Taylor Morrison's (TMHC) CEO Sheryl Palmer on Q2 2016 Results - Earnings Call Transcript

| About: Taylor Morrison (TMHC)

Start Time: 08:30

End Time: 09:32

Taylor Morrison (NYSE:TMHC)

Q2 2016 Earnings Conference Call

August 03, 2016, 08:30 AM ET

Executives

Sheryl Palmer - President and CEO

Dave Cone - CFO

Jason Lenderman - VP, IR and Treasury

Analysts

Anthony Trainor - Credit Suisse

Ivy Zelman - Zelman & Associates

Tim Daley - Deutsche Bank

Jack Micenko - Susquehanna Financial Group

Will Randow - Citigroup

Stephen East - Evercore ISI

Patrick Kealey - FBR Capital Markets

Alvaro Lacayo - Gabelli & Company

Alex Barron - Housing Research Center

Operator

Welcome to Taylor Morrison’s Second Quarter 2016 Earnings Conference Call. My name is Vanessa, and I’ll be your operator for today’s call. At this time, all participants are in a listen-only mode, and later we will conduct a question-and-answer session. Please note that this conference is being recorded.

I would now turn the call over to Mr. Jason Lenderman, Vice President, Investor Relations and Treasury. You may begin.

Jason Lenderman

Thank you, Vanessa, and welcome everyone to Taylor Morrison’s second quarter 2016 earnings conference call. With me today are Sheryl Palmer, President and Chief Executive Officer; and Dave Cone, Executive Vice President and Chief Financial Officer.

Sheryl will begin the call with an overview of our business performance and our strategic priorities. Dave will take you through a financial review of our results along with our guidance for the next quarter and for the full year. Then, Sheryl will conclude with the outlook for the business after which we will be happy to take your questions.

Before I turn the call over to Sheryl, let me remind you that today’s call, including the question-and-answer session, includes forward-looking statements that are subject to the Safe Harbor statement for forward-looking information that you will find in today’s news release. These statements are subject to risks and uncertainties that could cause actual results to differ materially from our expectations and projections. These risks and uncertainties include, but are not limited to, those factors identified in the release and in our filings with the Securities and Exchange Commission and we do not undertake any obligation to update our forward-looking statements.

Now, let me turn the call over to Sheryl Palmer.

Sheryl Palmer

Thank you, Jason, and good morning, everyone. We appreciate you joining us today as we share our results for the second quarter of 2016. I’d like to start by providing an enormous and heartfelt thank you to the Taylor Morrison teams for their efforts day-in and day-out to help us achieve our strong performance. It’s because of these efforts that we met or exceeded all of our quarterly guidance, and I believe our results are a testament to the passion and dedication of our people.

Our ability to perform is anchored by a sound strategic foundation coupled with a desire to evolve and continuously improve. These tenants are critical in enabling consistent performance as sometimes challenging local, national, and international events influence the pace of play within the housing recovery.

We stand firm in our belief that the homebuilding industry is in the midst of a sustained and measured recovery, and that the sector and more notably Taylor Morrison is well positioned for continued growth and efficiency through the maturation of the cycle. Much of our belief is bolstered by demographic tailwinds coming in the form of household formations for millennials and boomers attaining new life stage milestones.

New production starts continue to track below historic trends and are not keeping pace with household formations, and we continue to see indicators pointing to healthy demand fundamentals in most of our markets. Months of supply continues at somewhat constrained levels with both new and existing homes at or around five months, which is near similar levels as this time last year.

Other metrics such as starts and permits continue to produce positive trajectories and a healthy year-over-year comparison. As we evaluate these metrics, they lend credence to the theory of a shallow sloped recovery. And as we all know, cycles are not measured in days, weeks or months, and a longer-term view allows us to remain focused on the bigger picture and not falling prey to daily headline reactions.

Similar to the housing recovery, the financial health of the consumer is improving at a gradual but still optimistic pace. The percentage of underwater mortgages has been in single digits for four straight quarters and it improved sequentially in the last reported quarter by 50 basis points, and mortgage rates are still at all-time lows. These factors suggest that households have improved purchasing power as it relates to potential home purchases.

Now circling back to our strategy and an update on our integrations. We continue to seek a balance with our land investment strategy and maximizing operational effectiveness given our rapid growth these last few years. Our strategic priorities have always been and will continue to be rooted in our aspiration to generate top quartile results and to be both the employer and builder of choice throughout the sector. As we have discussed in previous calls, we are focused on driving value from our most recent acquisitions, as the new businesses are integrated into the Taylor Morrison fabric.

Just passing the one-year anniversaries of our entrance into Atlanta, Chicago, Raleigh, and Charlotte, we are proud to share that the integration efforts are near complete. We have absorbed four separate businesses in less than four years and three of those in the last 18 months. Our integration efforts have gone better than we could have anticipated and each division is acclimating well into the Taylor Morrison family.

We are adamant believers in first getting the people part right and making sure that we have the talent to execute our strategy while promoting the type of people-driven culture that encourages teamwork, problem solving, accountability, and a deep desire to deliver.

A natural outcome of these integration efforts have been in exercise a self-reflection and a welcomed opportunity to evaluate existing tools and processes. This exercise allowed us to challenge ourselves to find the right balance between field autonomy and the scale provided by centralized support, feeding nicely into our desire for excellence. This has and continues to be an exciting and necessary part of our transformation.

This desire is a result of our growth and perhaps more importantly our internal expectations, as we seek to maximize our potential and newfound reach. Since 2013, we have grown our U.S. business by 102% as measured in community count, 58% in closings and 90% in revenue. This type of expansion demands a strategy that balances a disciplined execution and is adaptive to market conditions, as we continuously evaluate and enhance the business.

Fortunately, most of these enhancements only require us to make minor tweaks and slightly adjust the operational dials. An easy illustration of this has been our focus to refine the management of our completed spec inventory. Dave will share more with you around this initiative and you will soon understand why I’m so pleased with the organization's response.

Now focusing on our results, we were able to deliver more than expected sales, closings, margin and earnings during the second quarter. We closed 1,816 homes which represented a 23% increase over the prior year. We increased community count by 29% year-over-year to an average of 315 communities.

Net sales order 2,025 in the quarter, up about 8%. This growth rate is down from what we saw in April which points to a deceleration through the quarter. However, as we pointed out on the Q1 call, it’s important to consider this number in context of last year's growth rates. Our Q2 growth rate from 2015 was 22.3%. So when coupled with 8% this year, our two-year stacked growth rate is more than 30%.

Our third quarter has gotten off to a very strong start with July sales 30% higher than the same month last year. Q2 sales per outlet came in at 2.14 per month. As we stated last quarter, we will manage this somewhere between 2 and 2.2 depending on the quarter and would expect to be somewhere in between for the full year. Finally, cancellations were about 12.8%. Overall, a solid second quarter in spite of the market impediments and weather issues that tried to get in our way.

Now I will turn the call over to Dave for the financial review.

Dave Cone

Thanks, Sheryl, and hello everyone. For the second quarter, net income was 45.4 million and $0.37 in earnings per share. Please note that during the second quarter of last year, we did incur an expense related to the early extinguishment of debt for the redemption of our 2020 notes.

The total amount for that transaction was 33.3 million or 20.7 million on a tax effective basis. When adjusting for that expense, the year-over-year growth in net income was 14% and 12% for EPS.

Home closings gross margin, including capitalized interest, was 18.1% which was ahead of our expectations due to mix and better-than-expected margins on our finished spec inventory that we sold and closed during the quarter.

Relative to the second quarter last year, the year-over-year margin decline was primarily due to higher land residuals while construction costs were neutral. This was partially offset by lower capitalized interest per unit this quarter due to our decision to partially pay down and refinance the remaining balance of our 7.0075% notes to take advantage of lower rates last year.

Moving to mortgage operations, we generated 13.5 million of revenue during the quarter representing a 37% increase over the prior year. Gross profit was 5.3 million while our capture rate increased by 300 basis points year-over-year coming in at 80%.

SG&A as a percentage of home closings revenue came in at 11%. As we have discussed previously, we anticipate a deleveraging SG&A in the first half of the year as we anniversary investments back into the business related to people and systems, as well as integration costs in support of our acquisitions. In fact, the work we are doing to generate strong efficiencies should allow us the opportunity for further leverage for years to come.

Our earnings before income taxes totaled 67.8 million or 7.9% of total revenue. Income taxes totaled 22 million for the quarter, representing an effective rate of 32.6%. During the quarter, we spent 162 million in land purchases and development and we continue to be on track to spend about $1 billion for the year.

The split in land acquisition and development continues to equalize to a range that is closer to 50-50 compared to last year where the split skewed closer to 60-40, with the majority in land acquisition. This shift is a conscious decision as we move to monetize our assets in the maturing cycle.

Our total land bank at the end of Q2 consisted of approximately 43,000 lots owned and controlled. The percentage of lots owned was approximately 73% with the remainder under control. On average, our land bank had a 6.1 years of supply at quarter end based on a trailing 12 months of closings.

Our strong land bank continues to be a strategic advantage for us and one that provides flexibility and how we set our land acquisition strategy. The land market continues to be competitive in most areas from a pricing perspective, but since we are in a position to be selective we can choose the positions that best fit our core-only strategy and where we are paying fair market price for the asset.

This is a direct tie-in to our capital allocation philosophy which is governed by the principle of making investments based on the best use of cash. This philosophy promotes the management of the portfolio as a whole, and it helps us to navigate the volatility that is bound to impact individual markets.

Our investment priorities remain consistent and that we will evaluate ways to invest organically back into our business and then explore growth opportunities through M&A, although that is probably less of a priority now given our recent accomplishments and footprint expansion. We will optimize our debt leverage to keep our balance sheet strong and nimble, and finally we look for ways to return cash to shareholders.

To that point, we have purchased $19.7 million of stock in the second quarter, bringing our total purchase to $24.7 million through June 30. This leaves 10.3 million remaining on our $50 million authorization. We will continue to be opportunistic when trading levels are compelling.

Our investment philosophy will continue to be a critical component in driving short-term performance while securing the long-term health of the overall business and maximizing returns.

We ended the quarter with about 132 million of cash and our net debt to capital ratio was 42.4%. At quarter end, we had outstanding borrowings of 215 million under a $500 million unsecured revolving credit facility. Similar to last quarter, our cash position strengthened as a result of our strategy to manage finished specs to a lower ratio than in the past.

At the beginning of the year, we increased our focus on our finished spec inventory to better optimize our balance sheet. In the past, we had 1 to 1.5 finished specs per community. Our focused effort has reduced our finished spec inventory to less than one per community at the end of the second quarter.

As we have managed this ratio down, we have seen some margin pressure but we have been able to limit the impact to levels that are encouraging relative to what we anticipated.

I want to be clear. Spec inventory remains a key component of our strategy and we continue to manage an average of four to five specs in process per community. What is different is simply our focused discipline to sell and close a home before or very soon after they are complete.

I echo Sheryl's earlier comments and praise for our team members as this renewed focus on specs was a true team effort. Last year, the industry faced significant weather and labor challenges. We faced similar challenges this year but from our vantage point, they appear less severe.

From a homebuilding operations perspective, we feel our production schedules are in good shape and we continue to see sales in line with our expectations. In addition, I want to mention another area of opportunity and timing that have come together to allow us to capitalize on certain market conditions, our long-term strategic assets.

As you know, these land assets represent legacy land that we have held for either appreciation or tax reasons. In some cases, we have begun to bring these assets to market as active communities. However, we still have some legacy positions that we believe are not core to our strategy and we have held them on the books to maximize certain tax benefits.

Last month marked a key date for us as the tax holding period expired, and we are now able to fully utilize these assets without any reduction to our tax benefits. For these land positions, we sought opportunities to monetize the assets through land sales. I'm happy to report that we have contracted and closed on various sales of just over 1,200 lots for 17 million, generating a land margin of 14 million in July.

The level of land sales in the third quarter will be above historical amounts and should not be taken as the new run rate for modeling purposes. As landfills are often opportunistic and difficult to predict, we are not providing guidance on the timing of any additional land sales at this time. These land sales will have a minor impact on the optics of our years of supply, as you will see this decrease in our Q3 report on earnings.

At quarter end, we had an increase of 5.4% in our backlog to 3,642 units with a sales value of 1.8 billion. Our incentive strategy remains relatively stable and we have not relied on it heavily to drive volume. This observation is relevant for our to-be-built business as well as our spec business even in light of our active strategy to manage our completed spec ratio down.

We anticipate incentives to remain stable at the portfolio level with some oscillations at the market level. Our approach to incentives is rooted in our pricing philosophy and our strongly held belief in the quality of our land positions.

Now let's turn to our guidance. For the full year, our guidance remains unchanged with an average community count between 310 and 320, leading to a maintained monthly absorption pace between 2 and 2.2. We anticipate closings growth to be between 10% and 15%. GAAP home closings margin, including capitalized interest, will in the low- to mid-18% range.

Our SG&A as a percentage of homebuilding revenue is expected to be around 10%. Beyond 2016, we remain focused on leveraging SG&A through continued cost control and efficiency. JV income is expected to be between 10 million and 15 million. And we anticipate an effective tax rate between 33% and 35%. Land and development spend is expected to be at or just below $1 billion for the year.

For the third quarter, we anticipate community count to be generally flat sequentially to Q2. Closings are planned to be between 1,700 and 1,800 with GAAP home closings margin, including capitalized interest, expected to be about 18%.

Thanks. And I'll now turn the call back over to Sheryl.

Sheryl Palmer

Thank you, Dave. I’d like to take a moment to touch on a few of our markets across the country and provide some color on what we're saying in the field. I’ll start with Phoenix, which continues to be a very strong market for us. I cannot be more pleased with the quality of our land positions, and even though Phoenix maintains its status as a hot market, it does not mean it comes without its own challenges.

Labor continues to be a constricting factor in that market. Volumes are up year-over-year and certain trades continue to struggle to meet demand. Across the country, we work closely with our divisions to instill a superior plan production cadence in order to assist our trade partners in improving their efficiency. We are optimistic the labor issue will continue to improve, but I would again cautious all to recognize that the changed labor infrastructure must evolve over time for us to see historic housing start levels again.

Our three markets in California are operating in areas where overall demand continues to be healthy, but I would say timing on a number of new community openings has created some volatility in our weekly paces. The California markets also continue to see disproportionate municipality delays and more specifically delays with permitting and utility providers.

We find these challenges to be dramatically consistent across all three markets with varying levels of severity. As Dave mentioned, land continues to be very competitive and our investment strategy remains focused on deal structure and remaining true to our stay core approach.

Moving next to the Central area. We know all too well how the oil industry’s challenges influenced the Houston market. And while we are not out of the woods yet, Houston had exhibited signs of stabilization. The price of oil has rebounded since the mid-20 lows as of late and that has further helped. But I think the bottom start is performing prior to that uptick. It was a function of that market adapting to its new normal.

When looking at traffic, we can see promising trends that suggest stabilization is beginning to take hold. For June, overall market traffic was up more than 8% on a sequential basis and up 15% year-over-year. Taylor Morrison Houston had its strongest sales results during the second quarter of last year. And as we expected, our business was down year-over-year due to that difficult comp. Having said that, I was pleased to see their closing margin was the second highest in the last six quarters just behind our performance in Q1.

Taking a look at Dallas which continues to demonstrate solid market fundamentals and a very healthy supply and demand environment. With the ongoing market success, the developer community in Dallas has been challenged putting lots in front of the local builders, which aided our organic expansion strategy to bring the Taylor Morrison brand to town. We are pleased to see that Taylor Morrison new community and product work is gaining momentum with expected sales to start in Q1 of 2017.

As we have discussed on prior calls, Austin took a bit of a pause in 2015 as the market has produced unsustainable pricing trajectories. We now see some of the fundamentals reverting to levels that are historically much more reasonable.

We can close with Florida, which is a strong market for us containing a high level of product diversity. That diversity ranges from townhome to our traditional master-planned communities to our extremely successful active adult communities.

Our active adult communities have become a real differentiator for us, which given the growth of that penetration in just the last few years is extremely exciting. Overall, the Florida markets are operating at very healthy levels.

We will continue to monitor the fundamentals on a market-by-market basis and make adjustments accordingly as the data dictates. In total, we feel good about the makeup of our portfolio.

Before opening the call to questions, I want to take a moment to share some interesting data around our first-time buyer population. One might think that with our average sales price we would not be the builder of choice for many first-time customers. I'm guessing this thought is even more pronounced when considering first-time millennial buyers and the thought of us playing in that space.

I’m pleased to say that we actually penetrate these segments quite deeply. In fact, we served the first-time buyer in a very meaningful way. What’s more, our first-time buyer is not one-size-fits-all. It's actually a diverse group with various wants and needs. The first-time buyer we typically see will deviate from the stereotypical profile often reported in the media. For us, they represent a financially secure and economically savvy customer group.

Let me dive into some statistics to give you a better appreciation of what we're seeing. As a company, approximately 20% of our buyers fall into this segment. At this group, more than half of them are millennials and about a third of them are Generation X.

Diving even deeper into some of our markets, we see that the first-time millennial buyer isn’t buying a typical entry-level home as previous generations did. They have waited and are prepared and financially equipped to buy the home of their dreams.

Take California for example. In the Bay area, more than a third of our buyers are first-timers. These first-time buyers are buying homes with an AFP of around 685,000 and carrying an annual median income of almost 145,000; circling back to my previous comment of their choice to potentially delay making a home purchase but being financially equipped to do so.

Interestingly enough, our Houston business generates a substantial amount of volume through this customer segment. 35% of our customers in Houston are first-time buyers with about half of those being millennials. And of course, there's Atlanta, a market we entered more than a year ago specifically targeted to serve the affordable first-time buyer and today we see approximately 50% of first-time buyers purchasing in these communities.

Now taking a financing lens to the group, a third of our closings year-to-date processed through our mortgage operations were first-time buyers. These customers bought homes with an AFP of around 370,000, had an average credit score of 720 and a DTI of 36%. We don't anticipate this customer segment slowing down with 33% of our mortgage operations existing backlog being represented by this group.

Because we so adamantly believe in the cycle ahead of us and with the 85 million millennials that will soon be buying homes, it’s critical for us to analyze and serve the vast wants and needs of this diverse group today and well into the future.

With that, I’d like to open the call to questions. Operator, please provide our participations with instructions.

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. [Operator Instructions]. And it looks like we have our first question from Mike Dahl with Credit Suisse.

Anthony Trainor

Hi. Thanks for taking the question. This is Anthony Trainor filling in for Mike this morning. So my first question, I just want to touch based on the positive July trends, so what was the July comparison from last year? And then how did the monthly comparisons in '15 pan out in both August and September?

Sheryl Palmer

Well, good morning. Yes, we were really pleased with our July sales. As you saw, we were 30% up. As we look at the quarter coming into the July, our strongest month was April and then May was good and June decelerated a bit with July up quite significantly. When I look at it year-over-year, the comps are pretty tough in Q3. July was up almost 10% but that’s pretty light compared to the balance of the quarter. August was up year-over-year in '15 26.5% and September 18.5. So I think the message there very similar to our last two quarter calls is we need to be very careful not to expect that run rate as we make it through the quarter. We’re quite delighted with the July sales but just like we said in April, I would not expect the way the comps look going forward that we’re going to maintain that 30% increase quite different.

Anthony Trainor

Great. Thanks for the color, Sheryl. And then just to follow up, I guess, when you look at your strong July trends, how do those trends compare regionally?

Sheryl Palmer

So, if you look around the country and very similar to I think what I said on the call; July, we were up in all regions but the bulk of that came from the East. The Central was up slightly which I’m quite delighted about giving the trend we’ve seen over the last two quarters and the West was up quite nicely as well. So the good news is it wasn’t a market carrying that, it was really good performance across the portfolio.

Anthony Trainor

Great. Thanks.

Sheryl Palmer

Thank you.

Operator

Thank you. Our next question comes from Ivy Zelman with Zelman & Associates.

Ivy Zelman

Hi. Good morning. Thanks for taking my questions. Sheryl, listening to you I appreciate and compliment you guys on the transparency and specifically on guidance. And I think one of the things we all look at is over the last few years, you guys have been very busy strategically, exiting Canada, making pretty significant acquisitions, opportunities in various markets to diversify. And we look at your returns today, which are at about 9% on equity and we’re forecasting something in that, call it, sub-10, right around 10. Unfortunately, at book value I think that the investment community is kind of questioning is where can returns go? How are you going to drive shareholder value and create an acceleration in returns? How are the acquisitions actually performing relative to where you underwrote them? And recognizing you are incrementally buying back stock, I think the way, David, you described that you’ll be opportunistic depending on stock price, at book value, isn't that a great buy? So I know that's a tough one, but a couple in there. And you didn't leave out commentary around some of the markets you acquired company assets in, including Chicago and Atlanta, on your market-to-market commentary. So, maybe combined, how they are performing relative to where you underwrote them? And then talk about returns, please.

Sheryl Palmer

Yes. Dave, maybe you’ll take the return piece and then I’ll touch up on the markets.

Dave Cone

Yes. Ivy, returns is something that we’re very focused on and as you articulated, it’s a bit of a transformation for us between divesting out of Canada and then bringing on the three new businesses. So obviously that’s going to create a little bit of a drag kind of on a year-over-year basis when we look at where we are now to the prior year. And we see some of that again in our SG&A as we delevered there in the first half. So we’re working through really this transformation. And then as we move forward, we feel like we’re going to be able to drive efficiency in the business both on the SG&A line and probably some opportunity on the homebuilding margin side as well. And we’re going to be able to turn the assets maybe a little bit more quickly and that’s going to lead to returns that will be accretive going forward. And that’s really the way we think about it is how do we drive year-over-year accretion. We don’t necessarily have a set target out there. But we know we have the opportunity to increase that each year.

Sheryl Palmer

Yes, I couldn’t agree more, Ivy. As you articulated and I appreciate it, we’ve been very busy the last few years and this has been a long-term plan. And we were focused on one, diversity; two, driving top line growth. And now as Dave said, it’s really about driving bottom line growth, maximizing our pricing power, maintaining the SG&A leverage we’ve always been known for. But most importantly it’s really going to be around operational excellence and making sure our execution is tight to get those turns up that Dave spoke about. To your next question, Ivy, on some of the markets. I tried to provide a high level, but let me focus in on the new acquisitions. I’ll start with Atlanta. I couldn’t be more pleased. As you know, we are just over a year in one business and just a matter of months in the second business, and the two businesses are working very nicely together. We’re serving a very broad range of consumer groups. So with the second acquisition, we’ve really brought in a much more in-town product profile and it’s a very nice complement to the first-time buyer product that we offered all of last year through the JEH acquisition. But the market is holding very nicely. We’re seeing pricing power, we’re seeing volume, we’re seeing better than anticipated margins. I feel good about it, the integration, the synergies really across Georgia. Carolinas, also very strong. What we want there is to get our scale up. They’re still two small businesses for us but we haven’t seen any softening, both very strong markets and as I said, most importantly there it’s about getting the new communities open, it’s our acquisition strategy, it’s really about working to gain scale. The other one would be Chicago and I would tell you that one’s a little softer than we expected and that one is not performing to our underwriting. The others have actually exceeded our expectations. We are doing a lot of work around product repositioning, submarket orientation, production efficiency really across the board. All the reasons we added that to the portfolio we still feel very good about. It’s a very small business for us. It’s our smallest but we think in the years to come, we have some good expectations.

Dave Cone

And then just maybe the last thing you mentioned the share repurchase, Ivy, we did do a little bit more there in the second quarter. We generated more cash than we had originally anticipated through closings. And then we made pretty good movement on our finished spec inventory, which finished spec inventory is also tied to enhancing the returns. But given the discount that we’re trading at it’s really hard to imagine right now a better return on investments and buying back the stock. So we’re going to continue to assess that going forward. It always comes down to putting the capital to work where we believe we’re going to get the longest best returns and we’re going to be opportunistic going forward as we move through the year.

Ivy Zelman

Both answers were very helpful and I realize you guys have a six-year supply of land and look like you’re very well positioned. My only food for thought would be that your stock seems like one of the most attractive buys right here, so I would be aggressive and be buying here. But I’ll let someone --

Sheryl Palmer

We couldn’t agree more with you, Ivy. Thank you.

Ivy Zelman

Okay. Thanks.

Operator

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

Tim Daley

This is actually Tim Daley on for Nishu today. So my first question is just regarding the quote in the press release about the construction costs were neutral to gross margins. I was just wondering if you could break that down for us. So were costs flat year-over-year on a square foot basis or was it that they increased in line with the ASP increase?

Dave Cone

It’s more they increased in line with ASPs. We’re looking at as a percentage of homebuilding revenue. What we saw for the second quarter were direct costs were up a bit in a few things like lumber, OSB, steel, drywall and of course a little bit there on labor as well. We have price locks in place that helps mitigate some of the cost of lumber. But the challenge continues to be on the labor side. We’re seeing some easing in the first half. We should probably expect it to tighten a bit in the second half, especially in a high volume market such as Phoenix, but we’re in better shape from production capacity going forward. Helping us to adjust where we have the limited labor in the markets and that’s more through better planning and coordination with the trades.

Tim Daley

All right, great. Thank you. And then I guess kind of partially a follow on to that. Just curious as to – obviously the specs coming in a bit higher on the gross margin and then your expectations. Just curious about how they were selling, where they were selling and regionally where you saw this gross margin strength? And did this – was that kind of higher than expected gross margins there due to this more moderate pace of construction cost increase?

Dave Cone

Yes, the specs, they’re generally across the board. We have some areas a little bit more concentration. But it really goes back to what our expectation was. Some of these were aged specs. So we are essentially making a guess on what we thought we could sell them for and that was baked into our margin guidance. We ended up selling them for less of an incentive than we had originally thought and that’s where we got a little bit more of the margin pickup than we had contemplated.

Sheryl Palmer

And to Dave’s point, it really was across the portfolio. We had inventory across the portfolio. There was only a couple of markets that we probably were – we had a little higher aged inventory that we would have liked. But I think the margin surprise was across the board.

Tim Daley

Great. Thank you.

Operator

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

Unidentified Analyst

Hi. This is Neil [ph] in for Mike. So I appreciate the color on labor constraints in Phoenix earlier, but I guess in Houston how are you thinking about maybe the potential labor transfer from the oil industry to homebuilding given the E&P cutbacks we’re seeing? Is that a bit slower versus your original expectations or are you seeing some relief?

Sheryl Palmer

Yes, we are seeing some relief but it’s always slower coming back than going out the door. But we are not feeling the type of – the labor crunch for sure that we felt over the last two, three years. The thing that puts it a little out of whack is some of the weather issues we’ve had. But we are rebidding really every trade across the board. The teams have done a very good job about tightening that up. And for the first time in probably three, four years there, we’re actually having trades knocking at the door looking for work.

Dave Cone

And that’s coming through now on the cost side, we’re starting to see those come down.

Unidentified Analyst

That’s great to hear. Are you seeing that across other regions or just mostly concentrated to Houston?

Sheryl Palmer

The relief is really only Houston. I don’t think I – we are competitively bidding and looking at our production cycles, on our planned production to make it easier for the trades, but what we’re really trying to do is offset increases more than seeing any benefit today, to be honest.

Unidentified Analyst

Got you. Okay. That’s all for me. Thanks.

Sheryl Palmer

Thank you.

Operator

Our next question comes from Jack Micenko with SIG.

Jack Micenko

Hi. Good morning. Dave, I hope you could help us understand the 10% G&A number for the year? 1Q and 2Q were both above the prior year. Big dollar increase in G&A year-over-year, obviously some community count growth driving that. But to get to the 10, it looks like you got to be – year-over-year declines at least in the third or fourth quarter to get to that 10% number because you had good deliveries this good quarter and the guidance kind of helped the same on the top line. So help us understand that – do expenses go down on a dollar basis in the back half?

Dave Cone

It’s a good question, Jack. So I guess let’s talk about where we started, right. So we did deleverage in the first half here in the second quarter. That is due to the M&A and integration costs for the new markets as well as the markets. These new markets typically run a little bit higher SG&A. And over time we’re going to work that down. You’ll see a little bit of that kind of in the back half more so in '17. But we also made a lot of investments back into the business in people and systems, which we did last year and a little bit in the first quarter. So what we had said was we’re going to see deleverage in the first half and then I think in the prepared remarks, my comment was somewhat flattish as a percentage in Q3 and then we’re going to see leverage in Q4. Some things to consider too in the back half and maybe looking at Q3, we expect to see some movement in ASP probably up in the mid-single digits. G&A dollars are going to stay relatively flat to Q2. So a combination of those factors will get us to flattish Q3 and some decent leverage in Q4.

Jack Micenko

Okay, that’s helpful. And then 43,000 lots total. On your math, it looks like you own outright 31,000 of those including the 1,200 that you sold. What would you define as the non-core part of the 31 that’s left? Just help us size the embedded opportunity there from future land sales. I know you’re not giving guidance beyond the quarter, but how big is that inventory, would you define as non-core?

Dave Cone

Yes, it’s probably, Jack, about 1,900 lots and I’d tell you they’re on our books for about 6,000 a lot. So from a dollar perspective not much and not significant I wouldn’t say on a lot perspective either.

Sheryl Palmer

And it’s going to take some time.

Dave Cone

Yes. Some of those we’ll look to sell. It can take 12 to 18 months until that all transpires though.

Jack Micenko

Okay. But then similar probably decent margin content I’d assume as well, like the sale that you talked about in July?

Dave Cone

Yes, I’d like to believe they’re going to be decent. I don’t think they’re going to be at the level of July. That’s the point we’re trying to make. That’s a pretty significant margin. We had one piece in particular that resulted in the bulk of the lots sold that were on our books for basically next to nothing. So we got the big margin bump there. I think you’re going to see something a lot more modest going forward.

Jack Micenko

All right, great. Thank you.

Operator

Thank you. Our next question comes from Will Randow with Citigroup.

Will Randow

Hi. Good morning, guys, and thanks for taking my question.

Sheryl Palmer

Good morning.

Will Randow

On the mortgage credit availability front you mentioned for example – if I remember correctly even maybe it would have been Atlanta, average credit score about 720. Can you talk about some of the things that are being done to, if you will, ease up credit availability that you’ve seen over the past, I’ll call it, quarter and going forward?

Sheryl Palmer

Will, we haven’t really seen the number of challenges that people articulate from quarter-to-quarter. Given the quality of our buyer group, we really are able to get these folks through some more mortgage process. When I look at our buyers, even when I look at our first-time buyers, Will, we’re dealing with folks that have an 83% loan to value on average. Like I said, 36%, 37% debt to income, a high percentage of them are millennials but we’re dealing with average household income’s well over 100,000; credit scores ranging from 700 to 760 across our portfolio. So with our mortgage operation they have done just a really stellar job in getting them through the process.

Will Randow

That makes sense. And on an unrelated follow up to Jack’s question, in terms of – when I look at sales commission and marketing costs, is there any room to bring that down or are there natural impediments, if you will, like external brokered commissions that would keep that level elevated over the next year or two?

Sheryl Palmer

I think there’s always opportunities and that’s what I said in the script. We’re always looking for ways to improve. As we’ve opened a pretty high number of new communities this year that certainly has thrown it a little bit more out of whack than you would normally see given just a more steady growth. On the broker side, that’s very market specific. We have some high participation in some markets and certainly with the specs I think we probably saw a little bit more. But we’re going to continue to cooperate with brokers across the portfolio.

Will Randow

All right. Thanks again and congrats on the buyback and progress.

Sheryl Palmer

Thanks so much.

Operator

Thank you. Our next question comes from Stephen East with Wells Fargo [sic] Evercore ISI.

Stephen East

Good morning, Sheryl and Dave.

Sheryl Palmer

Good morning, Stephen.

Stephen East

Sheryl, you mentioned some of the land sales were coming because of the maturation of the cycle and as you look at that and you think about your land buying as you move forward and really your community growth, not looking for a forecast for community growth but looking for as you look out several years, what type of growth would you all be satisfied from the community perspective? And what do you think that sort of implies for land spin moving forward? And if it implies a smaller amount, where do you go beyond share repurchase? Would you prefer to pay down debt or do you get back on the M&A train? How does it look?

Sheryl Palmer

So let me take the first part of it, Dave, and maybe we can then talk through the share side. As you said, Stephen, we’re probably not going to give a whole lot of clear guidance on what the subsequent years look like. What I would tell you is from a strategy standpoint, if you look at the book that we have today, the lots owned are reducing every quarter. We think that’s appropriate given where we are in the cycle. The lots controlled are increasing every quarter. So overall, our overall land position even though you’re seeing it reduce – and if I go back to – gosh, if I go back to the IPO I think what we said three years ago when we were sitting there at 9.5 years of supply is that over the next two to three years you should expect us to average in that six to seven range given that we’re a developer. And obviously the magic is really in the individual market supplies because you have quite a range from very, very low to some of our higher master-planned communities. I think the other thing worth noting is the type of land deals. I’ve mentioned over the last three, four quarters that we’ve really changed the average duration in the land deals we’re acquiring, the number of lots and we’re getting the benefit of our early investments, those large community positions and how that’s continuing to come through the business. So I think that sort of cadence is what you would expect to see. How that translates into community growth, we’ll have to see. I’m fairly certain that you won’t see the types of numbers you’ve seen over the last two, three years averaging 25% to 35% growth. I think you should expect to see us more in line with the competitive set, which I think is generally expected somewhere in the single digits. That’s all dependent on market circumstances, Stephen, and I would say the same about M&A.

Stephen East

Okay, all right. Thanks. And Dave, what would you do – would it be debt pay down or do you think you would move towards more share repurchase?

Dave Cone

We’ll go with our capital allocation philosophy. So obviously with the money we look at reinvesting back in the business organically, we always have a habit of looking at potential M&A. But as you know, market conditions have to be right and that’s obviously not really the case in our opinion right now where we see kind of a spread between buyer and seller. But market will ultimately help drive that. From a debt pay down perspective, honestly, I don’t see us necessarily paying down any of our senior notes, at least any time soon. If you look at the blended average of the rate, it’s 5.5%. They’re all sub-6%, so relatively cheap money. So that would lead us down to returning any excess cash to shareholders. There is opportunity to look at maybe a more sustained buyback program. We’re obviously limited around our float right now. And then of course another opportunity down the road could be dividends.

Stephen East

Okay, I got you.

Dave Cone

But I would just tell you that our goal ultimately Stephen is to return any excess cash to shareholders.

Stephen East

Okay, all right. And then on the gross margin, last quarter in your conference call you thought 2Q would be the low point because of purchase accounting and specs. But now the third quarter is going to shape up similar to the second quarter. What’s changed out there and how permanent do you think that change is?

Dave Cone

Yes, we outperformed our guidance there in the second quarter and that was really more mix based. We just skewed towards some higher margin rate areas than we expected. If you look at – we over-performed on closings and a lot of that was actually in Phoenix and Houston, two of our higher margin markets. If you take Houston as an example, we were probably a bit conservative there given we’ve had issues in the past with weather and utilities. And just one example, we’re able to bring in 30 closings from Q3 in our Riverstone community there in Houston, which have some absolutely great margins. So really what you saw is a little bit of pull forward from Q3, end of Q2 and that’s why we’re holding steady on our annual rate for gross margin.

Stephen East

Okay. Perfect. Thanks a lot.

Operator

Thank you. Our next question comes from Patrick Kealey with FBR & Company.

Patrick Kealey

Hi. Good morning, everyone. Thanks for taking my questions.

Sheryl Palmer

Good morning.

Patrick Kealey

So I wanted to focus first, obviously I appreciated all the detail on your first-time buyers, so when we think about capital allocated to land going forward, is it fair to assume that kind of given those trends there may be more of a focus on this type of buyer when you’re going out and buying land, or should we expect it to be – continuing to be relatively broad based but be kind of advantageous given prices in maybe certain markets?

Sheryl Palmer

Yes, the interesting thing about the first-time buyer is really being able to source the land where your residual will allow you to serve that buyer group, right. We’re always looking for the highest and best use of every land opportunity. And we actually have, we’re very fortunate given the length of our larger master plans that we can be pretty nimble there based on market conditions. The honest answer is we’re going to be very focused on co-locations in certain markets where the supply and demand characteristics make sense. And the first-time buyer continues to be an important part of our overall consumer mix, as does the adult and that first-time move-up buyer. If you look at the overall land bank, you can see that – as we’ve talked about before, maybe you can’t see in great detail, but what we see is that we still have opportunities from building scale in our newer markets. So there’s certainly some great focus there. And those tend to be a little bit more disproportionate to that first-time buyer group.

Patrick Kealey

Okay, great. Thanks. That’s helpful. And then obviously with what you all have been doing, like you said, lot of supply coming down, focus on shorter life products and then obviously this spec strategy, there’s a big focus on balance sheet efficiency here. So understanding there’s a few different moving parts and obviously the power that better inventory turns can have on ROEs, when do you expect kind of all these – these different prongs to really be hitting on all cylinders? And is it something that we can expect in the next, maybe we’ll call it 12 months or is it more from the understanding of, look, it’s a longer term play. But as we sit here and think out 2Q '17, inventory turns are probably better given kind of the initiatives you’ve launched.

Dave Cone

Yes, I would say – it’s a great question. It’s probably something more in line with 12 to 24 months. Some of the things that we’re working on we kind of have to cycle through. So it’s a little bit longer maybe then seeing as end of the year or beginning of next year.

Sheryl Palmer

But the trajectory – we’ll start seeing the trajectory quarter-to-quarter, but Dave’s right. The overall expectation that we have is going to continue to evolve over the next 12 to 24 months.

Dave Cone

Yes. And we’ve actually started to see it quarter-to-quarter now. It’s inching up slowing. But you’re right. Our focus is on really balance sheet management and driving efficiency there to drive the return.

Patrick Kealey

Okay, great. Thanks for the time.

Sheryl Palmer

Thank you.

Operator

Thank you. Our next question comes from Alvaro Lacayo with Gabelli.

Alvaro Lacayo

Good morning.

Sheryl Palmer

Good morning.

Alvaro Lacayo

I wanted to ask a question on absorption. So it looks like the first half of absorptions were down year-on-year and then based on the guidance you’re providing, it looks like you’re expecting at least flat for the second half. Maybe if you could just provide some puts and takes about your expectations, and what gives you conviction around the absorption pace based on the guidance you provided?

Sheryl Palmer

Yes, as you said our first task as we expected was down. Some of that has to do with the comps, specifically in our Central area and a little bit in the West in our California positions and the way we were going in and out of communities. As I look to the second half of the year, I do expect us to be flat. We do have different comps in Q3, as I mentioned at the start of the call or the start of the Q&A. And so I’m not saying it’s an easy comp but I have a great deal of confidence based on what we’re seeing in the markets today that we should be able to, even with the difficult comps, remain in an absorption pace that’s flat. Obviously, we’re also dealing with just normal seasonal paces as we kind of travel through the second half of the year.

Alvaro Lacayo

Okay. And then just a little more color on Phoenix, just on the back of some competitor comments calling Phoenix suffered some weakness. Can you just talk about sort of the performance there on a sequential basis Q2 versus Q1 and then maybe some commentary around pricing power?

Sheryl Palmer

Yes. I heard that. I can’t respond to others. I can only share with you that we have a great market here in Phoenix for us. And this seems to be a consistent theme for us for, I don’t know, at least the last three years where we don’t – we seem to be a little contrarian to what others are articulating. When I look at sequential year-over-year, we’re down. Most of that’s self-inflicted. We just can’t build them this quick. When I look over the last few quarters, really over the last 12 months, we’re basically at or flat. So I continue to credit the teams’ work on the quality of their land positions. I continue to credit the execution they have. We are working hard to deliver the homes. But I couldn’t be more pleased with the sales pace we’re seeing. From a pricing power standpoint, we’ve got a great deal of discipline in our pricing approach on a community-by-community basis. We’re pleased with the pace. We’re pleased with the margins. We don’t want to shut that off. But we don’t seem to be having the same experience others are communicating.

Dave Cone

We’re raising prices, it’s just modest, as Sheryl said, because we’re trying to keep that momentum going. But we actually have communities where we saw people waiting for releases to purchase the home. So it does really get down to our positions and how strong they are in the market.

Sheryl Palmer

In fact, when we look – to Dave’s point, when we look at the portfolio across the market, I would tell you in the quarter we raised prices in a strong majority of our communities.

Alvaro Lacayo

Okay, great. Thanks for the color.

Sheryl Palmer

Thank you.

Operator

Thank you. Our next question comes from Alex Barron with Housing Research.

Alex Barron

Thanks. Good morning.

Sheryl Palmer

Good morning.

Alex Barron

I was hoping you could elaborate a little bit more on the Texas markets and how – the differences you’re seeing between Dallas, Austin, and Houston both in terms of sales rate and incentives and pricing trends? And I’m particularly curious about Houston. Obviously the Central region was down 17%. So I’m wondering if the bulk of that pull down was due to Houston or whether the other markets are down as well.

Sheryl Palmer

Yes, a fair question. The bulk was Houston when I absolutely look at the markets. And hopefully we signal that to the market, because we had just an amazing first half and actually our Taylor Morrison business had a very strong first half and third quarter last year. So we were in unprecedented paces in 2014 and '15. And so I would say that we have moderated to a much more normal place. Austin was also a bit down from a pace and an overall sales – sales based on community count was pretty close to flat but pace was slightly off. And like I said, we are starting to see that come back. Darling Dallas was slightly up. And the Dallas market has been very solid. And we’ve seen paces and pricing move pretty aggressively over the last 18 months or so. I have a little caution there because I think we’ve seen that market move so quickly. And I think even especially at the lower price points, I think pricing has moved up pretty aggressively and I think that’s starting to challenge affordability. I think the entry level is really getting redefined there. It’s almost now 300 plus is where you’re seeing most of the start action in the marketplace and that’s really been forced by land prices. But still a very tight supply and VDL is still way below equilibrium. So I think the market will continue to move along nicely but probably not at the pace that we’ve seen over the last 12 to 18 months.

Alex Barron

Okay. One of your other competitors commented that Dallas I guess – I think they used the word hit a speed bump in June. I was wondering if you guys saw something similar or maybe it was just more particular to them.

Sheryl Palmer

We didn’t hit a speed bump in the second quarter. I think the numbers were quite nice. When I look at the July activity, both traffic and sales I would say hit a speed bump and I think that’s what it is. As we move into August, September we’ll see. And even based on the first week of August and the sales activity they’ve had in the first couple days, I think July was more of an anomaly. But, no, our second quarter was quite strong.

Alex Barron

Okay, great. Thanks a lot.

Sheryl Palmer

Thank you.

Operator

Thank you. It seems we have no further questions at this time. I will now turn the call over to Sheryl Palmer for closing remarks.

Sheryl Palmer

Thank you everyone for joining us while we share our second quarter results, I appreciate it. Have a great day.

Operator

Thank you. Ladies and gentlemen, this concludes today’s conference. We thank you for participating and you may now disconnect.

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