Welcome to the D.R. Horton, America's builder, the largest builder in the United States, third quarter 2017 earnings conference call. At this time, all participants are in a listen-only mode. An interactive question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Jessica Hansen, Vice President of Investor Relations for D.R. Horton. Thank you. You may begin.
Thank you, Donna. Good morning. Welcome to our call to discuss our results for the third quarter of fiscal 2017. 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, 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-K 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.drhorton.com. We plan to file our 10-Q this week. After this call, we will post updated supplementary data to our investor relations site on the presentation 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. I will turn the call over to David Auld, our President and CEO.
Thank you, Jessica. 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 is producing strong results in 2017. In the third quarter, our consolidated pre-tax income increased 17% to $444 million on $3.8 billion of revenue. Our pre-tax profit margin was 11.8%. The value of our homes sold increased 13%. For the nine months ended June, our consolidated pre-tax income increased 21% to $1.1 billion on an 18% increase in revenue to $9.9 billion. Our pre-tax profit margin for the nine-month period improved 30 basis points to 11.2%.
These results put us on track to deliver our guidance on all metrics for the full year of 2017, and reflect the strength of our operational teams and diverse product offerings across our broad national footprint. Our continued strategic focus is to produce double-digit annual growth in both revenue and pre-tax profits while generating annual positive operating cash flows and increasing our returns. For the trailing 12 months, our homebuilding return on inventory was 16.3%, an improvement of 200 basis points from 14.3% a year ago. With 27,600 homes in inventory at the end of June and 252,000 lots owned and controlled, we are well positioned for the fourth quarter and further growth in 2018. Mike?
Net income for the third quarter increased 16% to $289 million, or $0.76 per diluted share, compared to $250 million or $0.66 per diluted share in the prior year quarter. Our consolidated pre-tax income for the quarter increased 17% to $444 million versus $379 million a year ago, and homebuilding pre-tax income increased 19% to $415 million, compared to $348 million. Our backlog conversion rate for the third quarter was 85%. Our third quarter home sales revenues increased 17% to $3.7 billion on 12,497 homes closed, up from $3.1 billion on 10,739 homes closed in the prior year quarter. Our average closing price for the quarter was $293,100, up 1% compared to last year. This quarter, entry-level homes marketed under our Express Homes brand accounted for 33% of homes closed and 25% 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 15 markets across 12 states, and customer response to these affordable homes and communities offering a low-maintenance lifestyle has been positive. Bill?
The value of our net sales orders in the third quarter increased 13% from the prior year quarter to $3.9 billion, and homes sold increased 11% to 13,040 homes. Our average number of active selling communities increased 1% from the prior year quarter and 2% sequentially from our second quarter. Our average sales price on net sales orders in the third quarter was $296,900, and the 21% cancellation rate during the quarter was consistent with the prior year. The value of our backlog increased 6% from a year ago to $4.6 billion, with an average sales price per home of $306,400, and homes in backlog increased 3% to 15,161 homes. Jessica?
Our gross profit margin on home sales revenue in the third quarter was 19.8%. Consistent with our expectations in the first half of the year. Our gross margin decreased 50 basis points compared to the prior year quarter due to higher litigation costs. In the current housing market, we continue to expect our average home sales gross margin to be around 20%, with quarterly fluctuations that may range from 19%-21% due to product and geographic mix, as well as the relative impact of warranty, litigation, and interest costs. Bill?
In the third quarter, home building SG&A expense as a percentage of revenues improved 50 basis points from the prior year quarter to 8.4% due to better leverage of our fixed overhead costs from increased revenues. We remain focused on controlling our SG&A while ensuring that our infrastructure adequately supports our growth. Jessica?
Financial Services pre-tax income in the third quarter was $29.3 million compared to $30.2 million in the prior year quarter. 95% 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 55% of D.R. Horton home buyers. FHA and VA loans accounted for 48% of the mortgage company's volume. Borrowers originating loans with DHI Mortgage this quarter had an average FICO score of 719 and an average loan-to-value ratio of 89%. First-time homebuyers represented 46% of the closings handled by our mortgage company, consistent with the prior year quarter. Mike?
We ended the third quarter with 27,600 homes in inventory. 12,800 of our total homes were unsold, with 9,200 in various stages of construction and 3,600 completed. Compared to a year ago, we have 9% more homes in inventory, putting us in a strong position for the fourth quarter and into fiscal 2018. Our investment in lots, land, and development during the third quarter totaled $1.1 billion, of which $740 million was for finished lots and land, and $360 million was for land development. During the nine months ended June, we invested $2.8 billion in lots, land, and development, compared to $2 billion in the same period of last year. 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 plan to continue to invest in land and lots at a rate to support our expected growth. David?
This quarter, we achieved our previously stated goal of a 50% owned, 50% optioned land and lot pipeline. At June 30th, our land and lot portfolio consisted of 252,000 lots, of which 125,000 are owned and 127,000 are controlled through option contracts. 83,000 of our total lots are finished, of which 33,000 are owned and 50,000 are optioned. We have increased our option lot position 41% from a year ago, and we plan to continue expanding our relationship with land developers across our national footprint to further increase the option portion of our land supply. Our 252,000 total lot portfolio is a strong competitive advantage in the current housing market and sufficient lot supply to support our targeted growth. Mike?
On June 29th, we entered into a definitive merger agreement to acquire 75% of the currently outstanding shares of Forestar Group, a publicly traded residential real estate development company, for $17.75 per share in cash, or approximately $560 million of total cash consideration. The strategic relationship between D.R. Horton and Forestar will significantly grow Forestar into a large national residential and development company, selling lots to D.R. Horton and other home builders. Forestar will remain a public company with access to the capital markets to support its future growth. The proposed merger accelerates our strategy of expanding D.R. Horton's relationships with land developers and ultimately increasing the option portion of our land and lot position to enhance operational efficiency and returns. As a reminder, there is a slide deck with additional details about the transaction available on the investor relations section of our website at investor.drhorton.com/FOR.
We remain confident in the growth plan for Forestar as outlined in that presentation. Our interactions with the Forestar team have been very positive, and we are pleased with the progress we are making on the acquisition. The transaction is expected to close in our first fiscal quarter of 2018, subject to the approval of Forestar shareholders and other customary closing conditions. We expect the preliminary Form S-4 to be filed by Forestar soon and will have no other information to share until after the closing date. We are excited about the value that this relationship will create for both D.R. Horton and Forestar shareholders. Bill?
At June 30th, our home building liquidity included $461 million of unrestricted home building cash and $900 million of available capacity on our revolving credit facility. Our home building leverage ratio improved 520 basis points from a year ago to 24.8%. In May, we repaid $350 million of senior notes at their maturity, and the balance of our public notes outstanding at the end of the quarter was $2.4 billion. We have $400 million of senior note maturities in the next 12 months. During the quarter, we repurchased 1.85 million shares of our common stock for $60.6 million, which partially offset dilution from equity awards. At June 30th, our shareholders' equity was $7.4 billion, and book value per share was $19.87, up 14% from a year ago.
Subsequent to quarter end, our board of directors increased our share repurchase authorization to $200 million effective through July 2018, replacing the prior authorization. Our balanced capital approach is centered on being flexible, opportunistic, and disciplined. Our top cash flow priorities are to consolidate market share by investing in our home building business and strategic acquisitions, pay off senior notes at maturity, and return capital to our shareholders through dividends and share repurchases. Our balance sheet strength, liquidity, consistent earnings growth, and cash flow generation are increasing our flexibility, and we plan to maintain our disciplined, opportunistic position to improve the long-term value of the company. Jessica?
Looking forward to the fourth quarter, we expect our homes closed to approximate a beginning backlog conversion rate in the range of 88%-90%. This will result in homes closed for the full year of fiscal 2017 in the range of 45,800-46,200 homes, and consolidated revenues of $13.9 billion-$14.1 billion, both of which are above the high end of our initial guidance range. We anticipate our home sales gross margin in the fourth quarter will be around 20%, and we expect our fourth quarter home building SG&A to be in the range of 8.3%-8.4% of home building revenues. We estimate that our fourth quarter financial services operating margin will be in the range of 32%-34%. We expect our tax rate in the fourth quarter to be approximately 35.2%, and our fourth quarter diluted share count to be around 380 million shares.
We now expect our consolidated pre-tax operating margin for the full year of 2017 to be in a range of 11.3%-11.5%, and we expect approximately $300 million of positive cash flow from operations for the year. Our expectations are based on today's market conditions. Our preliminary expectations for fiscal 2018 are for consolidated revenues to increase 10%-15% and to achieve a consolidated pre-tax margin of approximately 11.5% for the full year of fiscal 2018. We also expect to generate positive cash flow from operations for a fourth consecutive year in a range of $300 million-$500 million. We anticipate our tax rate for fiscal 2018 will be approximately 35.5%, and that our diluted share count next year may increase up to 1%. Our preliminary guidance for fiscal 2018 is for our current operations and does not include any impact from Forestar.
We do expect Forestar to be accretive but not material to our earnings in fiscal 2018, and we'll provide more information after we close on the transaction. David?
In closing, our third quarter and year-to-date growth in sales, closings, and profits is a result of the strength of our people and operating platform. We are striving to be the leading builder in each of our markets and to continue to expand our industry-leading market share. We have been the largest builder in the U.S. for 15 consecutive years. According to Builder Magazine's recent Local Leader issue, in 2016, we were the number one builder in four of the top five U.S. housing markets, and we believe we will be the number one in all five of those markets in 2017. Also, in 2016, we were a top five builder in 28 of the top 50 largest housing markets. We remain focused on growing both our revenue and pre-tax profits at a double-digit annual pace while continuing to generate annual positive operating cash flows and improve returns.
We are well-positioned to do so with our solid balance sheet, broad geographic footprint, diversified product offering across our D.R. Horton, Emerald, Express, and Freedom brands, attractive finished lot and land position, and most importantly, our outstanding team across the country. We thank the entire D.R. Horton team for their focus and hard work. We look forward to finishing this year strong and to continue growing and improving our operations together in 2018. This concludes our prepared remarks. We will now host questions.
Thank you. At this time, we will be conducting a question-and-answer session. If you would like to ask a question, please press *1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press *2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. In the interest of time, we ask that you limit yourself to one question and one follow-up. Once again, that is *1 to register questions. Our first question is coming from Stephen East of Wells Fargo. Please proceed with your question.
Thank you, good morning, guys. I'll start with the gross margin. Jessica Hansen, you mentioned that third quarter you had 50 basis points of legal. Maybe you could just give us an idea of what that is. More importantly, fourth quarter around 20% implies it may be down some. I guess, what are you all seeing as the drivers of that when we're looking at price, cost? One of your competitors yesterday mentioned heightened incentives in a few markets. Just maybe what's driving the thought process there of where you're going with your gross margin?
Sure. We'll have our detail on our gross margin historically as we always do in our supplementary data, what you'll see in that is in terms of the true just lot level prior to interest, property tax, warranty and lit, and those types of charges, our margin has been very steady. On a year-over-year basis, it was down about 20 basis points
In that case, that really is just driven by slightly higher land costs, which we have been talking about. In terms of our stick and brick costs, our revenues have been covering that. They did on a year-over-year basis, and sequentially, they were essentially on top of our cost increase. We continue to see a very consistent gross margin. We did refer to the higher litigation costs. We've had that for a couple of quarters now, that's why we continue to reiterate our 19%-21% gross margin guide as kind of our broader range outside of the around 20%, because we do have some variability to some of those charges. Every once in a while, it fluctuates a little bit.
Okay. Fair enough. Bill, you talked on the capital structure, your cash flow expected, et cetera. Where do you all want to take your debt? I mean, at 20%, I think most builders would love to be at that level already. You're generating close to half a billion next year even before Forestar. What's the focus there on debt, and where do you want to take it?
We certainly like our position. We're in a flexible, opportunistic position as we look at each year and look at our business plans, which we'll be spending a lot of time on that with our operators over the next couple of months, preparing, putting kind of final touches on being prepared for fiscal 2018. We will look at where we feel like our cash flow will be. We'll look at our opportunities to invest. From there, determine further actions with our cash, whether we take our debt down further or replace it, how much we do in terms of dividends and share repurchase, and then obviously further opportunities to invest in the business, including acquisitions.
Yeah.
We do have the purchase price of Forestar, which we would expect to be paid in Q1 of fiscal 2018 of around $560 million. Certainly that's a use of cash that we'll be looking at closely. We don't have a target debt level. We like being flexible. If we feel like that's the best decision for utilizing our cash is to continue to reduce our debt, we certainly will.
Okay. Do you have a targeted land spend?
We're going to spend on land and development at a level so that we maintain our lot portfolio at a similar level to today. We do expect to continue to try to get more efficient with what we own as we continue to grow our option position. We would expect, all things considered, if our revenues are expected to grow at 10%-15%, we would expect our land spend to grow accordingly to just keep the lot pipeline sufficient for that growth.
Fair enough. All right. Thank you.
Thank you. Our next question is coming from Alan Ratner of Zelman & Associates. Please proceed with your question.
Hey, guys. Good morning. Nice quarter. Congrats on the consistent results here.
Thanks.
My first question is kind of a follow-up on that last line of thinking on the land portfolio. You guys had a really nice pickup in your lot supply this quarter, both owned and optioned, and congrats on getting to the 50/50 target. I guess just thinking about the owned piece, which is about 125,000 lots. I know you're on current underwriting. The goal and the target is to effectively get your cash back within two years there. You're running up 25% year-over-year on the lot count, up 12% on the owned piece.
If we just assumed you turned through those owned lots in a two-year period, I know that's somewhat oversimplified because there's legacy lots in there which might be sitting there for a while, but it would imply a pretty sharp acceleration in the volume, even probably above that 10%-15% rate in order to get to that type of cash generation. Just curious kind of how you see the volume trending. I know you guided to 10%-15%, but with the lot count up seemingly more than that, is there anything else we should be paying attention to?
I think, Alan, we have done a great job. Our team has done a phenomenal job increasing the option lot position in line with the strategy we have. We don't see an acceleration beyond the 10%-15% we're looking for next year, even though that lot supply is coming up and we've got a two-year cash back return hurdle we talk about. We look upon that as capital invested in land and lots, plus the margin we achieve on selling those homes goes back towards the capital reduction and how we reclaim that initial capital commitment. Projects we're buying certainly have durations longer than two years. It's not exactly going to see that kind of a ramp in growth beyond our 10%-15% expectation.
Okay. No, that's helpful.
We're investing to hit a 10%-15% increase year-over-year over year. We have a plan. We're trying to be very disciplined with that plan, maximizing returns as we continue to grow at this rate.
Got it. That's a very helpful clarification. Thank you for that. Second question, just in terms of market conditions today. If you go back a year ago, your fiscal fourth quarter, you did see a bit of a pullback in your order growth. I remember you guys talking about just in the market back then, you saw some discounting from some of the calendar-reporting companies that you guys were instead deciding to focus more on building up your inventory in anticipation of the spring, which obviously worked out very well.
Just now that you're roughly a month or so into your fiscal fourth quarter here, do you see a similar dynamic playing out where other builders might be trying to capture some year-end sales here, and it might impact your order results in the fourth quarter, or does it feel like the market is a little bit firmer from a pricing standpoint?
Right now, it feels very firm. We monitor week to week. We're hitting targets week to week. Feel very good about the fourth quarter, the way it's setting up right now. We don't control what other builders do. We're not going to force sales just to have one quarter look better than the market's going to give us. Again, we're managing this thing long-term. We're very interested in how we're setting up for 2018 right now. Feel very good about fourth quarter, both sales and deliveries.
We feel good about the inventory position we have on the ground and coming out of the ground right now. We are feeling good about getting set up for the first and second quarters of 2018.
Great. Thanks a lot, guys. Good luck.
Thanks, Alan.
Thanks.
Thank you. Our next question is coming from Robert Wetenhall of RBC Capital Markets. Please proceed with your question.
Hey, good morning. Nice quarter.
Morning. Thank you.
Thank you, Bob.
Hey, just wanted to ask you, order growth was up 50% in the Southwest. Deliveries are crushing it in the Southwest, the Southeast, and the East. From your standpoint, is demand coming in ahead of your expectations? Where are you seeing the most demand? I mean, the pace has really soared. It's higher than we were anticipating. How are you explaining it, do you view this as sustainable?
Southwest really has been driven by our Phoenix operation. I think we've talked over the last couple of quarters that we've been repositioning in Phoenix, pushing down a price point, realigning management. That's paying off. They are taking market share at a torrid pace right now. The reality is that they're improving their margin as they're doing it. We feel very good about Southwest. As far as the East and Florida, that's really just getting flags online. Market's very good, been very good. The Florida market's very difficult to get flags up and get lots in front of you. Our operators out there have done a great job positioning.
Got it.
Taking some of the pressure off the market's been carrying us for all these years. Going to focus a little more on margin there.
That's helpful. It seems like you're seeing demand across the board, plus great execution. Could you speak for a minute, what are you doing on the SG&A side? You obviously are executing well against your volume-driven operating strategy, you're getting great SG&A leverage. How much is left? Is there room for improvement? Is there anything you can do to lever your overheads to drive net margin performance? Great quarter, good luck.
Thank you, Bob.
Thanks, Bob. There's always a little more in SG&A. Really our focus is just to continue to watch everything that we do. We certainly want to make sure we have an infrastructure to support growth, but just watch everything that we spend, watch every ad that we make, every hire that we make, to make sure that it's absolutely needed. If we're doing that while we're growing the business at 10%-15%, we would expect to continue to squeeze out a little bit more out of SG&A, whether that's 10 basis points or 30 basis points, it may fluctuate a bit, but we would expect to continue to push it down a little bit further as we go into 2018.
We ask our operators to get better every day, and make it a little easier to build houses in the field and sell houses in the sales offices. If we keep doing that.
We're working.
We're going to keep getting better.
Sounds good, guys. Good luck.
Thank you.
Thank you. Our next question is coming from Carl Reichardt of BTIG. Please proceed with your question.
Thanks. Good morning, folks. I wanted to ask about, as you look out at your community mix on the next couple of years, as you're looking at land now, are you looking at changing the mix, maybe moving away from Emerald, where it seems like we're seeing a bit of saturation in a few markets that move up price points and shifting more towards Express and Freedom? You mentioned, was it over $500,000, your sales were 6%, I think, in terms of delivery volume, but 15%. Is that Emerald plus stuff that's over 500? I'm just trying to get a sense of whether or not your mix over time is likely to continue to shift towards those low-end price points.
We're going to shift our mix to where the market is, we do want to maintain broad product offerings regardless of cycle. It's just in terms of what percentage goes to what brand, it's going to vary depending on where we're at in the cycle. We do plan to maintain an Emerald presence and ultimately grow that business as well. There'll be a time where the move-up buyer is back and very strong in that market, and we want to have that platform and that ability to deliver those higher-end homes as well. The greater than $500,000 mark that we talk about, Carl, that is a mix. There is a lot of Emerald in that. There is also some Horton products that falls into that price point as well.
In our supplementary data, we give both a brand stratification and a price point stratification, where you can see both of those mixes and what that looks like for a trailing eight quarters.
Right. Of course. Thanks, Jess. Just as a follow-up, can you talk a little bit about how the Freedom rollout looks as we look forward the next couple of years or so? I think if I recall correctly, the ramp was, I think, a third of your markets, and I'm just kind of curious, maybe a little more detail on how that's been rolling out, how absorptions are tracking, too. Thanks much.
This is David. We're very excited and very happy with the Freedom rollout. Positioning that product takes a little bit longer than the typical Express or Horton project because there are certain zoning requirements that make it a better deal that take a little longer. The rollout, I think we're 15 markets.
We're starting to see it impact, to a minimal extent right now, our closings, but I think over the next couple of years, it's going to be a very significant part of what we do. I think we've been guiding to a third to a quarter of our markets that rolling out.
Yeah, we'll probably be closer to a quarter just because it is a little bit slower, as David mentioned, versus the third we'd originally talked about. We're very happy with our progress and expect that 15 markets to continue to grow as we move throughout 2018.
We'll probably start accelerating at some point, because we do have a lot in pipeline that we're trying to get to market. Very excited, though. Never mind. I'm not going to say the word.
Thanks, folks.
I almost gave you a Trumpism.
Thank you. Our next question is coming from Michael Rehaut of JPMorgan. Please proceed with your question.
Hi, thanks. Good morning, everyone. First question, just want to go back to the land and Forestar. As said before, the increase in option lots has really been extremely impressive, essentially doubling it over the last six quarters or so. The question is, as you look at Forestar now over the next year or two, clearly you haven't had an issue getting option lots on your own. The owned portion is still up there. Obviously, getting a little under 50% was a great achievement as well.
Going forward, would you anticipate essentially keeping your option lot supply on your own books going forward, or would effectively you're looking at all either owned and option kind of being funneled towards Forestar, and your overall lot position might stay at these levels, maybe even start to decline, and all incremental land deals owned and option will be pushed towards Forestar?
Michael, this is Mike. We will continue to have direct relationships with, from D.R. Horton to our land development partners that we have across the country today and look to grow those relationships. In addition, we will continue to maintain a level of land purchasing at D.R. Horton and development. We see Forestar as being very helpful in us in not having to increase our development activities as we continue to grow the business.
As we continue to see double-digit growth year-over-year, that calls for more and more lots to be needed by the builder to start houses on. We'd like to maintain our current development activities at a consistent level to where we are today, which is about half of our current level of development. As we move forward and grow more of our future home deliveries off of lots developed by others, whether they're third-party developers or whether they are projects that Forestar puts on the ground for the home builder. We see Forestar as an important part of our land and lot strategy going forward, but it's another supplement to the relationships we have built with the land developers across the country, and we'll continue to invest in those relationships moving forward.
Okay. No, that's helpful, Mike.
I guess just secondly, on the fiscal 2018 pre-tax margin guidance of 11.5%, that compares to fiscal 2017 of 11.3%-11.5%. It seems like if I'm getting that right, and thinking about the components, you're more or less looking for a steady gross margin and maybe flat to 20 basis points of incremental leverage on the SG&A. Just want to know if I'm thinking about that right, and if that's the case, it appears that relative to a few years ago, you're more or less approaching kind of like a steady state margin, all else equal from, let's say, a pricing and cost inflation dynamic standpoint, where really going forward, the bus is going to be more driven by top line. Absolutely trying to get a little bit more on the SG&A. Is that fair in terms of how to think about it?
Mike, in terms of the guidance to 11.5%, that is the right way to think about it. We continue to guide and have seen very stable gross margins, and then continue to leverage SG&A a bit. At this early date here in July, talking about the full fiscal year 2018, we do feel like we can squeeze that a little bit. Guiding to 11.5%, a slight improvement is where we feel comfortable today. As we get closer and as we get into 2018, if we feel like we've got more opportunity, we would certainly adjust our guidance there as well. Certainly beyond the next quarter, and as we look to where we are as a business, we feel really good, and we're kind of in the middle of our normal operating margin range at about 20%.
Historically, 19%-21% has kind of been our range, and we've been at a very steady level, kind of in the middle of this range, really for the last couple of years. We feel like that's still where the business is today. As we grow our volume, certainly the biggest driver of our earnings growth is going to come from our top-line growth, growing that 10%-15%. To the extent that the market gives us a bit on the gross margin, we're certainly going to take it. We're certainly going to continue to try to drive a bit more operating margin from SG&A. We're not projecting significant increases in operating margin, but certainly a continued consistent margin and work to improve it on the SG&A side.
Great. Quick clarification, the quarter markets for Freedom Homes, that's expected to be by the end of this fiscal year, correct?
2017. Do you remember?
Sure.
Basically, towards the end of 2017.
Right. Great. Thank you.
Thank you. Our next question is coming from John Lovallo of Bank of America. Please proceed with your question.
Hey, guys. Thanks for getting me in here. The first question would be, I guess, how would you characterize order growth throughout the quarter, and maybe more broadly, how would you characterize the overall demand environment? Some of your competitors have said that demand remains very strong and quite possibly is accelerating. Would you agree with that kind of characterization?
This time of year in the market, I don't know the accelerating part. I will say, it's very consistent market. It's week to week, flag to flag. It's just kind of almost boring, it's so consistent. It's a great market for people that can operate efficiently and put good value in front of buyers. We're seeing the benefit of that.
Okay. In terms of the 10%-15% top-line growth, what kind of community count growth are you contemplating in that?
John, we did see for the first time this quarter our community count tick up ever so slightly on a year-over-year basis, and I think the second quarter in a row, it went up sequentially. We've kind of hit that inflection point that we've been expecting to come in the back half of the year. We wouldn't expect it to grow significantly in 2018, but I think a low, probably no higher than mid-single-digit range, maybe by the time we get to the end of 2018. Continued improvement in absorption, supplemented by a little bit of community count growth next year.
Great. Thanks, guys.
Thank you. Our next question is coming from Kenneth Zener of KeyBanc Capital Markets. Please proceed with your question.
Good morning, everybody.
Morning.
Morning.
I'm going to try and go, your 10%-15% growth target for next year, this year was very much comprised of pace. The way we look at pace, sequentially, things have been pretty seasonal and pretty predictable. If that were the case again, it seems as though your approach on these communities and pace would lead to perhaps the same level of unit volumes that you've seen, orders going into closings. Is there something about your business that would, if demand were to pick up and not be boring, could you, or would you stop yourself from exceeding that 15% volume? Is there something intuitively designed around your business that would stop you from getting that if the market wanted to go higher?
No. Are we going to not sell houses when people want to buy them? That's not going to be the case. I will say, if we have an opportunity to stay on pace and increase margin, we're going to do that. If in fact, we do see some kind of acceleration, we will take a little margin, and we'll take a little bit more pace. The end goal for every flag is to maximize the return we make on that investment. If that means tweaking margin, then we'll tweak margin. If that means tweaking pace, we'll tweak pace.
Okay.
It's good times for us.
Since it's so boring, and you guys went to this stable gross margin about two years ago, and it seems, certainly guidance from other builders, there's been more than two now, have talked about kind of really sequential improvements looking into the back half of the year, which would be a change from the kind of compression trends that we'd seen in recent years. I ask, David, because you said, "If the market gives us gross margins, we'll take it." I'm sure it's kind of tongue in cheek, but it does appear that other builders are finding stability that you're seeing.
Ken, that's not tongue in cheek. That is our operating platform and thought process. We set these communities up to hit a certain absorption target, and we adjust margin to maximize the return at that target. That's why we're so consistent on our deliveries. First of all, we're able to build houses without expanding our build cycles. It does a lot of good things for us.
Would you say that you're more inclined to see gross margin expansion this year versus last year? Could you couch that considering we're seeing stability in others, you were the first to see stability, logically you might be.
It depends on what the market does. Right now, very consistent margins, very consistent absorptions. We've got a good balance. If the other builders who are seeing this acceleration are correct, yeah, I would say we're going to see some margin expansion. I'm just telling you right now what we're seeing is a very solid, very consistent, high demand, low inventory market that feels like it's going to continue.
Ken, I do think you hear other builders talk to seasonality in their gross margins as well, which I don't know if that's playing into their commentary for the back half of the year. We don't have fixed costs in our gross margin, we don't experience that kind of seasonality in the back half of the year.
Less the fixed cost then. What is the commission percentage generally that goes into your gross margin and out of SG&A? Thank you.
It's around 2.7%-2.8%. At times up to 3% in our margin.
Great.
Thank you. Our next question is coming from Stephen Kim of Evercore ISI. Please go ahead.
Hey, guys, it's Steve Kim. Apologies if this question was asked, curious about the gross margins for next year implied by the pre-tax GAAP number. We know that pre-tax GAAP number includes a lot of things in it, one of the things you mentioned today was that you have this litigation expense that was going to run a little higher and had been for a couple of quarters now. I was curious as to what, in the way of your outlook for next year, you're embedding in terms of the trajectory for either warranty and litigation, or anything else that might be a little unusual that typically gets backed out into 2018.
Steve, we do see some more variability in items like warranty and litigation than we do in other components of our margin. Our guidance for next year is still right down the middle of our historic range at around 20%. There certainly could be some quarterly variability as we've seen from time to time in those other areas. We're not anticipating anything unusual, either positive or negative in terms of those other items. We do continue to see the benefit of our reduced debt with our interest charges and our margin continuing to be reduced. At the same time, we do see cost pressures in the core business, especially on the lot side right now that we're absorbing a little bit as well. Again, we don't see significant volatility and aren't embedding any significant volatility into our assumptions.
The expectations we're putting out there kind of reflect the increased lot cost that we've seen coming through on some of the closings. That's kind of an outcropping of our land and lot strategy, is to try to buy more lots finished, see that come through, and it's helping us drive our returns up. Our home building pre-tax return on inventory has improved 200 basis points over the past 12 months, and that's been very helpful for us.
No, clearly. With respect to Express specifically, I believe that when you first launched that product line, your anticipation was that it was going to garner lower gross margins. As you actually got into it, through effective execution, you actually, I believe, found that the margins there have been much more comparable to your company average. I was curious as to whether that's still the case today and whether that's your expectation going forward.
Yes, Steve, you stated that dead on. Our Express gross margin has been better than we originally anticipated when we launched the brand in the spring of 2014, and it's right in line with our company average, and we really don't see anything today that would anticipate that changing as we move throughout fiscal 2018.
Excellent. Okay. Thanks very much, guys.
Thank you. Our next question is coming from Susan Maklari of Credit Suisse. Please proceed with your question.
Thank you. Good morning.
Good morning.
Can you talk a little bit to perhaps what you're seeing in the Texas markets? It seems like you had some good results down there. Can you just talk a little bit about what's actually going on on the ground?
Texas is a very good market for us. We benefit from being incredibly well-positioned. I think we're the top builder in every market in Texas, and just great execution combined with solid demand and tight inventories. We love Texas.
Okay. I'm wondering if you could just dive in a little bit more into the raw material inflation that you're seeing, kind of what's been going on there, and how you're thinking about that as we move through the fourth quarter and then into 2018.
Sure. We haven't seen any significant moves in our raw material cost inputs. I know lumber's been the headline out there. It really has been a lot of headline noise. We've seen a slight tick-up in our lumber costs year to date, but nothing significant. We've clearly offset that in terms of our revenues offsetting our stick and brick costs. We're really not seeing any noticeable changes in any of our raw material costs at this point.
Okay. You expect that to stay relatively consistent then?
Yes.
Okay, perfect. Thank you.
Thank you. Our next question is coming from Jay McCanless of Wedbush Securities. Please go ahead.
Hi. Good morning, everyone.
Good morning.
Quick question on the Midwest segment and the order decline there. Can you talk about geographically what's going on and how you guys are addressing it?
Well, the Midwest segment is a pretty small region for us. Some of those markets, we have reworked a little bit of the management leadership in one of those markets, and we feel pretty good about where that team's going to be positioned in 2018 and 2019. I think we're going to see some improvements in those markets. They've been pretty consistent. They're just like a lot of other places, fairly supply-constrained. Chicago market, still a little slow. Seems to be a little slow coming out compared to the balance of the country. The other markets, I think we'll see some good things in 2018 and 2019.
The other question I had, just to Express specifically, what type of pricing power are you seeing there? I know some of your competitors have announced new brand names and new products to maybe target that brand name or to target Express. What are you guys seeing right now, and how's the pricing power for you guys on that Express brand?
The key to the Express brand is affordability and keeping that very broad customer segment where the most people can buy the most house. The pricing power is probably higher or greater than where we have pushed pricing in Express, because we are very sensitive to maintaining a very affordable product. Those buyers typically are not the most sophisticated, and you can make kind of a smoke and mirror presentation with them. At the end of the day, we're selling houses to people that we want to sell a second, third, and fourth house. We want it to be a great investment for them. We want to give them a great house. That's a long way of saying, yes, there's probably pricing power there.
As long as we can maintain the margins we're making and the absorptions we're making, and retain a very affordable, very well-built house, we like that model. We like what it's doing for our returns.
Jay, you will see in our supplemental information that our average ASP on Express continues to tick up a little bit. That's more of a reflection of our geographic mix, though, as we continue to roll Express out and it continues to penetrate some of the higher priced markets a little bit greater, than it had been in prior quarters. We obviously will move price somewhat, but we are continuing to stay very focused on affordability. In terms of other builders in the entry-level space, first time home buyer space, certainly, we're seeing other builders start to introduce new names, new brands, new communities out there. As we've said for a long while, that market is pretty large, and there's a lot of demand from those entry-level buyers today. There's a lot of room for other participants to participate in that market.
We're still focused on penetrating that and gaining as much market share as we can there, because we feel like there's still a lot of demand and very little supply to that entry-level buyer.
Sounds great. Thanks for taking my questions.
Thank you. Our next question is coming from Jack Micenko of SIG. Please go ahead, sir.
Hi. Good morning. Wanted to just clarify your tone on the share buybacks. Did you up the authorization? Should we think of the buyback approach status quo, or is there an incremental focus on share repurchase here as you generate cash and get your debt levels lower? You did seem to call it out a bit more in the prepared comments as well. I'm just trying to gauge what the real message is.
Thanks, Jack. We have had an authorization outstanding for quite some time on share repurchases. Actually, we've talked about potentially starting to repurchase shares to offset dilution. Actually, this quarter was the first quarter in which we've actually repurchased any shares under that authorization. It was a step forward for us into an era of beginning to start to offset our dilution from our share creep. We would expect to continue to at least partially offset that dilution. Our board did increase our authorization to a $200 million level, effective for the next year. That is an increase from the prior year authorization of $100 million. Certainly as the business has grown, as our profits grow, as we continue to expect strong cash flow generation, we do expect to continue to be able to repurchase shares within that authorization going forward.
Yes, we are saying a little bit more about it because we've actually repurchased some shares this quarter.
Okay. Around your 2018 outlook, you talk about driving more of the top line through absorption. You're also going to grow, I think Freedom's going to be somewhat of a driver of growth. How do we think about Freedom versus Express absorptions? Do they absorb about the same, faster, slower? What's that mean to that expectation for further absorption improvement next year?
We will find out what happens as time goes on. I can tell you the way we're believing it's going to take place right now is, the Freedom will come in at a little lower absorption than the Express program, but we think we can get a little bit more margin there, so that the returns are going to be equivalent to that push to 20% we're trying to get to. Right now we're seeing very strong demand. Part of it is, there's just nothing else in the market like it. It's just been harder to roll it out than we really kind of thought it would because of zoning requirements and really city approvals and things. We're very excited about it. I think it's going to be great.
Okay. Thank you.
Thank you. Our next question is coming from Alex Barrón of Housing Research Center. Please go ahead.
Yeah. Thanks. Congratulations on the results. I wanted to ask about the leverage. You guys, I think at this point, have the lowest leverage of any builder. I'm curious if the thought process is to stay here or you're just being opportunistic about more other opportunities. My second question has to do with, heard some rumblings that some of these rental companies are thinking of developing entire communities for I guess, single-family communities for rent, and given your platform of being very efficient to develop homes, I'm wondering if that's something that you guys are potentially contemplating on doing, entering those types of deals.
I'll take the second question first, Alex. Thank you very much for your comments. We've heard some of the rumblings about that as well, probably just rumors or articles written here and there. We have not really explored the build-out of a community, and for ourselves as a full rental community. We've had great demand selling houses, and generally, we prefer to sell them. More capital efficient for us, and that's the way it has historically worked for us. We'll see how they do with the full-on rental communities. If we do see it's something that can make good business sense for us to bring our building platform to bear, community development expertise to bear in developing a rental community, maybe that's something we will pursue. At this point, we have no immediate plans to pursue that.
Then, Alex, in terms of the leverage, we do like our flexible, opportunistic position we're in today. As we look at opportunities to invest in the business, we just try to balance that with where we want to keep our liquidity. To the extent that we have capital available to continue to reduce debt, we certainly will. If we see enough opportunities to invest in the business that we need to replace the debt and not reduce it further, we'll do that as well. I certainly like our position, willing to take the debt lower if need be, and the cash flow's available. Certainly, it's got us in a really strong position to be able to really take advantage of opportunities as we see them in the marketplace.
Great. Thanks. Congrats again.
Thank you.
Thanks.
Thanks, Alex.
Thank you. We're showing time for one additional question today. Our last question will be coming from Mike Dahl of Barclays. Please go ahead.
Hi, thanks for fitting me in. A couple quick ones. First, related to the guidance and some of the comments around absorption and community count. Just hoping to get a little clarification on just how the 10%-15% in dollar terms breaks out, because presumably, mix is continuing to shift towards Freedom Homes and Express Homes, which, while you've had some pricing power there, is still mixing lower. What's generally your expectation for how ASPs play out for next year when you add that all together?
We don't give specific guidance on ASP or community count, really. We end up talking about it because obviously you guys want to hear about that. We do talk about it directionally, but no specific guidance for a reason, because those are two of the hardest for us to predict. ASP being very much market driven, coupled with a lot of mix impacts that we have had going on that you already referenced, Mike. We've continued to expect our ASP to be around flat. In reality, it's continued to creep up at a low single-digit % here for the last year or two. We'll see as we move throughout 2018, but once again, not really expecting a whole lot of movement on the ASP front.
Okay, that's still helpful. Secondly, just if we think about some of the comments around price, obviously there's kind of a push and pull. You've got some power in the market on the low end, but you want to manage and make sure it's an affordable product in those segments. You mentioned that the cost side is fairly benign for you guys. Can you give us any level of quantification, since overall margins are stable, what the underlying land costs are inflating at currently and what the embedded expectation is for 2018?
Sure. We saw our lot cost at the beginning of the year be up a high single-digit %. Now that we've moved into the back half of the year, that's moderated a bit, and this quarter, on a year-over-year basis, was up a mid-single digit %. We would expect in 2018 to continue to have an increase in our lot costs. Hopefully, it maintains that mid-single-digit range that we're at today, or trends down just ever so slightly to a low single-digit.
Okay, great. Thanks. Good luck into your end.
Thank you.
Thanks, Mike.
Thank you. At this time, I'd 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 today and look forward to speaking with you again in November to share what we think is going to be a great year end. To the Horton family, thank you for yet another strong quarter and an outstanding execution in 2017. It is an honor to be here, appreciate everything you do. Thank you.
Ladies and gentlemen, thank you for your participation. This concludes today's conference. You may disconnect your lines at this time, have a wonderful day.