Meritage Homes Corp (MTH) 2012 Q2 法說會逐字稿

Good morning and welcome to the Meritage Homes, second quarter, 2012 conference call. All participants will be in a listen-only mode.

(Operator Instructions)

After today's presentation there will be an opportunity to ask questions.

(Operator Instructions)

Please note, this is being recorded and I would now like to turn the conference over to Brent Anderson. Please go ahead.

Thank you Emily. Good morning everyone. I'd like to welcome you to our analyst conference call today.

Our second quarter 2012 ended June 30 and we issued a press release with our results before the market opened today. If you need a copy of the release, with the slides that accompany our webcast, you can find them on our website at investors.meritagehomes.com, or by selecting the investors link at the top of our home page.

Turn to slide 2, our statements during this call and the accompanying materials contain projections and forward-looking statements which are the current opinions of Management and subject to change. We undertake no obligation to update these projections or opinions. Additionally, our actual results may be materially different than our expectations due to various risk factors. For information regarding these risk factors, please see our press release and our most recent filings with the Securities and Exchange Commission, specifically our 2011 annual report on Form 10-K and our first quarter 10-Q.

Today's presentation also includes certain non-GAAP financial measures as defined by the SEC. To comply with SEC rules we provided the reconciliation of these non-GAAP measures in our earnings press release.

With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage Homes, and Larry Seay, our Executive Vice President and CFO. We expect our call to be concluded in about an hour and a replay of the call will be available on our website within an hour or so after we conclude the call. It will remain active for 30 days.

I will now turn the call over to Mr. Hilton to review our second quarter results. Steve?

Thank you Brent. I would like to welcome everyone to our call today.

We are excited to report earnings of $0.24 per diluted share for our second quarter in addition to the 49% increase in orders that we pre announced on July 8. The earnings leverage we have been expecting to see was clearly evident this quarter, as our 22% increase in closes over 2011 drove a 28% increase in home closing revenue, a 31% increase in gross profit, and net income of $8 million. We carried approximately two thirds of the additional $12 million in gross profit to the bottom line, increasing our net income by $7.4 million, and our adjusted pretax income by $8.1 million year-over-year.

Net income for the second quarter of 2012 included a $5.8 million loss on the early extinguishment of debt, largely offset by a $5.2 million tax benefit, due to a partial reversal of our deferred tax asset at reserve, which Larry will explain later. Excluding those items and impairments of $863,000 this year compared to $590,000 in the quarter of 2011, our adjusted pretax income was $9.5 million for the second quarter of 2012, and our resulting adjusted pretax margin was 3.4% compared to 0.6 of a point last year. We believe this is a better indicator of our earnings power and expect to expand it further as we leverage our increased closings and revenue, to grow our earnings at a faster rate.

Turning to slide 5. Home closing revenue benefited from a 5% year-over-year increase in average closing price, mostly reflecting mix issues rather than price appreciation. As a greater portion of our closings this year were on larger homes and homes in higher priced markets.

We only began raising prices broadly in the first quarter this year, so we expect most of the impact from rising prices to appear in our second half revenue and earnings. Some of our home price appreciations being offset by higher costs for land and construction which are moderating our gross margin expansion. However, we improved our second quarter gross margin by 50 basis points year-over-year to 18.5% from 18% in 2011. We believe that some of these cost increases are due to temporary supply and demand imbalances caused by the rapid increase in home sales this year. As suppliers and contractors ramp up to support the increased volume of activity, some of these cost pressures should diminish in the coming quarters.

As we've said before, we expect our gross margins to gradually increase toward our 20% target gross margin over time. We also expect to see continued improvement in our net margins as we leverage our fixed costs while growing our closings and revenue. Our average sales price on second quarter orders increased 10% year-over-year, again, mostly driven by mix. As demand for our homes increased during the second quarter, we continue to raise prices in many communities across almost all of our markets, which we believe accounted for about one third of the increase in ASP on our second quarter orders.

Turn to slide 6. The spring selling season continued longer than usual this year, right through the end of June. In fact, June was our eighth consecutive month of year-over-year increases in orders. I commend our sales teams who have sold more than 400 homes per month, since March of this year. We're optimistic that this strong and steady demand we have experienced to date may somewhat mitigate the normal seasonal slowdown we would expect to see in the later half of the year.

The second quarter 2012 also marked our fifth quarter in a row to report year-over-year growth in orders. Net orders increased 49% over the prior year, to a total of 1,353 in the second quarter of 2012, representing our largest quarter in four years since the second quarter 2008. We sold an average of 9 homes per community, the highest we've seen since the first quarter 2007, and amongst the best in the industry. The sales pace is 41% higher than the second quarter 2011, and 20% above the first quarter of this year. We believe that our industry leading energy efficiency gives Meritage a competitive advantage and our highly desirable locations and some of the best sub markets in the country also contribute to our relatively higher sales per community.

Turning to slide 7. This slide provides details on our order growth by state. I'll hit the highlights.

California delivered the strongest performance nearly tripling orders with a 28% increase in communities and much higher orders per community than last year. Their average sales price also increased 11%, resulting in a 229% increase in order value over the prior year. Arizona delivered 61% more orders than a year ago, with approximately the same number of communities as last year. Arizona's total order value increased 69%, when combined with a 5% increase in average selling price.

Florida showed continued strength, growing orders by 47% and total order value by 54%, as our ASP there, also increased by 5%. We opened our first communities in Tampa in June and recorded our first sales there. North Carolina also contributed 40 sales this quarter in just their third quarter of operation since opening their first communities for sale.

Texas has been improving at a more tempered pace. Orders were up 8%, despite having fewer communities opened this year, and 3% increase in average price resulted in a 12% increase in Texas's order value.

Our cancellation rate in the second quarter fell to 13% from 15% last year. As a result of stronger sales and prices, the total value of our orders and the backlog at quarter end grew by 75%, to its highest point since the third quarter of 2008. With a backlog of more than 1,600 homes under contract, and almost 2,500 homes sold in the first half of this year, we believe that we will close between 4,000 and 4,300 homes in total during 2012. Which puts us in a much better position to report strong revenue earnings growth over 2011.

I will now turn it over to Larry Seay to review our financial results for the quarter and then open it up for questions. Larry?

Thank you Steve.

I will pick it up on slide 8. As Steve said, the earnings leverage in our business was clearly shown this quarter. Commissions and other sales costs improved by 40 basis points year-over-year, our absolute selling expenses increased by 23%, lower than our 28% increase in home closing revenue, as we better leveraged the fixed portion of our selling cost. We achieved even greater leverage in our general and administrative expenses, which improved 90 basis points year-over-year, decreasing to 5.9% of revenue, from 6.8% in the second quarter of 2011.

While we may see some additional modest increases in the absolute level of G&A expenses as we grow, we expect these additions to be at a much slower pace than our top line growth. Additionally, our interest expense declined to $6.3 million, or 2.2% of revenue from $7.5 million or 3.4% of revenue last year. As we capitalized more of our total interest incurred to homes under construction and home sites under development. Those assets have grown in support of our increased sales. As a result of higher revenues and leveraging our fixed expenses, our earnings before taxes increased by 280% in the second quarter of 2012 compared to 2011.

Slide 9. We also recorded a $5.2 million net tax benefit for the quarter, as we reversed substantially all of the allowance we had previously taken against our differed state tax asset in Florida. Florida's piece of our DTA allowance, is separately evaluated to the state tax rules there. Based on our growth and profitability in Florida over the last couple of years, we were able to reverse most of the DTA in realty to Florida, in the second quarter of this year.

At June 30, 2012, our total DTA was $95 million and the total remaining balance of the reserve against our DTA is approximately $87 million. $68 million for federal deferred income taxes and $19 million for deferred state income taxes. Including a remaining balance of approximately $1 million for Florida. We believe that we can reverse the vast majority of our remaining $87 million allowance against our DTA as we continue to report profitable results over the next few quarters.

Slide 10. We opened 19 new communities and closed out of 18 communities during the quarter, growing our total active community count to 151 at quarter end, up from 150 at the beginning of the quarter, and from 145 at the end of the second quarter of 2011. Our goal remains 165 active communities by year end 2012 and our current expectations are to add another net 20 to 35 communities in 2013. We spent approximately $88 million to purchase approximately 1,900 lots during the second quarter 2012, and another $28 million on development of unfinished lots.

We also contracted for approximately 2,100 new lots in 36 communities during the quarter. About two thirds were unfinished and one third were finished lots. 68% were in Arizona and Texas, 21% in North Carolina and Colorado and 8% in Florida. We ended the first quarter with a total supply of lots of approximately 17,600, which equates to approximately 5 year supply based on trailing 12 months closings, or 4.2 year supply based on trailing 12 months orders. ¶

Slide 11. We further strengthened our balance sheet this quarter and are well positioned to support future growth. We completed our issuance of notes due in 2022 and the retirement of our 2015 issue and part of our 2017 issue, which extended our nearest maturities to 2017, and resulted in the $5.8 million loss on early extinguishment of debt.

Subsequent to quarter end we issued 2,645,000 shares of stock in a follow-on offering which raised $87 million of cash to fund our growth. By issuing equity we added capacity to grow our balance sheet, to support additional revenue growth, while maintaining modest leverage. Our pro forma net debt-to-capital ratio at June 30 would have been 34.3% with the added cash and equity rather, than the 44.1% we reported.

In addition, we completed a new $125 million unsecured revolving credit facility earlier this week, to provide additional liquidity that can be used for short term working capital as our orders grow. We ended the quarter with $205 million in cash and cash equivalents, restricted cash and securities, compared to $333 million at the beginning of the year. The great majority of the decline can be attributed to $140 million increase in total real estate inventory since the beginning of the year.

Now I will turn it back over to Steve for closing comments.

Thank you Larry.

In summary, we continue to demonstrate progress this quarter by reporting strong results across almost every critical operating metric, punctuated by our 49% order growth, and sevenfold increase in adjusted pretax earnings. We are cautiously optimistic the housing market will continue to recover as the employment picture improves and the US economy grows. Job growth combined with low interest rates and a record high affordability should drive higher demand for homes, and with the low levels of listings we see in our markets today, that increased demand should translate to increased homebuilding activity and higher sales.

Those factors combined with our substantial backlog and overhead leverage, give us confidence that we can continue to report strong earnings growth in the second half of the year. We are capitalizing on the opportunities presented as the housing market recovers, and believe that we are well positioned with a strong balance sheet, very good land positions, and a differentiated product offering and a great organization full of talented people.

Thank you for your attention and we will now open it up for questions. The operator will remind you of the instructions. Operator?

(Operator Instructions)

Michael Rehaut, JP Morgan.

The first question I had was on gross margins. You kind of mentioned that a third of your ASP increase was due to positive price. So, all else equal, that could assume pretty meaningful improvement in margins even in the back half of this year, maybe 4Q rather than 3Q. But also offsetting that, the higher, some of the creeping labor and material costs.

So, how should we think about further improvement? I think your comments are largely still around modest or moderate improvement, but a 3% plus rise in price would maybe suggest even with some inflation -- material inflation creep something a little but more meaningful. So any thoughts around that?

Yes, I hate to stick my neck out too far as to exactly how much it's going to increase over the next couple, few quarters, but I do think we're going to get back to 20 within a year plus or minus. So, I think you could expect similar improvements to what you saw this quarter, next quarter and the quarter after. And I think that 3% price increase points to that. So, I just hate to try to be more specific than that because I don't want to be wrong but I'm feeling pretty bullish that the gross margin should continue to incline -- increase.

Larry, you want to add on to that?

I think you do have to be careful. There are cost increases going on out there and I would say at least half of the sales price improvements are being eaten up by cost increases because the subs have out there, not making money for many years and they are seeing these headlines we see, and are pushing on price. Of course, we are pushing back as hard but it is a constant back and forth battle, so that is why we are somewhat cautious about projecting really strong margin increases, and why we kind of project modest or moderate increases.

Great. I appreciate that additional color.

Secondly, on the SG&A, as a percent of revenue a little bit above what we were looking for. If you look at 2Q versus 1Q, SG&A went up roughly $6 million while revenues went up $77 million, that is a 8% incremental rate above where I would think you would be more like a 4% or 5% with commission. So, any thoughts around that in that 4% to 5% of variables that is still a good way to think about future leverage?

Larry?

Yes. We break that out in the press release back in the summary operating results and we prefer to break a commissions and other selling costs separately. I think you will continue to see a little bit of leverage on the selling costs as we do have a portion of those being fixed.

But, the great majority comes from the G&A portion. You did see our G&A portion go up. Last quarter, I think we said we thought we would see the G&A kind of being the $15 million to $16 million and we're up to $16.5 million.

So, there is some variability in G&A that we're having to add to support growth but, it's not nearly a one to one relationship. So we do think most of the gross margin improvement we are picking up from increased revenue is going to be falling to the bottom line because G&A will increase at a much more modest pace. It's difficult for us to say exactly how much the G&A is going to go up, but we think it will be relatively modest, but I'm not going to give any precise percentage.

I would say based upon our backlog and our conversion rate, looking forward we're certainly going to close more houses in Q3 than we closed in Q2 which will allow us to leverage that G&A even farther or so. So, I'm expecting it to continue to come down.

It's at 5.8%, 5.9% now so you should continue to see that percentage drop through the year.

Okay. Just a quick modeling question, the interest expense, is that something we could continue to see decline and also the other income at $3 million, a bit above where it was the past couple of quarters. Any thoughts there?

On interest expense, yes you will continue to see it decline as we grow our work in process and lots under development. And the trajectory of that decline is hard to project but it will go down some. And then on other income, that is mainly comprised of mortgage company income. So, as we increase volumes, the other income will go up because we generate more income from the mortgage JV's we have.

Dan Oppenheim, Credit Suisse.

Was wondering if you can talk a little bit more in terms of the margins as you think about the mix shift in the orders here? How much impact that is likely to have on your -- the margins and then I guess relatedly, since at it relates to California there, the land -- the lot count was coming down a little bit. How are you finding the land market in California at this point and the opportunities there in terms of the margins available?

Larry, why don't you take the first part and I will take the second.

The margin improvement between mix, our margins are not that radically different across the board. Our margins in Texas tend to be a little softer than on the coast where there's a little more pricing power typically. Also, our margins in Colorado tend to be a little bit softer, on the other hand, we typically make up that in lower G&A in those states, so the net operating margin in those states don't wind up being too far different.

But in generally speaking and modeling, I would be modeling a slightly higher margin in the coastal type states like Florida or California generally speaking, as particularly as the recovery continues because that is typically where there is less supply and there's more pricing power.

So, regarding California, the land market their is very tight. Traditionally it always is tighter in California than other states but it's very tight right now. We purposely slowed down our land acquisitions in Southern California over the last couple quarters because we'd bought quite a bit there earlier last year. And we've been ramping up our acquisitions in Northern California, our land acquisitions and expect to have several deals on the books this quarter and next quarter. California is an important state for us and we want to continue to grow our business there.

Thanks very much.

Nishu Sood, Deutsche Bank.

Following up on that land topic, there is a pretty widespread belief amongst investors that there is a severe overall shortage of quality land out there, and it is severe enough that it could restrict growth. I think there's even a Journal article about it yesterday. Now our capital rates, your plans for growth kind of argue otherwise. I was just wondering if we could get your thoughts on that whether it will constrict growth or not.

I think there is a looming shortage of lots. The question just is -- and land, the question just is how severe is it? I don't think it's as quite as severe as people are reporting that it is.

I think the development curve is just going to be longer because we're going to have to go out and buy more undeveloped lots. As you saw, two thirds of the lots we bought this last quarter were undeveloped versus developed, and I think that's going to continue and it's probably going to be even a higher percentage. There is land to buy, we're just going to have to pick and choose the best deals, the right deals.

Fortunately for us we had bought a lot of land in the Phoenix market earlier than a lot of our competition. So, we have avoided some of the high prices that people are paying today. We are pretty stocked here for the next couple of years.

But we certainly need to buy land in the Southeast. We are a new builder in Tampa, we're a new builder in Raleigh and Charlotte and we have to buy a lot of land there to get our businesses up and running. The land game is very challenging but I think we can navigate through it.

Having said that, we were able to improve our land -- increase our land purchases in the second quarter as we saw sales be stronger. So, we have had success in ramping up the land pipeline to some extent and I would expect us to continue to see a ramped up land purchase pipeline, it may not be quite as strong as the second quarter but it will be stronger than it was prior to that.

Right, so the supply responds obviously as conditions get better. So related to that, your community count goal of 165 for year end, 15% to 20% growth for next year, the land to feed that growth, is that land you already have under control, or will you need to go out and purchase to meet those goals?

We already have 2012 under control. Those are communities that we have already bought. It's just a function of getting them open in time to meet the 165 number for 2012.

For 2013, we still have to buy some land to get to those numbers, and that's what we're doing this quarter, next quarter and the quarter after. Obviously we buy finished lots, we're going to open them faster, and if we have lots we have to develop, we're need to get them sooner than later. So, those are -- 2012 we feel pretty strong about, 2013 we're going to have to work hard to get there.

Great, and just real quick on your revolver. With your revolver, how low would you let your cash balance go now?

I still think we would keep a significant cash reserve. Our thinking is that in past quarters we has said we were kind of comfortable operating with about a $250 million on balance sheet cash position, or so. And with a revolver in place we would probably say well, we have $125 million of liquidity in a revolver so we could let cash come down another $100 million or so on balance sheet and we would still have the $250 million or so of total liquidity.

Thanks.

David Goldberg, UBS.

Steve, in the opening comments you talked about the selling season extending further into June then maybe people expected and maybe certainly than maybe you guys expected in kind of being stronger than you expected. I'm wondering if you are seeing some seasonality? You had talked about year-over-year order growth as you move through the quarter for eight consecutive quarters, but I'm wondering if you could talk about that on a kind of -- on a seasonal basis. If you're seeing a drop off even though maybe it's better than last year. Is it dropping off at this point or is there limited seasonality as we move into July?

It's dropping off in July a little bit. For a whole variety of reasons. Number one, it is a hundred degrees plus in a lot of our markets and people are not as active out in the market looking for homes in the middle of the summer. It is seasonally slower.

Number two, frankly, a lot of builders including ourself, our salespeople have sold a lot of houses. They've got a big backlog. It's hard to really motivate them, we've got to push them hard to keep building that backlog so they have a natural tendency to slow down a little bit. And I think to some degree we are all kind of reloading -- we're reloading our shelves and getting new phases opened up in a lot of communities.

Yes, July is going to be less than June, but it's going to be better than last July. There is certainly some seasonality. But, my comments related to June being much better than June a year ago, and really traditionally after Memorial Day things really start to slow down and they just didn't slow down that much this year.

Got it, and just as a follow-up question. In the opening remarks you talked about the green product and how that's helping to differentiate Meritage product, relative to some of the peers. I'm just wondering when you think about the competitive advantage that, that gives you, are you seeing peers starting to maybe mimic what you are doing, are you finding ways to continue to innovate to keep that kind of competitive advantage and the distance away from peers at the same length or do you think it is shortening or narrowing?

I think everybody has a green initiative to some degree. And people are constantly looking for ways to make their homes more energy efficient and market that to the customer. But, I don't think anybody has gone as far as we have on a national basis, or is even close to going as far as we have. Certainly with the spray foam insulation being the centerpiece of our energy efficiency strategy, no one is doing that, even on a regional basis yet. So, I think that gives us a competitive advantage and I think it shows up in our sales per community, which is the metric that I can point to which is really the differentiator.

Thank you.

Steven Kim, Barclays.

I wanted to ask you a little bit about your ability to maintain the very strong rate of growth that you posted in the quarter. If you look for example at the markets you are in, do you have the ability, to -- if you saw another up in the market to grow or add more than the 20 or 35 communities you talked about in 2013 or should we think of 35 as really being the limit for you, really pretty much no matter what the environment may hold in terms of demand?

Yes. I would say 35 is the top end. It may not be the ultimate limit, but we're going to have to really chop a lot of wood to get 35 done.

That's openings, right not a net number?

That is open where we've sold a house. So, our definition is --.

That is a net number. So, that is an increase in community count from 165 to 200 if it were 35.

As the markets heating up, we're closing communities faster than we anticipated also. So we have to replace those and add net new ones. So, the 20 to 35 is net new ones.

Thanks for that. Then the second question relates to appraisals. It's one of the things that we've been hearing off and on from various builders that appraisals have sort of limited the ability to raise prices. That obviously hasn't obviously shut down your ability to raise prices. Was curious if you could talk about whether you are seeing appraisals fade as an impediment for the industry, in particularly for you, and if so what are some of the mechanisms by which that is fading?

The only appraisal issues we are really dealing with right now on a significant basis is VA. It's almost impossible to sell a VA home in Phoenix because the VA appraisers just won't consider the appreciation that we have experienced in the market. So, unfortunately we are just not able to allow customers to get VA loans in Phoenix.

That said, it's a very small part of our business here, and then same in other markets. I would say in a market like San Antonio where it is a big VA market, a lot of military bases there, they haven't experienced a price appreciation so it's not really an issue. But I'd say that is the one area that we are having real appraisal challenges, but fortunately overall it's a very, very small part of our overall business.

Thanks.

Alan Ratner, Zelman & Associates.

First question is just on the community count guidance, should we expect to see that growth outsized to any specific markets or do you think that's going to be pretty evenly weighted across your footprint?

Well, I think it's the Southeast is where it's going to really happen for us, because we are brand new in three markets there. So we're going to put quite a few communities online in those markets. And then we need to build up our community count again in Texas, it has been declining, and we need to start turning it around the other way. So, I think the Southeast and Texas is where you're going to see most of the community count growth.

Got it. Thanks.

The second question is on Vegas, I know you guys are in the process of exiting there, but we are starting to see some incrementally more positive data coming out of there and looking at your quarter, you actually sold a lot of homes and I'm not sure how much of that was kind of fire sale type pricing to get out of the market. Just curious if, I think we can all say in retrospect that the recovery we are seeing in Phoenix kind of happened a lot quicker and sooner than you had expected. So just curious if the recent trends there are causing you to take another look at Vegas or if you would even consider taking a look there if the positive trends continue?

No, I don't think we are interested in changing our position on Vegas for a variety of issues I don't want to get into on this call but we are not excited about Vegas over the long term. The market pickup has allowed us to get through some of our positions there a little quicker. We sold one of our land positions there to a competitor and that is what caused most of the impairment that we took. We have a few more land positions up there, we are hoping to build -- to sell here in the next 6 to 12 months and repatriate some of that capital back to corporate and then put it out in some other markets. No, Vegas is not somewhere we're going to replant the flag.

Thanks a lot.

Will Randow, Citi.

Giving your vantage point, particularly in the Phoenix market, do you believe that market might be getting overheated? What are your views on it over the next few years in terms from a pricing perspective as well as from a demand perspective?

I think from a house price perspective, the price has a long way to go and I think you are going to see pretty significant appreciation over the next couple of years. They are making real jobs in Phoenix, the economy is improving down here. There is a lot of people that have been on the fence that want to buy a house in this market, and as the prices go up, more people will be able to enter the market. The fact that 50% of the homeowners in the Phoenix area are underwater is what's driving the prices up because that is limited the supply, so you'll have more buyers and you'll have more sellers and I think the market will just continue to get better.

Now on the land side, I do think land prices have somewhat overshot housing prices. Particularly in the last three or four months. I think you got to be real careful buying land in Phoenix right now because the prices have gotten really high, really quick. Fortunately for us we have a pretty strong lot position. We bought a lot of lots here last year and a lot lots in the early part of the year.

Thanks for that. I believe on the last call you guys mentioned you thought that your conversion rate could drop to down call it, the high 70%'s. Clearly it didn't do it this time around, but what are you thinking for the second half on that as well as the cancellation rate has kind of hit a pretty low level?

The cancellation rate is kind of surprising to us. It's hard to complain about that. Some people could argue we are not selling hard enough, but it's hard to argue that when you had a 49% growth rate in orders. It's hard to predict the cancellation rate.

As far as the conversion rate I would hope it would be 75% or better. It's probably going to drop into the 70%'s at some point here, but hopefully not lower than 75%.

Okay, thanks guys.

Jade Rahmani, KBW.

Can you discuss what drove the decline in commissions as a percentage of revenues? And is the current rate a sustainable rate to use going forward?

I think some of the decline in commissions came from the fact that we sold less specs. Specs are generally sold through realtors. We were selling so many build to suits or dirt sales we call them, that we're not be able to get our spec houses in the ground as fast as we would like. Which is limiting our inventory of specs, which is driving the sales of specs down. That may change over time but I think probably for the short term we will continue that trend.

That's helpful. Secondly, on the mortgage environment, you did mention the other income. It's widely known that gain on sale margins on mortgage originations are elevated right now because of the current interest rate environment, as well as capacity constraints on refi's. I wondered if you have enough granularity in your mortgage JV's to know whether this level of income is sustainable or could decline as gain on sale margins moderate?

It doesn't really apply to us because we are just a pure mortgage broker. So, it's a transaction fee for us, we're not doing any mortgage banking. It's just with the net that we make on the origination fee.

So it is a fixed fee per loan sold?

Right.

It is more fixed. Our -- the basis points that fall to our side of the JV have fairly consistently been around 100 basis points.

It's been kind that way kind of forever.

Okay. Great, that's helpful.

Joshua Pollard, Goldman Sachs.

If current underlying trends in sales were to hold, what does your net order absorption rate look like in 3Q and 4Q? In other words, if normal seasonality were to just hold, is it the 15% decline, Q-on-Q in 3Q and then maybe another 10% in 4Q? Or should I be thinking about different numbers?

That's hard. Last year, Q3 and Q2 were almost the same, there was no decline in Q3 from Q2. It's hard to think that this year there won't be -- there's going to be decline I think. There's no way we're going to be able to reproduce Q2 into Q3 so there will be some decline.

Percentage wise I don't know. On the other hand, when you get into Q4, there was a pretty good decline from Q2, I think it was about --.

I was just saying if you look back to last year, I see in 3Q it is pretty flat and then you were down 22% from 3Q to 4Q but I'm trying to understand to what degree was 2011, the second half normal versus what we've definitely normalized in terms of home prices going down and that expectation by consumers? I guess I want to see what you guys think should normally happen, and then I guess it will be up to us to figure out what will happen off of that?

I think Q4 was kind of normal but I think Q3 last year was a little bit abnormal. We were having sales, we were pushing hard. We were throwing in the kitchen sink to try to hold volume. Volume is important and certainly right now for us to be able to build our backlog into 2013, but on the other hand we are pushing our margin and we want to drive margin up at the same time.

So, it is real hard to compare year-to-year, the environments are different. I'm having a hard time giving you a forecast on what the next couple of quarters are going to be. I can tell you to look at our backlog more where the closings are going to be but I can't tell you on the sales.

As you take a look into your backlog, how much higher are your margins of backlog been, your margins on current deliveries? I guess I will stop there and maybe ask one more question on DTAs. If you could elaborate on those comments, that would be great. Are you guys expecting to get a bit every quarter, are you expecting by the time you hit the end of the year you're able to just fully bring everything else back, I'd love some more clarity? Thanks guys.

What can we say about the backlog gross margin you think?

Certainly the backlog gross margin has improved, whether we want to throw out percentages, again, it is the cost side that gives us a little bit of worriness, but certainly the backlog gross margins that we should be delivering in the second -- the third and fourth quarter are improved over the first half.

DTA?

On the DTA side, the Florida -- we would hope that the $1 million left in Florida we get picked up over the next couple of quarters as we continue to show profitability there. And for the federal and the rest of the states, it is a number of factors that come into play whether we are out of our measurement period of cumulative loss, how strong the quarters are, how many quarters are profitability, a number of factors. We would hope that we might have a possibility of booking something in the fourth quarter, but on the other hand it could very well slide into the, I would think, the first half of next year.

And because our DTA -- federal DTA is relatively smaller compared to the profitability we are making now, I would think that when we do take it on, it would come on mostly in one quarter. The great majority of it would probably hit in one quarter but whether it's the fourth quarter or first quarter, it is hard to say at this point.

I appreciate you guys.

Stephen East, ISI Group.

Steve, if I could go back to some of the comments you were talking about on volumes versus pricing, I know earlier you all really preferred volumes over pricing, now as you've ramped up your backlog pretty significantly. And you look at if you were up 25% or 30% in dollars in orders, ideally how would you like that to be split?

It's a delicate balance between volume and price. We need to get our gross margins back up to 20% and we need to continue to push our volumes higher. It is a market-by-market.

I am more focused on sales per community. We've got to have every community at three sales per month, optimally at four. We really leverage our overhead in a community at four, but it has to be at least at three. So, we're at three right now but certainly we've got some communities that are doing four, five or six a month. And we have some that are still doing one or two. So, it is a micro management issue market-by-market and I can't really craft a general statement on how much we're going to push price versus how much we're going to push volume.

If I hear what you're saying though, it sounds like you're still probably more in the volume camp versus the pricing camp at least right now?

Oh yes, the leverage of the overhead we get, for just closing an extra 100 or 200 units a quarter, is phenomenal. We've got to keep that volume going to really start to make money.

Okay, I got you. And then if you look at what you are seeing in land inflation across the markets, you've talked some about the construction costs but on the land side, sort of what would you say is probably typical and are there still better pricing opportunities I guess on the land side?

I think the values -- land prices are more attractive in Texas and the Southeast. I think the land in the West has really gotten pricey, really quickly. You just have to be careful. We are looking at land now that in the West we wouldn't bring on for two or three years, because we got a pretty good inventory, particularly in Arizona for the next couple of years.

To be clear, that's land that probably needs some entitlement that we would tie up under contract and title it while it's still under contract and we have refundable earnest money and start development. It's not land we put on our books and just sit on for three years.

Correct.

If you had to take a stab at it, would you say land across all of your markets is up 10%, 20%? What do you think is happening?

I haven't really figured it out on a global basis. I would say in Arizona it is more than that, a lot more than that. California maybe to a lesser degree, and Texas maybe 10% to 20%. Southeast, plus or minus 20%.

That's really helpful, thank you.

Adam Rudiger, Wells Fargo.

I'm following up on that land commentary. What do think the gross margin difference is on, you mentioned earlier that the bulk of your lots that you purchased, are undeveloped, what is the gross margin difference on undeveloped land in your pro forma versus finished lots?

We factor in -- in development, we factor in cost of capital that really to a larger degree take that up. But, a finished lot doesn't have nearly the amount of carry cost and development costs of carry loaded into it. So, if you pull that out you're probably talking a 2% or 3% differential without that cost of carry in. One you factor that cost of carry in, it generally neutralizes that difference although there is still a better margin on development deals but it's not a huge differential.

Going back to the labor issues, I'm just curious, Steve, how prevalent is that across your footprint? Is it a handful of the Phoenix's or it across all of your states? And in your opinion, where you are seeing the greatest shortages, how quickly does that labor come back do you think?

I'm not hearing about any real issues or shortages outside of Arizona.

Okay.

Certainly there are subcontractors in other markets are trying to push price, but as far as manning our jobs and getting guys out there to build houses, we are not experiencing any issues outside of Arizona.

So earlier when you talked about half of your price increases are being offset by materials and labor, you're talking -- that seems on a Company wide basis, that is more materials than labor?

I think it is more labor and contractor profit and just contractor's ability to push prices because they can.

So, it's not shortages?

There is no material shortage anywhere. There is no labor shortage anywhere outside of Arizona from our perspective. The market here is having a hard time adjusting to an almost 100% increase in building permits. But I'm pretty confident over the next few quarters that it will. Not only are they having to pay their workers more money, but they are trying to make more money as they should and as they can because there is much more demand.

Thank you.

Joel Locker, FBN Securities.

I just wanted to talk to you about the actual community count you have in the pipeline. I know we've touched on it before in the call but just how many do you have in the pipeline to open in the third quarter and the fourth quarter and so far slated for 2013 outside of any new land purchases that you have from this point forward?

We have over 100 communities that we have closed on or control that we expect to open over the next couple of years. I would say we have enough communities in the pipeline to get to that 165 number for this year, by the end of the year. We've got to buy some more to get to the 20 or 35 additional net new communities for next year. I don't want to give a specific number how many we have to buy. But we wouldn't put the 165 out for this year unless we had it and we were really positive we could get it done.

Right. When you mentioned July orders being up year-over-year but you're taking a pause, everybody was reloading. What kind of -- are you talking up 10% or up 50% like you saw in the second quarter?

It's going to be something less than the 49%, but it's going to be up, I can't tell you yet. Our orders like a lot of builders, are weighted towards the end of the month. We have certain incentives, certain price increases that usually come at month end. So, the last weekend of the month is always a big selling weekend for us, and that's coming up this weekend, so I don't want to put too much out there on what July is going to be because I have to see what happens this weekend.

Thanks a lot.

Alex Barron, Housing Research Center.

I want to ask you about your guidance, I guess you guys are somewhat conservative but I don't get the 4,000 units if I just look at what you've already sold in the last 12 months, I get a lot higher than that. So I'm just trying to figure out are you guys just kind of building in just extreme conservatism. Or is it some of these concerns about labor, being able to get the houses done or what is going on?

It is on closings so we've closed about 1,800 units for the year. And we have got another 1,600 or so in backlog. That's going to put us at about 3,400 right, if we close all of our backlog and then we've got to sell houses in July and August. And pretty much after August, you're not going to be able to close it unless it is a spec, right.

If you just estimate what July and August sales are going to be add that to the 3,400 and then throw in some specs on top of that -- you know, I think most of the analysts are in that same range that we put out today. I don't know, maybe we did a little bit more but I don't know how we could be that far off based on what we have out there right now.

Okay.

We're talking closings, not orders.

No, I'm talking closings too. In terms of going back to the Phoenix market, I was there a couple weeks ago again, and a lot of guys were talking about these crazy land prices up 50% and thinking that from year-to-date and saying it could go higher by the end of the year. They were saying that you guys were one of the guys that were I guess earlier on continuously buying land as opposed to waiting to the last minute to jump on and start buying it now. So that is good, but I guess my question is, do you feel that right now, in order to be buying land, you necessarily have to be pricing in or building in strong price appreciation to justify the land prices?

I think you would have to if we were going to go out and pay $1,500 [a front flip] for land today. You going to have to estimate that the prices are going to be higher on houses than they are at this moment. I think we can do that to some degree for land that is two or three years out, which is what we're trying to do, but I would be afraid to do that for land that you're going to bring on the market within a year. I think that is why the Phoenix market to me, is a little bit -- if you don't have land here right now, you are at a disadvantage.

So, given that, how do you see -- what is your strategy like? Is it to start moving out further to the so-called B and C markets or is to just keep in the A markets and just keeping up --?

No, because we've got 11 or 12 positions we bought here last year or even earlier that are all in A and B markets. So, we can dramatically grow our business in this market in 2013 and even into 2014 without having to go out into those C markets. But certainly builders are going to go out into those markets because there is a big price difference between the C market land and the A and B market land.

I am as bullish about our positions in Phoenix as I am in any market that we are in because as you said we got out here early and we have land that has really appreciated here. I'm hoping that's going to flow through in the margins.

Yes, well that seems to be the challenge. Because labor prices are also going up.

Sure

So, we will see. Okay, thanks.

At this time, I'm not showing any questions in the question que.

Thank you for your participation and attention to our call and we look forward to talking to you again next quarter. Have a good day.

This concludes the conference, thank you for attending today's presentation. You may now disconnect.