Good morning, and welcome to the D. R. Horton America's Builder, the Largest Builder in the United States Second Quarter 2018 Earnings Conference Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation.
As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jessica Hansen, Vice President of Investor Relations. You may
begin. Thank you, Donna, and good morning. Welcome to our call to discuss our results for the Q2 of fiscal 2018. Before we get started, today's call may include comments that constitute forward looking statements as defined by the Private Securities Litigation Reform Act of 1995. Although D.
R. Horton believes any such statements are based on reasonable assumptions, there is no assurance that actual outcomes will not be materially different. All forward looking statements are based upon information available to D. R. Horton on the date of this conference call and D.
R. Horton does not undertake any obligation to publicly update or revise any forward looking statements. Additional information about issues that could lead to material changes in performance is contained in D. R. Horton's Annual Report on Form 10 ks and our most recent quarterly report on Form 10 Q, both of which are filed with the Securities and Exchange Commission.
This morning's earnings release can be found on our website at investor. Dlhorton.com, and we plan to file our 10 Q by early next week. Consistent with the Q1, our consolidated financials present our homebuilding, 4 Star Land Development, Financial Services and other operations on a combined basis. The segment information following the consolidated financials in our press release includes detailed financial information for all of our reporting segments. And as a reminder, after this call, we will post updated supplementary data to our Investor Relations site on the Presentations section under News and Events for your reference.
The supplementary information includes data on our homebuilding return on inventory, home sales gross margin, changes in active selling communities, product mix and our mortgage operations. Now, I will turn the
call over to David Auld, our President and CEO. Thank you, Jessica, and good morning. In addition to Jessica, I am pleased to be joined on this call by Mike Murray, our Executive Vice President and Chief Operating Officer and Bill Wheat, our Executive Vice President and Chief Financial Officer. The D. R.
Horton team delivered a solid second quarter and the spring selling season is off to a strong start with our sales increasing 13% from the prior year. In the Q2, our consolidated pre tax increased 26 percent to $445,000,000 on a 17% increase in revenues to $3,800,000,000 Our pre tax profit margin improved 80 basis points to 11.7%. These results reflect the strength of our operational teams, our diverse product offerings and the leverage of both our national and local scale across our broad geographic footprint. Our continued strategic focus is to produce double digit annual growth in both revenue and pre tax profits, while increasing our annual operating cash flows and returns. For the trailing 12 months, our homebuilding return on inventory was 17.6%, an improvement of 160 basis points from 16% a year ago.
With 29,400 homes in inventory at the end of March 258,000 lots owned and controlled, we are well positioned for the remainder of 2018 and future years. Mike?
Net income attributable to D. R. Wharton for the 2nd quarter increased 53% to $351,000,000 or $0.91 per diluted share compared to $229,000,000 or $0.60 per diluted share in the prior year quarter. Our effective tax rates for the quarter year to date reflect the rate reduction from the Tax Act of 2017. An excess tax benefit related to stock based compensation in the February Bipartisan Budget Act of 2018, which retroactively reinstated the federal tax credit for energy homes.
The current year's 6 month period also includes a onetime noncash tax charge of 108 point $7,000,000 to remeasure the company's net deferred tax assets as a result of the Tax Act. Our consolidated pretax income for the quarter increased 26% to $445,000,000 versus $354,000,000 a year ago, and homebuilding pretax income increased 29% to $416,000,000 compared to $322,000,000 Our current quarter results include $30,100,000 of pretax inventory and land option charges to cost of sales, of which $24,500,000 relates to the settlement of an outstanding dispute associated with the land transaction. Our backlog conversion rate for the Q2 was 100 percent at the high end of our guidance range. As a result, our 2nd quarter home sales revenues increased 16% to $3,700,000,000 on 12,281 homes closed, up from $3,200,000,000 on 10,006 185 homes closed in the prior year quarter. Our average closing price for the quarter was $299,000 up 1% from the prior year quarter.
This quarter, entry level homes marketed under our Express Homes brand accounted for 38% of homes closed and 30% of home sales revenue. Our homes for higher end move up and luxury buyers priced greater than $500,000 were 6% of homes closed and 15% of home sales revenue. Our active adult Freedom Homes brand is now being offered in 25 markets across 14 states and accounted for 2% of homes closed and 1.5% of home sales revenue in the 2nd quarter. Bill?
The value of our net sales orders in the 2nd quarter increased 13% from the prior year quarter to $4,700,000,000 and homes sold increased 13% to 15,828 homes. Our average number of active selling communities decreased 1% from the prior year quarter. Our average sales price on net sales orders in the Q2 was $299,600 and the 19% cancellation rate during the quarter was consistent with the Q2 of last year. The value of our backlog increased 9% from a year ago to $4,800,000,000 with an average sales price per home of $305,100 and homes in backlog increased 8% to 15,841 Homes. Jessica?
Our gross profit margin on home sales revenue in the 2nd quarter was 20.8%, consistent with the Q1 and an improvement of 100 basis points from the prior year quarter. 60 basis points of the improvement from the prior year quarter was due to lower interest, litigation and warranty costs and 40 basis points was due to controlling construction cost increases, while also reducing incentives or raising prices in communities where we are achieving our targeted absorption. Based on current market conditions and our results for the first half of the year, we now expect our gross margin will be in the range of 20.5% percent to 21% for the full fiscal year with quarterly fluctuations that may be outside of the range due to product and geographic mix as well as the relative impact of warranty, litigation and interest costs. Bill?
In the 2nd quarter, homebuilding SG and A expense as a percentage of revenues was 8.8%, an improvement of 50 basis points from the prior year quarter. We remain focused on controlling our SG and A while ensuring that our infrastructure adequately supports our expected growth. Jessica?
Financial Services pretax income in the 2nd quarter was $31,400,000 with a pretax profit margin of 33% compared to $32,200,000 of pretax income and a 37 percent pretax profit margin in the prior year quarter. Financial Services profit margin declined this quarter primarily from lower pricing on loan origination sales due to competitive pressures in the mortgage market. 97 percent of our mortgage company's loan originations during the quarter related to homes closed by our homebuilding operations and our mortgage company handled the financing for 57% of D. R. Horton homebuyers.
FHA and VA loans accounted for 43% of the mortgage company's volume. Borrowers originating loans with DHI Mortgage this quarter had an average FICO score of 722 and an average loan to value ratio of 88%. First time homebuyers represented 45% of the closings handled by our mortgage company
2nd quarter with 29,400 homes in inventory, 14,200 of our total homes were unsold with 10,400 in various stages of construction and 3,800 completed. Compared to a year ago, we have more homes in inventory, which positions us well for the remainder of the spring selling season in fiscal 2018. David?
Our homebuilding investment and lots, land and development during the Q2 totaled $862,000,000 of which $504,000,000 was for finished lots and land acquisition and $358,000,000 was for land development. Our underwriting criteria and operational expectations for new communities remain consistent at a minimum 20% annual pre tax return on inventory and a return of our initial cash investment within 24 months. We expect our homebuilding operations to invest approximately $4,000,000,000 in lots, land and development in 2018. Bill?
At March 31, our homebuilding land and lot portfolio consisted of 258,000 lots, of which 124,000 or 48 percent were owned and 134,000 or 52% were controlled through option 103,000 of our total homebuilding lots were finished, of which 35,000 were owned and 68,000 were optioned. 8,700 of our option lots at March 31 were owned or controlled by Forestar. We have increased our option lot position 23% from a year ago and we believe we can increase the option portion of our total land and lot pipeline to 60% over the next few years, while keeping our number of owned lots near the current level. We plan to continue expanding our relationships with land developers across the country, as well as growing our majority owned 4 Star land development operations. Our 258,000 homebuilding block portfolio is a strong competitive advantage in the current housing market and sufficient to support our expected growth.
Mike? As most of
you know, Four Star Group became a majority owned subsidiary of D. R. Horton in October 2017. Forestar is a publicly traded land development company with operations in 18 markets in 10 states. D.
R. Horton's alignment with Forestar advances our strategy of expanding relationships with land developers across the country to increase our access to option land and lot positions and enhance operational efficiency and returns. The interactions between D. R. Horton and Forestar continue to be extremely productive, and we are excited about the value this relationship will create over the long term for both D.
R. Horton and Forestar's shareholders. Forestar's operating results for the 3 month period ended March 31 and from the date of acquisition are fully consolidated in our financial statements with the 25% interest D. R. Horton does not own reported as non controlling interest.
The segment information tables provided in our press release present Forestar's financials on its historical cost basis, while the impact of purchase accounting and intersegment profit eliminations are presented separately. During the quarter, Forestar sold a portion of its assets for 232,000,000 This strategic asset sale included projects owned both directly and indirectly through joint ventures and consisted of approximately 750 developed and underdevelopment lots, 4,000 undeveloped lots, 730 unentitled acres, a multifamily development site and an interest in 1 multifamily property. This sale provided capital for future growth, while also streamlining Forestar's operations. Both D. R.
Horton and Forestar continue to identify land development opportunities to expand Forestar's platform. Since the acquisition closed in October, Forestar has been evaluating 38 opportunities, primarily sourced by BR Horton, and Forestar had closed on 21 of those opportunities as of March 31. All of the projects are located in high demand markets that Doctor Horton currently serves. These 38 communities are expected to yield approximately 15,000 finished lots, the majority of which may be sold to Doctor Horton in accordance with the master supply agreement between the two companies. Jessica?
Looking forward, we continue to expect Forestar to invest approximately $400,000,000 in land acquisition and development this year and to obtain a bank credit facility by the end of the fiscal year to help fund its working capital needs. In fiscal 2018, we also expect Forestar to deliver approximately 1200 lots and generate $90,000,000 in revenue. In fiscal 2019, we expect Forestar to deliver approximately 4,000 lots, generate $300,000,000 to $350,000,000 in revenue and access the public markets for additional growth capital as conditions permit. In fiscal 2020, we expect Forestar to deliver approximately 10,000 lots and generate $700,000,000 to $800,000,000 in revenue. Over the next 3 years, we anticipate Forestar's stabilized pre tax operating margin will be in the range of 10% to 12% and Forestar is targeting a net debt to capital ratio of 40%.
The expectations I just outlined are for Forestar's stand alone results. Due to the impact of inter segment profit eliminations, we do not expect Forestar to have a material impact on D. R. Horton's fiscal 2018 earnings. Bill?
At March 31, our homebuilding liquidity included $529,000,000 of unrestricted homebuilding cash and $1,000,000,000 of available capacity on our revolving credit facility. Our homebuilding leverage ratio improved 380 basis points from a year ago to 24.2%. The balance of our homebuilding public notes outstanding at the end of the quarter was $2,400,000,000 and we have $500,000,000 of senior note maturities in the next twelve months. During the 1st 6 months of fiscal 2018, our Homebuilding segment generated $90,700,000 of operating cash flows and our consolidated cash used in operations was $98,800,000 Excluding Forestar, we generated $59,500,000 of cash from operations for the current year 6 month period. During the quarter, we paid cash dividends of $47,100,000 and we repurchased 500,000 shares of our common stock for $22,500,000 Our remaining stock repurchase authorization at March 31, 2018 was $152,100,000 At March 31, our stockholders' equity was $8,200,000,000 and book value per share was $21.72 up 13% from a year ago.
David?
Our balanced capital approach focuses on being flexible, opportunistic and disciplined. Our balance sheet strength, liquidity, earnings growth and cash flow generation are increasing our flexibility and we plan to utilize our strong position to enhance the long term value of the company. Our top cash flow priorities are to consolidate market share by investing in our homebuilding business and strategic acquisitions, reduce or maintain debt levels and return capital to our shareholders through dividends and share repurchases. After increasing our guidance for pre tax profit margin in our press release this morning, excluding Forestar, we now expect to generate at least $800,000,000 of cash from operations in 2018, growing to over $1,250,000,000 annually in 2020. Jessica?
Looking forward and as outlined in our press release this morning, we are updating our expectations for 2018 based on current market conditions and our results for the first half
of the year. We now expect to generate a consolidated pre tax margin of 12.1% to 12.3%. We expect consolidated revenues of between 15 point $9,000,000,000 $16,300,000,000 and to close between 51552,500 homes. We anticipate our home sales gross margin for fiscal 2018 will be in the range of 20.5% to 21% with the potential for quarterly fluctuations outside of this range. We estimate our annual homebuilding SG and A expense will be around 8.7%.
We expect our financial services operating margin for the year to be around 30%. We are now forecasting a fiscal 2018 income tax rate of approximately 25% excluding the one time deferred tax asset charge we took in the Q1 and we expect our outstanding share count to increase by less than 1% in fiscal 2018. And as David just mentioned, we now expect to generate at least $800,000,000 of positive cash flow from operations in fiscal 2018 excluding Forestar. For the Q3 of 2018, we expect our number of homes closed beginning backlog conversion rate in the range of 87% to 89%. We anticipate our 3rd quarter home sales gross margin will be in the range of 20.5 percent to 21% and we expect our homebuilding SG and A in the 3rd quarter to be in the range of 8.2% to 8.3% of homebuilding revenues.
We expect our income tax rate in both the 3rd and 4th quarters to be between 25% 26%. Over the longer term and as we generate increased cash flows, we expect to pay down debt and decrease our leverage, increase our dividend and repurchase shares to offset dilution with the target to keep our outstanding share count flat by 2020. David? To conclude and reiterate,
our growth in sales, closings, profits, returns and cash flow is a result of the strength of our long tenured people and well established operating platforms across the country. We are striving to be the leading builder in each of our markets and to continue to expand our industry leading market share. We remain focused on growing both our revenue and pre tax profits at a double digit annual pace, while increasing our annual operating cash flows and improving returns in our business and to our shareholders. We are well positioned to do so with our solid balance sheet, broad geographic footprint, diversified product offerings across our D. R.
Horton, Emerald, Express and Freedom brands, attractive finish lot and land positions, and most importantly, our outstanding team across the country. We thank the entire D. R. Horton team for their continued focus and hard work. We look forward to growing and improving our operations during our 40th anniversary year, while preparing for great opportunities in the years to come.
This concludes our prepared remarks. We will now host questions.
Thank you. The floor is now open for questions. Our first question is coming from John Lovallo of Bank of America Merrill Lynch. Please go ahead.
Good morning, guys, and thank you for taking my questions. First question is, Forestar's stock has held up really well, I mean, particularly relative to the group. And frankly, most of the investors that we speak with are aware and really very much on board with the asset light thesis and the strategy to issue equity to not only fund the business, but dilute your stake down. I guess the question is why not do this sooner than later?
John, thank you for the question. I think what we're focused on at Forestar, 1st and foremost, is building a great operational platform. When we bought the company in October, just about a little over 6 months ago, they had not really been focused on driving a community development business in the way we need it built. And so first things first is realigning the team and the people that are in place there, building the interactions between D. R.
Horton and Forestar and building a strong operating platform. We think that building for the long term will help any capital raises when
we go to the markets next year. And John, fortunately, they started with a lot of cash. And so they had $400,000,000 of cash at the date of the transaction. So from the standpoint of a need for capital to fund that growth, there wasn't an immediate need. They were also able to generate cash by selling some of their legacy portfolio as well.
And so we believe that focusing on operations, putting them in place to support us for the long term, which is really what will drive long term value is most important. And certainly then, capital raises, both equity and debt down the line from Forestar will be an important part of their strategy, but it was not necessary here in this 1st year.
That makes sense. Okay. And then clearly there's a lot of concern in the market about interest rates and about construction costs. I mean your orders and margins should help ease some of those concerns there. But are you guys seeing in the field any caution from buyer potential buyers on rates?
And maybe if you could just update us on what your stick and brick costs are running year over year please?
We're actually seeing more buyers come in and better qualified buyers today. As I indicated in the prepared remarks, our FICO score this quarter was 722, which is the highest it's been in several years and that's with Express continuing to become a bigger piece of our business. So we're really not seeing rates have any noticeable impact on demand. And for us, it's still is all about jobs and affordability. So as long as those two things are good, we don't expect an impact on demand even if rates do continue to rise gradually as we move throughout the year, which I think is our expectation today.
Your question about cost, John, our stick and brick cost per square foot was up low single digit. Our lot cost per square foot was up mid single digit and then clearly our revenue per square foot was enough to offset that to show the steady
and improving year over year margin.
So really more of the same in terms of revenues outpacing stick and brick costs. Our guys have done a phenomenal job controlling cost increases in a rising cost environment and we've been able to offset it with price.
John, this is David. I would say the optimism that's out there in the market today, slight increase in rates that we've seen are really fueling demand. And it's if rates just continue to move slowly, I see a long sustained housing market.
Very encouraging guys. Thanks for the time.
Thank you.
Thank you. Our next question is coming from Stephen East of Wells Fargo. Please go ahead.
Thank you. Good morning, everybody. Just following on Forestar a little bit. Mike, maybe you could give us an update on the build out for Forestar, what you all are doing. So eventually this becomes a standalone operation other than Horton sourcing everything?
And when would you expect to start to see that occur where they are sourcing more than what Horton's bringing to the table?
Where they are sourcing more than what Horton's bringing to the table. That will be probably at some point down the road. I mean, one of the things we talked about last summer when we were working on this and kind of explaining our strategy was that we have hundreds of people across the country today that are out. Their whole focus is to identify new land and community opportunities. And Forestar still has, I think, 35 to 40 people on the team.
And while there has been some new folks added, and I think we will continue to see a team built out over the next 12 to 18, 24 months, it's going to be a bit of time before they're able to source as many deals as we're able to source and provide opportunities for them to evaluate. So I don't see that in the near term and the medium to long term certainly. That is a key goal for them to be able to be sustainable and independent of us in terms of their own lot supply and pipeline?
Yes. Steve, this is David. We had the 4 star guidance up yesterday, day before, kind of just going over operational plans. And I think their primary focus, their internal goals are to create independence from Wharton and they are looking at deals today that will be sourced directly by them. But they got to have people.
The thing that makes us different is people and they got to do that.
I think in the past 90 days, they've closed on 2 deals that were advantage of. So they are out, they are actively working it. It's just in this business, it's a very large funnel where you start with a lot and you work it down over a period of time to get there. So the larger your starting number is, the more likely you're going to be
able to close some of that. And an important part of putting them in position to be able to do that down the line is expanding their platform across the Horton footprint, leveraging the Horton structure today to give them a presence in more markets than they're in today and then that will then put them in position to source more land independently down the line. But fortunately, we've got the opportunity for them to show tremendous growth, just to grow their operations by leveraging Horton in the short term.
Okay. And would that mean one follow-up on that. Would that mean would roll ups play a significant part in that? And then my other question just revolved around cash flow. As you look out, when would you start seeing your cash flow get better because of Forestar's activities?
And I didn't really hear any commentary about actively looking on the M and A side. Is that going to play into it also? So
on the roll up opportunities within Forestar, that is something they certainly will be evaluating as they're looking to build the team. And with that like on the builder side, we'll be very opportunistic. We continue to look at various M and A opportunities in the builder side opportunistically where it makes sense to add people to the team, potentially new products in new markets.
And our D. R. Horton cash flow guidance already includes what we expect as a result of Forestar and moving to 60% optioned here over the next few years and growing that cash flow number to over 1.25 $1,000,000,000 annually by 2020.
Okay. Thanks a lot.
Thank you. Our next question is coming from Alan Ratner of Zelman and Associates. Please go ahead.
Hey, guys. Good morning.
Good morning, Alan.
So a question on price point. Obviously, you guys have been an early mover at the entry level. We heard another builder yesterday who's more of a move up builder actually mentioned the fact that they're seeing less competition now as other builders have kind of moved into your space on the entry level side. And I remember last quarter, I think it was you actually highlighted at some point maybe an opportunity might present itself to get more active and move up. So I was curious kind of if you could just talk a little bit about the dynamics you're seeing across your portfolio.
Do you still feel like entry level is a space that has a lot of runway to go based on the new entrance into that arena? And are you starting to see more opportunities unfold and move up given, I guess, some builders leaving that space?
Well, we haven't really seen anybody leave that space. But I can tell you the entry level demographics and really the delay in what used to be the 25s buying houses to 35s, that group of people is there's more demand than is currently being serviced. So we're focused on returns. The entry level is driving the best returns. I think as time moves, we will see that shift kind of up the price curve.
But right now today, it's awfully good in that $250,000,000 to $300,000,000 range.
Got it. Great. Okay, good to hear. And then second question, if I look at your order growth, it was remarkably consistent across the regions. But just curious if you could talk a little bit about which markets you're seeing, maybe the strongest pricing power relative to cost inflation and where you're seeing the best opportunity to drive growth going forward?
Texas, Florida continue to be very, very strong markets. Arizona has come on incredibly strong for us over the last couple of years. A lot of stability in California, the price points we're selling. Northwest continues to be very, very strong and we're getting a little better than Northeast. So we like to see that consistency.
That's something we strive for and really pretty proud of what our people are doing out there.
And when you see our supplemental data here in a little while, Alan, after the call, you'll see that really our absorptions were up strongly across the board in all of our regions.
Any markets that jump out on the other side where maybe pricing sitting a bit of a wall or absorption growth is a bit more challenging?
I got to tell you, we're not seeing that right now. Even what has been our weaker markets have stabilized and we're seeing if not significant absorption gains, we're seeing margin moving up a little bit. The market is very good right now. There are a lot of people out there that don't own a house that they want to figure out how to get in 1. And they feel good enough to take the risk to decide a mortgage and close.
So job growth is strong. Consumer optimism is way up. Consumer confidence is way up. A lot of good things happening in the country right now.
Great. Good to hear. Good luck, guys.
Thank you. Our next question is coming from Carl Reichardt of BTIG. Please go ahead.
Thank you. Good morning, everyone. Good morning. I wanted to ask about flag count, which I think was flat or a little bit down. When do you expect that you might see a sort of a reacceleration in the growth in number of communities year on year, especially given that the lot count is kind of building now behind the store
count? Carl, we do still expect to see growth over time in our community count. We've seen periods where we're slightly up. This quarter, we were down 1% year over year. Over the medium to longer term, we expect to see modest growth there.
Predicting exactly when that inflection point hits by quarter is a little bit difficult for us. But we've been seeing continued improving absorptions as we continue to improve our execution and how we're meeting the market across our markets. And that's been able to drive steady double digit growth now for several years with very modest community count growth. But we do expect that to inflect, but predicting exactly when it's a little bit hard.
Okay. Thanks, Bill. And then I wanted to ask about co broke costs. I know for a long time you've looked at Buyers Brokers as a really important set of partners for you and you've worked with them closely over a long period of time. How are you thinking about those relationships on sort of a longer term basis?
Are those kinds of costs that you have to pay out something that you could work to lower over time? I'm just kind of interested in how you think about that sort of strategically and tactically. Thanks.
Strategically, we think of them as partners and we're going to continue to work with that community at a level that really is unique in industry. Now over time, will their economics change? Will they have to become more efficient and more competitive? Yes. But at least in my mind, they're going to be the resale market is so much bigger than the new home market.
And whether it's online, whether it's some other type, that interaction with people at point of sale, I think is still going to be a part of how you get a transaction closed. So we love realtors. We're going to continue to support realtors and to me they're as big a part of the cost of the house as a necessary part of the house as concrete and lumber because they drive the industry.
Thanks David.
Thank you. Our next question is coming from Michael Rehaut of JPMorgan. Please go ahead.
Thanks. Good morning, everyone, and nice results. Good morning. Thank you, Michael. First question, wanted to go back to the shift to lot optioning.
And obviously, you've had a lot of success there. And with the most recent quarter this most recent quarter at 52%, you continue to make a very consistent solid move towards that 60%. If you extrapolate 2% a quarter, not that 1 quarter is indicative of a trend, it could suggest that maybe you're going to get to that 60% not in a couple of years, but perhaps on a shorter timeframe. I was curious if that's a possibility to get to a 60% type of mark over the next 12, 18 months instead of the next 2 to 3 years? And what impact that might have from a return perspective, return on equity, return on capital?
Michael, that's it. That has been a consistent driver of our improving returns on our investments. And as we look from where we were 6 months ago, we've picked up 2% in that mix. And so we're going to continue to push that business so that we're buying more lots on an option basis and engaging with developers and looking for ways to work with them on an optioning basis. I don't know that we won't get there in 18 months, but it might also take us 30 months to get there.
It's a little bit of a snapshot point in time at the quarter ends that we're measuring that and land and lots are purchased and contracted on a dynamic basis throughout the year. So we're consistently looking to move metric up and consistently looking to improve our returns. It's a big part of our regional presidents division, presidents compensation plan is to be focused on returns. So they are the ones that make this happen and they do it deal by deal, market by market. Our goal is
not only consistency, but sustainability. And we've talked in the past about achieving something if you can't grow it and maintain it really is kind of a false achievement. So everything we're doing is set up to execute quarter to quarter, a little better and sustain it off down the road into the future. The quarter to quarter, 52%, 53%, 54, That's really not in our minds or anything that we spend a lot of time thinking about.
Right. I appreciate that. No, I understand. I think second question, I just wanted to focus a little bit on the margin side. And kind of a 2 part here, you were able to raise your gross margin guidance for the year.
And I was just thinking about over the next year or 2, is this 20.5% to 21% a range that you see as sustainable? Or do you see a little bit of possible upside to that as you continue to lever some of the fixed costs or some get more efficiencies? Conversely, on the SG and A, just any thoughts around the fact that you reiterated the full year SG and A guidance ratio despite raising the revenues. Typically, you'd see a little bit of leverage incremental leverage if you were to raise revenues all else equal. And how do you think about SG and A over the next 2 or 3 years?
Mike, I'll kind of start at the bottom line and then we'll kind of go back to the pieces. We're 1st and foremost focused on improving our returns. And there's a lot of levers that allow us to achieve that certainly as we've already touched on managing our inventory investments and our options is part of that. But we're very focused on improving our P and L metrics there as well to drive continued and improving returns. We're certainly seeing a good healthy housing market, which is allowing us to see good stability and some lift in our margins, which has driven the adjustments in our guide on margin as well.
And then with our volume, we're getting good leverage on SG and A as well, and we would expect to we continue to do that to work to improve that line item as well, all with the driver of improving our returns.
And as we've been working to improve returns, velocity of capital absorption pace within a given community is critical to achieving the returns. And so we're very pleased that executing on that strategy, maintaining the disciplined absorption and starts plans that we have in place community by community, we're able to see improving margins in today's environment.
I guess just being a little more specific though on SG and A, was there any type of reason why you weren't able to get a little bit more leverage off of a higher revenue base all else equal? I mean, the question is more revolved around are we kind of reaching a point where SG and A is at a natural level? Or is there incremental leverage there?
Thank you. Please resume.
Our sincere apologies for the interruption. Mike, Bill is going to answer your question now.
Sorry about that, Mike. You were asking about our SG and A and our annual guidance. Yes, I mean, we're certainly pleased with where we are year to date on our SG and A. Our annual guidance from a revenue standpoint, we have increased the bottom end of our revenue range. Our top end of the revenue range is still in place.
And so from an annual standpoint, we felt like our annual guidance still realistic and reasonable relative to that annual revenue guide. But certainly, we're focused on achieving that and hopefully beating it. But at this point in time, we felt like the annual guidance was still at a reasonable level.
Great. Thank you.
Thank you. Our next question is coming from Jack Micenko of Susquehanna. Please go ahead.
Hey, good morning guys. This is actually Sean Mosley on for Jack this morning. So just getting back to rates and the impact on your buyers, the concern is obviously around sensitivity to rates and given your entry level mix is higher there. But can you maybe speak to some of the tools that you guys have under your belt to offset some of that pressure for that value going forward? I mean, we've heard of point buy downs in some cases and longer rate locks.
We're not seeing those kind of products with any kind of widespread use right now. As Jessica mentioned before, we're seeing kind of an increasing pool of better qualified buyers. Even with our larger exposure to the entry level in Express, our mortgage company FICO score is the highest it's been in years, this last quarter on current originations. And while interest rates are going up, I do think they're going up for the reasons we hoped is that it strengthened the economy and we're seeing people with more jobs and better incomes, which are 2 of the primary drivers household formations and home purchase decisions.
And what we would typically see first as buyers become more challenged if rates do continue to rise to a level that impacts affordability to any large extent is just a shift down in size of the home they're going to buy. So we have multiple floor plans in our communities. And right now, our average square footage in an Express community may be 2,000 square feet, but we've got a 1500 or 1600 square foot plan available that we're just not selling as many of. And as rates rise and affordability becomes more of a challenge, people still need to buy homes. They may just buy a little less home rather than the larger home.
We're not seeing that today as Mike indicated, but that would typically be the 1st shift and we can flex very quickly to do that.
Right. That's helpful. And then switching to Forestar, as I look at the SG and A expense line, it's down 40% sequentially. So was that you guys just rightsizing the business this quarter? And when do you expect to get to that normalized 10% to 12% pretax margin by?
Jack, the Q1 for them, the prior quarter included a lot of their transaction costs. So they had a lot of unusual costs associated with the transaction, both costs associated with it as well as change of control type payments to employees. So this quarter is closer to a normalized SG and A rate for them. We would expect over time for their SG and A to need to grow, obviously, as they build out their platform. And then as they get to a normalized pace where they're delivering really the new profile of deals, the faster turning deals that they'll be delivering to D.
R. Horton in 2019 and really by 2020 than that pretax operating margin of 10% to 12% would be our expectation at the current time.
Okay. So you expect it by next year at some point?
I think they'll be in that park. They're still working through legacy assets, some of which are higher margin, but lower turn. Newer assets will be a faster turn. And so I'd say by late 2019 and into 2020, you should start to see their profile get closer to that stabilized level that we described.
Great. Thank you.
Thanks, Don.
Thank you. Our next question is coming from Ken Zener of KeyBanc Capital Markets. Please go ahead.
Good morning, everybody. Good morning, Dan.
I'd like you to comment on units under construction to improve investors' understanding of your business. With closings at 100% of backlog, I think that's less insightful than 40 closings 44 percent of prior quarters units under construction. So my one question has 3 parts. Please explain why you carry a spec unit for each unit in backlog? How you locally manage your construction cycles without a top down infrastructure?
And then, how does this help your asset velocity and lower your land risk, which is at 2.5 years supply? Thank you. That's it.
First part of the question, why do we carry specs and what ratio is appropriate? I mean, we manage the spec levels community by community, looking at construction cycle times, looking at sales demand in that submarket and what the planned absorption is for that community. And we will start a number of homes that are unsold to meet the expected delivery demand that we're going to see in that. And our operating process is to start the home and sell into that production cycle. But that's done at a community by community level and we will adjust those starts and that inventory level up or down depending upon market reaction and how our sales efforts are going.
I'm not exactly sure what the second part of your question was about managing the construction cycle, top down because we certainly don't. That is a very local submarket by submarket with the teams in place that know their market the best, know their trades the best, what the trades are capable of doing and to maximize the efficiency with those trades to get the best labor pricing. On a national basis, what we're able to do on the pricing side is work a lot of our national trade partners on leveraging our scale and purchasing power to keep our input costs as low as possible.
And then you mentioned the asset velocity and really what our local operators are doing when they're managing this community by community. When they open a community, they have a planned business plan that is designed to strike the best balance between pace and price margin to generate the best return. And so they are executing to that plan. And clearly asset turn, asset velocity, monthly absorption is an important part of that. And then that's what they guide their business to.
If they just start a little hot and they're selling a little bit more, they're more likely to moderate their pace to hit their absorption pace and push price and margin. If they're starting a little slow, they will push their absorption to make sure they stick to their absorption plan and make sure they do that to optimize their returns. So it's really governed by optimizing that balance to generate the best returns community by community.
And that's driving the return off of the land or lot investment does de risk that land or lot investment because we're going to move through that capital in the timeframe that we expected to at the outset of the project. Thereby, we pull that capital back into the company and we're able
to redeploy it into current market. And so spec strategy is a key part of that in order to turn the land inventory and to keep that consistent pace going having that inventory of specs in place to anticipate what we want to sell, what our absorption plans are for each month in that community is a vital part of it.
And having adequate supply specs in every community makes this a viable alternative to the existing home sales that are out there, which as David mentioned before, is a much larger market than the new home sales.
Thank you.
Thank you. Our next question is coming from Jay McCanless of Wedbush Securities. Please go ahead.
Hey, good morning. Thanks for taking my questions. The first one I have by my count, Horton is the 4th builder this week to raise their full year gross margin targets. Can you talk about what's changed versus the last conference call and maybe what you guys and the industry are seeing that gives you more confidence on that line item?
Yes, Chad, I would say 3 more months through the spring is really we're seeing that the environment is good. We're seeing that we're hitting our absorption pace, we're seeing that we continue to have the ability to offset cost with price community by community has given us that confidence level. And so we're pleased to be able to do that. And what we see today is continued stability, healthy market that we think the latter half of the year should support that higher guidance.
Okay. That's great. And then also wanted to touch on you guys with Freedom were one of the first movers on this empty nester trend that seems to be gaining steam. Are you guys tracking anything in the field for your other product lines in terms of how many more empty nesters or 55 plus buyers are coming in maybe versus this time last year or a few years ago?
We're not really I wouldn't say we're tracking. As we establish our Freedom flags in the markets, We're seeing better and better success. The Express communities have absorbed a lot of that 55, I'd call them blue collar retiree, because it's just a lower cost lifestyle. I mean that's a from a demographic standpoint, it's a huge trend. And it also dovetails into the migration from high tax states to low tax states.
So it's we believe it's a long term trend that we're going to see a lot of demand for the foreseeable future.
Great.
And can you remind us just what are the long term targets for how many Freedom flags you want out there?
Yes. We're in 7 day markets. Some markets significantly bigger than others. But our goal is to get them rolled out, kind of like our Express program to a level in each market that the market will absorb. So it's going to be a big part of our growth over the next 5, 7 years.
Okay, great. Thanks for taking my question.
Thank you. Our next question is coming from Stephen Kim of Evercore ISI. Please go ahead.
Yes, thanks very much guys. And again, congratulations on the good results.
Good afternoon. My first question
yes, my first question actually relates to production efficiencies. Obviously, you guys with the rollout of Express way before the competition really got a jump on that and it's been a huge part of the success of the company over
the last few years.
I was curious about what you thought about the opportunity to maybe take the next step in terms of productivity with the use of or the partnering with companies that do panelizations or factory construction for the sake of simplicity, I'll call them like e builders. And so my question is basically 2 parts. 1, what percent of the homes that you build today are using some expensive use of panelization? And is this an area that you're really focused on? And 2, do you think the productivity gains that you might get will continue to be through low tech strategies?
Or do you think the integration of things like robotics or BIM modeling, logistics software, etcetera, along with factory production holds a real promise?
So first question, we do use panelization in various markets and it's market by market where those capabilities exist in the market and can provide a timely and cost effective solution for our local building operations. We are very happy using panelization and we look to expand that and work with a truss plant in a given market to expand to see if they're capable of moving the next step in panelization. So we do that. I don't have a percentage for you of what the breakdown is across the country, but it is something that we do monitor and measure and continually challenge our existing assumptions about what the most efficient way is to deliver a home to a customer. In terms of the higher tech, I would say broadly, yes, Stephen.
I think there will be production efficiencies to be gained in our industry through this. Do I know which one it is yet? No, I don't. But we are evaluating those and we are watching those and we're very interested in paying attention to what's happening there. I think there's some really interesting things happening and I think we're excited to be to play a part in that.
Yes, that makes sense. I just want to follow-up on that, if I could, Michael. You mentioned that it depends your use depends a little bit on if the local market can support your use of that. And I was curious if you that seemed to suggest there may be some sort of a bottleneck in certain markets. And I was curious if that supply issue or bottleneck had to do with an availability of capital.
And if that's so, if you would be interested in partnering with some of these kind of initiatives to sort of get them jump started to get to the kind of scale where they could actually support somebody of your size?
Again, it is going to vary very much market by market where there are markets where there are very efficient labor sources that are able to stick frame a home and construct a home in the traditional fashion, it's a difficult barrier to overcome the cost efficiencies it takes to bring panelization in place. Other markets that are higher labor cost markets, we've seen more rapid adoption of panelization.
I will say, Stephen, affordability in housing is just going to become more and more difficult to maintain. And even at our express level, there are still a significant amount of the population that's priced out of homeownership. So we have got to get better. And I think technology and different ways of thinking about constructing houses is going to be how that takes place, because I don't see labor going down and I don't see materials going down. And land certainly is not going to go down.
So how you build a house, I mean that's to me everybody at some point in their life ought to be able to own a house. And that's just not the case today in the United States and it's certainly not the case in the world. So that's something we think about a lot.
Over time this industry and this company will put that puzzle together, marrying the technology, marrying the new techniques with the unique attributes of how you build out a community. Every piece of real estate is different. Every local market is different. But marrying those things market by market will happen and will happen for this industry and for this company.
It was a very important take to me when I was able to buy my first house. And I can tell you, I think that helped me become the success Whatever success I've achieved, I think that was a part of it. So everybody ought to get to experience it.
Well, that's great. I really appreciate it. And I wish I had bought the same house you did. And I wish how that is.
Don't be confused, I lost money on the house. But I was a 13.5% interest rate and my payment was ridiculously high for a guy starting out.
All right. Well, thanks very much guys. Appreciate it.
Thank you, Steve. Appreciate it.
Thank you. Our next question is coming from Nishu Sood of Deutsche Bank. Please go ahead.
Thanks. So I just wanted to ask about your updated thoughts on share repurchases. Obviously, the cash flow outlook is very strong. Obviously, you're raising the guidance for this year. And obviously, Forestar is on track to be more self sufficient next year.
You maintained your intention to just buy back to the extent to offset dilution. Any updated thoughts on going beyond that?
Over the longer term issue, yes, so we would expect that we would do that. But for the short run, we are getting established with being a consistent repurchase for our shares each quarter. We have not historically done that on a consistent basis. So we are in the early stages of beginning a long term share repurchase program. And so right now we're starting at a level that we're comfortable with within our cash flow.
Obviously, our cash flow is used for a number of purposes this year. We had a major acquisition early in the year. We continue to pay a dividend at a healthy rate as well. And so we're beginning the share repurchase at a modest level, but we would expect it would increase over time. First step is to offset dilution here by 2020.
And then as our share as our cash flow grows, as our business grows, we would expect that to grow continue to grow over time as well. Again,
it's about consistent and sustainable over a long period of time. The flash buys in my experience don't do much for the shareholders long term.
Got it. And what do you need to see specifically to feel that the to conclude basically that you've been successful in creating a consistent cash flow generating machine. I mean, you're going to be over $800,000,000 this year. And at this stage of the cycle when the market is going well, that's a very strong number. And I think you've $1,250,000,000 target for 2019 or you didn't mention it.
I would love to know if your real thoughts on that are different. So coming out of $120,000,000 you will have been
3 years averaging about $1,000,000,000 a year. At that stage, do you say we've been successful in our goals and
maybe we can consider a sustainable
program?
Sustainable program? What exactly are you going to use to judge that kind of metric or number wise?
Well, it's going to
be on balance with all aspects of our business. What we see overall in our business, what we see in our opportunities to continue to invest and grow in our business, what we see on the M and A front, as well as then what we just see in terms of our outlook on the market. So what I would say is we do believe that we have been very successful at building a cash flow generating machine. We've generated positive cash flow for 3 straight years. This will be the 4th year.
And it gave us the confidence to begin the share repurchase program. And so now we will just build on that quarter by quarter, year by year. And as we continue to make progress quarter by quarter, then I would expect the share repurchase to increase alongside it.
Got you. And
We're going to stay opportunistic too. I mean the investment we made in Forestar, we think is going to be significantly better for our shareholders than increasing our stock buyback by $500,000,000 this year. So it's we're out there looking at the market and making what we believe are the best long term decisions for our shareholders.
Got it. Got it. And on Forestar, the 10,000 lot delivery goal, I think that was the 3rd year out for fiscal 2020. As you've been developing the pipeline, any kind of updated thinking on what percentage of those might be delivered to Doctor Horton and what percentage might be external? How D.
R. Horton linked will do you expect Forestar to be at that stage, especially now that you have some clarity with 38 deals having been vetted so far?
The 1st couple of years here, 2018, 2019, 2020, it's going to be very more heavily weighted towards Wharton than it will be over the longer term. Over the longer term, as David mentioned earlier, we met with the Forrester team this week and they would expect to deliver to other builders over the longer term 20% to 30% of their deliveries to other builders. It's going to take them a bit of time to develop their sourcing capabilities, but they do have existing relationships with other builders today and are delivering lots to other builders today, but their sourcing capabilities are going to be largely driven by Horton here in the short run. But 20% to 30% would be a good range for them for the long term for other builders.
Great. Thank you.
Thank you. At this time, I would like to turn the floor back over to management for any additional or closing comments.
Thank you, Donna. We appreciate everyone's time on the call and look forward to speaking with you again in July to share our Q3 results. And to the D. R. Horton team, another spectacular quarter.
It makes us proud to sit up here and be able to represent you. Thank you.
Ladies and gentlemen, thank you for your participation. This concludes today's conference. You may disconnect your lines at this time and have a wonderful day.