D.R. Horton, Inc.

Greetings and welcome to the third quarter 2019 earnings conference call for D.R. Horton, America's builder, the largest builder in the United States. At this time, all participants are in listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Jessica Hansen, Vice President, Investor Relations for D.R. Horton. Please go ahead.

Thank you, Kevin, and good morning. Welcome to our call to discuss our results for the third quarter of fiscal 2019. Before we get started, today's call may include comments that constitute forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995. Although D.L. Horton believes any such statements are based on reasonable assumptions, there is no assurance that actual outcomes will not be materially different. All forward-looking statements are based upon information available to D.L. Horton on the date of this conference call, and D.O. Horton does not undertake any obligation to publicly update or revise any forward-looking statements. Additional information about issues that could lead to material changes in performance is contained in D.O. Horton's annual report on Form 10-K and most recent quarterly report on Form 10-Q, both of which are filed with the Securities and Exchange Commission. This morning's earnings release can be found on our website at investor.dohorton.com, and we plan to file our 10-Q this week. After this call, we will post an investor presentation and supplementary data to our investor relations site on the presentation section under news and events for your reference. The supplementary data relates to our humbling return on inventory, home sales growth margin, changes in active selling communities, our product mix, and mortgage operations. Now I will turn the call over to David Auld, our president and CEO.

Thank you, Jessica, and good morning. In addition to Jessica, I am pleased to be joined on this call by Mike Murray, our Executive Vice President and Chief Operating Officer, and Bill Wheat, our Executive Vice President and Chief Financial Officer. The Dale Horton team delivered a strong third quarter of 2019. Our consolidated revenues increased 11% to $4.9 billion. Pre-tax income was $627 million, and our pre-tax profit margin was 12.8%. The spring selling season was solid, and our home building gross margins improved sequentially. These results reflect the strength of our operational teams, our ability to leverage the DL Horton scale across our broad geographic footprint, and our product positioning to offer affordable homes across multiple brands. As we have discussed on our last few calls, affordability concerns caused some moderation of demand for homes in late fiscal 2018 and early fiscal 2019. And in response, we increased sales incentives to improve our sales pace. Interest rates on mortgage loans has since decreased, and we reduced the level of incentives offered as the spring progressed. We continue to see good demand and a limit to supply homes at affordable prices across our markets. At the same time, economic fundamentals and financing availability remain solid. We are pleased with our product positioning and our sales volumes of the June quarter and in July. which were in line with our expectations and normal seasonality. Our strategic focus is to continue consolidating market share while growing our revenues and profits, generating strong annual cash flows and returns, and maintaining a flexible financial position. With a conservative balance sheet that includes an ample supply of homes, lots, and land to support growth, we are well positioned for the remainder of 2019 and future years, right?

Net income attributable to D.R. Horton for the third quarter of fiscal 2019 increased 5% to $475 million compared to $454 million in the prior year quarter, and net income per diluted share increased 7% to $1.26. Our consolidated pre-tax income for the quarter increased to $627 million, and our home building pre-tax income was $562 million. Our third quarter home sales revenues increased 11% to $4.7 billion on 15,971 homes closed, up from $4.3 billion on 14,114 homes closed in the prior year. Our average closing price for the quarter was down 2% from last year to $296,400, while the average size of our homes closed was down 3%, reflecting our ongoing efforts to keep our homes affordable. Bill?

Net sales orders in the third quarter increased 6% to 15,588 homes, and the value of those orders was $4.7 billion, up 8% from $4.4 billion in the prior year. Our average number of active selling communities increased 9% from the prior year and 1% sequentially. Excluding the builders we acquired earlier this year, both our third quarter net sales orders and our average number of active selling communities increased 3% year over year. Our average sales price on net sales orders in the third quarter was $302,000, up 1% from the prior year. The cancellation rate for the third quarter was 20%, compared to 21% in the same quarter last year. Jessica?

Our gross profit margin on home sales revenue in the third quarter was 20.3%, up 100 basis points sequentially from the March quarter. The sequential increase in our gross margin from the March to June quarter exceeded our expectations, and was primarily due to lower incentives and lumber costs. Based on today's market conditions, we currently expect our home sales gross margin in the fourth quarter to increase sequentially from the third quarter, subject to possible fluctuations due to product and geographic mix, as well as the relative impact of warranty, litigation, and purchase accounting. Bill?

In the third quarter, home building SG&A expense as a percentage of revenues was 8.1%, flat with the prior year quarter. Year-to-date, home building SG&A expense was 8.8% of revenues compared to 8.7% last year. We remain focused on managing our SG&A efficiently while ensuring that our infrastructure adequately supports opportunities to increase our market share over the long term.

Mike? We ended the quarter with 29,200 homes in inventory. 14,800 of our homes were unsold with 9,200 in various stages of construction and 5,600 completed. Our current inventory of homes puts us in a great position to finish the year strong. Our home building investments in lots, land, and development during the third quarter totaled $875 million, of which $470 million was for land and finished lots and $405 million was for land development. Our underwriting criteria and operational expectations for new communities remain consistent. At a minimum 20% annual pre-tax return on inventory, and the return of our initial cash investment within 24 months. David?

At June 30th, our home building lot position consisted of 300,000 lots, of which 39% were owned and 61% were controlled. 29% of our total owned lots are finished, and 55% of our controlled lots are or will be finished when we purchase them. We continue working to increase our lot position being developed by third parties by supporting the expansion of Four Star's national lot manufacturing platform and expanding our relationship with lot developers across the country. Our current lot portfolio includes an ample supply of lots for homes at affordable price points and continues to provide a strong competitive advantage. Jessica?

Financial services pre-tax income in the third quarter increased to $48.1 million from $30.3 million in the prior year. Financial services pre-tax profit margin for the quarter was 40.2%, up from 31.2% in the prior year due to improved loan sale execution. 98% of our mortgage companies' loan originations during the quarter related to homes closed by our home building operations, and our mortgage company handled the financing for 58% of D.O. Horton homebuyers. FHA and VA loans accounted for 45% of the mortgage company's volume. Borrowers originating loans with BHI Mortgage this quarter had an average FICO score of 720 and an average loan-to-value ratio of 88%. First-time homebuyers represented 51% of the closings handled by our mortgage company, up from 48% in the prior year, reflecting our continued focus on offering affordable homes for entry-level buyers. Mike?

Four Star, our majority-owned subsidiary, is a publicly traded residential lot manufacturer now operating in 50 markets across 20 states. At June 30th, Four Star owned and controlled approximately 37,400 lots, of which 24,100 are under contract with D.R. Horton or subject to a right of first offer. During the nine months ended June 30th, Four Star delivered 2,224 lots and is on track to deliver 4,000 lots in fiscal 2019, generating $320 to $350 million of revenue and deliver approximately 10,000 lots in fiscal 2020, generating $700 to $800 million of revenue. These expectations are for Four Star's standalone results. Four Star is making steady progress in building its operational platform and capital structure to support its significant growth plans. During the quarter, Four Star issued $350 million of senior notes. Four Star's liquidity, capital base, and lot position at June 30th are sufficient to support their planned deliveries through fiscal 2021. Subject to market conditions, Four Star expects to opportunistically access the equity and debt capital markets to provide additional long-term growth capital while managing to a net leverage ratio of 40% or less. Four Star hosted their quarterly earnings call last Thursday and has an updated presentation on their investor site at investor.fourstar.com that describes Four Star's unique lot manufacturing model and its significant growth and value creation opportunity. David?

DHA Communities is our multifamily rental company focused on suburban garden-style apartments with current operations primarily in Texas, Arizona, and Florida. During the quarter, DHA Communities sold its second apartment project located in Houston for $60 million dollars and recognized a gain on sale of $22,600,000. DHI Communities has five projects under active construction, one project that was substantially completed at the end of the quarter, which we currently expect to be sold in early fiscal 2020. DHI Communities' total assets were $167 million at June 30th. Bill?

Our balanced capital approach focuses on being flexible, opportunistic, and disciplined. Our balance sheet strength and multi-year earnings and cash flow generation have increased our flexibility, and we are utilizing our strong position to enhance the long-term value of the company. During the first nine months of fiscal 2019, our cash provided by home building operations was $605.7 million. At June 30th, we had $1.6 billion of home building liquidity, including $578 million of unrestricted home building cash and $1 billion of available capacity on our revolving credit facility. Our home building leverage ratio improved 370 basis points from a year ago to 18.5%. The balance of our home building public notes outstanding at the end of the quarter was $1.9 billion, and we have $500 million of senior note maturities due in the next 12 months. At June 30th, our stockholders' equity was $9.6 billion, and book value per share was $26.08, up 14% from a year ago. During the quarter, we paid cash dividends of $56 million. We also repurchased 3.7 million shares of common stock for $159.3 million, utilizing the remainder of our outstanding authorization. Our stock repurchases for the first nine months of the year totaled 9.8 million shares for $375.5 million, resulting in a 2% decline in our outstanding share count at the end of the quarter compared to a year ago. Subsequent to quarter end, our board issued a new authorization to repurchase up to $1 billion of our common stock with no expiration date. Our top priorities for cash flow utilization remain to consolidate market share by investing in our home building business and strategic acquisitions, reduce home building leverage, and return capital to our shareholders through dividends and share repurchases. Jessica?

Looking forward to the fourth quarter of fiscal 2019, we expect to generate consolidated revenues in a range of $4.75 to $4.9 billion and to close approximately 15,700 to 16,000 homes. We expect our home sales gross margin in the fourth quarter to be in the range of 20.4 to 20.7 percent and home building SG&A in the fourth quarter to be approximately 8.1 to 8.3 percent of home building revenues. We anticipate a financial services pre-tax profit margin in the fourth quarter in the range of 31 to 34%, and we expect our income tax rate to be approximately 24.5%. For the full fiscal year of 2019, we still expect to generate cash flow from home building operations of at least $1 billion, and we expect our outstanding share count to be down approximately 2% at the end of the year compared to the end of fiscal 2018. Based on today's market conditions, Our expected growth for fiscal 2020 is currently in the mid to high single-digit percentage range for both consolidated revenues and homes closed. We expect to get further fiscal 2020 guidance on our November earnings call. David?

In closing, our results reflect the strength of our long-tenured, well-established operating platform across the country. We are striving to be the leading builder in each of our markets, and to expand our industry-leading market share. We have been the largest builder by volume in the United States for 17 consecutive years. According to Builder Magazine's recent local leaders issue, in 2018, we were the number one builder in all of the top five U.S. housing markets, and D.R. Horton was a top five builder in 31 of the top 50 housing markets. We are focused on consolidating market share while growing our revenues and profits and generating strong annual cash flows and returns while maintaining a flexible financial position. We are well positioned to do so with our conservative balance sheet, broad geographic footprint, affordable product offerings across multiple brands, attractive finish lot and land position, and most importantly, our outstanding experienced team across the country. Thank you to the entire D.R. Horton team for your focus and hard work. We are incredibly well positioned to continue growing and improving our operations. This concludes our prepared remarks. We will now pose questions.

Thank you. Thank you. We'll now be conducting a question and answer session. If you'd like to be placed in the question queue, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Once again, that is star 1 if you'd like to be placed in the question queue. One moment, please, while we poll for questions. Our first question today is coming from Carl Reichart from BTIG. Your line is now live. 1, everybody.

1. 1.

I wanted to talk a little bit just, first of all, on the south-central and the southwest regions where we're off a little bit. Can you just talk, maybe, Mike or David, about community count versus absorption rates there? I think southwest is short communities now, and the plans to kind of regrow those regions?

Yes. What we're seeing in the southwest is that we are short communities relative to where we were, and, frankly, that's a function of our success we've had in those markets. We've sold communities at faster paces than anticipated, and the replacement communities are not yet online. And we will be looking to replace those communities, replace those flags. South Central, you know, frankly, is going up against a very tough sales comp last year. I think they were up over 20% in this quarter. And while their community count is going to be about flat, absorptions did not grow as much, but we're, frankly, pretty satisfied with the absorptions we had there this year based on what we saw in the late fall and early winter. and then seeing the margin expansion that we've been able to achieve with a little stronger selling season.

And the specifics will be in our supplemental presentation, as they always are, Carl. But just for reference, our southwest active selling communities were down 13% year over year, right in line with the sales orders. So very, very strong absorption still out of that market.

Thanks, Jessica. And then just as a follow-up, we've talked a lot about local market share and the advantages that can bring. And we've seen some peers of yours move to lower price points, and they're delivering greater order growth than you, but at margins that are well below. Can you talk a little bit about, as the rubber meets the road here in what has been a soft-dish market, can you talk about how you've been leveraging market share and to protect those margins, grow those margins, and keep your absorptions reasonably strong. Thanks, Case. Call us, David.

You know, we've been in this affordability push for the last five years. We have incredibly well-positioned communities, very deep, and a lot of supply. And, you know, it's not something that is going to continue to outgrow the overall percentage of what we grow. It is driven growth for the last three or four years. It's fully rolled out. And from a competitive standpoint, yes, there are people pushing down in price. They're having to give away more margin than we are because they're not as well positioned or as deeply positioned as we are. So we feel very good about what we've done, where we've been, and I feel very good about the pace and margin balance that we're now executing.

Thanks, David. I appreciate it.

Thanks. Our next question is coming from John Lovallo from Bank of America. Your line is now live.

Hey, guys. Thank you for taking my questions. The first one is on the billion-dollar share repurchase authorization. That seems like a little bit of a pivot for you guys, and we think it's pretty positive, but... Maybe just give us a little help on what drove the decision. And then in terms of expected cadence of repos, I mean, would you expect to be kind of consistent buyers each quarter, more opportunistically? How should we think about that?

Thanks, John. This is Bill. This is the next step for us. We've begun being a more consistent repurchaser of our shares over the last couple of years, and generally the pace of our repurchases have been increasing significantly. over the quarters with opportunistic fluctuations when we see a pullback in the stock. But we're repurchasing shares out of our cash flow, and as our cash flow has increased, we've increased our repurchases. So we see this authorization as kind of the next step in that process. We do expect to continue to be a consistent repurchaser, but we will see some fluctuations quarter to quarter depending on what we see in the opportunities. The authorization has no expiration date, so it doesn't necessarily imply a specific cadence or a specific timeframe that would all be spent. But we feel like that was the appropriate amount to authorize, to put out in front of us and signal to the market that we're going to continue to be a consistent repurchaser.

Yep, that makes a lot of sense. Okay, and then in terms of July kind of being in line with normal seasonality and then that coupled with the 2020 outlook that you guys put out there, It seems like the market is doing reasonably well here. I mean, one of the pushback that we get from some folks is that, you know, lower interest rates kind of resulted in some pull forward orders over the past couple of quarters. That doesn't seem to be the case, but I just wanted to get your view on that.

That's not my belief, I can tell you. I think that there is tremendous opportunities, tremendous demand in the affordability market households being formed and jobs being created. And there's just a limit in my supply even today. So I think the demand is there if you can position and drive a price that they can buy.

Okay. Thank you, guys.

Thank you. Our next question is coming from Alan Ratner from Zellman & Associates. Your line is now live.

Hey, guys. Good morning. Thanks for taking my question. Nice job with the margin improvement. I think we were actually surprised that you were able to drive that level of improvement. And at the same time, it looks like you had a lot of success selling specs in the quarter. I think this is the first time in quite a while where your homes and inventory is actually down slightly year over year. Just curious if you could talk a little bit about, you know, did you see, was that a concerted effort to drive that spec count lower during the quarter, or was that just a function of where the demand was? And I guess more broadly, with your inventory position down slightly, is that by design, or are there some headwinds that might be slowing the construction cycle, you know, labor, weather, et cetera? So just talk through all that would be great. Thank you.

Sure. Thank you, Alan. This is Mike. Would touch on it that seasonally we would expect to see our homes inventory build in the earlier quarters and then start to kind of run down as we satisfy some of that spring selling demand. I think this quarter we had 38% of the homes we closed this quarter were sold in the quarter as well. And so a lot of that reflected with the enhanced margins, our reduced incentives and seeing, you know, a buyer return to the market and a little bit of tailwind on some material costs, most notably lumber. We have inventory positioned where we like it right now, going into our fourth quarter. We have more inventory right now than we had this time last year, and we expect to be well positioned at September 30th to start fiscal 20 as well. We're not seeing any real elongation of bill times. I mean, we're continuing to do what we do.

Gotcha. That's helpful. And then just on the pricing environment, you mentioned pulling back on incentives. Can you talk a little bit about, you know, the percentage of communities where you raise net prices either through lower incentives or outright base price increases? I think your order price actually ticked higher year over year, which was the first time in quite a while, but I know there's a lot of mix involved there. So, you know, are you seeing pricing power? What percentage of your communities or which markets are you seeing it in and to what magnitude? Thank you.

So generally, most of the improvement in our gross margin was driven purely by lower incentives and not from pricing power. I would say today versus, you know, at any point really last year in fiscal 2018, we still have less pricing power today than we did a year ago. But the pullback in rates has helped. So it's a little bit better sequentially in that regard. But the main driver to our gross margin in Q3 and also what we're expecting in terms of improvement in Q4 is is more from the pullback on incentives and that continued rollback than it is pure pricing power.

Do you have those numbers handy, Jessica, just percentage of ASP that are incentives today versus, you know, a year ago, a quarter ago, just so we can kind of see?

So we don't typically quantify incentives because to us, you know, whether it's price or if it's something flowing through cost of sales, it all falls out in the margin. So to us, margin is the best grade, and we don't typically try to quantify incentives that way.

Understood. Thanks, guys.

Thank you. Our next question is coming from Eric Bossart from Cleveland Research Company. Your line is now live.

Good morning. To follow up just to make sure we understand the path forward with incentives and pricing is, you know, talk about your comfort of what you're doing in both those areas now, if the progress that you saw in this quarter is the new normal or if you feel like there's further opportunity in the area of incentives and pricing.

I think, Eric, it's something we continue to measure and manage community by community, and our operators in the field are making those pricing decisions to meet the market that they see in front of them. I would expect that we would, as Jessica mentioned in the gross margin guidance, continue to see a little bit improved margin into our fourth quarter based on the selling environment we're in today and the strength of the buyer that's coming to our doors. We feel really good about that. I think we're going to see some further expansion in margin, and as well as maintaining the pace that we're at.

And then secondly, the guidance looks like now your full-year deliveries will be at the high end of the range you established earlier. What's different within that? Is that a better market or better market share? How would you sort of segment between those two factors that are contributing to you getting to the high end of the range?

I think it's just a better visibility as we've gotten through the spring and we've been able to see our pace continue at a solid pace. We have a greater confidence level in our ability to sell and sell through the homes that we have and deliver on during this fiscal year. Just the sequential improvement in visibility I think was the primary factor. It's a very solid market as evidenced by our ability to pull back incentives throughout the quarter, and I think we're still seeing a very solid market out here as we go into our Q4.

Thank you.

Thank you. Our next question is coming from Truman Patterson from Wells Fargo. Your line is now live.

Hi. Good morning, everybody. First, I wanted to look at your option lot count. As a percent of total lots, it ticked down a little bit sequentially. I figured you guys would have continued increasing this given, you know, four-star, et cetera. Could you guys just discuss a little bit about what drove this and that land environment in general? Are you seeing... the availability of option land or developers improving.

In terms of the change in the option percentage stream, I think that number is very dynamic. It moves, you know, every time we sign a contract or take down lots or cancel a contract. And so there's a lot of volatility in that, you know, directionally that the general trend we've had over the past few quarters and past few years, frankly, as we've been working on this, has been to push it higher And we're continuing to work at that. We're working with developers, both Four Star and other third-party developers constantly, looking for ways to expand that controlled lot position and partner with them to deliver communities and lots to us. Availability, it's still a tough job to find the right land and to get it entitled in today's market and bring it into production. But it's something our team across the country works very hard at every day.

Okay, thanks for that. And then on, you know, you guys gave us a little bit on 2020 guidance, I believe, mid to high single-digit revenue growth. Could you just maybe break that out, how you're thinking about market conditions and with that, you know, your all's community account growth possibly versus absorption improvements?

Sure, Truman. That's our preliminary fiscal 2020 guidance. And so today, it's only July, we're going to stick with just consolidated revenue growth and homes closed in the mid to high single-digit percentage range. And we'll give further, you know, breakdown in color in November when we've completed our fiscal year end.

Obviously, the only perspective we can give on that is based on today's market conditions. So that's, you know, assuming the conditions remain relatively consistent with today. Okay.

But directionally, would you assume that your core community count continues to grow?

We've never given specific guidance on community count, and we're just going to stick with what we currently expect for fiscal 20. And we may have a little bit of nonspecific guidance, but color on community count in November. But today, that's what we feel comfortable with for our preliminary guidance.

Okay. Thank you. Nice quarter.

Thank you. Thank you. Thank you. Our next question is coming from Michael Reholt from JPMorgan. Your line is now live.

Thanks. Good morning, everyone, and congrats on the results. The first question I had was on sales pace, and I guess it's a little bit of a pace versus price question, but, you know, more focused around sales pace. You know, you've had some competitors that, you know, have sales pace up anywhere from mid- single digits to, you know, healthy, very healthy double digit rates. Um, you guys are a little bit more, you know, plus or minus flattest this year, but in contrast, you know, you've had, you know, strong double digit sales pace growth for the prior, you know, three, four years. So my question is, you know, are you just at a point in the market, you know, your own shift towards first time, which kind of led the industry, um, you know, kind of in a more of a steady state and, you know, it's kind of taking the market as it is. Because it seems like, you know, most other builders talk about, you know, this improved strength or improving strength at entry level that's driving that higher sales pace, whereas you might already, you know, have been there and benefited. You know, trying to just reconcile that because obviously also, you know, it seems like you're a little bit more comfortable today not necessarily adhering, you know, at any price adhering to the double digit top line growth and focusing a little bit more on a balanced approach. So just trying to get a sense of, you know, along with this question, I apologize, but, you know, that more flattish sales pace, you know, kind of how that reconciles with some of the other builders we're seeing and versus your own positioning, you know, over the last few years.

Michael, thank you very much. This is Mike. I think the way to start with the answer to the question is we've tried to move to the entry level to the affordable product positioning with Express five years ago, and we have been out rolling that out and seeing very good absorption and demand for that product very well received over the past five years, and we did fuel a lot of years of double-digit top-line growth in units. We, as David mentioned before in the call, secured a lot of very good long-term land positions and opportunities in that. And we are now at a place in our rollout that is fairly mature. We're getting good absorptions for our community. And from a balance perspective, we're looking at the pace and price and focusing on what's driving the best returns for our inventory investment. And that's what we're seeing today, that we've got a pace that we're very satisfied with in our communities, looking at each one of them individually, and then looking to see what can we do to adjust incentives, adjust product offerings, to enhance margin that then increases overall return in those communities as we're working through them. So by and large, we have done the rollout to the entry level, and now we're looking to kind of, if you would, trim the sails on the business plan a little bit to maximize the returns we're getting out of those communities and continuing to look for new communities to replace those. And so others, you know, we've been saying for a long time, as we've opened up communities, we see great demand, and we were not able to satisfy all that demand. So some others have come in and are helping to meet a bit of that demand, but we still feel really good about our positioning and the performance we're getting out of those.

Great. No, that's helpful, and it makes sense, obviously. So thanks for that. I guess, secondly, you know, on the lot positioning, again, notice that the option lot percentage ticked down a point sequentially in the third quarter after, again, several years of very impressive growth and gains in that number. How should we think about the option lot percentage course over the next couple of years? Obviously, the low 60s kind of exceeded your goal or hit your goal faster than expected. Should we kind of expect this type of range to be more of the new normal, or is there kind of another leg up in the option lot percentage over the next couple of years?

I think you asked the question the right way in the term of years to look at this. It is a fairly volatile measurement, and we have been very fortunate the past several quarters it has done nothing but increase. But it will bounce a little bit from time to time, but directionally, over the next few years, we would still expect that controlled lock position to climb above its current level. I wouldn't say that there's going to be a rapid accelerated lag with that or anything we can point to as a catalyst to take it immediately up 3% to 5%, 7%, 10%. But continually, as we're continuing to adjust our business to focus on returns, we're looking to continue to control more land and partner with more third parties in delivering lots to the builder.

Great. Thank you. Thank you.

Thank you. Our next question is coming from Matthew Boulay from Barclays. Your line is now live.

Morning. Thank you for taking my questions. I wanted to ask, back on the inventory side, just looking at the finished versus under construction spec, it looked like the finished spec was was a little higher as a mix than it typically is. Can you just elaborate a little on why that is? Obviously, you gave us that near-term margin guide, but just kind of any implications around margins or incentives from where that finished spec position is?

Thank you. No, we certainly are in strong position to sell and to deliver on what our guidance is for Q4 fiscal 19 and In fiscal 20, and the finished spec position gives us an ability to sell and close homes in the same quarter. So we're pleased with that positioning, but really no implications on our margin guide. We expect our margins to still tick up into Q4 and feel good about our positioning in the market to continue to maintain margins at that level.

We have a very strong focus on completed and unsold specs over a period of time. And that number for homes greater than six months that have been completed and unsold has stayed in a really tight 400 to 600 homes range, which on our overall base of inventory of almost 30,000 homes is very manageable. And as Bill said, you know, we feel like we're in a very strong position for Q4.

Okay, perfect. And then just secondly, Back on the closings guide, you know, 7% to 9% in the fourth quarter, but, you know, just looking at the backlog units and, you know, as we just talked about, that inventory units are down year over year. So clearly the backlog conversion is stepping up nicely. So is it really just what you're seeing in the sales environment in July? Is labor, you know, perhaps loosening? Just what are you guys seeing that's allowing for that type of improvement in backlog conversion? Thank you.

I think one of the things we discussed on is that we have a fair bit of completed homes, both unsold as well as sold. That will be delivered in the fourth quarter. In the aggregate, our homes and inventory are up year over year. They're down sequentially, which is seasonally what we would expect to do in our business plan. So we have the homes out there. We're going to close them in the fourth quarter.

All right. Got it. Thank you very much.

Thank you. Thank you. Our next question is coming from Ken Zenner from KeyBank Capital Markets. Your line is now live.

Good morning, everybody.

Good morning, Kim.

So if we could just do a little math here. Basically, you're running a lot more pre-built homes in one queue, so you closed a higher percent in three queues, how I look at your 38% number that you disclosed for intra-quarter orders closing. What I'm interested in is your closing for 4Q at the low end, 15,700, up to 16,000. That's interesting in that you have a pretty high percent of your under construction, which is how we do everything. Can you explain why that low end of guidance, which is 54% of units under construction, would be up from 49% last year? I know you have spec pre-built. homes, which is normal, and you had a last year. So, are you getting higher conversion cycles, or what is it?

Well, to be specific about the completed specs that we've referenced a couple of times, we have almost 6,000, actually 5,600 completed specs at the end of this year. Last year, we only had about 3,600. So, we are in a very strong position to deliver on that guidance. And right behind those completed specs, we also have homes that are close to completion that we can also sell and close in the same quarter.

Okay. Now, using that same logic where you guys – well, you guys referred to seasonal order pay, so kind of your pay sequentially – And in prior years, you know, you've been given guidance where your implication was because of the entry level or other type of products, you saw greater absorption. So my question to you is this. I mean, is there any reason as you gave guidance for FY20 that you'd see anything other than normal seasonality?

Not that we see today. I mean, we don't have a crystal ball to what the spring selling season looks like, but where we sit today, we anticipate normal seasonality.

And then last question, could you, given the mix, you know, in the third quarter of 38%, I think there's normally 35% inter-quarter closings, what was the spread, would you say, between those, you know, pre-built homes being ordered and closed versus your backlogged?

The stuff we sell and close in the same quarter is almost 100% homes that were already started going into the quarter.

And the margin differential between those and backlog?

We generally just look at our spec margin versus our build job margin, and generally our specs run a slightly lower gross margin than our build jobs, but they turn faster. So from a return perspective, they're always accretive.

And then, you know, roughly 80% of the homes that close are spec. So really, you know, our overall margin really does reflect largely our spec margin.

I would say that, you know, the houses we sold and closed in the quarter, we probably achieved a better margin on those than we would have if we would have sold them in the first quarter or the second quarter.

Right. Yeah, it is an interesting dynamic.

And I think that is part of the margin lift we saw.

Thank you, everybody.

Thank you again. Thank you. Our next question is coming from Jack Messinko from SIG. Your line is now live.

Hi, good morning. I wanted to just sort of back up on incentives a little bit. I think it's been pretty well telegraphed in the market that a large competitor has been using incentives to meet a volume goal, and I think some other larger peers of yours have sort of called it out. Margin B this quarter, is it I guess I'm curious, was it the market and some of those pressures getting better? I think, David, earlier you talked about positioning of your assets, certainly market segmentation at an entry level. Your margin improvement, how much of it is those three items? Is it the market just getting better, or is it the affordance?

I would say the affordability. We gained affordability in the quarter because interest rates dropped, lever prices dropped. were reduced a little bit, which both those things helped, I think, margin. But I can tell you we get up every day thinking about positioning and how we're trying to put the right house, right lot, right community, and then have it priced to turn. And so, and I know it's sacrilege to say this, but we really don't look at the other builders much. At least I don't. We're just trying to get better in our community presentations, our community offerings, and stay competitive every day. I would say it's more Horton than the market, but I'm probably slightly biased there.

Okay. And then on the apartment business, I know it started out as kind of a smaller initiative, but and I think he's built, I think so far, a lot of these maybe near master plans or areas we were already building. Is that mandate or strategy changed? I mean, are you still merchant-billed? Did we see a pivot to owning some of these for cash flow? Obviously, there's a couple of the publics doing the same thing. And then just a reminder on project-level financing, is that all on Horton's balance sheet? Are you partnering? And how do we think about that a year from now?

You know, I'd say when we started this, We thought it was going to work hand in hand with our home building operation. Where we started it was in communities where we had apartment zoned land we owned that typically we would have sold. It felt like we could drive higher value for our shareholders by building it out and selling it. Our long-term strategy, is to sustain and then scale that program. And whether we buy it, whether we hold them, sell them, is going to depend on market and cap rates and pipeline of deals we've got coming. Right now, as we're learning the business, we're selling. And they actually, even Bill Wheat was a little skeptical going into it, but... they're driving pretty good returns. And as we look at, you know, our pipeline of stuff that's under construction right now, it looks like a business that's going to be able to – we're going to be able to scale.

Jack, in terms of financing, it's all on our balance sheet today, but we are assessing, you know, what that looks like in the future, and we'd expect to utilize some level of third-party capital at some point. Ultimately, it looks like –

Ultimately, it comes back to people. And I can tell you what our community guys have done in establishing platforms and getting the right people in the right slots has been very impressive. So we like what we see so far.

Thank you. Thank you. Our next question is coming from Stephen Kim from Evercore ISI. Your line is now live.

Good quarter. I wanted to talk a little bit about your 2020 guide. In particular, this year, you decided not to include a margin guide in 2020. And just wanted to get into that a little bit. Obviously, there's a lot, you know, we can't know about what the next year is going to bring in terms of the economy and demand, you know, from rates. But there are two things, two factors that I think we can maybe think about qualitatively. One is the margin on spec, and the second is the lumber benefit, which you're seeing in your term. On the specs, David, I believe you mentioned that you thought that margins on specs are usually a little lower than the bill to order, but not right now, and in part because of the drop in rates. I'm imagining some folks wanted to close quickly and lock in those rates. That benefit to your margin on your spec relative to BTO, I would assume shouldn't – we shouldn't assume that's going to continue unless rates drop further, which is not something that I would assume you would bake into your outlook. And then secondly, in terms of lumber benefit, I'm thinking, you know, we don't know how much that was. I'd be curious if you could give it to us. But I assume that benefit shouldn't be assumed to continue in 2020 either, right? So these are two things that maybe, you know, would win the margin next year. Are there material offsets to these things that you could point to that might give us some hope that margins could grow next year?

Hey, Steve. It's Jessica. As we've kind of outlined, we get preliminary guidance with what we felt comfortable with today that we can commit to for fiscal 2020, and it's all subject to today's market conditions. We're going to focus, as we always have, on maximizing returns, and gross margin is going to be a product of both the overall market and what it takes from a price and pace perspective, community by community, to maximize returns. And so we're not going to try in July to give any sort of gross margin color for fiscal 20, other than continuing to make sure we're balancing pace and price to maximize returns.

And just... You know, I may have misspoke, but just to clarify what I thought I said, the houses we sold and closed in Q3 were at a higher margin than if we would have sold and closed the houses we sold and closed in Q1. It's facts because incentives have abated and we are seeing less of a need to incentivize a finished house to get it under contract and closed.

But what I said earlier about set margins generally being lower than billed job margins is still true. That was true this quarter, and that would be in any base case scenario we have.

Got it. Okay, that is helpful. Appreciate that. And I guess, could you give some color with respect to the lumber benefit? You didn't really talk specifically about that. Could you just dimensionalize that for us in some manner?

We probably would quantify that as about, in our sequential margin improvement, you know, probably about 20 to 30 bits of tailwind came from lower lumber costs in the homes we closed this quarter versus what we closed in the second quarter.

Okay, that's really helpful. And then the last one for me is I think you mentioned somewhere along your remarks that the cycle time had not changed. So your cycle time hasn't improved and it hasn't deteriorated, I assume. is what that means. And then therefore, I guess I'm thinking into next year or just as we go forward, if we're going to improve the returns without the margin, is it possible for you to do that effectively without increasing or shortening your build time on average?

We've not seen our bill times lengthen this year, and they have not contracted as much as we would have liked either. But that does remain an area of focus to us, is how do we be better stewards of the capital and turn that capital more efficiently? And getting bill times to be as efficient as possible is certainly a huge part of that, and that's something we do get up every day and think about how to do that. I mean, David talked about we try to enhance margin every day. We also try to enhance the bill time. We talk about our cash flow cycles. That's a big part of our cash flow cycle. You're exactly right.

That is an area we need to focus on.

Great. Thank you very much, Guy.

Thanks. My next question is coming from Mike Dahl from RBC Capital Market. Your line is now live.

Good morning. Thanks for taking my questions. My first question was still around kind of the pace versus margin or return discussion and following up on, Jessica, what I think you just said and what Mike and David also touched on earlier. I know it's not all one size fits all, but at a high level, what I'm trying to figure out is you go into the year with a, generally speaking, kind of a unit goal. You put inventory on the ground that positions you to meet that. And so the question is, you know, as you go through the year and demand kind of fluctuates, is it the right way to think about what to expect from your results that the swing line is actually on gross margins versus upside or downside on units, just because I think there's still a question of, you know, whether there's some bigger picture strategic shift in the way you're thinking about volume versus margin or returns at this point or if this is really just a function of market dynamics.

You know, at least I talk about one of my traveling divisions. Margin is the grade. You know, if you do a great job of positioning the product for the price point and demand that exists, then you're going to run a very high margin in excess of 20%. If you do a very poor job of positioning price point product, then you're probably going to run a lower margin because you're, you know, we are going to hit a certain pace. We are going to maintain production in the community. and then adjust off that process. So, you know, we do put a plan out there. We do have expectations. And when we get everything right, the margins run very, very high. When the market's working with us, the margins improve. So we are going to run at a pace.

Okay. In the short term, that margin grade is what the difference is between how well we do and how well we want to do. But in a little bit longer term, we can moderate, adjust the pace based upon market conditions as we're seeing to maximize the return. And more broadly, as we've, over the past five years, ten years, coming out of the downturn, attained a lot of market share and scale, we've been able to then focus on how best to maximize the company's return on equity and what are some of the levers we can pull there. And consistently driving cash flow, creating opportunities for us to de-risk the balance sheet, invest in equity, new opportunities for us to grow the business, or to return more capital to shareholders, that we think is the most accretive way to drive value for our shareholders.

Okay, thanks for that. And then my second question is just a follow-up to Steve's question around lumber. You quantified that as 20 to 30 basis points sequential benefit in 3Q. I was wondering what the what the sequential benefit is in your 4Q guide versus 3Q specifically related to lumber, and then can you give us at a higher level your direct cost trends on a – I know your home size is shrinking, so maybe on a per-square-foot basis would be helpful.

I'll come in on Q4 first. A bit of tailwind on lumber is a component of our guide of – of a sequential improvement of 10 to 40 basis points in gross margin in Q4. Don't have a specific component of that because, you know, mix will impact that in actuality, but it is a component of our guide for a sequential increase.

Yeah, and outside of incentives and lumber, really our revenues per square foot and our costs per square foot were relatively flat sequentially, other than the two pieces that we called out, which drove the improvement in our gross margin.

Okay, great. Thank you.

Thank you. Our next question is coming from Jade Romani from KBW. Your line is now live.

Good morning. This is Ryan on for Jade. Thanks for taking the questions. Just first, thinking bigger picture, do you think that the fundamental structure of the home building industry is really too fragmented and therefore presents an opportunity for someone like D.R. Horton to consolidate over the intermediate term?

Well, we've been consolidating, and I can tell you our Our plan is to continue to consolidate. If you look at the industry, when we went public, it was public builders for about 3% of the overall market. And every year since then, the publics have gained more market share, and we have gained more market share than the other publics. And I, for one, don't see that changing.

And I guess, you know, dovetailing off of that topic, Do you think that there are material scale economies that would further benefit the company in the majority of your markets, or is that thought process somewhat overblown?

That's a big focus of ours. While we're certainly the largest volume builder in the country, we're not number one in every market. So we're focused on what can we do in each market to aggregate market share, and become the largest builder. We're top five and 31 of the top 50 markets, so we see plenty of opportunity to still consolidate market by market, and really that happens at the community level every day.

Great. Thanks for the commentary.

Thank you. Our next question today is coming from Jay McCandless from Wedbush. Your line is now live.

Hey, thanks for putting me in. The first question I had, could you talk about how orders trended on a monthly basis through the quarter, and then if you could quantify what you see so far in July?

You know, Jay, I think we entered the call. David mentioned that we've seen in our June quarter and our July sales, you know, through – we can't talk about today yet, but through most of the month, We've just seen normal seasonality and in line with our expectations, so putting us right where we want to be to deliver the fourth quarter we've talked about.

And then I think I've commented on it a couple times, but the expansion of the affordable product has basically been completed. I was wondering if that applies to freedom as well and maybe what you're seeing from active adult demand and also move-up demand since Most everyone's been focused on affordable. We'd love to hear how some of these other sectors are performing.

You know, the Freedom brand is still early in the rollout. We have gotten much better at positioning that product, but we are not anywhere near where we want to be at this point. I will say that every community we've rolled out seems to be a little better positioned, a little better reception from the community. the customer and it's a brand that's going to be a part of this company for a long time and I think we'll at some point approach 10% plus of our deliveries. The luxury brand, again, we continue to get better at it. Nowhere near where we want to be. It gives us areas of focus. Right now, the affordable product lines have driven returns and growth and We pay our guys based upon returns and profits. So their focus has been on delivering what the buyer wants. But there will be a point in time where that will drive a better return than entry level, at least it has been in past cycles. So very happy with everything we're doing. We've just got to get better.

Thank you for taking my question.

Thank you. Our final question today is coming from Buck Horn from Raymond James. Your line is now live.

Hey, thank you. Good morning. Question, I think you touched on the lumber benefits you're getting. I was wondering if you could quantify for us a little bit either on cost per square foot or otherwise just how labor costs have been trending throughout the quarter and also what you're seeing in terms of land inflation that's out there. And my secondary question to that would just be how you're pricing lot that are coming from Four Star? How do you negotiate those prices?

First part of the question on terms of labor costs, we're not seeing a lot of other changes really in our stick and brick costs. Labor costs right now, quarter to quarter, holding in flat. We're pleased with the relationships and the teams we have out there negotiating those. Land and development costs are always a challenge that we work back against. A lot of our deep positions and And markets fail of health with that, and we've not seen a lot of cost inflation coming through on this quarter's closings. So we're happy with the benefit that's produced. And then the third part of the question, I think, was Four Star's lot pricing. You know, we look at, for an opportunity that we bring to Four Star that we have tied up, we negotiate with Four Star, and they have return hurdles and metrics that they have to achieve and And our land teams know what those are, and they'll bring those projects to them, and they'll negotiate the takedown structures and the pricing to achieve those return hurdles. And if it works for both parties, we go forward with the deal if Four Star does it. If it doesn't work, we can't find a way to make it work, then it's not a deal Four Star does. For an opportunity that Four Star sources, we have the opportunity to get up to half the lots tied up, but that's really a right of first offer or first refusal. on those parcels, and they have their return hurdles. They're out there competitively bidding at the marketplace with other builders, and they'll work with us where it makes sense, and they'll work with other builders where it makes sense as well. So they sell both to Fortin, and they sell to third-party builders as well.

That's great. All right, if I can throw one last one in here to Talyn. Let's switch gears, give the mortgage market a little bit. There was some concern already, some questions out of the industry just with the FHFA discussing, you know, letting the paths around GST loans and debt-to-income ratios, letting that path expire in early 2021. I know we're a long way up from there, but just wondering if you could give us a feel or if you have any metrics around how many of your buyers could be And, you know, affected by a change in those underwriting parameters, how many of your buyers have BPI ratios over 43% or anything around that?

Sure, Buck. I think you kind of hit the nail on the head with how we would start, which is 2021 is a long ways out. So I think a lot can happen between then. And does it, you know, fully expire and go away? Or does some middle ground be reached between now and then? We'll see. So it's a long ways out. In terms of our buyers and their debt to income for the buyers that are utilizing our mortgage company, on average for our entire mortgage company this quarter, the DTI percentage was about 42%. So we do have a decent amount of our buyers that would be at that 43% or above. but that doesn't mean just because if the patch were to go away for conventional, there's not a product for them. They'd still be eligible potentially for an FHA loan. And then the first question we also always ask is, do you have other sources of income that we can verify that we haven't yet to go into that equation? So typically any sort of change that gets implemented like that is not 100% fallout. Our mortgage company does a phenomenal job working with buyers in our pipeline to find them a different product. And if this patch were to expire, which I don't know that that's anybody's base case scenario right now, I feel confident that we'd figure our way through it without a lot of fallout.

Thank you so much. Really helpful. Thank you both.

Thank you. We reach out of our question and answer session. I'd like to turn the floor back over to management for any further or closing comments.

Thank you, Kevin. We appreciate everybody's time on the call today and look forward to speaking with you again in November. And to the DR Horn team, outstanding quarter. Thank you. We are forever grateful up here for what you guys do out there. And I guess we'll talk to you sooner than November.

Thanks, everyone.

Thank you. That does conclude today's teleconference. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.