D.R. Horton, Inc. (DHI) Earnings Call Transcript & Summary

Good morning. Thanks for joining us. Sorry for the delay. We're excited to continue the conference our last session before lunch. So we have a little time on the back end if we need to. But my name is Mike Rehaut. I'm the senior analyst covering homebuilding and building products companies for JPMorgan for over 20 years now. This is our 16th Annual Homebuilding and Building Products Conference, and we're excited to have with us D.R. Horton, the largest homebuilder in the United States by volume and revenues, I believe. D.R. Horton has been a long time participant in the conference, and we very much appreciate their continued participation. We have with us CFO, Bill Wheat; as well as VP of Investor Relations, Jessica Hansen, Bill, Jessica, welcome to the conference.

Thanks for having us, Mike, and thank you all for your time today.

We're going to kick this off with some industry-level questions. This will be a fireside chat format. We have a bunch of industry questions as well as company-specific questions. If anyone from the audience wants to submit a question, you can feel free to do so, and I'll be happy to pass those along as well. Just kicking it off, maybe just what's top of mind, I think, in general for investors is just, any updated comments on demand? And I'll ask it a couple of different ways. It's obviously, it's sometimes hard to update intra-quarter. But number one, would you characterize the recent improvement in demand as being consistent with normal seasonality that you typically see during the spring selling season in terms of month-over-month improvement or something that's a little bit stronger? And how has May trended so far relative to the last few months?

Overall, Mike, it has felt like a more normal spring, really the first week we've had in quite some time. We're seeing good solid fundamental demand, especially at entry-level pricing at the lower price points, and the way the weeks have progressed through the last several months has felt more like a normal spring. When you look at our actual sales statistics, we saw a bigger jump from our December quarter to our March quarter than we normally would have. We had a 73% jump versus normally around a 50% jump. But I would overall characterize it as a fairly normal spring with good, consistent demand throughout. It feels like buyers have adjusted to the higher interest rate environment. Obviously, builders have adjusted with some pricing, with some incentives. And we're using interest rate buydowns there as well, but there is definitely a good solid level of fundamental demand.

And without getting too granular into the last few weeks, I mean is it fair to say that those trends have continued into May in terms of normal seasonality or maybe even a little better than normal seasonality?

I think we would still characterize it as a good, solid normal pattern. Typically, as builders get into the month of May and into June, that's when you start to see the seasonal weekly patterns start to decline sequentially slightly, but I think we're seeing what we would normally expect to see.

Right. Perfect. Maybe just along those lines, I mean kind of on the one hand, demand trends; on the other hand, price. Or they kind of go hand-in-hand often times. We have heard, obviously over the past few weeks throughout earnings season, around pricing starting to stabilize. Many builders reporting are talking to at least half of their communities showing some modest -- at least a modest level of a price increase incentives and/or incentives coming down. How would you describe pricing trends over the last couple of months up until today?

On our earnings call the end of April, we used the word stabilize quite a bit. We were seeing signs -- early signs of stabilization, and I think that we would continue to make that sort of commentary. We are seeing stabilization across the board in terms of pricing and incentive levels. I think that just reflects the macro environment, whereas interest rates have stabilized within a reasonable range. And I think buyer expectations have adjusted accordingly as well. So I think all the commentary you're hearing across the market is pretty consistent with what we're seeing as well.

Great. Great. Another big topic has been affordability. And obviously, D.R. Horton is a leader in the entry-level space in the affordable space. It's always been a focus of yours. How do you view current levels of affordability? And specifically, how should we think about your ASP and price point over the next couple of years to the extent that you view this as a big area of either concern or an opportunity to address?

Continued opportunity is definitely how we look at it. We weren't necessarily cheering when our ASP crossed $400,000 for one time because we like to deliver as many homes as possible and hit as affordable price point as we can because that's the biggest piece of Americans that can afford to buy a house. So we're going to continue to make adjustments in our business. We have seen our ASP come down from that peak that it hit last year, and it will be dependent on market conditions where it ultimately goes. But as Bill said, we are seeing signs of stabilization in our business that's both on the pricing side and the incentive front, and feel good about our ability to continue to consolidate share through market conditions with one of the lowest price points in the industry, roughly $100,000 lower on average than the rest of the space. We continue to start more and more of our smaller floor plans. We've seen our average square footage tick down really this entire cycle a low single-digit percentage. And so I would expect probably to continue to see a gradual mix shift on that front, and we'll just continue to meet the market to do what we can do to consolidate share and maximize returns.

Great. Great. And obviously, I think even as you said on your last earnings call, stabilization is going to be a big reframe. But just circling back to that for a moment, I was hoping to kind of try and take us through the peak to trough adjustment in pricing that you've seen over the last 2 or 3 quarters and also incentives as well. I mean a lot of times we're talking about net pricing, which is the combination of the 2, but maybe if we could kind of break it down in terms of where we've gone in terms of base pricing roughly, peak to trough as well as incentives and where we are today.

We peaked at just over $400,000 on our average selling price on closings. And to date, we're in the $370,000s. So that's a little less than 10% net. We do -- there is a portion of our incentives that is netted against the sales price, particularly with regard to some of our interest rate buydowns. And so I think we would look at today from our perspective, our pricing has adjusted somewhere in the mid-single digits on a gross basis. Added to that, the impact of the interest rate buydowns is taking us down to the high single digits, to the 10% range. Somewhere in that range is where we feel like we are if we stabilize in this current area. That's contingent on what the interest rate environment does going forward. Obviously, if interest rates move up further, then there may be further adjustments necessary. But for where we are today, somewhere in that high single-digit range.

Right, right. And not to put too fine of a point on it, but just to maybe appreciate some of the nuance here. We have heard, as I said, other builders talk about maybe small increases here or there. When you talk about stabilization, does that kind of incorporate that? Maybe some markets perhaps are still making slight adjustments on the downside. The stabilization kind of say, okay, on a net basis, maybe we're flattish, but there's some that are up. There are some that are still adjusting. I mean how should we think about that term as it relates to pricing trends over the last month or 2?

No, that's fair. Homebuilding is a local business. Each market will have to respond individually and, in some markets, probably need a bit more adjustments than others. And so yes, we still have some that are still adjusting. We have others that have stabilized, and we have others that are able to increase prices a little bit. And of course, we manage this at the community level. And so in each individual community, that's where the actions are occurring.

Right, right. No, I appreciate that. Maybe just talk a little bit about the land market. I'm actually thinking about the land market and even on another angle, the M&A front. And the commonality, I think, of 2 of these areas, from my perspective is to the extent that there's any changes going on coming out of the regional banking volatility. And when you think about the land market, perhaps there are some owners that maybe to the extent that credit is tightened or lending standards or cap rates, et cetera, have been moved. I don't know if that causes results in any opportunity on the land side. Kind of shifting gears a little bit on the M&A front, you've always been opportunistic in acquiring, at points, bolt-ons in different markets, local regional builders. So I'm just kind of curious in both of these areas. I know it's kind of a long-winded question, I apologize. If you've seen any incremental opportunity over the last couple of months, either on the land side or the M&A front as it relates to the recent volatility on the banking side.

I think it's a little early there. We do believe with the adjustments that the regional banks are having to make, their cost of capital is increasing. They're going to have to be more selective with where they place capital, and so I think there will be some adjustments. I think there will be some impact to some developers across the country, to some smaller builders who are relying on the regional banks. But it's a little bit early to see that today, so it's something we'll be watching closely. And obviously, we want to stay in a position where we can be opportunistic. In the basic land market for homebuilders, with the relatively modest correction that the market has seen, we haven't really seen any real change in land pricing based on the market correction. But I do believe that this -- the banking industry adjustment will likely create some opportunities. It's just a little bit early right now.

And on the M&A side, we do continue to have an interest in that regard, Mike. But the great thing about our positioning today is we can be very selective and opportunistic and wait and see if any of those opportunities present themselves. We continue to have an interest just on the smaller scale, like you've seen us do really this entire cycle while we've acquired builders. Not really any aspirations of doing any public to public. We're positioned to do what we'd like to do organically and continue to consolidate share in the markets we currently operate in and continue expanding our footprint either through acquisition or through our new market start-up team that's gotten really good at going into new markets on their own and getting us profitable and generating good returns very quickly.

Great. Great. Maybe I'm kind of maybe shifting a little bit to some more company-specific questions, and so they're kind of sporadic different topics here. So we'll kind of hit on some of these. Number one I have is on Forestar. Your plan since originally initially acquiring 75% of the company has been to eventually deconsolidate the company, which would require, I believe, an ownership stake under 35%. You're currently at 65%. So can you give us an update as to the status of this plan and how you see Forestar progressing with regards to these numbers over the next few years?

Sure. The overall plan was to grow Forestar from its very small platform that it had to become a large national lot developer for homebuilders, including obviously for D.R. Horton. And so they're still in the process of doing that. They're today in about 50 markets. Of course, we operate in 110 markets today. And so they're still in the process of growing that platform across the U.S. Obviously, we've had a volatile market for the last several years, and so we've all had to make some adjustments. And Forestar has had to operate rather conservatively for the last 18 months or so, just to kind of make sure to navigate through the volatile market that we've seen with interest rates rising. And so their growth pattern has paused a little bit here in the short term. But as things stabilize, we would expect that growth to pick back up again, and they'll resume on their growth path to becoming the national developer that they aspire to be and that we want them to be. Our plan for our ownership really runs a parallel with the operational plans. And so ultimately, yes, our goal is still to -- for our ownership to be reduced, whether it's through Forestar issuing equity that would dilute our position or, ultimately, we would expect to sell of our shares at some point. But with where the market has been with where sentiment stock valuations have been during this time, that hasn't necessarily presented a great opportunity for us in the near term -- in the recent term, but still expect that, that will occur in the coming years. No set time line. But we would expect that as they get closer to becoming who we expect them to be across the country that, along with that will come the valuation that will open up some opportunities for us to reduce our ownership. So that's still definitely part of the basic plan for us.

And given some of the cash flow generation that Forestar has been able to generate even in stronger periods prior to the most -- the last few quarters, it seems like they've been able to be cash flow positive. It does seem like given their own set of liquidity, what's available to them and their own cash flow generation, does it make sense to think in terms of more secondary offerings by D.R. Horton as opposed to Forestar capital raising that would lead your ownership that way?

The -- we've been very pleased with their ability to be profitable, to be efficient, to generate good returns. And yes, they have not had to issue the amount of equity that we would have originally modeled. That's good news. It is post our dilution to not go as quickly as we might have originally modeled, but that's good from the fundamentals of Forestar's business. And so yes, I think it's reasonable to assume that they may not have to issue as much equity as primary as originally we'd have assumed. That still remains to be seen. It depends on what their opportunities for growth are, and there may be an opportunity for them to still issue equity. But yes, I think versus original expectations. I believe they probably will not have to issue as much equity. And more likely, more of our dilution would come from selling shares.

Right. No that makes sense. Makes sense. Got a question from the audience around capital structure. Your debt to cap is obviously very low relative to history. What's the optimal way to run your balance sheet going forward? I mean, obviously, there's still a certain amount of uncertainty out there, but your balance sheet is in an incredibly strong position. And sometimes even in periods of stress, it only gets stronger. So as we get out of kind of the near-term uncertainty, what should we expect there? And also how to think about share buyback as part of that view?

Yes. It has served our company very well to maintain a very strong, conservative balance sheet with low leverage and strong liquidity, and so we are very committed to continuing to maintain a very low leverage level and an increasing liquidity over time. What that's allowed us to do, we've still been able to grow at the pace that we'd like to. We've gained more market share in the industry than anyone. So we've still been able to grow the business, grow the earnings power. And as we've gotten more efficient, our cash flow has increased dramatically. And so as we position our balance sheet, position our liquidity position, that's opened up the opportunity for us to provide stronger returns to shareholders. Our shareholder -- or our share repurchases have increased significantly over the last several years, and we would expect them to increase further in the coming years. So as we grow the business, we've been able to grow our rental business as well and generating increasing cash flow, that just provides us more opportunity for share repurchase.

Great. Great. Maybe to shift gears a moment. Also, I mean you actually just touched on it, though, the rental operations. I know that's obviously been a big area of investment and focus in terms of in the last couple of years. Currently, profit from the rental operations has been, in the first half of the year, about 6% of total pretax income. I believe your total investments are closer to about 10% of your asset base. So how should we think about this over the next 3 to 5 years in terms of where it can go?

Yes, yes. We've been growing that platform, both on the multifamily building garden-style apartments with the single-family rental, which has been growing significantly as well. We still expect further growth in the investment level there. That growth pace will moderate over the next couple of years versus the pace you've seen in the last couple of years, but the profit percentage contribution will accelerate as those investments we've made mature into completed leased-up properties that we're able to sell. And so you'll begin to see that acceleration in the back half of fiscal '23 and into fiscal '24. We don't have a set target as far as the percentage of our overall assets or profit level. We really let the market tell us market by market, where the market acceptance is for that product. But we think we have a great opportunity to complete the build-out and have a mature platform that is producing efficiently rental properties, and something that's unique in the industry today and something that's in very high demand. People need a place to live, and not everyone is going to own a home. And so producing properties for rental, both single-family, multifamily, we think is going to be a very important part of our platform for the long term.

Great. Great. Actually, I had a couple of questions in the queue that I missed. Going back to an earlier topic around incentives, and I think I just want to circle back on that as I do think it's an area of investor interest and helpful to clarify. So the question is, first of all, broadly, if you could comment what percent -- what your percentage of incentives were as a percent of sales price, what they were in the first quarter versus your historical average and then also to be able to just to walk through the mechanics of the rate buydown. And where rate buydowns are currently, what does that mean in terms of how it flows through and the impact on price or margin?

So we generally haven't talked about incentives as a percentage of revenue because some incentives, as you know, net against revenue, and others go through cost of sales. So we typically just talk about how it falls out in our gross margin. And if you look at our gross margin several quarters ago, call it roughly 28% down to 21.6% in our March quarter, the majority of that decline would be from interest rate buydowns. Roughly 60% to 65% of the homes that we've been closing have had a rate buydown associated with them. And a general rule of thumb is that to buy down a rate by a point, which is generally what we've been offering as a percentage point below market, is about 400 basis points of hit to gross margin. And so the other differential to the decline in our gross margin with that being the largest piece would really just be our ability to no longer cover our cost increases with price since we have seen our pricing level out and our increased level of incentives. So we feel pretty good about where we are today, continuing to offer rate buydowns in a lot of cases. But as you alluded to earlier in some of your conversations with other builders in selective communities, have seen the ability to start to gradually increase price again. In some cases, that may mean we continue to offer the rate buydown because it's a very popular incentive, and it's a more cost-effective way of us addressing affordability than necessarily just taking it off the base price of the house. But as Bill said, we continue to make those decisions community by community at the local level. Our local operators are doing that to maximize returns in each of their individual communities.

Great. No, that's very, very helpful. And so when you talk about going from 28% to 21.6% and about 400 bps from the incentive or the rate buydown, the other talk about price versus cost, I mean that on a basic level, it sounds like it's just basically the price adjustments that you've had to make to base prices as well. Is that fair to say? Or...

Yes, it's a combination of continued cost pressures outside of lumber. Lumber has obviously been a benefit. But outside of that, I mean we're still in an inflationary environment. And although we've had selective success on cost reductions, that's all on current and future home starts, so not things that you would see actually coming through our P&L until '24. And so it's a combination of not being able to raise price and continuing to have cost inflation flowing through our business, net of the benefit we've seen from a lumber perspective.

Right. Right. No, I appreciate that. Maybe staying on the topic of margins for a moment. I wanted to shift to SG&A, and that's always been one of your strengths being -- respectively having one of the lowest or the lowest SG&A ratio in the industry. In fiscal '22, it reached 6.9%. Just wanted to think about, given the low levels here, maybe you could just remind us about at a roughly 7% SG&A, what's fixed versus variable? And how to think about incremental leverage going forward to the extent you certainly plan to continue to grow your business. There -- where could that go and if there's any even structural improvements, i.e., digital or other areas? Just trying to think about the mechanics of that as well.

Sure. We did get some nice leverage on our SG&A due to the significant run-up we saw in our average sales prices. But a lot of what we've seen from an SG&A perspective, we do believe to be sustainable. We don't expect to go back to the 10% historical run rate that builders usually were talked about at. Our SG&A will likely be [indiscernible] that is what we refer to as people costs, and we're closing more homes per employee today than we would have in prior cycles. And so that's sustainable, whether it be technology advances in terms of the tools that we're able to give our sales and construction people in the field and our ability to continue to leverage just our overall cost structure. The biggest variable component of our SG&A is our internal sales commissions, and that runs roughly 2% of the sales price of the house. So we don't sell the house, we don't pay the commission. So that's pure variable. And then there's some incremental variable that's tied to just our community count that we have, our completed specs and maintenance along the subdivision level. So we feel very good about our ability to continue to control costs through cycles and that we do have a sustainable advantage in our SG&A structure going forward versus that old bogey at 10%. Do you have anything to add, Bill?

No. I think we're in a good spot here as we see stabilization and then start to grow from here that while we'll be up slightly this year versus last year in terms of percentage of revenue, we should be able to leverage it back down to prior year levels and go from there as we grow.

Let's just make sure, I apologize if I missed it, one of the challenges of moderating while people are picking you left, right and center. But you said that commission is about 2%. There's some other variable costs. So what would be the total -- in terms of SG&A, the -- either as a percent of total sales or a percent of SG&A, what's fixed versus variable? I apologize.

Roughly 3% to 5% of sales would be variable. So we've got the 2% standard sales commission plus the other things that I alluded to that can vary over time.

Right. No, I appreciate that. Maybe just kind of also talking a little bit about the demographic opportunity, Freedom Homes has been kind of a low single-digit contributor for the last few years. Emerald, and I know it's not just Emerald that serves the higher-end buyer, but that's been maybe 1% or 2%. When this was kind of -- these were kind of rolled out a few years ago, I was thinking maybe others as well that this kind of was a potentially a longer-term extension of how you want to aggregate share in the marketplace outside of your core strength of entry level. So how should we think about those other demographic segments over time? Is this something where perhaps you put a little more emphasis into or growing these brands relative to your overall market share goals?

I think we view both the active adult, so our Freedom brand and the luxury end of the business, as longer-term opportunities for our business. We've established that in certain of our markets where it's made sense, and there is certainly opportunity for us to grow those over time. Over the last few years, there's been such an opportunity and such a need in the marketplace to address the affordability equation and to address the undersupply at the entry-level, first-time buyer segment. That's where the lion's share of our investment has gone. And you've seen that result in our growth and our market share gains. And so that's been probably the greater opportunity during this season for our company. That, combined within the opportunity in the rental space with so much need and so much capital seeking product, especially on the single-family rental side, but the opportunity for us to carve out a lot of market share on the multifamily rental side as well. Those have been nearer-term opportunities for us that have taken priority. But I still think we have an opportunity over the longer term as the largest provider of housing in the U.S. to spend some time and spend some investment at some point into both the senior adults and the luxury segment. We're not stating that as necessarily a top priority today, but we've established a position there. I think we've refined how we've approached those segments and the communities that we have had open, and I think there are definitely opportunities for us longer term.

Great. Great. I also have a question from -- another question from the audience around return on equity. Been pretty stable over the last few quarters in the high teens range. Is this a good level to be thinking about over the future or over the next few years? Is there room to bring that number up meaningfully through either further movement of the balance sheet in terms of your land positioning? I mean, obviously, you've kind of moved to a very high percentage of optioning, share repurchase. Just interested in where you think that number could go.

Yes. We're definitely focused on maintaining as high a level of ROE as we can. We do still have some opportunity, I think, to move the option portion of our land pipeline a bit higher, perhaps to the low 80s level from where we are today in the mid-70s. So that could be some incremental movement there. But then the business itself is going to be generating more cash flow on a go-forward basis than we have over the last 2 years as we grew the rental platform, which will help to augment our share repurchase as we discussed earlier. So definitely, we expect to be able to use share repurchase to keep our ROE up. Our goal would be to keep it at the current level or higher. Obviously, where the business is, where the margins in the business is, where net income percentages does have some impact on that. So as that normalizes and stabilizes, hopefully, we can still see that element of the equation stabilize. And then from there, it's just how efficient can we be with our capital and how best can we return it to shareholders, and that is definitely a focus of ours.

Right. Right. Got another question here. I've kind of mostly through my own, and so it's good timing. And we only have 2 or 3 more minutes here, I think. If you could provide a commentary on percent of COGS from land. And if building on higher-cost land purchasing in 2020 -- purchased in '21, perhaps even in '22, would be a consideration in terms of how you're thinking about your gross margins over the next year or 2.

We continue to focus on returns rather than just an absolute gross margin. And so every time that we look to bring an incremental piece of land on our balance sheet, we have the opportunity to re-underwrite it based on today's market conditions. And so that's a great thing about the flexibility of our lot position today. is we have a relatively short owned lot supply of roughly, call it, 1.5, 1.6 years. And the rest of it is tied up through option contracts that we can re-underwrite based on current market conditions and choose to move forward with, look to renegotiate or walk away. But the hurdle for us is really that 20% pretax return on inventory investment. And so some of our deals are going to continue to pencil north of a 20% gross margin, but we can generate a 20% return on a finished lot deal at a sub-20% margin at the right turnover. So we'll continue to see where gross margin shakes out. We really think about that as mostly a function of market conditions, and it does feel like it's slightly higher over the longer term going forward because of the scale advantages we have, the lower interest and cost of sales that we have today. But we will continue to meet the market and do what we need to do to maximize returns.

And specific to land costs, we are seeing an increase on our lot costs and would expect that to continue. That's part of our base case as far as we look on costs over the next few years. We do have a lot of optionality with our costs in our land and lots with 75% being optioned. If a deal doesn't work for us, we still have optionality until we own it. And so that does give us some selectivity in bringing deals online, but our base case would be that land and lot costs are probably still going to continue increasing.

Great. Well, that's -- we're coming up right on the 20-minute mark past the hour, 35 minutes for the session. So we'll cut it off here. Again, I want to thank you, Bill and Jessica, for participating. It's great to see you guys. So again, Bill, Jessica, thanks so much for participating. Great to see you. Have a great rest of the day, and we'll see you soon.

Thanks, Mike. Same to you and everyone on the line.

Thanks, Mike. Thank you, all.