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DR Horton (NYSE:DHI)

Q1 2012 Earnings Call

January 27, 2012 10:00 am ET

Executives

Bill W. Wheat - Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Mike Murray -

Stacey H. Dwyer - Executive Vice President, Treasurer and In Charge of Investor Relations

Donald J. Tomnitz - Vice Chairman, Chief Executive Officer, President and Member of Executive Committee

Analysts

Steven Bachman - RBC Capital Markets, LLC, Research Division

Joel Locker - FBN Securities, Inc., Research Division

Michael Rehaut - JP Morgan Chase & Co, Research Division

David Goldberg - UBS Investment Bank, Research Division

Nishu Sood - Deutsche Bank AG, Research Division

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division

Daniel Oppenheim - Crédit Suisse AG, Research Division

Susan Berliner - JP Morgan Chase & Co, Research Division

Stephen Kim - Barclays Capital, Research Division

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Michael G. Smith - JMP Securities LLC, Research Division

Kenneth R. Zener - KeyBanc Capital Markets Inc., Research Division

James McCanless - Guggenheim Securities, LLC, Research Division

Alex Barrón - Housing Research Center, LLC

Jack Micenko - Susquehanna Financial Group, LLLP, Research Division

Operator

Good morning, and welcome to the D.R. Horton, America's Builder, the largest builder in the United States of America, First Quarter 2012 Earnings Release Conference Call. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Donald Tomnitz, President and CEO. Thank you. Mr. Tomnitz, you may begin.

Donald J. Tomnitz

Thank you, and good morning. Joining me this morning are Bill Wheat, Executive Vice President and CFO; Stacey Dwyer, Executive Vice President and Treasurer; and Mike Murray, Vice President and Controller.

Before we get started, Stacey?

Stacey H. Dwyer

Some comments made on this call may 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. Don?

Donald J. Tomnitz

We're off to a strong start for fiscal 2012. We made $27.7 million in net income in our first quarter, and we are focused on maintaining profitability in each upcoming quarter. The spring selling season begins soon, and our sales and operational teams across the company are energized and prepared for increasing traffic and sales activity with homes available in inventory and a good supply of finished lots to meet the potential additional demand.

If 2012 is the first year of the U.S. housing recovery, we expect it to reflect uneven improvement across our operating markets with some markets experiencing increases in demand and others remaining weak. We remain flexible with a profitable business model at current demand levels but have the ability to increase our production in response to a stronger demand.

Although macroeconomic and housing conditions remain soft, we are cautiously optimistic for the remainder of 2012 after achieving almost a $50 million improvement in pretax income compared to the year-ago quarter. Mike?

Mike Murray

In the first quarter, our homebuilding operations generated pretax income of $25 million, and our financial services operations generated pretax income of $4.2 million. Income tax expense of $1.5 million primarily represents state income taxes.

Our net income for the quarter was $27.7 million or $0.09 per diluted share compared to a net loss of $20.4 million or $0.06 per diluted share in the prior-year quarter. Bill?

Bill W. Wheat

Our first quarter home sales revenues increased 16% to $884 million on 4,118 homes closed from $761 million on 3,637 homes closed in the year-ago quarter. Our average closing price for the quarter was up 3% compared to the prior year and was flat sequentially at $214,700. Don?

Donald J. Tomnitz

Net sales orders for the first quarter were up 13% from last year to 3,794 homes on a 3% decrease in active-selling communities. In the December quarter, our average sales price on net sales orders of $217,000 was up 3% compared to the prior-year quarter and down 1% sequentially. Our cancellation rate for the first quarter was 26%. Our sales backlog at December 31, 2011, increased 18% from the prior year to 4,530 homes or $975 million. Stacey?

Stacey H. Dwyer

Our gross profit margin on home sales revenue in the first quarter was 16.8%, up 120 basis points from the year-ago period. 100 basis points of the increase was due to cost improvements and decreased incentives and discounts. 60 basis points of the increase was due to a reduction in amortized interest and property taxes. Also contributing 40 basis points to the margin increase was a reduction in the cost of remaining development obligations for completed projects and collection of old development receivables in excess of previous estimates. Partially offsetting these increases was an 80-basis-point decrease related to costs for warranty and construction defect claims.

Sequentially, while incentives and discounts were flat, our gross margin improved 70 basis points, again primarily due to a reduction in the cost of remaining development obligations for completed projects and collection of old development receivables in excess of previous estimates. Bill?

Bill W. Wheat

Homebuilding SG&A expense for the quarter, which includes corporate overhead, was $119 million, essentially flat with the year-ago quarter, on a 13% increase in homes closed. As a percentage of homebuilding revenues, SG&A was 13.4% compared to 15.5% in the year-ago quarter, reflecting both the improvement in volume and our continued efforts to reduce costs.

We also continued to see the benefits of our aggressive debt reduction over the past several years, as homebuilding interest expense was down 57% from the year-ago quarter to $6.9 million, and our first quarter homebuilding interest incurred decreased 21% to $27.9 million. Mike?

Mike Murray

Financial services pretax income for the quarter was $4.2 million, which included $1.7 million of recourse expense. 83% of our mortgage company's loan originations during the quarter related to homes closed by our homebuilding operations. Our mortgage company handled the financing for 60% of our homebuyers this quarter with virtually all loans meeting eligibility requirements for sale with Fannie Mae, Freddie Mac or Ginnie Mae.

Government loans accounted for 57% of our mortgage company's volume this quarter, down from 61% in the year-ago quarter. Our mortgage company's new borrowers during the quarter had an average FICO score of 710 and an average loan-to-value ratio of 91%. Stacey?

Stacey H. Dwyer

This September, our total inventory increased by approximately $30 million, excluding non-cash items. We increased our investment in residential land and lots by $40 million and reduced our homes in inventory by $10 million. Our homes in inventory at the end of December totaled 10,200 homes, down 300 homes from September. As of December 31, 1,100 of our homes were models, 5,700 were speculative homes and 2,700 of the specs were completed. We expect our number of homes in inventory to increase in the March and June quarters in response to seasonal demand. Don?

Donald J. Tomnitz

In our first fiscal quarter, our investments in land, lots and development costs totaled $229 million, which reflects that we continue to find good opportunities to open new communities and replenish our finished lot supply. Future investments in finished lots, land and development will remain largely dependent on our sales base. We remain focused on managing our supply of owned, finished lots in line with our sales demand in a low-risk, capital-efficient manner.

At December 31, 2011, we controlled approximately 115 lots of which 86,000 are owned, 29,000 are option. Our current finished lots supply includes 22,000 owned lots and 23,000 option lots. We also expect an additional 27,000 of our total controlled lots to be developed within the next 12 to 18 months for a finished lot pipeline of at least 72,000 lots available to us over the next 2 years. Bill?

Bill W. Wheat

We used $3 million of cash in operations in the December quarter, primarily due to our investments in residential land and lots and a reduction of accounts payables, offset by our net income and decreases in mortgage loans held for sale and homes in inventory.

We ended the quarter with $1 billion of homebuilding unrestricted cash and marketable securities. During the quarter, we repurchased $10.8 million of our 6.5% senior notes due 2016. The balance of our public notes outstanding at December 31 was just under $1.6 billion, with no maturities until May of 2013. Mike?

Mike Murray

At December 31, our homebuilding leverage ratio, net of cash and marketable securities, was 17.5% compared to 17% a year ago. Gross homebuilding leverage at December 31 improved 650 basis points to 37.4% from a year ago due to debt reductions and increased equity. Stacey?

Stacey H. Dwyer

Before we move to Q&A, we wanted to share our expectations for some of our operating metrics. With 4,530 homes in backlog and an expected conversion rate below 90%, we expect fewer closings in Q2 than in Q1, consistent with recent years’ trends. Seasonally, Q2 and Q3 experienced the strongest sales demand, which then results in our strongest deliveries in Q3 and Q4.

Our current expectation is for home sales gross margin to remain in the mid-16% range. We anticipate a seasonal increase in SG&A expense in the second quarter primarily due to payroll taxes and seasonal advertising, which will result in a higher SG&A percentage in Q2 versus Q1.

In Q3 and Q4, variable components will increase the absolute SG&A expense amount. However, our SG&A percentage should improve as we close more homes and leverage our fixed cost structure. Don?

Donald J. Tomnitz

Simply put, our business feels more positive. We're entering fiscal year '12 feeling better than we have in 6 years, and it's been a long 6 years. We've started the year with $28 million of net income and double-digit percentage increases in our sales, closings and backlog in the first quarter.

January sales are also up year-over-year in line with our expectations. Both our gross margin and SG&A percentages improved versus last year, and our balance sheet and liquidity remain strong.

While the housing industry and the overall economy have not gained significant traction, we are increasing our market share by finding attractive opportunities across our markets that are producing improved results for D.R. Horton. We remain focused on achieving profitability in each quarter and for fiscal year '12.

As always, we want to thank all of our DHI team members. We've been the largest builder in America for the past 10 years, and you have just delivered a tremendous first quarter. We are very proud of the results you have produced, and we look forward to a great fiscal year '12. We’ve worked hard to position our company for profitability. Now let's go lead the industry into the next up cycle and sell more homes, leverage our fixed cost and continue to outperform the competition.

This concludes our prepared remarks. Now we'll host any questions you may have.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of David Goldberg from UBS.

David Goldberg - UBS Investment Bank, Research Division

My first question was on the change in FICO score. Sequentially, it feels like it's up a little bit versus where we were, maybe not too -- so much first quarter of '11 -- of '10, excuse me -- yes, excuse me, fiscal first quarter of '11, but certainly throughout kind of fiscal '11, it seems like it's come up. Is that mix shift, or are you guys seeing any change in underwriting at this point?

Stacey H. Dwyer

I don't think there's any substantial change in underwriting. We noticed the same thing you did, that Q1 was a little bit stronger. It was in line with Q1 last year but stronger than the balance of fiscal year '11. I don't know that we can attribute to that in -- to anything in particular.

David Goldberg - UBS Investment Bank, Research Division

Okay, easy enough. Next question was a little bit more theoretical. I kind of wanted to look out, and Don, I think, in the prepared remarks, you mentioned that community count was down 3%. And I kind of wanted to talk about, as you look forward into the recovery, how do you think the land position that you have today supports the growth pattern and the growth expectations that you have? And if you think, if you could kind of think about your land position in terms of the usability, given current conditions, and how active you're going to have to be in the land market, do you think you control and own enough and option enough land now to go out and grow the way you want to, outside of the kind of increasing the leverage in existing communities?

Donald J. Tomnitz

Well, I do believe we have adequate lots for the next 2 years, as I mentioned in my comments. I do believe, as we work through this calendar year and somewhat into calendar year '13, that the finished lot supply in good markets is going to be depleted. And we're focusing on tying up as many good deals as we can currently to, in anticipation of that. Clearly, at some point in time, we'll have to get back into the land development business, as we have been in the past. I want to remind you that our go-forward plan is to have a lean -- really, a light and lean land supply. Our current underwriting guidelines require that with any land that we invest in and any land that we develop, that we get our capital returned in 18 months, sometimes, at the worst-case basis, if it's a great deal, 24 months. But currently, our plan is and has been for the last several years, as we move forward, anything greater than a 2-year supply, we're going to be partnering with other land developers and make sure that they hold those lots that will require greater than 2 years, as opposed to us holding them on our balance sheet. So I feel good about where we are. We still are, clearly, the preferred buyer of banks and developers because we're the largest builder. We're also starting the most specs of anybody in the market. And we're selling the most homes of anyone in the market. So I feel like, as we continue to work on a depleted land and lot supply, we continue to be the preferred buyer.

Operator

Our next question comes from the line of Dan Oppenheim from Crédit Suisse.

Daniel Oppenheim - Crédit Suisse AG, Research Division

I was wondering, you talked about being cautiously optimistic of the -- about the spring here, and that’s a bit less quittable [ph] than your comments over the expectations in recent years, but wondering how that relates to the thoughts in terms of specs. You've done a very good job of managing that in the past. How much more do you think you will build based on the cautious optimism that you have right now?

Donald J. Tomnitz

Well, frankly, we're cautious. I think, clearly, we have clearly repositioned this company, have it in a great position today to capitalize on the market that is going to materialize, given the current economic situations. I think the cloud that hangs over us and the reason that we use the adjective "cautious" is because there are a lot of issues both internationally as well as nationally that we have no control over. So as a result, we're just focusing on probably the next 12 months ahead when we say "cautious" because there is an election coming, there are a lot of issues on the table and we don't know how those are going to impact the homebuilding business, Dan.

Operator

Our next question comes from the line of Nishu Sood from Deutsche Bank.

Nishu Sood - Deutsche Bank AG, Research Division

I wanted to ask -- a very interesting statement you made about developing 27,000 lots, I believe you said, over the next 18 months. So I wanted to understand the dynamics of that. Does that mean -- is that simply a statement about the lack of availability of finished lots and, therefore, the need to develop? Is this coming from lots that are -- projects that are mothballed? Or is this the pursuit of new projects, new development opportunities in the market?

Bill W. Wheat

Yes, Nishu, I can clarify just a bit. The 27,000 lots, those are lots that we own today that are either partially developed or undeveloped but that our expectations with our current business plans would anticipate that we would begin to develop those lots in the next 12 to 18 months. Obviously, the choice of whether to invest the capital and develop those lots will be dependent on our sales base. But in terms of looking at our land and lot pipeline, those 27,000 lots are available to us to be developed and to be finished for our sales if the sales warrant it.

Nishu Sood - Deutsche Bank AG, Research Division

Got it, got it. So this is coming from your own land pipeline. Now the general view, I think, that investors have taken that mothballing becomes a necessity because -- had become a necessity because demand had shrunk and that therefore there were certain areas where it became unprofitable to build. Is this then a tentative indicator that demand is spreading back to that, let's say, areas that were C grade before and that the economics are becoming more feasible? Or how should we interpret that?

Bill W. Wheat

No, this is really no change in our outlook in terms of C markets, as you call them. We still have about 43,000 lots that are mothballed that we do not expect to be developing within the next 12 to 18 months. Some of those might come online after that time frame, but some could be much significantly longer.

Donald J. Tomnitz

The demand clearly is still in the A markets, and that's where refocusing. And clearly, to the extent that we bring a portion of those or all of the 27,000 lots into development, those are going to be in good locations where basically, heretofore, we've been able to find option lots that would have precluded us from having to develop the lots.

Operator

Our next question comes from the line of Michael Rehaut from JPMorgan.

Michael Rehaut - JP Morgan Chase & Co, Research Division

First question, I -- hello?

Bill W. Wheat

Yes, we're here.

[Technical Difficulty]

Michael Rehaut - JP Morgan Chase & Co, Research Division

On a cell, so sorry if there's any static. The first question was just on comments with regards to January and you also, if I heard you correctly, say that the housing industry hasn't yet gained significant momentum. And so the question, in effect, is there's been a lot of speculation around current demand and to the extent that there is a lot of views that there is some positive momentum here. How are we to think about the -- entering the spring, are you seeing things pick up at all? Or is it just more along the same type of pace that you're currently seeing in fourth -- that you've saw in the December quarter?

Donald J. Tomnitz

What I can tell you is, as you know, Don Horton and I spend quite a bit of time in the field, 2 to 3 weeks a month. And both his travels and my travels, which have been to separate markets, as we visit with each and every one of our sales people as we travel through the markets, indicates that our sales people are optimistic because their traffic's up and there are more buyers in their models each and every week that we have progressed since December. So obviously, December is a very slow period of the year for us, with the holiday season and so forth. But certainly, into January, we felt very, very good about our traffic and our sales.

Michael Rehaut - JP Morgan Chase & Co, Research Division

Okay. Second question, I guess, maybe a 2-parter, if I can cheat a little bit. But you mentioned community count down 3% year-over-year. I was hoping maybe you could share what you expect that to be, community count growth in 2012. And secondly, if you could highlight any regions that were, let's say, stronger than corporate average or weaker than corporate average.

Donald J. Tomnitz

Well, I think that the 3% down is just, it's an accounting issue. It's a point in time. And we expect our community count and count in the rest of the calendar year '12 to increase, and that's going to be contingent, obviously, on our ability to find good and profitable land and lot deals. I'm going to refrain from commenting on markets because of 2 things: One, I think Bobby [ph] does a great job of grading the markets; and secondly, I think that our good markets need to be kept to ourselves as we continue to exploit the markets ourselves, as opposed to letting our competitors know about our good markets.

Operator

Our next question comes from the line of Jade Rahmani with ABW (sic) [KBW].

Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division

It's Jade Rahmani from KBW. I wanted to ask about the deferred tax asset. We are seeing quite a few banks recapture their DTA after several quarters of profitability. And you guys have been profitable for 4 quarters in the past 2 years and indicated you expect to be profitable each quarter this year. Do you expect to reverse it this year? And is this a once-a-year review that happens with your fiscal year end?

Bill W. Wheat

Yes, Jade, we do review this every quarter. And I can update you on where we are this quarter. If you recall, last quarter, at the end of our fiscal year '11, we commented that one of the significant pieces of negative evidence that weigh into our decision is the fact that we have been in a cumulative loss position on a 3-year trailing basis. And based on the way the standard reads that we have to apply, that is a piece of evidence that is very difficult to overcome to justify reversing the valuation allowance. At September 30, that 3-year loss position was at $445 million. At December 31, that 3-year loss position has dropped to $355 million. Our expectation is that we will emerge from a 3-year loss position by our fourth quarter of fiscal 2012, and at that time, that significant piece of negative evidence gets pulled out of our valuation. And at that point in time, then that could be the earliest possible quarter in which the valuation allowance could be reversed. And at that point, we will have to weigh in on how profitable our year has been, how significant it has been and how sustainable we feel our earnings stream is at that point in time as we look forward into fiscal 2013. And we certainly do expect the valuation allowance to be reversed. Q4 this year would be the earliest, and, but there is the chance that it could be a few more quarters into fiscal '13.

Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. And just to follow up, I want to confirm, as a profitable company, that you expect to pay no federal cash taxes so long as you have this significant DTA? And then secondly, once the reverses, just technically, that you would be accruing a tax rate in your income statement.

Bill W. Wheat

Yes, second part first. When we reverse the valuation allowance, we will be accruing our standard income tax expense. In the past, that has been, for federal and state combined, around a 38% rate. That would be our current estimate after we reverse the allowance. In terms of taxes paid, there will be state taxes that we would to expect to pay in the states where we are profitable. Right now, our estimate on that is around a 3% rate on our pretax income. We will, perhaps to the extent we have taxable income overall, have to pay a slight amount of federal income tax due to the alternative minimum tax requirements in the tax law. They won't let you get away with 0 tax. Right now, our estimate for what we might have to pay in Alt Min Tax is 2%, an effective rate of 2%. So that's what's reflected in our current quarter. We have a 5% effective income tax rate. That reflects 3% for the state, 2% for federal. Now Alt Min, when you pay it in the future, we will get to use that as a credit against future income in later years after we've used up our NOL against future years of income.

Operator

Our next question comes from the line of Adam Rudiger from Wells Fargo.

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

Don, you mentioned that you spend a lot of time in the field. And you also commented in your opening remarks, or one of your comments, that your business feels more positive. I was wondering if you could elaborate on those 2 comments and share with us any patterns or themes that you've been picking up from your buyers and what's driving them to take the plunge right now, if there's any kind of elasticity towards rates or, really, what themes you're picking up on.

Donald J. Tomnitz

Well, I think the real key factor is that the availability of foreclosed homes still remains low. And, but most importantly, the process through which the buyer has to go through in order to have a small-percentage chance of securing, actually, closing, on a foreclosed home is very laborious. Furthermore, the state of most of these foreclosed homes are in a difficult position. They require quite a bit of work. And even though the buyer has to come up with a down payment and with our homes, they typically would have to come with what we call a lot of cash out of pocket to make the foreclosed home more livable. So if you take a look at that process and those factors associated with foreclosed homes and then take a look at the fact that they can buy a new home in a new community that has better school systems, in many instances, and better neighbors than what they're living around, then in many instances, we have the best buy for that buyer out there in a timely process. Also, you have to remember, a number of these buyers are all of the sudden becoming qualified or they're getting the down payment, and they don't want to have to wait 3 to 4 or 5 months to see if they're going to get a foreclosed home and be able to close on it and then take the cash out of their pocket to own it. The new homebuying process today is a very seamless process and a very timely process. With the number of specs that we have available out there on the ground for realtors and our buyers, we offer the preeminent buy relative to the foreclosed homes.

Stacey H. Dwyer

I think another factor that's driving some of the demand, Adam, is we've had very high affordability for a while. But rents were also relatively low. And now we're starting to see more headlines and hear from more of our buyers that they are seeing their rates increase, and that improves the equation when they're looking at their house payment compared to their rent payment.

Adam Rudiger - Wells Fargo Securities, LLC, Research Division

That's interesting. So the consensus seems to be out there that we bottomed and the outlook is getting more favorable. And so I think, when that happens, people start looking a little bit more -- looking out further into the future and thinking about what the longer-term earnings power is. Can you -- for all the builders. Can you share any thoughts on what you think 3, 4, 5 years out, what you think the earnings power in margins might look like?

Donald J. Tomnitz

Well, I would say to you that, clearly, there've been a number of small- and medium-sized builders who have left the market. They do not have the financing. If you look at the public builders, we have continued to acquire more and more market share in each one of our markets. As we continue to control the land and lot supply, which is necessary as we go forward, and of course, with our strong balance sheet, that affords us the opportunity to control the land, control the lots and to be able to, most importantly, develop the lots when the demand increases. I believe that D.R. Horton, as a company, has an opportunity to continue to acquire market share and increase our market share in each and every market. My personal goal, and again I'll say my personal goal, as we go through all of this, is I believe that, 5 years out, that we're coming very close to our 50,000 units that we closed in 2006. So that tells you what I think the possibility is for us in this industry.

Bill W. Wheat

Just to tag on with operating margins, in terms of our historical operating margins, we have always targeted a 20% gross margin, 10% SG&A, so 10% dropping to the pretax line. So we are working towards that. We're not there today, but we believe we'll continue to progress. And as the market improves, we will get back to those historic operating margins, as well.

Donald J. Tomnitz

And perhaps, the last thing I'd like to say is that, clearly, if you look at all of our competitors in the industry, we have the strongest balance sheet in the industry. So clearly, we have the balance sheet to get to that 50,000 units and continue to meet the demand as it moves forward and continue to take market share.

Operator

Our next question comes from the line of Joel Locker from FBN Securities.

Joel Locker - FBN Securities, Inc., Research Division

You guys bought back, what, 3 million shares or so, just to offset some of that dilution on the convertible. I just wanted to see what your idea of that going forward was, if you're going to offset more by buying more shares maybe possibly lower or how you looked at the dilution factor of the convertible.

Stacey H. Dwyer

Sure. We had an opportunity in the spring where we still had an abundance of cash above our $1 billion target goal. We were, at the same time, retiring debt and increasing our land investment, and we were also taking the opportunity to retire some stock at prices we thought were attractive at the time. Going forward, we're closer to the $1 billion target cash that we have, and we're going to be weighing all of those opportunities, going forward. Our capital structure on the debt side is much more in line with what, where we need it to be. Our gross leverage is now down under 40%, but we're starting to see more opportunities to invest in our core business, as well. As demand increases, we'll need some of our capital for cash -- or for homes in inventory. So we're going to be weighing those. So I don't know that we have any firm expectations of what further share repurchases would be, but we're going to take care of the core business first.

Joel Locker - FBN Securities, Inc., Research Division

And if you’re modeling, if your share price averages $14 going forward, would that count in the diluted share count, going forward?

Stacey H. Dwyer

The diluted share count is actually an earnings calculation, and we need to earn a certain amount of net income. Right now, I believe the number is around $70 million in a quarter, before the convert would become dilutive because, for the calculation to include the shares, we would add back the interest that's flowing through our income statement related to the convert. So it's really more than the stock price. It's the amount of earnings that we have and whether the share count would be dilutive. And actually, if we earn $70 million even if the stock is below the 13.06 [ph], we would include the shares.

Operator

Our next question comes from the line of Mike Widner from Stifel, Nicolaus.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Without going into kind of market-by-market detail, I was wondering if you could talk about, sort of on a percentage basis, where would you describe markets as sustainably or, at least apparently, sustainably getting better and getting closer to, not necessarily normal, but substantial improvement? And how, what percentage of the markets would you say are still kind of stuck in the mud, for lack of a better word?

Donald J. Tomnitz

I'm going to be very general because, again, I don't want to talk specifically about our markets any longer. But I would say to you, as Don Horton says, the Sun Belt continues to be where a lot of people want to live and are focusing on living in the future. So those markets are good for us. And as a comparison, I would say that the North continues to be weak for us compared to the Sun Belt markets.

Michael R. Widner - Stifel, Nicolaus & Co., Inc., Research Division

Got you. So and then another question, I guess. You talked about getting back to 50,000 units. Obviously, that's a pretty robust growth trend from here. One way to get there is kind of 25% growth a year for the next 5 years, or another way is that it takes 10 years and it's slower growth. So just as you contemplate kind of how all this nonsense unfurls both in the U.S. and globally, what's your expectation?

Donald J. Tomnitz

Well, first of all, I qualified that as a personal goal. I thought that was a major accomplishment for us in 2006 to close 50,000 units, more than any builder in the U.S. had ever closed before. And certainly, we led industry with that number. I don't know if it's going to take us 5 years, I don't know whether it's going to take us 7 years. I just know that our balance sheet is positioned for us to be able to come back to that number more quickly than many anticipate and certainly quicker -- more quickly than other competitors in the industry.

Operator

Our next question comes from the line of Bob Wetenhall from RBC Capital Markets.

Steven Bachman - RBC Capital Markets, LLC, Research Division

This is Steven Bachman, in for Bob Wetenhall. Just a couple of quick questions. You made several comments on SG&A towards the end of your prepared comments. But in terms of the full year, do you expect SG&A to be relatively flat in '12 versus the $480 million in '11?

Stacey H. Dwyer

We would expect our percentage to be improved compared to '11. A lot of what the absolute dollar amount does, though, will be dependent on the absolute level of homes closed because a portion of that is going to be a variable cost. So if we have significantly higher homes closed, the dollars will be higher. If we have flat homes closed, then we would expect our dollars to be lower than what we incurred last year.

Steven Bachman - RBC Capital Markets, LLC, Research Division

Fair enough. And I guess the follow-up being, the cancellation rate was 26%, which is on the low end compared to the last few quarters. We were just wondering if you were seeing any trend shifts in cancellation activity or if it was just noise in the quarter.

Mike Murray

Probably just noise in the quarter. We're still seeing a lot of the same drivers of cancellations, primarily mortgage qualification.

Operator

Our next question comes from the line of Stephen Kim from Barclays Capital.

Stephen Kim - Barclays Capital, Research Division

My first question relates to your comments that, as, that if the recovery occurs in '12, which I think it will, but if it does, you expected it to be not uniform across the country. Some markets will outperform others and that sort of thing. I was curious as to whether or not you could give us an idea, the markets which you are seeing or anticipating to see greater -- stronger trends, what does your margin profile look like in those markets, understanding that some geographies tend to have better margin profiles, generally speaking?

Donald J. Tomnitz

Well, again, I would say to you, and I'm not going to, again, not going to speak specifically about specific markets, Steve. But again, if you look at our Sun Belt markets and certainly our coastal markets, I think that's clearly where we’re seeing some of our best gross margins today. And I think there's a reason for that, and I think a number of our coastal markets have had horrific declines in lot prices over the course of the past 5 or 6 years. And in many instances, we're offering houses, finished houses for what the lots were costing 5 or 6 years ago, so there's an incredible buying opportunity for people who have that -- who can qualify and who want to own a second home in those markets.

Bill W. Wheat

And there will be additional information in the 10-Q on a regional basis. We report our 6 operating regions in our segment reporting in our financials and in the MD&A that will have some commentary around the reasons why certain regions are more profitable and what's driving the changes there as well, so there will be some additional color in the 10-Q.

Donald J. Tomnitz

And I just came out of one of our markets where our gross margins were running 25% to 30%. And you wouldn't believe me if I told you that, and I certainly wouldn’t tell anybody where I was. So as a result, we do have some markets that are over-performing.

Stephen Kim - Barclays Capital, Research Division

Yes, well, that's great, and that's good to hear. I guess my second question relates to your comments about your personal goal, getting back. I don't want to make too much of this. I know that it can be misinterpreted. And that's -- my intent is not to belabor it, but -- so my question relates to, as we look forward, what we can expect in terms of market share for Horton, which obviously, I know that, that's something that you work very hard and are very proud about, maintaining strong market shares in your markets. At the peak, we saw an unusually large percentage of the starts in the country that were single-family detached for sale. And the conventional wisdom today is that it is unlikely that the mix of starts at the, as we get back into recovery, will have quite the same proportion of single-family detached for-sale housing. So I was wondering, A, whether you've factored that into your thinking of where you think you can grow and the targets you set internally; and then secondly, whether or not you think there's an opportunity to alter your mix of products so that you can capture more of whatever starts happen to come through over the next 5 years.

Donald J. Tomnitz

Okay. Well, first of all, let me say, clearly, it goes without saying, but I want to say it, clearly, and that is we're interested in growth, but we're always at this company interested in profitable growth. So notwithstanding the fact of my personal goal, we're never going to achieve my personal goal if the profitability is not there first. Secondly, we have, as a company, and especially in the 2003, '04, '05 and '06 time period, had a myriad of products out there on the marketplace, anywhere from single-family detached to single-family condos, detached condos, to townhouses, to triplexes, to podium-type buildings. And so we're capable, as we've proven, to build any type of product. Where we see the demand today clearly is in single-family detached with a small smattering of townhouse and, to a lesser extent, detached condos, single-family detached condos. So as a result, what we're focused on today is single-family detached. When that market becomes saturated, then we clearly have the experience and are prepared to move into the other different types of housing products, which we've proven that we can do in the past.

Operator

Our next question comes from the line of Ken Zener of KeyBanc Capital Markets.

Kenneth R. Zener - KeyBanc Capital Markets Inc., Research Division

Two questions. If this is the bottom of the market, it’s kind of a good problem question. But your discipline around not buying land, wanting to be a short builder to avoid the, some of the issues we had at the peak of the last cycle relative to the long-land position, it kind of, it's -- you're really limiting your upside, I would say, given kind of your low net leverage at current levels, as well as the potential DTA. Can you kind of talk about how you're balancing the conservative approach you've taken through this, in the last few years relative to the fact that, if you do buy land and builders tend to make outsized margins on land versus the vertical construction cost, what should we look for because, I mean, you do -- and especially lands, finished lands running out?

Donald J. Tomnitz

What you should look for is for us to continue to lead the foray into increasing our sales, increasing our closings based upon acquiring additional land and lot positions, as we continue to do today. Our only caveat is, is that we're not going to risk our already sterling strong balance sheet by getting into land positions that are in excess of 2 years. And we believe that we can continue to produce the kind of volume and the profitability by laying off anything that's greater than 2 years to an investor or to a partner to hold that land that's in greater than 2 years. No one in the home building industry that I know of, including ourselves, were intelligent enough to figure out when to start laying off land quickly enough. So all of us ended up trashing our balance sheets within -- and had future impairments based upon our inability to determine how much land we should hold at a specific time. So I guess, after all these years with Horton, 28 years, and D.R. being in the business longer than that, we've got our balance sheet back to the strongest in the industry. We're not going to risk that in anticipation of a market that may have a future dip. And who knows what the market may bring? Currently, we sort of think that this is the bottom of the market. We're not certain. If you’ll recall, back 3 and 4 years ago, there were a number of people who were a lot smarter than we, or at least they thought, who were out picking out finished lots deals and land positions, and basically, the market continued to work downward from that position. So once again, our position is we're going to grow profitably and we're going to grow faster than virtually any other builder, but we're going to do it in a sane way to preserve our balance sheet.

Kenneth R. Zener - KeyBanc Capital Markets Inc., Research Division

Just I -- on the mothballed units, Bill, you talked -- I thought I heard you say 43,000. What was that last year and last quarter? Because I thought it was a bit lower even though it's staying about 20% of your inventory dollars. And then can you talk about the distribution of these mothballed lots relative to your comments around finished lots and the end markets expiring over the next 2 years? So does your excess lots, mothballed lots, happen to coincide where development of lots is going to have to occur?

Bill W. Wheat

In terms of the number of mothballed lots, we're 4-flat with a quarter ago. And a year ago, we were at 44,000, so we're down about 1,000 there. And then in terms of the location of our mothballed lots, typically, these are in areas that are a little bit further out from where the development is occurring today. It will take some market improvement and market expansion in general before we would feel the need to bring some amount of that land on. And then the other element that characterizes some of the, our held land is the fact that it would take significant development investment to bring that, those lots to market. And today, the returns aren’t sufficient to justify that additional investment.

Operator

Our next question comes from the line of Michael Smith from JMP Securities.

Michael G. Smith - JMP Securities LLC, Research Division

Just most of my questions have been answered, but I'll do a follow-up to something you said, DT. You -- I'm just trying to understand this a little bit better. You talked about, I think, if I remember correctly, earlier you were saying that the overall housing market wasn't getting a whole lot more traction. But clearly, you guys are seeing a pick-up, and you said even specifically in December and January, seeing a pick-up in your traffic levels and the number of buyers you have in your models. So I'm assuming, and you mentioned this briefly, that you're kind of chalking that up to market share gains. Is there any way for you to either quantify that or give more color on it? I mean, is it sort of universal across all your markets, more concentrated in some markets than others? And how do you get a sense of what those market share gains are and how strong they are, other than just anecdotally noticing that maybe the overall market is pretty flat but you guys are obviously doing better on the traffic front?

Donald J. Tomnitz

I think a lot of it has to do with DR and I being in these markets and assessing the situations ourselves. Clearly, I will say to you, as I said earlier, where we're getting better traction than -- is in the Sun Belt areas and the coastal markets than we are in the northern markets. And I think that will continue to be true.

Stacey H. Dwyer

There's generally, in each of our markets, at least one firm that tracks the relative performance of the homebuilders in that market, so that information is generally available. And we can track by specific market what our market share is based on either sales or building permits, generally are the 2 metrics that are tracked.

Michael G. Smith - JMP Securities LLC, Research Division

So then let me ask you as a follow-up. Going forward, the sort of optimism part of the cautious optimism, is that based more on the idea that you guys will continue because you're in a strong position and you have the balance sheet that you do, and you guys will continue to gain market share in at least most of your markets versus optimism that the worm is turning on the overall housing market? I mean, could you see a sort of flat 2012 in the overall market but you guys continue to outperform because of those market share gains?

Donald J. Tomnitz

I think that we could see a slight improvement in the overall market for the entire industry in 2012. We would be disappointed if we didn't get our lion's share of that increase, so as a result, it's just slow methodical improvement. We don't expect the new home industry to go back to 750,000 units overnight. I believe that, for the new home industry, clearly, as I've said before, that we are seeing some drivers coming our way from people tired of dealing with foreclosures and short sales, and also the affordability that's present in the new home industry today. So as a result, all those factors combined, I think there's going to be a slight upward trend in 2012 and, hopefully, a slightly better upward trend in 2013 as the economy, U.S. economy begins to recover and we start generating some new jobs in this country. The one driver that we're missing in our industry and the reason we're scrapping around in the marketplace trying to get additional market share is because there are no new jobs being created of any significance. And until we get our act together, the new job creation -- the new home building industry will continue to scrape along the bottom with little ups and little downs, but no significant improvement.

Operator

Our next question comes from the line of Alex Barrón from Housing Research Center.

Alex Barrón - Housing Research Center, LLC

So my question is, when we met, I guess, about a year ago, I think, at the time, your company's goals were to kind of focus on reducing debt and using the free cash flow for that purpose. And I guess, kind of where you sit now, I'm wondering if you're still going to -- if that's still part of the strategy, to kind of keep one foot on the brakes and one foot on the accelerator or if you think your $1 billion of cash would be more towards the use of buying land? Like, how -- I mean, given that your optioning land, it doesn't sound like you need a lot of capital, so how are you thinking about that?

Donald J. Tomnitz

Well, clearly, we're cautiously optimistic, and I think that's a good analogy: We've got one foot on the brake and one foot on the accelerator because, again, we don't see any substantial, significant, immediate improvement in the industry. It's going to be slow and methodical as we work our way back up, so we are very, very, very protective of our $1 billion in cash. And we are also very, very conservative, so we look forward in terms of land positions. And as I said earlier, we're not interested in buying anything where we have to get our capital back in greater than 2 years right now, and frankly, most of it's 18 months. So we're prepared and positioned and experienced to do whatever is necessary to capitalize on an expanding market, if and when we see a substantial increase in the market.

Alex Barrón - Housing Research Center, LLC

Okay. My other question is, are you starting to see or hear anecdotally that people who went through the foreclosure or short-sale process and have been renting for the last few years, are they starting to come back into your sales offices to buy? And if so, how are you capitalizing on this trend, if that's what's happening?

Donald J. Tomnitz

Well, I think we have seen those people. And we have people in our own company who have gone through the short sale and the foreclosure process who thought they were going to get a great deal, and many of them have come back and bought a D.R. Horton home, thank you. But at the same time, I think that, that's still a very laborious process, as I've said.

Stacey H. Dwyer

Yes, and Alex, I think you may be asking a different question in terms of people who actually had their home foreclosed on and are now looking to buy another home. Is that right? We'll assume it is. But yes, we do see some of that. There's a certain time frame after a short sale and a little bit longer time frame after a foreclosure where people can come back into the market. And their credit doesn’t reflect the effects of those occurrences. So we have seen some of that picking up, and that's one of the things that we've mentioned a few times. Our mortgage company has the DHI Mortgage Home Buyers Club that helps people work toward home ownership, and we have been working with some people who have been through those situations before.

Operator

[Operator Instructions] Our next question comes from the line of Susan Berliner from JPMorgan.

Susan Berliner - JP Morgan Chase & Co, Research Division

I just want to talk a little bit about the mortgage side, I guess, with regards -- just would love your updated opinion, are DTAs mostly behind you guys at this point? And have any of your customers talked about mortgage availability being a little bit easier over the past couple of quarters? Or where does it stand?

Donald J. Tomnitz

I don't see any -- well, as Stacey said earlier, the mortgage qualification process is still a strenuous process. And it's -- the mortgage companies, in general, have higher underwriting guidelines than they had 3, 4, 5 years ago. So we don't see any relief in that respect at all.

Susan Berliner - JP Morgan Chase & Co, Research Division

Okay. And mortgage put-backs, are those kind of behind you, do you think, at this point?

Donald J. Tomnitz

We still have a few of those coming back to us. We have had very few relative to the number of mortgages that we underwrote over the years. We continue to be well accrued for any potential put-backs. And frankly, we evaluate each and every put-back, and to the extent that we disagree with it, we're fighting very hard with those mortgage companies who are trying to put those back to us for reasons that are difficult to understand.

Bill W. Wheat

Then in the current quarter, we did have $1.7 million of recourse expense, so still some impact there. And our total accrual or reserve in the mortgage company remains at about $32 million.

Operator

Our next question comes from the line of Jay McCanless from Guggenheim.

James McCanless - Guggenheim Securities, LLC, Research Division

First question, could you please repeat the guidance you gave at the end of the prepared remarks?

Stacey H. Dwyer

At a very high level, Jay, without reading the whole thing, we basically said: with a lower backlog and a conversion rate below 90%, fewer closings in Q2 than Q1; strongest sales in Q2 and Q3 lead to strongest closings in Q3 and Q4; gross margins to remain in the mid-16% range; sequential increase in SG&A expense in the second quarter, which will result in a higher SG&A percentage, but in Q3 and Q4, higher absolute SG&A but lower percentages.

James McCanless - Guggenheim Securities, LLC, Research Division

And then the other question that I had. On last quarter's conference call, I believe there was a discussion about culling neighborhoods, unprofitable neighborhoods, culling unprofitable specs. Where are you with that process? And has the sales activity that you've seen over the last 2 months, has that changed the process? And just a general update on what you're thinking with those now.

Donald J. Tomnitz

Clearly, we have continued the culling process of our lower-margin subdivisions. We try to retrade them initially, rework the sales price on the lot. If the seller is not willing to do that, then we exit that subdivision. Where most of that happened, quite frankly, is in the Carolinas, and we've made a lot of progress in terms of culling our lower-margin subdivisions in the Carolinas. It's a continuing process, and even though we believe we are entering into profitable contracts, at times, we don't, and we go back and rework those contracts or cull those. But that'll be a continuing process of the company.

Bill W. Wheat

It's the same thing on our spec inventory. It's a continual process month to month, week to week. Our sales teams are focused on moving aged inventory and keeping our spec inventory in line with sales, so it's just an ongoing part of our management.

Donald J. Tomnitz

But as far as our specs are concerned, we continue to offer the right number of specs in the right number communities. Every once in a while, we'll get an aged spec, and there is an incentive to move that spec. But it's a strong position for us to be in because realtors across the country sell -- still sell a large percentage of our homes, for which we are very grateful because they bring a qualified buyer to us, and it's a seamless process once that realtor brings that buyer into our sales office.

Operator

Our next question comes from the line of Jack Micenko from SIG.

Jack Micenko - Susquehanna Financial Group, LLLP, Research Division

Most have been asked and answered, but I was just thinking about this commentary that we had just wrapped up on spec. And slow methodical overall, but it does seem like the industry -- one of the bigger opportunities for the industry is this notion of higher rents and continued higher rents. So just wondering sort of philosophically, you've always been a spec builder. Specs ramp into the seasonal demand period, as well, but have you, this year, maybe thought about your spec business a little differently, given the rise in rents? Is there anything you can talk to there, just sort of conceptually?

Donald J. Tomnitz

Well, I think, one -- the answer to your question, our spec strategy has not been dictated or changed much by the rent increases that we've -- that other buyers -- or renters are experiencing. I will say one thing: They may be disappointed with the increases in the rental rates, but one of the big factors that's preventing them from becoming a non-renter is the fact that either their credit history needs to be improved or the fact that they don't have the down payment. So as a result, as Stacey mentioned earlier, our Home Buyers Club are taking those people and converting them into homebuyers as we educate them on the financial system, which most of those people are good credit risk. It's just that they have not understood the financial reporting system and gotten themselves into some difficulty in terms of their credit history. And our Home Buyers Club is doing a fantastic job of converting those people into homebuyers. And most of those that we get through the process and graduate are D.R. Horton buyers.

Jack Micenko - Susquehanna Financial Group, LLLP, Research Division

Okay. And then on the mothballed side. I mean, is it basically coming down to employment levels? Obviously, a lot goes into what makes a mothball not a mothball, going forward. But how do we think about -- is it new home pricing? I mean, obviously, you've probably written this stuff down. It doesn't make sense to sell it here. But does employment need to move out to those areas? Or is it we need to see 10%, 12% price increases? I mean, how are you thinking about the mothballed generally?

Donald J. Tomnitz

I think, generally, we have less, as we mentioned, land. It's all in a continuum of probably from 1 to 10 years, but most of it's somewhere in the 3- to 5-year range, my perception is. And as the depleted -- as the lot supply, the finished lot supply becomes depleted, and that's going to be one driver. The second driver is just, clearly, the land component of a finished lot today in many markets is nominal, and so as a result, we're going to have to have some increase in housing prices to justify being able to pay the land seller something for their land or for our land to have the value that we've got on it in our books today in order to bring it into development. So I think it's a function of 2 things. But clearly, we're depleting the finished lot supply. And as we finish -- we deplete that finished lot supply, we're going to have to start developing lots. And as a result, there's going to be some increase in the value of housing prices as that depleted lot supply occurs, and land will become developable for us that we've got mothballed.

Operator

Our last question comes from the line of Jade Rahmani from KBW.

Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division

Just 2 quick follow-ups. One is on the watchlist. I didn't hear you guys give a brief update, if you care to share that? And then secondly, the FHA regionally disclosed additional risk reduction steps, including requiring indemnifications from certain lenders. Wondering if you think that could have any impact.

Mike Murray

Jade, on the watchlist, we had a watchlist of $363 million at the end of December, which is slightly up from $354 million at the end of September. But primarily, that's been pretty much in-line, and that's reflective of the more stable market conditions we've seen. Have not seen a lot of change in that, and that showed up as low impairments this quarter.

Jade J. Rahmani - Keefe, Bruyette, & Woods, Inc., Research Division

Okay. And then just the FHA, on their additional requirements for lender indemnification. Anything on the FHA?

Mike Murray

We haven't seen anything or had a chance to evaluate that at this point.

Operator

There are no further questions at this time. I would like to turn the floor back over to Mr. Tomnitz for closing comments.

Donald J. Tomnitz

Thank you. And thank you for joining our Q1 Conference Call. As you can tell, we are very pleased with our Q1 performance. And again, we'd like to thank all of our DHI team members for a great quarter.

And as usual, and as I saw on the back of a ship in the harbor recently, to quote, the name of the boat was "Never Enough." And frankly, there's never enough performance and good performance from us, and as you can tell, our investors and our shareholders expect more from us, so please, go out there. We have a big challenge in Q2. And we expect to be able to achieve profitability in Q2, Q3, Q4 and have a very, very good and profitable fiscal year '12.

Thank you.

Operator

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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