Beazer Homes USA's (BZH) CEO Allan Merrill on Q3 2014 Results - Earnings Call Transcript

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Beazer Homes USA, Inc. (NYSE:BZH)

Q3 2014 Earnings Conference Call

July 31, 2014 10:00 AM ET


Carey Phelps – Director, IR

Allan Merrill – President and CEO

Bob Salomon – EVP, CFO and Chief Accounting Officer


David Goldberg – UBS

Alan Ratner – Zelman & Associates

Michael Rehaut – JPMorgan

Adam Rudiger – Wells Fargo Securities

Eli Hackel – Goldman Sachs

Jay McCanless – Sterne Agee

Alex Barrón – Housing Research Center


Good morning, and welcome to the Beazer Homes Earnings Conference Call for Quarter Ending June 30, 2014. The call is being recorded and a replay will be available on the company’s website later today. In addition, PowerPoint slides, intended to accompany this call, are available on the Investor Relations section of the company’s website at

At this point, I will turn the call over to Carey Phelps, Director of Investor Relations.

Carey Phelps

Thank you, Brian. Good morning, and welcome to the Beazer Homes conference call discussing our results for the third quarter of fiscal 2014.

Before we begin, you should be aware that during this call, we will be making forward-looking statements. Such statements involve known and unknown risks, uncertainties and other factors, which are described in our SEC filings, including our Form 10-K, which may cause actual results to differ materially.

Any forward-looking statement speaks only as of the date on which such statement is made and except as required by law, we do not undertake any obligation to update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. New factors emerge from time to time, and it is not possible for management to predict all such factors.

Joining me today are Allan Merrill, our President and Chief Executive Officer; and Bob Salomon, our Executive Vice President and Chief Financial Officer. Following their prepared remarks, we will take questions in the time remaining. I will now turn the call over to Allan.

Allan Merrill

Thank you, Carey, and thank you for joining us. We were pleased to report profitable results for our fiscal third quarter, excluding the loss related to our bond refinancing. This is the first time we’ve made money from operations in the third quarter since 2006. And the gratifying part is we made more than $6 million while closing nearly the same number of homes as last year when we lost just over $5 million.

You might be wondering how did that $12 million, turnaround happen. Well, there are number of things that we can point to including higher average sales prices driven by both an improving mix of communities and higher prices nationally, higher gross margins resulting from our initiatives to manage every community aggressively and the tight leash on overheads.

In terms of numbers, in the third quarter we improved revenue by 13% to $355 million, grew ASPs by $31,000 or 12% and expanded gross margin by 240 basis points to 22.7% which together allowed us to increased adjusted EBITDA by 45% to $32 million. We also invested $129 million in land and land development to grow our community count.

The results reported today, largely reflects from sales from prior quarters, so they aren’t necessarily representative of the current selling environment. For that, we have to look to our new homeowners who are a function of both absorption rates and community count.

Our orders were down about 6.5% versus last year, as a result of slightly lower absorption rates and slightly fewer communities.

The absorption rate of 3.1 sales per community per month was fractionally lower than last year’s 3.2. We think this absorption rate reflects a very good outcome and what is still a challenging new home sales environment. In fact, I’ll be surprised if 3.1 doesn’t turn out to be very near the top of our peer group when all the results for the quarter were published.

Of course, we’d like to sell more homes. But if we can sustain this pace while holding or improving prices and margins will be very heavy.

On the community count side, we increased our end of period number of active communities sequentially by 4, and got to the low end of our expected range of average selling communities for the quarter. But we had hoped to do better.

We ended up selling in a slightly different mix of communities than we expected and some of the new communities became active later in the quarter than we had estimated. I’ll give you a little more fulsome description of the community count numbers in a minute. For now, let me just say that average in fewer active communities than we had hoped for isn’t a reflection of any long-term operational and market issue.

Taking together, I’m proud of our accomplishments this quarter and of the relentless efforts by our team to improve the aspects of the business that are within our control and to make the best of the housing recovery such as it is. These efforts have put us in a position to be confident while record a GAAP profit for the full fiscal year with momentum for even better results in the years ahead.

Last November, we introduced our 2B10 plan, to reach $2 billion in revenue with a 10% EBITDA margin over the next 2 to 3 years. This plan calls for improvements in 5 key metrics, including sales per community, average selling price, average community count, gross margin and SG&A. I’ll spend a few minutes of community counts and then turn the call over to Bob to go through our results and the other 2B10 items.

We ended the quarter with 142 active communities and averaged 140 for the quarter. The average was down 3% versus last year. And I said earlier, at the low end of the range of 140 to 150 active communities that we expected to have were of fiscal third quarter.

During the third quarter, we opened or made active 17 communities and closed out 13. And in order for us to count a community as active, we have to sell the first two homes. Our challenge this quarter was twofold. We expected to get the first two sales in 5 to 10 more communities than we did and we expected many of the 17 communities to get active a month or two sooner during the quarter than they did.

That’s not a sign that these communities are destined to be losers, it was mostly a sign that we were too optimistic in assuming we could make sales before we opened their respective model homes.

All that does happen sometimes, particularly when we are selling out of a nearby community, making a lot of sales without a full sales presence is a tough thing to get on.

Taking a step back, for the full year we’ve added 48 communities and closed out a 40, leaving us up 8. With what we have under development and soon to open, we’re poised for great year-over-year community count growth in the quarters ahead.

Now here is what we think community counts are growing, and yes, I think we can agree we haven’t covered ourselves in glory trying to predict community counts, but helps brings eternal so I’ll take another shot.

In addition to the 142 active communities that we had on June 30, we now have 57 communities under development and 33 communities whose purchases have been approved but have not yet closed. We expect 45 of these 90 communities to go active in the next six months.

On the other side, at the end of June, we also had 33 communities with fewer than 20 homes left to sell. Think of these as the near-term closeouts. So if you just follow the math, 45 minus 33, we would add 12 new communities by December 31.

One fact about making community count estimates that has become painfully clear is that it is easier for us to reach end of period targets than to precisely estimate the average counts during the quarter. That’s because it’s very hard to predict the month in which each community will go active, work flows out during the quarter.

The fourth quarter offers us a good example of this. We think that we’ll end September with 150 or more communities which will be up 12% year-over-year. But even if we prove to be exactly right about this, the average number could vary quite a bit. If each new community goes active in the potential closeout, sellout, in the exact month predicted in our internal forecast, we’ll have 150 communities on average.

On the other hand, if the new communities only become active in the last month of the quarter, the average would be closer to 140. My educated guess is that we’ll end up somewhere in between but higher than last year in all events.

Assuming you’ve now heard enough about community counts, I’m going to turn the call over to Bob to provide more details on the quarter and the progress we’ve made on the other parts of our 2B10 plan. Bob?

Bob Salomon

Thanks Allan. Starting with revenue, for the quarter, our total revenue was $355 million, up 13% versus a year ago. On a trailing 12-month basis, total revenue was $1.36 billion, up 10% versus the prior 12-month period as we continue to make progress towards our 2B10 objectives.

We continue to sell solid page (ph) this quarter quoting 3.1 sales per community per month versus 3.2 last year. There are many variables and impact sales per community when comparing one year to another, there are plenty of regional differences.

This year we had increases in absorptions compared to last year in Houston, Indianapolis and Charleston and slight decreases Phoenix, Las Vegas and Tampa, all of which still sold at least three homes per community per month. The only division that has lower absorption rates and fell far below our expectations was New Jersey, where we add 8 communities.

On a trailing 12-month basis, our sales per community per month held steady at 2.9, very favorably to 2.7 last year.

Decreases in all three segments, our ASP rose to $285,000 for the quarter, up 12% versus last year, and our ASP backlog grew to $300,000 providing evidence that we’re on track to reach the target for this portion of our 2B10 metrics in the coming quarters.

The increases in our ASPs are not simply reflection of improving market conditions but also a direct result of the operational improvements we began several years ago. For example, the 18% growth in ASP in the Southeast segment driven by contributions from newer communities with updated plans that are located in better school districts.

Our backlog conversion rate of 57% for the quarter within the middle of the range we provided on our last call and in land last year. As in prior years, we expect our fourth quarter conversion rate to be considerably higher, slightly more than 75% and as we anticipate ending the year with around 5,000 closings.

The significant portion of our backlog scheduled to close during the fourth quarter and an ample supply of specs in our newly active and soon to be active communities were in position to reach this goal.

Turning now to EBITDA. At the end of June, our LTM adjusted EBITDA grew to $113 million up almost 90% versus last year. Our EBITDA margin on an LTM basis is 8.4% up substantially from last year when it was 4.9%.

As we increased our closings in our fiscal fourth quarter, you will see further improvement in adjusted EBITDA and our adjusted EBITDA margins.

The third quarter, our home building gross margin was 22.7%. It was up 240 basis points versus last year. All three of our operating segments reported year-over-year growth in margins and our gross profit exceeded $61,000 for closings upwards of $11,000 or 22% as compared with the year ago.

As it relates to our 2B10 plan, gross margin on a trailing 12-month basis was 21.9% up 330 basis points last year and nearly reaching our 2B10 target of 22%.

Gross profit increased to $57,500 put on close on a trailing 12-month basis, to $44,800 last year, represented a 28% year-over-year improvement.

For the fourth quarter, we expect our gross margin to be above last year’s 21.4% but not quite as high as 22.7% reported this quarter. As with every quarter we expected different mix of closings by geography and by product size, both of which impact gross margins.

Specifically, we expect our east segment to contribute a larger share of closing either this quarter or during last year’s fourth quarter. While we are encouraged by improvement in our east segment’s gross margins, they remain slightly lower than in our other segments.

SG&A was 14.2% of revenue this quarter, an increase from 13.6% last year but down from 16.2% last quarter as we had expected. In dollar terms, excluding commissions, our G&A went up by $36 million driven by several factors.

First, last year we benefited from $1.4 million in insurance reimbursements which we didn’t have this year. Second, we increased our advertising spend by just over $1 million to support new community openings and to generate interest in our coming soon communities. Finally, our headcount was up about 10%, there our community grew.

Looking ahead to a fourth quarter, we anticipate our G&A dollars will increase modestly compared to last year, up less than $5 million, resulting in SG&A as a percentage of total revenue below last year’s fourth quarter, which was 12.3%. This leads us to estimate that full year SG&A should be around 13% of total revenue down from 13.5% last year.

Looking at SG&A at per homes closed basis, we continue to be amongst the lowest cost operators in the industry. Through the quarter, we spent $129 million on land and land development in line with the amounts we spent every quarter this fiscal year.

Based on our investments to date in land transactions and we new works, we now intend land spending in excess of $520 million for all of fiscal 2014.

With our increased land spending, our inventory levels have continued to rise. At the end of June, we had nearly $1.6 billion of total inventory up $323 million or 25% from last year. This increase in inventory has allowed us to add approximately 2,800 lots to our portfolio since last year bringing our total owned and controlled lots to nearly 30,000 lots at June 30.

Looking at our capital structure, in April we successfully refinanced our 9.8% senior notes due 2018, with 5.75% unsecured, senior notes due 2019 and reduced our annual cash interest expense by over $8 million. As we have said before, our net to capital markets activity is likely to be a refinancing of our 2019 notes, which occurred yields, could result in more than $5 million of annual interest savings.

At the end of the third quarter, with no significant debt maturities until 2016, $206 million of unrestricted cash and an un-drawn $150 million revolver all, providing us with sufficient liquidity to meet our 2B10 objectives.

Finally, we currently estimate that we would be able to use approximately $479 million or about $15 a share in deferred tax assets offset our future tax liabilities. This estimate is about $1 per share higher than in previous quarters due primarily to a favorable tax appeal ruling that we received earlier this month. This appeal related to a carry-back of certain tax items, which will recorded as the tax benefit during our fiscal fourth quarter.

We expect to receive $26 million of cash plus interest hopefully by September 30. After returning for this tax benefit, we expect that we’ll be able to use the remaining $453 million in deferred tax assets to offset cash tax liabilities in the future.

As we discussed in the past the exact timing of bringing our deferred tax asset back on our balance sheet is not known, but we do expect to start the process during fiscal 2015.

Before turning the call back over to Allan, I’d like to mention one other item that will impact our fourth quarter financial results. On July 1, these were pre-owned rental homes which we founded in 2011 were sold to American homes for rent. As a result of this transaction, we received Class-A common stock in AMH and we recorded a gain of approximately $6 million during our fiscal fourth quarter.

With that, let me turn the call back over to Allan for his closing remarks.

Allan Merrill

Thank you, Bob. When our management team took over three years ago, we were near to end of the year in which we lost $200 million. We made it our overarching financial goal to return to sustainable profitability as soon as possible.

You’ve seen that phrase and many of our press releases have heard it on these earnings calls. The good news is that we expect to accomplish that objective this year. Specifically, we expect full-year adjusted EBITDA to be at least $45 million above last year and net income excluding the bond loss, the gain on the sale of pre-owned homes and the tax pick-up to be above $20 million.

Including all of those items, we expect our full-year GAAP net income to be above $30 million. So, with or without the one-time items, we expect to make money this year. Now, there won’t be any confetti or champagne because we know how much more work we have to do. But we will be very pleased to deliver those results.

In terms of our more detailed operational metrics, for the full year of fiscal 2014, we now expect sales per community per month of about 3. ASP is pushing towards $290,000, and end of the year community count of approximately 150. Home building gross margins slightly above 22%, and SG&A as a percentage of total revenue of approximately 13%. Achieving all of those objectives will represent excellent progress in year one of our 2B10 plan.

I’d like to end with a few comments about housing market and our stock price. Investor and media sentiment regarding for-sale housing in the home building industry has turned very negative in recent months. And our stock has fallen 30% this year. Both reactions seem overdone in my opinion.

In terms of the overall housing market, I don’t pretend to know more than the economists, the analysts and the demographers who study housing. It is clear that the home sales environment remains softer this year than most of the experts predicted. But there is still a lot to like about the housing market right now.

We have improving employment conditions, stronger household formation, very low mortgage rates, steadily rising apartment rental and limited new and resale inventory. Yes, the lending environment is still overly restricted for certain borrowers, despite serious efforts by vendors to reestablish more traditional mortgage underwriting practices.

By taking together, the underlying fundamentals for new home sales have rarely been as favorable as they are today.

As it relates Beazer in our share price, I know our best defense to the stock price over time is to improve profitability. And the evidence will show that we’ve already improved LTM EBITDA by $140 million in the past three years. Despite all the challenges facing us and before we had had the assistance of a growing community counts.

But it’s also my job to make the case for a higher share price, and here is my pitch. We have radically changed our divisional leadership and our culture. That has allowed us to become a very sound operator. Our sales absorption rates are top of our industry our overheads are among the lowest. We are now generating gross margins in line with our peers and we’re about to get help from a growing community count.

With our capital structure, we have the liquidity to reach our 2B10 goals and a lot of earnings leverage from future operational and market improvements. We’ve also got $300 million in legacy assets that will add to future profitability as we bring them online.

Finally, once we remove the valuation allowance on our DTA, which we expect to begin doing during fiscal 2015, we’ll have the book value above $20 a share. With our earnings potential it seems illogical to me that we would be the only builder to trade below book value.

The bottom line is that we’re excited about the future and we look forward to reporting even stronger results in future quarters. Thanks for joining the call today.

At this point, I’ll ask the operator to take us into Q&A.

Question-and-Answer Session


Thank you. (Operator Instructions). David Goldberg – UBS, your line is open.

David Goldberg – UBS

Thanks. Good morning everybody and good quarter.

Carey Phelps

Hi Dave.

Allan Merrill

Good morning.

David Goldberg – UBS

I guess the first question I want to talk about was with community counts and trying to get an idea. And I know it’s difficult to predict the timing of when communities are going to open. But I also know that as the corporate management team you want to make sure that you have – that you’re keeping people in the field very, very diligent in terms of moving the process along, going as quickly as possible.

And so, I was wondering if you can talk about how the timing for community count openings is kind of controlled or the over-side at corporate. And maybe is that part of your division people’s pay and compensation packages. Maybe you can just talk about kind of how you keep control that when obviously it’s a difficult thing to predict?

Allan Merrill

Well, there are two primary elements to that David, and the first one, maybe there are three. There is an entitlement and approvals part. But once you’re on a piece raw ground you got to make sure that you’ve got all of the permits and approvals in place to actually move. You can be zoned for a certain property type but you’ve got to get your final map approved before you start moving there.

So tightening that up making sure that we’ve got that dialed in that’s the first challenge. And I would tell you, not this quarter so much but earlier this year, I think there were few communities where we were surprised that it took longer to get maps processed than we expected.

Now, the second part of it is clearly, actually we have to do the physical on-site land development. You’ve got to put in roads and pipes and curbs and gutters and I would tell you that part of the overhead that we talked about hiring this year and have hired is to beef up our land development capability.

Senior guy here at our corporate office with 20 plus years of experience more people in the divisions to manage those schedules.

The challenge with land development, it’s a little bit different than I think other industries that there is sequencing. So if you get behind it’s hard to put more equipment on a site to catch up.

And so managing it through each of the stages and understanding day-by-day, week-by-week where we are is clearly a discipline that two or three years ago we weren’t opening a lot of new communities. And if we were, we weren’t doing a lot of land development.

So, we’ve had to adopt a much more rigorous scheduling system for those communities. Those report up to us as corporate monthly. And if there is a variation week-to-week that is by more than a couple of weeks, we’ll see it in for month. I would tell you, I think if I gave a report card across 16 divisions, I think probably we’ve only got three divisions that are still in kind of C category in managing those timelines but rest are kind of on the AB and we’re working hard on it.

What I talked about this week or this quarter is the sort of third leg of it, which is you start to get to land development under control. You’re moving towards having finished lots on the ground and then you’ve got kind of rage. You’re starting a model home you need a building permit to do that. You want to get it dealt and then you need to get it furnished and grand open.

Where do you start trying to take sales? I mean, you can put a guy with a card table and an umbrella out on a site before you start moving dirt, that’s not likely to work very well. You can put a trailer on the site. Sometimes that works. You can sell the community from an adjacent community and sometimes that works.

But the fail-safe, the go to normal course of events is you got to fully completed and decorated model and staff, and that’s really when you start trying to make sales.

I think if I look back to the make order and I think about where our expectations were versus where the June quarter where our expectations were versus what actually happened, there were too many instances where we were hopeful about making sales either from sales trailers or adjacent communities. And I went back and looked at it and studied more closely when the grand opening of the models was, that’s really where I think our disappointment came from in the community count.

So, as I now look at Q4 and look beyond, you can be assured that I’ve got a little tighter visibility or little closer visibility into when models are opening.

Now, let’s be clear, I’m not letting our team off to hook to start making sales as soon as they can. In many cases, we can’t sell out of the trailer and we can sell from an adjacent community. And we want to try and do that. But I think our estimating of that and the optimism embedded in that let us this quarter, is related to the average active community count.

David Goldberg – UBS

That was great color, thank you. Thank you for that. And then, just as a follow-up, Bob mentioned that you guys are – you increased some of the marketing expenses for the new community and some of the grand openings. And I was wondering if you can talk about kind of how your marketing expenditures are maybe changing in terms of media that you’re using to try to hit clients.

And maybe kind of what you’re seeing in terms of – maybe trying to gain some extra excitement from some clients and draw some traffic maybe from other builders. Is there any change and what kind of marketing techniques are you using on the sales side to try to, that’s sounds interest what feels like kind of stagnant housing market?

Allan Merrill

So, there are a couple of different things there. And I won’t in one category go into a lot of detail because there are very few competitive advantages in this industry. And I’m not arguing that we have one. But if we did I wouldn’t want to give it all away.

I think the thing I’m alluding to is online marketing and social media marketing. There is no question that that is the lion’s share of the working ad budget for our company. That’s I’m guessing true for most of our peers. But the ways in which one does that are – there are lots of options. And some things work better for events, other things work better on kind of a drift basis to kind of sustain a level of visibility. But we have continued to increase in dollar amount and refine in an application our online spending.

I spent seven years in the internet running an online advertising platform on a real-estate industry. So this is an area that I personally spend a lot of time, I want to make sure that we’re not stuck in tunnel. And you can think about getting left behind by being in the newspapers that are being online as the consumer profiles change and buyer profiles change online, we have to be in different places and in different ways.

And what’s becoming increasingly challenging is you’ve really got to have earned online media presence not just paid online media presence. And finding organic ways to do that involving customers in the buy-process and having them talk about us, there is some infrastructure that we can put in place to do that. But those references, those experiences are frankly incredibly value and you can’t just pay for them.

So that’s a big part of what we’re doing. But around new communities there really are two things. You got to get you signage right and you have got to get integrated into the realtor community.

So we’ve thrown every manner of party, event for Realtors and local market that you imagine. We’ve rented movie theaters, we’ve done hot-air balloon rides, we’ve had carnivals, I mean we’ve got to make sure that the people who are in touch with two thirds to three quarters of our buyers, that they know we’re coming. They know what our value proposition is, and they know what will be available on land. So that realtor relations is a very big part of that.

And then the signage is key, being on the right billboards, being in the right locations, that’s one area that so called old media that hasn’t changed. In fact, if anything that’s become more important. That’s kind of what we’re doing in the category of media spend and behavior spending.

The other side of it is what we’ve done inside the models. And we have really changed our sales centers. Some of our peers have done some really creative things. What we’ve tried to do is to make the experience, with taking a floor plan at an elevation, a little bit more tactile. There is a lot of brouhaha that, digital sales centers and fancy iPads and everything. That’s okay.

But honestly the experience of having a magnetized board where you could sort of look at and touch and feel how a floor plan can change with our choice options, we have found that that has been very, very effective. So we spend a little bit of money updating our sales centers to create a different experience not just more screens and more media but also things that you can touch and play with.

But those are kind of the categories both outside and then inside our models where we’re spending money to create enthusiasm in which, your right to describe is a kind of a tepid environment.

David Goldberg – UBS

Thank you. That’s great color.


Next question, Alan Ratner – Zelman & Associates.

Alan Ratner – Zelman & Associates

Hi guys, good morning, and thanks again for all the disclosures and guidance. Allan or Bob, on your absorption guidance to hit three sales per month for the full year in fact you look at where you’ve run through the first three quarters of the year, I think you’re at about 2.85 sales per community.

So to hit that number would imply an actual acceleration and absorptions in the back half or in the fourth quarter at least kind of maintaining that 3Q level. And that’s kind of counter to a normal seasonality as I was hoping you might give us a little bit of read on July or you can kind of give us some insight into why you’re optimistic that your absorptions in 4Q can be actually above that 3Q level?

Allan Merrill

So, optimistic wouldn’t be exactly the word I would use. Let me sort of frame it this way for you Alan. And I’ll sort of start with the quarter, and then I’ll give you a couple of comments about July.

I think about the fourth quarter is kind of being framed by with a low end expectations it’s reasonable when what’s kind of a high-end expectation that’s reasonable. And there obviously are two variables, one is the absorption rate, the other is the community count. Because as I’ve talked about the average community count is in question, I gave kind of a simplistic example of it could be 140 or how it could be 150, and you can figure out that makes a big difference.

So, let me say from a boundary condition standpoint, if we talk about what would be a disappointing outcome, it would be to be at or below the level where we were last year in the fourth quarter, which was I think from memory 1,190 or 1,192 orders. That would translate into an absorption rate of about 2.8 on 140 communities. And we clearly expect to do better than that.

If you look at the other side and say okay, well, if we were at three sales in the fourth quarter on 150 communities, again, optimistic and a little optimistic, that would be 1,350 orders.

And I think that our bias within that range is slightly higher but not all the way to the top. And that’s why I said in our kind of wrap up, we expect a full year sales per month per community to be about 3. If I told you at the end of the year it was 2.95 that’s certainly insider range I think, we’d be very happy with at this point.

We were probably a 10th light in third quarter and a 10th light in second quarter, so the math is what the math is, which is obviously what your question is getting at. But we’ve got these 45 communities, many of which are going to get active in the first and second month of the quarter. Typically when we get a community active and we get that first sale, we get the second and the third and the fourth sale pretty quickly. So that’s an element of that I guess, if we were going to use the word optimistic, the optimism that I’ve got.

Now, all of that said I tried to frame for you an expectation for the quarter that ducktails up with where we expect to be for the year. I don’t have all the July results, but the first few weeks in July have not been stiller.

So, you’d say, well gee, if you’ve got two or three weeks that don’t feel great, why not further reduce your expectations. And I think part of it is, we looked at our own intra-quarter patterns. And we’ve typically done better in August and September than in July. And I think that we’re processed as I look at our new home communities or new openings coming down the pipe.

The other thing is and you didn’t ask but I want to put this in context, if I think about the third quarter, April was pretty slow relative to expectations. And frankly year-over-year May was better and June was quite a bit better. So, I’m glad we didn’t panic in the middle of April or at the beginning of May and say, gosh, April wasn’t what we wanted. So we needed to go fuller bunch of weathers and do radical things.

I think we’re executing well, we’re driving the right traffic. The demographics and the income levels of the traffic we’re driving are good. We’re making conversions it’s taking a little bit longer. And I really feel like that’s the environment that we’re in. So, I’m not too worried about two or three week’s worth of sales in July. But I want to be clear the first few weeks have not been great.

Alan Ratner – Zelman & Associates

That’s very helpful. Thank you very much. And the second question on the margin guidance, your 22 target on the 2B10 you’re there now and kind of given some of the recent shattering in the industry from some other builders about incentives creeping higher.

And I think you guys might have had sales of anything in June as well. Just curious, in the near term, kind of, is the current level of margins you’re at now that you’re at that target. Should we think about you now focusing more on the volume side and looking to either maintain in the margins here or do you think that there is some potential upside further from here?

Allan Merrill

Now, I know that mix is always going to play a real role in this. And in the next quarter, Bob talked about the east segment where we’ve made some big investments. We’ve got better communities and better located communities coming soon. So I’m pretty optimistic that our east margins are moving up.

Now there challenges as you know out west where margins could be under some pressure. And I think we will just under-25 and our gross margins this quarter out west. And I think those are going to be under some pressure. So the mix is really the trick for us to try and dial-in, quarter-to-quarter-to-quarter. And so we try to be clear about that for the fourth quarter.

I think as I think about the business over a slightly longer period of time, that low 20s range, 22-ish plus or minus up a little bit, we hope is what we’re shooting for. But we’ve never tried to pretend that we’re in upper 20s margin builder, that’s not the positioning that we have – that’s the land position that we have.

So, I don’t see that happening. We are going to grow into (inaudible) to create risk to where we are. We have withstood others incentive strategies before with new product in our 4P plans that we’re dialing in every single week. We know how to compete. But I don’t think there is tons of upside from here or from where we are.

And then, that kind of pivots to the other part of your question which is more volume, damn right, I mean that’s where the community count is going to – I think be the next wave of operational improvement for us.

I mean, I don’t think anybody will argue that we’ve improved absorption rates to a pretty darn good level. We’ve improved gross margins to a pretty darn good level. I think we bring the community count to bear now and that’s where the volume growth comes from.

Alan Ratner – Zelman & Associates

Thanks a lot.


Next question, Michael Rehaut, JPMorgan.

Michael Rehaut – JPMorgan

Thanks, good morning everyone. The first question I had was on actually the interest expense came down nicely in the quarter in terms of what was not qualified parameterization. And you also had some leverage on a year-over-year basis in terms of what was in COGS.

Particularly on the not qualified front, but maybe you could also talk to COGS as well as percent of sales, how are you thinking about that in the fourth quarter and given the trends that you’re seeing in terms of how you’re seeing about land investment and potential for some revenue growth next year, how should we think about 2015 if you could give us any kind of directional sense, guidance probably is a little premature right now?

Bob Salomon

Sure Michael. As you know this is a pretty complicated area, I’m going to try that. We believe the 10,000 foot level and hopefully answers, your questions. Our total interest incurred I think on a go forward basis from a cash perspective is about $152 million.

And if you think about the direct expense talked about qualified assets versus unqualified assets and if you do a simple formula where you subtract your debt, you take your debt and you subtract your eligible assets for capitalization. And if you looked at our inventory total today, the eligible assets are just over $1 billion.

So, when you back out land health future development, health for sale and those things where you can’t capitalize interest, you leave about 30% of the interest incurred that you have will go directly to the bottom, to the interest expense line below COGS.

So, that leaves about 70% to be capitalized. And when you think about how you relieve that capitalized portion in any year, obviously there is an impact of what’s happening to your eligible assets if it’s increasing, you probably will relieve a little bit less on a go-forward basis. If it’s decreasing you’re relieve a little bit more as you lead into not only what you capitalize this year but also some of that balance of capitalized interest.

So I think we have been giving guidance about what’s going to happen with inventory in the next year, in the land spend which is going to be the big driver of our inventory. But I think that might be a way for you to think about it on a go forward basis.

Michael Rehaut – JPMorgan

I mean, I appreciate the mechanics in terms of how you’re getting there. I guess, just I don’t know if I missed on that answer because again, the interest did come down nicely, has been coming down nicely, particularly in the third quarter it did come down nicely. And I know obviously like you said it involves some view on the inventory balances.

But I mean, is it safe to say at this point given the directional trends in terms of your spending plans that the – at least the not qualified interest as a percent of incurred that continue to come down as you perhaps work through some of the non-qualified assets or build the qualified assets?

Bob Salomon

Absolutely, that’s exactly what we would expect to happen.

Michael Rehaut – JPMorgan

Okay. Second question just on the SG&A, certainly appreciate – you guys pointing out obviously then on a per-closing basis you’re very competitive or at the – you’re better end of the range within the industry. But obviously still as a percent of sales, still runs a little high and that has to do with some of the, I guess, just basic math of the revenue and fixed overhead perhaps.

But you have come down over the past couple of years. How do you guys think about SG&A in general as a steady state, I mean, in the past cycle actually the company was very, very consistent at like about 10.5% ratio. And I mean, is that something where we could obviously not for 2015 but over time is that kind of a goal for the company?

Allan Merrill

Let me address a couple of points Michael. I’m not going to take it from the perspective of what the company is to do because unfortunately some of what the company used to do in absorption rates and margins wasn’t so good. So, I don’t want to go there. But I would tell you, with revenue growth we clearly have an ambition to drive that SG&A as we talked about our 2B10 plan on a full year basis, initially the 12 and then lower than that. And we can do that. And we will do that.

But one thing and I haven’t spent a lot of time talking about it because it is frankly irritating to have to talk about but it’s a fact. And I want to put it out there. We signed an agreement with the government a number of years ago related to our behaviors. And included in that was a restitution time and a penalty which relates to approximately 4% of our adjusted EBITDA.

And we’re going to be paying it for a couple more years. As we have turned the corner and started making money, we’re now spending money on that agreement. And this year we’ll spend on the order of $6 million which is flowing through G&A on that deferred prosecution agreement and we got two more years of that. That’s going to be almost half a point on our SG&A number this year.

And it is what it is, it’s an agreement we signed, it’s an obligation we have, we honor our obligations. But I just think when we look at are we being competitive, that’s a per unit thing on a percentage basis, the number kind of make some sense. I think we haven’t done a good job of necessarily explaining all of the things that are in there. And that’s frankly a pretty lumpy one that we’re going to have for a couple of years.

Now it will go away, we will handled debt to all of our obligations but that’s a headwind if you want to call it that inside that number that I don’t think folks have really focused on.

Michael Rehaut – JPMorgan

No, that’s certainly very helpful Allan. And just to clarify on that that’s something that is expected to be paid through fiscal ‘15 or fiscal ‘16?

Allan Merrill

Through ‘16.

Michael Rehaut – JPMorgan

Okay. Thanks.

Allan Merrill

And it’s very complicated formula but I’ll tell you, if you take kind of our adjusted EBITDA number and take 4%, it’s pretty close. In the agreement itself there some pluses and minuses to the debt emission of EBITDA but that sort of a rough order of magnitude to kind of think about, that will continue to exist for a couple of years and then it will go away.

Michael Rehaut – JPMorgan

I appreciate it.


Next question, Adam Rudiger, Wells Fargo Securities.

Adam Rudiger – Wells Fargo Securities

Hi, thanks for taking my question. Going back to your pitch at the end of your prepared remarks about the stock price, if I were to kind of a devil’s advocate or think about the things that maybe would be offset to that. One of them is just interest incurred. It’s well above peers.

Do you – so that’s a significant, another significant kind of headwind that you’re carrying. When do you – what is your thought on that, you mentioned some potential to refinance some additional debt? But any expectation on when that might normalize, I mean, I think it’s about 9% on a run rate basis, peers are on 2% to 3% as a percentage of sales?

Allan Merrill

We certainly start to oblige with a lot more debt than we had eligible assets. And it’s an awful tough thing to get profitable when you have $1.5 billion of debt and at the time I think we had about $600 million of working assets. And as Bob said, so called eligible assets are up to $1 billion. So we have been growing that nicely. And we’re going to continue to grow that.

At the same time we’ve been attacking the cash interest expense with refinancing transactions including the one in April.

What I don’t think makes any sense is to try and equitize to sell really, really cheap stock to pay-off bonds for yield in low single-digits. I want to be clear that I don’t see that happening. We’re going to have to grow into this balance sheet.

The good news Adam is this is the year where our EBITDA exceeds our cash interest expense. And so, all growth from this point in EBITDA kind of gets us to the bottom line. So, it’s been a mountain to climb. It is the reason that we are if not last, among the last to get profitable, that’s a fact. But going forward, having covered the nut, we don’t see any occasions to increase the nut and in fact there will be incremental opportunities to reduce it.

Bob telegraphed it once the 2019 that had a coupon on the nine category and I know the high yield market with some disarray right now but I don’t think our refine rate and that’s going to be nine. I think it’s going to be lower than that. Every point is $2.5 million of cash interest savings.

Then we’re going to go after other parts of the capital structure and it’s why we only have two buns in our entire cap structure that are non-call light. Like having that call protection so that as we improve the credit characteristics of the business, we’re able to refinance and lower our costs.

The last thing on this and I know it was in my pitch and it’s kind of in your devil’s advocacy is, what’s the right credit rating for this company, what’s the right interest cost for this company. I can’t tell you, I mean, the market will tell us but I am sure that when we have the benefit of that deferred tax asset on our books, people start looking at debt to equity not at 6 or 7 times but at two or three times.

We have a feeling that will be well received in the bond market which is an additional benefit that we’re going to use to try and drive further savings out of that cash interest cost.

Adam Rudiger – Wells Fargo Securities

Okay, thank you. And then, you also mentioned in your prepared remarks and you still think you have a lot of work to do. If you have gross margins where they should be or where they’re going to be for a while, so that’s kind of heavy lifting is done there and maybe the same thing on cost, you’ve just talked about some of the heavy lifting on – lifting still on interest.

Where else do you see then, what’s the biggest hard work still you have left, what’s the other next area?

Allan Merrill

The next area is getting communities open. I tried to be realistic and not funny, but we haven’t covered ourselves in glory and our ability to predict these openings. And I’m embarrassed by that. It is a fact. But we’ve been spending the money on land and land development for the last year and half.

Those communities are coming. We didn’t lose them, nobody else has them they will open. And I think that is – we’ve got to get them open and then I need to perform at or above the levels of the existing communities when they do. So, opening on time, we’re opening as soon as possible and opening well is crucial.

I think the other area for us and it’s not in next quarter, even next two quarters kind of thing, we’ve got $300 million in land health for future development and working on the land plans and the highest and best use of some of those assets. I’m really confident that we can create EBIT and earnings per share from those assets that aren’t in anybody’s estimates right now and we’ve got to do that. So those are two big areas that we’re working on.

Adam Rudiger – Wells Fargo Securities

It makes sense. Thanks for taking my questions.


Next question, Eli Hackel, Goldman Sachs.

Eli Hackel – Goldman Sachs

Thanks. Good morning, just wanted to touch on absorptions and community count growth in the context of what is sort of a moderate overall housing environment. I just wanted to focus maybe on your ability to keep absorptions flat with growing community count at the same time demand isn’t growing very much. I mean, many builders are aggressively growing the community count at a time where demand doesn’t seem to be growing at the same pace. So, what’s the confidence that absorptions could stay at these levels over the next 12 months or so?

Allan Merrill

I can’t give you my 2015 forecast because we’re not doing that on this call. So, I appreciate your questions. I think we in slower combining communities and slower to open them in part because we try to be selective and it’s sort of tough right.

There was a window in the market where we could have bought a lot of communities. I’m not sure how well it would have performed but we would have checked a box on community count. What we tried to do is be a little bit more patient and by communities where when we open they’re going to open right. And by right I mean not be dilutive to our objective metric targets.

And so that has been part of our underwriting, the scoring that we use on our existing communities in terms of absorption rates and contribution margins. We use on our perspective deals. And if they aren’t equal to and moving beyond where we are on our 2B10 metrics we don’t want to do those deals.

So, you’re right. One of the things and I’m going to sidebar for a second because it’s actually something we talked about all the time. We’re going to open a new community and we’re going to open it typically in a context where they’re existing competitors.

This is important. When we know we’re going to be opening a community, we’re not the only ones who know it. And so, I joke with our team but it’s true, it’s not like our competitors are going to throw a welcome to the neighborhood party for us.

What they’re going to try and do is get as much intelligence as they can about how we’re going to open, what’s our product, what are our elevations, what’s our value proposition and just as soon as we open, they’re going to counterpunch us. That’s the nature of this industry. So, we know that.

So the question is what’s our response to the counter punch not just how are we going to open. And it’s that second dimension anticipating and we won’t get it right every time. But our thought process is we got to open in the context of what the current competitive environment is. We have to anticipate that someone is going to react to that and we want to be almost instantaneously ready to react to that.

Now this is not just a price lever game. I always talked about 4 Ps, the product and the way we’re marketing and the price which by the way is inclusive of base price and options and lot premiums and all those things. We got a very sophisticated open strategy for every community based on initial open, reaction to response, etcetera. So I can’t tell you that every community is going to open a big pocket, it won’t.

But I can tell you the thought process and the work that goes into getting ready to open, it’s probably one of the things that if my division presidents were on this call, they would say all the trouble we give them about being ready is one of the things that gets in the way of getting open fast. That’s been an unfortunate headwind to date. I hope that that puts us in good state or better state than what otherwise be the case as we look out the next 12 months.

Eli Hackel – Goldman Sachs

Okay. So then just to clarify, just on the point. So if you’re on open community and there is one competitor right now but by the time you open, maybe there is going to be four competitors because everyone is opening those communities in similar area. You’re taking that into account.

Allan Merrill

Well, if we get surprised by a new competitor and it has happened one time. We have opened one community this year where the rain of tears was leaded know that xyz was going to happen. And we missed it. I mean, it was knowable. These communities aren’t stealth bombers I mean you can see them coming a mile away. So yes, we missed one.

And that was an object less than on our Friday sales call that I promise nobody enjoyed, we won’t make that mistake again.

Eli Hackel – Goldman Sachs

Great. Thanks very much.


Next question comes from Jay McCanless, Sterne Agee. Your line is open.

Jay McCanless – Sterne Agee

Good morning, everyone, first question just to clarify the $26 million cash plus interest, if you receive it by the end of the fourth quarter, that’s going to appear on the income statement?

Bob Salomon

Yes, it’s going to appear on the income statement regardless of what our receiving cash by the end of September.

Jay McCanless – Sterne Agee

Okay, I just wanted to clarify that.

Bob Salomon

We don’t get the cash, it will be in accounts receivable.

Jay McCanless – Sterne Agee

Okay, perfect. Second question and on page 29 of the deck, you’ve done a good job of bringing the inventory health for future development down. Just wanted to find out what progress you’ve made on the assets in Northern California that you’ve referenced on past calls? And if bringing those back on would be any help in terms of lowering the interest expense on the income statement?

Allan Merrill

And the answer is yes. Now, we did make active, one of the Northern Cal assets that was outside of a term of flood delays. And I think last quarter and talking about ‘13 out there, we are working on had plans to get approved in that municipality. And we expect to be open in that market in our fiscal first quarter of ‘15. But we are getting a little benefit to the interest of that.

The other communities in Northern California and their very large ones that are affected by the Natomas flood basin. I think we’ll be active in fiscal ‘15 but probably second or third quarter. And just for those that have been kind of paying attention to Sacramento, the President signed the Word Act I think in June.

We’re about 12 months away we believe from being able to pull building permits in Sacramento. But there is work on the land plan and work on the building plans that will take place prior to that. It’s a very highly choreographed deal with FEMA, the Corps of Engineers, the city and the county on both the land plan and the building plans. But I think there will be in ‘15 assets in Northern California that get activated that we won’t have any closings from those incremental assets in ‘15, they’ll start to affect with the eligible asset pool what’s like, which will have an effect on interest expense.

Jay McCanless – Sterne Agee

Okay, great. Thank you for that color. And then, one other question, just talking about the competitive environment and what you said so far about July sales. If you had to pin it on one thing or the other, would you say that the weakness in July is attributable to actions by your competitors or does it just seem to be a slacker demand pace than what you saw in July of ‘13?

Allan Merrill

I’m not good enough to be honest to tell you July of this year versus July of last year and sort of how it feels because so many things have happened in the mean time. I would tell you that, I don’t think that there is a specific competitive activity by one or more peers that have changed the market dynamic.

I just don’t get that feedback. I talk to our guys at least once a week and their Sales Vice President, that’s not what I’m hearing there is a lack of urgency. And we have to kind of manufacture it. Somebody referred to the fact that we had a June sales event, we did. By the way we’re going to have an August sales event. We’re going to be at Toyota and have a seller phone every month if we have to.

The fact is we did it in February, we did it in June, we’ll do it again in August. Now the good news is that having events, here the focus as the mind creates attention, it creates little momentum. It hasn’t been dilatory as to margins. So, I think that’s one of the things people assume, you’re going to have in a wig, you’re going to go crush your margins, well, that’s not been the pattern.

So, I can’t tell you that we won’t be aggressive. If we have to, absolutely we’re going to sell some homes. But I do feel like that the market is requiring us and our peers to manufacture urgency or events or enthusiasm. And either we are they didn’t do it very well this month so we’ll do better next month.

Jay McCanless – Sterne Agee

Okay, great. Thank you.


Our last question today comes from Alex Barrón, Housing Research Center.

Alex Barrón – Housing Research Center

Good morning, guys. I wanted to ask you about the sale of the rental homes and AMH shares that you got. Are you going to hang on to those or are you going to sell them?

Allan Merrill

Well, right now we’re under a restriction because they don’t have an effective registration statement. And after that the board and we will decide. I don’t think in the long-term, we are likely to be shareholders. We don’t have a specific date pack which will or want to sell.

But I will tell you, I think the considerate decision by the board of the Pre-Owned Homes Company of which I was Chair to take AMH’s stock reflective of lot of confidence that AMH is an exceptionally well-run company and frankly had, we thought the best match of assets with the pristine assets that we had.

I like that single-family rental space, I like the assets that we and they have, I like their scale. So, I think that’s a – I think that’s a very attractive asset for us. But long-term, it’s not a strategic asset. It’s clearly not one that investors should expect will hold forever. I just don’t have at the moment, a timeline by which we’ll sell it.

We’d like to redeploy that money in our core business that at the moment that extra $26 million isn’t the thing that’s going to make a difference in our growth trajectory. And I still think that things are ahead for that single-family rental category and from AMH in particular.

Alex Barrón – Housing Research Center

Got it. And my other question was I guess one of the larger competitors last week, I guess I’m signal that they intend to increase their sales base and that they were willing to sacrifice margin. You guys seem to be willing to or signaling you’re going to increase your sales base but you don’t think your margins are going to go down or am I wrong or you’re just – compared to – prepared to compete head-to-head to just pick your sales pace?

Allan Merrill

We’re kind of talking about trying to hold serve on our sales pace. We start to get into these fine-tune discussions with the difference between 3.01 and 3.1. And it’s very hard. But at this 3-ish level, we want to say there. We’d love it to go up. I’m not going to do things though to drive it up. We’ll try and protect it at around that level.

I know there will be seasonality one of the other questions was about that. The first quarter won’t be at that level, it never is. But in the near-term, I think our objective is to try as I said in the opening, to kind of hold our pace and price and margin and I think we’re well positioned to do that.

Alex Barrón – Housing Research Center

Great. Thank you.

Allan Merrill

All right. Well, I want to thank everybody for joining the call. I know that I made you indulge me and let me make my pitch for our share price. And I also know that we got to go out and earn it. But I appreciate your attention, your questions. And look forward to talking to you next quarter. Thank you.


Thank you. And once again, that does conclude the call for today. You may disconnect your phone lines at this time.

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