Welcome to the LGI Homes first quarter 2018 conference call. Today's call is being recorded, and a replay will be available on the company's website later today at www.lgihomes.com. We have allocated an hour for prepared remarks and Q&A. If you require any assistance during the call, please press star then zero on your touch-tone telephone. At this time, I would like to turn the call over to Rachel Eaton, Chief Marketing Officer at LGI Homes. Ms. Eaton, you may begin.
Thank you. Welcome to the LGI Homes conference call discussing our results for the first quarter of 2018. Today's conference call will contain forward-looking statements that include, among other things, statements regarding LGI's business strategy, outlook, plans, objectives, and guidance for 2018. All such statements reflect current expectations. However, they do involve assumptions, estimates, and other risks and uncertainties that could cause our expectations to prove to be incorrect. You should review our filings with the SEC, including our risk factors and cautionary statement about forward-looking statements section, for a discussion of the risks, uncertainties, and other factors that could cause our actual results to differ materially from those anticipated in these forward-looking statements. These forward-looking statements are not guarantees of future performance.
You should consider these forward-looking statements in light of the related risks, and you should not place undue reliance on these forward-looking statements, which speak only as of the date of this conference call. Adjusted gross margin, a non-GAAP financial measure, will be discussed on this conference call. The presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. A reconciliation of adjusted gross margin to gross margin, the most comparable measure prepared in accordance with GAAP, is included in the earnings press release that we issued this morning and in our quarterly report on Form 10-Q for the first quarter of 2018 that we expect to file with the SEC later today. This filing will be accessible on the SEC's website and in the investor section of our website at lgihomes.com.
Joining me today are Eric Lipar, LGI Homes' Chief Executive Officer, and Charles Merdian, the company's Chief Financial Officer. With that, I will now turn the call over to Eric.
Thank you, Rachel, and welcome to everyone on this call. We appreciate your continued interest in LGI Homes. During today's call, I will summarize the highlights and results from the first quarter of 2018. Charles will follow up to discuss our financial results in more detail. After he is done, we will conclude with comments on what we are seeing for the second quarter and our expectations for the remainder of 2018 before we open the call for questions. For the first quarter, we closed 1,244 homes, a 63.5% increase in home closings compared to the 761 homes closed during the first quarter of last year. We also generated approximately $279 million in home sales revenue, which represents a 71.3% increase over the first quarter of 2017. Absorption in the first quarter averaged 5.4 closings per community per month company-wide.
This was an increase over the first quarter of last year's absorption pace of 3.8 closings per month. Our top market on a closings per community basis was Tampa at 7.7 closings per month, followed by Houston at 7.1, then Orlando and Seattle, both at 6.3 closings per month. Company-wide, we ended the first quarter with 79 active communities, which is a net increase of 10 over the 69 active communities that we had at the end of the first quarter last year. During the first quarter of 2018, our Central division added five communities, our Southeast division added four, our Northwest division added two, and our Florida division and Midwest division each added one community. These additions were offset by a decrease of three communities in our Southwest division due to community closeouts and transitioning between projects. Breaking it down, let's look at highlights from our Central division operations.
Comprised of results from Houston, San Antonio, Dallas-Fort Worth, Austin, and now the Oklahoma City market, our Central division generated 521 closings in the first quarter, representing approximately 42% of our total closings. These 521 closings also represent a 65% increase in closings for the Central division over the first quarter of last year. In addition, the absorption rate in the Central division was one of the strongest across all divisions, averaging 6.1 closings per community per month. During March, we closed on our first home in the Oklahoma City market, expanding our Central division outside of the state of Texas. Our concentration outside of Texas continued to increase during the first quarter, making up 58% of our closings. The Southwest division represented 16% of our home closings, the Southeast division represented 18%, the Florida division represented 17%, and the Northwest division represented 7%.
As we have discussed on previous calls, we anticipate that our percentage of closings outside of Texas will continue to increase. Another highlight of the first quarter was the results from our Northwest division. We had strong absorption of 5.5 closings per community per month at an average sales price of $337,000, up from $321,000 in the first quarter of last year. In addition, the Northwest division closed 88 homes compared to 40 homes closed in the first quarter of last year, which is an increase of 120% year-over-year. With that, I'd like to turn the call over to Charles Merdian, our Chief Financial Officer, for a more in-depth review of our financial results.
Thanks, Eric. As previously mentioned, home sales revenues for the quarter were $279 million based on 1,244 homes closed, which represents a 71.3% increase over the first quarter of 2017. Sales prices realized from homes closed during the first quarter ranged from the $140s to over $500,000 and averaged $224,296, a 4.8% year-over-year increase. The increase in average sales price year-over-year reflects changes in product mix, price points in certain new markets, and a favorable pricing environment. In the first quarter, approximate average sales prices by division were $206,000 in Central, $276,000 in the Southwest, $197,000 in the Southeast, $203,000 in Florida, and $337,000 in the Northwest. Gross margin as a percentage of sales was 24.8% this quarter, compared to 26.7% for the same quarter last year.
Our adjusted gross margin was 26.4% this quarter, compared to 28% for the first quarter of 2017, a 160 basis point decrease. Sequentially, gross margins increased 40 basis points, and adjusted gross margins increased 60 basis points quarter-over-quarter. Adjusted gross margin excludes approximately $4.3 million of capitalized interest charged to cost of sales during the quarter, representing approximately 155 basis points consistent with previous quarters. Combined selling, general, and administrative expenses for the first quarter were 13.8% of home sales revenue, compared to 16.8% in the prior year. We believe that SG&A will vary quarter-to-quarter based on home sales revenue, and for the full year, we expect SG&A as a percentage of revenue to be 20 to 50 basis points lower compared to our 2017 full-year results.
Selling expenses for the quarter were $22.9 million, or 8.2% of home sales revenue, compared to $16.1 million, or 9.9% of home sales revenues for the first quarter of 2017, which is a 170 basis point decrease. The decrease in selling expenses as a percentage of home sales revenue is due to operating leverage realized related to advertising costs. General and administrative expenses were 5.5% of home sales revenue, compared to 6.9% for the first quarter of 2017, a 140 basis point decrease. Decrease in general and administrative expenses as a percentage of home sales revenue reflects operating leverage realized from the higher number of homes closed. Pre-tax income for the quarter was $31.2 million, or 11.2% of home sales revenue, an increase of 90 basis points over the same quarter in 2017.
This is the strongest first quarter earnings in LGI history and represents an 85% increase in pre-tax income dollars over the same quarter last year. For the first quarter, our effective tax rate of 12.6% is lower than our annual expected effective tax rate, primarily due to the result of deductions in excess of compensation costs or windfalls for share-based payments. Excluding the windfall deduction, our effective tax rate would have been approximately 24%, and we would expect that the second through fourth quarter effective tax rate will be between 23.5% and 24.5%. We generated net income in the quarter of $27.3 million, or 9.8% of home sales revenue, which represents earnings per share of $1.23 per basic share and $1.10 per diluted share. Weighted shares outstanding for calculating diluted earnings per share are impacted by our outstanding convertible notes.
In the first quarter of 2018, our average stock price was $67.65, exceeding the conversion price, therefore the convertible notes were determined to be diluted. This resulted in an approximate 2.2 million share increase to the weighted average shares outstanding for the diluted EPS calculation for the quarter. First quarter gross orders were 2,264 and net orders were 1,798. Ending backlog for the first quarter was 1,370 homes, compared to 1,087 last year, the cancellation rate for the first quarter of 2018 was 20.6%. We ended the first quarter with a portfolio of approximately 45,300 owned and controlled lots, up from approximately 39,700 at the end of last year. As of March 31st, we had approximately $52 million in cash, over $1 billion of real estate inventory, and total assets over $1.2 billion.
We had $510 million outstanding on our revolving credit facility, our borrowing capacity was approximately $84 million. In addition, we had $70 million in convertible notes outstanding, as mentioned on last quarter's call, during the first quarter, we settled $15 million in principal and issued approximately 500,000 shares of our common stock related to these notes. Our gross debt to capitalization was approximately 52%, net debt to capitalization was approximately 50%. At this point, I would like to turn it back over to Eric.
Thanks, Charles. In summary, we had another outstanding quarter. Let me provide some guidance and thoughts on what we are seeing thus far in this quarter and looking ahead into the remainder of the year. The second quarter is off to a great start with 606 closings in April, up 66% from the 365 closings in April of last year. The 606 closings came from 79 active communities, resulting in a very solid absorption pace, averaging just over 7.7 closings per community per month. We are also continuing our nationwide expansion, focusing on increasing our community count. As previously discussed, we believe we are on track to end the year between 85 and 90 active communities. We have started construction in our first communities in the Sacramento, California, and Birmingham, Alabama markets.
Both of these projects will start sales later this quarter, with closings expected in the third quarter of this year. We also have closed on our first project in Las Vegas. Construction and sales will begin later this year, with closings expected in the fourth quarter of this year or the first quarter of next year. Based on the strength of our first quarter closings and our strong start to the second quarter, we offer the following guidance for the remainder of the year. We expect to close between 6,000 and 7,000 homes in 2018. We believe our average sales price in 2018 will end the year between $220,000 and $230,000. We predict our gross margin will end the year between 24% and 26%. We expect adjusted gross margin, which excludes the effects of interest and purchase accounting, will continue to be strong, ending the year between 25.5% and 27.5%.
Given our continued belief that we will close between 6,000 and 7,000 homes and our reaffirmed guidance of average sales price, gross margins, and community count, we continue to believe our full-year basic earnings per share will be between $6 and $7 per share. We will be happy to take your questions.
Ladies and gentlemen, if you do have a question at this time, please press star then one on your touchtone telephone. Again, for any questions, please press star then one. Our first question comes from Nishu Sood of Deutsche Bank. Your line is open.
Thank you. Eric, let me just start out. Obviously, the results looked strong on the margins, the SG&A especially. The stock reaction today runs counter to that. I think that may be because despite the very strong closing pace you have had year-to-date, you are not taking your guidance ranges up. I was just wondering if you could walk through the dynamics and thinking around that, please.
Sure, Nishu. This is Eric. Appreciate those comments. We look at that every quarter, and based on our history, we want to be conservative with our guidance. We have had a real strong first four months of the year. We have some pretty easy comps that we have had four straight months of 60% increases over last year. Looking at the rest of the year, we went over it with our board of directors, and we want to make sure we hit our guidance. Historically, that six to eight closings a month is really where we have been. At 6,000 closings, our guidance on that, we would have to average 6.3 closings per month for the rest of the year. At 7,000, it is 7.9 based on an average community count.
Our guidance, we feel, is right in line with that 6-8 historical averages, we feel real good about the start of the second quarter. We averaged 7.7 closings per community. We think May, based on what we're seeing and a couple of communities closing out, will still be strong, but be more in the 6.3-6.5 closings per community. We think we're going to stay in that range, in that 6-8 closings per month range. The math works out to 6,000-7,000 for the year. We'll certainly look at that every quarter and very likely to tighten that guidance as we get further into the year. For now, we thought it was best to continue with that guidance.
Got it. The range is pretty wide. I guess the way to characterize it is you may have moved up within the range a little bit, the range is still good?
Absolutely. I mean, the range is still good. We're very confident in the range. We always want to hit our guidance, we're off to a great start, really positive about the business.
Got it. On SG&A, very strong performance this quarter. Obviously, clearly it seems, or I guess as part of the question, it seems like you're benefiting from your continued investment in digital initiatives. Charles, if I understood your guidance correctly, I think you actually are now expecting a little less improvement in the SG&A ratio this year. I was just wondering if you could talk through the dynamics on that, please.
This is Charles. I'll start, and Eric can add on the digital and on the marketing spend. What we're thinking, if you look back on a quarter-over-quarter basis between the second and the fourth quarters, we're expecting the SG&A % to be similar, so in the range of where we were last year. We've got investments. Certainly, we have geographic investments and overhead that we're working through. The primary driver in the first quarter on selling expenses is really the advertising costs and the marketing costs, like you mentioned. Putting that in context, comparing to first quarter of 2017, the ratio was higher due to the overall lower closings and lower revenue driven by the inventory gaps that we had in some of our high-performing markets.
If you look at it quarter-over-quarter for the rest of the year, we think the SG&A ratio is going to be similar. That puts us somewhere in that 20-50 basis point range for the full year, depending on where we come in on the closing guidance.
Nishu, I can add to that as far as a little bit more on the digital marketing. Our marketing team here at corporate continues to do a great job of driving leads to our community. In the first quarter, again, we had over 100,000 inquiries or 100,000 leads from customers looking to purchase an LGI Homes. We have got oversized leverage, if you will, and have not needed to spend our full advertising budget in order to drive leads to our communities. I'm sure there's going to be a question around rates and what we're seeing. As rates continue to go up, and we're advertising a higher price point because of costs going up and advertising higher monthly payments, one of the things that we're forecasting is needing to spend a little bit more money on marketing.
We're certainly willing to do that since we've been so efficient to drive the number of leads we need to hit our closing numbers. We're probably a little conservative on our guidance, giving us some room to spend more money if needed to combat a higher interest rate environment.
Got you. Okay. Last one for me. Last year, your demand pace was so strong that your ramp-up in starts, I think, last year, Charles, you gave this stat, I think, last time was somewhere at 60% plus in terms of starts, 2017 versus 2016. That led to some inefficiencies on the gross margin line. Where are we now on that? Is the production machine caught up with demand now that the demand environment has been at this level for some time? Therefore, could there be some benefit to gross margins if that's the case in the back half of the year?
Sure. Great question. Yes, last year we did see kind of end of the first quarter and into the summer, quite a bit of ramp-up, if you will, in terms of our inventory production. We ended the year close to around 3,000 units, either completed or in process. We ended the first quarter around 3,400 units. We still have been overall increasing our investment in our direct construction to give us the ability to hit the high end of the closings per community range that Eric mentioned. I think we have seen overall what I would refer to probably as a tapering. I think the production issue has, I guess a way to describe it may be stabilized in that sense, a lot more consistency on a month-over-month basis in terms of how many starts we're putting into the system on a monthly basis.
That has definitely helped on the cost side as well. I think what we're looking at from what we can see at this point is that materials and labor have really kind of, both in the frequency and dollar amount of increases, have been less impactful over the last three or four months, which potentially could give us some upside. As Eric mentioned, there still are some headwinds for us in terms of affordability and how much pricing power we can really achieve. I think we're looking really at more consistent gross margins to the first quarter than a significant ramp-up in the back end.
Great. Thank you for the details.
Thank you.
You bet.
Our next question comes from Michael Rehaut of JPMorgan. Your line is open.
This is from Mike. I guess I want to start on the gross margin performance relative to your guidance. What were some of the things you see as driving the upside? Really any comments on the puts and takes there.
Yeah, sure. This is Charles, Eric can add. I think following up on the earlier question, I think we definitely saw some pricing power. We mentioned on the last call that we were raising prices in January. We were able to do that. I think some of the issues we were seeing in terms of rapid and significant price increases settled a little bit, that worked to our advantage as well. I think combination of those two factors led to the gross margin this quarter maybe being a little bit higher than what we guided to in the last call. I think, like I mentioned, I think we're maybe not expecting to see it increase as much on the back end as maybe we mentioned earlier as well.
Okay. That helps a lot. Wanted to ask a quick one on capital structure. Even though net debt to cap has ticked up a bit, it seems like you're pretty much in line with where you want to be from a leverage standpoint. Maybe could you update us on what you're thinking as far as capital structure to finance the growth you've been seeing?
Yeah, sure. Great question. First of all, we've been focused on reinvesting our profits. It's been one of our key components of our capital structure. We've earned over $300 million since our IPO and been able to reinvest that into the business. We've also been very successful managing, like you mentioned, our debt to cap in that 50% range. We've done that through our credit facility through increases year-over-year. We have an annual renewal that's coming up this month as well. We continue to consider all of our options from our long-term capital structure, the convertible notes, which we mentioned $15 million of which were converted this quarter. The maturity date on those convertible notes are November of 2019, we're also thinking ahead in terms of making sure that we'll have the capacity to settle those convertible notes as well.
We also believe our capital structure will continue to evolve. We're looking at the other options available to us, certainly taking into account what's happening in the markets, availability of capital, the size of issuance, those type of factors. We continue to believe that over time, that our capital structure will evolve as well.
Okay. Appreciate it.
You bet.
Our next question comes from Stephen East of Wells Fargo. Your line is open.
Thank you. Good afternoon, guys. Last quarter, Eric, you talked some about wholesale closings that you had in the quarter. Could you talk a little bit about what you had this quarter and what you think is the outlook for the rest of the year, if you all try to forecast that, and just the impact on gross margin and SG&A so we know what was really going on?
Thanks, Stephen. Appreciate the question. From a wholesale standpoint, we had 31 closings in the first quarter, that's about 2.5% of our closings. Average sales price is around $220,000, pretty consistent with our average sales price of our LGI Homes retail business. For the rest of the year, guidance would be the same as we mentioned previously. We expect to close 200 to 300 houses in the wholesale business this year, which puts us maybe a little bit higher percentage overall, more in the 3%-4% range. Same impact to gross margin. The first quarter is about 20 basis points on gross margin, then maybe slightly higher than that, 30-50 basis points in the second, third, and fourth quarter, just as a percentage, probably be slightly higher as a percentage of the wholesale business.
Got you. Okay. One follow on with that, how do you view those sales versus your normalized sales? Are you agnostic between the two? The other question I had was, last quarter, also, you talked about land market getting a bit more competitive. We've actually heard some move-up competitors say, "Hey, that market's maybe getting a little bit less competitive." Just any changes you're seeing as you go through the markets?
On the wholesale business, we underwrite to the same operating income or pre-tax income, if you will. We're really indifferent on the financial aspect of it on a one-off basis. What we really like about the wholesale business and why it's such a positive for our company is we only sell the wholesale homes in communities where we have the supply to do it. Not necessarily underperforming communities, but performing communities where we have extra land or extra lots on the ground. It's really a win-win situation where it helps move some inventory and creates a similar pre-tax net income, then overall, you're getting the additional leverage on your SG&A by adding those additional closings.
Got you.
Your second question, Stephen, was on the move-up business?
No, welll, just your land market. Last quarter you talked about, yeah, you were seeing it get a little bit more competitive, and some of your peers are saying that the move-up market's getting a little bit less competitive because of the movement toward entry-level. Just wondering if you're seeing that change any more than what you saw in the fourth quarter.
Yeah, I don't think we've seen much of a change. We certainly have noticed other public builders and some privates talking about the strong demand for entry-level, and I think that's positive for LGI. I think everybody realized that the demand for that first-time home buyer is there, and a lot of demographics in our favor as far as renters getting into the first-time home buyer markets. I'd say the land business is similar. We've got a lot of deals in the pipeline. You saw our owned and controlled lots have increased since the last quarter. Underwriting to the same guidelines, and we think we're in good shape from a land position.
All right. Thank you.
You're welcome.
Our next question comes from Carl Reichardt of BTIG. Your line is open.
Thanks. Morning, guys.
Good morning.
You've got to all my questions except for one. When you're looking at lot cost acceleration, I'm curious, especially as you move into new markets, where are you seeing lot costs accelerate most significantly out of your markets? I'm operating under the assumption that the business models continue to be to look at markets that are somewhat untrammeled by some of your larger peers to some extent to get to affordable price points. I'm just curious if you think around the country where you see the most inflation.
Yeah. This is Charles. I'll start. I think, to your point, lot cost as a percentage of revenues has definitely increased. We talked a little bit that on the last call. Our average lot cost as a percentage of revenue is in the mid-18%, so roughly 18.5%, which is continuing to increase. It's one of those items that we believe are going to continue to be a factor in terms of increasing costs. I think you're right, it is more geographic. Even in the case in some of our longer-term markets like Texas, the next replacement or the community that replaces one that's being closed out, the cost to develop those lots or purchase those lots are going to be higher, and usually a little bit further out as well.
Even though we are in the tertiary sub-markets compared to our peers, I think lot costs are definitely one of those factors that we expect to continue to increase.
Okay. Thanks, Charles. Actually, I do have one other follow-up. If you look at your traffic conversion rates, which I know you don't disclose, how did they look in Q1 relative to Q1 last year?
Very similar, Carl. We're still seeing strong demand, like we talked about, still having a lot of leads coming in. The mortgage availability, I'd say, is consistent. It's more available than it was a couple of years ago, but I'd say consistent year-over-year. Certainly a lot of training, constant never-ending improvement is part of our culture here at LGI. We got a lot of new markets, a lot of new managers, a lot of new salespeople coming through the system, we have to continuously do a lot of training, but our conversion ratios are very similar.
Great. Appreciate it. Thanks, Eric.
You bet.
Again, ladies and gentlemen, if you would like to ask a question, please press star then one on your touch-tone telephone. We do have a question from Alex Barron of Housing Research Center. Your line is open.
Thanks. Hey, good job, guys.
Thank you.
I wanted to ask, I guess in this rising rate environment, do you perceive that as being more of a negative or more of a positive, meaning that you'll lose more buyers who can't afford a home, or you'll gain more buyers who can't afford more expensive homes?
Right now, Alex, this is Eric speaking. Right now, we're seeing it as a positive because we are selling at a higher interest rate environment, and we have been for at least arguably the last four to six months, and we're continuing to see strong demand. Going along with the higher interest rates, you as well as also seeing increased job growth, tax reform has put a few more dollars in our customers' paycheck, which we see as positive. Right now, I think everybody's feeling pretty good. We're seeing strong demand. So far, interest rates have had, I'd say, a neutral to positive effect. Certainly as rates increase and the monthly payment increases, some customers may not qualify. Some customers may have to buy a smaller square footage house to qualify. Some customers may have to come down into an LGI Homes from a potential move up.
Right now, I'd say neutral to positive is outweighing the negatives in a high interest rate environment or a rising interest rate environment. We think this weekend is the best time in history to buy a house because rates are only going up from here, and we're seeing strong demand.
Okay. How about as you're seeing more builders, I guess, moving in your direction in terms of price point, do you feel the environment's become more competitive or not really due to your own kind of the way you guys market to people?
Yeah. There's certainly more builders coming into the entry-level space, so it'd be more competitive in that regard, but we don't think that will have any negative influence on our results. We're really focused on what we're doing here at LGI and not focused on what everyone else is doing. The fact that everyone is in agreement that the entry-level buyer is really in a strong position right now, like I said earlier, the demographics on our side, and we're seeing strong demand. I think it's a positive testament of what we believe in, that it's a very strong market right now. We're not too worried about the competition. We're focused on what we're doing, and it won't impact our results. Overall, we think it's a positive that everybody's talking about the strength of the entry-level market.
Okay. One last one. I didn't see any deliveries from the Midwest region. Any reason for that?
No, just because we're just getting started up there, so you'll see that coming next quarter.
Got it. Okay, thanks.
All right. You're welcome.
Our last question comes from Jay McCanless of Wedbush. Your line is open.
Hey, good afternoon, guys. Thanks for fitting me in. Apologies if you've already addressed this, but wanted to find out what % of communities you raised price this quarter, and with input costs continuing to go up, how much are you guys been able to cover on pricing to offset that?
Yeah. I'll take it first, Jay. Then Charles can jump in if he wants. We look at price increases and our prices quite frequently, do a real deep analysis every quarter. In January, we did a price increase in virtually all of our communities. Then again in April, because we're still seeing prices and costs increase. In April, we did another price increase in virtually all of our communities. 80%, 90% plus of our communities had a price increase in April because that was necessary because we're continuing to see costs increase. We talked about it earlier on the call, we anticipate gross margins being similar. We anticipate costs continue to rise for the second, third, and fourth quarter and us continuing to have to raise prices to offset those costs to keep gross margin neutral.
Great. The second question I had, Freddie Mac announced that they're going to be starting a new 3% down mortgage program with no income restrictions beginning in July. I didn't know if you guys have had a chance to look at that program, what impact that might have on buyers who maybe are knocked out of the FHA limit in certain areas.
Yeah, I saw the headline. We have not done a lot of research on that. We'll rely on our preferred mortgage partners to really give us the details once that program is really confirmed, and we can potentially roll it out to our customers. If it's a program that would open up availability of mortgages to more people, that certainly would be a positive for LGI.
Okay. Sounds great. Thanks, guys.
Thanks, Jay.
Yeah, thanks.
I'm showing no further questions over the phone lines at this time. I would now like to turn the call back over to Eric Lipar for closing remarks.
Thanks, everyone, for participating on today's call and for your continued interest in LGI Homes. Have a great day.
Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program, and you may now disconnect. Everyone, have a great day.