Tri Pointe Homes Inc (Delaware)

NYSE:TPH

Earnings Call Transcript 2017-Q4

[Operator]

Greetings and welcome to the TRI Pointe Group Fourth Quarter and Full Year 2017 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions]. As a reminder, this conference is being recorded.

I would now like to turn the conference over to Chris Martin, Vice President of Finance and Investor Relations. Thank you. You may begin.

[Chris Martin, VP, Finance and IR]

Good morning and welcome to TRI Pointe Group's earnings conference call. Earlier today, the company released its financial results for the fourth quarter and full year ending December 31, 2017. Documents detailing these results, including a slide deck under the Presentations tab are available on the company's Investor Relations web site at www.tripointegroup.com.

Before the call begins, I would like to remind everyone that certain statements made in the course of this call, which are not historical facts, including statements concerning future financial and operating performance, are forward-looking statements that involve risks and uncertainties. A discussion of such risks and uncertainties and other important factors, that could cause actual operating results to differ materially from those described in the forward-looking statements are detailed in the company's filings made with the SEC, including in its most recent Annual Report on Form 10-K and its quarterly report on Form 10-Q.

Except as required by law, the company undertakes no duty to update these forward-looking statements that are made during the course of this call. Additionally, non-GAAP financial measures will be discussed on this conference call. Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with GAAP can be accessed through the TRI Pointe's web site and in its filings with the SEC.

Hosting the call today is Doug Bauer, the company's Chief Executive Officer; Mike Grubbs, the company's Chief Financial Officer; and Tom Mitchell, the company's Chief Operating Officer and President.

With that, I will now turn the call over to Doug.

[Doug Bauer, CEO]

Thank you, Chris, and good morning to everyone joining us in today's call. I will start by reviewing our fourth quarter and full year 2017 results, and also provide some insight into where our business stands and where it is headed.

Throughout the year, 2017 presented Tri Pointe Group with a unique set of opportunities and challenges. On the positive front, Tri Pointe Group benefitted from a study [ph] improving domestic economy, increased consumer confidence and strong housing fundamentals in the markets in which we build.

Challenges included material cost increases and scarcity of trade labor and weather related events in both California and Texas, that deeply impacted the life in the affected areas.

As evidenced by our full year results, Tri Pointe Group was able to make the most out of its opportunities in 2017, and found effective solutions to adversity when it arose. Highlights for 2017 included year-over-year net new home order growth of 19% and home sales revenue growth of 17%. We also reduced our SG&A expense as a percentage of home sales revenue by 70 basis points to 10.1%, the lowest in our company's history.

Additionally, we ended the year with a backlog dollar value of approximately $1 billion, which was an increase of 56% from the end of 2016.

We are proud of our accomplishments in 2017 and believe that Tri Pointe Group can build on these successes in the coming years, as we continue to capitalize on favorable, industry fundamentals, and execute a unique and differentiated operating strategy. Tri Pointe Group is different by design, and we believe that this mindset drives us to be an industry innovator and create value for our customer and shareholders.

While many in the industry look for ways to commoditize the home buying experience, Tri Pointe Group has taken the opposite approach. We believe that home buying customers are looking for a unique experience, including communities and homes that cater to their wants, needs and lifestyles. That is why we put an emphasis on thoughtful community planning and unique home buying, that center around the customer and location. We feel that this emphasis has been a driving factor, behind our ability to generate average sales prices for new home order rates in excess of our publicly traded homebuilder peer group average.

Tri Pointe Group will also understand, that each buyers and their life stage is unique. New home features and community amenities that appeal to millennial young family, often distinctly different than [indiscernible] appeal to empty nest or baby boomers. We are constantly studying the buying patterns and consumer preferences of the different homebuyer segment, so that each of our communities reflect these distinct trends. Our research has resulted in truly innovative new home concepts, that challenge the status quo in homebuilding, from our attainable, millennial oriented responsive homes, which feature lock-off suites and cutting edge home smart connected technology, to our Life 260 Concept, which redefines how and where baby boomers spend the next chapter of their lives. We believe these innovative, consumer oriented concepts will continue to be a big driver of our success in each of our markets.

Evidence of our value creation could be seen in our performance in a number of our markets for the fourth quarter. Our operations in California, once again produced great results, with new home orders up 32% year-over-year. We have broadened our product portfolio in San Diego to include more affordable home offerings, and the response has been tremendous, resulting in company best absorption rates and profit margin.

Absorption rates and profit margins were also strong in the Inland Empire, where more value oriented buyers have taken advantage of FHA loan limits. Demand for our homes in Northern California also continue to be strong, particularly in the core Bay Area. We will continue to invest in the land constrained California markets, including the startup of our Sacramento Division, which we believe is poised for growth.

Quadrant Homes in Seattle market has benefitted from strong local market fundamentals, and the repositioning we embarked few years back, deliveries, orders and profit margins were all up in the fourth quarter and pre-tax income for the brand grew in excess of 200% year-over-year. Quadrant Homes is a perfect example of how thoughtful planning and innovative design, coupled with healthy market fundamentals, can lead to significant improvements to the bottom line.

Our operations in the Southwest continue to perform well and produce solid order activity during the fourth quarter. The Las Vegas market has continued to improve, and we are seeing strong demand at all price points. Fourth quarter gross margins in both Arizona and Colorado improved in excess of 200 basis points as compared to last year's fourth quarter. Las Vegas, Arizona and Colorado should see margin improvement, as we introduce better located, more affordable communities in 2018.

Fourth quarter gross margins also expanded year-over-year for Trendmaker Homes in Texas. Houston has shown great resilience, following the devastation of Hurricane Harvey, and we are very optimistic about our prospect in this market, as we head into this spring. Thanks to the adjustments we made to our product and strengthening the economy.

In Austin, the difficult phase of establishing a new presence is behind us, and we see a real opportunity to increase our share of the new homebuilding market in this vibrant and growing city, especially at the entry level.

In the Mid-Atlantic, we continue to experience improving market conditions. In 2017, new home orders were up 14% and deliveries were up 11% year-over-year, with our new leadership in place and the quality of our new land acquisitions, we were optimistic about the growth of Winchester Homes.

With that, I'd like to turn it over to Mike, for more detail on our performance this quarter.

[Mike Grubbs, CFO]

Thanks Doug. Good morning, and welcome everyone to today's call. I am going to highlight some of our results and key financial metrics for the fourth quarter and full year ending December 31, 2017, and then finish my remarks with our expectations and outlook for the first quarter and full year 2018. At times, I will be referring to certain information from our slide deck, posted on our web site that Chris mentioned earlier.

Overall the fourth quarter marked a meaningful conclusion to 2017, with strong financial and operating results, including significant progress on our long term California assets.

Slide 6 of the earnings call slide deck provides some of the financial and operating highlights from our fourth quarter. Home sales revenue was $1.1 billion on 1,757 homes delivered, at an average sales price of $639,000. Our homebuilding gross margin percentage for the quarter was 21.7%, and our SG&A expense, as a percentage of home sales revenue, was 7.2%. Net income came in at $74 million or $0.49 per diluted share. Our fourth quarter net income included a $22 million tax charge, related to the remeasurement of the company's net deferred tax assets, as a result of the Tax Cut and Job Act which was signed into law during the fourth quarter.

In addition, we recorded a pre-tax charge of $13.2 million, related to the impairment of an investment and an unconsolidated entity. Excluding these charges, adjusted net income was $107.4 million or $0.70 per diluted share.

Slide 7 of the earnings call slide deck provides the financial and operating highlights from our full year. Home sales revenue was $2.7 billion on 4,697 homes delivered, at an average sales price of $582,000. Our homebuilding gross margin percentage for the year was 20.5%, and our SG&A expense, as a percentage of home sales revenue was 10.1%. Net income came in at $187.2 million or $1.21 per diluted share. Excluding the tax charge and impairment I previously mentioned, adjusted net income was $220.6 million or $1.42 per diluted share.

We ended 2017 posting a 17% increase in our net new home orders for the fourth quarter, on a 4% increase in average selling communities compared to the same quarter of 2016. For the full year, we posted a 19% increase in net new home orders on an 8% increase in average selling communities compared to 2016.

During the year, we continued the development and the buildout of our long term California assets, which we expect to become a larger percentage of our orders and deliveries moving forward. During the fourth quarter, 14% of our net new home orders were from these long term California assets, up from 12% in the same quarter last year. And for the full year, 17% of our net new home orders were from these long term California assets, up from 11% in 2016.

As for our active selling communities, during the fourth quarter, we opened 14 new communities, nine in California and one each in Arizona, Maryland, Nevada, Texas and Washington. Of the nine new communities in California, four were from the long term California assets at our Western Community in San Diego, which opened in December to great success with 28 orders.

We closed out 11 communities during the quarter, resulting in an ending active selling community count of 130, of which 12 are from our long term California assets.

Our active selling communities at the end of the year is shown by state on slide 8. As I previously mentioned, for the fourth quarter, we reported a 17% increase in net new home orders, average community count was up 4% than the prior year period. Our overall absorption rate increased 13% to 2.8 homes per community per month for the fourth quarter, compared to 2.5 in the previous year period.

For the full year, the company-wide absorption rate was 3.3 orders per community per month, up from three in 2016. You can see the historical monthly cadence of orders on slide 33.

As we roll forward in 2018, we continue to see strong demand. Through the first six weeks of this year, our net new home orders were up 15% year-over-year. We ended the fourth quarter with 1,571 homes in backlog, which was a 32% increase compared to the same quarter last year. The average build price and backlog increased 19% to $657,000 and the total dollar value of our backlog increased 56% year-over-year to over $1 billion.

During the fourth quarter, we completed 78% of our third quarter ending backlog, delivering 1,757 homes, which was a 23% increase compared to the same quarter last year. The average sales price of homes delivered with $639,000, up 18% in the same quarter last year, and up 9% from last quarter. This resulted in home sales revenue for the fourth quarter of $1.1 billion, up 46% from the same quarter last year.

Our homebuilding gross margin percentage for the fourth quarter was 21.7%, which was on the higher end of our guidance range and an increase of 170 basis points compared to the same quarter last year.

For the fourth quarter, SG&A expense, as a percentage of home sales revenue was 7.2%. This was a 200 basis point improvement compared to 9.2% for the same period in 2017, and a 300 basis point improvement from the third quarter. Year-over-year improvement in our SG&A percent was largely due to increased leverage, as a result of 46% increase in home sales revenue.

During the fourth quarter, we invested $111 million in land acquisition and $137 million in land development. For the full year, we invested an aggregate total of $870 million in land acquisition and land development. The focus of our land acquisition strategy of 2018 is to target land for communities which will deliver homes primarily in 2020 and beyond, as we currently own or control all of the land needed to meet our plan deliveries in 2018. 95% of our planned deliveries in 2019 and over 70% of our planned deliveries in 2020.

At quarter end, we owned or controlled over 27,000 lots, of which 60% are located in California. Based on the 2017 deliveries, the number of years of lots owned or controlled in 5.8. It is our continued goal to shorten the duration of our land pipeline to approximately five years, by continuing to focus on accelerating our long term California assets, and investing in faster turning communities in all of our markets.

A detailed breakdown of our lots owned will be reflected in our Annual Report on Form 10-K which we filed later today, and in addition, there s a summary of lots owned or controlled by state on page 32 in the slide deck.

Turning to the balance sheet, at year end, we had approximately $3.1 billion of real estate inventory. Our total outstanding debt was $1.5 billion, resulting in ratio of debt-to-capital of 43.3%, and that ratio of net debt to net capital of 38.1%.

We ended the quarter with $875 million of liquidity, consisting of $283 million of cash on hand and $592 million available under our unsecured revolving credit facility.

With respect to our stock repurchase program, we did not purchase any shares during the fourth quarter. For the full year, the company repurchased approximately 9 million shares, at a weighted average price of $12.48, for a total aggregate dollar amount of $112 million. We have recently replaced our previous stock repurchase program, with a $100 million authorization and will expire in March 2019.

And now, I'd like to summarize our outlook for the full year and first quarter 2018. For the full year 2018, we expect to grow average selling communities by 5% on a year-over-year basis from 2017, and deliver between 5,100 and 5,400 homes, at an average sales price of approximately $610,000. The company anticipates it's full year homebuilding gross margin percentage to be in the range of 20.5% to 21.5% and SG&A expense to be in the range of 9.9% to 10.3% of home sales revenue. The company anticipates it's effective tax rate will be in the range of 25% to 26%.

For the first quarter, the company expects to open eight new communities and close out 11, resulting in 127 active selling communities as of March 31, 2018. In addition, we anticipate delivering approximately 55% of our 1,571 units in backlog at the end of the year, at an average sales price in the range of $630,000 to $640,000. The company anticipates it's homebuilding gross margin percentage to be in the range of 21.5% to 22.5% for the first quarter, and SG&A expense to be in the range of 13% to 13.5% of home sales revenue.

But before I turn the call back over to Doug, I just wanted to make a comment about increasing our SG&A guidance. It's primarily through the adoption in 2018, of the new revenue accounting standard ASC 606. Moving forward into 2018, certain office model upgrades and other marketing costs, which used to be capitalized to our projects and rent through cost of sales will now be running through a selling expense. And although the impact of, mainly geography on the income statement, when you look at the life of the project, it's really a net change to net margins, it's just the geography on the income statement, but because of the timing differences, some of these costs will be expensed at the opening of the project that used to be amortized over the life of the project. So it's impacting our SG&A percentage by about 20 to 30 basis points moving forward.

With that, I'd like to now turn the call back over to Doug for some closing remarks.

[Doug Bauer, CEO]

Well, thanks Mike. Back in 2015, we hosted an Investor Day in Del Mar, California, through which we established a goal of delivering 5,100 to 5,400 homes in 2017. At the time, we were a little over a year removed from the closing of the transformative transaction, with Weyerhaeuser Real Estate Company. We knew the potential inherent in each of our homebuilding brands to achieve this growth objective.

Fast forward to today, and we believe we are in a great position to deliver on this potential. With over 1,500 homes and backlog to start the year in 130 actively selling communities in which to sell and deliver homes.

Consistent with our favorable view of our industry, we continue to approach the business with a forward thinking mindset, and an eye towards the future, understanding that homebuilding is a constantly evolving industry, and that we must evolve with it. Each of our homebuilding brands has room to grow in their respective markets, and make incremental contributions to the top and bottom line going forward.

Our results in 2017 was evidence, that we continue to execute at a high level, and I am confident we will continue this trend in 2018. Beyond 2018, we expect to continue to expand our operations through measured growth, and responsible balance sheet and cash flow management, while continuing our disciplined acquisition activity. We have a clear vision of where we want to be, and how we want to get there. Now it's up to us, to execute on that vision.

Finally, I want to thank all the Tri Pointe Group team members, who made this year such a success. You are the ones who turn our company's vision into reality, and I am appreciative of all your hard work.

That concludes our prepared remarks, and we will be happy to take your questions. Thank you.

[Operator]

[Operator Instructions]. Our first question is from Alan Ratner with Zelman and Associates. Please proceed with your question.

[Alan Ratner, Zelman and Associates]

Hey guy, good morning and congrats on a good quarter, and great year.

[Doug Bauer, CEO]

Thanks Alan.

[Alan Ratner, Zelman and Associates]

So obviously, you had the 2018 guidance out there for several years, and I know, back at the time, maybe there was some skepticism about your ability to hit it in now as the market is obviously strengthened, we are sitting here today and you guys are in a great position. If I kind of looked at where your backlog is right now and the guidance for 2018, which obviously has remained unchanged on the volume side, it seems to imply that you are expecting a deceleration obviously from a very strong growth that you saw in 2017, especially, the back half of the year, and I know there is a lot that goes into that, and you guys open communities or closing out of communities. There is certainly a multiyear plan that kind of goes into your thinking there. But at the same time, there is some skittishness I'd say, regarding rising rates and the impact that that might have on demand, especially in some of the higher cost to markets. So I was hoping you could just give a little bit more color, your orders are up 15% year-to-date, very solid, but January was up a bit more than that, so it implies some deceleration. So can you just kind of walk us through a little bit about the demand outlook, what you are seeing right now, how much of that deceleration that you are expecting here is more a function of where the business plan is, versus a view on demand? And any color you can give us, just in general, around your homebuyer affordability patterns, what they are saying regarding the moving rates, just to get some more context to that? Thank you.

[Doug Bauer, CEO]

Well Alan, this is Doug. That's I think about 10 or 15 questions. So listen, I don't actually look at it as decelerating, actually I am quite pleased with -- regarding our backlog, 56%. We obviously have those sales in backlogs, and a lot of those people are all set, ready to go. Obviously, there is timing differences between community openings and closings, but overall, when you see unit delivery, revenue and earnings growth in the double digit fashion, going into 2018 compared to 2017, we are very pleased and very excited about the growth from 2017 to 2018.

As far as the demand, as we pointed out, the first weeks we continue to see strong demand. Anecdotally, as we talk to our sales teams, some people are definitely going to hop off the couch and get into the sales office, because of the perception that rates will continue to increase. Our buyer profile is less immune to interest rate changes compared to the entry level buyer. 30% of our activity is entry level, and the balance is between move up, about 52% in the balance luxury. So we don't really feel that interest rate pinch right now, and historically, you see a nice little surge, and then as you look back into some of the previous cycles that I have seen, and I go back to 1999 and 1996, you tend to see a little bit of a decline, but then you see an increase in volume, and with the demand supply characteristics in the housing industry right now, we are very excited about this year and the growth potential. We have got a lot of new communities coming on in the second half of the year.

Tom, do you want to add anything to that? It's a lot of questions from Alan.

[Tom Mitchell, President and COO]

Alan, I would echo what Doug has reiterated on the demand side. Really, across the board, in all markets and all price segments, we are seeing strong demand from the consumer and are really optimistic that it's going to continue through the spring selling season.

[Alan Ratner, Zelman and Associates]

Great. All right guys. Thanks a lot. Thanks for answering all those questions. Appreciate it.

[Doug Bauer, CEO]

Thanks.

[Operator]

Our next question is from Stephen Kim with Evercore ISI. Please proceed with your question.

[Christopher Shook, Evercore]

Hi, good morning. This is actually Chris on for Steve. My first question is about your community count growth guidance. Obviously, it's much lower than what you initially anticipated at your 2016 Investor Day, and is there anything other than just faster than anticipated closings, that are responsible for this, and are there any plans materializing to accelerate it?

[Mike Grubbs, CFO]

Yeah, this is Mike. I mean, I think we have started daylighting that back after our second quarter last year, when we saw the increased absorption pace beyond what we had been planning, is that the community count which is not going to be achieved from our 2016 Investor Day, and it's all directly driven by the faster close-outs. So we saw that this year, and we are going to see that -- or last year in 2017, we are going to see that this year in 2018 as well. We still open well over 65 communities this year, but we are closing a fairly large amount as well, because of the accelerated pace that we have seen.

[Christopher Shook, Evercore]

Okay. And then so you are seeing sort of heighted activity moving Inland in California with obviously the Inland Empire opening up in Sacramento, and assuming -- obviously those are more entry level affordability or [indiscernible] products. Are those producing similar margins to what you have in the higher ASP coastal communities, and is there sort of any impact on your full year margin guidance from growth in those communities?

[Mike Grubbs, CFO]

Well just so I understand your question, you mentioned Inland Empire, I think. Inland Empire has continued to deliver margins in excess of the company average, because of the basis that we have in our land out there from our transaction with Weyerhaeuser. But they do not deliver the same margins as our high end California products, from the long term California assets, those will generate margins in excess of that.

[Christopher Shook, Evercore]

All right. Well thank you very much.

[Operator]

Our next question is from Mike Dahl with Barclays. Please proceed with your question.

[Mike Dahl, Barclays]

Hi. Thanks for taking my questions. Just a follow-up on a comment there in the opening remarks about the long term communities. Thanks for providing the details on what it currently represents; how should we think about it, as we get out through 2018 by year end, but I think we should be at the point where you have got some nice openings on some of the long term assets. What mix of your communities at year end should we expect the long term California assets to represent?

[Mike Grubbs, CFO]

Hey Mike, it's Mike. I think this year, we are delivering roughly about 1,000 units from the long term California assets. So when you look at the midpoint of the guidance, it's roughly 20%. And community count, as I mentioned at the end of 2017 was -- well it was 130 with some of the long term California assets, and that number will be up -- probably slightly based on the year end community number, but as a percentage basis.

[Mike Dahl, Barclays]

Got it. Okay. And then, just going back to the accounting change on SG&A, so it sounds like early in the community life, you have now some stepped up expenses as far as recognition goes, how should we be thinking about what that means for kind of a steadier state SG&A beyond this first year that you apply those changes?

[Mike Grubbs, CFO]

I think that will be determined here pretty soon. But I think that roughly about 20 to 30 basis points over what we had originally anticipated. So going into this year, we anticipated the range to be 9.7 to 9.9, so let's call that in the midpoint, 9.8, and now we are seeing the midpoint is roughly 10.1. I think about a 30 point difference is what you'd see moving forward.

Now effectively, as we open communities, we are going to get the impact of that up in our margin right, because we are just moving costs from margin down to SG&A. So maybe not in year one, but in year two, you should get the corresponding bump in gross margin to offset that.

[Mike Dahl, Barclays]

So I guess, what I am getting at there is, as the -- it sounds like community life margins, if we are looking from an operating margin standpoint, shouldn't be affected, but should we think of kind of later life in the community as actually having step up margins, as a result of this change, kind of front loaded and so the end of -- as you get towards the end of communities, the margin profile is even better than what you would have previously thought?

[Mike Grubbs, CFO]

That's correct.

[Mike Dahl, Barclays]

Got it. Thanks guys.

[Operator]

Our next question is from Stephen East with Wells Fargo. Please proceed with your question.

[Stephen East, Wells Fargo]

Guys, congratulations on a nice quarter there. Doug, maybe I will start with what you said, with your closing remarks. You all have a vision that you are driving toward -- maybe you could talk a little bit about what that vision looks like as we move beyond 2018 into 2019 and 2020, and what's different in your vision than maybe what's going on today?

[Doug Bauer, CEO]

Yeah, that's a good question. We continue to be very inquisitive, primarily in the southeast, the northwest and Dallas. We look at this business over the next five to 10 years, and frankly, over this next decade, we'd like to see our top and bottom line actually double. But those are some ambitious goals, but we are going to maintain our vision inside our balance sheet, and we call it measured growth. As I mentioned earlier, when you look at deliveries, revenue and earnings for 2017 to 2018, well over double digit growth, I am very proud of that, and hopefully we can continue to see that. But you also have to have a mindset in this business, having been doing it for 30 years that, you are going to hit a bump in the road, you are going to hit a hiccup, so you always want to make sure you maintain a strong balance sheet liquidity to take advantage of opportunity. So we will be very disciplined as we continue to look at that vision over the next five to 10 years.

[Stephen East, Wells Fargo]

All right, great. Thank you. I appreciate that. And then, on your orders, you all saw some significant price increases. I guess, a couple of different questions here, one, could you talk about how much of that is mix, either product or geography? I assume a lot of it is geography versus real HPA and maybe what you are actually seeing in that price appreciation? And then on Tri Pointe, orders up 62%, how much of that was community growth versus running those hard, and what's the thought process, if it is just running those hard?

[Doug Bauer, CEO]

As far as revenue growth, pricing growth, you are talking in absolute dollars, Stephen?

[Stephen East, Wells Fargo]

Yeah, the orders. I am sorry, the order ASP, you jumped up pretty significantly. Just trying to understand how much of that is mix, either geographic or product versus real price appreciation and you know, what you are seeing out there? And then on Tri Pointe orders, your units were up about 62%, so just wanting to understand that?

[Doug Bauer, CEO]

Got you.

[Mike Grubbs, CFO]

Stephen, it's Mike. Community count was up about 15% in Tri Pointe. We really saw increased absorptions across the board in all of our Tri Pointe brands, even more specifically, even in Colorado, we saw good absorption in the fourth quarter. So absorptions were up 52 and communities 15% on an average --

[Stephen East, Wells Fargo]

Got it.

[Tom Mitchell, President and COO]

And Stephen, this is Tom. As we guided to, we expected a lot of that order growth, as we were shifting our mix into more entry level product. We opened several new communities at much more affordable price point, that enabled us to have that outsized absorption.

[Stephen East, Wells Fargo]

Got you. Okay. So geographically though, your ASP went up a lot year-over-year in the orders, so just trying to reconcile those two thought processes?

[Mike Grubbs, CFO]

It's primarily mix, when you look at ASPs. I mean, we do see price appreciation in a lot of our markets, but it's primarily driven by mix.

[Stephen East, Wells Fargo]

Okay. Thanks a lot.

[Operator]

Our next question is from Jack Micenko with SIG. Please proceed with your question.

[Soham Bhonsle, SIG]

Hey good morning guys, this is Soham on for Jack this morning. My first question was on gross margin. So as we think about gross margin for the year, could you may be give us the outlook for California deliveries mix and not just the long dated assets, but entirely California? That's what really drives the margin to the high or low end; because it seems like with your first quarter guidance, that there has been some push out of those deliveries in the first quarter with the 55% backlog conversion. So just trying to get a sense of what California could look like this year?

[Mike Grubbs, CFO]

Yeah California, let me do that math. Typically, California is around 40% of overall deliveries, and I will give you a more precise number maybe follow-up the call, once I look at that. Typically it's around 40%. A lot of the backlog that we have sitting there is California, and some of the longer dated assets and some of the larger ASPs, that's why our ASP is so high and backlog, and it's just taking longer to produce those homes, so they are maybe not converting as quickly as the product did last year.

[Soham Bhonsle, SIG]

Okay. And then I guess, Doug, last quarter you talked about becoming more capital efficient going forward, and so is there any update on the land development off balance sheet, and is there any formal ROE target that you guys are looking for this year?

[Doug Bauer, CEO]

We continue to interact with a number of land bankers, and we will continue to look at that as an opportunity to focus on delivering and improving our ROE into the mid-teens, as our long term objective. So we will continue to look at doing that, that has a long term effect. But as we look at our land acquisition efforts to continue to grow, we want to be mindful of mitigating risk and cash flow management, so we will continue to pursue those activities, as we go forward.

[Mike Grubbs, CFO]

And Soham, it's Mike. It's about 42% this year, California deliveries are about 42% of the overall -- if you count back to the midpoint of the range.

[Soham Bhonsle, SIG]

Okay. And then could we just get some color on the charge in the quarter? Is that onetime in nature or ongoing?

[Mike Grubbs, CFO]

No, that's a onetime charge [indiscernible] which is a joint venture that's unconsolidated, it has been on the books since 1999, it just [indiscernible] entitlement. Doesn't really impact our long term plan, and doesn't impact any of our California long term assets at all.

[Soham Bhonsle, SIG]

Okay, great. Thank you.

[Operator]

Our next question is from Nishu Sood with Deutsche Bank. Please proceed with your question.

[Nishu Sood, Deutsche Bank]

Thank you. Just following up on that discussion about the rate of backlog conversion. Mike, I think you have done a pretty good job of laying out the order surge that you have had in the past, five or six quarters, so obviously a good problem resulting from that, as well as the higher percentage of California closings, which take longer to deliver on. So that kind of -- is the backdrop that you have given us for the slowing version of backlog -- but it has been, the slowdown has been worsening, as we have gone along here, if you kind of look at the quarters through 2017. At what stage do we find kind of a normal rate of backlog conversion, given what you are doing with your portfolio, in terms of these longer term assets?

[Mike Grubbs, CFO]

Well I mean, I think you have seen the success of our absorption rate, that's why backlogs are up and production -- I'd say our backlog is more dirt [ph] starts versus speck starts. We have moved away from a little bit of the speck starts in some of our markets. So we are just naturally taking longer to produce those, because those aren't available at the sale. And then with our higher absorption rate, I'd say probably by 2019, as we get maybe a little bit higher cadence on our deliveries, it's probably going to level back out to what the 2016 rates were.

[Nishu Sood, Deutsche Bank]

So does that imply some kind of bounce back? And I know, you folks don't compute backlog conversion ratio to run your numbers, but obviously everyone models it that way. So does that imply somewhat of a bounce back or that we kind of stabilize in 2019?

[Mike Grubbs, CFO]

No I think it's more of a stabilization.

[Nishu Sood, Deutsche Bank]

Got it. Got it. And also wanted to ask about -- obviously the demand environment is terrific, as we have seen in your absorption numbers. Tax reform would seem to add to overall growth, but folks have been concerned about the anti-housing reform of tax reform, they have stayed local and the property tax -- and the one state where that would seem to impact most, of course is California. Now it's way too early to even say what the longer term effects will be. So wanted to understand, what work you folks have been doing in terms of looking at your buyer pool, what sort of effect it might have, how that might influence what sort of product you are putting out there, or any other kind of thoughts you have on being ready for what that might bring, if anything?

[Mike Grubbs, CFO]

Well actually, as you look at the Tax Reform Act in California, it actually helps many of our homebuyers. Obviously, if you are -- move up luxury, I should say luxury buyer meets you in the $1 million plus range, that person has more discretionary income, and puts down frankly a larger down payment. So their purchase decisions are -- and we have done this research -- are coming into the sales office based on sales or property tax, actually based on a family for a life changing event. But for the rest of it, the portfolio, we continue to look at a good healthy mix of entry level and move up. Our entry level mix is going up in the low 30% range, move up is 50%. So we will continue to look at that. Price point of entry level on move up in California, now that means you are going to build more [indiscernible] program along the coastal parts of the state, and then obviously, in the Inland Empire, which is a market that we really dominate, our average loan amount there is $340,000 with our Inland Empire Group.

So we are not really affected by this tax reform act. Frankly those people actually are having more disposable income with a higher standard deduction. So we continue to see pretty good order activity, as we get into the first part of the year.

[Tom Mitchell, President and COO]

Nishu, this is Tom. One thing I'd add to that, one area of product that we are really excited about this year, is getting more into our age targeted active adult offerings. So we see that as being really additive to our mix and are looking forward to that. And so far, it's something we have -- all our sales team talking about with the buyers. We have not seen any negative impact from the tax reform act and so far, it's business as usual. But as you said, maybe too early to tell. But bottom line, we think it will be more positive than negative.

[Nishu Sood, Deutsche Bank]

Okay. Thanks for your thoughts.

[Doug Bauer, CEO]

Thanks Nishu.

[Operator]

Our next question is from Jay McCanless with WedBush Securities. Please proceed with your question.

[Jay McCanless, WedBush]

Good morning guys. So the first question I have, and I have got a follow-up to it, is kind of a two part question on pricing. Number one, what percentage of communities you guys raised prices this quarter, and then can you talk about your ability to price through some of the rising input costs that everyone has been discussing?

[Doug Bauer, CEO]

The first six weeks of the years, we are gradually increasing pricing throughout all our communities and in our markets and we are kind of forecasting around a 4% pricing increase this year. Generally speaking, Jay, we are battling labor and material cost increases in offsetting them, and in most cases we are. So the net pack, is generally 1% to 2%, if you are in a stronger market. But when you look at material labor costs, which was last year, they range from a low of 2% to as high of 8%, on average about 5%, 5.5%. So you are constantly battling between offsetting those cost increases with the price increases.

[Jay McCanless, WedBush]

Okay. That's good to hear. And then my follow-up question, one of your competitor's made or is planning to make an acquisition of a builder that's in your backyard of your Inland Empire and then also close to some of your Texas assets. What is the acquisition, what's the [indiscernible] acquisition outlook? What are you seeing out there, or could the acquisition potentially help Tri Pointe move to the next phase, or expand in some different markets?

[Doug Bauer, CEO]

Well as I mentioned to Stephen a little bit ago, Jay; I mean, as we look at the Tri Pointe Group, next five to 10 years, we have got an ambitious goal of -- in the next decade, doubling our revenues and income. So that's going to come through measured growth in our six brands, with some of the organic growth we have, as well as, we will be inquisitive about many of the market areas that we are in, and some of the market areas that we are not in. But we are going to be very disciplined. Sometimes it's better to be in second place, when you look at maybe some of the acquisition activity that you have seen out there. We are very blessed to have a very strong land presence in the Inland Empire through the WRECO transaction. So we pretty much dominate that market and have a huge cost advantage on our land bases.

[Jay McCanless, WedBush]

Okay. Sounds great. Thank you.

[Operator]

Our next question is from Mark Weintraub with Buckingham Research. Please proceed with your question.

[Mark Weintraub, Buckingham Research]

Thank you. First just clarifying, on the 20 to 30 basis points, the increase in SG&A, I understand that -- so that's now being expensed where, previously, if I understood correctly, it was being capitalized and then would run through the gross margin? And so, if I understood correctly as well, you are saying that there is effectively a one year type lag, so that this year, we are seeing the 20 to 30 basis points increase in the SG&A, but we are not seeing the offsetting reductions in the gross margin, but that would start then showing up next year. Is that the right way to understand what's going on?

[Mike Grubbs, CFO]

Yeah Mark, and when you look at an individual project, the life of a project, there is no change to net margin. But at the early stage, when you are opening up the model complex, spending dollars, we typically have fairly upgraded model. You are seeing the impact of that hit SG&A in year one, but then you are going to get the corresponding benefit of that in year two and three margin moving forward. So net, at the end of the day, there is no effect.

2018, we are taking the immediate impacts, so we are having to do an adjustment to move those costs down below the line, and so it's going to hit sales and marketing, as well as over the 65 new communities that we are opening this year, there will be some upfront costs associated with that as well. But there is no corresponding deliveries in 2018.

[Mark Weintraub, Buckingham Research]

So effectively, since you capture gross margin guidance constant, with what it had been, and your SG&A went up by just this 20 to 30 -- effectively, accounting change. So really the only impact was that, you are looking for higher ASPs than what you had been previously, from a fundamental standpoint. And so I just wanted to come back to -- is that just because of the higher costs, you are expecting to touch that? And/or is it actually a shift in mix from what you had been expecting a few months ago?

[Mike Grubbs, CFO]

Yeah. I mean, we had a very tight range -- again, this is Mike. We had a very tight range on our SG&A, as a percentage of home sales revenue that we put out there at the end of 2016. So that was a tight range of 9.7 to 9.9, but we had a very broad range on our margins, a 100 basis point range in our margin. And so what we are saying is -- we think there is going to be a 20 to 30 basis point impact on our SG&A this year, that we did not expect in 2016. But within our margin, whatever benefit we might get from that, it's still within our 100 basis point range that we had in margin. So that's why we didn't change our margin range.

[Mark Weintraub, Buckingham Research]

Okay. And then, just really quickly, I believe you scaling back the land sales program significantly this year, just wanted to get an update, what expectations you have, if any, on land sales?

[Mike Grubbs, CFO]

I am glad you asked that question. We do not anticipate any significant land sales moving forward over the next few years in any of our California assets.

[Mark Weintraub, Buckingham Research]

Okay. Thank you.

[Operator]

Our next question is from Will Randow with Citigroup. Please proceed with your question.

[Will Randow, Citigroup]

Hey good morning guys and congratulations on the progress.

[Doug Bauer, CEO]

Thanks Will.

[Will Randow, Citigroup]

I guess, just to follow-up on cost inflation. You have hit on this in a few different ways, but can you talk about what you experienced in the fourth quarter, relative to, call it, real price increases? Meaning, was there incremental margin spread? And then for 2018, are you assuming that pricing power exceeds cost inflation or matches it, as you know historically, you have assumed, matches it?

[Doug Bauer, CEO]

Will, this is Doug. For the year, and I will have to get back to you on the actual quarter. Our labor and material cost increases, across the company, average about 5%, 5.5% increases; and were generally offset by revenue in almost all our markets. We are continuing to forecast roughly the same going into 2018. It's a very tough market out there, it's something that you need to have very strong operating teams with lots of experience, and we have those to do that.

[Will Randow, Citigroup]

Got it. And then, on free cash flow conversion, given that you have most of your land locked up through 2020, obviously there is grading and related development costs. Are you expecting your free cash flow conversion ratio to continue to step up over the next three years, or could you kind of talk us through that from a modeling perspective?

[Doug Bauer, CEO]

Well, we were about $100 million positive cash flow this year. We have been daylighting that --

[Mike Grubbs, CFO]

Last year.

[Doug Bauer, CEO]

Last year sorry. This year is the last year in my head, 2017 was $100 million positive cash flow, and we have been talking about it for a long time, and we thought, moving forward from 2018, since the development of our long term asset that we ought to be able to generate positive cash flow moving forward. We still have those expectations. I would say that we did spend less money last year in land and land acquisition, than we had anticipated. Our original range was $900 million to $1.1 billion, and we spent about just below $900 million for the year. So some of that land development is going to roll into 2019. But our expectation is just to try to maintain positive cash flow moving forward.

[Will Randow, Citigroup]

Thanks guys and congrats again.

[Operator]

[Operator Instructions]. Our next question is from Alex Barron with Housing Research Center. Please proceed with your question.

[Alex Barron, Housing Research Center]

Thank you and great job guys. I wanted to ask if you guys could comment on -- is there any significant difference in the performance of your Texas division, Houston versus Austin, or can you kind of help us understand how the Austin division is doing so far?

[Doug Bauer, CEO]

Yeah. I mean, definitely, when you do a startup, your entry costs and your execution won't be as generous as your operation has been in business for what, about 40, 50 years. So that's behind us, and we are poised to take advantage of that market and that community. Our Austin team has focused and will continue to focus a little bit more on the market entry than you will see in Houston. But Houston did enjoy margin increase in the last year, and I would expect Austin will this year. But it definitely lags -- Austin definitely lags Houston, just in a startup capacity, over the last couple of years.

[Alex Barron, Housing Research Center]

Got it. And I also wanted to ask, well -- sneak in two questions; one was, what drove the Colorado performance this quarter? Usually, fourth quarter is lower than the rest of the quarters, but you had a pretty strong Colorado, and in fact, it [indiscernible] on Southern California. Has there been any noticeable difference in the last few weeks in terms of orders given, the rate increase versus coastal California?

[Tom Mitchell, President and COO]

Hey Alex, this is Tom. On Colorado, as I mentioned, we were finally able to get some of those more affordable products performing in the marketplace in the fourth quarter, and that's really what led to the outsized absorption, comparatively to the fourth quarter of 2016. So we are really excited about that. We feel we have a much better mix going forward, to drive higher absorption.

And on the California side, over the last couple of weeks, we really have not seen any dramatic change in absorption and demand levels, and quite a consistent level of traffic as well.

[Alex Barron, Housing Research Center]

Okay. Thank you so much.

[Operator]

Ladies and gentlemen, we have reached the end of our question-and-answer session. I would like to turn the call back over to Doug Bauer for closing remarks.

[Doug Bauer, CEO]

Well thank you to everyone joining us for today's call. We look forward to chatting with all of you next quarter and hope you have a great day. Thank you very much.

[Operator]

Thank you. This concludes today's conference. You may disconnect your lines at this time and thank you for your participation.