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.
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, and good morning. Welcome to our call to discuss our results for the Q3 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 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 investors.
Drhorton.com, and 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 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'm 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 Q3, our consolidated pre tax income increased 17% to $444,000,000 on $3,800,000,000 of revenue. Our pre tax profit margin was 11.8% and the value of our homes sold increased 13%. For the 9 months ended June, our consolidated pre tax income increased 21% to $1,100,000,000 on an 18% increase in revenue to $9,900,000,000 Our pre tax profit margin for the 9 month period improved 30 basis points to 11.2%. These results put us on strong, 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 pretax 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 Q4 and further growth in 2018. Mike?
Net income for the 3rd quarter increased 16% to $289,000,000 or
0 point
$0.66 per diluted share in the prior year quarter. Our consolidated pretax income for the quarter increased 17% to $444,000,000 versus $379,000,000 a year ago and homebuilding pretax income increased 19% to $415,000,000 compared to $348,000,000 Our backlog conversion rate for the 3rd quarter was 85%. As a result, our 3rd quarter home sales revenues increased 17% to $3,700,000,000 on 12,497 homes closed, up from $3,100,000,000 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 Q3 increased 13% from the prior year quarter to $3,900,000,000 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 Q2. Our average sales price on net sales orders in the Q3 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 $4,600,000,000 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 3rd 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% to 21% due to product and geographic mix as well as the relative impact of warranty, litigation and interest costs. Bill?
In the Q3, homebuilding SG and 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 and A while ensuring that our infrastructure adequately supports our growth. Jessica?
Financial Services pretax income in the 3rd quarter was $29,300,000 compared to 30 point $2,000,000 in the prior year quarter. 95 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 55 percent of D. R. Horton homebuyers. 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 7 19 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 Q3 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 Q4 and into fiscal 2018. Our investment in lots, land and development during the Q3 totaled $1,100,000,000 of which $740,000,000 was for finished lots and land and $360,000,000 was for land development. During the 9 months ended June, we invested $2,800,000,000 in lots, land and development compared to $2,000,000,000 in the same period of last year. Our underwriting criteria and operational expectations for new communities remain consistent at a minimum 20% annual pretax 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 30, 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 29, 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 $560,000,000 of total cash consideration. The strategic relationship between D. R. Horton and Forestar will significantly grow Forestar into a large national residential land development company selling lots to D. R.
Horton and other homebuilders. 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 1st fiscal quarter of 2018 subject to the approval of Forestar's shareholders and other customary closing conditions.
We expect the preliminary S-four 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 30, our homebuilding liquidity included $461,000,000 of unrestricted homebuilding cash and $900,000,000 of available capacity on our revolving credit facility.
Our homebuilding leverage ratio improved 5 20 basis points from a year ago to 24.8%. In May, we repaid $350,000,000 of senior notes at their maturity and the balance of our public notes outstanding at the end of the quarter was $2,400,000,000 We have $400,000,000 of senior note maturities in the next 12 months. During the quarter, we repurchased 1,850,000 shares of our common stock for $60,600,000 which partially offset dilution from equity awards. At June 30, our shareholders' equity was $7,400,000,000 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 $200,000,000 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 homebuilding 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 Q4, we expect our homes closed to approximate a beginning backlog conversion rate in the range of 88% to 90%. This will result in homes closed for the full year of fiscal 2017 in the range of 45,800 to 46,200 homes and consolidated revenues of $13,900,000,000 to $14,100,000,000 both of which are above the high end of our initial guidance range. We anticipate our home sales gross margin in the 4th quarter will be around 20% and we expect our 4th quarter homebuilding SG and A to be in the range of 8.3% percent to 8.4 percent of homebuilding revenues. We estimate that our 4th quarter financial services operating margin will be in the range of 32% to 34%. We expect our tax rate in the 4th quarter to be approximately 35.2% and our 4th quarter diluted share count to be around 380,000,000 shares.
We now expect our consolidated pre tax operating margin for the full year of 2017 to be in a range of 11.3% to 11.5% and we expect approximately $300,000,000 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% to 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 4th consecutive year in a range of $300,000,000 to $500,000,000 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 Q3 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 continue to expand our industry leading market share. We have been the largest builder in the United States for 15 consecutive years. According to Builder Magazine's recent Local Leader issue, in 2016, we were the number one builder in 4 of the top 5 U. S.
Housing markets, and we believe we will be the number 1 in all 5 of those markets in 2017. Also in 2016, we were a top 5 builder and 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 improved 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
Our first question is coming from Stephen East of Wells Fargo. Please proceed with your question.
Thank you and good morning guys. I'll start with the gross margin. Jessica, you mentioned that Q3 you had 50 bps of legal, maybe you could just give us an idea of what that is. But more importantly, 4th 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 and 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, very steady. On a year over year basis, it was down about 20 basis points in that case and that really is just driven by slightly higher land costs, which we have been talking about. So 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.
So we continue to see a very consistent gross margin and then we did refer to the higher litigation costs and that is we have had that for a couple of quarters now and that's why we continue to reiterate our 19% to 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 and every once in a while it fluctuates a little bit.
Okay, fair enough. Fair enough. And then, Bill, you talked on the capital structure, your cash flow expected, etcetera. 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.
So you're generating close to $500,000,000 next year even before Four Star. So 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, look at our opportunities to invest, and then 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. We do have the purchase price of 4 Star, which we would expect to be paid in Q1 of fiscal 2018 of around $560,000,000 So certainly, that is 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. We're certainly 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. I do we do expect to continue to try to get more efficient with what we own as we continue to grow our option position. But we up we would expect our land spend to grow accordingly to just keep the lot pipeline sufficient to support that growth.
Fair enough. All right. Thank you.
Thank you. Our next question is coming from Alan Ratner of Zelman and Associates. Please proceed with your question.
Hey, guys. Good morning. Nice quarter. Congrats on the consistent results here. My first question is kind of a follow-up on that last line of thinking on the land portfolio.
So you guys had really nice pickup in your lot supply this quarter, both owned and optioned and congrats on getting to the fifty-fifty 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 2 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 own lots in a 2 year period, and 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% to 15% rate in order to get to that type of cash generation. So just curious kind of how you see the volume trending. I know you guided to 10% to 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 lock position in line with the strategy we have. But we don't see an acceleration beyond the 10% to 15% we're looking for next year, even though that lot supply is coming up and we've got a 2 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. So projects we're buying certainly have durations longer than 2 years then. So it's not exactly going to see that kind of a growth of ramp in growth beyond our 10% to 15% expectation.
Okay. That's helpful.
We're investing to hit a 10% to 15% increase year over year over year. So it's 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 Q4, you did see a bit of a pullback in your order growth.
And 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. So just now that you're roughly a month or so into your fiscal Q4 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 Q4? 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 Q4, 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 1 quarter look better than the market is going to give us. But again, we're managing this thing long term. We're very interested in how we're setting up for 2018 right now. I feel very good about Q4, both sales and deliveries.
And the inventory position we have on the ground and coming out of the ground right now, feeling good about getting set up for the 1st and second quarters of 2018.
Great. Thanks a lot guys. Good luck.
Thanks, Tom.
Thank you. Our next question is coming from Bob Wettenhall of RBC Capital Markets. Please proceed with your question.
Hey, good morning. Nice quarter.
Good morning. Thank you, Bob.
Hey, just wanted to ask you, order growth was at 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? And where are you seeing the most demand? I mean, the pace is really toward, it's higher than we were anticipating. How are you explaining it?
And 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 at price point, realigning management. That's paying off. They are taking market share at a torrid pace right now. And the reality is they're improving their margin as they're doing it.
So we feel very, very good about Southwest. As far as the East and Florida, that's really just getting flags online. Market is very good, been very good. Florida market is very difficult to get flags up and get lots in front of you. And our operators out there have done a great job positioning.
Taking some of the pressure off, the market's been carrying us
for all these years. So
we'll just focus a little more on margin there.
That's helpful. So 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 and A side? You obviously are executing well against your volume driven operating strategy and getting great SG and 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 and good luck.
Thank you, Bob. Thanks, Bob. There's always a little more in SG and A. And 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's absolutely needed.
And then if we're doing that while we're growing the business at 10% to 15%, we would expect to continue to squeeze out a little bit more out of SG and A, whether that's 10 basis points or 30 basis points would 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 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, so 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. And you mentioned, I think, that your 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 $500,000 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, but 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 are at in the cycle, but we do plan to maintain an Emerald presence and ultimately grow that business as well. And there will 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, but there is also some important products that falls into that price point as well.
So 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 8 quarters.
Right, of course. Thanks, Jess. And then, as a follow-up, can you talk a little bit about how the Freedom rollout looks as we look forward to the next couple of years or so? And 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.
Yes, we'll probably be closer to a quarter just because it is a little bit slower as David mentioned versus the 3rd we'd originally talked about. But we're very happy with our progress and expect that 15 markets to continue to grow as
we move throughout 2018. 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. It's going to be a 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, I just want to go back to the Land and Forestar. And as I said before, the increase in option lots has really been extremely impressive, essentially doubling it over the last 6 quarters or so. So the question is, as you look at Forestar now over the next year or 2, 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, do you anticipate that 4 Star will be more would you anticipate kind of 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 4 Star and your overall lot position might stay at these levels, maybe even start to decline and all incremental land deals owned in option will be pushed towards 4 Star?
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 4 Star as being very helpful in us and not having to increase our development activities as we continue to grow with 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.
But as we move forward and grow, 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 homebuilder. So 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 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 'eighteen pre tax margin guidance at 11.5% that compares to fiscal 2017 of 11.3.11 5%. So 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 bps of incremental leverage on the SG and A. So 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. I mean, absolutely trying to get a little bit more on the SG and A, but is that fair in terms of how to think about it?
Yes, Mike. And 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 continue to leverage SG and A a bit. And at this early day here in July, talking about the full fiscal year 'eighteen, we do feel like we can squeeze out a little bit. So guiding to 11.5, a slight improvement is where we feel comfortable today.
As we get closer and as we get into 'eighteen, if we feel like we've got more opportunity, we would certainly adjust our guidance there as well. But then, certainly then beyond the next quarter and as we look to where we are as a business, we feel really good and we are kind of in the middle of our normal operating margin range at about 20%. Historically, 19% to 21% is kind of been our range. We've been at a very steady level kind of in the middle of this range really for the last couple of years. And we feel like that's still where the business is today.
And then 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% to 15%. And to the extent that the market gives us a bit on the gross margin, we are certainly going to take it. And then we are certainly going to continue to try to drive a bit more operating margin from SG and A. But we don't we're not projecting significant increases in operating margin, but certainly continue consistent margin and work to improve it on the SG and A side.
Great. And then quick clarification, the quarter markets for Freedom Brands, that's expected to be by the end of this fiscal year, correct?
2017. Sure. They say towards the end of 2017.
Right. Great. Thank you.
Our next question is coming from John Yulvayo 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 kind of order growth throughout the quarter? And maybe more broadly, how would you characterize the overall demand environment? And 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 and we're seeing the benefit of that.
Okay. And then in terms of the 10% to 15% top line growth, I mean, what kind of community count growth are you kind of 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. So 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. So 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 Ken Zener of KeyBanc Capital Markets. Please proceed with
your question. Good morning, everybody.
Good morning.
I'm going to kind of try and get your 10% to 15% growth target for next year. This year was very much comprised of pace. And 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, I don't think it's certainly not or we're 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. So 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.
And if that means tweaking margin, then we'll tweak margin. If that means tweaking pace, we'll tweak pace. It's good times for us.
So since it's so boring, and you guys went to the stable gross margin about 2 years ago, and it seems certainly guidance from other builders, there's been more than 2 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've seen in recent years. And I asked 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.
Dan, 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. And that's why we're so consistent on our deliveries. And first of all, we're able to build houses on a without expanding our bill cycles.
I mean, 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? Kind of could you couch that considering we're seeing stability in others and you were the first to see stability? So logically you might
It depends on what the market does. Right now, very consistent margins, very consistent absorptions. We've got a good balance as we if the other builders that we're seeing this acceleration are correct, then yes, 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, but we don't have fixed costs in our gross margin. And so we don't experience that kind of seasonality in the back half of the year.
Yes. Less fixed cost than what is the commission percentage generally that goes into your gross margin and added SG and A? Thank you.
It's around 2.7%, 2.8%. It times up to 3% of our 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, but curious about the gross margins for next year implied by the pre tax GAAP number. We know that that pre tax GAAP number includes a lot of things in it and 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. So 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 sort of unusual that typically gets backed out into 2018?
Yes, Steve, we do see some more variability in items like warranty and litigation that we do in other components of our margin. But our guidance for next year is still kind of right down the middle of our historic range at around 20%. And there certainly could be some quarterly variability as we've seen from time to time in those other areas. But 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.
But 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. But again, we don't see significant volatility and aren't embedding any significant volatility into our assumptions.
And 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 homebuilding pretax return on inventories improved 200 basis points over the past 12 months and that's been very helpful for us.
Yes. No, no, clearly. And then with respect to Express specifically, I believe that when you first launched that product line, your anticipation was that
it was going to garner
much more comparable to your company average. I was curious as to whether that's still 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 And
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, 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 with combined with solid demand and tight inventories. So we love Texas.
Okay. And then 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 Q4 and then into 2018?
Sure, Sue. We haven't seen any significant moves in our raw material cost inputs. I know lumber has 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 and we clearly offset that in terms of our revenues offsetting our stick and brick costs.
So we're really not seeing any noticeable changes in any of our raw material costs at this point.
Okay. And so 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 are we have reworked a little bit of the management leadership in one of those markets, and we feel pretty good about where that team is going to be positioned in 2018 2019. So 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. But the other markets, I think, we'll see some good things in 2018 2019.
And then the other question I had, just to express specifically what type of pricing power you're seeing there? And 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 making the keeping that very broad customer segment where the most people can buy the most house. And so 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. But at the end of the day, we're selling houses to people that we want to sell a second, third and 4th house. We want it to be a great investment for them and we want to give them a great house.
So that's a long way of saying, yes, there's probably pricing power there. But as long as we can maintain the margins we're making and 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.
And J. E, we'll 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. But it's not we obviously will move price somewhat, but we are continuing to stay very focused on affordability. And then in terms of other builders in the entry level space, first time homebuyer space, certainly, we're seeing other builders start to introduce new names, new brands, new communities out there.
But 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. So there's a lot of room for other participants to participate in that market, but 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. I wanted to just clarify your tone on the share buybacks. I mean, debt levels come down further, generating cash. You bought back some stock this quarter, as you always do to offset the stock comp. But then you up the authorization.
So is this more status 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? Because you did seem to call it out a bit more in the prepared comments as well. Just trying to gauge what the real message is?
Yes. Thanks, Jack. We have had an authorization outstanding for quite some time on share repurchases. Actually, and we've talked about potentially starting to repurchase shares to offset dilution. Actually, this quarter was the Q1 in which we've actually repurchased any shares under that authorization.
So, it was a step forward for us into an era of beginning to start to offset our dilution from our share And we would expect to continue to at least partially offset that dilution. Our Board did increase our authorization to a $200,000,000 level effective for the next year. That is an increase from the prior year authorization of 100,000,000 dollars So 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. So yes, we are staying a little bit more about it because we've actually repurchased some shares this quarter.
Okay. And then around your 2018 outlook, you talk about driving more of the top line through absorption. You're also going to grow. I think Freedom is 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? And 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. And it's right now, we're seeing very, very strong demand. Part of it is 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.
But 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 Barron of Housing Research Center. Please go ahead.
Yes, thanks. Congratulations on the results. I wanted to ask about the leverage. So you guys, I think, at this point have the lowest leverage of any builder. I'm curious if you guys the thought process is to stay here or you're just being opportunistic about more other opportunities?
And 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, wondering if that's something that you guys are potentially contemplating on doing entering those types of deals?
On the 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 at 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. 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. But at this point, we have no immediate plans to pursue that.
And 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. And to the extent that we have capital available to continue to reduce debt, we certainly will. But if we see enough opportunities to invest in the business that we need to replace the debt and not reduce it further, then we'll do that as well. So I certainly like our position, willing to take the debt lower if need be and the cash flows available.
But certainly, it's got us in a really strong position. We'll be able to really take advantage of opportunities as we see them in the marketplace.
Great. Thanks. Congrats again.
Thank you. 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 of quick ones. First related to the guide and some of the comments around absorption and community count. Just hoping to get a little clarification on just how the 10% to 15% in dollar terms breaks out because presumably mix is continuing to shift towards Freedom and Express, which while you've had some pricing power there is still mixing lower.
So what's generally your expectation for how ASPs play out for next year when you kind of add that altogether?
So we don't give specific guidance on ASP or community count really. I mean we end up talking about it because obviously you guys want to hear about that. ASP being very much market driven, coupled with a lot of mix impacts that we have had going on that you already referenced, Mike. So we continue to expect our ASP to be around flat. In reality, it's continued to creep up at a low single digit percentage here for the last year or 2.
So we'll see as we move throughout 'eighteen, but once again not really expecting a whole lot of movement on the ASP front.
Okay. That's still helpful. And then 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 at that in those segments. You mentioned that the cost side is fairly benign for you guys.
So 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 costs at the beginning of the year be up a high single digit percentage. 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 percentage. So we would expect in 'eighteen to continue to have an increase in our lot costs. But 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 and good luck into year 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. And to the Horton family, thank you for yet another strong quarter and an outstanding execution in 2017. It is an honor to be here and 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 and have a wonderful day.