M.D.C. Holdings' (MDC) CEO Larry Mizel On Q4 2016 Results - Earnings Call Transcript

| About: M.D.C. Holdings, (MDC)
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M.D.C. Holdings, Inc. (NYSE:MDC) Q4 2016 Earnings Conference Call February 1, 2017 12:30 PM ET


Kevin McCarty - VP of Finance and Corporate Controller

Larry Mizel - Chairman and CEO

Bob Martin - CFO


Stephen Kim - Evercore ISI

Nishu Sood - Deutsche Bank

Alan Ratner - Zelman & Associates

Michael Rehaut - JPMorgan

Will Randow - Citigroup

John Lovallo - Bank of America Merrill Lynch

Alex Barron - Housing Research Center

Truman Patterson - Wells Fargo Securities


Good morning, my name is Lisa and I will be your conference operator today. At this time, I would like to welcome everyone to the M.D.C. Holdings 2016 fourth quarter earnings conference call. [Operator Instructions]. Thank you. Kevin McCarty, Vice President of Finance and Corporate Controller, you may begin your conference.

Kevin McCarty

Thank you, Lisa. Good morning, ladies and gentlemen and welcome to the M.D.C. Holdings 2016 fourth quarter earnings conference call. On the call with me today I have Larry Mizel, Chairman and Chief Executive Officer; and Bob Martin, Chief Financial Officer.

At this time, all participants are in a listen-only mode. After finishing our prepared remarks, we will conduct a question-and-answer session, at which time, we request that participants limit themselves to one question and one follow-up question.

Please note that this conference is being recorded and will be available for replay. For information on how to access the replay, please visit our website at MDCHoldings.com.

Before turning the call over to Larry, it should be noted that certain statements made during this conference call, including those related to M.D.C.'s business, financial condition, results of operations, cash flows, strategies and prospects and responses to questions may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors that may cause the Company's actual results, performance or achievements to be materially different from the results, performance or achievements expressed or implied by the forward-looking statements. These and other factors that could impact the Company's actual performance are set forth in the Company's 2016 Form 10-K which is scheduled to be filed with the SEC today.

It should also be noted that SEC Regulation G requires that certain information accompany the use of non-GAAP financial measures. Any information required by Regulation G is posted on our website and our webcast slides. And now, I will turn the call over to Mr. Mizel for his opening remarks.

Larry Mizel

Thank you, Kevin. I'm pleased to announce 2016 fourth quarter net income of $40.4 million or $0.78 per share, a 79% increase over the prior year. This improvement was primarily the result of a 29% year over year improvement in our home sale revenues to $716 million.

During 2016, we focused on increasing our returns. After our strong fourth quarter, I am pleased to say that we improved our return on equity by almost 300 basis points for the 2016 full year. Throughout 2016, the homebuilding industry was supported by strong economic fundamentals, including low unemployment, improving consumer confidence and higher income levels. In addition, mortgage interest rates remained near record lows for the majority of the year.

These low interest rates bolstered consumer buying power, despite the increase in home prices that has been prevalent in recent years. However, during the fourth quarter, we started to see interest rates rise which underscores a need to focus on affordability. To that end, we have continued to execute on the rollout of our more affordable Seasons collection which has been well received by potential home buyers based on our initial experience.

During the fourth quarter, Seasons projects accounted for almost 20% of all the lots we acquired. This demonstrates our commitment to affordability which we believe will be a key driver of national new home sales growth.

We also believe that our new plans can help improve our inventory turnover based on the higher sales velocity and shorter cycle times that this project offers - this product offers. This would provide a key component in driving higher returns.

Seasons will continue to be only a small part of our business for the next few quarters, as we work to develop recently acquired land into new communities featuring these plans. However, we're also executing on other strategies to achieve affordability.

For example, we have now opened our high density Cityscape series in several locations, providing relative affordability for infill locations. We have also introduced new plans within our traditional move-up line of homes, carefully designed and engineered to achieve a better price for our customers.

Throughout the year, we remained committed to our build-to-order strategy. We believe this is a better way to operate giving most of our customers the opportunity to personalize their homes to meet their individual preferences.

In addition, it allows us to dedicate the bulk of our work-in-process capital into homes already under contract which decreases the level of risk on our balance sheet. As of the end of the year, 85% of our homes in production were already sold, well above the level from a year ago.

Against the back drop of improving financial results, we have continued to reward our shareholders with a strong dividend, unsurpassed in the industry in both yield and consistency of payments. We have sustained our quarterly dividend at the current level of $0.25 per share for more than 11 years. This includes during the most recent housing downturn, with all other dividend-paying builders either reduced or eliminated their dividend programs. Also in the fourth quarter, as a supplement to our $0.25 per share cash payment, we paid a special 5% stock dividend.

As we look forward to 2017 spring selling season, our outlook remains positive. Even with the looming threat of rising interest rates and the potential for changes to government policy under a new presidential administration, consistent with how we started 2016, our backlog to start 2017 is again up significantly. In addition, we have added liquidity - we have adequate liquidity of just over $900 million and a balance sheet that ranks as one of the strongest in the industry, providing ample resources for continued investments in quality homebuilding assets that meets our underwriting guidelines.

During the fourth quarter, our all-time Company home closing surpassed the 190,000 unit mark. This achievement came as we approach another notable milestone, the 40th anniversary of the beginning of our homebuilding operations in 1977.

Thank you for your interest and attention. I will now turn the call over to Bob Martin for more specific financial highlights of our 2016 fourth quarter. Bob?

Bob Martin

Thank you, Larry. Our home sale revenues increased 29% from the prior year to $716 million as a result of a 24% increase in closings which was our highest fourth quarter closings in nine years. We also had a 4% increase in average selling price. Our fourth quarter backlog conversion rate was down year over year from 49% to 46%, reflecting the impact of construction cycle times that were roughly 10% higher than a year ago. On a sequential basis, however, our overall cycle times were flat, allowing our backlog conversion rate to increase by 800 basis points from the third quarter. Looking forward to the first quarter, we expect our backlog conversion rate to be slightly below the 39% rate we experienced in the first quarter of 2016.

Our gross margins from home sales percentage was flat year over year. Excluding impairments and warranty adjustments, our gross margin was still fairly flat, down only 20 basis points to 16.9%.

Looking at the sequential trend relative to the third quarter, our fourth quarter 2016 gross margin percentage increased by 60 basis points; however most of this variance was the result of warranty adjustments and impairments. When those items are excluded, gross margin from home sales was higher by just 20 basis points.

With rising land prices and a tight labor market, the opportunities for margin expansion seem to be limited. However, we believe that the relative stability of our gross margins to this point shows that we have been successful overall in using home price increases to offset rising input costs.

It's important to note that even though our gross margin percentage is flat year over year, because we increased our average selling price, the gross margin dollars we realized per home close was up by $2,500. The $3.9 million of impairment that we took during the quarter related to the three assets, one each in Virginia, Maryland and Colorado.

Moving on to SG&A, we were pleased to see operating leverage for the quarter, as our SG&A rate fell by 200 basis points from 11.5% to 9.5%, due in large part to our significant year-over-year increase in home sale revenues. Our total dollar SG&A expense was up for the quarter, driven by a $4.5 million increase in commission and a $2.5 million increase in marketing.

These increases were primarily due to the growth in our closings unit volume and home sales revenues. The higher commissions and marketing expenses were partially offset by a $3.7 million decline in general administrative expenses, primarily due to lower stock-based compensation expense.

The dollar value of our orders increased 5% year over year to $473 million. The increase was entirely due to a 5% increase in the average price of the orders, primarily as a result of a shift in mix to higher price communities. Unit net orders were almost unchanged versus the prior year at 1,018, as both our absorption rate and our average active subdivisions were nearly flat year over year.

Our Seasons collection accounted for roughly 5% of total orders for the fourth quarter, consistent with the percentage we saw in the third quarter. The rollout of this product is a key focus for the Company, but it will take some time to see a more significant impact on our unit volume, as the communities we have recently purchased for this product need to complete development activities and community set-up procedures during the coming quarters.

We ended the year with an estimated sales value for our homes and backlog of $1.38 billion which was up 31% year over year. The increase was mostly the result of a 24% increase in the number of units in backlog to 2,884 homes. We expect this strong backlog to drive a year-over-year increase in closings and home sale revenues for the 2017 first quarter.

Our cancellation rate was flat year over year at 27% for both the 2016 and 2015 fourth quarter. As a percentage of beginning backlog, our cancellation rate was actually down 400 basis points year over year to 11%.

Active subdivision count was down slightly to 164 at the end of the 2016 fourth quarter from 167 a year ago. To end the year, we had roughly 10 fewer subdivisions in the category we call soon to be active than in the soon to be inactive category. In other words, we're a little bit heavier in subdivisions that are on the verge of sell out relative to those that are just opening.

That tells us that our active subdivisions trajectory over the next couple of quarters is likely to be slightly down relative to where we ended 2016. For the fourth quarter, we acquired 1,133 lots for $94 million, a decrease from the same quarter a year ago, but up sequentially from the third quarter of 2016. The fourth quarter activity occurred mostly in California, Colorado and Arizona and to a lesser extent in Washington and Nevada. We spent an additional $65 million on development expenditures, bringing our total spend for the quarter to $159 million.

Lots we acquired in the fourth quarter were in 30 subdivisions, including 18 new projects. Almost half of the lots we purchased were finished, meaning they have a greater likelihood of contributing to unit volume activity in 2017. Finally, as Larry alluded to earlier, for the second consecutive quarter, about 20% of the lots that we acquired are intended for our new Seasons product.

At the end of the quarter, we owned or controlled 14,670 lots which represented about a 2.9-year supply on a trailing 12-month delivery basis and a 4% decrease from a year ago. While our supply is down year over year, it's still in line with our strategic range. And with more than $900 million available in available liquidity to end 2016, we have more than enough resources to react quickly to land acquisition opportunities as we find them.

Our key production metrics continue to improve year over year, giving us confidence that we can drive year-over-year increases in deliveries and home sales revenues to start 2017. Our fourth quarter form starts were up 23%, marking the fifth consecutive quarter of year-over-year increases.

Our homes completed or under construction, excluding models, at the end of the quarter increased 16% from the same period in the prior year. This increase is important, as these units make up a big part of what we can close during the first half of 2017.

In addition, consistent with our build-to-order strategy, 85% of the work-in-process units you see here at the end of the fourth quarter are already sold, compared to 76% a year ago. We believe the high percentage sold speaks to the quality of our balance sheet, with limited speculation in unsold units.

Given where we stand from a backlog and production standpoint, we expect top-line growth during the first half of 2017 which should drive bottom-line growth, barring unforeseen circumstances. And as we work to grow our business, we will continue to focus on improving overall Company returns. To that end and as Larry already mentioned, return on equity increased 200 basis points year over year in 2016. Note that the majority of the increase, about 220 basis points, came in just the last two quarters.

This demonstrates the strong impact of the operating leverage that we established in the back half of 2016. It is also noteworthy that the increase in our return on equity occurred without changing our risk profile. In fact, we have seen improvements in some of our key risk measures.

This includes net homebuilding debt-to-capital which decreased 460 basis points to 26.6% and our overall investment in unsold homes which is down 35% to approximately $110 million. That concludes our prepared remarks. So at this time, we would like to open up the call for questions.

Question-and-Answer Session


[Operator Instructions]. Our first question comes from the line of Stephen Kim from Evercore ISI.

Stephen Kim

I wanted to ask you a little bit about Seasons, thanks for the color on there. We tried to visit one of your Seasons products actually down in Florida. And the one thing that I wanted to try to get clear in my mind is to what degree is the Seasons product going to offer a much more limited array of options and upgrades? So in other words, to what degree is Seasons going to represent a bit of a departure for you from your emphasis on build to order?

Bob Martin

Well, I wouldn't call it a departure. One of the things that's unique about our first-time product, the Seasons product, is we do still offer the ability for our customer to customize to their individual preferences.

Is the full slate of upgrades available to them? No. For example, if you have a very high-end appliance, you're really not going to find that in a Seasons product, clearly. So the array of availability might not be out there, but the ability to choose will still be there.

Stephen Kim

Okay, that's helpful. My second question, staying on the build to order, just bigger picture. Larry, I definitely hear what you're saying about one of the benefits of a build-to-order strategy is that it ensures that you are minimizing your risk, to the greatest degree possible, on your sticks-and-bricks portion of your inventory. But generally, it's been my view that as people think about risk for a builder, land risk is usually a much greater concern than sticks and bricks.

Now in the past, your Company has had very, very light land ownership relative to your peers. The difference between the amount of years owned today versus peers isn't quite as great as it used to be. And so I was wondering, why you think that the benefit of risk reduction on the width side is important enough to offset potentially or giving up, forsaking some efficiencies that you would get from, in a land-constrained environment, a labor-constrained environment like we have today, from moving more to a spec model in this environment that we have today, given your relatively heavier land exposure to peers.

Larry Mizel

Well, our exposure to peers on land, as your first part of the comment, is substantially lower. We run with a two- to three-year supply and I think many in the industry is double that. And having done this for four decades, everyone knows when there's an oops in the market, the land losses are substantial.

We found that we're able to build at a rapid enough pace with pre-sales in today's world that we have better gross profit margins, even now in our dirt starts over specs. And we have, as Bob said, 85% of our backlog of our work under construction are pre-sales.

We just went through this last 9 or 10 years and if you look at our balance sheet and our liquidity through that 10-year period, I think we were one of the few in the industry that maintained a quality balance sheet throughout the decade. And the comment is also we continued now almost 11 years of our cash dividend.

So we found that being a conservative large builder is the DNA that we have and we adjust as the market adjusts. But we're focused on continuing to raise our return on equity. And every day, we think on how to have better execution, better information for more efficiencies and wherever I can find an opportunity to reduce risk, that's the DNA we have. And it's a little different than others.

But as I commented, we were able to maintain a robust dividend and we have a low net debt to capital. And we're very proud on how we run a conservative business in an industry that has a little volatility from time to time. And that's my short-form answer, but I can give you a longer one, but I think there's a time limit for even me.


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

Nishu Sood

Just wanted to ask about the stock dividend in 4Q, stock dividend, slightly unusual, so what's the rationale behind a one-off 5% stock dividend in 4Q?

Larry Mizel

It increases the amount of shares outstanding, we think over time, it will help liquidity in the market and it's also an opportunity to increase the return. Because we're very focused on shareholder return and there's multiple ways that TSR and part of it, we believe is we know mathematically it's a flat calculation that is a pragmatic factual, including as you see how the stock has traded, the 5% dividend which was the stock dividend, really traded well into the market.

And those shares will continue to receive the benefit of the $1-a-share dividend as it is designated as we go forward. So we think that having more liquidity in the market will be better execution and I think that's one of our goals is to improve market performance.

Nishu Sood

Got it, so there won't be any adjustment to the rate of cash dividend to downward to account for the 5%, it will increase with that. Okay got it.

Larry Mizel

Everybody gets their piece of the pie.

Bob Martin

It's already out there really, Nishu, because before the stock dividend, we had a $0.25 per share declaration and payment of dividend. And then afterward, we had another one that was declared in January of 2017, not paid yet but on the additional stock. So we're still paying at that $0.25 per share, per quarter level even after the stock dividend was paid.

Nishu Sood

Turning to the rate at which you're closing your backlog, most of the other builders at this stage have begun to see a year-over-year improvement in the rate at which they are converting or delivering their backlog. In 1Q, it sounds like you will continue to have a downward trend. I would have thought that the shift to build to order would have been mostly in that number already. Obviously, that's going to stretch your deliveries out and depress that ratio a little bit. So can you just walk us through that a little bit? Is labor still the main factor behind that? When would we expect the rate at which you're able to convert your backlog to begin to improve on a year-over-year basis?

Bob Martin

Yes, I think you're on the right track, Nishu in that the spread has gotten narrower, the year-over-year change in our backlog conversion rate. For example, we were down by just 300 basis points this quarter, whereas if you went to earlier in the year, that the spread was a lot larger when you do the year-over-year comparisons.

So you note for the first quarter that the comment was slightly lower than the 39%. I think it's appropriate to be cautious given that we've seen 10 consecutive quarters of year-over-year decrease in our backlog conversion rate.

And not to mention the fact that you mentioned the build-to-order strategy, our unsold inventory is still down year over year. That hasn't stabilized and actually, we think that's a good thing.

So we think we've got a lot of potential as we move forward and as I indicated in my prepared remarks, we've seen our cycle times be a little bit more stable over the course of the past couple quarters. And I think that gets to what you're talking about is the potential to pull through and see the stabilization of that conversion rate.


Our next question comes from the line of Alan Ratner from Zelman & Associates.

Alan Ratner

Nice job with the ROE improvement and Larry, congratulations on the upcoming 40th anniversary. Very impressive. If we look at the quarter, most metrics were in line or better than we were looking for. The one exception was your unit order growth.

And if I look at the regional break out, it really, in the shortfall all came, at least relative to our expectations, out of Phoenix, actually Arizona. You had a pretty large drop in absorptions there and if I recall, I believe the Seasons rollout was already in Phoenix. I think that was one of the first markets where you did rollout that product. So I would have expected absorptions to be a bit stronger there.

So I was hoping you could just give us a little bit more color, what you're seeing in Phoenix, what you saw throughout the quarter that drove that absorption rate lower and if you expect that to rebound in 2017, thank you.

Bob Martin

Yes, I think, Alan, one of the things we saw in Arizona is our cancellation rate was a little bit higher. One thing in focusing on a more affordable product, one thing it unfortunately comes with is a little bit higher cancellation rate potentially and it's really just one quarter. I wouldn't put a whole lot of stock in it. I think really what it comes down to is what is our performance in the spring selling season.

We made a couple of changes in the ranks of management down there, hired a new Sales Manager, for example. And we're taking decisive action to make sure we have all of the right pieces in place as we go into the spring selling season. But I think you're right, just a little bit of a higher cancellation rate in Arizona was something that held it back a little bit.

Alan Ratner

I appreciate that, Bob. Just expanding on that a little bit, do you have any color on what drove that can rate? Did you start to see it accelerate as rates moved higher? The fact that you're at the build to order, your buyers have to sit in backlog a little bit longer, maybe take on more interest rate risk. So is that something that resulted in increased cancellations, just not being able to afford or qualify under the higher rates?

Bob Martin

That's one of the bigger reasons, as it has been for a while now, bigger reasons for cancellations. And it's not just Arizona. Everywhere we see that is one of the primary reasons for cancellations. The other big one is just buyer's remorse, so that's a piece of it.

And no doubt about it, there is an element where you've see prices rise quite a bit over the past couple of years. We're really just on the cusp of really introducing this new, more affordable product, even in Arizona, it's still fairly limited at this point. So I think we're doing the right thing in focusing on that affordable product and your point there just underscores what we're doing with that.


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

Michael Rehaut

First question I had and I apologize, I was off briefly before if I missed this. But I was wondering if you could give us a sense from a directional standpoint how should we think about community count growth for 2017? It was up slightly for most of 2016. Should there be any type of growth? And if you could give us a degree of magnitude, if possible, low, mid, high single-digits. How should we think about the community rollout going forward from a net basis?

Bob Martin

Yes, Michael. Yes, we did talk about it a little bit on the call, but I'd be happy to go over it. And one of the things I'd mentioned is when we look at where we stand at the end of 2016, we've got rough numbers, about 10 more communities that are in the what we call soon-to-be-inactive category relative to soon to be active. Which is a fancy way of saying we've got more that are going off than coming on, 10 more, in that category.

So all else equal, that leads us to believe that we'll see a slight decline in our community count over the next couple quarters. And I just told you it's 10 more in that one category than the others, so that should give you an idea about magnitude.

As for the back half of the year, a lot of what happens there is really dependent upon what we're able to get done on a lot of the new communities we've recently have gotten on board, including communities that are dedicated to the Seasons product. So I don't want to say a whole lot about the back half of the year. I think we've got a shot of bringing it back up in the back half of the year, but we'll provide more color on that as we get into the coming quarters.

Michael Rehaut

And secondly, with the Seasons rollout and maybe considering any type of, perhaps, geographic shifts in exposures, also hoping for any comments in terms of perhaps how to think about gross margins and sales pace for 2017, as it relates to comparing that to where you've been in 2016.

Bob Martin

Yes, so you've got a couple in there. In terms of asset exposure, really the only notable change and we talked about this, we talked about it in our last Q and you'll see it again in our upcoming 10-K, is we haven't invested as much in the Mid-Atlantic and that's been intentional. The returns out there haven't been as good for us as we would like to see them. Not to mention that there's a little bit more uncertainty out there with the change in guard from a political standpoint.

Other than that, I don't know that there's a whole lot of other direction one way or the other on asset base. I had mentioned on the call some of the notable markets we did invest in, Colorado, California, Arizona, Vegas, Washington, so some of the usual suspects in the West where we've got very strong operations. So not a whole lot more there.

On the margin front, really my word on that, as I did my prepared remarks, was and continues to be it's really feeling like a stable environment. That's the way it’s been.

If you look back in the past six, seven quarters from peak to trough, it's not more than 70-basis-points differential once you take out things like impairments and warranty adjustments. And fourth quarter, we were right in the middle of that range.

So the other comment I made was simply that in an environment where labor is still tight, land prices still are going up, it's tough to say there's a lot of opportunity for margin expansion. But to this point, we've done a good job of offsetting those cost increases which increases our home prices.

And then pace, I think pace is something that is highly dependent upon what kind of spring selling season we've run into. And as you know, that's really just ramping up right now. So I think we'd be in a better position to talk about where pace is going for 2017 once we get through the initial phases of the spring selling season after we're done with Q1.

Michael Rehaut

And just lastly, Bob, do you have a sense of what Seasons and I apologize if I missed this before, but what you expect Seasons to represent roughly in terms of closings, percent of closings in 2017 versus 2016?

Bob Martin

What we said is 2017 is still going to be a period of ramp up for us. Seasons, when you think about where the closings were in the fourth quarter for Seasons, it was really only 2% of closings. That might ramp up a little bit from there, but I wouldn't expect it to get into the double digits until we get to 2018. So still relatively small, but a definite focus for us.


Our next question comes from the line of Will Randow from Citigroup.

Will Randow

On free cash flow or operating cash flow, you guys have had it looks like one of the strongest years since 2009. When you're thinking about that going forward in terms of working capital inflows or outflows, how should we think about the next couple years? And is that a reflection of your views on the cycle or just a one-off?

Bob Martin

Well, I don't think that the one year worth of cash flow is a reflection of our views on the cycle. I think as we look at land acquisition, we look at every opportunity as it comes up and we invest in the ones that we think meet our underwriting criteria. It just so happens that resulted in a little bit more outflow this year.

I think as we look further down the road, we want to be a bigger Company. We've talked about the notion that we think the first-time customer can be a bigger part of the market. It might be the missing part of the market that leads the overall industry to higher levels of new home sales and we have every intention of participating in that. So over time, that would mean that we would increase our asset base.

Will Randow

And then, just two bookkeeping items. G&A down, if I remember correctly, somewhere between $3 million to $4 million and on stock comp, how should we think about G&A next year related to stock comp versus 2016? And you guys are running a low 30%s tax rate in 2016. Should we expect a re-occurrence or how should we think about that?

Bob Martin

I think, let's see, first of all, on the G&A front, you have got to be a little bit careful because there's a lot of different things that can come up. I would say here in the fourth quarter, there was a couple of little adjustments to bonus accruals and things of that nature that were positive, as far as G&A goes. So that leads it to be a little bit lower than it otherwise would be.

You've got things like, in our first quarter, for example, we see expense coming through from the contribution we make to a foundation that we typically do on an annual basis. Things like that which lead me to believe that for the first quarter, it could float up by $2 million to $3 million, with some of that being single quarter items.

The other thing I just want to make sure you're cognizant of is there are performance share units that we have. There's an extensive disclosure on our last 10-Q and will be in our 10-K for those performance share units, as is appropriate for U.S. GAAP.

There is no expense going through our income statement right now. And I won't belabor the point because there's plenty of detail in our public disclosures, but depending upon how we view the required performance or the actual performance relative to what performance is required to achieve those performance units, that could create some noise, some additional expense in a coming quarter. But we really won't know until we get there, so it's a quarter-by quarter analysis.

As far as the tax rate goes, I know one of the big things that has helped our tax rate this year has been Section 199, manufacturing deduction which we finally were able to actually take advantage of this year because we were paying taxes.

And then, another thing is energy credits. Now, to this point, I don't know that the energy credit piece is going to continue. I think that's worth, in order of magnitude,100 basis points? Somewhere around 100 basis points to our tax rate.

Oftentimes, the government will renew that last minute or even renew it at the end of the year, in which you take that deduction. So that could still change, but for right now, that would tell us that we might have 100, 120 basis points extra percentage to our tax rate increase.


[Operator Instructions]. Our next question comes from the line of John Lovallo from Bank of America.

John Lovallo

The first question, just a follow-up actually on the last question, I believe, if I remember correctly, that G&A in the first quarter of 2016 I think was, I want to say it was inflated by somewhere around 70 basis points from excess stock comp. So the first part of the question is, is that the performance units that you were talking about? And is there any - the second part of it would be is there anything in particular about the first quarter where there would be more of an impact?

Bob Martin

Yes, no, it wasn't the performance units; it was a different stock grant, that's basically expense - expensing that stock grant was done in the second quarter of 2016. So there was about $2.5 million in the first quarter of 2016 related to stock comp that particular tranche, that won't be there in the first quarter of 2017. That much we know.

And then on the conversation a couple callers ago, sequentially going from Q4 to Q1 with a couple ins and outs, what I can see right now, there could be a $2 million to $3 million sequential increase but nothing really that significant.

John Lovallo

That's helpful and then you guys are pretty focused on moving into the entry level here. Are there opportunities out there, potentially inorganic opportunities, that you could pursue?

Bob Martin

When you say inorganic opportunities, what do you mean by that?

John Lovallo

Sorry, acquisitions.

Bob Martin

Oh, just acquisitions of actual builders?

John Lovallo


Bob Martin

It's something that we have done from time to time. Last one was acquisition into Seattle; we did that about five years ago. Typically, when we do it, it's free market entry. I would say we look, we see what's out there. It's not, generally speaking then, the way we've grown our business. So I wouldn't create any expectations for that other than the fact that we keep our eyes open and we've got available liquidity in case we see an opportunity that's compelling.


Our next question comes from the line of Armando Barron from Housing Research Center.

Alex Barron

I was wondering, it's Alex. I was wondering if you could comment a bit on the progression of the orders in the quarter, whether you saw a pretty steady month-to-month trend or was there a noticeable change after the election when the rates started going up?

Bob Martin

I don't know that there's anything to really read in there. The problem is it's the fourth quarter, so you're at your lowest seasonal level of orders anyway. So it's hard to tell is it just that you had a state of cancellations or is it that you had something else? Because your overall order activity is pretty low, so I think it's tough really to take anything out of the monthly trends in our fourth quarter.

Alex Barron

Okay and if we were to assume that the interest rates stay above 4 the rest of the year, what is your expectation as far as what buyers are likely to do? Are they - do you think that they're just likely to trade down, basically, to the new type of homes you guys are building? And what, if anything, are you guys doing about people who might potentially be in a bit of a bind, who maybe ordered a home in September at a lower interest rate and by the time they get to the closing table, find themselves at a higher interest rate?

Bob Martin

Yes, well first of all, it's hard to predict exactly what the consumers do at current levels of interest rate. My thought on that is we're still at very, very low levels of interest rates, historically, low levels of interest rates. And we've been able to, as a country, produce a lot more, produce and sell a lot more new housing at much higher levels of interest rates.

So I think the lynch pin really is how is the economy doing. Do people have jobs, do they have confidence and is their income growing? And so far, the news on all those fronts has generally been good, at least it was for most of 2016.

When we talk about affordable products, we really think about not only the consumer who might be priced out of the bigger product, the more traditional product because prices have risen or interest rates have risen, but also a new tranche of consumers who maybe haven't even owned a home yet and is truly looking for that entry-level housing. And that consumer that ultimately increases the overall pool of new home sales in the U.S.. So we don't think it has to be a tradeoff between bigger and smaller houses necessarily.


Our next question comes from the line of Truman Patterson from Wells Fargo.

Truman Patterson

I was hoping you could just help me walk through this. You guys guided that the next several quarters, the community count will be down sequentially which implies maybe a flat to down community count for the full year. I'm just hoping you can help us walk through your absorption improvement, whether you think you can see an improvement in absorptions throughout 2017. Is it largely from the Seasons or is there something else internally that you are all doing?

Bob Martin

Well again, it's tough to predict on the absorption rate where we're going to be at. Only being right at the threshold to start of the spring selling season, it's hard to prognosticate on that at this point. As to, just going through it again, the notion of having some slight decline in our community count in the first half of the year is what I talked about a little bit earlier.

In terms of the full year, what I said is it remains to be seen how many of these communities really were able to get in place in the back half of the year. So not really prognosticating yet on what is going to happen in the back half of the year.

But as far as the Seasons contribution to the whole thing, what's really happened is we've been able to take our Seasons product, introduce it in some land that we already had on balance sheet. For the most part, it's on land that we already had on balance sheet as the initial foyer into our Seasons business and it's been quite successful I think is how we'd characterize it.

And now, we've got a whole plate of communities that we really started acquiring in the third quarter of 2016 that need to be developed and need to be brought through the appropriate procedures to get the community up and running. So that's happening as we speak, but that's going to take a couple quarters.

And so all that means, I wouldn't expect the Seasons part of the equation necessarily to be the driver of a higher absorption rate in the first couple of quarters of next year. I think it's a little bit further out before that becomes a more significant part of the business.

Truman Patterson

Okay, great and then in 2016, I know that you all have started to focus on returns a little bit more. You all stated that ROE was up about 300 Bps in 2016. Do you guys have a target for that going into 2017? And then on another note, you all mentioned that you were pulling back your land purchasing in the Mid-Atlantic as the market was weaker. Have you noticed, have incentives started to tick, up the past quarter or two or has there been any pricing pressure in that market?

Bob Martin

In the Mid-Atlantic, I don't think I would necessarily describe it like that. Our volumes have been relatively low. Actually Virginia, you saw absorption rates actually go up year over year, so it's just been a little bit skittish for us. It's not performed well, so I don't think we've got enough at this point to say there's a big trend there at this point. And then what was the other part of your question, I'm sorry?

Truman Patterson

It was just ROE, what you guys' target is for 2017.

Bob Martin

Yes, I don't think we've put one out there really. I think for 2017, we start the year with a higher backlog than we had a year ago, 31% higher in terms of the absolute sales value of that backlog. And that gives us the opportunity over the next couple of quarters to increase our revenues on a similar equity base to where we were a year ago. So that puts us in a good position to start 2017.

But for all of the reasons we talked about, just where we stand with our Seasons product, we're still transitioning over to that new product. I don't think it's quite the time to put out a firm target on firm equity at this point. But I think really how we're approaching it is making sure we've got the right business model of practices in place which includes our build-to-order model and making sure that we've got as many dollars as we can invested in that model because we think that's a good risk profile.

And that we get our Seasons line in place, because ultimately, long term, if we're right and that does, that first-time consumer is a bigger part of the business, then that will be accretive to returns. Not to mention the fact that the Seasons product is more efficient to build and can increase turnover and provide return-friendly benefits on that level.


We have no further questions in queue. I'll turn the call back to the presenters.

Bob Martin

Great. Well thank you all for being on the call today. We look forward to speaking with you again following the release of our results for the first quarter of 2017.


This concludes today's conference call. You may now disconnect.

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