M.D.C. Holdings, Inc.
Q3 2018 Earnings Call Transcript

Published: 2 Nov 2018

[Operator:]

Good afternoon and welcome to the M.D.C Holdings 2018 Third Quarter Conference Call. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Derek Kimmerle, Director of SEC Reporting. Please go ahead.

[Derek Kimmerle:]

Thank you, Kate. Good morning, ladies and gentlemen, and welcome to M.D.C Holdings 2018 Third Quarter Earnings Conference Call. On the call with me today, I have Larry Mizel, Chairman and Chief Executive Officer and Bob Martin, Chief Financial Officer. At this time, all participants are in a listen-only mode. After finishing our prepared remarks, we will conduct the question-and-answer session at which time we will request the participants to limit themselves to one question and one follow-up question. Please note that this conference is being recorded and will be available for replay. For information on how to access the replay, please visit our website at mdcholdings.com. Before turning the call over to Larry, it should be noted that certain statements made during this conference call, including those related to MDC’s business, financial condition, results of operation, cash flows, strategies and prospects and responses to questions may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements involve known and unknown risks, uncertainties and other factors that may cause the company’s actual results, performance or achievements to be materially different from the results, performance or achievements expressed or implied by the forward-looking statements. These and other factors that could impact the company’s actual performance are set forth in the company’s third quarter 2018 Form 10-Q which was filed with the SEC earlier this morning. It should also be noted that SEC Regulation G requires that certain information accompany the use of non-GAAP financial measures. Any information required by Regulation G is posted on our website within our webcast slides. And now, I will turn the call over to Mr. Mizel for his opening remarks.

[Larry Mizel:]

Thank you, Derek, and good morning to everyone joining us on the call today. I’m pleased to announce that MDC Holdings posted another quarter of strong financial results, highlighted by year-over-year home sales revenue growth of 31%, gross margin expansion, excluding impairments of 210 basis points and pre-tax income growth adjusted for gains on investments of 72%. We also continue to execute on our affordable growth strategy during the quarter, without our lot purchase approval activity focused on more affordable product offerings which can continue to be well received in the marketplace. We believe that the affordable product segment offers the best return on investment in the housing market thanks to pent-up demand from first-time buyers and the lack of available supply at these price points. While some may fear that raising interest rates will turn these buyers away from purchasing a home, history has shown that consumers will move forward with our home purchase in a rising rate environment, provided they feel confident in their employment status. Additionally, it is important to remember that the recent rise in interest rates has not occurred in a vacuum, instead it has largely been caused by the strength of the U.S. economy, which is spurred higher employment levels, increased wages and boosted consumer sentiment to an 18-year high. All of these factors are critical to a household formation and they are much more impactful on the home purchase decision than the mortgage rates. In the short run, however, the onset of rising interest rates have slowed new home sales activity in number of our markets, particularly when coupled with significant increases in the home prices that we’ve seen in many areas. We believe that this kind of slowdown is normal and rational response on behalf of the buyers as they reassess their purchase options. However, it does not signal the end of the current housing cycle in our opinion, which is why we continue to make investments in our operations around the country. Periodic shifts in market dynamics are a natural occurrence over the course of the housing cycle and can prove to be advantageous for well capitalized public builders such as MDC. Our seasoned management team has successfully navigated our companies who had a number of mortgage rate environments through the years. And we believe that we are in a great position to be successful in today’s market as well. The future looks bright for our company, giving the fundamental backdrop in our industry and the strategic investments we’ve made over the last few years to increase our product offerings to include a higher concentration of affordable home plans. We look forward to sharing a more in-depth look at our strategy and our company’s future at our investor events scheduled for November 7th and 8th here in Denver. With that, I’d like to turn it over to Bob who will provide more details about our results this quarter.

[Bob Martin:]

Thanks, Larry, and good morning everyone. As reported, our pre-tax income for the third quarter decreased from $89.7 million in the prior year to $67.4 million this year. However, the decrease related entirely to a decrease in our gain on investments, which was an extraordinary $52.2 million in the 2017 third quarter, compared to a more typical $3 million in the 2018 third quarter. If those gains were excluded for both periods, pre-tax income would have increased by 72% year-over-year from $37.5 million to $64.4 million. Looking at net income, the decrease in pre-tax income was partially offset by a reduced tax rate, which dropped from 31.8% for the 2017 third quarter to 20.8% for the 2018 third quarter. As was the case in the first two quarters of 2018, the decrease in rate was in large part due to the Tax Cuts and Jobs Act. In addition, we booked a discrete tax benefit of $3.2 million or 480 basis points for the 2018 third quarter. This discrete benefit was related to the identification of additional homes that are eligible for the Section 45L energy-efficient home credit. It was the primary reason why our actual 2018 third quarter tax rate was lower than our previously-disclosed estimate of 25% to 27%. For the final three months of 2018, we are estimating an effective tax rate between 17% and 19%. This is lower than the estimates we have given in recent quarters, as we are now expecting to recognize a one-time benefit in the fourth quarter related to certain changes in our tax methods. Our home sale revenues for the 2018 third quarter were up 31% year-over-year to $766 million, due to a 20% increase in the number of homes delivered and 9% increase in the average selling price of these homes. Our backlog conversion rate was 40%, which was in line with the expected range for Q3 that we discussed on our previous call and higher than 38% from a year ago. Colorado, the most significant year-over-year improvement in backlog conversion, as the prior year was adversely impacted by the joist issue we discussed at length in the second half of last year. On the other hand, our Northern California and Phoenix markets had no significant decreases based on labor constraints that are increasing cycle times in those markets. Looking forward to the fourth quarter, we estimate that our backlog conversion rate will be in the 45% to 47% range, compared with 45% backlog conversion rate that we achieved in the fourth quarter of 2017. The year-over-year increase in our average selling price from last year was driven both by price increases across our markets and a shift in mix to some of our higher priced communities in our California markets. It is worth noting, however, that our average selling price has come down from a recent high of nearly $500,000. The decrease is due in part to the continued expansion of our more affordable Seasons Collection, which grew to 17% of closings for the third quarter versus only 8% a year ago. Our gross margin from home sales was up 140 basis points year-over-year to 17.7%. Excluding the impact of impairments from both periods, our gross margin from home sales was up 210 basis points to 19.2%. All of our homebuilding segments realized an improvement in their pre-impairment gross margin from home sales with the West segment showing the largest improvement and the North segment showing the highest absolute level overall. The impairment for the 2018 third quarter occurred almost entirely in Southern California in a single subdivision that has an average selling price at the high-end for new homes in its sub-market. Overall, we are seeing fewer subdivisions at risk for impairment as evidenced by the number of subdivisions tested for impairment in the 2018 third quarter, which was approximately half the number of tested in the same quarter a year ago. Our gross margin and backlog to end the quarter remained healthy at a level that will roughly even with the 2018 third quarter closing gross margin, excluding impairments of 19.2%. However, it should be noted that the gross margin level we actually realized in future periods could be impacted by cost increases, cancellations, impairments, reserve adjustments and other factors. With home sale revenue increasing by 31% year-over-year, we are pleased to see our SG&A rate dropped 90 basis points to 10.9%. Our total dollar SG&A expense for the 2018 third quarter was up $14.4 million from the 2017 third quarter. Similar to prior quarters, this was driven mostly by increased compensation costs as well as increased commissions expenses driven by a higher level of closings. Our last 12 months pretax return on equity was down 70 basis points as reported. However, excluding investment sale gains, which are not a core part of our business, pretax return on equity rose by 310 basis points year-over-year. Because of the expansion of our gross margin and our improved operating leverage, our homebuilding operating margin, defined as our gross margin for home sales minus our SG&A rate grew by 220 basis points year-over-year. Excluding impairment charges, the increase was 300 basis points. The dollar value for net orders decreased 3% year-over-year to $581.2 million as a 2% increase in our unit net orders was more than offset by a 4% decrease in our average selling price. We continue to see our more affordable Seasons Collection comprise a larger percentage of our overall net new orders accounting for 22% of our total for the 2018 third quarter, compared to just 12% a year ago. Net order average selling price was also influenced by a shift in mix from California, which is our highest priced market to Arizona, which is one of our lowest priced markets. Our monthly absorption rate was a healthy 2.67 for the quarter, although it was down 4% from the same quarter a year ago. Despite the slight drop in absorption rate, our unit net orders rose slightly on the strength of an average subdivision count that increased from 152 in the 2017 third quarter to 161 in the 2018 third quarter. With a significant percentage of our new communities featuring affordable price points, which have generally seen stronger demand in recent quarters relative to move up communities, we are optimistic about maintaining a healthy order pace in the future periods. Our East segment experienced double-digit growth in absorption rates on the strength of improvements in both Florida and the Mid-Atlantic. Our Mountain segment experienced a year-over-year absorption rate decline due mostly to modestly slower activity in Colorado where we increase prices significantly in prior quarters in response to market demand, which allowed us to offset increases and improve gross margins. Our absorption rate in the West was down only slightly as double-digit increases in Arizona and Nevada were offset by double-digit declines in California and Washington. In all markets, we continue to review pricing at a community level on a routine basis with an objective of making adjustments as necessary to maintain an appropriate balance between margin and pace. We ended the quarter with an estimated sales value for our homes in backlog of $1.8 billion, which was up 6% year-over-year, driven primarily by an increase in the number of homes in backlog. The average selling price of homes in backlog was down 1% year-over-year to $487,000, and down 4% from our peak of $507,000 at the end of 2017. Active subdivision count was at 158 at the end of 2018 third quarter, up 3% from 154 a year ago and up 5% from 151 at the end of fiscal year 2017. The mountain segment accounted for the year-over-year growth, offset somewhat by modest declines in the West and East regions. As you can see from the chart on the right, at the end of September, we reached a recent high for the number of subdivisions that we believe will soon be active and it is significantly exceeds the number of subdivision that will be soon selling out. This favorable dynamic gives us confidence that our goal of a 10% year-over-year increase in active subdivisions at the end of 2018, is still in reach. For the 2018 third quarter, we acquired 2,489 lots, up from 2,004 a year ago. The heaviest concentration was in our mountain segment, which accounted for 49% of the acquired lots. Our East segment accounted for 24% of lots acquired, compared to just 10% a year ago and the West accounted for about 27%. Approximately 47% of lots acquired in the third quarter were finished lots. Lots we acquired in the third quarter covered 46 communities, including 27 new communities. From a product mix standpoint, 44% of the acquired lots. Lots we acquired during the 2018 third quarter are intended for our Seasons Collection. Acquisition spend for lots was $154 million. After accounting for an additional $85 million of development costs, our total land spend for the quarter was $239 million. We approved 2,878 lots for acquisition during the quarter with 70% of the total coming from our West segment. Our Seasons Collection represented 36% of these lot approvals. At the end of the quarter, we owned or controlled 25,011 lots, up 32% year-over-year and 37% of these lots are controlled via option. Our financial position remained strong at the end of the quarter, as shown by quarter-end liquidity of $1.1 billion and net debt to capital of 26.1%. Additionally, we are proud to announce that just today, we closed on an increase in our homebuilding line of credit from $700 million to $1 billion and out of the year to the term of the facility, which now extends to the end of 2023. With that, I will now turn the call back to the operator for our question-and-answer session. Operator? Just one moment, we had a technical issue here.

[Operator:]

We will now begin the question-and-answer session. [Operator Instructions]. The first question will come from John Lovallo of Bank of America. Please go ahead.

[John Lovallo:]

Hey guys, thank you for taking my questions. The first one here is, Larry, you noted some softening in demand at the higher price points in certain markets, which is pretty consistent with what we’re hearing. How would you characterize the demand for the Season’s product that was still pretty robust and then maybe you can comment on October order trends?

[Larry Mizel:]

I’m going let Bob comment on order trends, but I would say the Seasons product has been well received throughout all of our markets. And we’re very pleased with its performance and the market is received it well also.

[Bob Martin:]

Yes. Just speaking to October in particular. I would say our orders were softer in October. We are still seeing good traffic and writing a lot of contracts. We are also seeing some uptick in the level of cancellations. I think that’s understandable, as our customers digest the impact of higher home prices and higher interest rates. The other thing I would note is you should keep in mind that last year, we sold virtually no seasonal [drop-off to] net orders going from Q3 to Q4, which is very unusual for our business. So we are up against a very difficult comparison for net orders in Q4.

[John Lovallo:]

Okay, that’s helpful. And then as a follow-up and I know this is going to sound like an audit question because we normally don’t think about CapEx and D&A in this business, but it looks like both CapEx and D&A have moved up pretty significantly over the first three quarters on a year-over-year basis. And just kind of back of the envelope, it would imply that the D&A expense in the third quarter could be something like a 50 basis point year-over-year hit to gross margin. Are we missing something here or if not, what’s driving this?

[Bob Martin:]

I mean I think what you’re seeing is the impact of 606 where we had to make a switch with our deferred marketing into PP&E essentially. So some of that expense which is from deferred marketing to depreciation.

[John Lovallo:]

Okay. Thanks guys.

[Operator:]

The next question is from Alan Ratner of Zelman & Associates. Please go ahead.

[Alan Ratner:]

Hey guys, good afternoon and thanks for taking my questions. So first one, you guys have been very active in the land market over the last year. You probably have put up the largest increase in lot count among your peer group. Obviously, I think a lot of those lots were probably underwritten in the environment that was stronger than the one we are seeing today. So, I guess the two-part question here is one, how does the as these slot start to flow through to active communities? How are the economics looking versus when you originally underwrote them? And two, are there any situations on option deals where you’ve had success or are starting to go back to the land sellers and try to renegotiate?

[Larry Mizel:]

Alan, as you know this business is a little cyclical and since our strategy is small parcels of land where we have the outlook of three years to work through each of the parcels and each of the sub-divisions are underwritten sequentially as they’re done in light of the market and as the market changes, we change in our assumptions and I think this has been very opportunistic for us, especially with the recent softening of the market with someone that has a very highly controlled land supply, we we’re able to cycle in and cycle out quicker than most of the other builders. And the one thing about the land sellers now that we are always in the market and we are not sure – I’m making sure everyone’s aware of market conditions and the need for adjustments and the strategy of what we’ve always followed on the short land supply, this has really worked in our favor with the slight slowdown in the market and we expect that over the next period of time, it’ll even more so and the strategy of how we run our business with very few specs and the ability to have good pricing. Alan we’ll, I think work in our favor in this transitionary period and going forward.

[Alan Ratner:]

I appreciate that, Larry and I think your comment on the specs is interesting because we have seen from some other builders that have made a similar push towards entry level like you guys, but have done it from a different angle of really predominantly specs. I think the spec count across the industry have really started to climb here and I’m curious as you look at your entry level business which is more to be built. Are you seeing a lot of incentivizing going on for builders that are may be sitting on more product on the ground than they otherwise would like? And how is that impacting your ability to sell on the to be built side?

[Larry Mizel:]

We compete with everyone, every day, whatever they do, they need to meet their objectives. The one thing that we have with very few specs, we’re able to have disciplined and disciplined in pricing. We’ve seen that in some cases, our specs are bringing a little bit more gross profit margin then the Derek [ph] start because where they are in the production cycle and we don’t have the pressure to incentive the sale as aggressively as someone who has thousands of specs because they need to move that inventory. And as you’ve watched us over the years, we have a nominal amount of finished specs and gives us a lot of discipline on pricing.

[Alan Ratner:]

Thanks a lot.

[Operator:]

The next question is from Michael Rehaut of JPMorgan. Please go ahead.

[Maggie Wellborn:]

This is actually Maggie Wellborn on for Mike today. When you said that about 70% of the [indiscernible] in the West at this quarter and then kind of [indiscernible]. What I was wondering is looking into 2019, will this trend continuous on focusing on the West or are you looking kind of towards a different geographic mix?

[Bob Martin:]

Yes, there is a little bit of volatility quarter-to-quarter in which deals get approved where. I think we’re looking to grow in each of the markets that we built in. So, I wouldn’t necessarily left this one quarter kind of define how we’re thinking about it.

[Maggie Wellborn:]

Okay. Also last call you kind of talked about the shift towards more affordable lines and you said that you will obviously could get to 40% or 50% of sales in those. So, what I was wondering is, is there kind of a time horizon on that, is that still the goal and how are you thinking about that shift as you move into 2019?

[Bob Martin:]

Yes, I mean, I think we’re still thinking about that shift getting into that call, 50% of our mix into that affordable range. We don’t have a timetable for it. If you look at Q3, 17% of our closings were seasons and you add additional closings on top of that. That we’re in other products that are – that have an eye towards affordability like our Landmark Collection and our Cityscape’s Collection. And further to that point, we also have some other products that we intend to release pretty soon that are intended for affordability. So we are working on it from a lot of different angles and we do expect that to be our goal for that type of product.

[Maggie Wellborn:]

Okay. Thank you.

[Operator:]

The next question is from Stephen Kim of Evercore ISI. Please go ahead.

[Stephen Kim:]

Thanks very much guys. Just wanted to follow-up on the comment about the cancellations. I noticed that on a backlog basis, your cancellation rate was really pretty flat year-over-year, frankly it was like 12%, it was 11% I believe last year. Correct me if I’m wrong. And so, I was curious, your comment about October as a percentage of backlog is your – you can rate that you’re experiencing noticeably higher than it was in the year ago period.

[Larry Mizel:]

Yes, a little bit.

[Stephen Kim:]

And could you provide a color…

[Bob Martin:]

We haven’t color.

[Bob Martin:]

Go ahead sorry.

[Stephen Kim:]

Sorry, go ahead.

[Bob Martin:]

I was just going to say, it’s obviously, they are only one day ins. We haven’t pull out of time now to analyze it, but yes, it is a little bit higher in October.

[Stephen Kim:]

Got it. And I guess, providing a little bit of color on that in terms of, are you seeing that more on the entry level side or are you seeing that pretty much across the board or is it more skewed to sort of the higher price points, a number of the builders sort of talked about that being a little bit more on the higher end of the market, so anything there? And then also, I was curious if you could comment a little bit more about the land strategy. If I could to set that up a little bit, on one hand, you’re not – you guys aren’t the first to get into the entry level. And so, one might think that the prices for land may have shot up there, but on the other hand, right now, you’re seeing a lot of folks, which who are perhaps cutting back a little bit on their land spend what we’re hearing. And so I was curious, if you were sort of the opinion that during this period of time, you have an opportunity to make some opportunistic buys.

[Bob Martin:]

I guess on the first part, I really haven’t had a great opportunity to analyze in detail what happened in October. Yes, other than I would say overall, as we’ve indicated that a few times on the call, we see that entry level that affordable price point is showing a little bit more strength. So not a whole lot more to add there in terms of where exactly that the cancellations are coming from. We’ll have more on that on our fourth quarter call. I think in terms of your – the last part of your question, the land strategy. I think, we really are set up our strong balance sheet. It really does provide us with some potential advantages. The current sales softness may ultimately provide well capitalized builders like us with better long-term opportunities that wouldn’t otherwise be available if things were perpetually upward trending. So, we tend to think that with a strong balance sheet, we control our own destiny.

[Stephen Kim:]

Yes, that’s great. Thanks a lot guys.

[Operator:]

The next question is from Stephen East of Wells Fargo.

[Paul Przybylski:]

Thanks. This is Paul Przybylski on for Stephen. Martin, if you could give us some color on your incentives, looking at quarters versus closing – closings and the type of incentive that seems to be most successful. And if you had seen now, the incentives accelerate in September and October, and if that has had any negative impact on your most recent backlog margins.

[Bob Martin:]

Yes, I guess, first of all on the backlog margins through the end of Q3, those held up pretty well as we indicated, it’s in line with where closings were in Q3. So we feel pretty good about that part. I do think, incentives on orders were a little bit higher in Q3 than they were a year ago, even a quarter ago, might be 150 basis points. But, then again that’s against higher pricing too, so you have somewhat of a balancing effect there. So we certainly are willing to pull the levers as necessary to make sure we maintain an appropriate level of absorption rate.

[Paul Przybylski:]

And then I guess, if you look at Southern California and the Pacific Northwest, it seem to be having the most meaningful pause due to rates and pricing. Denver has very similar dynamics. Is there something that’s Denver apart, because it seems like demand there is holding up much better than the West Coast?

[Bob Martin:]

Yes, I mean Denver has been a great market for us, clearly because we’ve operated here for a long time, and we know a lot about the market. It’s not to say Denver is immune to increase pricing, but it is more affordable on a relative basis versus a lot of the West Coast. And it is a place where a lot of people want to move, it’s got a great quality of life, and we’re seeing a lot of companies move in because of that. And I think of it, just as having – just a little bit more affordability than you do on some of the coastal markets. So I think that helps out as well.

[Paul Przybylski:]

Okay. Thank you.

[Operator:]

The next question is from Nishu Sood of Deutsche Bank. Please go ahead.

[Nishu Sood:]

Your guide for 4Q in terms of closings, the backlog conversion ratio, second quarter in a row here will be up a couple percentage points year-over-year. Can you walk us through what has been driving that? Has that been the move to the entry level, obviously a smaller product likely, shorter construction cycles, is it bad or it’s something else, and would we expect that to continue as you increase the penetration of the entry level product in your portfolio?

[Bob Martin:]

Yes. Well, I think the entry level certainly helps with that, although it’s still a pretty small portion of our closing. So I don’t think that’s already is fully played out, which speaks to the second part of your question. I think it can continue to help us as we move forward. The other thing I would note is that, a year ago in Q3 and Q4, we were dealing with the joist issue in Colorado, so that had somewhat of an impact of subduing our backlog conversion rate in both the third and fourth quarter of last year.

[Nishu Sood:]

And also 10% community count growth in 2018, you are sticking to that goal for 2018. I think that’s the strongest amongst the public builders, if you factor out acquisitions. Given that you’re viewing the recent slowdown as a pause versus a turn in the cycle, would you be aiming for something similar in 2019 or would – does it merit a slower pace of growth in 2019?

[Bob Martin:]

I think that story has yet to play out, I think certainly we would love to see that in 2019. I think the work we’ve already done from subdivision approval to this point gives us that opportunity, but we’re going to take a look at the market just like anybody else, and make sure that, that demand is there, whether it’s in Q4, clearly, it’s harder to see in Q4 since it’s a seasonally slow period or going into Q1 of next year. So more to come on that, but I think we’ve at least done enough work already where that’s a possibility for us.

[Nishu Sood:]

Okay. Thank you.

[Operator:]

The next question is from Jay McCanless of Wedbush. Please go ahead.

[Jay McCanless:]

Thanks. Good afternoon. Thanks for taking my questions. The first one I had on spec. It looks like total specs were up about 49% versus last year. Is that a function of community growth or if certain areas where specs to start selling like they were in this time last year?

[Bob Martin:]

It’s really more a function of the strategic build of specs. We do have some circumstances where it makes more sense, just from a construction standpoint, if you have one unsold lot between two sold lots. If you have communities that are on the front end, as you know, we are opening a lot of communities makes sense start a couple, as we’re starting up the community to show a little bit of construction activity. So things like that are driving that increase.

[Jay McCanless:]

The second question I had, just wanted to dig down a little bit more into incentives. Are the incentives that you’re offering now things like rate by their own or an upgraded kitchen, something like that versus price cuts and are you seeing any of your competitors meaningfully start to cut prices to move some of their specs?

[Bob Martin:]

I think our incentives, they come in a number of different forms. I know offering money towards closing in whatever way she perform towards closing costs, that’s something that we typically do. We do have a rate buydown program that we use for a lot of consumers and then home gallery upgrade sometimes will offer incentives for that. So there’s a lot of ways to do it. I wouldn’t say it’s coming in a material way in the form of base price cuts at this point. Yes, I guess in terms of the competitors and what they’re doing on specs, it certainly seems that some of the builders if they’re coming up against a reporting period do tend to offer a little bit more to decrease their inventory towards the end of the period. As Larry indicated earlier, though since we don’t have a whole lot of spec inventory out there yet we don’t feel that pressure as much, because we have limited inventory to start with.

[Jay McCanless:]

Okay. Thanks for taking my questions.

[Operator:]

The next question is from Alex Barron of Housing Research Center. Please go ahead.

[Alex Barron:]

Thank you, and good morning. Larry, you’ve always been kind of very forward-looking when it comes to the cycle. And right now, I guess, you indicated you are still buying land because it seems like you still think there is room ahead. So what would need to change in the market environment for you to kind of step on the bricks on land or at least on option land? What would you need to see changes?

[Larry Mizel:]

I think we’re in the strong economy. We have a high level of consumer confidence. I see that home price owner – home ownership itself has increased slightly. So the statistic I’m sure you saw it and it’s a good market. You have limited availability of product. You have certainly affordable mortgage rates. And there is not an over-built situation in the marketplace. I think we’re fortunate and that doesn’t mean there’s not positives from time-to-time during a cycle, but I still believe we’re early in the housing cycle and we’re not – pricing may have gotten a little aggressive, rates went up a little bit, but the demand is great if people can afford it. So you say, we had a deal with affordability and cost of mortgages, those of us is have been around for a few decades. We remember when you had a 16%, 30-year mortgage and you could sell all the houses you could build, but so today at five-and-change surely average sales price is higher. But I believe that housing will continue to remain strong and maybe slower than it has been as an industry a little bit, but the pause has only been recent, meaning the last six months or so and look forward to getting through the end of the year and I think it will be a very robust spring selling season might even be starting early, but we’re usually the most cautious on the street and it’s proven to give us the financial attitude to do what we do. But as long as we don’t speculate land and we only buy what we need and as long as we don’t speculate with our work in process, which is about 90% of it is our work in process is pre-sales. I believe we’re in a position to move with the market. And at this point, I’m confident that the market is reasonable and reasonable is okay, doesn’t have to be spectacular. In the building business, the guys that can last long as usually end up making a good living and we are part of that history. And as Bob commented, that’s where you got everything was the last sentence of his prepared remarks. Earlier in the day, we filed an 8-K announcing we had concluded a new $1 billion revolver, which would indicate that the financial institutions in our industry have confidence in us and we have confidence in ourselves.

[Alex Barron:]

Got it. Sounds good. And then Bob, like in terms of the impairment, you guys took just generally speaking, what is it that would need to happen to drive an impairment?

[Bob Martin:]

Well, on a tactical basis, it’s the undiscounted cash flows still negative. So when you look at the carrying value of your asset that’s on your books at that point in time, you’re not expected on a discounted basis to get that carrying value back and then at that point once you own to a negative territory, you apply a discount rate to those cash flows and that’s what ultimately produces the amount of impairment. So clearly, cost increases or price decreases or extra incentives, any of those kind of things from an operational standpoint could cause impairment.

[Alex Barron:]

Got it. Okay. Thanks a lot.

[Operator:]

The next question is from Buck Horne of Raymond James. Please go ahead.

[Buck Horne:]

Hey, thanks. Just a quick one. I was wondering if you had any sort of anecdotes or data points on early traffic indicators or early demand indicators like physical traffic into the communities or website activity through October, just something to an early stage demand patterns that you’re tracking?

[Bob Martin:]

Yes. Well, we don’t have, I guess, a specific number on that. What I’m hearing is that the traffic remains good in our communities. We’re getting a good level of traffic through. I did mention, we’re seeing a little bit more on the cancellation side, but still good activity, but again, I would reiterate that we’re up against a pretty tough comparison from last year, given that there was no seasonal drop-off from Q3 to Q4.

[Buck Horne:]

Okay, thanks. And going back to the other labor comments that I think you saw some cycle time increases in Arizona and California. Would you characterize that as the labor availability getting worse than it was last year or what’s kind of driving that and what kind of labor cost inflation rates are you’re facing across the various markets?

[Bob Martin:]

Yes. Arizona, Phoenix in particular in Northern California, I don’t think it’s less labor, it’s just you had more of a kind of onset of demand. Arizona, for example, is one of our stronger markets for an absorption rate perspective in the third quarter. And I think, with that increased activity, you’ve got more starts and just more demand for that labor. The labor pool just hasn’t had chance to quite catch up yet.

[Buck Horne:]

And do you think – is that something that’s going to linger in the next year and would have potentially spread to other markets? Is there a sense that labor is tightening up elsewhere?

[Bob Martin:]

Nothing tightening, I think it’s just a matter of it. Once you get those kind of influxes in demand, you just end up with a little bit of kind of a backup with the trades, whereas they just have more to do and it just takes more time for them to get to the individual houses. So it’s really tough to tell whether or not that will extend to next year. Certainly, it’s reasonable to think if you have a pretty quick increase in order activity and therefore an increase in starts that just puts a higher constraint, higher strain on your subcontractor base.

[Buck Horne:]

Okay. Thank you.

[Operator:]

The next question is from Ken Zener of KeyBanc. Please go ahead.

[Ken Zener:]

Good morning. My question, you guys have talked about seasonal orders and Bob, you mentioned obviously last year in the fourth quarter, you guys had an exceptional quarter with pace not slowing down. And we tend to model things quantitatively, so my question to you is this, historically, long-term in the last three years, you generally have a pace decline of about 20% sequentially. Realizing your community count is going to be up about 10% year-over-year, is there any reason to think normal seasonal trends would not transpire, not trying to focus on Southern California or these kind of weak spots, but just generally order pace tend to decline and that order pace decline is greater than your strong community count growth. Is it a logical to assume that you might have kind of down orders even though you’ve had such good community growth as well as obviously improving gross margins, but just mechanically, is there any reason that your 10% community count is really not going to be overwhelmed by the usual kind of decline that we have in order pace in the quarter?

[Bob Martin:]

Well, as you’re indicating that rough number, that 20% decline is the norm. In fact, as I looked back at the last 20 years or so, I think last year was the only time, where you didn’t see a decrease. So just from a kind of raw quantitative analysis, that makes sense. Just on the notion of the subdivision count, note that, that’s a 10% increase by the end of the year. So, right now as of 9/30 rather we stood at 158. So that would be 158 if we got exactly 10%, going on to 166 by the end of the quarter. So, all of those subdivisions are going to be in full swing.

[Ken Zener:]

Right...

[Bob Martin:]

So…

[Ken Zener:]

I’m just trying to think about it mechanically, because you are obviously getting seasonal results, your margins are good, despite what the headlines are. So, I just didn’t – I know you guys are going to be talking about perhaps so many things in your Analyst Day. So, thank you very much.

[Operator:]

There are no other questions at this time. This concludes our question-and-answer session and also our conference. Thank you for attending today’s presentation. You may now disconnect.