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Executives

Drew Mackintosh - VP, IR

Larry Nicholson - CEO

Gordon Milne - EVP & CFO

Dave Fristoe - SVP & Controller

Analysts

Michael Rehaut - JPMorgan

Alan Ratner - Zelman & Associates

Adam Rudiger - Wells Fargo Securities

Joel Locker - FTN Securities

Anto Savarirajan - Goldman Sachs

Megan McGrath - MKM Partners

David Oppenheim - Credit Suisse

Nishu Sood - Deutsche Bank

David Goldberg - UBS

Alex Barron - Housing Research Center

Ken Zener - Key Bank

Paul Robusky - ISI Group

Buck Horne - Raymond James

Joshua Pollard - Goldman Sachs

The Ryland Group Inc., (RYL) Q2 2012 Earnings Call July 26, 2012 12:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the Ryland Group Second Quarter Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. (Operator Instructions). As a reminder, today’s call is being recorded.

I would now like to turn the conference over to your host Mr. Drew Mackintosh. You may begin.

Drew Mackintosh

Thank you. Good morning and welcome to Ryland’s second quarter 2012 earnings call. Today’s call is being transmitted live over the Internet and can be accessed through Ryland’s Investor Relation section of the website at www.ryland.com.

In a moment I’ll be turning over the conference call to Larry Nicholson, Ryland’s Chief Executive Officer. Also joining us today are Gordon Milne, Executive Vice President and Chief Financial Officer; and Dave Fristoe, Senior Vice President and Controller.

Before we begin, please be aware certain statements in this conference call are forward-looking statements based on assumptions and uncertainties that include general economic, business and competitive factors as well as the factors set forth in the company’s press release. These factors and others may cause actual results to differ from the statements made in this conference call.

With that out of the way, I’ll now turn the call over to Larry Nicholson.

Larry Nicholson

Thanks Drew. Good morning and thank you for joining us today as we go over our results for the second quarter of 2012. yesterday afternoon we reported fully diluted earnings of $0.14 for the period ending June 30 making it the first time in six years that we reported a profit in the second quarter.

Given the operating results we posted this period we are excited about what lies ahead. Our sales pace accelerated in many of our markets resulting in a net order growth of 42%, homes in backlog rose by 47% giving us the confidence in the revenue and the closing results that we will report in the third and fourth quarter of this year.

With a view to the future of our company our land activity picked up significantly in the quarter, most notably we announced the purchase of the assets that were operations of Timberstone Homes in Charlotte and Raleigh.

Our cost of capital declined, thanks to a successful placement of $225 million in convertible senior notes. These accomplishments combined with the improvements we've seen in the broader housing market lay the foundation for better operizational results in the second half of 2012.

We continue to execute on our business model and emphasize return on capital, geographic diversity and a decentralized approach. We believe that this strategy will lead to above average returns for our company and our shareholders as the housing emerges from one of the worst downturns in history. We are excited about the direction in which the housing market and Ryland are headed.

With that here are the details for the quarter.

Revenues from Homebuilding segment came in at $285 million, a 39% increase over the second quarter of 2011. Our north, south and Texas regions each contributed around $80 million in revenues to the total while the west generated a little over $40 million. The west contribution to both revenues and profits should rise going forward, thanks to our reinvestment in the region and the recovery of several of the western markets have experienced over the last few months.

Unit closings increased 36% in the quarter to a total of 1115, and the average closing price grew 2.4% to $254,000. average homebuilding gross margins expanded 180 basis points to 18.7%, thanks primarily to the benefit of higher closing volume on the fixed portion of our cost of sales and the emergence of better pricing power in several markets. Sales incentives as a percent of homebuilding revenues were 10.4% compared to 11.6% for the same period in 2011.

We continue to raise prices and scale back incentives in communities with a sales base and traffic levels allow us to do so. However, the appraisal process oftentimes inhibits our ability to raise them as aggressively as we would like.

Revenue growth once again outpaced SG&A leading to another reduction in SG&A as a percent of sale ratio. Including corporate expense SG&A declined 140 basis points compared to last year coming in 16.3% of revenues. We expect that number to decline further as our closing volumes increase.

Net home sales for the quarter were 1398 homes, a 42% increase from the second quarter of 2011. We experienced robust sales growth in each of our regions with particularly strong growth in the west where orders rose 242%. Sales growth in the west region was added by a 28% increase in average community count as compared to last year. Excluding the west, sales in the remaining three regions averaged 26% over last year.

An overall improvement in the absorption rate to 2.2 per month was the main factor behind the pickup in sales as active community account only grew by 4%. Divisions that experienced above average absorption rates during the quarter were Las Vegas, Southern California, Washington DC, and the twin cities. The cancellation rate remained steady at 20% slightly lower than the 21% for the same period last year.

We entered the third quarter with 2277 homes in backlog, our highest level in three years. On a dollar basis, backlog grew by 55%, thanks to an average prices of $270,000 on homes we sold but not yet delivered.

Increased sales contributions from higher priced markets like Southern California, Denver and Washington DC were the main drivers behind the higher ASP and backlog.

Turning to the balance sheet, we ended the quarter with $733 million in cash, $1.047 billion of homebuilding debt, and $455 million on equity for a net debt to capital ratio of 41%. These figures reflect the $225 million convertible senior note offering we executed in May. But do not include the subsequent redemption of the 6-7/8 senior notes due in 2013, which we completed earlier this month.

This redemption reduced cash by a $177 million and brought our homebuilding debt down to $880 million. The net impact of the combined transaction resulted in a decline in our average cost of debt from 6.9% to 5.6%, a reduction in our annual interest cost by $7.8 million, and an increase in our weighted average debt maturity from 4.8 years to 5.8 years.

Another transaction is not reflected in our financial statements is our recently completed acquisition of Timberstone Homes, which added over 1100 lot spread over 20 active communities in the Charlotte and Raleigh markets. This acquisitions make Raleigh on a top five builder in the improving Charlotte market, giving our local division a critical mass to better leverage overhead expenses and source new land deals. It also establishes our presence in Raleigh, a market we have been eager to penetrate for sometime now. Another benefit of this acquisition was the addition of 145 units to backlog, the majority of which will close by the end of the year.

We are excited about the addition of Timberstone team to Ryland and look forward to a seamless and successful transition as one company going forward.

Excluding Timberstone, we spent $69 million in land acquisition and $28 million on site development in the second quarter, bringing our year-to-date totals to $166 million for land acquisition and $52 million for site development. Our lot account at the end of the period stood at 25,449 lots with a breakdown of 15,244 owned and 10,205 auctioned. We continue to make progress towards our desired split of 50% owned and 50% auctioned.

We made considerable strides with respect to our departure from Dallas and Jacksonville in the quarter, reducing our assets in those markets to $16 million. These asset sales generated a net profit of $223,000 for the company. Following the completion of a deal in Dallas that closed last week, we have just $4 million in unsold inventory remaining in those two markets.

Turning now to our financial services segment, we recorded a pretax gain of $2.9 million in the quarter compared to $2 million in a year ago period. Higher mortgage origination volumes and gains associated with our hedging activity accounted for the increase in profit. 42% of our buyers used the prime loan, 54% opted for government loan, and the remaining 4% qualified for USDA loan.

The average FICO score for the buyers that used our mortgage company was 727 and the average loan to value was 90%.

The mortgage qualification process continues to be a difficult path to navigate and we are fortunate to have a team of great mortgage professionals at Ryland to assist our homebuyers.

In conclusion, while we are pleased with the profit we generated in the second quarter, we are even more excited about our results with the remainder of 2012. The 55% increase in backlog value will lead to higher revenues increase leverage of our fix cost in future quarters. The recent convertible secured note transaction lowers our interest expense and bolsters our cost of capital advantage over many of our competitors.

The increase of land acquisition activity gives us the communities we need to hit the growth targets we have set for the company. These financial and operational highlights did not have nearly the impact on this quarter's earnings as they will in future quarters. We look forward to reaping the benefit from these achievements in the second half of 2012 and beyond.

The goals for the remainder of this year have not changed. Grow community count excess of 10%, increase profit margins with a combination of higher volume, gradual price increases and cost controls and stay active in the land market. We demonstrated an ability to achieve these goals in the first and the second quarters of 2012 and we expect this to continue as we finish out the year.

Finally, I would like to thank all of our employees for another great quarter. After years of declining home sales losses and layoffs, it is nice to see things to start to go the other way. While some of the premiere results can be attributed to overall rebound in the market, the most significant factor our recent success is the hard work and determination exhibited by our employees. You are the engine that drives this organization forward and I am grateful for your effort.

That concludes our prepared remarks and we will be now happy to take questions.

Question-and-Answer Session

Operator

(Operator Instructions).

Our first question comes from Michael Rehaut of JPMorgan. Your line is open.

Michael Rehaut - JPMorgan

Yeah, first question on the gross margins. We have a couple of company report and all have shown good improvement sequentially. At the same time, the pricing is continues to improve. So what are your thoughts in the back half in terms of not only perhaps holding on to the gains that you have seen already but further expansion as we get into 3Q and 4Q?

Larry Nicholson

Well, I think we look at our backlog like we see continued improvement. We do continue to see pricing power in markets, so that is a good sign. So, I think we feel pretty positive about going forward. I don’t know if we really want to give guidance as to margin growth but I mean I think we will say that we should see sequential improvement quarter-by-quarter.

Michael Rehaut - JPMorgan

Great. And also in terms of SG&A, it's a little bit higher than we were looking for, should we expect may be the variable rate to be above what they were it would be if you just truly modeled commissions due to existing in a new communities kind of building up the infrastructure a little bit?

Larry Nicholson

You know I think what we're looking as this is second half of the year, we're going to open more communities I think in the third quarter than we opened in the first six months and then even more in the fourth quarter. So, we got a lot of communities coming over the ground rate now that cost as many SG&A in the second quarter that going to show the benefits in the third and fourth quarter. So, I think second half for openings.

Gordon Milne

We also have $1 million of drag as you see in SG&A in the quarter related to the acquisition, the Timberstone acquisition and feasibility costs write-ups.

Michael Rehaut - JPMorgan

Okay. So, one last quick one if I could, just on that in terms of the opening of the communities, any thoughts around community growth in 2013, should we assume that that the communities overall should continue to grow I mean now without asking for specific growth guidance, but should the trend continue to be in an upward fashion?

Gordon Milne

Absolutely.

Operator

Thank you. Our next question comes from Alan Ratner from Zelman & Associates. Your line is open.

Alan Ratner - Zelman & Associates

Hey guys congratulation on the good quarter. I think were you just added in that the data point on there is about a $1 million of your cost associated with the acquisition in the quarter. I just wanted to clarify that; that flowed through the corporate line, which was about $7.1 million?

Gordon Milne

No that came through SG&A and it was only about $0.5 million related to the acquisition, there is another $350 million related to feasibility and then some other costs.

Alan Ratner - Zelman & Associates

Okay. So if I look at the corporate line then, there is a whole bit of a sequential increase there, I think it had been closer to $5 million you said in the quarter end and you were north of $7 million this quarter. So can you talk about what drove that and kind of where we should think about that going forward? I know you mentioned that I think it was may be some compensation accruals in the press release about that. You just have been fair little bit more granularity there?

Gordon Milne

Well that was primary the results of the increase in the stock price exchange. So I mean.

Alan Ratner - Zelman & Associates

Okay.

Gordon Milne

It's hard to predict where the stock will go, but probably don't expect low. Yeah, you can get that as well if we can.

Alan Ratner - Zelman & Associates

Got it. Okay. Second, just on the Timberstone acquisition, should we expect any and I guess to drag on margins resulting from I guess purchase accounting for homes that are in backlog and you're going to go with any over the next few quarters?

Larry Nicholson

No.

Gordon Milne

No.

Alan Ratner - Zelman & Associates

Okay. Since that was a short and sweet answer there, may be just that talk a little bit about the decision to pursue the acquisition around in Charlotte versus kind of a company grow organically there and that's something you would think about pursuing other markets down at this point or whether to go as more organic?

Gordon Milne

Well. I think what we saw Alan was an opportunity to jump start our business in Charlotte obviously has the downtown occurred we shrunk that business to a very small size. We were rebuild and it saw the opportunity to pickup some communities who could jump start it and also help us in Raleigh where we would get an open start. They had immediately accretive to us. So, we thought it was a positive transaction and we will continue to look at other opportunities such as that.

Operator

Thank you. Our next question comes from Adam Rudiger of Wells Fargo Securities. Your line is open.

Adam Rudiger - Wells Fargo Securities

My first question Larry is on capital allocation and then how you think about the company going forward. I think historically Ryland to the company correct me if I'm wrong, you didn't want to allocate more than 10% capital growth in any specific market and some of the recent things you've been doing makes me, so you're interested in kind of concentrating a bit more in few markets. I was wondering if as you think about the future of the company what the underline principles are in terms of diversity and capital allocation?

Larry Nicholson

Well, I think its still principle of the company. I think there is early market I think we've got one at 10%, whether so it's Washington D.C. and it's a market we got a lot of communities could open their share. Other than that market we're not very far over with 10% in that market I think the goal is still keeping all diversified around the countries there. So, I don't think we really changed the kind of one of the principles of our company to stay diversified around the country.

Adam Rudiger - Wells Fargo Securities

Then secondly can you just explain I think you had a really nice sequential increase in revenues, your gross margins have been pretty stable for three quarters in a row. Can you address the operating leverage, why we didn't see a lot more this quarter?

Gordon Milne

Well, I think as I mentioned earlier we've got 80 communities we're planned on opening in the second half of the year. So, we got a lot of things coming on and it cost us some money to get those ready. They don't they're not producing revenues and income, but they're getting ready for it. But that's a big number of communities coming out of the ground in the second half, that doesn't include the Timberstone. So, we're pretty excited about that going forward, it did cost us a little bit. What we see with the backlog we've got SG&A in third and fourth quarters should see some pretty significant improvement in those margins going forward on SG&A.

Adam Rudiger - Wells Fargo Securities

Are any of those costs, I was thinking more about the gross margins, are any of those costs associated with new communities in cost of goods this quarter?

Gordon Milne

Well some SG&A in the quarter.

Adam Rudiger - Wells Fargo Securities

Right. I'm sure its why given this the strong sequential increase in revenues that did not see more of a gross margin expansion sequentially?

Gordon Milne

Well, we had pretty continuous increase in gross margins. I think our margin is compared pretty well, the other builders margins, so I mean and we said we'd see more improvement as the quarters go on. But I -- we are not unhappy with where our margins are at.

Operator

Our next question comes from (inaudible) Citi. Your line is open.

Unidentified Analyst

Just had a couple questions here. The first one is, in terms of the breakdown of lots for Timberstone or between Charlotte and Raleigh. And then, I think about that from my total perspective of Ryland and including Timberstone?

Larry Nicholson

And I do not know if we have that right here, we can get it for you but. I do not known if we breakdown (inaudible).

Gordon Milne

They are mainly in --

Larry Nicholson

Mostly, the majority of more Raleigh, there was I want to say we picked up five communities in Raleigh, so I would say we heavily weighted towards Charlotte. But we will get you the number.

Unidentified Analyst

Okay. Thank you. And then, in terms of the attractiveness of that market, can you talk about the drivers that made you one enter the market. And possibly, are you back doing any price appreciation kind of in your purchased price for that acquisition?

Larry Nicholson

Well, I think it is a market that A, we are in, years ago we exited it. We were about to go back into that market right before there when all the wheels came off. So, it is always been a market that has had good economic growth, stable employment, high median income, lot of positive things and they also exist there today. So, which is the market that we really felt that we needed to be in for the long-term.

Charlotte, on the other hand, has had top sliding for the last couple of years obviously, with financial community there. And I think that long-term we still believe that that's a good community and that we did not put any appreciation into our models. We run it the same way we run our land acquisition process, so there is no appreciation. And felt like it was a great opportunity for us to contribute positively as I said right away. And we picked up the backlog units and so we think it is a really good opportunity for us.

Unidentified Analyst

And then I figure you looked at the lots just kind of on the contrary for Jacksonville. It seems like that market is coming back, does it still makes sense to exit?

Larry Nicholson

Yes.

Unidentified Analyst

Okay.

Larry Nicholson

There is a better use of our capital. So, I mean I guess what I say at this point is we have exited the market if I have to make a decision for we're putting capital there and put capital Raleigh, I'd rather put it in Raleigh. And there is probably a few other markets that we are looking into right now that are stronger than Jacksonville.

Operator

Our next question comes from Joel Locker of FTN Securities. Your line is open.

Joel Locker - FTN Securities

Hi, guys. Just what is it, just your community account, how many did you open in the second quarter actually?

Gordon Milne

Hang on a second we're digging.

Joel Locker - FTN Securities

Sure. And then how many the Timberstone community -- what was that actually you said five in Raleigh and how in Charlotte?

Gordon Milne

It's 20 total.

Joel Locker - FTN Securities

20 total in the second quarter?

Gordon Milne

Yes, actually it was third quarter.

Larry Nicholson

That was 2nd of July closed.

Joel Locker - FTN Securities

Right, right, but I'm saying you opened, you said there was 20 total communities go along with Timberstone?

Larry Nicholson

No, it was 20 what we picked up from Timberstone.

Joel Locker - FTN Securities

Right, and then what about anything or just obviously you're going to buy more land for 2013 in communities, but how many communities are slated to fall apart for token in 2013?

Larry Nicholson

We don't really give that guidance. We haven't given that guidance.

Gordon Milne

To answer your previous question we opened 20 and closed 20 during the quarter.

Joel Locker - FTN Securities

20 and 20, all right, and then just on your lot breakdown you said 50,200 owned roughly how many of those are finished?

Gordon Milne

I'd say 65, 70% of them.

Joel Locker - FTN Securities

65%, 70%. All right, thanks a lot guys.

Operator

The next question comes from Joshua Pollard of Goldman Sachs. Your line is open.

Anto Savarirajan - Goldman Sachs

This is Anto Savarirajan filling in for Josh. Can you split up your state and federal DTAs for us and talk about the potential for DTAs coming back faster than certain states?

Larry Nicholson

All I can say is it was a novel approach. I think the first one we've seen that Americas doing this morning and until now we thought it all moved at once both state and federal. So we're not going to give out state by state DTAs I know where we're in the 15 or 20 states so, but it's an interesting concept, I don't think I've seen it before and looking for it.

Anto Savarirajan - Goldman Sachs

Can you split out -- split for us how much is state and how much is federal?

Larry Nicholson

No, I don't have those numbers. Each would have one number on our books; we haven't split it out everything.

Gordon Milne

We haven't, if we were not able to.

Larry Nicholson

Yeah.

Gordon Milne

Okay.

Anto Savarirajan - Goldman Sachs

Understood. Earlier this year the view was that your growth would predominantly come from existing markets and new markets won't -- will only be a smaller piece, does that still hold given the pace of what we've seen with builders, orders, and how do you fit that into your '13 and '14 growth strategies?

Gordon Milne

Well, we think we're in most of the quality markets in the country and then with the addition of Raleigh. So we think we're well positioned for growth and really try and deleverage the overhead in existing divisions and think there is opportunity to take market share in those existing divisions. Well at the same time researching other markets but our big interest has grown, the existing operations we have.

Larry Nicholson

Yeah. Community account is going to grow we think significantly and then second those options were still just 2.2 a month. In a normal it would be closer to 3 or 4, which would give us more significant growth. So I think growth is going to come through the accounts and not just on to going to do markets.

Operator

Our next question comes from Megan McGrath of MKM Partners. Your line is open.

Megan McGrath - MKM Partners

Thanks. Just wanted to ask a little bit about the financing market as regards cancellation rate, obviously the market feels a lot better now than it did a year ago but your cancellation rate is pretty much flat from last year, is that just a sign to us that the financing market is still about the same as it was a year ago or was than anything else going out there?

Gordon Milne

Yeah, I mean, I think that historically we've always been around 20%. I think that it's a function of; we do a lot on the front end to qualify people to make sure that we're writing quality contracts, people who close houses and then obviously always have some issues whether it's personal, financial, through the process. So we've a pretty rigorous upfront process but we're comfortable with cancellation rate of 20%.

Megan McGrath - MKM Partners

Okay. And then for your community count say 80 that you're opening in the back half of this year are they mostly still coming in the West where you're seeing all that growth or how do they look geographically?

Gordon Milne

I'd say we have a large growth in the Mid-Atlantic and DC markets, Southern California. Florida will open a fair amount of communities in the second half of the year so but the higher priced markets are definitely having growth. Capital that we invested in Washington D.C., a year 18 months ago, bringing those lots on. So we're excited about that and Southern California would be getting into a two or three new communities that are very well positioned and should do very well. So we see lots of positive things in those markets, but really across the board everybody is opening communities and are having good results and we're excited for that.

Operator

Thank you. Our next question comes from David Oppenheim of Credit Suisse. Your line is open.

David Oppenheim - Credit Suisse

Was wondering if you could also you doesn't give a perspective in terms of trends during the quarter and talk about some of the monthly orders, any chance you could do that now?

Gordon Milne

Sure. April was 441, May was 471, and June was 503. So sequentially every month got a little better and July has been positive.

David Oppenheim - Credit Suisse

Positive in terms of just up year-over-year, any more color there?

Larry Nicholson

All of the above. Yeah, its been good. Obviously, we have Timberstone that will contribute to that, but we continue to see good activity in the sales centers. We would expect it to be up over the last year by a decent margin.

David Oppenheim - Credit Suisse

Okay. And then in terms of the community account growth much of it in the west and during the growth, as you think about the remainder of the year how much -- is there more of a focus on bringing on communities there? How should we think about that geographically?

Gordon Milne

Yeah, I think its more spread out in the second half of the year. Like Larry said, a lot in Washington area, probably our one of our big areas of increased community count, Washington DC, but the churn is spread out right around the company.

Operator

Thank you. Our next question comes from Nishu Sood of Deutsche Bank. Your line is open.

Nishu Sood - Deutsche Bank

How much did you probably spend on the Timberstone acquisition?

Gordon Milne

(inaudible) line.

Nishu Sood - Deutsche Bank

About $35 million, and so even if I take that into account, your cash balance as a percent of your overall assets is still one of the highest in the industry. So, clearly you've been putting it to work over the past year or 18 months or so. But does that imply kind of above group average growth trend for the next several years or what's your view on that?

Larry Nicholson

I hope you are right.

Gordon Milne

The sooner we get the capital we'll be able to grow fast. So, the other one was in the second quarter and that was before we did Timberstone so, and we're see good activity out in the field finding land. So, I mean, capital is not hurting us on the growth side.

Nishu Sood - Deutsche Bank

With that, and obviously as you spend cash balance down your gross debt to capital would rise from -- and so your net debt to capital will rise from that 41%. Was that part of your thinking behind doing a convert issuance as these things are good, you put the cash balance to work and then it will lower your debt to capital obviously, if that converts. Was that part of that thinking?

Gordon Milne

Yeah, it'd be part of the thinking. I mean, part of it was we could save a lot of money over the next six, seven years if (inaudible) converts out I think somewhere between $6 million and $7 million in interest but that’s a big number. And so its there but there's also reason to do a convert I think that that was one of them.

Operator

Our next question comes from the line of David Goldberg of UBS. Your line is open.

David Goldberg - UBS

My first question was, and Gordon, you mentioned before that the kind of 2.2 sales per community and kind of moving back to what's 3 to 4 and what I'm trying to get an idea is how you guys benchmark your sales pace against the rest of the market. And what I'm really trying to get at is there any sense that you guys are maybe slowing down sales, trying to recapture a little bit of margin, maybe think the market is getting better and so, you slow things down a little bit you kind of meter out your sales pace, or is it really push to get back that 3 or 4?

Larry Nicholson

Well, I think it’s a tough balance, Dave. I think what you try to do is raise prices as much as you can without losing velocity because once you lose velocity in a community its tough to get it back so. But I think we're trying to do both, we're trying to maximize. But the other you have to consider is on lots that cannot be replaced in the current market you have to maximize value. So, you make slow absorptions now to really maximize the dollar amount because in a lot of markets, as I'm sure you've heard from all the other builders, finished lots are getting a little bit tougher to find, so you want to make sure you want to maximize those. But it’s a very fine line to make sure you can keep absorptions going and maximize pricing.

David Goldberg - UBS

And then just as a follow up question, sorry -- as a follow up question, actually looking into the land market, looking to buy more land and as you kind of consider the future community account growth, how much development work are you having to do and what does that do the timeline in terms of bringing new communities online? In other words, if you want to design land that you want to bring on in '14, are you having to buy maybe early next year because there is more development work and so, you need to get into process earlier?

Larry Nicholson

Well, market by market is a little bit different. Obviously, our first focus is to buy finished lots. Where we don’t buy finished lots, we want to buy fully entitled shovel-ready projects so that we can move them forward timely and get them in the ground. But there are some markets and then DC is a good example where we made a fairly sizable capital investment there, here 18 months ago and those communities are just coming to light today. So, but that’s the way the market works and we got to do what we have to do to make sure that we're competitive in the market and we have enough communities open.

Operator

Our next question comes from Alex Barron of Housing Research Center. Your line is open.

Alex Barron - Housing Research Center

I know you kind of mentioned you see margins improving in the back half, but I kind of want to see if you can add a little bit more commentary the balance between your ability to raise and how much of price increases are going to cover cost increases in either labor, land or whatever?

Larry Nicholson

Well, I think we've -- obviously there has been some pressure on the cost side and we've been more than able to cover that with price increases and expect to be able to continue that. As far as margin improvement we really done give guidance but what I would tell you is we continue obviously to get out of legacy communities and get into newer communities where the margins are higher, the absorptions are better, so all that has a very positive impact on margins, so that is the real thing. And as Gordon said opened 80 communities new communities in second half of year will definitely impact that and what we see in backlog is defiantly positive.

Alex Barron - Housing Research Center

Okay. I guess I did not intend this my second question, but on the 80 that is a gross number, right that is not a net number?

Larry Nicholson

Yeah, we gave guidance, so like 10% to 20% will be for the year we will be at the higher end of that range.

Alex Barron - Housing Research Center

Okay. Now, as far as you guys find lands I know obviously, every market is a little different. And maybe Phoenix is one other more crazier markets out there, but are you guys seeing significant land appreciation or is it just in a few markets like that and if so, are you having the build price appreciation into your proforma to be able to justify buying stuff?

Alex Barron - Housing Research Center

Well, as always when the market starts to improve to develop first thing there is lots worth more but we work -- we use current economics when we run our model, so there is a price appreciation in the model. And there is some pressure in certain markets and we are not actively in Phoenix, so I cannot speak to Phoenix. But there are other markets that are pretty aggressive right now. But there is still opportunities based on what the absorptions are today and the current market pricing, we can get deals done.

Operator

Thank you. Our next question comes from Ken Zener of Key Bank. Your line is open.

Ken Zener - Key Bank

For the SG&A I wonder if you can help us map this out or understand it a little more. Given that you are opening up these 80, the gross communities, I realize that some of that will be netted against ones that are closing. And is that reasonable by saying that maybe it is a 150 or 75,000 annualized per community which would 80 comes at and it is basically $14 million on the gross number but let's say $7 million and half of those the 80 so and the closed down community. Is that already in the SG&A base right now or is that fixed SG&A for the construction managers and the sales person already in the incremental, is that already in the SG&A?

Gordon Milne

Well, some of it is and some of it is not and we probably would not go out and confirm your numbers, but we certainly have not started incurring those costs. But I would not say that they are all in there yet, we have impairments to go but we obviously have to get a start on some of these communities and get some people in place.

Ken Zener - Key Bank

Right and some area already added, okay. And then, I guess on the gross margin maybe this is if I could frame it a little differently, and it is obviously, a number that’s inline with your peers, but if I look at the gross margin I think you guys in past have talked about maybe $7 million or $8 million of fixed cost and there it seems to add based on volume maybe a 100 basis points, I think your incentives were down maybe 50 bps sequentially. So, is it that you guys just see higher direct materials, labor or is it more just really a matter of community mix?

Gordon Milne

Primarily, mix. We are not seeing higher direct cost, we are actually lower.

Larry Nicholson

Less percentage.

Gordon Milne

Less percentage higher dollar.

Operator

Thank you. Our next question comes from Paul Robusky of ISI Group. Your line is open.

Paul Robusky - ISI Group

Yeah, I was wondering on the SG&A, outside of the community opening cost and the Timberstone if you had any opportunity for further reduction there?

Gordon Milne

I am sorry, can you repeat that Paul?

Paul Robusky - ISI Group

Yeah, on the SG&A, outside of your community opening cost and which is spent for Timberstone, if you have any further reductions available at that line?

Gordon Milne

Well, the reductions are more coming from volume increases in the second half of the year. The bigger backlog we have more closings and we hope a lot of our SG&A is fixed so, (inaudible).

Paul Robusky - ISI Group

Compensation (inaudible)?

Larry Nicholson

Yeah, and there is a little bit of severance burn off in there are too little go away.

Gordon Milne

In other words, in the first half we had severance and some lingering so you will see some improvement as a result of that.

Paul Robusky - ISI Group

Okay. And then, we are getting some mixed messages on labor shortages, I was wondering if you could add any color on what you are seeing?

Larry Nicholson

Well, I mean if it started to be an issue in some market it is mostly with framers right now. So, really what it is doing is it is prolong in cycle time here right now. But we are getting our houses built. And I think we all anticipated at some point there will be a labor issue just because of you know lot of people left the industry and so, usually labor will lag a little bit. So, I think as we get through this cycle where with the height of the construction process in the summer it will start to tail off, it will give us some time to re-grow for next year to make sure we have an up trades in place.

Operator

Thank you. Our next question comes from Buck Horne of Raymond James. Your line is open.

Buck Horne - Raymond James

Just quick housekeeping one, do you have the spec count in quarter end both finished in other construction. And also, just you mentioned how the appraisal process I think in your opening comments seems to be limiting your ability to get prices increases in certain areas. I am just wondering if you could elaborate on what you are seeing with the appraisal process out there?

Larry Nicholson

Okay. Spec count total was 590 at the end of the quarter, a 180 finished, 410 unfinished. I think what it does is I think there is places we feel like we can probably raise price even more than we have, but we cannot be the appraisal because it is just moving faster than the appraiser willing to move it. So, its not every market but it is some markets. It's not as big of a problem as it probably was two quarters ago, but it is a problem.

Buck Horne - Raymond James

And one last one. I was wondering if you can talk about maybe if you've had any mix shift between your entry level homes and your move up homes and even quantify kind of what you're seeing there in terms of what product you're getting more incremental strength with and what you think is driving that?

Larry Nicholson

I think the move up market, as we said, probably last quarters has definitely improved. With the ability of the resale market, its gotten better in most cities so people can resell their homes, and they've been interested in new homes. So, I would say the move up market and the move down market is still real strong. The entry level market is still a challenge because there the biggest issue to get financed. But definitely I mean most of the lots we've buying them in first move up.

Buck Horne - Raymond James

And what percentage of your closings would you say is entry level product right now?

Larry Nicholson

Probably 30%.

Operator

Our next question comes from Joshua Pollard of Goldman Sachs. Your line is open.

Joshua Pollard - Goldman Sachs

I just wanted to ask one quick follow up. I'm trying to understand what normal seasonality means for your order trends as we head into the back half of the year. Could you give a sense of what percentage your net absorption rates typically go down in a normal third quarter and again a normal fourth quarter? And I'm looking at both of those on a quarter on quarter basis.

Larry Nicholson

I think we gave up on normal.

Joshua Pollard - Goldman Sachs

I hear you.

Larry Nicholson

What I would tell you is the second half of last year was a little better than we anticipated. I don’t think we had normal seasonality as much as we would in the past, but we would expect absorptions and (inaudible) numbers I'm not going to say there -- if you were three in the second quarter you might go to 2.5, 2.6 maybe in the third quarter and down a little bit in the fourth quarter.

Operator

Our next question comes from the line of Alan Ratner - Zelman & Associates. Your line is open.

Alan Ratner - Zelman & Associates

Larry, I was hoping to get your thoughts on the DC market since that’s one where you admittedly are taking a pretty big bet, and sounds like you have some new product online there. And NVR is obviously the big gorilla in that market, reported some disappointing results in the past quarter and they're stating it could be some company specific issues going on there, but just curious if you're any signs of slowing in DC maybe ahead of the upcoming and if you're at all concerned about that bringing this level of product online at this point of the year?

Larry Nicholson

Well, I think DC has slowed a little bit but I still think it is a robust market. I think that it's over-performed probably last year a little bit. Real comfortable with the positions we are bringing on, the locations, the product type, the pricing. They are great locations in areas where there is not a lot of demand. So I still feel real good about the market.

We always wonder what will happen in election year based on what we see the year after election years all has the positive impact on permits and especially in our market. So, we will take the chance if that's the case, but we think we are well positioned there and we will do fine.

Operator

Thank you. Our next question comes from Alex Barron - Housing Research Center. Your line is open.

Alex Barron - Housing Research Center

Yeah, thanks. I know it's probably early given that you guys just posted your first quarter at the EPS level profitability, but wondering if you think it's reasonable to expect you will get the DTA back in 2013?

Gordon Milne

Yes, we would expect to get back in 2013.

Operator

We have a follow up question from Megan McGrath, MKM Partners. Your line is open.

Megan McGrath - MKM Partners

Hi, thanks. Just wanted to get your update about around interest expense, I think about a year you were expecting it to taper off may a little bit more than a had as your inventory grew. So, what are your expectations now in terms of interest expense?

Gordon Milne

Well, its going down, you know we paid off the 13s much higher interest rate than the converts came in out. So, let's kind of say it's a lot. And then our inventory balance continues to grow. So the amount that going to hit the expense line has dropped by quite a bit and by what first quarter next year?

Larry Nicholson

First or second quarter.

Gordon Milne

We should do we still have all interest capitalized.

Operator

Next question comes from Joel Locker of FBN Securities. Your line is open.

Joel Locker - FBN Securities

Hi, guys. Just you guys mentioned the framers and stuff taking a little longer on cycle times. Do you expect your backlog conversion I mean in the last couple of quarters have been hanging around 55% 56%, but do you decline with the higher backlog just on a numerical basis, just been the log large numbers and the framing issues?

Larry Nicholson

Yeah, I would say in the near term though we would expect to continue to improve that a little bit. So, we don't see it being a big issue rest of the year.

Joel Locker - FBN Securities

Right. And what was -- what's the third quarter charge going to be for debt redemption?

Gordon Milne

Somewhere between $9 million and $10 million.

Operator

I am showing no further questions in the queue at this time. I will turn the call back to management for closing remarks

Larry Nicholson

Thanks for joining us today. We look forward to see in next quarter.

Operator

Thank you, ladies and gentleman, this concludes the conference for today. You may all disconnect, and have a wonderful day.

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