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Greetings, and welcome to the third quarter 2018 conference call for D.R. Horton, America's Builder, the largest builder in the United States. [Operator Instructions] As a reminder this conference is being recorded.
It's now my pleasure to introduce your host, Jessica Hansen, Vice President, Investor Relations for D.R. Horton. Jessica, please go ahead.
Thank you, Kevin, and good morning. Welcome to our call to discuss our results for the third quarter of fiscal 2018. 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.R. 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.R. Horton on the date of this conference call, and D.R. 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.R. Horton's annual report on Form 10-K and our 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 in investor.drhorton.com, and we plan to file our 10-Q in the next few days. Consistent with the last 2 quarters, our consolidated financials present our homebuilding, Forestar land development, financial services and other operations on a combined basis. The segment information following the consolidated financials in our press release includes detailed financial information for all of our reporting segments. And as a reminder, after this call, we will post updated supplementary data to our Investor Relations site on the Presentations section under News & Events for your reference. The supplementary information includes data on our homebuilding return on inventory, home sales gross margin, changes in active selling communities, product mix and our mortgage operations. Now I will turn the call over to Mike Murray, our Executive Vice President and Chief Operating Officer.
Thank you, Jessica, and good morning. In addition to Jessica, I am pleased to be joined by Bill Wheat, our Executive Vice President and Chief Financial Officer. Our President and CEO, David Auld, sends his apologies for not being on the call today. He is not feeling well, and we expect him back in the office in a day or 2. The D.R. Horton team continues to produce strong results in 2018. In the third quarter, consolidated pretax income increased 39% to $616 million on a 17% increase in revenues to $4.4 billion. Our pretax profit margin improved 210 basis points to 13.9%, and our 12% sales growth was consistent with our business plan. For the 9 months ended June 30, consolidated pretax income increased 30% to $1.5 billion on a 16% increase in revenue to $11.6 million. Our pretax profit margin for the 9-month period improved 140 basis points to 12.6%. These results put us on track to meet or exceed our guidance on all metrics for the full year of 2018, and it reflects the strength of our operational team's diverse product offerings and ability to leverage our scale across a broad geographic footprint. Our continued strategic focus is to produce double-digit annual growth in both revenue and pretax profits while increasing annual operating cash flows and returns. For the trailing 12 months, our homebuilding return on inventory was 19.1%, an improvement of 280 basis points from a year ago. For the 9 months ended June, we generated $534 million of cash from operations, excluding Forestar. With 29,800 homes in inventory at the end of June and 278,000 lots owned and controlled, we are well positioned for the fourth quarter and to support further growth in 2019. Bill?
Net income attributable to D.R. Horton for the third quarter increased 57% to $454 million or $1.18 per diluted share compared to $289 million or $0.76 per diluted share in the prior year quarter. Our consolidated pretax income for the quarter increased 39% to $616 million versus $445 million a year ago, and homebuilding pretax income increased 42% to $590 million compared to $415 million. Our backlog conversion rate for the third quarter was 89%, at the high-end of our guidance range. As a result, our third quarter home sales revenue increased 16% to $4.3 billion on 14,114 homes closed, up from $3.7 billion on 12,497 homes closed in the prior year quarter. Our average closing price for the quarter was $302,000, up 3% from the prior year quarter. The value of our net sales orders in the third quarter increased 13% from the prior year to $4.4 billion, and homes sold increased 12% to 14,650 homes. Our third quarter sales growth was driven by a 15% increase in community sales pace, offset by a 3% decrease in our average number of active selling communities. Our average community count was flat sequentially from the second quarter. Our average sales price on net sales orders in the third quarter was $298,000, and the 21% cancellation rate during the quarter was consistent with the same quarter last year. The value of our backlog increased 7% from a year ago to $5 billion with an average sales price per home of $301,000, and homes in backlog increased 9% to 16,536 homes. Jessica?
We are experiencing healthy market conditions across most of our markets with solid demand, especially at affordable price points, and the supply of new homes remains limited. In this environment, we are reducing sales incentives or raising prices in communities where we are achieving our targeted sales base while striving to ensure that our product offerings remain affordable. Land and construction costs are generally increasing, and we are utilizing our scale and relationships to control cost increases. Our gross profit margin on home sales revenue in the third quarter improved 110 basis points sequentially from March and 210 basis points from the prior year quarter to 21.9%. 120 basis points of the improvement from last year was due to net sales price increases in excess of lot and construction cost increases. An additional 60 basis points of the increase was due to lower litigation and warranty costs, 20 basis points was from lower interest costs and the remaining 10 basis points of improvement was due to less impacts from purchase accounting. Based on current market conditions, we expect our fourth quarter home sales gross margin will be relatively consistent with the third quarter. However, as a reminder, we may experience quarterly fluctuations in our gross margin due to product and geographic mix as well as the relative impact of warranty, litigation and interest costs. Bill?
In the third quarter, homebuilding SG&A expense as a percentage of our revenues was 8.1%, an improvement of 30 basis points from the prior year quarter. Fiscal year-to-date homebuilding SG&A was 8.7%, which was also down 30 basis points from the prior year period. We remain focused on controlling our SG&A while ensuring that our infrastructure adequately supports our expected growth. Jessica?
Financial services pretax income in the third quarter was $30.3 million with a pretax profit margin of 31% compared to $33.9 million of pretax income and a 37% pretax profit margin in the prior year quarter. Financial services profit margin declined this quarter primarily from lower pricing on loan origination sales due to competitive pressures in the mortgage market. 97% of our mortgage company's loan originations during the quarter related to homes closed by our homebuilding operations, and our mortgage company handled the financing for 56% of D.R. Horton homebuyers. FHA and VA loans accounted for 43% of the mortgage company's volume. Borrowers originating loans with DHI Mortgage this quarter had an average FICO score of 721 and an average loan-to-value ratio of 88%. First-time homebuyers represented 48% of the closings handled by our mortgage company, up from 46% in the same quarter last year. Mike?
We ended the third quarter with 29,800 homes in inventory. 14,000 of our total homes were unsold, with 10,400 in various stages of construction and 3,600 completed. Compared to a year ago, we had 8% more homes in inventory. Bill?
Our homebuilding investments in lots, land and development during the third quarter totaled $929 million, of which $502 million was for finished lots and land acquisition and $427 million was for land development. During the 9 months ended June, we invested $2.7 billion in lots, land and development consistent with the same period last year. Our underwriting criteria and operational expectations for new communities remain consistent at a minimum 20% annual pretax return on inventory and a return of our initial cash investment within 24 months. At June 30, our homebuilding lot position consisted of 278,000 lots, of which 122,000 or 44% were owned and 156,000 or 56% were controlled through option contracts. 109,000 of our total homebuilding lots were finished, of which 34,000 were owned and 75,000 were optioned. 11,100 of our option lots at June 30 were owned or controlled by Forestar. We have increased our homebuilding option lot position 23% from a year ago and are making progress towards our target to have 60% of our total homebuilding lot pipeline optioned while keeping our number of owned lots near the current level. We plan to continue expanding our relationships with land developers across the country as well as growing our majority-owned Forestar lot development operations. Our 278,000 homebuilding lot portfolio is a strong competitive advantage in the current housing market and sufficient to support our expected growth. Mike?
Forestar, our majority-owned subsidiary, is a publicly-traded lot development company now operating in 20 markets and 11 states. At June 30, Forestar owned and controlled approximately 19,100 lots, of which 1,200 are finished. 11,100 of Forestar's lots are under contract with D.R. Horton or subject to a right of first offer under the master supply agreement between our 2 companies. Our expectation for Forestar are consistent with what we shared on last quarter's call. Forestar is on track to grow its annual deliveries to approximately 10,000 lots, generating $700 million to $800 million in revenue in fiscal 2020 with a stabilized pretax profit margin in the range of 10% to 12%. These expectations are for Forestar's standalone results. Forestar's long-term success will be dependent on its ability to maintain strong operating liquidity and raise growth capital. We are pleased to report that Forestar's process to obtain a bank credit facility is going well and is expected to be finalized by the end of this fiscal year. We also expect Forestar to file a shelf registration statement and to access the public debt and/or equity markets in fiscal 2019 as conditions permit. Forestar is targeting a long-term net debt to capital ratio of 40% or less. D.R. Horton's alignment with Forestar is advancing our strategy to increase our access to option lot positions and enhance our operational efficiency and returns. We are very excited about Forestar's growing operating platform and the value this relationship will create over the long-term for both D.R. Horton and Forestar shareholders. Bill?
At June 30, our homebuilding liquidity included $748 million of unrestricted homebuilding cash and $1.2 billion of available capacity on our revolving credit facility. Our homebuilding leverage ratio improved 260 basis points from a year ago to 22.2%. The balance of our homebuilding public notes outstanding at the end of the quarter was $2.4 billion, and we have $500 million of senior note maturities in the next 12 months. During the first 9 months of fiscal 2018, our consolidated cash provided by operations was $306.5 million. And excluding Forestar, we generated $533.8 million of cash from operations for the 9-month period. We expect to achieve our target of greater than $800 million in operating cash flow for fiscal 2018. During the quarter, we paid cash dividends of $47.2 million, and we repurchased approximately 609,000 shares of our common stock for $27 million. At June 30, our stockholders' equity was $8.6 billion, and book value per share was $22.80, up 15% from a year ago. Subsequent to quarter end, our Board of Directors increased our share repurchase authorization to $400 million, effective through September 2019, replacing the prior authorization. Mike?
Our balanced capital approach focuses on being flexible, opportunistic and disciplined. Our balance sheet strength, liquidity, earnings growth and cash flow generation are increasing our flexibility, and we plan to utilize our strong position to enhance long-term value of the company. Our top cash flow priorities are to consolidate market share by investing in our homebuilding business and strategic acquisitions, reduce homebuilding leverage and return capital to our shareholders through dividends and share repurchases. We have been actively pursuing select acquisitions across the country and expect to deploy more capital for this purpose over the next year. This quarter, we purchased the assets of 2 small private builders for approximately $18 million. We acquired Lexington Homes to enter the Spokane, Washington market and Permian Homes to solidify our position as the largest builder in the Midland-Odessa market in Texas. We welcome the Lexington and Permian teams to the D.R. Horton family. Jessica?
As we mentioned in our press release this morning, based on current market conditions and our results for the first 9 months of the year, we are increasing our guidance for consolidated pretax profit margin for fiscal 2018 to a range of 12.7% to 12.9% on expected consolidated revenues of $16.1 billion to $16.3 billion this year. In the fourth quarter, we expect our number of homes closed will approximate a beginning backlog conversion rate in the range of 90% to 93%. We anticipate our fourth quarter home sales gross margin will be relatively consistent with the third quarter, and we expect our homebuilding SG&A in the fourth quarter to be around 8% of homebuilding revenues. We expect our income tax rate in the fourth quarter to be approximately 26%. Our expectations are based on current market conditions. Our preliminary expectations for fiscal 2019 are for consolidated revenues to increase 10% to 15% and to achieve a consolidated pretax margin of approximately 13% for the full year of fiscal 2019. We anticipate our tax rate for fiscal 2019 will be approximately 25%, and that our outstanding share count will remain consistent with fiscal 2018. Looking further out, we expect to continue to grow our annual revenues and profits at a double-digit pace and increase our annual operating cash flows, excluding Forestar, to over $1.25 billion by fiscal 2020. We also expect to maintain our homebuilding pretax return on inventory around 20%, beginning in fiscal 2019. Mike?
To conclude and reiterate, our growth in sales, closings, profits, returns and cash flows is a result of the strength of our long tenured people and well-established operating platforms 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 remain focused on growing both our revenues and pretax profits at a double-digit annual pace while increasing our annual operating cash flows and improving returns in our business and to our shareholders. We are well positioned to do so with our solid balance sheet, broad geographic footprint, diversified product offerings across our D.R. Horton, Emerald, Express and Freedom brands, attractive finished lot and land positions and, most importantly, our outstanding team across the country. We thank the entire D.R. Horton team for their continued focus and hard work. We look forward to finishing our 40th anniversary year strong while preparing for great opportunities in the years to come. This concludes our prepared remarks. We will now host any questions.
[Operator Instructions] Our first question today is coming from Stephen East from Wells Fargo.
First, I'll start with the land. The option jumped up to 56%. It's a big jump. You all have been talking about getting to 60%. It seems like now maybe that 60% is readily achievable. So I just would like to understand your thoughts there. And then how did Forestar play a role in any of that jump and what we should expect moving forward? I know they've acquired, as of last quarter, they had 21 deals. How many deals do they have in place now?
Well, Stephen, we are very excited about the progress we're making towards increasing our option percentage. We're at 56% this quarter, but we do expect fluctuations up and down in that number. It's a fairly dynamic measurement, and it can move a little bit day-to-day. In fact, it does move a bit day-to-day. We are making progress in the right direction, but we expect to see that continue to fluctuate. But we do believe we will be achieving the 60% target, probably not going to be by the end of this week, but we will be doing that over the next couple of years.
And the Forestar lot count in our option position is 11,100 of our 156,000 option lots. So it is playing a role in that percentage moving up. We're not planning to provide project counts anymore. We're providing their market count, their owned and option lot position each quarter going forward. We would, of course, expect to update guidance as necessary for lot deliveries and revenues. But we really believe that their lot position is the best indicator of progress and their future growth.
Okay, fair enough. Fair enough. And then as you look at your order growth, a lot of talk in the markets, and we've seen some builders not deliver particularly good order paces. Could you talk about a little bit what you saw in demand through the quarter and then what you all were seeing out West and, in particular, California?
Stephen, we saw a good demand throughout the quarter. I mean, there's normal seasonality, played itself out in the quarter as we expected it would, but we had very good demand across our footprint, specifically out West in California. At the price points we're serving, we see a lot of buyers, a lot of demand, a lot of traffic. We don't have a lot of standing available inventory out in our West region at all, especially in California. Demand has been very strong. Our absorptions per community, I think, out West were up 15%, and really excited about the projects that the team has positioned us in there and the execution against those projects.
Next question is coming from John Lovallo from Bank of America Merrill Lynch.
The first question is a very interesting comment about your balance sheet strength, liquidity and your earnings growth increasing your strategic and financial flexibility. I just want to maybe dig in a little bit deeper there and how you guys are thinking about, a, acquisitions, are there bigger targets out there that might make sense for you guys to get deeper in your markets? And then, b, your appetite for share repurchases, considering the $400 million that you put in place and what we think is a pretty big dislocation between your current stock price in reality.
John, I'll take the acquisition part of that question. It is very much a big part of our capital allocation plans. We've been actively looking, and we are actively looking. The 2 acquisitions we did this quarter were somewhat small, but they were -- put us into a new market and was accretive in another market that we really like and believe in. We have several more that we're looking at over the next few quarters in the year and probably $400 million to $600 million of purchase price on what we're looking at today. We continue to be primarily interested in private builders with very high-quality teams, where we either consolidate share in markets that we already operate in or enter new markets and further expand the footprint across the country. That's been the primary focus to date.
And John, this is Bill. In terms of our capital allocation, we're -- obviously, flexibility is key to us right now, and we still see great opportunities in our housing markets to continue to invest in that and aggregate market share and, obviously, acquisitions are an important part of that as well. With that flexibility, we have begun to repurchase shares. We began repurchasing shares about a year ago. And as we stated before, we want to be consistent in that. We want to be able to do that consistently over a long term with our first step, our first benchmark in that, beginning to keep our outstanding share count flat. And currently, we're on track to do that here by fiscal 2019. And I think the key for our share repurchase program is we want to be able to continue to do it consistently and then increase it incrementally over the next year. And then over the longer term, we'll evaluate that alongside all of our other opportunities at different points in the market.
Okay, that's helpful. And then as a follow-up, in fiscal year '19, you guys reiterated the -- that there'll either be a debt or equity raise out of Forestar. What is -- what will it take kind of to get things moving there on that front? I think, clearly, issuing equity out of Forestar, I think, would be a major catalyst for your shares. I mean what do you guys kind of need to see before you'd be comfortable doing that?
Well, we've been focused, first and foremost, on putting a bank facility in place. And so that is ongoing. That's going very well. We expect that to get completed by this -- the end of this next quarter, by the end of the fiscal year, which has been our target. And alongside that, we'll begin the process of preparing Forestar for the public market. So following a shelf, working with rating agencies to prepare for the debt markets, with the target of them being -- having them in a position to go to the public markets next year. We would -- now we would probably anticipate a debt offering first as they have very little debt on their balance sheet. And so we would do that, certainly, demonstrate the ability for them to raise debt capital and then have an eye on the equity markets as well. We certainly believe that an equity raise for Forestar is an important part, I do agree with you there. But at this point, we're focused on bank facility first and then likely debt market second.
And Forestar has $370 million of cash on their balance sheet today, which is sufficient for their near-term working capital needs, especially once they get the bank credit facility in place.
Our next question is coming from Alan Ratner from Zelman & Associates.
Great job on the orders, very impressive considering some of the other mixed data points we're seeing out there. So I generally think about your inventory -- homes and inventory that you provide us every quarter as a pretty good leading indicator of where you kind of see the volume side of the business going since such a high percentage of your sales are specs. I think you mentioned inventory is up about 8% year-over-year, which is obviously solid growth, a little bit below kind of the double-digit range you've been growing the business recently. So I guess, I was just curious, if you think about your '19 guide for 10% to 15% top line growth, do you have implied in there kind of an implicit organic growth expectation versus what you might expect to see coming through M&A given the pipeline you're looking at today?
In our forward guidance on growth, Alan, what we're looking at is purely organic. The M&A work, we're planning to execute it. But our 10% to 15% growth, we believe, is very achievable with the organic lot positions we have today.
Okay. So any M&A would be potentially additive to that?
To within a 10% or 15%, yes, so within that range.
Got it. And then second question, again kind of on the inventory topic within the industry, we have seen new home inventory starting to climb up a little bit. I think some of that might be a function of maybe some of your peers entering the entry-level space and spec-ed more than they traditionally have. It doesn't sound like you're really seeing much pressure on the incentive front or pricing side from competitors. But as you look into the back half of the year and you look at some of the results your peers are reporting, is there any conservatism on your side under the premise that some other builders might incentivize to drive their volume numbers up? Obviously, you guys have grown very consistently, but others have not been quite as consistent. So if they do start to incentivize, how do you think about that affecting your business and your overall inventory position?
So the decision to incentivize or not and how it impacts us is a community-by-community decision and very specific, and we would monitor and react or proactively take action at a given community. And that's what -- our local teams are monitoring that day to day to day, ensuring that we have the sales pace we desire for a given community while maximizing our returns in that community. So from a macro level at sort of the perspective we have here at corporate office, we are entrusting our local divisions to make those right decisions to drive their pace and achieve the returns they're looking for. Not feeling that we're going to see a lot of competitive market -- margin pressure broadly spaced because we're seeing that every day to day, and we're posting margin returns that we are today from the communities.
Yes. And generally, I would agree we're still not seeing much inventory growth out there, especially at the affordable price points, we're still very limited supply in the market place which is allowing us right now to raise price and reduce incentives, which is showing up in our margin.
Our next question is coming from Michael Rehaut from JPMorgan.
Also hope David is feeling better. First question, I just kind of wanted to circle back to a question on demand. Obviously, you've gotten a couple of questions already on it. But I think it bears -- warrants some focus just given what's gone on in the market the last week or 2 and some of the, as previously said, mixed results from the competitors. Your results really stand out in contrast. And kind of recognizing that you said you thought there was good demand throughout the quarter and across your footprint even California, clearly, it seems like there's some contrasting data points out there. And a couple of builders pointing to May being a little softer, even your competitor earlier this morning talking about even some weakness on the first-time front, which is particularly surprising. So again, I guess, I just wanted to, in my first question, just revisit. And maybe ask another way, the order growth that you saw or the sales pace that you saw, obviously, adjusting for seasonality that -- was there any, I guess, change in patterns? Was May a little bit weaker? Was June a little bit stronger that's of note? And as it relates to the first-time strength, do you feel that you're perhaps just better positioned from a price standpoint and an affordability standpoint that allows you guys to perhaps be a little bit better insulated from any minor or moderate demand volatility?
Sure. Mike, I'll take a stab at that. I think you asked several questions in there, so I hope I'll hit them all. But for the quarter, we saw typical seasonality. So we saw very strong demand as we moved throughout the quarter and just typical seasonality as we moved into that early summertime. We do believe that our outperformance as it pertains to our sales really is because of our positioning and our product offerings across the country. If you look at our results this quarter, it will be posted in our supplementary data after the call, but Express was 37% of our sales and closings and our new Freedom brand is now 3% of our sales. So those are very affordable product offerings that we are very focused on keeping affordable. So there's still extremely limited supply at affordable price points. And so where we can get that product on the ground, we continue to see very robust demand and no sign of weakness at those price points. So I think that's the main reason that's differentiating us when you look at our sales versus some of the other results out there in the industry today.
Appreciate that, Jessica. And I guess, a second question, just the strength on the gross margins coming in above your guidance and you expect it to also be achievable in the fourth quarter. It seems like some of that will carry over into fiscal '19 as well as you're expecting a little bit higher pretax and I'd assume kind of driven roughly equally by gross and SG&A. I guess, as the demand environment, to the extent that it does change at all, is that something where -- I mean, when you're looking at the gross margins, where they are today, do you see that as kind of a peakish type number where you feel that the gross margins don't necessarily need or shouldn't go much higher and that now you can use more of a pivot, if you need to, towards maintaining or ensuring that volume growth? Or is that something that you'd like to see go even higher over the next year or 2?
Thanks, Mike. As we've stated pretty consistently, we're first focused on returns. And so we operate our business community-by-community, making the decisions each day, balancing pace and price, margin and absorption to generate the best return on our inventory investment. And in this limited supply environment with very strong demand and with our positioning, in a great position for that demand at affordable price points, right now the market is giving us the opportunity to reduce incentives and increase prices. And that results in higher gross margins. So in a market environment such as this, we're seeing that opportunity. But we will continue to focus on returns regardless of how the market may change in the future. We're really primarily focused on returns, first and foremost. That being said, with what we can see in the market today, we see a healthy market. We see very good demand. We still see a very good balance of supply and demand. And so that's reflected on our guidance both for the fourth quarter and our preliminary guidance for 2019. We see an environment where we should be able to maintain our gross margins in the range of where we are today and where we reported in the third quarter. There can be quarters that are slightly higher than that. There can be quarters slightly lower, but we expect to be able to maintain margins at a sustainable level, around the same level as Q3. Our implication for our operating margin increase next year assumes relatively flat gross margins with the current level with continued leverage on SG&A.
Our next question is coming from Ken Zener from KeyBanc Capital Markets.
So we were out looking at places in Northern California, since everyone is talking about it, just the other day. And it was very clear to us that your spec approach enables you to get orders inter-quarter versus someone taking an order for, let's say, January or February. So I think that helps support what we're seeing in your orders. But relative to that, could you comment on the spread of specs versus backlog orders, the gross margin, a? And then, b, do you think there is an impact of rising existing inventory on new home sale pace within specific markets?
Yes. First, Ken, on the margin on specs. Clearly, in a market today -- like today with limited supply, our margins on specs are better than usual. The spread between our margins on specs versus build jobs is tighter than normal because we're in a rising price environment, limited supply and we have inventory on the ground, so that's resulting in better margins than normal. And then in terms of the order pace and the reports of orders in a market is certainly affected by the amount of supply. Hard to sell houses if there's not much supply. So clearly, as we have introduced new communities, introduced product at affordable price points in markets that did not have it before, I do believe we're unlocking demand and releasing pent-up demand that's in markets today.
And as we look at existing supply that's out there in the marketplace, the first place we look at available supply is in our own neighborhood, and we're seeing that less than half the homes we have in our inventory are available for sale. We're selling a lot of homes before they're completed, before -- during the construction process. And so we're not seeing excess new home supply coming to bear in the places we're most concerned about, which is at or near our neighborhoods.
Our next question is coming from Eric Bosshard from Cleveland Research Company.
Bill, the comment that you made of raising price and reducing incentives in an environment where some are seeing a little bit of a pause in orders, just can you talk a little more about that? I know you just spoke to where inventories are, but what do you think that you're doing that's allowing you to have that success during a period of time where it's perhaps wobbling a bit for some others?
I think it starts with positioning. It's positioning our product and our communities at an affordable price and having available inventory as well. Our spec strategy, I think the customers are looking for a home that they can have some certainty on when they can move in. And so I think that's put us in a good position to be able to move price and not have to incent very much today. We balance that always with, first and foremost, focusing on returns and achieving our target sales pace in each community. And we're also always keeping an eye on making sure that our products remain affordable. So while we are certainly seeing some increase in pricing and net incentives today, we will continue to make sure that our products remain affordable.
And our scale, clearly, both nationally and locally, is a huge driver of us being able to keep our costs in check. Nationally, on the material side, we've got fantastic partners that are helping us navigate a rising cost environment. And when you look at our true stick and brick or just building cost, our purchasing teams have done a fantastic job on that front as well. And our local scale has really helped us along with our Express homes business model, limiting floor plans, limiting options and building the same floor plan and house over and over and over again so our trades can be very efficient, and we can pay them less for that work, but they can make more money because they can get through so many more houses being that much more efficient. We continue to see this quarter, our revenues slightly outpace our stick and brick costs on a per square footage basis on a year-over-year basis. And the cost inflation we saw in the stick and brick and both the lot, the lot cost side, was right around the mid-single-digit range.
Secondly, Forestar is -- it seems like you're off to a good start as you project out 12 or 18 months. How do you think -- how the business is run and what the results look like is influenced by Forestar? How's life different as you have that integrated and start to scale that?
Yes. As we see life, we're starting to see that life take shape now where we're being much more collaborative early on in deal flow and working with Forestar in determining which projects would be good candidates to -- for Forestar to bring to market. And they're identifying some opportunities organically that are -- will be accretive to the Horton portfolio as well as their third-party builder sales. So we're excited about seeing that growth, that growth that they have, the capital that they have today and will increase over the next year. It's going to be an exciting time for them to recruit more folks to their team and continue to build out their operational capabilities over the next 12 to 18 months. And that's what -- frankly, what we're most excited about is really putting a great organic team together that's going to be a national lot developer with access to deep pools of capital at a cost advantage to what that marketplace is like today.
Our next question is coming from Mike Dahl from RBC Capital Markets.
I wanted to follow up on the response to one of the prior questions on costs. I think you said, stick and brick was up mid-single digits. A, I was curious if you could give us whether that includes labor; and then, b, outside of lumber, what are some of the other areas that you're seeing the most meaningful cost pressures?
Sure, Mike. The stick and brick, when we use that phrase, we really mean labor and materials, so it's all-inclusive. We continue to see that mid-single-digit cost inflation being driven almost solely by labor. Although, we think we're doing a great job keeping our labor costs in check, it is a tight labor supply environment, and we're having to continue to pay a little bit more to get our houses built. But we're more than happy to do that in the market we're in today and are working to continue to be as efficient as possible to reduce labor costs where we can. Outside of lumber has been a cost pressure. It probably is the headliner, a little bit of noise commodity-wise to concrete. But generally speaking, anywhere we've seen an increase, we've had a category where we've been able to offset it. We're now nationally exclusive in over 30 product categories, and those don't all renew at the same time. So each year, when we go back out to market with our national exclusive agreements that are renewing, we've had very good success in either just locking in our current pricing and not having to take a price increase or even reducing our prices further. So really appreciate all of our trade partners out there today that are helping us along the way.
That's interesting. Then on the gross margin conversation, as it relates to next year, it's interesting because just given how quickly and meaningfully you've ramped up your option portfolio over the past 1.5 years plus, I would think that a greater mix of deliveries next year will be coming from land that was originally optioned and normally you'd see some tradeoff on gross margin. So can you just talk to -- are we seeing that mix occur and just the pricing power is such that you're able to overcome that? Or just how should we think about that over the next year?
Yes. Mike, we've been seeing that mix shift over the last several years. Three years ago or so, we were around 30% option lots, and now we're north of 50%. And so we've been able to -- we certainly pay more for a finished lot when we buy it from a third-party developer. But we've been able to, obviously, improve our returns through that process. And with our focus on executing well community by community, we've been able to offset that increase in lot price and still maintain good margins. And so we still believe we're in good position that even as our option percentage continues to rise further, we believe our operations are in a great shape to be able to absorb that and keep our margins at a -- at the level relatively close to today's level.
Our next question is coming from Susan Maklari from Crédit Suisse.
Can you talk a little bit to, I guess, the rollout that you're seeing within the Freedom product? I mean, it sounds like that's definitely gaining some momentum there. And so can you talk to what you're seeing on that side?
Yes, Susan, thank you. We are enjoying some success with Freedom. It's rolling out slower, certainly, than Express rolled out, but we expected it was going to be slower. But it's growing. I think it's about 3% of sales right now, which is a significant increase from where it was. It's growing as a part of our overall product mix, and it's -- and that's overall against a growing backdrop, so it's doing really well. We get that product on the ground, and we see the buyer really like the product we're offering. The sense of community we're trying to create in an affordable platform for those buyers, where we can take a retiree that's a little concerned about monthly expenses, and still try to give them a lot of the lifestyle value of the Freedom home of the active adult neighborhood in a plan that's exactly right for their lifestyles: 2 bedrooms, a flex room, 2.5 bathrooms. It's a great focus for us in a one-story home.
So you'll see in our brand stratification that we'll post after the call, the ASP on Freedom today is right around $260,000. And that typical home Mike talked about is about 1,800 square feet. So focused on keeping it as affordable as possible just as we have with our Express brand.
Okay, great. That's helpful color. And then, I guess, can you talk a little bit to what you're seeing just in terms of some of the labor and the raw material side of things there? Obviously, we're hearing of a lot of inflation coming through with some of the suppliers. Can you talk to how you're thinking about that?
Certainly, on the labor side, one of the things we look at is our build times. And we have seen our teams maintain consistent build times for the past several years. From when we start a home to complete it, that time has not moved but by a few days up or down on our completions and deliveries. And so part of that speaks to the spec strategy we have, part of that speaks to the local scale we have in given markets and long and deep relationships with those labor suppliers. And as Jessica mentioned before, our returns-focused approach to the communities to drive to the pace, we believe, is appropriate creates a more efficient platform for that labor so that they're able to get to more houses, get to more simplistic processes in those houses. And they can, frankly, charge us less per square foot but still make more money for themselves on a day-to-day basis. So we're really excited about the results we're seeing there and how our teams are delivering and staying on top of that labor.
Our next question is coming from Nishu Sood from Deutsche Bank.
So going back to the gross margin question. Very, very strong performance here, and it looks like it will be sustained into next year. As we think about earlier in the cycle, normal margin range was closer to 20%. Now we're 150, 200 basis points above that. What do you see as the major drivers of that? And also just related to that, on new deals, do they pencil to the higher gross margin rate in the pro formas? Or do we need to see this favorable price versus mix to kind of sustain this higher level that we're seeing now?
And I know I sound like a broken record a little bit, but we do focus, first and foremost, on returns. And then the market in each community then and our ability to achieve our sales pace then helps us determine whether the margin will be higher than pro forma or lower than pro forma. So when we are pro forma-ing a project, yes, typically the gross margins are in the high teens to the low 20s, it's usually somewhere in that range. But really, our underwriting hurdle is to achieve a 20% net return on inventory investment based on the pretax income of the project, and that is always at 20% or better on every investment that we're making. And so yes, we're in a good environment right now. There's very -- I think that really, the main driver is there is very limited supply of new homes in the market, especially at affordable price points. And with our positioning and the execution of our teams and the continued improvements and efficiency throughout our business, I believe those are the primary drivers behind what has now manifested itself in our gross margins here this quarter. One other aspect in our gross margins, which we talked about a bit last year, we had a period where our litigation and warranty costs were a bit higher than normal. The last 3 quarters or so, those costs have been at a more normal range. And so this quarter, 60 basis points of our year-over-year improvement in gross margin was from a reduction of litigation and warranty costs. We do expect those levels to remain pretty consistent going forward, which is again as part of our guide for margins to remain consistent.
The other sustained improvement in our gross margins that we expect is from lower interest costs as we continue to delever our homebuilding business. And we think that's a big advantage in terms of what we've done with our balance sheet and the limited interest costs we now have to carry and cover in our gross margin.
Got it, very helpful. And second question on Forestar. Obviously, with the successful rollout of the Forestar plan, looking ahead to the capital raise, the 40% leverage ratio on a net debt to cap basis that you're targeting for that, that's normally what you would see for a homebuilder. One might think that on a land development business, somewhat higher risk might merit a lower targeted debt to cap. Obviously, there's no debt at the moment, we're so far off from it, but just wanted to understand the thinking behind that, to that level.
Sure. We stated 40% or less. Today, it's significantly less than that. Today, they have negative leverage. And so as we look at the 40%, we look at that as a longer-term cap, really kind of a maximum level that they would operate at, which certainly is comparable to some homebuilders. But when you look across the homebuilder universe, there's builders operating at a higher level of leverage than that. But they're not going to be at 40% overnight. It's something that as they grow out their platform, as they grow out their earning capacity, that, that would be kind of a maximum level over time.
And the way we expect to run Forestar is really not what I think people traditionally think about, a historical land developer platform. We're really thinking of Forestar as a lot manufacturer that's going to have D.R. Horton, the largest builder in the country, as one of its largest customers who needs an immense amount of finished lots. And there is a shortage of finished lots across the entire country today. So we think Forestar has a very unique opportunity to take advantage of that opportunity in the market and plan to run with the modest leverage to help them grow that platform that there's a need for in the industry today.
It will be a much more efficient model than you've seen in the land development business. Not going to be large concentrations of individual assets, it's going to be spread across a broad geographic footprint with fast-turning lot deliveries.
Production-focused, return-focused developer.
Our next question is coming from Jack Micenko from SIG.
This is actually Soham Bhonsle on for Jack this morning. Just wanted to revisit the issue of buyer behavior and wanted to see if you guys are seeing any change there today in terms of square footage being bought or buyers moving to ARM loans today.
No, we're really not, which really, to us, points to the market still being affordable at least where we're positioned in the market. We continue to see our FICO score be very strong. We saw our first-time homebuyer percentage tick up. Our average square footage is relatively consistent. And really, even the percentage of our buyers that are purchasing an attached product, whether it be a duplex or a townhome, hasn't risen that much either. So kind of all of those signs for us point to the market still, generally speaking, in most parts of the country, is pretty affordable. There's just a lack of supply, which does impact demand.
Okay, great. That's helpful. And then second one was on order growth next year. And so sort of as we think about the drivers for growth next year, how much of your order growth is going to be driven by community count versus an improvement in pace, especially as you face higher land, labor and material costs?
So Soham, we don't ever guide to community count officially for a reason. It's one of the hardest things for us to manage. We really focus internally more first on our houses and our lot position, and that will tell you where we're headed. As long as we have the houses and the lots, that tells you that we are going to be replenishing at a minimum our community count, if not ultimately growing it. We have said that we would expect it to grow at some point. We still haven't seen that. It was down 3% year-over-year, but it was essentially flat sequentially. So feeling very confident about our ability to meet our 10% to 15% consolidated revenue targets with 278,000 lots owned and controlled and almost 30,000 homes in inventory today.
I guess, another way to ask it is, do you continue to see pace improvement into next year?
Yes.
Beyond today?
Yes.
Yes.
Our next question is coming from Stephen Kim from Evercore ISI.
My first question related to the West. I think you indicated that you are continuing to see some very strong results out there. I think you said absorptions were up about 15%. I think that would imply that the community count was probably down about a comparable amount since your orders were about flat. And so I was wondering if you could...
Steve, I was actually -- I probably pulled the number out of my head, and I should have looked at schedule. Our absorption pace was actually up 7% in the West. So the community count would imply, it could be about down 7%.
All right. Well, that diffuses that question because 7% would be no problem.
Sorry about that.
Yes, no sweat at all. So let me shift gears then. So my -- one of the things I was thinking about was related to your capital allocation, in particular repurchases as well as the M&A. So on the repurchases side, I think you said that you upped your -- or you have a new authorization of about $400 million. That replaces, I think, a $200 million authorization. But you've only used, I think, a little less than half of that over its life. And so I was curious if you could talk about the degree to which the $400 million is likely to be pursued opportunistically or if it's going to be programmatic, and if there was any sort of valuation metric that you would be using to get more opportunistic if that's what you chose to do.
All right. Thanks, Steve. As we've begun our share repurchase program, we are programmatic about it. We're going to be consistent. For the time being, our expectation is to keep our outstanding share count flat until 2019. Our authorization for $400 million is essentially a 15-month or a 5-quarter authorization to extend it out through September of 2019 whereas, previously, it was ending in July. But we do expect to spend the majority of that authorization. We expect to spend a higher percentage of that authorization than we did the prior authorization, which ended in July.
Okay, that's helpful. And then on the M&A side, historically, as you've looked to acquire companies, the main focus generally centered around land banks. And historically, you and many others also focused very much on a price-to-book type valuation methodology. Was curious if you could talk about the $400 million to $600 million that you think you might be willing to spend in the upcoming year or so, if there would be anything different about that, this go around. And if so, what would those differences perhaps be?
I think we're going to look at those metrics you referenced and attributes of a good land or lot position. Most importantly, we're looking at good operating teams, the people that would be joining the company. We're looking at what their particular lot supplies are, what markets they serve, whether they're in a geography that we currently exist in and how we would be complementary to each other there, whether they're in a new geography and is that a place we'd like to get into and expand our footprint. It's a lot of the same ways we've always looked at it. And most importantly, bringing on good people has been -- consistently, the thing that pays back on an acquisition year-after-year are adding good people to the team. That's the most important part of the whole process for us because after the land bank you acquire on day one is gone, you have the people.
Our final question today is coming from Jay McCanless from Wedbush Securities.
First question, any color on July, what you're seeing from order trends?
Really just more of the same, in line with our business plan, and think we're very well positioned to finish the year out strong.
Okay. And then a two-part question on California. Could you talk about what percentage of the current community count is located there? And then also just talk about land availability. You've got a couple of tough comps coming up for orders over the next 2 quarters and just seeing what the land availability is like to drive the neighborhood and the order growth out there.
I think, in the short term, we feel pretty good about the land availability. It's already kind of crystallized in the lots and flags for short-term sales. In terms of the longer-term, California is always a challenging land market, where we have teams that are very focused on positioning us to be in front of what we believe is the best part of the market, which is affordable housing, below certain price points in various submarkets. And that's what our focus has been to continue to execute against those price points, and that's what we're seeing our growth coming from by and large.
And then, Jay, we don't disclose our community count by state or by region. However, I can share that California is about 1/3 of the exposure of this cycle as what we had last cycle, really by choice. We've got more diverse product offerings and a more diverse footprint where we can go find acceptable and attractive returns across the entire country. So although we really like California and we're very happy with our investments there, they are at a lower level this cycle compared to prior cycles.
Yes. And Jay, I would tell you that within California and across our geography, the travel that D.R. has had, David's had, I've been out on the road the past 6 to 8 weeks, we continue to see the same things, very enthusiastic and energized sales teams in the models, seeing good activity in demand in our communities and neighborhoods, and the land positions that we're looking at are very strong. The opportunities we have under contract, about to have under contract and are currently bringing through development or third-party developers are bringing to market. Really excited about the positioning we have against the backdrop of a market that has good job growth, undersupplied in housing, still a very accommodative interest rate environment and good consumer confidence on the outlook for the economy. So we are very enthusiastic about where the market is right now.
Thank you. We've reached the end of our question-and-answer session. I'd like to turn the floor back over to management for any further closing comments.
Thank you, Kevin. We appreciate everyone's time on the call today and look forward to speaking with you again in November to share our year-end results. And to the D.R. Horton team, on behalf of D.R. and David, again, we thank you for your efforts every day to continually make our company better and take care of our customers. Go deliver a great fourth quarter and keep the machine driving in the next year. Thank you.