KB Home's (KBH) CEO Jeff Mezger on Q2 2016 Results - Earnings Call Transcript

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KB Home (NYSE:KBH)

Q2 2016 Earnings Conference Call

June 21, 2016, 05:00 PM ET

Executives

Jill Peters - SVP, IR

Jeff Mezger - President and CEO

Jeff Kaminski - EVP and CFO

Analysts

Susan Maklari - UBS

Michael Rehaut - JPMorgan

Dennis McGill - Zelman & Associates

Tim Daley - Deutsche Bank

Mike Dahl - Credit Suisse

John Lovallo - Merrill Lynch

Jade Rahmani - K.B.W.

Michael Eisen - RBC Capital Markets

Patrick Kealey - FBR Capital Markets

Alex Barron - Housing Authority Research Center

Operator

Good morning. My name is Shay [ph] and I'll be your conference operator today.

I would like to welcome everyone to the KB Home 2016 Second Quarter Earnings Conference Call.

[Operator Instructions] Today's conference call is being recorded and will be available for replay at the Company's website kbhome.com through July 21.

Now I would like to turn the conference over to Jill Peters, Senior Vice President, Investor Relations. Jill, you may now begin.

Jill Peters

Thank you, Shay [ph]. Good afternoon everyone and thank you for joining us today to review our second quarter results. With me are Jeff Mezger, President and Chief Executive Officer; Jeff Kaminski, Executive Vice President and Chief Financial Officer; Bill Hollinger, Senior Vice President and Chief Accounting Officer; and Thad Johnson, Senior Vice President and Corporate Treasurer.

Before we begin, let me note that during this call, items will be discussed that are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future results and the Company does not undertake any obligation to update them. Due to a number of factors outside of the Company's control, including those detailed in today's press release and in its filings with the Securities and Exchange Commission, actual results could be materially different from those stated or implied in the forward-looking statements.

In addition, a reconciliation of the non-GAAP measures referenced during today's discussion to their most directly comparable GAAP measures can be found in today's press release and/or on the Investor Relations page of our website at kbhome.com.

And with that, I will turn the call over to Jeff Mezger.

Jeff Mezger

Thanks, Jill, and good afternoon everyone. I'm going to start with a brief overview of our second quarter results, followed by a business update. Then Jeff Kaminski will take you through our financial results in greater detail and discuss our guidance for the third quarter of 2016 as well as the full year, after which we will open the call for your questions.

Our performance in the second quarter was quite strong, with meaningful progress across a number of financial and operational measures, led by a 30% increase in total revenues to $811 million. We capitalized on our robust backlog position entering the second quarter to produce a substantial increase in deliveries, which were also up 30%, with each of our four regions generating delivery increases in excess of 20%.

As a result of our top line growth, significant improvement in operating margin and lower interest expense, we grew net income inclusive of all inventory-related charges by 63% year over year to $15.6 million.

In the second quarter, the value of our net orders increased 14% to $1.2 billion, a healthy level of growth, particularly in light of the 38% year-over-year growth in net order value in the second quarter of last year. On a seasonal basis, our net orders typically reach their highest point of the year in the second quarter. We had a successful spring selling season this year with our highest second quarter net order performance in the past eight years. We generated 3,249 net orders, up 8% from a year ago.

We grand-opened 24 communities and closed out 23. Our grand openings for the quarter were roughly half the number we had in the second quarter of last year, which resulted in our average community count decreasing about 2% from a year ago. Generally the grand opening period drives the highest sales in the life of a community. So our ability to achieve solid net order growth with a slightly lower community count and fewer grand openings highlights the underlying strength of our sales.

There's no question that improving market conditions contributed to our favorable results in the second quarter. We were also successful improving net orders in our reactivated communities and in communities that were previously underperforming relative to their sales goals. As a result, we achieved average net orders of 4.5 per month per community for the first time in many years.

On a regional basis, the West Coast delivered the highest year-over-year order comparison at 29%, with net orders of nearly 1,000 homes, reflecting an increase in average community count of 15% and the highest sales per community of our four regions. This outcome is even more significant considering the West Coast produced a 32% sales comparison in the year-ago quarter.

While the coastal markets in California remained strong, higher prices in these areas pushed demand further inland, which is where the majority of our order growth came from during the quarter. As an example, net orders in our Central California division more than doubled.

In the Bay Area, we continued to work through the transition of community openings relative to close-outs. Five of the six openings that we anticipated for the second quarter are now open, in addition to the four communities we opened in the first quarter. We did experience a delay in one community, which is now set to open for sales in the third quarter of this year. We expect the Bay Area will cross over to community count growth in the third quarter.

Our Southwest region returned to a positive sales comparison in the second quarter, driven by ongoing strength in Las Vegas which continued to generate one of the highest sales rates per community in the Company.

In our Central region, our largest business in terms of units, we continued to see healthy results. Net orders were up in this region in spite of severely inclement weather across Texas and in Colorado. In Houston, demand trends appear to be stabilizing, particularly at our price points. Our average community count in Houston was down 13% from a year ago but our orders per community actually improved and our total sales in Houston were down 7%.

Our Austin division was a particularly strong contributor to the region's overall performance. We're the second largest builder in this market and continued to grow our market share with a sizable increase in net orders.

Wrapping up the regional commentary, net sales per community were up in the Southeast, although total net orders were down due to a decline in community count. In the Metro D.C. division, we closed out of four communities and ended the quarter with only three remaining open communities. As we announced last month, we are exiting the Metro D.C. market and expect to complete this process by mid-2017. While it's never an easy decision to exit a market, it is the right decision for the Company in order to optimize returns on invested capital and drive stockholder value over the long run.

Activating land that has been held for future development is also a key area of focus as we work to improve our return. Since the beginning of 2015, we have successfully reactivated 24 communities, and with market conditions improving, we are continuing to evaluate additional communities for reactivation. These reactivated communities typically generate below Company average gross margins, which is offset by positive leverage on SG&A. And as a result, we can grow our top line while maintaining our operating margins, increase our earnings, and generate cash that we can then reinvest in opportunities that we expect will produce higher returns. As Jeff will discuss in a moment, we are increasing our revenue expectation for this year, reflecting the improved sales results from our reactivated and underperforming communities.

In closing, we expect the housing market to continue its measured recovery with steady economic growth, along with increasing household formation, favorable demographics, low interest rates, and the attractiveness of owning versus rent fueling demand. We expect the convergence of healthy demand and low inventory levels to positively influence new home sales for some time.

With first-time buyers representing 52% of our deliveries in the second quarter and keeping in mind that this segment has historically accounted for more than half of our deliveries, we are well-positioned to continue to serve the re-emerging demand from this buyer segment.

With the healthy backlog of approximately $1.8 billion in place, sales momentum, and improved execution, we believe we are poised to continue achieving our performance objectives.

With that, I'll now turn the call over to Jeff for the financial review.

Jeff Kaminski

Thank you, Jeff, and good afternoon everyone. I will now review the financial highlights of our second quarter performance as well as our outlook for the third quarter and full year.

In the quarter, housing revenues grew 33% from the year ago to $807 million, fueled by a 30% increase in homes delivered and a 2% rise in our overall average selling price. Each of our four regions generated a strong double-digit increase in homes delivered, which drove significant year-over-year improvements in our home-building operating income, operating margin, and bottom line for the quarter.

We were particularly pleased with the increase in our backlog conversion rate to 54%, which reflected improved performance by mortgage lenders, higher-than-anticipated sales and deliveries of standing inventory, and shorter construction cycle time. However, we are cautious about projecting similar cycle time improvements for the second half of the year given anticipated seasonally heightened demand for construction services and the tight supply of skilled trades in many markets.

For the third quarter we expect to generate housing revenues in the range of $900 million to $960 million, and for the full year we are raising our housing revenue guidance to a range of $3.45 billion to $3.7 billion based on our strong second quarter net order performance.

Our overall average selling price of homes delivered in the quarter increased 2% year over year to approximately $347,000. This increase was lower than anticipated, largely due to a mix shift within our West Coast region as a greater proportion of deliveries were from communities with lower ASPs in our coastal market and a higher proportion of overall regional deliveries came from our inland California market that produced very favorable delivery results relative to expectations for the quarter.

As a result, the ASP for our West Coast region declined 2% year over year while our other three regions combined posted an increase of nearly 7%.

For the 2016 third quarter, we are projecting an overall average selling price in the range of $375,000 to $380,000. In light of the robust 29% net order growth in our West Coast region during the second quarter, we expect the mix shift towards higher-priced deliveries for the balance of the year, supporting our expectation for a 4% to 6% year-over-year increase in our full year ASP.

Before reviewing the remaining financial metrics, I will provide more specifics on the components of the inventory-related charges that impacted the quarter. The $11.7 million total included $6.8 million relating to the wind-down of our Metro Washington, D.C. operations that we announced last month, and $4.9 million for four land option contract abandonments in other markets, and an impairment for reactivated community in our West Coast region.

It is important to note that, of the $11.7 million of total inventory related charges affecting our home-building operating income, only $6.4 million impacted our housing gross profit margin. The remaining $5.3 million, which related to planned future land sales, was included in our land sale results.

Our housing gross profit margin of 15.5% for the second quarter included the $6.4 million of inventory impairment and abandonment charges I just mentioned, which equated to an impact of 80 basis points. Without these inventory related charges, our gross margin was 16.3%. Excluding both the inventory-related charges and the amortization of previously capitalized interest, our adjusted housing gross profit margin was 20.7%, up 40 basis points from the 2015 second quarter.

Our selling, general and administrative expense ratio of 11.6% for the second quarter improved 140 basis points from the year-earlier quarter, due to favorable leverage on the higher housing revenues in the quarter and our ongoing cost containment initiatives.

Home-building operating income margin for the quarter increased 30 basis points year over year to 3.2%. In addition to the inventory-related charges, the second quarter operating margin included the impact of approximately $600,000 for severance and increased employee incentive accruals relating to the Metro Washington, D.C. wind-down. After excluding total inventory related charges from both periods, this metric improved 170 basis points from the year-earlier quarter to 4.7%.

Turning now to our operating margin guidance, as a result of the increased orders and absorption pays at both our reactivated communities and other lower-margin communities that were previously underperforming relative to their sales goals, we are tempering our housing gross margin expectations for the second half of the year. Assuming no inventory impairment or land option contract abandonment charges, we believe our third quarter gross margin will improve on a sequential basis to approximately 16.5% and anticipate that we will be in the range of 16.7% to 16.9% for the full year. We currently expect the improvement in operating leverage from the increased second quarter order absorption pace to offset the expected impact on second half consolidated gross margin.

We also anticipate our third quarter SG&A expense ratio to be approximately 10.8% and the full year ratio to be just below 11%, an improvement relative to both our previous guidance and the prior-year result. Considering this offsetting impact, we believe our full-year operating income margin, excluding inventory-related charges, will be in the range of 5.8% to 6.0%.

Income tax expense for the quarter represented an effective tax rate of 37.1% and included a favorable impact of $400,000 of federal energy tax credit. In the same quarter 2015, we recognized $1.7 million of such tax credits on much lower pretax earnings, resulting in a 24.5% effective tax rate. These energy credits are a direct result of our sustainability and energy efficiency initiatives. We expect to recognize a larger amount of this tax credit during the second half of 2016 and project an effective tax rate of approximately 31% for the third quarter and in the range of 32% to 34% for the full year.

Our second quarter average community count of 242 was down slightly from the 248 in the same quarter 2015, which had increased 30% from the previous year. We ended the quarter with 242 communities, about flat sequentially but down 7% from a year ago. Included in the 242 communities at quarter-end were 37 communities previously classified as land held for future development.

As mentioned earlier, during the quarter many of these communities realized accelerated order absorption rate. By activating these communities we reduced our land held for future development by approximately $100 million from the end of the 2015 second quarter. The community activations have also contributed to the decrease in our interest expense by expanding the qualifying asset base we use to determine capitalized interest. The monetization of these land positions is contributing to increased asset efficiency and improved return. We plan to continue to unlock our investments in these properties and redeploy the capital into assets with expected higher income-producing potential.

We anticipate our average community count will decline by about 7% in the 2016 third quarter as compared to the same quarter 2015, which had increased 30% from the previous year. For the full year of 2016, we still expect our average community count to be relatively flat compared to 2015, which had expanded 22% from 2014. Looking beyond the current year, we believe our planned openings will drive and increase in our community count beginning in the first quarter of 2017.

During the second quarter we invested approximately $317 million in land and land development, with $127 million or 40% of the total representing land acquisitions and the remainder spent on development to convert owned land into new communities.

We ended the quarter with unrestricted cash of $275 million, compared to $440 million at the end of the second quarter of last year. As a reminder, we use approximately $200 million of that cash in June of 2015 to retire senior notes upon maturity and approximately $86 million for common stock repurchases in the 2016 first quarter.

In conclusion, we are pleased with our strong second quarter performance and are confident about our ability to achieve our goals and produce further improvements in the second half of the year.

We will now take your questions. Operator, please open the lines.

Question-and-Answer Session

Operator

Thank you. At this time we will be conducting a question-and-answer session. [Operator Instructions]

Our first question comes from Susan Maklari from UBS.

Susan Maklari - UBS

Thank you. Good evening. Just to start out with, you know, you kind of talked a little bit about the real strength that you saw in the West and it seems like that perhaps counter to what we've been hearing from some peers and just in general in our channel check, can you just talk a little bit about your success there, how you think about bringing those communities online? I know you mentioned that you expect the Bay Area to have some pros [ph] as we look at the second half of the year, but any kind of color you can add?

Jeff Mezger

Sure. But Susan, you've followed us for a while and I've told this story before about how the California market can ebb and flow. And what we're seeing right now is continued strength along the coasts, both north and south, that's moved pricing up, and so it's an affordability challenge in the more expensive coastal areas and it pushes demand further inland. And as we saw, as the quarter unfolded, the inland areas sold well and had good momentum coming out of the quarter.

So we're holding our scale in the Bay Area as an example, where we're transitioning out of old communities, opening new, and we expect to have community count growth here in the third quarter once again. The real pickup though came out of the central Cal division up there, whether it's Sacramento or Stockton and on down, a combination of local demand and also some of the commuters that will go out until they can find a home that meets ours needs that they can afford, because they can't afford necessarily close end of the bay. But it's a fairly traditional housing recovery that picked up some steam for us in the quarter both north and south.

Susan Maklari - UBS

Okay. And then, you know, you obviously talked about how you're getting this improvement that's coming through in sort of entry-level or first-time buyers. You know, can you kind of talk a little bit about how you think about that buyer today and what they're looking for and how you've positioned the product relative to perhaps some past cycles where the buyer profile was a bit different there?

Jeff Mezger

Yeah. We've been, I think part of our success in the pickup and sales is repositioning some of our communities where we may build a new model and offer it that's smaller in footage. It'll have a, you know, three-bedroom or four-bedroom count, but a little smaller home. We've lowered some of the spec levels down where the spec levels were higher, and in our business model where it's a presold start, the buyer goes to the studio and personalizes their home with what they find is important, and at a high level, I don't know that the consumers really changed that much. It's a - if it's a first-time buyer in the lower-priced area, there's - they want big kitchens, they want nice bathrooms, great rooms have been popular for a while. So I don't know that the way they live has necessarily changed that much. A little more technology. And what we do is sustainability is very important to this consumer.

Operator

Thank you. Our next question comes from Michael Rehaut from JPMorgan.

Michael Rehaut - JPMorgan

Thanks. Good afternoon everyone. You know, just wanted to dive in a little bit more on California and some of the regions. And, you know, I apologize if you hit this earlier in your prepared remarks, I jumped on a little bit late, but just wanted to get a sense, when you talk about, you know, kind of the improved demand on the first time, and you know, particularly as it, you know finally percolating from the coast to inland, wanted to get a sense also of just how much of that - how much of the demand and the improved demand that you're seeing is more due to communities opening at a price point that's within the FHA loan limits and just kind of allows you to capture perhaps a part of the market that might not be as well-served as other parts of the market.

Jeff Mezger

That's certainly part of it, Mike. When we position a community, one of the first question we ask ourselves is what's the FHA loan limit in this region, and we try to position product that will fall within that. But interestingly, in both the Central Valley and Inland Empire, the sales were occurring above the FHA loan limits for the most part because they, well, after they were lowered, became a much smaller component of the business.

And what the trade-offs are in a conventional-owned, you have to put 10% down. Buyers try to put 20% down to afford - to avoid paying the mortgage insurance, but it's easier to qualify on the conventionals right now.

So the payment's actually a little less because FHA has a higher mortgage insurance, and I don't know that we have the statistics specifically to California, but FHA is not the lion's share of the business, it's more stronger demand, and they're finding ways to acquire home with conventional loans.

Michael Rehaut - JPMorgan

Okay. So just to make sure I understand --

Jeff Mezger

I'm sorry, Mike. That's specific to California. In most of our other business, we're operating within FHA loan limits where we're seeing similar strength.

Michael Rehaut - JPMorgan

Okay. Thank you, Jeff. I mean, just so I understand it right, I mean, you know, are you seeing improved strengths because of - so you're saying that you're seeing improved strengths more just from existing communities benefiting - getting better sales pays or better demand at existing communities that were also opened in the first quarter as opposed to kind of, you know, any type of, you know, opening of a group of communities this quarter that, you know, kind of took with it some, you know, kind of drove some of the results.

Jeff Mezger

I would say that in that context, that it would be more the reactivations. Jeff can give you the number on what - we track our sales lift from reactivations but we were successful in opening more communities in the quarter.

Jeff Kaminski

Yeah. Just specifically on the reactivated communities, it's about 15% of our total communities right now average opened for the quarter. It was about 14% last year. And to put it in perspective, as far as the impact on the absorptions this year, those 14% for the communities that were opened in the same quarter last year generated about 10% of the total sales, so they were pacing pretty much well below company average. And this year we're very successful in increasing the pace of those communities up to actually slightly better than the Company average. So that 15% of the communities generated about 16% of the sales in this year's second quarter. So we saw a nice lift on that.

The, as Jeff mentioned, the total Company was at about 4.5 per community per month in the quarter and it was pretty evenly split between the reactivated communities and the rest of the business. So it was nice to see that improvement. You know, generally those communities had been a bit challenged, which is the reason why they were inactive for a while, and being able to improve the pace in those communities to the extent we were able to get it up to in the second quarter was very pleasing.

Michael Rehaut - JPMorgan

Okay. One last quick one if I could, just on the gross margins. Appreciate the updated thoughts there. And, you know, but for the year, in the second half, gross margins, a little less than we were looking for, positively obviously more than offset by, you know, SG&A gains. But on the gross margin front, I mean, how should we think about the cadence or, you know, the amount of improvement potentially in 2017? I know you're not giving guidance for next year, but should we just kind of work off of this lower base or are there kind of temporary things that might just be impacting 2H16 that might not be as influential for next year?

Jeff Kaminski

Right. Well, a lot will depend on what happens on the orders in the back half of the year obviously. I mean when you look at the adjustment we made on the gross margins in the back half, the expectation that we had for base or core communities came in about as planned for the second quarter as far as the order absorption pace and the deliveries that we think those will generate in the back half of the year.

The positive surprise was what we did with the reactivations, like we talked about earlier, and some of the other what we call lower-margin communities that were pacing below our sales goals in the quarter. And by lifting those, we did add top line revenue. It was incrementally negative to the gross margin percentage. But at the bottom line dollars it's actually accretive and it was also offset by SG&A leverage. So, you know, on balance a positive, and I think the overall balance or positive point on that is just what it'll do to returns over time as we continue to work that balance down.

In the back half of the year, you know, we'll see where those communities pace out at. We hope to continue to see them pacing strong. We do have more activations planned in the back half of the year, and we'll track those as we go and help guide you guys on the first part of 2017 as we get through the next couple of quarters. Right now we remain focused on the goals for this year and also very importantly on increasing our operating margin and our returns. And we recognize a very important component of improving both of those is the gross margins, so we'll continue to focus on that.

Operator

Thank you. Our next question comes from Dennis McGill from Zelman & Associates.

Dennis McGill - Zelman & Associates

Hi, Jeff. Just to continue on that plan on the gross margin. If - I want to make sure I understood the comment you made earlier on mix. You had negative mix in the second quarter from some of the strength in those inland markets, but you were still up year over year on gross margin including that. So I guess relative to expectations, margin would have looked even better had those communities not outperformed.

If I'm understanding that correctly, can you maybe walk through in the second half of the year how you're thinking about the change in margin between I guess apples to apples pricing power mix similar to what you talked about there and then anything that might be impacting it from a fixed cost standpoint?

Jeff Kaminski

Right. Well, in the back half of the year, you know, what we normally is the improved leverage on the fixed cost that we have in cost of sales, so that's certainly a component that we'll see impacting it. It's offset slightly by what we're seeing as an increasing mix of these reactivated communities. And to put it in perspective, we have a range of margin on those communities that are kind of mid-single-digit, call it 5% or 6%, to mid-double-digit 15%, 16%. There's obviously a few communities trailing below that mark and obviously above. But overall that's about where it's tracking at.

So with that group of communities and if the average is say within the low double digits, to the extent we drive mix and increase absorption pace into those communities, it does affect the second half margin. That's really the impact that we're seeing relative to prior guidance.

As far as consecutive quarters goes, you know, we're seeing, as we talked about, or as I talked about in the prepared remarks, an estimate of about 16.5% in the third quarter and mid to high 17% in the fourth quarter as we'll see more deliveries coming out of the West Coast relative to the rest of the business, and even within the West Coast region, the coastal markets relative to the inland markets, we'll see a bit of a shift in delivery mix occurring in that base as well.

So it's been more a net side that we're seeing the changes in gross margin than pricing or cost or anything else. I mean the costs - our index costs so far year to date versus the beginning of the year is up about 1.6%. We believe we've offset most of what with pricing, and really not seeing many other impacts other than just the mix that we see in our backlog right now.

Dennis McGill - Zelman & Associates

Okay, that's helpful. And then second question would just be as it relates to the exit of D.C., the Southeast region has been a trailing region from a margin perspective. Is there any way you could frame what the exit would do to that segment, maybe talk to what pro forma 2015 would have looked like ex-D.C., put some numbers around it?

Jeff Kaminski

The D.C. business is pretty small in the overall scheme of things to the Company, so it really doesn't move the needle much. It does incrementally improve the Southeast region's results, and I think we will see that as we move into next year. But, you know, as far as moving the needle on the overall Company, it's just not significant enough.

Operator

Thank you. Our next question comes from Nishu Sood from Deutsche Bank.

Tim Daley - Deutsche Bank

Hi, this is actually Tim Daley for Nishu. Thank you for taking my question.

So my first question relates to the reactivated communities. So, thinking of it in the anecdote that you guys gave us that about 15% of current communities are reactivated projects and compared to about 14% last year. It seems that, just correct me if I'm getting this wrong, that as you kind of keep community count flat, it's more of a replacing close-outs with the reactivated communities. Is this correct? And if so, what percent of the kind of apples to apples 15% that you gave us should we expect for two-half 2016 and then 2017 going forward?

Jeff Kaminski

Right. So the percentage I gave you was on deliveries and that has remained relatively constant. I mean, over the past year it's been right about 85-15. The large difference that we see in the back half of the year is just the absorption pace. So while it was, like I mentioned earlier, while it was about that same percentage of our total communities, the pace of those communities was trailing the company average. So by the pickup in that, we'll see I think a little more balanced mix.

We are opening, you know, significant number of communities in the back half of the year that are new communities on new land that's been recently developed and have grand-opened. At the same time we do have additional plans and we hope to be able to reactivate additional communities in the back half of the year. I think Jeff gave the number that over the past year and a half or so we activated and grand-opened about 24 communities. We hope to grand-open probably at least 10 communities in the back half of the year, so I don't think it's going to change the mix much. I think, you know, it'll remain relatively constant. And some of those reactivations will replace other reactivated communities that'll be closing out.

Tim Daley - Deutsche Bank

All right, understood. Then --

Jeff Mezger

But as we - Tim, as we head in the 2017 and we will see our community counts start to grow again, it's not an all or none. We're working to open communities in every city and newer acquisitions that we've made, and actually my hope would be that you see the new acquisitions grow faster than the reactivations, but they link back together because you take the cash from these as you monetize them and build through them, and it helps you with your growth trajectory from there too. But it's both.

Tim Daley - Deutsche Bank

Understood, understood. And then just kind of quickly following up on that. So, from an operating margin perspective, obviously, am I to think that, you know, obviously the gross margins were a bit lower, but does that mean that you guys are getting a bit of a help on the SG&A end from these communities? From an operating margin perspective, how would that look --

Jeff Kaminski

Yes, absolutely. In fact, the operating margin improvement, and this is coming both from the volume push that we've seen in the reactivated communities, as well as our base business, as well as our underperforming communities, so we did see improvement in what I'd call all three categories of communities, but the leverage improvement is significant enough to offset the incremental downward movement in the gross margins. So, you know, as we guided for the full year, this 5.8% to 6.0% operating margin for the full year should be pretty much right on top the prior guidance that you guys have from last quarter.

Operator

Our next question comes from Mike Dahl from Credit Suisse.

Mike Dahl - Credit Suisse

Hi. Thanks for all the color so far and taking my questions.

Jeff, not to harp on the reactivations too much but do have a couple of more questions here. I just want to understand or be clear on the, you know, the pace versus margin side. So when you're talking about the pace in these communities having improved up to or above Company average, was this a function of something that you were intentionally doing on price or incentives to drive it or has the market just come to you from a geographic standpoint to the point where, you know, the absorption just organically picked up?

Jeff Mezger

Yeah, Mike, I think there's a few things at play and you've touched on a couple of them. Certainly the markets have improved where a lot of these communities are located, so that's helped with it. As I mentioned in a previous response, we've done a lot with product rotation where we're offering a new model that's a little bit smaller to lower the pricing in the community. We've lowered spec levels which will lower the base pricing in the communities. So we go there and make sure our products aligned with that consumer and the household incomes in that area. Then you had the market lift. And if we have a community that's not selling, well, we have to do something to get it going, so we could end up taking some price.

And we look at every community every week and we have an optimal combination of margin and absorption that we target. And if it's hitting the sales pace, we'll push price. And we did a lot of that too in the quarter. And if it's below, you'll have to do something to get back online.

Underneath it, what we're pleased with is the way that the - all these reactivations performed in the quarter relative to what they did a year ago. It's a more meaningful part of our business going forward.

Mike Dahl - Credit Suisse

Got it. Got it. And then I think you mentioned that there was part of the -- part of the $5 million charge this quarter outside of the D.C. exit was related to a reactivation. Was that charge taken upon reactivation or was that an instance where you had to act to bring pace up? That's kind of part one of that question.

And then part two of it is, could you just help us size up, you know, if you're bringing on 10 more reactivating, 10 more of these communities, you know, how many are kind of borderline or would be on some sort of impairment watch list as they come on?

Jeff Kaminski

Just addressing I guess your first question. The asset was a legacy asset. It's been on the balance sheet for quite some time. It was reactivated and grand-opened last year and we really haven't seen -- did not see the pace in that community that we expected on the grand opening. And as a result of that, I mean, if you grand-open a community and you're close to the mark-out [ph] as far as the impairment, if you're not pacing, it makes it worse obviously because your interest carry is going up and it could cause you just to go into an impairment situation just on that alone.

And that's really what's happened. We haven't seen pace in the community. We took the impairment this quarter. And obviously we expect to see it not only pacing but, you know, earning back some of that impairment dollars on the margin side as we go.

As far as the ten communities in the second half, there are really community-by-community specific decisions that we make. We don't have a hard-and-fast right now on what will come online, we evaluate them as we go with the divisions, propose them as part of our regular land committee process, and we evaluate them at that point.

I believe, you know, as we look forward -- well, let's look backward I guess just to put it in perspective. I mean, we activated 26 communities, or 24, excuse me, communities over the last year and half and we'd had relatively modest impairment activity relating to those. So, you know, I'd expect much of the same with the next few that we activate.

Operator

Thank you. Our next question comes from John Lovallo from Merrill Lynch.

John Lovallo - Merrill Lynch

Hey guys. Thanks for taking my call as well. I think, you know, in a recent conference call you guys had indicated that the Inland Empire was still kind of in the early innings of recovery, and we've seen some pretty meaningful pickup in the quarter here. And from some of your competitors we've heard, and I think this kind of touches on Mike Rehaut's question, we've heard of, you know, FHA loan limits, you know, some discounting to reach to keep things in the parameters there. Are you seeing that competitors? Are you seeing discounting in the Inland Empire? And if so, what is your reaction in terms of your existing communities?

Jeff Mezger

Yeah. I haven't heard, John, of a lot of heavy discounting at all out there. I think the builders are pretty disciplined in trying to max their margin. I did hear an anecdotal one situation where someone took steps to get below the FHA loan limit, and at the conference house, my observation was those loan limits changed two years ago. We've been operating with that restriction in place for a couple of years and you'd figure out a way to navigate around it.

So we're not seeing heavy discounting to get sales out there right now.

John Lovallo - Merrill Lynch

Okay, got you. And then, you know, depending on where your views on where we are in the cycle, you know, you guys are carrying some relatively high cost debt still on the balance sheet. I mean, any thoughts on, you know, either trying to take some of this down or refinance this?

Jeff Kaminski

Right. We've talked about on prior calls, you know, our next maturity is September of next year. It's the highest interest rate debt on our balance sheet, so we're very much looking forward to eliminating that off the balance sheet. We made comments in the past of our ability to pay that down with cash and intention to de-lever to get into our midterm range or mid-goal range of 40% to 50% leverage. So those plans remain intact and we'll continue to address that as time goes.

Operator

Our next question comes from John Micenko from CSG [ph] - SIG.

Unidentified Participant

Hey, hi. This is actually [inaudible] for Jack.

My first question was on absorption. So, you know, absorptions are up 16% this quarter, on a 2% decreasing community count. Could you maybe talk about the monthly cadence of sales pace? You know, in some of our groundwork we saw March sales pitch drop off from Feb and then pick back up in April. I mean, did you see the same? And then what about May?

Jeff Mezger

Yeah. Hold on a second. I thought we were up about 10%.

Jeff Kaminski

Yeah. Just to correct I think maybe some of your math, we were -- the community count was down about 2% in total. The net sales were up 8%, the absorption pace was up about 10%.

Unidentified Participant

Okay. Thanks.

Jeff Mezger

And sequentially as the quarter played out, we saw a fairly consistent market dynamics through the quarter, so, March, April, May held pretty well throughout, I think it got a little bit stronger toward the end.

Unidentified Participant

Okay. And then, I don't know if you guys disclosed this historically, but what was sales incentives as a percentage of revenue year over year?

Jeff Kaminski

Really wasn't much change year over year. We're a low incentive company anyway. I mean our business model is low net price and not to offer a lot of incentives, and we don't see much change or fluctuation in that either quarter to quarter sequentially or quarter to quarter year over year, and we did not see it in this quarter.

Operator

Thank you. Our next question comes from Jade Rahmani from K.B.W.

Jade Rahmani - K.B.W.

Good afternoon. Thanks for taking my question. Just wanted to ask as a follow-up to the leverage question, where you'll repay that 2017 debt maturity with cash on hand. Can you give a sense for the magnitude of benefit from reduced interest amortization that you would get on the gross margin side?

Jeff Kaminski

Right. Well, number one, it's, you know, 9% times the total debt, I think it's 265.

Unidentified Company Representative

$265 million.

Jeff Kaminski

That's out. So, you know, and the incurred interest would be pretty significant.

As far as interest amortization, it takes a while to work through the system. I mean, you know, first, it gets capitalized and the interest gets capitalized, the projects, as you open them for sales, and you activate and have active inventory. And as it amortizes out the other side, it takes a while to kind of work through. So, you know, reduce your debt levels first and improve your leverage, and following that, by a year or two, you'd see some benefits on the market coming through.

Jade Rahmani - K.B.W.

Thanks for that. And just in terms of supply in your markets, wanted to find out if you've seen any competition from single-family rentals.

Jeff Mezger

Not really. There - actually let me back up, right? If you're referring to people deciding whether to own or rent, there's a lot of single-family rentals out in the marketplace, so you'd have to say, as people are evaluating their choices, that that would be an alternative for them.

We have not seen a lot of products hit the market where they're trying to monetize their holdings and portfolio. I think they're still trying to get their arms around that. They've been pretty disciplined in that area.

Operator

Thank you. Our next question comes from Robert Wetenhall from RBC Capital Markets.

Michael Eisen - RBC Capital Markets

Good evening. It's actually Michael Eisen on for Robert. A quick question for you guys on the strong delivery growth you guys have had for the past couple of quarters. Is there anything in specific regions that may imply there was some pull forward in the quarter that in turn would imply a slower pace of delivery growth in the back half of the year? Any additional color on that would be very helpful. Appreciate it.

Jeff Mezger

Michael, one of the things that gives us confidence in the second half of the year is, heading into our third quarter with $1.8 billion in backlog value. So we've already got a lot of the backlog in place to support the second half revenues. So I don't know that we would say there was a pull-through in this region and it's fairly typical and pretty broad-based I would think on our closing performance. I don't know if --

Jeff Kaminski

Just, I mean, just to add to that a little bit, as I went through the prepared remarks, I mentioned a few of the factors that gave us a higher conversion rate this quarter and actually higher than our own expectations and higher than guidance, which we were certainly pleased with. I think your question's getting more to, you know, how do you peg the third and fourth quarters. And I would say, you know, just revert back to the guidance that we provided for the third and for the full year and you can extrapolate the fourth quarter out to full year guidance, and that probably gets you as close as, as we think, at this point in time as you could get to it.

But we consider it obviously the strength of the second quarter revenues and delivery number in the guidance, and we also considered the strengths of the second quarter net order growth and the mix shift slightly towards the West Coast region, which had very strong order growth in the quarter in those guidance numbers for both the third quarter and the full year.

Operator

Thank you. Our next question comes from Patrick Kealey from FBR.

Patrick Kealey - FBR Capital Markets

Hey everyone. Thanks for taking my question.

Wanted to circle back actually to the reactivated communities. Maybe thinking about it another way, what would you say the average life remaining in those communities would be just kind of thinking on how long it's going to take, you know, from a gross margin perspective but also maybe from a cash-free cycling perspective, like you said, maybe reallocating that into kind of high-return projects.

Jeff Kaminski

Well, you know, as far as getting that specific on the community, it's pretty hard to peg an average. You know, we have a number of reactivated communities that are now open and operating that have other phases that are still in active status. So we obviously need to work through the current phase in order to open the next phase or the phase after that of those communities, so it's, you know, a little bit of a mixed bag.

You know, we've made tremendous progress on the reactivator and mothballed communities over time. Like I mentioned in the prepared remarks, we're down $100 million from last year and we're down quite significantly, actually nearly $300 million from the peak of that. So, you know, it'll be some time to work through it all, certainly, but we're very pleased to have made the progress we achieved up to this point. And the more that we can get activated in sell-through, I think the better will be for, again, for returns and cash flow the Company.

Patrick Kealey - FBR Capital Markets

Okay, great. Thank you. And appreciate the color you gave earlier just on kind of monthly cadence within the quarter. Any update you can give us on maybe June trends and how they're tracking versus June 2015?

Jeff Mezger

Yup. Patrick, we're two weeks into the quarter so we typically don't give a lot of color on the current month activity. As I shared, May was probably a little bit stronger than March but we had a nice progression through the quarter with pretty consistent demand. We're pleased with the results.

Operator

Thank you. Our last question comes from Alex Barron from Housing Research Center.

Alex Barron - Housing Authority Research Center

Just kind of wanted to go over your margin guidance. You kind of said you expected 15-1/2% for the third quarter and then you give the full year guidance a little bit higher I guess in the fourth quarter. So what's happening in the fourth quarter to cause the margins to go higher? Is it just mix from a certain market or product side? Can you elaborate a little bit on that?

Jeff Kaminski

Sure. Yeah, it's pretty straightforward. In the fourth quarter we expect to have a higher mix out of our West Coast region, which carries higher margins, higher average margins than the rest of the business, supported again by the strong net order performance in the second quarter, and to be honest it's more or less just almost a normal seasonal trend that we see in our business where we have a higher mix of deliveries in West Coast late in the year.

And secondly, we do achieve a higher level of operating leverage on our gross margin because we do have some fixed costs included in our gross margin in our highest revenue quarter of the year, which is pretty much always our fourth quarter. So with the high revenues in the quarter we'll see the leverage comes through with the positive mix shift, we'll see that come through.

And then what I'd mention I guess as a third factor is we talked about a fair amount on last call, on the last quarter's call, some of the new openings that we have happening in West Coast region and have happened earlier in the year will produce what we expect to see nice margins coming out of those communities at high price points, which can really impact the overall Company's margins in a favorable way.

So those -- I'd determine those -- or say those three are the three main factors in the improvement.

Alex Barron - Housing Authority Research Center

Okay, great. And then as it pertained to the backlog conversion this quarter, I think you kind of warned not to expect maybe the same for third quarter, but what were some of the bigger factors you think that contributed to the pretty nice surprise there, especially like in the Texas market?

Jeff Kaminski

Right, right. Like we were saying earlier, I mean we saw -- I would say there were three main factors that favorably impacted it. One was the improvement in construction cycle time. As a company in total, we saw about a 10-day improvement in construction cycle time during the quarter. We did see better reliability and consistency with our mortgage partners for the quarter. So, loans that we had expected to close, closed. And I'd say we got quite a few over the line that were maybe in past quarters a little more questionable to get done in the quarter. So that was very helpful for us.

And kind of hand in hand and almost interrelated to the other two, in terms of spec sales or standing inventory, sales of standing inventory, we were able to -- our sales of standing inventory were fairly typical for us in the quarter as far as the blend. We're typically about 70-30 blend on that side, build-to-order versus standing inventory spec. But during the second quarter we were able to close more of those sales that were actually made in the quarter than we typically expect to close. And again, you know, the mortgage side helped on that and in some cases improved cycle time and construction help in that one as well. So those are the three main things.

Operator

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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