the back of the year.

You can and should expect us to have that impact the way we buy stock during the year.

And so, again, we've have talked about by the end of the year probably being low 40%'s in terms to debt to cap.

And I don't think there is a significant need for liquidity.

It will, obviously, depend on total closings, cash flow generation, profitability, but we think that within the construct of the capital structure today we think we can manage through it.

(Operator Instructions)

John Lovallo with Bank of America Merrill Lynch.

Thanks for taking my call.

The first question is the Midwest orders were notably stronger than we were looking for at least.

Did you guys see any pickup in demand in some of the Rust Belt states that may have coincided with consumer confidence that was very strong post-election there?

John, it is Ryan.

Thanks for the question.

We continue to like the strength of our business in the Midwest.

We've got excellent land positions there.

We have very good operators.

We have nice market share.

And as I noted in my prepared remarks, we did see a bump in consumer sentiment that I think certainly contributed to the strength in the year-over-year increases that we noted in the Midwest section.

Okay.

That is helpful.

And then order growth looks like it was largely driven by community count openings this quarter, and by our estimates absorptions were down slightly.

How are you guys thinking about the community count absorption kind of mix in 2017?

As I think Bob mentioned, John, we are expecting 5% to 10% growth in 2017.

That will be balanced throughout the year as we move through 2017.

We noted that our year-over-year increase in the fourth quarter was 17% community count growth, which was slightly outside the range that we had previously provided which was mostly being driven by the slow closeout of a few older communities.

We like the community count growth, and we are also very positive about what our absorptions were in the quarter.

John, the absorptions were actually -- if you look at them straight calculation down a little bit, but if you exclude the Wieland communities which we've talked about in the past being slower moving, we actually saw roughly 2% increase in absorptions, and across the universe that was, I think, flattish on the entry level, up 2% on move-up, and up 5% on the active adult.

We did see some growth there if you take out the impact of those slower moving Wieland communities.

Michael Rehaut with JPMorgan.

Thanks.

Good morning, everyone, and nice quarter.

I also have to say congratulations on the commission reclassification.

If it was not known that I am a homebuilding nerd, and I could be so excited about that, this should put that to rest, and I encourage others -- the few remaining builders -- to follow your lead.

Thanks, Michael.

Like to put a smile on your face.

Glad to make you happy, Mike.

There you go, a busy day too.

My first question, just going back to the sales pace a little bit, and wanted to understand, some of your peers have had absorption pace improvement in FY16.

And you highlighted flat on first-time and up 2% on move-up.

I am just trying to get a sense of where the gap might be to some of your peers?

Is it perhaps geographic?

Is it more of a pace versus price equation?

Or if there is certain community mix driving that?

I do think that, as this recovery progresses, particularly on the first-time side, which we are seeing a little bit more activity, I would expect some of the pace improvement to be a little bit better, everything else equal.

Mike, it's Ryan.

There is a lot in that question, I will take a couple pieces of it and then we may have to come back and clean up some of the loose ends.

We are very proud of the margins that we have.

It has been part of our value creation strategy aimed at driving overall return on invested capital.

Certainly, as I talked about in some of my prepared remarks, it is important to balance the pace and price equation.

Margins are one component of that.

Making sure that we are continuing to turn our assets are also part of that component.

But we like what is going on with our business.

We are turning our assets.

We've got strong margins, we've got strong profitability, we're growing our earnings.

Those are all very good things for our investors and for our shareholder base and we like what we are seeing.

Okay.

Fair enough.

I guess second question, just on the gross margins.

I believe you said pre-reclassification that the margins that you are expecting in 2017 are much closer to what you would consider longer-term gross margins.

I just wanted to know, if I recall that correctly, and if you still view that to be the case?

Mike, it is Bob.

I don't think we characterized margins as being something that can be, for lack of a better word, fixed.

They will move over time.

We have enjoyed for the last several years really high margins.

We still do.

The market will ultimately dictate where margins go from here.

But we do think that we are operating a little differently, the way we are creating floor plans, the way we are underwriting our land transactions should lend itself to continued strong margins.

But it is important to remember, we underwrite to return, so as an example the more option transactions we do could influence the margin.

Mix matters.

The more entry level or first-time business we do could influence margins.

As Ryan said, we feel very good about our margin profile today.

I do not want to say that it will be here forever, though.

And the other thing too, Mike, that I would add to Bob's comments there, we've made real improvement in our SG&A leverage.

Year-over-year we're going to show about 100 basis points of incremental leverage.

When you combine a very strong margin profile with some added SG&A leverage, you get down to the operating margin line that we've provided guidance of 11.5% to 12% also puts us in a very competitive spot within the peer set.

Bob Wetenhall with RBC Capital Markets.

Hey, good morning.

And I think this is a great quarter for you, guys.

It looks like you got price and pace and balance.

It sounds like the demand outlook is good.

Ryan, I just wanted to see if you could dig down a little bit into the SG&A leverage.

You are kind of higher than the peer group.

You, obviously, have a strong operational background.

Are the changes you need to make on the SG&A side a cost management issue, or is that just a function of driving sales higher and extracting the leverage out of the P&L?

Bob, it's a good question.

Thanks for the comments.

A couple of things that I would point out.

Excluding the insurance benefit that we realized in Q4, we are forecasting lowering 2017 SG&A as a percent of revenue by about 100 basis points, as I mentioned, and that is relative to 2016.

We are on track to drive meaningful overhead leverage in the business in 2017.

We talked in our last quarter earnings call, part of that was coming from pure growth in the business, part of that was coming from absolute cost reduction.

As to your comment about are costs higher?

We believe that part of the difference between us and some of our peers are the investments that we are making and delivering a superior product quality, as well as customer experience, and we think that is a differentiator for our Company and, frankly, is part of our strategy.

And we believe we get the benefit of that in higher gross margins.

A part of the reason you hear us talk about gross margins, SG&A leverage, and then ultimately operating margin and looking at in totality.

What I would tell you about SG&A, Bob, is SG&A discipline is going to be a focus of mine.

We have continued room for leverage and it will be a focus of mine to go and get it.

We are proud of the progress that we are making, but I don't think -- I know that is not where we are going to stop, so I will leave it at that.

It sounds like you have a game plan for that.

Bob, it sounds like your gross margin guidance is towards the low end of the range, and you also called out the fact that you got this favorable mix towards California which is driving up ASP.

I am just trying to understand, inside the gross margin, are you seeing a lot cost inflation and inflation on labor and materials which is offsetting the favorable mix?

What is the right way to think about gross margin?

And perhaps I am wrong on this, maybe it is an issue versus like a shift to spec or something?

Any clarity how to think about the next 12 months on gross margin would be great?

Yes, I think the way you said it to start that question is right.

As we cycle through, we are turning over a third of our asset base, or a third of our community count each year, and so the land that is feeding into our cost of sales is increasing over time.

Certainly, input costs are rising, particularly labor, and so what you are seeing is against the backdrop where non-mix adjusted pricing isn't increasing as rapidly as it was two or three years ago, we're feeling a little bit of pressure because our input costs are going up a little bit faster than that ASP has over the past 12 months compared to, say, 36 months ago.

So, for us is it a continuation of that theme in 2017.

I don't think you should think about in terms of spec versus not spec.

We are not changing our stripes there.

We've put a little bit more into the production pipeline, but it is only about 30%, which is not terribly different than it was a year ago.

And then mix, the mix question, it is not geographic, right.

Our margin profile doesn't change that much across different parts of the country.

Certainly, there is a little bit of a mix differential entry-level versus move-up versus the active adult space, and so that influences our margin.

But we don't see that having significant impact next year.

And then the other thing that, obviously, feeds into our margins is the interest expense.

Obviously, our interest costs are up in FY17 versus FY16 because of the debt -- the capital raises we did in net in 2016, but we think that essentially gets offset by volume differential, so we it is a neutral on our margin FY16 to FY17.

I don't know if that helps, but all those things factor in.

But I would tell you land and input cost, particularly labor, are the primary drivers.

Mike Dahl with Barclays Capital.

Hi, thanks for taking my questions.

I just wanted to go back to some of the comments around the land spend and the balance sheet.

It sounds like, just tying a couple of those things together, would suggest that cash from option should see real nice improvement in 2017 just to get to those balance sheet targets.

So I just wanted to get any sense of quantification you can provide on cash flow?

And then related to that, as you think about this seems to be a pivot towards a longer journey of improving turns, and if there is anything you can give us as far as also quantification for inventory turn targets?

That would be great.

Yes, I will start, Mike.

In terms of free cash flow generation we have not provided any guidance.

I think it is fair to say we expect the business to grow in 2017, and against that backdrop, not spending as much on land acquisition in particular, but also land development combined that we expect to be cash flow generative this year.

I think, if you take a step back, we are not pivoting away from investing in the business, but what we are doing is spending money today to improve the assets that we have acquired over the last couple years which we think generates growth in closings, and so we are spending more on development.

Historically, if you've gone back two years ago, we were probably that 50/50 land acquisition versus development spend.

Given the numbers that you saw today, that number is clearly moving more towards development, which bodes well for cash generation because what we are doing is improving the assets to generate sales and actually getting a return on our investment which you heard Ryan talk about.

We want to be balanced in that.

So we don't have our foot quite as heavy on the gas for growth for future acquisition, but we want to maintain the growth associated with the investments we've made over the last couple years.

And, Mike, as you heard us probably say in the prepared remarks, our ability to do that is really because of the 30% annual compound growth rate that we had on land acquisition investment, really starting in 2013.

So the health of our land pipeline is quite robust and we're set up for very nice success and very nice growth as we move into the future years.

I will take the piece on the question that you had about inventory turn.

Inventory turns is a huge part of driving the type of returns on investment that we are looking for.

Land is clearly the biggest investment that we have on our balance sheet, and so as we are going to move the needle on overall inventory turns the focus is squarely on efficiency of land.

You heard me talk about a focus being in getting more efficient and lean with our land inventory.

We provided a few more details on that today, but if you look at our current vintage of acquisitions that we are making, there is a heavy percentage of options which certainly help with the goal of driving inventory turns.

The average year supply is near three, even slightly below three, and the average size of those excluding of a couple large Del Webb acquisitions are around 100.

We think we are doing some very nice things that are different and going to create enhanced inventory turns for us in the future.

Right.

Okay, and that is what I was driving at because clearly this is one of the main levers to drive real improvement in returns over the next couple of years just in terms of how you are turning the land and managing the owned/option mix.

And so to follow up on that then -- because I think option deals have been difficult to come by in a lot of places and for a lot of builders.

Could you give us any examples of successes -- keep it broad regionally -- where you are having most success locking up new deals on the option side and where you are still seeing some challenges?

Thanks.

Mike, I will let Bob take that one.

Maybe I will just chime in with one little overriding comment, and then I will let Bob give you a little bit more color.

But 46% of our acquisitions recently had some component of an option mixed into the transaction.

Certainly, options are attractive.

We strive to get them.

We are not going to overpay, however, solely for the goal of having more options.

The goal, again, is to manage risk, to drive a better and higher return on invested capital.

When it makes sense to do options, we are certainly going to strive to do it.

I'll let Bob give you a little more color on some of the geographics.

Yes, Mike, we've talked about it before.

I don't know that there is a geographic ability to do it that is higher in one place versus another necessarily.

They are all individually negotiated.

Sometimes we choose to put a money partner in between, but that is a little bit more challenging because return is scarce on a relative basis and they want some, and we want some.

What I would offer is, markets where we have good, long, deep relationships with the land community and have high relative market share offer us more opportunities.

We get to see more deals.

We see them earlier, and so our opportunities there seem to lend themselves to more activity, again, where we have got, again, a long tenured land team and good relative market share.

Stephen Kim with Evercore ISI.

Guys, good quarter.

I wanted to ask you two questions, if I could, related to leverage, I guess.

First, I was wondering if you could let us -- tell us how you prioritize M&A in the current environment relative to repurchases, let's say, given that your leverage is already now expected to rise above your targeted range this year?

Stephen, this is Ryan.

Our prioritization of capital remains in the following order, investment into our ongoing operations, specifically land, is priority number one.

We include M&A in that same category.

So we look at it very much like a land transaction.

To the extent that we can do an M&A deal, it certainly gives us, in many cases, a ready now or a quicker land pipeline versus buying something raw that has to go through the entitlement process.

The second piece of our capital strategy was to continue to fund our dividend, which we are doing.

And then the third piece of that strategy was share buyback.

Given where we were at with the state of our business, we made a decision to announce a $1.5 billion share buyback that has taken place over the last 18 months.

We've executed on the $500 million piece of that in 2016 in the back half.

We are going to continue to execute against that plan for the $1 billion in 2017.

But, look, we are out in the market, we are looking for opportunities.

Certainly, valuation comes into play when we are looking at M&A.

No different than we would not overpay for a piece of raw land, we don't want to overpay for a potential acquisition either.

I will let Bob take the debt to cap piece.

Well, I think the only thing I would add to what Ryan just said, Stephen, is we've also always said that while the guard rails are 30% to 40%, we would go above or beneath them if we saw a compelling reason to do so, but that you should expect us to tell you when we do that and how we expect to get back into those guard rails.

So, example, if there were a transaction that we found compelling -- and I will make up a fact here -- push us to a 45% debt to cap ratio, we would do that if we thought it was beneficial to shareholders.

Having said that, we would probably expect as part of that dialogue to say here is how and when and where we would expect to drive that ratio back into our 30% to 40% range.

So certainly they are not mutually exclusive.

We can do both.

It really would boil down to Ryan's point, if we saw a compelling reason to buy it because we'd look at it as a land transaction.

Got it, that is very helpful actually.

Thanks.

My next question is a little bit more broad about leverage.

I think that having gone through the cycles that we all have, I think most people would say in the post-mortem that probably the most important thing that we need to keep in mind as a builder is to make sure that our leverage -- that we're keeping an eye on our leverage ratio at all times.

What strikes me as so interesting right now is that your two largest competitors seem to be prioritizing a more defensive approach, you might say, to leverage and their current net debt to cap ratios are moving below their historical norms.

One is way below, the other one is near the bottom end of the range that you had talked about.

It seems like it is moving somewhat lower.

You all have talked about moving to a balanced approach towards product mix, but your leverage is moving well above peers, when not too long ago you were among the lowest in the industry.

So from a leverage perspective, it seems you are essentially almost trading strategies with your peers, and I was wondering, could you sort of articulate for us what you think the essence of the disagreement is, or what you see differently?

And why is this the right time in the cycle to lever up rather than to delever?

I don't consider it, candidly, levering up.

We are at a higher rate than we were for all the reasons that Ryan just talked about.

We invested in the business, including M&A and two deals that were fairly significant capital users, and we are buying back our shares which, again, was part of the strategy.

And all with it -- if you remember back, I guess, it was December of 2014 when we did the investor day we said those are our priorities.

And, again, the guide rails are 30% to 40%.

I can't comment on what our peers are doing.

I think what you are hearing from most, and you are hearing from us, is we see continued growth in the space, so the ability to earn return on the investments we are making.

It is interesting, I don't think we are trading out our strategy.

We are executing on it and, yes, we are at the higher end of our range, but we think that we can delever that over time as we run the business.

So, interestingly, if you talk about land approach, while we are investing in the business, to everything you have heard us talk about, we are focused on shorter, faster turning, high asset efficiency transactions which we think mitigates risk.

And I think that is what you are getting at, risk management.

We think our strategy fits in that.

And so, not being defensive, I don't think we really have, quote/unquote, levered up.

Yes, it's a little bit higher, but certainly within the framework that we want to operate.

And, Stephen, I would also add to that.

When you look at the maturities of our long-term debt, it is very attractive.

So certainly we are paying attention to a number of things.

We are paying attention to what our absolute debt to cap rate is.

We pay attention to what we think the growth of the business looks like and the cash flow that's going to be generated, and then what those long-term maturities are.

And I think when we put all of that into the soup and we come out with what our strategy is, we like it a lot and we are running it.

Certainly, your job is to compare us to our peers and pay attention to the differences, but I think we are running our strategy as opposed to, as Bob said, as opposed to taking someone else's.

Stephen East with Wells Fargo Securities.

Thank you.

Good morning, guys.

Ryan, I will come back to the ROIC question in a minute, but I'll give you all a change of pace for a second.

You all are the third builder in three days that the fourth quarter orders are stronger than historical season patterns.

As we look at that, do you all think you are seeing pull-forward going on in the industry, or has demand just ramped from the third quarter for you all, and if you think for the industry?

And then when you look at your segments could you talk a little bit about it?

I was surprised that active adult was not stronger than it was from an orders perspective.

So if you could just talk about the three product segments and what you think you all are seeing?

Stephen, this is Ryan.

Thanks for the question.

A couple things here.

Let me take the segment question first.

When we look at the active adult segment, it is historically a segment that performs better in the spring selling season.

If you think about where the locations of those communities are.

They are in the southern states.

It is generally the folks that are migrating from north to south.

I don't know that anything abnormal is going on within that segment.

It is a -- other than it is a segment that I think is highly sensitive to consumer sentiment and consumer confidence levels.

We actually saw that get stronger as we moved to the quarter.

I would expect to probably see some added strength from that buyer group as we move into the first quarter.

Okay.

As far as demand and has it been pulled forward?

I don't believe that.

I believe that as we moved through the quarter we saw some choppiness.

There was certainly some choppiness and some consumer sentiment and consumer confidence lag, if you will, and maybe even a little bit of a vacuum that was created around the time of the election.

I think once we got past the election, things started to at least calm and folks had a little clearer picture of what their future might have looked like.

We have seen, as we talk to our operators and we listen to what is going on in our sales offices, we're seeing good consumer sentiment.

I think that is a positive thing for not only us but for the entire industry.

We saw little bit of an uptick in interest rates.

We talked about that.

We don't see that dampening overall demand or desire to purchase.

And we are optimistic about what prospects are for Q1.

Okay.

Fair enough.

And then, if you look at the returns, and just a couple questions around this, are you all more focused on ROE or ROIC?

And then as you look at the variety of drivers, I know you've touched in a variety of ways, but when you look at all the potential drivers, could you rank order sort of your focus, if you will, from incremental volumes, pricing, controlling your SG&A?

I know it is all of those things, but I am trying to understand how you all think about pulling the levers the most aggressively to hit your ROIC or ROE targets?

Stephen, we underwrite to ROIC.

That is the metric that we pay attention to.

I think ROE is certainly interesting and something that we look at, but it is not the metric that we underwrite to.

It is ROIC.

In terms of the levers, I think it is difficult to say there is a one-size-fits-all strategy.

Every single transaction is a little bit different.

Depending on the price point, the buyer group, the nature of the land transaction, we do, and we are making different decisions on a case-by-case basis to maximize margin.

Sometimes it is more price, less volume.

Sometimes it is more volume, less price because that is ultimately what is going to turn the asset and drive the returns that we are looking for.

I would tell you that we have made a pivot in the way that we are looking at this.

Historically, we were probably heavily focused on margin as being the primary driver, and we are leading the organization to have more of a balance and make the appropriate decisions on pace and price to get the intended outcome.

Got you.

That's great.

Thank you.

Alan Ratner with Zelman & Associates.

Hey, guys, nice quarter.

Good job.

Ryan, I appreciate your comments on the demand, recent trends there, and it is good to hear that you have a positive outlook and it does not appear to be any impact from the higher rates so far.

I guess just adding onto that line of questioning.

So your backlog conversion was very strong.

You came in above your guidance.

I know you are not a big spec builder, but I was curious if through the quarter as rates started to move, and maybe into January, have you seen any evidence of buyers looking to buy more spec home or homes that are closer to that delivery date to mitigate a potential continued increase in rates, or has the demand pattern between to-be-built and spec remained pretty constant over that time period?

We have not seen a huge shift in demand, Alan, and, frankly, we haven't altered our spec strategy.

If we go back a year ago, we introduced more spec into our overall production pipeline than we had been, say, two years ago, three years ago.

We are still running at a fairly low rate.

As Bob mentioned, we have got just over 600 finished specs, which is less than one per community, which is the number that we target.

We are still introducing specs into our system because it helps with production.

It helps to even out a production flow with our trade partners, and when we can provide them with consistency of work that is a good thing.

We want to keep our trade partners busy and on our job sites.

As far as consumers go, I think anytime there is a threat, or talk, of rates increasing it does create a little but of urgency, if you will, to make a buying decision, buy a spec, lock in a rate, get a loan closed.

As I mentioned, I think the fact that we are still at a very historically low rate, that all still works to, I think, the buyer's favor at the end of the day.

So we did not see a noticeable shift between spec and to-be-built.

Got it.

Thank you for that.

Second question, you made the comment about labor and keeping your trades busy.

I was down in Texas last week and one concern that some big builders down there have is that there is a pretty big migrant workforce base that typically shows up around this time of the year, ahead of the selling season.

Some these builders were just concerned given all the uncertainly on the immigration policy and the rhetoric that we might approach February and those workers may just not show up.

I am curious if you have had recent conversations with your trades?

Is that a concern you are hearing on the labor front?

Or has your workforce remained pretty steady and the subs are not overly concerned about that?

Our labor remains tight, but we are managing very effectively with the labor that is out there.

We've got some very strong relationships with our trade partners, and our division teams, our purchasing/procurement agents, our division presidents, our VPs of construction -- our folks on the ground have done, I think, an outstanding job in managing and maintaining those really strong relationships with vendors that, frankly, have a stable supply of labor.

As far as what's going to happen with immigration policy, I think we are watching like everybody in the entire country is, our Company, not just industry.

I think everybody is looking at what is going to happen with some of the policies out of the new administration.

Immigration is just one of those topics that we are paying attention to.

Jack Micenko with SIG.

Hey, good morning.

I wanted to understand what is different in your thinking on the margin outlook for 2017 compared to the fourth quarter?

You had a nice beat in the fourth quarter, and I think, the Wieland drag should be lifted going into next year.

So I am wondering what is behind the commentary towards the lower end?

Jack, I guess it is really a reiteration of what we talked about a little while ago.

We've got higher land, we've got higher labor, and we knew most of that 90 days ago, but certainly the interest rate increase and the impact on affordability factors into that.

Just on balance, our expectation is that we will be at that lower end.

They are still very high margins and always worth it to reiterate.

We don't underwrite the margins, we underwrite the return.

And we think that it will be return accretive, as well.

And, Jack, I'd just add to that.

The guidance we gave a quarter ago was 24% to 24.5%.

We've reiterated that guidance.

We have steered toward the lower end of it just based on what we are seeing in our backlog and some of the other factors that we anticipate in 2017.

Our expectations for cost increases, both labor and house, are in the 1% range to 2% range for 2017 which we see as very reasonable.

So to Bob's point, we have a lot of communities cycling out, a lot of communities cycling in.

Somewhere on the order of 250 out and 250 new come in.

So as we work through that, we look at the different margin profiles.

That is how we've kind of come up with our estimates, and we've tried to provide good transparency and communication to you all to help with the way you build your models.

Okay, great.

Got it.

And then, I think in your prepared comments you had said discounts, 90 Bps higher year to year, 40 Bps quarter to quarter.

Did I hear it right?

And second, the quarter-to-quarter number is almost half the year.

Is there a common thread there, or is that may be trying to offset some of the move in interest rate?

It looks like mortgage rates are up about that much in the fourth quarter.

I'm just curious what was driving the change there?

Yes, Jack, I think it is a bit of a mixed bag.

I certainly think some of it may have been interest rate related.

We also had, probably slightly, we had a few more specs going into the fourth quarter than we generally run at.

And we know just from buyer behavior, the margin profile on a home that is done and sitting on the ground is not as robust as one where a customer can pick out everything that they want to pick out the way they want to do it.

So probably a combination of both of those things.

Bob, I don't know if you have anything else you would add to that?

The only thing I would add, Jack, is it is 3.1% in the quarter.

It is a little over $12,000 a unit.

It is still moderate on relative terms.

To all the points that Ryan made, it is not like we are seeing it go up to 7% or something like that.

This concludes today's question-and-answer session.

Mr. Zeumer, at this time I would like to turn the conference back to you for any additional or closing remarks.

Great.

Thank you, everybody, for your time this morning on today's call.

If you have got any questions we will certainly be available over the remainder of the day.

Thank you.

This concludes today's call.

Thank you for your participation.

You may now disconnect.