LGI Homes Inc

NASDAQ:LGIH

Earnings Call Transcript 2017-Q4

[Operator]

Welcome to the LGI Homes Fourth Quarter 2017 Conference Call. Today’s call is being recorded and a replay will be available on the Company’s website later today at www.lgihomes.com. We have allocated an hour for prepared remarks and Q&A. [Operator Instructions]

At this time, I will turn the call over to Rachel Eaton, Chief Marketing Officer at LGI Homes. Ms. Eaton, you may begin.

[Rachel Eaton, Chief Marketing Officer]

Thank you. Welcome to the LGI Homes conference call discussing our results for the fourth quarter and full-year 2017. Today’s conference call will contain forward-looking statements that include among other things, statements regarding LGI’s business strategy, outlook, plans, objectives and guidance for 2018. All such statements reflect current expectations. However, they do involve assumptions, estimates and other risks and uncertainties that could cause our expectations to prove to be incorrect.

You should review our filings with the SEC, including our risk factors and cautionary statements about forward-looking statements section for a discussion of the risks, uncertainties, and other factors that could cause our actual results to differ materially from those anticipated in these forward-looking statements. These forward-looking statements are not guarantees of future performance. You should consider these forward-looking statements in light of the related risks and you should not place undue reliance on these forward-looking statements, which speak only as of the date of this conference call.

Additionally, adjusted gross margins and non-GAAP financial measures will be discussed on this conference call. The presentation of this information is not intended to be considered in isolation or as a substitute for the financial information presented in accordance with GAAP. A reconciliation of adjusted gross margin to gross margins, the most comparable measure prepared in accordance with GAAP is included in the earnings press release that we issued this morning and in our annual report on Form 10-K for the fiscal year ended December 31, 2017 that we expect to file with the SEC, later today. This filing will be accessible on the SEC’s website and in the Investors section of our website at lgihomes.com.

Joining me today are Eric Lipar, LGI Homes’ Chief Executive Officer; and Charles Merdian, the Company’s Chief Financial Officer.

With that, I’ll now turn the call over to Eric.

[Eric Lipar, CEO]

Thank you, Rachel, and welcome to everyone on this call. We appreciate your continued interest in LGI Homes.

2017 marked our fourth full-year as a public company. Our primary objective when we went public in 2013 was to access the capital markets to fuel our growth by replicating our business model across the country. Over the past four years, we have more than tripled the size of our organization. And today LGI Homes is selling across 11 states, in 21 markets, and we have start-up operations in four additional new markets including Sacramento, Oklahoma City, Birmingham, and Las Vegas.

As we have continued to grow, we have maintained the LGI culture, demonstrating that our unique operating model is sustainable. Our employees are our most vital assets and continue to make the difference. It is through the dedication and outstanding performance of our employees that we are able to leverage our systems and processes to deliver exceptional customer service and ultimately sales in closings. So, to all of our LGI employees, we appreciate and thank you for your commitments, loyalty, and hard work which have produced another year of record-setting results.

During today’s call, I’ll summarize the highlights from the fourth quarter and our 2017 full-year results, followed by Charles discussing our financial results in more detail. After he is done, we will conclude with comments on what we are seeing this quarter and our expectations for 2018, before we open the call for questions.

At the start of 2017, we provided guidance announcing our expectations to deliver more than 4,700 home closings and to have between 75 to 80 active communities by the end of the year. In addition, we provided guidance that we would deliver basic earnings per share to our investors in the range of $4 to $4.50, all while maintaining our gross margin at or near industry-leading levels between 25% and 27%, and adjusted gross margin between 26.5% and 28.5%. As reported during the year, we increased and refined our guidance for both closings and EPS. Today, I’m pleased to announce that for 2017, we met or exceeded our guidance in all areas.

We ended 2017 with a record 5,845 closings, exceeding our initial guidance of more than 4,700 closings by more than 1,100. Driving this record performance for the year was a record-breaking fourth quarter of 1,844 closings including 770 closings for the month of December. For the year, we averaged 6.7 closings per community per month, company-wide. This is the highest level we had experienced on an annual basis since we became a public company.

2017 demonstrated our ability to produce strong absorption rates as we continued to expand into new markets. Our top market on a closings per community basis was Fort Myers at 9.7 closings per month, followed by Dallas Fort Worth at 9.5, Houston at 8.2 and San Antonio at 8 closings per month. Of the markets we operated in with at least two active communities during 2017, all 16 of these markets achieved closing velocities greater than four closings per community per month.

Companywide, active communities at the end of 2017 increased to 78 from 63. 11 of the 15 active communities added during the year were outside of our Texas markets, contributing to the further geographic diversification of our business. During 2017, our Southeast division added six communities, our Central division added four, our Northwest division added two, and our Southwest, Florida and Midwest divisions added one community each.

Consistent with our stated strategy, we continue to gain ground and demonstrate success in our non-Texas markets. For the fiscal year, the share of our home closings in our markets outside of Texas increased from 48% of our home closings in 2016 to 58% in 2017.

Although our community count growth has been primarily outside the state of Texas, home closings for our Texas markets increased by 22% in 2017. In Florida where we only added one net community, closings increased by 70% year-over-year; and in the Northwest, closings increased by 466% from 53 in 2016 to 300 in 2017.

Due to continued momentum and solid performance during 2017, we raised our basic earnings per share guidance twice during the year. As a result of our very strong fourth quarter, we exceeded the top end of our guidance range ending the year with basic earnings per share of $5.24, a 45% increase above our $3.61 basic earnings per share for 2016.

During 2017, we had a goal of achieving $1 billion in home sales revenues. I’m proud to report that we generated home sales revenue of nearly $1.3 billion during 2017, nearly 50% more than our 2016 home sales revenues. This growth was driven by a 40.4% increase in home closings, combined with a 6.9% increase in average sales price for the year, in line with our guidance.

For more detailed financial results, I will now turn it over to our Chief Financial Officer, Charles Merdian.

[Charles Merdian, CFO]

Thanks, Eric.

Home sales revenue for the quarter were $405 million based on 1,844 homes closed, which represents a 71% increase over the fourth quarter of 2016. As Eric mentioned, home sales revenues for the year totaled nearly $1.3 billion a new record for LGI. Our average sales price was $219,618 for the fourth quarter, a 5.6% year-over-year increase and a 3.8% increase over the third quarter. The increase in average sales price year-over-year reflects changes in product mix, favorable pricing environment and new or replacement communities added during 2017 that have higher price points. Sales prices realized from homes closed during the fourth quarter range from 150s to the 530s. This includes 43 homes in Terrata communities which had an average net sales price of approximately $416,000.

For the year, we closed 108 homes in our Terrata communities, representing less than 2% of our overall closings. We expect closings from our Terrata communities to continue to be less than 5% of our overall business in 2018. This past year, we closed 201 wholesale units, generating $40.8 million of revenue in our communities. For the full-year, wholesale units reduced our gross margins by approximately 30 basis points. We believe that our wholesale business is accretive to the overall business as operating margins are similar. Our expectation is that wholesale closings will account for approximately 5% of our business in 2018.

Gross margin was 24.4% this quarter compared to 25.1% in the previous quarter and 27.2% for the same quarter last year. Our adjusted gross margin was 25.8% this quarter compared to 26.5% in the previous quarter and 28.5% for the fourth quarter of 2016. Gross margins were impacted in the second half of 2017 by increase production levels, increase in labor and materials, and community mix offset by increases in home prices. Increasing our production in many cases required us the higher additional subcontractors and trades, increasing our costs in order to meet the production demand.

For the year, gross margin was 25.5% compared to 26.4% for the full-year of 2016 and adjusted gross margin was 26.9% compared to 27.8% for the full-year 2016. Adjusted gross margin for the fourth quarter excludes approximately $5.9 million of capitalized interest, charged to cost of sales during the quarter, representing a 145 basis points and we expect this to remain in the range between 130 to 160 basis points for the upcoming year.

Combined selling, general and administrative expenses for the fourth quarter were 10.8% of revenues and 12% for the full-year. As a percentage of revenues, we believe that for the full-year 2018, we will continue to achieve operating leverage in our existing markets, offset by initial operating costs in new markets. Overall, we expect that we will see positive leverage with up to 40 basis-point decrease in SG&A as a percentage of revenue this year, given our previously published closing guidance range. SG&A will vary quarter-to-quarter based on home sales revenue and we typically expect the first quarter to have the highest SG&A ratio as our first quarter generally results in the lowest closings on the per community basis during the year.

Selling expenses were $28.6 million or 7.1% of home sales revenue compared to $18 million or 7.6% of home sales revenues for the fourth quarter of 2016, a 50 basis-point improvement. Selling expenses as a percentage of home sales revenues remain consistent from the previous quarter.

General and administrative expenses were 3.8% of home sales revenue compared to 5.1% of home sales revenue for the fourth quarter of 2016, a 130 basis-point improvement and the lowest percentage of home sales revenues since our IPO.

Pretax income for the quarter was $55 million or 13.6% of home sales revenue, an increase of 120 basis points over the same quarter in 2016. Year-over-year, pretax income was consistent at 13.6% of home sales revenue.

Our effective tax rate for the fourth quarter was slightly higher than previous quarters at approximately 35% due to a $1.1 million impact related to recent tax reform that resulted in a reduction in the value of our deferred tax assets. The impact is our most reasonable estimate based on our understanding of the Tax Cuts and Jobs Act, and may change as more information becomes available. We believe, based on the information available at this time that our effective tax rate for 2018 will range between 24.5% and 26% for the full year.

We generated net income of $35.6 million or 8.8% of home sales revenue for the fourth quarter of 2017, which represents earnings per share of $1.65 per basic share and $1.43 per diluted share. For the year, we generated net income of $113.3 million or $5.24 basic earnings per share and $4.73 diluted earnings per share. Weighted shares outstanding for calculating diluted earnings per share are impacted by our outstanding convertible notes and to a lesser extent our stock compensation.

In the fourth quarter of 2017, our average stock price was approximately $63.50, exceeding the conversion price and therefore the convertible notes were determined to be dilutive. This resulted in approximate 2.6 million share increase to the weighted average shares outstanding for the diluted EPS calculation for the quarter.

Fourth quarter gross orders were 1,897 and net orders were 1,332. Ending backlog for the year was 816 homes, an 83% increase over the prior year-end. The cancellation rate for the fourth quarter was 29.8% and for the year, our cancelation rate was 25.4%.

We ended the quarter with a portfolio of approximately 39,700 owned and controlled lots. And as of December 31st, approximately 11,700 of our 21,000 owned lots were either raw or under development. As of December 31st, we had approximately $68 million in cash, $919 million of real estate inventory and total assets of over $1 billion. At December 31st, we had $400 million outstanding under our revolving credit facility and our borrowing capacity was approximately $161 million. In addition, we had $85 million in convertible notes outstanding. Our gross debt-to-capitalization was approximately 49% and net debt-to-capitalization was approximately 45%.

During the fourth quarter, we completed our $25 million ATM or at-the-market equity program that was initiated in 2016. Approximately 87,000 shares were sold under the ATM program in the fourth quarter, generating net proceeds of $5.5 million. For the year, we sold approximately 355,000 shares under our 2016 ATM program, resulting in net proceeds of approximately $15.5 million. We ended 2017 with 21.8 million shares outstanding.

During the fourth quarter, we received conversion notices from the holders of $15 million in principal amount of our convertible notes. The notes were settled in January and February of this year, resulting in the payment of the $15 million principal amount and the issuance of approximately 500,000 shares of our common stock. There are $70 million in convertible notes remaining outstanding.

At this point, I would like to turn it back over to Eric.

[Eric Lipar, CEO]

Thanks, Charles. In summary, we had another impressive quarter and a phenomenal 2017. This past year, we continued to see robust demand for home ownership. In 2017, we increased our digital marketing initiatives driving quality traffic to our communities. Our new social media campaigns generated over 83,000 leads for the year, making up 26% of our total lead volume. We also saw increased inquiries from realtors due to a wider listing space on MLS, Craigslist, and Zillow. For the year, realtors represented 30% of our total closings, up from less than 5% at the time of our IPO. In addition, we continue to use extensive print advertising to attract potential buyers which continues to perform well for us. As we grow, we continue to explore new marketing initiatives to create additional efficiencies in our advertising spend. Advertising expense as a percentage of total homes sales revenue for the year was 1.2%, which marks our fourth consecutive year of decreases.

Not let me provide some guidance and thoughts on what we are seeing for the upcoming year. The first quarter of 2018 is off to a solid start with 277 closings in January, representing a year-over-year increase of 61%. February will also be a strong month of closings. We expect to end this month with approximately 360 closings, representing an increase of more than 60% from last February’s total of 224 home closings.

Based on our strong performance to-date and assuming a continuation of today’s housing market conditions for the remainder of this year, we offer the following guidance.

As we previously announced, we expect to close between 6,000 and 7,000 homes in 2018. We also plan to expand into four new markets this year; Oklahoma City, Birmingham, Sacramento, and Las Vegas. Because we are a systems-based company with proven processes in place, we believe our expansions into these new markets are well-positioned for success. Our goal is to simply duplicate what we have accomplished thus far in our current markets. Our expectation is that each of these markets will perform at a high level, produce results consistent with our existing communities and will be accretive to our operations. We expect all four of these markets to have closings in 2018. We believe our average sales price in 2018 will continue to increase, ending the year with an overall average sales price between $220,000 and $230,000.

Guidance for gross margin will be between 24% and 26%. We expect adjusted gross margin which excludes the effects of interest and purchase accounting will continue to be strong ending the year between 25.5% and 27.5%.

Given our home closing guidance along with an increase in average sales price, realized SG&A leverage and a lower effective corporate tax rate, we believe our basic earnings per share for the full-year of 2018 will be between $6 and $7 per share. In summary, we are very pleased with our results for the fourth quarter and the full-year of 2017. We are poised to take advantage of continued growth opportunities in existing and new markets and believe we are well-positioned to continue to grow our revenues, community count and earnings, allowing LGI Homes to achieve our long-term goals and objectives of producing market leading returns for our shareholders.

Now, we will be happy to take your questions.

[Operator]

[Operator Instructions] And our first question comes from the line of Jay McCanless from Wedbush. Your line is now open.

[Jay McCanless, Wedbush]

The first one I had relates to the guidance, gross margin guidance of 24% to 26% for ‘18. Just given the gross margin in your highest unit closing quarter was in the low 24s, can you walk us through some of the avenues or things that could happen to get you guys back up to the midpoint of the ‘18 guidance from where you were in the fourth quarter of ‘17?

[Charles Merdian, CFO]

Sure. Jay, this is Charles. I’ll start and then Eric can add. First of all, I think, what we saw in the last half of 2017 was the impact of increased production. We started over 7,000 homes this year in both our existing and our newer markets. And so, what that required us to do is to go out and get additional sub-contractors and trades, which had a cost to it to get those additional sub-contractors. We also saw increases as everyone else is seeing as well in material and labor increase, putting additional pressure on costs. And what was a little bit different I think this year was that those increases tended to be a little bit more frequent or at least the significance of the increases were more frequent that what we historically had seen. And then, the third component would be our wholesale business. So, as I mentioned earlier, this year, we had a 30 basis-point impact related to wholesale. So, included in our guidance for ‘18 is a 30 to 50 basis-point reduction in overall guidance from previous years, specifically related to the wholesale business.

[Jay McCanless, Wedbush]

So, 30 to 50 basis points in fiscal ‘18 also. And then, I believe on the -- can you repeat the SG&A guidance that you gave? I think, you said 40 basis points of deleverage in 2018 due to higher volumes?

[Charles Merdian, CFO]

Correct, yes. So, between the low end of 6,000 to the high end of 7,000, we think that’s a little leverage up to 40 basis points leverage on SG&A.

[Jay McCanless, Wedbush]

Okay. And with the convertibles that you guys paid out this quarter, where does the share count stand now, and approximately where should it be at quarter-end on a dilutive unit basis?

[Charles Merdian, CFO]

Sure. So, we ended the year at 21.8 million shares, the 0.5 million shares will flip between the dilutive calculation and into basic that we issued for the $15 million in convertible notes. We typically have in the first quarter an increase in basic shares related to stock compensation. So, we should -- and somewhere in the mid 22 million, 22.4 million, 22.7 million basic shares. And then, if the fourth quarter -- first quarter is similar to the fourth quarter in terms of the remaining dilutive effect, there was 2.6 million shares effect in the fourth quarter, at a $63 average stock price, so take those 0.5 million shares out, so there’d be about 2.1 million share impact related to the convertible notes in the first quarter.

[Jay McCanless, Wedbush]

Got it, okay. And then, the last question I had is in terms of pricing power, can you talk about maybe what percentage of your total communities do you think you have pricing power right now? And how are those trends developing in early 2018 as mortgage rates have started to move up?

[Eric Lipar, CEO]

Yes. Jay, this is Eric. I can handle that. I think, with the cost going up, we’re increasing prices in a 100% of our communities. We just had a price increase effect in the first three years, because of the cost that we’re talking about on this call with the margin. So, it’s necessary to increase the sales prices, because we could see costs continuing to go up regardless of rates are going to do, and that we’re going to have another pretty significant price increase in April. Again, in 95% plus of our communities, we see that trend continuing.

[Operator]

Thank you. And our next question comes from the line of Michael Rehaut from JP Morgan. Your line is now open.

[Michael Rehaut, JP Morgan]

Thanks. Good afternoon, everyone. First question, I just wanted to make sure I understood on the gross margins, which I think is causing a little bit of reaction in stock today in terms of the guidance. Obviously still very strong and industry leading, but a little bit of a different, slightly lower than last year. Charles, you broke out the wholesale business, which is very helpful. Just want to make sure, when you say 30 to 50 bps headwinds in 2018, on an incremental basis, you’re talking about zero to 20 correct?

[Charles Merdian, CFO]

In terms of year -- well, really referencing more or so from our historical guidance range. So, when we previously guided the 26.5 to 28.5 on adjusted basis, we would take essentially upto 50 basis points off of that. So, we’ve reduced our guidance by 100 basis points total from our historical range to our current range. So, 50 basis points of that is related to wholesale.

[Michael Rehaut, JP Morgan]

Right, 30 to 50. And then, would the difference be some of the other factors in terms of bridging the gap between the 30 to 50 to the 100 basis-point overall delta, would be some of the factors that impacted 4Q results, as you mentioned, adding subcontractors and trades, as well as labor and material inflation?

[Charles Merdian, CFO]

Sure. No, we definitely see some pressure in the early part of 2018 on gross margins. But, as we increase production that really took effect kind of early to mid part of last year and now in a lot of our -- particularly our newer markets, we’ve now established those trade relationships and have probably a little bit more leverage than maybe we did in the mid-to-late part of last year. So, we would expect between that and a combination of raising prices that Eric mentioned, would be able to catch us back up, if you will, in the back half of the year.

[Michael Rehaut, JP Morgan]

Okay. So, then, what in your view is the remaining delta in terms of the 100 basis-point reduction in the gross margin range, in addition to the wholesale business?

[Charles Merdian, CFO]

Yes. So, wholesale is 30 to 50. And the remainder is the combination of all of the above in terms of building our houses more efficiently, paying attention to bids and negotiating prices, working diligently on those areas and then offsetting it with our being little bit more aggressive in price increases in the short run.

[Michael Rehaut, JP Morgan]

Okay. So, I guess secondly on the SG&A. You mentioned 40 bps of expected leverage for this year. But I though you also referenced a range. I wasn’t clear if the range is more like 30 to 50, and 40 was at the midpoint, if you could just clarify there?

[Charles Merdian, CFO]

Sure, yes. So, the range is dependent on really the top-line, the revenue line item, so, the combination of fixed versus the variable costs. So we think if the closing guidance that we gave and ended up at the low end of the range, then, obviously there is going to be a little to no operating leverage realized in SG&A. But, if we end up at the high end of the range, then we think it’s up to 40 basis points, based on what we’re seeing right now.

[Michael Rehaut, JP Morgan]

Okay. And then, just last one, if I could. With the closing guidance range of 6,000 to 7,000, and you’re able to do almost 6,000 in fiscal in 2017, obviously, you’re off to a strong start this year. Just feels like all else equal, there is a little bit of conservatism at least at the low end of the range. What factors would result in coming in closer to the 6,000 which would be just fairly low growth range, significantly lower than what you’ve done in the past, obviously, just considering that you’re still expanding into new markets et cetera. Why the low end of that guidance?

[Eric Lipar, CEO]

Yes. Mike, this is Eric. I’ll start on this one. Our community count guidance is up 9% to 15% year-over-year. So, I think it really comes down to absorption rates for community and where our closing guidance is going to end up. And we thought it was prudent to come out with a wide range to start the year, and then we should narrow that as the year progresses. Like we talked about in the script, last year, 2016, we averaged 6.7 closings per community. And that was higher than our traditional 6 to 6.2 closings per community since we’ve been the public company. So, a pleasant surprise and unbelievable year in 2017 to increased absorption, as we’ve been hiring a whole lot of new people, as we’ve been entering markets and as we’ve been increasing our average sales price. And we are very optimistic on 2018. We think that trends continue. If we can average 6.7 closings per community per month again, then our closing increase will be right in line with community count of about 10% to 15%. So, it’s just a question of where those closings come in.

We’d like to be conservative every year as a public company. We’ve hit our annual guidance in every metric, and we want that trend to be continued -- to continue. So, we think we should start off the year being conservative with a little bit wider range on our guidance.

[Operator]

Thank you. And our next question comes from the line of Nishu Sood from Deutsche Bank. Your line is now open.

[Nishu Sood, Deutsche Bank]

Thanks. I also wanted to just talk about closings guidance for ‘18. I think, a lot of investors might look at the tremendous growth you had in the second half of ‘17 as you were just talking about, Eric. The slowdown obviously in the rate of growth in January and February obviously is up a lot year-over-year but there were the production issues last year which depressed the comps. You are having to raise prices a lot, obviously to match your construction costs and rates are obviously going up. So, I mean, I think, a lot of investors might look at that and see it as a affordability is getting constrained, interest rates are affecting your growth trajectory. So, just, I was wondering if you could kind of address your guidance relative to that way of thinking about it.

[Eric Lipar, CEO]

Sure, Nishu. This is Eric, again. And all good questions. I think, my answer is similar to what I said with Michael. But, when we put out the 6,000 to 7,000 closing guidance, that was right around first year. So, we’ve had a couple of months since then. We then feel it was necessary to change that guidance this early in the year because we still have a long ways to go. But certainly, based on sales, particularly over the last 30 days, sales have been very positive. We are seeing it in the February closing numbers but also February sales have been very strong. So, we are looking forward to seeing strong closings coming through in March and April. And we’ve been selling -- everybody is watching the rates and everybody knows the tenures of it, 2.9%. And we are selling with higher rates over the last 30 days. So, we have been selling, most of our customers in the high 4s and low 5s as far as the 30-year [ph] rates. And we are comfortable with that. And sales have remained strong. And I think, it’s because rates are going up with the economy strong, consumer confidence is strong, supply is very low. Jobs are being created. So, we feel really good about where we are with rates. And we do assume that rates will continue to increase another 25 to 50 to 75 basis points. And as long as that goes along with the economy still strengthening, jobs getting created, wage inflation, customers making more money, I think that’s going to be a very positive for LGI as well. So, we are feeling really good about the business, especially sales over the last 30 days.

[Nishu Sood, Deutsche Bank]

Got it. No, that’s helpful. 7,000 or I think Charles you said over 7,000 starts in ‘17 versus the 5,800-ish closings. Part of that was probably in the first few months of the year, the kind of difference, as you are kind of catching up with the inventory shortages. But it also implies a pretty heavy lean into production towards the end of the year, probably because you exceeded your guidance by quite a bit. But even then, like 7,000 still is a massive number. How should we think about that? I mean, it’s higher even than what you are contemplating for closings guidance for ‘18. So, maybe if you could just help us understand the context of that. How, it might accelerate sales maybe at some point in the first half of ‘18?

[Eric Lipar, CEO]

So, we started off the beginning in the year with about roughly 1,600 units, either in process or completed and ended the year with about 2,900. So, part of that I think was a little bit in ensuring to make sure we had enough available inventory for the first quarter, given what happened to us in the first quarter of ‘17. So, rather than tapering off production, which we typically historically had done in the fourth quarters, knowing that the first quarter might have a little bit of lower volume, we just kept production up and gave ourselves the opportunity to be able to even out or level out closings just a little bit better than maybe what we did in the first quarter of last year.

[Nishu Sood, Deutsche Bank]

And inventory, is that holding up sales do you think so far in 1Q or is there sufficient inventory to kind of sell it to the pace that your sales folks are seeing demand?

[Charles Merdian, CFO]

Yes. I think this is Charles, again. I’ll start. It’s really community specific. So, it really depends on each individual community on where the current inventory balance is versus where the current pending list is, where the backlog is. So, it’s community by community specific. But, I think overall, we are just in a much better spot in terms of if you will for inventory available to close over the next few months.

[Operator]

And our next question comes from the line of Stephen East from Wells Fargo. Your line is now open.

[Truman Patterson, Wells Fargo]

This is Truman Patterson on for Stephen East. Good afternoon. Hey, just wanted to touch on your gross margins again. I think, you guys have talked about labor costs and construction costs inflating. But, I wanted to touch on the higher lot costs, even in the gross margins. I think, you guys mentioned in the press release. Are you guys seeing any increased competition in your land markets? It appears that multiple peers are starting to rotate towards more of a kind of a true entry level product. And how should we think about that flowing through the P&L in 2018? And also, I don’t know if you guys gave this or not, but what are your backlog gross margins looking like currently?

[Eric Lipar, CEO]

Truman, this is Eric. I’ll start. I’d say, yes, we are seeing increased competition from a standpoint of -- everybody hears the same thing that we hear that more builders are entering the entry level space are more focused on the entry level buyer and we think that’s positive. We don’t think that’s going to have a negative impact. Obviously the results of ‘17 and the early results of 2018 would indicate that. We have seen land costs rise, all costs are increasing. I mean that was a consistent theme through 2017 whether it’s land development costs or the price of land or the price of material or the price of labor or the price of fees or doing business with the different municipalities. We think that trend is going to continue, a little bit because of competition but we think land prices were probably going to likely to continue to increase. We think the cost of development of these properties going to continue to increase, and material labors will continue to increase. And we need to offset that with aggressive price increases. And in a tight supply environment we should be able to mitigate extra cost.

With our price line, a couple of other points on gross margins, our difference between the third quarter and the fourth quarter, in order to have consistent gross margins, we would have increased our average price point by $1,200 or our average sales price. So, we missed it by $1,200 as far as the price increase. We should have increased our prices a little bit more and we missed on that. We didn’t think costs would increase that much.

The other thing that we’re seeing and Charles could have more thoroughly as far as we haven’t taken a lot of additional debt. And a lot of what has come through in acquisitions is lot of buy and finish lots from developers. And when we underwrite a finished lot deal, we underwrite it at 25% margin, whereas if we’re developing the property and taken on that development risk in that upfront capital necessary, we underwrite to a 28% margin. So, a little bit of mixed on how we’re replacing these communities as well will have an effect on the overall gross margin.

[Truman Patterson, Wells Fargo]

Okay. Go ahead.

[Charles Merdian, CFO]

Yes, I would just add to Eric’s point there. I mean, over time when we went public, our land costs as a percentage of our sales price were in the 13.5% to 14% range. So, our land costs now today are over 18%. So, we’ve observed increases in land costs, to Eric’s point, over the years. And that’s how we design and make plan selections and underwrite accounts for that. But, I think concur with Eric that we are seeing more finished lots deals and on-balance that helps from a capital allocation standpoint, but can add a little bit of pressure to the gross margin, but certainly within the range that we expect for the full-year.

And then, as far as the question on the backlog gross margins, I mean, these are first quarter closings, are generally homes that we’ve released purchase orders in the fourth quarter. So, it’s a little early for us to see exactly just with only January behind us in terms of closings and the month-end. So, we expect really at this point that like I mentioned before, we may be on the lower end of the range or at or near or maybe below in the beginning of the year, but then expect that to increase over time throughout the year.

[Truman Patterson, Wells Fargo]

Okay. Thanks, guys. That’s really helpful. And since we’re on the topic of affordability and you guys being able to push pricing, with rising interest rates as affordability becomes constrained, how long do you think it would take you to make product changes, value engineered to lower your price? And how long does that take to flow through your income statement? And jumping over to buyer demand and interest rate hikes, are you guys seeing any change in buyer behavior in January and February such as change in consumer for plan selections or possibly any pull forward in demand?

[Eric Lipar, CEO]

Truman, this is Eric. From a demand standpoint, demand is as strong as ever. We’re not spending our complete advertising budget right now because demand is strong. So, even though rates have increased across over the last quarter or two, demand is still there. And I think on your question as far as product change, I think the first thing that would happen and maybe happening some today is that the customer because of rates does not qualify or does not like the higher payment associated with a particular house, the first thing that’s going to happen is they’re just going to have to pick a smaller square footage floor plan in the same community. And certainly, we have limitations on that once you get to the smallest floor plan.

As far as product changes, I think we’re always keeping affordability in mind. With the fit and finish of the house, there is not that much you can do taking out a $1,000 or $2,000 in costs is not going to affect monthly payment that much, but we’re certainly always looking at our costs. The big drivers for us in what we’re looking at a new community, the new sections is square footages and keeping those as lean as we can and also density when it comes to new development and new sections to really drive that lot costs and keep it as affordable as we can.

[Operator]

Thank you. And our next question comes from Carl Reichardt from BTIG. Your line is now open.

[Carl Reichardt, BTIG]

Hey, guys. Just following up on Truman’s question. Have you seen over the last six weeks, a shift to ARM product for -- or maybe buyers and out of fixed?

[Eric Lipar, CEO]

No. Our preferred lenders don’t offer any ARM products. So, all fixed rates right now, still high-4s low-5s 30-year fixed rate, which is still a great rate. So, we haven’t seen any ARM products at all.

[Carl Reichardt, BTIG]

Okay, thanks. And then, you mentioned the 30%, I think you said it of your sales how driven by buyers brokerage. How is that affecting your margin? Do you expect that to change? I’m just little surprised by that just given the long-standing nature of your business model. What are you thinking about that on a go-forward basis, moving to the market, brokers more likely to be evolved, just curious how that impacts you?

[Eric Lipar, CEO]

Yes, sure. Great question, Carl. Yes, it’s been very positive for our business, the addition of realtors, and you can see that coming through in our SG&A expense that we’re continuing to get leverage on it. We’ve always thought about it as a company as our budget to drive leads to our communities. It’s 3% of revenue. And if we pay a realtor a 3% if we’re bringing up the customer, which is traditionally what we pay across the country, or we spend at going direct, the consumer makes no difference for us. We really like the realtor business. We think it’s additive to all the other leads that we get all the other 70% of our closings that come from other lead sources. So, we’re very positive about that. And we believe that’s increased for less than 5% to 30% of our business over the last five years, primarily because of two things. One is as our average sales price continues to go up and as we have expanded outside of Texas in the more expensive markets, realtors as a percentage of the business has definitely increased. And also, what we’ve heard from the realtors is there is such a low supply of finished houses out there. I mean, our niche is building houses in spec. So, we get the supply out there. We tend to have more inventory available than most other homebuilders, and that’s really appealing to the realtor community as well.

[Carl Reichardt, BTIG]

That makes a lot of sense. Thanks for that explanation. That helps a lot. Two other just real quick ones. Did your warranty expense as percentage of revenue increase in Q4 versus Q4 last year? And obviously, it bumps some in Q3. And I’d just like just a little update on that, as you look at warranty and your historical experience there. Are you seeing your need to book within your COGS growing?

[Charles Merdian, CFO]

Yes. So, this is Charles. I don’t have last year’s right in front of me. But certainly, as we’ve expanded outside of Texas and entered into some new markets that that has increased slightly. But, I don’t think it’s not increased very significantly. I mean, we are still focused on building quality home and our punch list items are relatively consistent across the country. So, I just don’t have the numbers right in front of me but I don’t believe it’s increased significantly by very much.

[Carl Reichardt, BTIG]

Okay. Thanks, Charles. And then, sorry last question. Any thoughts -- obviously, again, you’re financing the company to the line. We’ve talked before I think, you and I about fixing the debt or the thought about fixing the debt, as you look at rate moves now, what’s your thinking on capital structure over the next year or two? And thanks for the time.

[Charles Merdian, CFO]

Yes, sure, great question. So, we are constantly looking at all of the alternatives. Obviously, our credit facility which renews every May, we are taking a look at working with our administrative agent which is Wells Fargo, kind of working with them, working with our other financial advisors that keep our polls on what’s happening in the high yield market, evaluating that option as compared to our credit facility. Like I mentioned, the notice of conversations that we received, so our convertible notes were reduced by $15 million this year. The convertible notes mature at the end of 2019. So, we got our eye on that and making sure that if we receive any other notices of conversion in between them, we would be prepared for that. And then, we also keep possibly another ATM program, which was very successful for us. We realized success with that program to be able to ensure that we could balance out our leverage to kind of keep it in that 50% range. So, that’s really how we look at it.

[Operator]

Thank you. [Operator Instructions] And our next question comes from the line of Michael Martin from Michael J. Martin & Associates. Your line is now open.

[Michael Martin, Michael J. Martin & Associates]

Thanks for taking my call…

[Eric Lipar, CEO]

Are you there, Michael? We didn’t catch that question.

[Operator]

And I am showing no further questions over the phone lines at this time. I would like to turn the call back over to Eric Lipar for closing remarks.

[Eric Lipar, CEO]

Thank you. And thanks everyone for participating on the call today and your interest in LGI Homes. We look forward to sharing our achievements for 2018 throughout the year. Have a great day.

[Operator]

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. And you may now disconnect. Everyone have a great day.

[Eric Lipar, CEO]

Thank you.