D.R. Horton Inc (DHI) — Q1 2020 Earnings Call Transcript

Thank you, Kevin, and good morning. Welcome to our call to discuss our results for the first quarter of fiscal 2020. 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-K, which is filed with the Securities and Exchange Commission. This morning’s earnings release can be found on our website at investor.drhorton.com, and we plan to file our 10-Q in a day or two. After this call, we will post updated investor and supplementary data presentations to our Investor Relations site on the Presentations section under News & Events for your reference. 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 started the year off strong. Our consolidated pretax income for the quarter increased 39% to $523 million on a 14% increase in revenue to $4 billion. Our pretax profit margin improved 230 basis points to 13%, and our net sales orders increased 19%. Our homebuilding return on inventory for the trailing 12 months ended December 31st was 18.7%, and our consolidated return on equity for the same period was 18.2%. These results reflect the strength of our operational teams, our ability to leverage D.R. Horton’s scale across our broad geographic footprint, and our product positioning to offer homes at affordable price points across multiple brands. We continue to see good demand and a limited supply of homes at affordable prices across our markets, while economic fundamentals and financing availability remain strong. Our strategic focus is to continue consolidating market share while growing our revenues and profits, generating strong annual cash flows and returns, and maintaining a flexible financial position with a conservative balance sheet that includes an ample supply of homes, lots, and lands for growth. We are well-positioned for the remainder of 2020 and future years. Mike?

Diluted earnings per share for the first quarter of fiscal 2020 increased 53% to $1.16 per share, compared to $0.76 per share in the prior year quarter. Net income for the quarter increased 50% to $431 million, compared to $287 million. Our first quarter results included a tax benefit of $32.9 million related to federal energy-efficient homes tax credits that were retroactively reinstated. Our consolidated pretax income increased 39% to $523 million in the first quarter and our homebuilding pretax income increased 30% to $462 million. Our first quarter home sales revenues increased 13% to $3.9 billion on 12,959 homes closed, up from $3.4 billion on 11,500 homes closed in the prior year. Our average closing price for the quarter was up 1% from last year to $298,100 and the average size of our homes closed was down 2%, reflecting our ongoing efforts to keep our homes affordable. Bill?

Net sales orders in the first quarter increased 19% to 13,126 homes and the value of those orders was $3.9 billion, up 22% from $3.2 billion in the prior year. Our significant sales price increase over the prior year quarter reflects the moderation in demand that occurred in late calendar 2018. Our average number of active selling communities increased 6% from the prior year and was flat sequentially. Our average sales price on net sales orders in the first quarter was $300,900, up 3% from the prior year. The cancellation rate for the first quarter was 20% compared to 24% in the same quarter last year. Jessica?

Our gross profit margin on home sales revenue in the first quarter was 21%, flat sequentially from the September quarter, up 100 basis points compared to the prior year quarter and in line with our expectations. Based on today’s market conditions, we currently expect our home sales gross margin in the second quarter to be consistent with the first quarter, subject to possible fluctuations due to product and geographic mix, as well as the relative impacts of warranty, litigation, and purchase accounting. Bill?

In the first quarter, homebuilding SG&A expense as a percentage of revenues was 9.2%, down 30 basis points from 9.5% in the prior year quarter. We remain focused on controlling our SG&A while ensuring that our infrastructure adequately supports our growth. Mike?

We ended the first quarter with 30,200 homes in inventory. 18,400 of our total homes were unsold, of which 5,600 were completed. Our first quarter homebuilding investments in lots, land, and development totaled $1.3 billion, of which $890 million was for purchases of land and finished lots, while $410 million was for land development. Our underwriting criteria and operational expectations for new communities remained consistent at a minimum 20% annual pretax return on inventory and return of our initial cash within 24 months. David?

At December 31st, our homebuilding lot position consisted of approximately 320,000 lots, of which 39% were owned and 61% were controlled through purchase contracts. 33% of our total owned lots are finished, and at least 56% of our controlled lots will be finished when we purchase them. We continue working to increase our lot position being developed by third parties by supporting the growth of Forestar’s national lot manufacturing platform and expanding our relationship with lot developers across the country. Our current lot portfolio includes an ample supply of lots for homes at affordable price points and continues to provide a strong competitive advantage. Mike?

Forestar, our majority-owned subsidiary, is a publicly-traded residential lot manufacturer, operating in 51 markets across 20 states. At December 31st, Forestar’s lot position consisted of 44,500 lots, of which 32,200 are owned, and 12,300 are controlled through purchase contracts. 80% of Forestar’s owned lots are already under contract with D.R. Horton or are subject to a right of first offer under the master supply agreement. During the first quarter of fiscal 2020, Forestar delivered 2,422 lots and is on track to deliver 10,000 lots in fiscal 2020 and generate $800 million to $850 million of revenue. Forestar expects to deliver 12,000 lots and generate $900 million to $1 billion of revenue in fiscal 2021. These expectations are for Forestar’s standalone results. Forestar is separately capitalized from D.R. Horton and is committed to maintaining a long-term net debt to capital ratio of 40% or lower. At December 31st, Forestar’s net debt to capital ratio was 9.7%. Forestar has approximately $720 million of liquidity to fund its continued growth, which includes $370 million of unrestricted cash and $350 million of available capacity on its revolving credit facility. Forestar hosted their quarterly earnings call last Thursday and has an updated presentation on their Investors site and investor.forestar.com that describes Forestar’s unique lot manufacturing model, and a significant growth and value creation opportunity. Jessica?

Financial services pretax income in the first quarter increased 29% to $30.5 million and the pretax profit margin was 29.6%, up from 27.7% in the prior year. 97% 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 65% of our homebuyers. FHA and VA loans accounted for 49% of the mortgage company’s volume. Borrowers originating loans with DHI Mortgage this quarter had an average FICO score of 720 and an average loan to value ratio of 89%. First-time homebuyers represented 50% of the closings handled by our mortgage company, reflecting our continued focus on offering homes at affordable price points for entry-level buyers. David?

DHI Communities is our multifamily rental company focused on suburban garden-style apartments with operations primarily in Texas, Arizona, and Florida. During the quarter, DHI Communities sold its third apartment project located in Phoenix for $61.5 million and recognized a gain on sale of $31.2 million. DHI Communities has four projects under active construction and one project that was substantially complete at the end of the quarter. DHI Communities’ total assets were $210 million at December 31st. Bill?

Our balanced capital approach focuses on being flexible, opportunistic, and disciplined. Our balance sheet strength and operating results are providing increased flexibility, and we are utilizing our strong position to enhance the long-term value of the company. During the first three months of fiscal 2020, our cash used in homebuilding operations was $178.4 million, compared to $396.8 million in the prior year period. At December 31st, we had $2.6 billion of homebuilding liquidity, consisting of $1.2 billion of unrestricted homebuilding cash and $1.4 billion of available capacity on our homebuilding revolving credit facility. Our homebuilding leverage improved 370 basis points to 19.5%. The balance of our homebuilding public notes outstanding at the end of the quarter was $2.4 billion. And we have $500 million of senior notes maturing on February 15th, which we plan to repay, utilizing cash on hand and our revolving credit facility, as necessary. At December 31st, our stockholders’ equity was $10.2 billion and book value per share was $27.92, up 14% from a year ago. During the quarter, we paid cash dividends of $64.6 million. We also repurchased 3 million shares of common stock for $163.1 million, resulting in $732.6 million remaining on our stock repurchase authorization at December 31, 2019. Our outstanding share count was down 2%, year-over-year. Jessica?

Looking forward to the second quarter of fiscal 2020, we expect to generate consolidated revenues in a range of $4.25 billion to $4.4 billion and to close approximately 13,800 to 14,300 homes. We expect our home sales gross margin in the second quarter to be approximately 21% and homebuilding SG&A in the second quarter to be around 9% of homebuilding revenues. Based on today’s market conditions and our first quarter results, we now expect to generate consolidated revenues for the full year of $18.5 billion to $19.1 billion and to close between 60,000 and 61,500 homes. We expect our income tax rate in the second, third, and fourth quarters to be between 23% and 24%. We still expect to generate cash flow from homebuilding operations in excess of $1 billion for the full fiscal year of 2020, and we expect our outstanding share count to be down approximately 2% at the end of the year compared to the end of fiscal 2019. David?

In closing, our results reflect the strength of our well-established operating platform across the country. We are focused on consolidating market share while growing our revenues and profits and generating strong annual cash flows and returns while maintaining a flexible financial position. Our return on equity of 18.2% and our homebuilding return on inventory of 18.7% demonstrate our consistent focus and efforts. We’re well-positioned to continue this performance with our conservative balance sheet, broad geographic footprint, affordable product offerings across multiple brands, attractive finished lot and land positions, and most importantly, our outstanding experienced teams across the country. Thank you to the entire D.R. Horton team for your focus and hard work. We are incredibly well-positioned to continue growing and improving our operations. This concludes our prepared remarks. We will now host questions.

I wanted to ask something you guys often have talked about is the idea of getting your cash back out of your investments in land within two years. And with some of your peers moving to some of the products and markets that you serve, I’m just curious as to your perspective, David, on the land market in general for affordable homes and your ability to continue to run the model where you’re getting cash out in two years.

The cash out within two years is a strategy we've maintained since the downturn, and it's been very effective for us. I don't anticipate that changing. Regarding the overall market for purchasing land, it fundamentally hinges on the skilled individuals we have in these markets and the strong relationships they cultivate with landowners. We are confident in our ability to continue replacing what we’re building, and we've witnessed this happen repeatedly throughout the market.

And then, on similar lines with looking like starts are going to pick up with orders strong for lots of folks, I’m curious as to your perspective on the labor market, subs in particular, and what you’re seeing and thinking about in terms of the potential for increases in cost there this year, as these orders get built out?

There's always going to be pressure on costs. Labor is increasingly tight and will likely limit many people's ability to deliver homes. This relates back to the operating strategy we've adopted, which focuses on consistent starts in the community, broadening the labor base, and enhancing efficiency rather than just increasing headcount. We are very pleased with our achievements and have a loyal network of trades. As I mentioned in the last call, our trades don't have to pursue their payments. All these factors position us well. I believe this will be less of a challenge for us compared to others.

The first one on the order average selling price was a little over 300,000 in the quarter, which was a nice year-over-year increase. I understand that there’s some normalization following a difficult period last year. I'm curious, if we break down that number, is it driven by regional and product mix, or are you adjusting pricing on a like-for-like basis?

Part of it is regionally driven. If you look at our orders this year, the South Central was down 2% in terms of just the mix, the overall mix, and that’s actually our lowest ASP region. So, we continue to expect just modest sale price increases as we move throughout the year, and to cover our cost increases, but on the like-for-like basis nothing significant in the way of price.

I'm curious about your thoughts on the Forestar investment. Are you planning to continue diluting your stake by issuing equity out of Forestar, or are you considering selling down your actual ownership position?

Yes. We’re still on track with our plan there John to ultimately deconsolidate Forestar. We were pleased when they were able to issue their first primary equity offering in September, which diluted our position down from the original 75%; here in December, we’re sitting at 65%. We would expect additional equity issuances from Forestar over time that could continue to dilute our position. And then, as we’ve also said all along, there’s a potential that we could sell some of our shares. And at the point in time that we are ready to do that, we will have a plan in place that will complement the primary equity issuance. And those two things together would result in further dilution in our ownership position.

So, first one, I think last quarter you guys commented just when you thought about the full-year, your best guess at that point would be that gross margins would be kind of similar in that 21% range. And you obviously hit that this quarter and 2Q guide is similar as well. So, just first off, is there any change in your thinking in terms of the progression in margins through the year, obviously very strong sales environment? So, how should we think about as the year progresses, what happens to margin?

I think we’re going to see consistent margins into the second quarter. And then frankly, as usual this time of the year, the spring selling season will really dictate where margins go in Q3 and Q4. Early returns in the spring selling season have been very positive. So, we’re confident in giving our guidance of consistent margins in the Q2, but we’re going to have to wait and see what happens in the next several weeks.

For my second question, I've noticed that your home inventory has been trending lower on a year-over-year basis for the last few quarters. This quarter, it appears to be down about 10% compared to last year, which was slightly elevated due to the tougher sales environment. Are you observing an increase in sales from homes that are to be built? Have you adjusted your strategy regarding the optimal number of spec homes per community, which might explain the decline we're seeing? Or are you planning to increase that number as we move into spring?

There are a few factors affecting that number, Alan. First, compared to last year, we're down 5%. We've modified how we report homes in inventory by excluding model homes. Last year, our inventory was approximately 31,800, and this year it's at 30,200, showing a slight decrease. Last year might have been somewhat inflated due to the softer sales and operating environment we experienced in the fourth quarter of 2018. Additionally, we’ve discussed improving our turnover of housing inventory to generate a better return on our investment dollars. We're also seeing an opportunity to increase starts as demand rises. We haven't observed any significant changes in the mix between homes to be built and our speculative starts, maintaining about an 80-20 ratio consistently.

First question I had for you is on the land spend. The land spend was fairly high relative to our expectations this quarter. I’m talking specifically on the acquisition number of 890. And as a percentage of rev, that was probably the highest we’ve seen in six years. And, given your discipline and given your outlook on the business and your intention to basically get a return on that spend within 24 months, it seems that there’s a fair amount of optimism that’s implied by that strong land spend. So, I was wondering if you could talk a little bit more about that, maybe break that down for us, at least qualitatively, in terms of was that kind of a strong land spend fairly equally distributed across the country where there are certain opportunities that emerged in a particular region or a particular product type that garnered a lion share of that? If you could just talk about the relatively strong land spend in greater detail?

Sure, Stephen. When we start our land expenditures, there can be some fluctuations from quarter to quarter. The timing of deal closures and our business plans can create some variability. I want to emphasize that more than half of our land acquisition costs go toward finished lots, which we can move quickly. While I wouldn't say there are significant changes in our plans, I believe this variability is due to these fluctuations, with a substantial portion of our spending focused on finished lots. We remain optimistic and expect growth and certainty in fiscal '20, as the underlying fundamentals of our business are still strong. We are actively working to replenish our land and lot supply.

And we have to replenish it at a faster rate as we continue to grow our sales and closings pace. You have seen our owned lot count remained relatively flat for quite some time. So, it’s really just a function of having to replenish at a faster rate.

Great. Yes. That’s helpful. Second question relates to the broader macro environment or rather the broader environment with respect to housing policy. We’ve seen some interesting moves here as of late. We have seen the average DTIs, the high DTIs and high LTV lending be curtailed or reined back the FHFA. And yes, we’ve also heard that CFPD weigh in here and suggest they’re going to move to an APOR spread versus the DTI. I was curious as to whether or not you have looked into this. Some of what we’ve heard is that the move to the APOR spread would actually be stimulative to entry-level housing, on top of the dropping rates. That would seem to be extremely favorable for your business. And I was curious if you had looked at that at all. And if you have any view on whether or not these broader factors may be positive for your business the way it would appear to us?

Sure. High level, I think we’d agree with what you’re saying. That being said, it’s super early and out there and it’s not something that we spend a lot of time on. I’m sure our mortgage company would have a much more detailed response for you. But anything that continues to improve mortgage standards and makes it easier for people to get into a house clearly would be a benefit for our business. That being said, as David mentioned in his opening, financing availability is still good. I mean people that should be buying houses are who are buying houses today. And we’re not necessarily in favor of people with significantly high DTIs or really low credit scores being in a house because we’re very cognizant of what happened last cycle, and we don’t want any repeat of that.

So, your guidance is for mid to high single digit closing growth. You’ve bumped up the high end a little bit. But, is there anything structurally limiting you from going above the high end of that guidance, particularly on the land side and thinking availability of lots, your ability to get lots developed? And that also includes municipality constraints, delaying community openings that might create any kind of gap-outs?

Truman, we’re really excited about the way this year started off the first quarter and through the first several weeks of January, and we have increased our guidance as a result of that. Structurally, it’s a question of the lots that are out in front of us. We feel good about the community positioning we have, getting some communities opened. But right now, we’re not going to increase our guidance, based on where we are today in the spring selling season. But, we will certainly look to deliver all the homes we can. That’s the best returns we can do in fiscal ‘20.

Okay. So, put another way, there’s nothing structurally limiting you on the land side from going above that if the market is a bit healthier than what you expect as of today?

There is a finite number of homes we can build over the next 8.5, 9 months and deliver by September 30th. But, we’re comfortable with our guidance range today, and we’re just going to have to see what the spring is going to give us and where we end up in our inventory positioning in March and in April and May.

Our guidance already incorporates a higher housing inventory turnover than what we did last year. So, it reflects an improvement in terms of building, selling, and closing more houses this year than last year, which is what we continue to be focused on is there’s efficiencies in the business. But that is what limits further upside to our current guidance.

Okay. And then, sticking on the land side. Your option lots jumped nicely this quarter, as you all continue rotating towards more option land, how should we think about where that growth comes from? Is it primarily through Forestar? Is it more than an even balance between Forestar and your third-party developers? And then, any way you can put out a target over the next couple of years, what you think you can get that option land as a percentage of total up to?

We’re not going to set a hard target. Internally, we talk about goals, but that’s an internal conversation. And it’s kind of a balanced program. I think the Forestar platform is again built out. We’re very happy with the progress we’re making there. But, we are also equally focused on our third-party developers. And they are a part of the D.R. Horton family. And that pipeline continues to get better and bigger. And so, it’s a collection of the two. Primarily, it’s just focus. We’re treating capital as if it’s a precious commodity. And we’re going to try to treat it better than anybody else in the industry.

Good morning. Thank you for taking my questions. So, I wanted to ask on the SG&A side, since your guidance implies sort of flat percentage year-over-year, although you are growing the top line and kind of managing that inventory positioning. Is there any reason why we wouldn’t see a bit more leverage? And how should we think about that beyond the next quarter? Thank you.

To the extent we’re delivering on our closings guidance and showing mid to high single-digit growth in revenue, we do expect to see leverage on our SG&A and improvement year-over-year. We’re very pleased with the 30 basis points we saw in the first quarter. Based on what we see today and the volume we see in Q2, we do expect SG&A to be relatively flat with last year in Q2. But overall, we do expect some leverage for the year.

Okay. I appreciate that. And then, as you just mentioned, I believe to the prior question, your guidance for the Q2 closings does imply kind of a continued uptick on that conversion of your inventory positioning. But, you did also mention earlier that labor is kind of not surprisingly getting tighter. So, can you speak a bit about that balance? And what exactly are you guys doing on the ground that supports that improving efficiency? Thank you.

It comes down to relationships with our trade base. Since the downturn, we’ve maintained a steady and consistent level of production in our communities. As a result, our trade base has improved at building houses. When they’re not pursuing other work, they can focus on building more homes. We are able to construct more square footage using the same labor hours. This is a process we've developed throughout this cycle. Initially, we believed that labor would be a limiting factor in housing. However, we've effectively managed our trade base, ensuring they can earn a profit while we continue to deliver homes at a reasonable cost.

Matt, the other thing we look at here and we watch sort of from a high-level perspective is what our build times are doing in our process when we start a house, can we get it completed and then closed. And we’re not seeing those times elongate, which would be real, more acute indicators of labor shortages in various markets. So, the longstanding deep relationships we have with a lot of the labor suppliers, combined with a more efficient plan set, if you will, in our communities and focus on the first-time homebuyer and affordability, has driven our ability to continue to turn houses a little bit better, and we’re going to see a lot of improvement in that metric this year.

My first question is about your outlook for the year regarding community count and sales pace. Last quarter, you mentioned that you expected the average community count for the year to increase modestly compared to last year. Is that still your expectation? It seems to have remained flat sequentially for the past few quarters, but I assume you anticipate a slight upward trend. Additionally, regarding the sales pace, you've shown a nice improvement year-over-year. I'm interested in knowing if that was primarily influenced by market conditions or shifts in product or geographic mix, and how you see the upcoming quarter or two shaping up.

When considering community count, it’s the most challenging aspect for us to predict, which is why we don’t provide formal guidance on it. Our base case suggests that we expect it to increase at some point as the year progresses, but pinpointing when that change will occur is difficult. Regarding sales pace, as stated earlier, it reflects the decline in demand we observed in late 2018. Although we typically refrain from discussing comparisons, we faced a relatively favorable comparison. Our guidance for closings this year indicates that the year-over-year increase in sales will moderate from the first quarter and will vary throughout the second, third, and fourth quarters within a range that aligns with our closing growth expectations.

I guess, secondly, bigger picture, kind of maybe piggybacking off an earlier question of owned versus option. Maybe said a different way, your lot option percentage has obviously while huge amounts of progress, impressive progress over the last few years, now, it’s kind of been in that low-60s type of range, 60 to 61, 62, maybe over the last 3, 4 quarters. That increase over the last few years has been a big, big driver of your improved return profile. Just trying to get a sense of over the next two or three years, certainly, you’re not going to do the same type of degree of change on the lot option profile, as you have before, maybe you’ll drift up a little bit. I do recall you guys talking about a 70% number perhaps, but maybe now that’s not as concrete. But, how should we think about, over the next two or three years, the next big lever of improvement in returns? Would it be more from a share repurchasing standpoint or are other levers that perhaps we’re not thinking about?

We anticipate ongoing incremental improvement across all areas. Our aim is to keep increasing our option percentage, although we won't set a specific target. As Forestar continues to grow and enhance its platform, this will be a crucial part of our growth narrative, in addition to strengthening our partnerships with developers. As mentioned earlier in this call, we expect to accelerate the turnover of our housing inventory this year, which will enhance our returns. Moreover, as our operations become more efficient and generate additional cash, we will have greater flexibility in how we allocate our capital. Over the past few years, we've implemented a greater level of share repurchases and dividend payments to our shareholders, which has positively impacted our return on equity. As we keep making year-on-year improvements, I believe these strategies will enable us to further enhance both our operational returns and the returns we provide to our shareholders.

I wanted to discuss the sales pace further. In the first quarter, I believe this is likely the highest point since the crisis in terms of sales pace. I’m interested in understanding if the guidance indicates that this pace will keep improving throughout the year, albeit at a slower rate. Looking at the year-over-year improvement due to easier comparisons, is this growth seen across all product segments, or is it specific to certain types? Additionally, I'm curious if there are any regional differences that might contribute to further pace improvements in the latter half of this year or into next year.

I think we’re seeing generally increased absorptions at our more affordable price points, whether that’s the entire community or certain plans within more the traditional Horton branded communities. We are not heavily exposed to the luxury end of the market. So, we’re not experiencing if there is any lift there or not lift going on there. We can speak to that very well. But, across all of our geographies, we’re feeling pretty good about the traffic, pretty good about the demand, in the most recent quarter and in the quarters leading up to it.

And then, maybe the January trend the last couple of weeks, would it be consistent with what we saw in the fiscal first, or does that build sort of continue in the most recent couple weeks?

I’d say, we’ve seen normal seasonality week-to-week as we progressed in January. It seems like historically people talked about Super Bowl Sunday being the kickoff to the spring selling season. And we’ve noticed the past few years that seems to be starting a little bit earlier. And maybe it’s because the Cowboys did make the playoffs, people are buying houses sooner. So, we’re excited for Chiefs. And I think…

And the 49ers.

Just one more for me. A couple of jobs that you’ve got, looks like you’re trying to build a team on the single-family rental side. Could you just refresh us on the strategy there and the thoughts, owned versus build for others, and how you’re thinking about the business today?

Yes. We’re currently think about the business, we’re still early stages on it and we’re trying to get in and really understand the operations of the business and see where we add the most value to that process. Today, it’s probably more dipping our toe in the water on the owned side, but we are certainly looking at it hard, and have not shut the door on any possibility today.

So, you beat your closing guidance. I assume that was on higher intra-quarter order closings. Can you confirm that? And what was the percent for intra-quarter order closing in this 1Q versus last year?

You are correct that we exceeded that. This quarter, we sold and closed 40% in the same quarter, which is slightly above our typical performance. I have last year's figure, which was 37%.

Okay. Could you discuss any thoughts you have regarding the increase in efficiency and the margin spread, particularly in relation to the trend you've observed between backlog closings and the intra-quarter closing units?

On the first part, Ken, I would say, it’s pretty much in line with what we would expect, especially with the number of completed specs that we have. That allows us the opportunity to sell and close more homes within the quarter. So, I would expect that trend to continue. Last year, in the second quarter, we actually sold and closed 45% homes in the same quarter, sold and closed. If you look at the margin differential, that stayed relatively consistent and that there is a slight differential and a slightly lower margin on specs than there is on build jobs. That being said, really the only big differential is on our completed specs that have been completed and unsold for a period of multiple months. So, the earlier we sell it as a spec, the tighter that differential is. And as a reminder, about 80% of what we closed in a quarter started as spec. So, when you see that 21% home sales margin we reported this quarter, that’s by and large is a spec gross margin.

Why is the spec margin a bit lower than the first backlog if there is a price increase? What is causing that difference? Is there a need to discount it? That seems inconsistent with the strength of the orders.

No. it’s that we’re underwriting to a return. And as we turn our spec housing more quickly than build jobs, we are able to work for a slightly lower gross margin and get an equivalent return. In the build job, you are actually going to lose the price appreciation if you walk in before you start construction. And so, we like selling more in real time and capturing that margin as we move along the way.

Ken, many of our build job sales are actually homes that we had already planned to start. They were in the production planning phase but hadn't begun yet, though they were available for sale. Our average backlog time for customers in a build job isn't particularly long because we generally build affordable homes quite efficiently. Therefore, customers aren't waiting for an extended period for large design selections or lengthy permitting before we commence construction. Many of these homes will start shortly after the contract is signed. As a result, the margin difference between a traditional spec sale and a build job is quite narrow.

I appreciate that. And if I could, one last question. Did you guys pull most of your permits in California to get ahead of the solar mandate? Thank you.

No, I don’t think so. We’re responding to the market out there. The solar mandate will certainly increase costs. However, obtaining a permit and constructing a house when there is no demand will yield significantly lower returns than covering any extra expenses. So, we are continuing our standard operations. We have been aware of the solar mandate for several years, allowing us to prepare accordingly. Those costs have been factored into our underwriting, and as more homes incorporate solar, we expect those costs to decrease.

Quick question. Could you just put color on percentage of communities that you were able to raise price on, on a same plan basis?

Buck, we don’t have that information in terms of tracking across our neighborhoods. We’ve really have empowered our local operators to be looking to meet the market to drive returns, and that is certainly a function of pace and margin. And they’re looking to maximize that at every community, every week, every day frankly as to looking at what that pace is. And that’s something that we’re managing centrally. So, we don’t really have the ability to give you that color today.

When we discuss our revenues per square foot, it's a metric we have consistently reported, and we have provided that information today. Year-over-year, our revenue per square foot increased by approximately 3%, while our stick and brick costs decreased by around 0.5%. On a sequential basis, both our revenues per square foot and our stick and brick costs per square foot remained largely unchanged.

And switching over to just the multifamily investments. Just curious if you could provide any potential quarterly timing of expected sales or closings, or how do you think of potential gains on sale from the multifamily division, either this year, next year? How do you plan on growing that investment going forward?

Sure. In terms of timing, we expect to close a total of two projects in fiscal 2020. We closed our first one here in Q1. We did say that one of our communities is substantially complete, and so the process of stabilizing the rental situation and marketing it. So, we would expect to close that one later in fiscal 2020, don’t have a specific quarter guide for you on that. And then, we do expect the investment level in the DHI Communities to grow this year. We expect it to grow approximately 100% from the point at the start of the year over the course of this year, as their pipeline is growing, and their number of projects will begin to grow more directly over the course of fiscal 2020, which will ultimately result in some future years, delivering more than two a year. The lead time, the pipeline on those deals is 2 to 3 years long. So, we’re still a couple of years out from a significant increase of volume of project sales in DHI Communities.

Thank you. With respect to single-family rental and multifamily, do you have any interest as the company, and any interest in creating a permanent capital vehicle to hold those assets? In my experience, in the REIT sector, the highest valuation is ascribed to continual recurring earnings rather than gain on sale type earnings where it’s unpredictable to the market? Just curious as to your thoughts on that?

Yes, I understand that, Jade. We are aware of it, and it's something we are studying further as we advance in this business. Our initial goals have been to establish a robust and efficient operating platform, starting with multifamily properties. As we explore the single-family rental sector, we aim to implement the same strategy. Once we have that foundation in place, we plan to grow the platform and establish the necessary capital base. Therefore, as we consider our medium and long-term plans for capitalizing both of these businesses, we will certainly include that in our considerations for the future.

Thanks very much. Turning to financial leverage, was wondering if the total debt to capital at slightly below 20% is in line with your long-term target, or do you think there’s potentially improvement in that ratio in years to come?

Currently, we do not anticipate increasing our leverage. As we continue to generate cash and build our equity base, we believe our leverage will remain stable or possibly decrease. Our maximum leverage target is 35% or lower, and we have significant capacity under this limit. While we are allowing ourselves some flexibility for potential investments that may increase leverage, we do not foresee this occurring in the near future.

Hey. Thanks for taking my question. Can you give us an update on what’s happening with the Freedom brand? Any color on that buyer segment?

We continue to work on that product offering presentation and lifestyle. It’s something we’re happy with. I think it will be a larger and larger portion of our deliveries in the future. It’s a growing demographic. And we think we can provide a product and lifestyle that people are going to move into.

Are you expecting growth in that business in your annual guidance, or is that guidance mainly influenced by the entry-level segment?

It’s still the entry level bar driving the market. The Freedom brand for us is part of our long term meet the needs of as many buyers out there as we can. And I think as the market moves, it will become a more and more important part of what we’re doing.

Understood. And then, second question on your gross margin guidance, 21%.Can you maybe break out the cost buckets there, what’s your labor cost inflation expectation, material cost and then like cost.

Really just more of the same, so modest increases. I’d say labor has stayed in the low single-digit percentage range. Now that we’ve kind of cycled through the lumber headwinds that we had, materials, we essentially would expect to be net neutral. We always have some categories where costs are going up. But, our purchasing teams do a fantastic job of finding other categories to lower our costs and offset whatever increases we’re not able to push back on. And then, land really has been kind of a low to mid-single digit percentage increase, at least on a per square foot basis. And that really is not expected to change either. I mean, land costs aren’t coming down. As home prices, land costs typically follow. So, really just more of the same in ‘20 as what we experienced in ‘19, if you take out late calendar ‘18 incentive environment and the lumber costs that we cycled through.

What is the expectation for the tariff impact or lack thereof, or what do you have included in your estimates?

We’ve got price protection on most everything. If there is a modest impact from any of the tariffs, we’ve identified ways to offset that.

You mentioned the very positive early returns on spring selling season. Was that largely just a reference to strong orders in January, or was it other things that color that comment?

The primary thing is the order trends. I mean, that’s the first read we’re getting on what’s coming through. And they’re coming in at a great pace that we’ve expected, and we’re seeing good seasonal builds, week-to-week with that. And anecdotally, we’re not hearing about any pushback or pressure on pricing from the customer side of the marketplace today.

Kind of following up on that. Obviously, as Jessica just mentioned, you have a fairly benign cost environment now. As things heat up, labor does go higher, materials go higher, et cetera, do you have a sense as to what type of pricing power you might have in the current environment? And really, I recognize it’s always a question of taste versus price. But, I guess, at some point in time, when you try and push price, it could have a bigger impact than at other times. And certainly, we saw that in the last year or two. Do you think that we’ve created a bit more cushion in the environment, so that there would be more leeway on price, if costs start to go up, or do you think we haven’t exited that environment?

Feel really good about the market conditions we’re seeing today and the buyers that are coming in and their urgency to buy. So, I would say we have some cushion to work with in that. But again, we’re not just looking at a margin number, it is a return number, as you alluded to before, the pace versus price. And so, driving the communities at the planned absorptions, we found drive the highest returns. And then, the activity that begets that coming out of buyers seeing activity, seeing momentum, drives generally some pricing power and some margin expansion, executing at the community level. And that’s really where our focus is. And as it’s rolling up, we’ve seen pretty consistent margins the last couple of quarters, and we’re looking at that into next quarter. We’re optimistic about spring, and that’s going to tell us where margins ultimately go for this year.

And one last one. Where are your thoughts on offsite manufacturing as a way to potentially mitigate or improve the labor side of things in time?

We have many of our homes constructed with roof trusses that are made offsite. In some markets, we also use wall panelization. We constantly assess the most efficient ways to deliver homes in terms of time and cost to provide the best value for buyers. Our evaluation is ongoing, and we haven't observed any significant changes in the economics of this approach recently. Generally, most of our homes are framed with stick framing and trusses, but in certain markets, we do build roofs onsite.

Just two questions. On incentives, what are you guys doing with incentives now? And more importantly, what are you seeing from your competition?

Pretty stable environment there. Certainly on a year-over-year basis, our incentives are down significantly, but over the last couple of quarters, been pretty stable. It’s a normal environment where there’s usually some level of incentives related to closing costs. And then, community-by-community, there could be some specific incentives but nothing out of the ordinary certainly in our business. And really, we’re seeing pretty rational environment across other builders as well not hearing anything out of the ordinary.

I’d say, the market is good. People are, as Bill said, performing rationally. It’s a good time to be a homebuilder.

My second question. Just talking about what your average lot per community is right now and are you expecting that the trend up just to get the higher year-over-year unit closures you talked about the guidance?

It slightly trended up here over the last couple of years, Jay, as our absorptions have improved, that does allow our underwriting to hit our standards and use slightly larger communities. So, I would say that is incorporated in what we’re expecting for fiscal ‘20, but that’s really just been more of the same of what we’ve experienced each of the last few years. Multiple product types and larger communities allow us to drive more absorption. So, I don’t have our current average lot size or a lot count. Rough, I would say probably 150, 200 lots. But obviously, we’ve got significant variation in that. We’ve got communities that are 30 lots; we’ve got a community of 1,000 lots.

Some more options, some more owned. There’s a big mix there.

I guess, I just wanted to circle back a little bit to the guidance. Over the last two quarters, orders have been double-digit and a little bit off of that was maybe easier comp. But, I guess, I’m just curious, you guys just being conservative this early in the spring selling season basically, giving the single-digit order growth guidance or delivery guidance?

So, Alex, not to be repetitive, but really, it is a function of where we sit today, the number of houses we have, the number of houses we had going into the year. We did have a much easier comp this quarter compared to late calendar last year, when the market was completely different from what it is. And to remind everyone, we heavily incentivized into December and really ended the spring to continue those sales increases that we saw. I think we were the only builder in calendar 4Q of ‘18 that had an up quarter. Our sales were up about 3%, and that really was just a function of how heavily we incentivized in December to get there. So, October and November, you can read into were very tough months. And that led into a good comp this year, and 19% you though. I mean, it’s a good market. As Mike’s alluded to several times, we feel very good about the market today. But, we sit here today, we haven’t seen the spring selling season. We’ve got 5% fewer houses in the ground. So, if we’re able to push and get a few more starts in, and the spring is stronger than expected, could there be a little upside, potentially, but we don’t see a whole lot. And we did already raise the higher end of our guidance by about 500 homes.

And on balance, we’re looking at much stronger returns in fiscal 2020, because we’re still seeing a good pace. Even at the guidance level, we’re seeing a good pace, at better margins, better returns, and a better turn of our inventory this year as well. So, we’re very pleased with our positioning with the good market backdrop and with our plan for the year.

Got it. You mentioned that maintaining a strong sales pace leads to the best returns. Are you trying to adjust prices to ensure that this strong sales pace is not disrupted?

It depends on the community, Alex. It really just depends. If we’ve got another community replacing a community ready to go behind it, we’re going to most likely push more pace than we are priced because that’s the best thing that we can do is continue to turn our inventory, generate more revenue and profits in a shorter period of time. But, if it’s an area of the country where we don’t have a replacement community or for whatever reason that community is not replaceable, we are going to be more likely to push price. So, it’s always a balance community-by-community.

Thank you, Kevin. We appreciate everybody’s time on the call today and look forward to speaking to you again in April. And to the D.R. Horton team, outstanding first quarter. Thank you for your focus and hard work, and we’ve got a great year set up, let’s go deliver it.