Meritage Homes Corp (MTH) 2012 Q3 法說會逐字稿

Good day, and welcome to the Meritage Homes third-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 event is being recorded. I will now like to turn the conference over to Mr. Brent Anderson. Mr. Anderson, the floor is yours, sir.

Thank you, Mike. Good morning, everyone. I'd like you to -- welcome you to our analyst conference call today. Third quarter 2012 ended on September 30, and we issued our press release with our results before the market opened today. If you need a copy of the release or 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, the Safe Harbor language. 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 those risk factors, please see our press release and our most recent filings with the Securities and Exchange Commission, specifically our 2010 annual report on form 10-K and our 10-Qs for the first and second quarters of 2012. Today's presentation also includes certain non-GAAP financial measures, as defined by the SEC. To comply with their rules, we have provided a reconciliation of the non-GAAP measures in our earnings press release and in the slides.

Our speakers today are Mr. 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 will be available within an hour or so after that. It will be -- remain active for at least 30 days. I'll now turn the call over to Mr. Hilton to review our third-quarter results.

Thank you, Brent. I would like to welcome everyone to our call today. I am pleased with our results for the third quarter. We reported net earnings of $6.8 million, or diluted EPS of $0.19 per share, which could have been $0.43 per share, if not for an $8.7 million non-cash charge related to our ongoing and unresolved litigation surrounding the old South Edge joint venture in Las Vegas. By comparison, we reported a net loss of $3.2 million, or $0.10 per dilu -- a negative $0.10 per diluted share last year, so our year-over-year improvement was $0.53 per diluted share, if you exclude the charge for litigation reserve.

Our other key performance metrics improved across the board over the third quarter of 2011. Home closings were up 43%, closing revenue was up 54%, home closing gross margin was up 110 basis points, orders were up 33% with a 13% increase in ASPs on top of that. We knew the quarter -- the total backlog value up 70%, and we grew our total lot supply and raised additional capital to continue to take advantage of opportunities for additional growth as the market improves.

The housing market continues to show strength this year over last year within our markets. Many buyers who were previously hesitant, or unable to purchase a home, have gained confidence and are beginning to enter the market again. With listings down, buyers looking for a home are finding fewer alternatives available and are seeing prices increase, which creates urgency in turn.

Other potential buyers who may have been living in an existing home that was underwater have now see the value of their home appreciate, allowing them to move to a new home, which is good for move-up home builders like Meritage. Because most of our customers are move-up buyers who have an easier time getting a new mortgage, these recent trends have been positive for Meritage. We have seen an increase in demand, as orders were 39% higher through the first nine months of 2012 in a year-over-year comparison.

In addition to improving customer demand, we are achieving higher absorptions due to better locations of our communities, with fresh new product designs and industry-leading energy efficiency. Although recovery and demand has been pretty broad across all markets, with every state showing year-over-year gains in orders and backlog, the markets hardest hit during the downturn continue to outperform.

Slide 5. California led again this quarter with the strongest sales per community, at more than four per month, and more than doubled their orders from last year's third quarter. Their ASP was also up about 13%, which pushed their total order value up 131% over the prior year. For the first three quarters of 2012, California posted [144]% increase in orders, and their backlog value at the end of September 2012 was 212% higher than a year ago.

Arizona and Texas both increased their orders around 20% over the third quarter of 2011, and both had approximately 10% increase in ASPs, which resulted in order value growth of 33% for Arizona and 28% for Texas. Colorado and Florida have been strong markets for us since last year, so their order growth was less than our other markets. But their sales pace was also as strong as Northern California's. Colorado had 11 sales per average community, and Florida was over 10 sales per community.

Slide 6. We have kept up with our increase in orders by not only replacing the lots we have sold, but growing our total lot supply. We have approximately 1,800 more lots as of September 30, 2012 than we had one year earlier, and about 250 more that we had at the end of last quarter. We secured more than 1,900 lots in very good locations across nearly all of our markets in the third quarter, including several hundred in our new markets in Raleigh, Charlotte and Tampa.

Based on our backlog and expected conversion rate of around 75% for the fourth quarter, we believe we will close between 4,100 and 4,300 homes in 2012, and end the year with about 160 communities. Our goal is still to push towards 200 communities by the end of 2013, which is dependent on our ability to buy and develop land fast enough to replace communities that are selling out faster than expected.

Assuming that the housing market continues to improve, we believe that we can grow sales by 20% to 30% next year, with a combination of growth in communities and slightly higher average sales per community for 2013. With that, I will turn it over to Larry to review a few other highlights of the quarter. Larry?

Thanks Steve. Turning to slide 7, the earnings leverage in our operations was clearly evident again this quarter, as it was last quarter. We increased home closing revenue by 54% on a 43% increase in closings and an 8% higher average closing price. That translated into a 63% increase in gross profit, as our gross margin improved 18.6% for the third quarter of 2012 from 17.5% last year. Our commissions and other selling costs increased at a slower pace in our revenues, at only 31% year over year, dropping 140 basis points as a percent of revenue.

In general and administrative expenses increased to an even lesser degree, only 17% year over year, providing additional leveraged earnings, as we expected. Interest expense decreased in nominal terms by $2.5 million and by 100 -- 200 basis points as a percent of revenue. Despite slightly higher interest incurred, a greater portion of it was capitalized to land under development and homes under construction.

The end result of all that leverage was that we generated $16.1 million in adjusted pretax income during the third quarter of 2012, excluding impairments in the litigation-related charge, compared to a $2 million loss in the third quarter of 2011. Net earnings were reduced by an $8.7 million charge to increase the reserve accrual related to litigations surrounding the South Edge joint venture in Nevada. The JV has been in litigation since 2008, and we increased our reserves due to a recent court ruling, which we are contesting.

We have recently filed claims against certain joint venture partners to recover any amounts we may be required to pay in connection with the South Edge litigation, and such recovery would serve to reduce or eliminate the need for our South Edge reserve. This does not affect our current operations in Las Vegas, which we are exiting after we sell through our two remaining active communities there.

Turning to slide 8. We completed a few financing transactions in third quarter of 2012 that strengthened our balance sheet and provided additional capital and liquidity to fund our growth and allow us to take advantage of future opportunities. We raised approximately $87 million through our equity offering for 2.65 million common shares in July.

We raised another $122 million in September with the issuance of 126.5 million of 1.875% convertible senior notes due in 2032. We were pleased with our rate and our 47.5% conversion premium. We also put a $125 million credit facility in place in July to provide additional liquidity. This credit facility is unsecured.

And, we reinvested some of that cash back into the business for growth. We spent approximately $144 million on land and development during the third quarter, closing on a total of 2,229 lots. Our earliest at maturity is 2017, our spec inventory totaled 595 homes at September 30, 2012. 209 were finished and 386 were under construction, compared to a total of 515 at September 30, 2011. We ended the quarter with total cash and security in all forms of $387 million, up from $357 million a year ago.

We had 17,842 lots under control, of which 85% were owned, compared to 16,049 lots at September 30, 2011. Our net DTA reserve at September 30, 2012 was approximately $93 million, and we still expect that to be reversed and the asset brought back onto our balance sheet in the next few quarters. With that, I'll turn it back over to Steve for a few summary comments before we begin Q&A.

All in all, it was a very good quarter. Our results improved across the board, which we believe was partially due to the early recovery in the housing and the homebuilding markets. But also, a direct result of our strategies and the changes we have made over the last several years. We believe the home building industry can continue to rebound and grow, and that it will serve as a catalyst to help our national economy recover, which is good for everyone. It will hopefully mean several more years of growth.

I thank you for your attention. I will now open up for questions. The operator will remind you of the instructions. Operator?

Thank you, sir. We will now begin the question and answer section.

(Operator Instructions)

At this time we will pause momentarily to assemble our roster. Michael Rehaut, JPMorgan.

Hi. This is actually Jason Marcus in for Mike. My first question is, I was wondering if you could talk a little bit about pricing and incentive trends as they occurred throughout the quarter? And maybe which markets you have seen the most pricing power in, and how you think about the drivers of being able to further raise prices as you go forward?

We have raised prices in about 85% of our communities in the quarter. I would say we have had the strongest price increases in California and Arizona. Prices have been slightly up to relatively flat in Texas. We will continue to have pricing power in the fourth quarter, probably similar to what we saw in the third quarter. Larry you want to add on that?

Sure. I might add, percentage-wise, there is quite a variance between different communities. So you have some communities that had no price increases, but other communities during the quarter that may have had price increases of 5%, 10%. Averages in Phoenix are ranging at 5% prices increases.

-- for the quarter.

For the quarter. Right. You are seeing ability to raise prices.

My next question is about the land market. Was wondering if you could comment a little on the recent land market trends that you have seen, maybe in terms of the competition and pricing you have seen there over the last quarter or so? It would also be interesting to know what types of land deals you are focusing on in terms of locations, maybe if you are staying with the A locations or if you are venturing more towards some B locations at this point?

The land market is tracking the housing market, and the land market in the hottest markets is most difficult. California and Phoenix prices have risen on land dramatically, and it is tougher to find good land in those markets in particular. That said, we are continuing to selectively buy land. Fortunately, in Phoenix we bought quite a bit of land here early, so we haven't had to buy as much land here in the last couple quarters. So we are being more selective. What was the other part of your question about the land?

If you are staying with A locations or if you are venturing out a little bit toward [home]?

It is harder to find lots in A locations. We are buying some more Bs, a C here and there that could potentially become a B. We are doing more developments, finding very few finished lots, finding very few option deals. Most of what we are buying is mapped lots that we have to develop that will take about a year to bring online.

Okay, great. Thanks.

Stephen Kim, Barclays.

Steve, last quarter when I asked you about margins and where you thought margins could go, we have in our notes here that you had talked about a normal quote-unquote gross margin as being around 21%. I was curious as, given the strong pricing we have seen in the rise in your margins this quarter, if you think that a higher number is likely to be considered normal this cycle?

I thought I said 20%, but we will have to check that. We have always been saying normal margin after construction overhead is around 20%, and before construction overhead is about 23%. We still believe that over the next five quarters or so, we are going to get back to 20%. I expect more margin improvement in the fourth quarter. Certainly we have raised prices in a lot of our communities over the last couple -- this quarter and the quarter previously. Which should start to flow through in the next couple quarters. That is what we are expecting.

Could you clarify that -- (multiple speakers) I know margin -- Before or after interest?

After interest. The 20% is after capitalized interest. We do not report gross margin without interest because we view it as a normal operating cost that we incurred in the day-in and day-out. To back it out is like backing out some normal cost. So we just don't report that.

So that might be the difference, because our capitalized interest -- is it about 1%, Larry?

Yes. It's about -- it may be a little bit more than that. We are expensing more, so we have 2% down below operating income.

So that number that Steve is giving me, is that after just capitalized interest, or is that after directly expensed interest as well?

It is capitalized interest only because that is what is in reported gross margin.

That is fine.

Okay.

Secondly, Steve, could you talk about what you are seeing from your peers, your competitors in the marketplace, in terms of their pricing discipline? Are you seeing -- I would imagine at this point it's still very early on, so folks are definitely looking to push price. Are you seeing clear evidence of that across the markets, or are there certain players who, for whatever reason, are trying to grab volume and putting downward pressure in any way on pricing?

No. It is accurate to say that most builders are focused on margin improvement and are being disciplined about pricing and regulating their volumes. There's always exceptions, of course, in different markets with different communities, positions the guys want to get out of for whatever reason. Not saying any -- everybody is approaching it in a similar fashion, I believe.

Ivy Zelman, Zelman & Associates.

It would be helpful, given your size, Steve, for you to dig into (inaudible) that there is a lot of concern about Phoenix flowing. Those concerns are overdone, considering the lack of inventory there. I am hoping for the first part of my question you can just tell us what you think the environment looks like. Is it just again your point about builders being more strategic in terms of sales and pricing?

Yes. Phoenix is -- continues to be very strong. We could sell as many homes here as we wanted if we took the governor off. But we have been aggressive about pushing prices here. We pushed prices over 6% in Q2 and over 5% in Q3. Builders are bringing communities out of mothball here. It is quite surprising that we had -- we had maybe four communities here that were mothballed, and three of them pencil now. We can make a near normal margin in those communities. I don't have a lot of concerns about Phoenix.

The inventory still remains tight for the resale market, particularly in the better markets in the southeast valley. The high-tech quarter around Intel is hiring a lot of people Very low unemployment in that area of the city, and housing market in general is very strong. Some of the slowdown and permits is because the builders are regulating their sales. There has been significant cost pressure here in the market. The labor basis had a little bit of trouble keeping up, but that is going to get resolved over time, and it is a short-term problem.

Thank you.

Hopefully that answered your question.

Definitely. Thank you. My second question relates to your corporate G&A. It was up nearly $3 million sequentially and year-over-year. So is this really a function of the new market's community count growth? And is it the right run rate we should be thinking about going forward? (multiple speakers)

The G&A increase is really caused by two things. To a small extent, it is being caused by additional overhead in some of our start-up communities, but, our start-up divisions, I should say. But the great majority of the increase is really increased bonuses from people starting to meet their performance targets. Bonuses were very modest over the last few years. A lot of that just relates to additional restrictive stock and bonus -- cash bonus compensation. (multiple speakers)

There probably is a bit of adjustment, though, in there. It might not be quite that same run rate. Wouldn't you say, Larry?

Yes. What happens is, it is not clear at the beginning of the year whether we will meet all of our goals, so the bonus accruals are lesser in the beginning part of the year. Then as people get closer to meeting them, we accrual more. There is more of an accrual this quarter than there was the last two quarters.

That's helpful. Last question, if I may. You guys -- when you think about how much of your land and lots that you have on balance sheet, is there any way for you to -- one, maybe you do this already, but break out what percent is finished versus raw and/or partially developed, I know you have been acquiring partially developed lots? Then, assuming you can give us that, what percent of your lots are currently mothballed, just a ballpark?

From the mothball perspective, we disclose this in our queue now, in case. We have about $40 million of mothballed assets. That represents about 11 communities and maybe about 2000 lots. Again, some of that stuff is partially developed and developed. As far as the total split between developed lots and undeveloped lots, we are running -- now that as we have been buying more lots that need to be developed, we are running more of the 60%, 65%, 70% of our lots are really under development. Not too many lots are raw, but with the unbalance being finished.

So, our percentage of lots under development, which is the great majority of our lots that are in some form of being developed, is growing. I would expect it to continue to grow, so it could get up to 70% or 75% of being under development. I need to emphasize that a lot of that stuff is being very close to being finished because we are starting to build houses on it. It is not all raw, is the point. Very little of it is actually just raw.

Got it. Thanks -- (multiple speakers).

I would just add two things. Number one, that our mothballed communities should drop significantly over the next couple quarters because we are -- made decisions here recently to -- As I mentioned earlier, bring several of those communities out of mothball and you will see those start to come online next two quarters. Then, lastly, I would say two-thirds to three-quarters of all the lots that we are buying today are development lots. As I said, we are finding very few finished lots, particularly in the West, hardly any in the West for that matter. But, we are finding some in Texas and in the Southeast, but most of everything we're doing now is development.

Steve, when you say -- everything you are buying -- is that generally for production in terms of going vertical for '14 now, or are you still buying for '13?

We are buying a little bit for '13, but not very much. Most of the we are buying right now is for '14. We might have a couple more months left that we can find something that we can open up by the end of '13.

Okay. Clear, guys. Thanks.

Dan Oppenheim, Credit Suisse.

You have done a great job over time in terms of shifting geographic markets based on what you are seeing out there. Wondering what you're doing now as you think about the improving buyer confidence. -- In terms of going -- thinking about '13 and '14 in terms of communities with larger homes, higher price points and thus to take advantage of the increased buyer confidence there?

I don't think we're doing anything different. We are just going to continue to execute our strategy. We are going to continue to focus on market share in our existing markets to really get some traction in market share in our newer markets in Charlotte and Tampa and stick to the game plan. We are moving up a little bit on the price band because we are seeing a bit more strength in the higher-priced homes. But, I don't really foresee any significant changes to what we have been doing.

The other question, just geographically, where do you s -- how much of what we are seeing in terms of the shift away from Texas really going to be? Intentional move versus the demand in the other markets, where do see Texas as a percentage of overall volume over the next couple of years? What would your goal be for, call it the West versus Texas and other markets?

The peak of the market in '04 to '06 timeframe, Texas was about maybe one-third to 40% of our business. I expect it to come back into that range over time. We certainly have aspirations to get bigger in California. Historically, we have been relatively small in markets like Denver, which we are getting -- we are much more aggressive in and are getting much bigger in. We want to expand our presence in Florida. We have a very strong position in Orlando. Want to match that in Tampa. The Carolinas are important to us as well. We have got to get bigger there. We have a lot of opportunities for growth.

Great. Thank you.

Stephen East, ISI Group.

Good quarter, guys. Steve, if I look at your sales pace that you talked about that is achievable at 2013, you have already laid out where your gross margins can go over the next five quarters. What should we expect from the SG& A as far as the leverage that you have here? You're talking about opening a lot of communities, etcetera. Trying to understand that path as we move forward.

We are very focused on continuing to drive it down. We think our commission costs and sales costs are still a little too high, and we've got to reduce those. I don't want to give you a precise target or number, but we are cognizant of the fact that as we ramp up our activity, we need to improve in that area. Larry, do want to add on that?

Yes, I have used a general rule of thumb that you can -- that G&A can grow at only one-third of the rate of revenue. This quarter it actually grew less than that, but in the last couple of quarters, actually, but over a longer term, that is a reasonable expectation. It could be less, it could be a little more, but that one-third of just G&A. I am not talking about commissions or selling costs, but G&A, that gives a really good leverage results by growing your rate of overhead by only one-third of the revenue.

Okay. The next question, if I look at -- you had great ASP growth, and if I look at price versus mix, you have talked about both of them. Could you just break that out? Then also, California had great growth. You have already said you're trying to grow in Florida. What should we expect in California? Is this growth heavily driven by community growth as we look over the next year or two, or is it much more an absorption gain?

It has been more absorption than community-count growth. We need to grow community count, but, again, it is hard to find land in California. It is certainly going to be very difficult to come anywhere close to the growth rates we have experienced over the last several quarters. They have all been now in three digits, so I expect growth to moderate there, but I do expect to California to remain strong.

Okay. The price versus mix on your orders ASP?

Why don't you take that, Larry?

Again, I would say if you look at the percentage top line average price increase that we are reporting, year over year, a great portion of that is mix-driven. You can look at, as we talked about, seeing our sells really grow in the high-priced states of California and Florida, and to some extent, Arizona, compared to Texas. I generally think in terms of about two-thirds of that top line percentage increase being mix-driven, and one-third being, what we were talking about earlier in the call, which is the true price increase.

Okay. If I can sneak in one more quickly, Larry? The DTA -- will that come back all at once?

Probably, or pretty much nearly all at once. There may be a state or two that doesn't come back on, but our DTA is smaller relative to our ability to generate earnings than other builders. I see as once we cross the threshold of being able to book it, bringing it all online at one time.

Okay. Thank you.

David Goldberg, UBS.

Last quarter you provided some helpful color in terms of the pressure of cost increases. If I remember correctly, you said something like half or more of the price appreciation was being swallowed up by cost increases. If I think about that directionally today, where would you put that? Would you say that it is a bigger percentage being swallowed up by cost increases, or smaller percentage?

It is about the same. I would say it is about the same.

That includes potentially higher land costs? It is about the same still?

Yes. Certainly, construction costs and higher land costs are eating up at least half of the price increase.

Got it. My follow-up question, Steve, in the commentary, you talked about there are some labor shortages out there today. You are very confident those are going to resolve themselves as we look forward, and that makes sense. What I'm trying to get more color on is -- do you think the reason there is a labor shortage is because there is available labor out there, but the subcontractors are either unwilling or unable, essentially, to bring on more laborers, more employees, or are they just nervous to do so because they are not confident enough in the recovery yet? Or do think it is just because there is an absence of trained labor and skilled labor in some of these trades, where it is going to take some more time to bring in unskilled labor and get them trained up and get them to a productivity level that would be -- representative of where we were before the downturn really started to take its toll?

First of all, this is only the third quarter of real substantive recovery. A lot of trades were hesitant to go out and invest in more trucks and equipment, and hire more people until they really believe this was a real recovery. We had a slow start there. Number two, a lot of trades were -- I want to focus on my margins before I want to focus on my volume. They were going to push prices first, which a lot of them did -- they could. Once they made the decision to expand and hire more labor, it does not happen overnight. It takes them a little bit of time to get people on board and trained.

Then there is new contractors that were maybe previously in business that are coming back into the market and it is taking them time to ramp up. So, the capacity will adjust over time, because were still operating at historically low levels. Once the market has come back into balance, you will have plenty of contractors to build your houses.

Is it fair to summarize, though, it is a healing process, from a subcontractor position, is already starting to catch up? We are moving into the process itself?

Oh, absolutely. We had some real trouble last quarter getting framers out here in Phoenix and other places. We have made some adjustments and built some relationships and brought some other contractors in. It is not easy today, but it has improved.

Thank you.

Joshua Pollard, Goldman Sachs.

You said only a small improvement in absorption pace next year. Is that by design, or is that your forecast for the market? In other words, are you guys looking to constrain sales such that there is only a small increase? Or are you guys just assuming a relatively flat year for '13 from an industry standpoint?

No, is more of a conservative forecast. We recognize there is going to be more competition next year. Certainly, we're going to be focused on margins and pushing prices. So, certainly, we could have better improvement in sales per community, but we are only forecasting a nominal amount at this point right now. A quarter or two from now I could tell you more.

You actually hit on my next question Steve. New competition, market share in your markets as you guys push prices instead of a volume. Do you see large amounts of market share going towards private? Are you seeing them begin to build up their businesses already? Is there any interest in joint ventures this cycle again?

First, I see most the competition coming from other publics. Some publics that have been somewhat quiet in certain markets are waking up and getting more aggressive, and they are really out pushing hard to buy land. I see more competition from those guys than I do from privates. The privates are still capital constrained, other than large regional privates, the Sheas and the Weeklies, those kinds of builders. They have capital, but the smaller guys are building 100 to 300 homes a year. I do not see them making a big impact in any markets right now. We're really competing with more of our public homebuilder peers.

Okay. The last question was just on joint ventures. We look across the last seven years, and joint ventures actually worked the way they were supposed to. They stopped some of the larger builders from actually having to go bankrupt. I'd love to hear your thoughts on getting into joint ventures, post what you saw this quarter on South Edge, just in general.

No. I don't see that much going on or hear about the much going on, joint ventures. There might be situations where two builders go in and split a land position, but I wouldn't call that a joint venture, per se. Those Vegas joint ventures didn't turn out too well. We are not eager to get into those types of situations again.

I do think over time land banking will start to come back. We have been hearing about some players that might possibly be coming back into the business. We are excited about that. We would like to do some land banking again, but it is still pretty early.

Last question. October still as good as things were in the third quarter?

Yes, I would say so. October is still looking right in line with what our expectations are. We are pretty happy with what we have seen in the first few weeks.

All right. Thanks a lot, guys. Keep up the good work.

Okay. Thank you.

Nishu Sood, Deutsche Bank.

This is Rob Hansen on for Nishu. The green initiative for you guys has been a big differentiator, especially against the resale market the past few years. With foreclosures declining and the market turning up on its own, is the green initiative going to be emphasized as much as it has been in the past?

Oh, absolutely. We think it is a big part of our strategy and the culture of our company. We don't intend to abandon it or move off of it or dilute it as the market improves. We're going to stick with it and continue to be a leader in building green homes. I would say the solar component of it is probably having less of an influence because the utility rebates are going away. Some of the federal tax credits are in jeopardy in that area, so I don't know that we will be doing as much solar going forward. But as far as the rest of it, we are very committed to it.

All right. Earlier in the call, you mentioned that sometimes you will buy C location lots. What would that take for it to become a B or an A? Is it price appreciation, volumes, or some combination? Just wanted to get some color there?

It is a lot of factors we look at. We look at foreclosures, or listings in the area. We look at its proximity to schools, employment, highways, commute times, a lot of availability in the area, what does the competition look like. We look at a whole variety of factors, and there is not a hard line. This is a hard line for the As and a hard line for the Bs and the Cs.

We have certainly some opportunities in communities that were pretty distressed a year ago, but look a lot better today because some of the stress has cleared and the location is not bad. It is pretty good. It is a C or maybe was a C, and it could become a B. We're certainly pursuing some of those. We are not going out to the hinterlands, though, I can tell you that, and buying stuff that is an hour drive from anywhere.

I would add, they are really in transition, so it is really a market that the B property that is a little closer in from the C is getting built out. There is not really much in the way of available land to buy. We are just going, just a little bit farther out, and it's a transitioning from a C to a B. So even though we might still classify it as a C, we can see the transition starting to happen.

All right. Thank you.

Alex Barron, Housing Research Center.

I wanted to get your opinion on something. It seems like a lot of the markets have been pretty resilient this late into the year, and California actually seems to be getting stronger. Florida seems to be doing pretty good. But, Phoenix is the only one that seems to have slowed. What do you guys attribute that to?

I spoke to that with Ivy when she asked her question. A lot of builders in Phoenix are regulating their sales. They are focused on price. You could sell as many homes as you wanted in a lot of communities, but you cannot keep up with the production. It has taken little bit of time for the trade base to adjust in this market.

With that, builders are managing their sales to four, five or six homes per month. That has had an impact on the overall market. Builders are trying to bring new communities online to replace old communities that are selling out, and that has taken some time as well. I don't think that you can expect that the torrid pace of improvement that we saw here earlier in the year can continue,. But I would expect through '13 you are going to see still very solid growth in the Phoenix market.

Okay. That seems fair. In terms of your gross margins this quarter, I thought we would have seen a little bit more sequential improvement. Any thoughts on that?

Just be patient. You will see more next quarter We are going to get to that 20% over the next four or five quarters, but it is coming. It is coming.

Okay. Thanks.

We presently have two more questions in the queue. Jade Rahmani, KBW.

I was wondering if you could provide some color on what percentage of your current landholdings were acquired post 2009, and if you have a sense for price appreciation, on average, for this part of the portfolio versus where assets are carried?

I do not know if do we have the precise number, but I would say it is probably 75%, 80% post 2009. Larry, what about the rest of it?

What was the second part of the question please?

If you have a sense for any magnitude of price appreciation, on average, for that part of the portfolio versus where the assets are carried?

Certainly, the rising market has improved -- has raised all boats. Some of the older property that was impaired or mothballed over the last year, it has gotten a lot farther away from a potential future impairment. So I would view any future impairments as being highly unlikely at this point. But, it is hard for me to gauge that, bouncing off the impairment price, how much it has recovered. It depends upon each market.

I would add that we have seen a substantial improvement off the bottom with lot prices. While that is good in that it has helped some of the older land, obviously, it has made buying new land a bit more challenging. But, we have been able to keep up with land price increases by raising prices and repositioning into better locations. The land prices have bounced quite a little bit in, particularly markets like Phoenix.

Okay. That's helpful. A technical question regarding the convert. Do you plan to use the if-converted method so that we will see the full impact of share dilution in the fourth quarter. And will you amortize any interest on that, as you would straight that through COGS?

The way we are accounting for this, we met all the traps to hurdles to not bifurcate. Essentially, there is no equity component that we have booked relating to the convert. The interest that runs through the income statement is going to be the stated rate on the notes.

So, no fourth quarter dilution to the share count?

We are counting the shares as diluted shares, I believe, but I will double-check on that. I am not absolutely certain.

Okay.

That is at least for fully diluted calculation.

Adam Rudiger, Wells Fargo.

I want to go back to Arizona for a second, but from a slightly different angle, because it seems like it is the epicenter of a lot of the trends and issues and concerns that people have. Could you just talk about -- walk us through a chronology of what has happened this year. What I am interested in is gross margin, so you raised prices and demand improved. And earlier in the year the materials and labor moved up, and then you are seeing a slowing pace. I am just curious, if you look at your Arizona or your Phoenix communities, how gross margins have trend through the year and really what the trend line or chronology is?

Going into this year, most of our gross margins were pretty substandard here. Because we didn't have really any price appreciation last year, other than a few select communities. Margins have really turned around because we have raised prices more than 10% in the last couple of quarters. Most of our gross margins today are at or above our underwriting expectations in Phoenix. At the same time we are starting to bring a few communities back online that we had mothballed, as we had said earlier.

The Phoenix market was operating with such low numbers, any substantive improvement made major headlines. This was a market that was 65,000 single-family housing starts at the peak, that was doing 7,000 starts last year. Going from 7,000 to 12,000 or 13,000 is a massive improvement, but it is still half of the long-term historical average in the market. Although the improvements were enormous in the market, we are still operating at very low levels compared to long-term historical averages. But, as I said earlier, I see a lot of builders in the market that are carefully regulating their pricing and their sales pace. They're raising prices every four or five sales, and they're having trouble with getting their homes built, so they are regulating the sales pace as well.

If the gross margins in Phoenix, the rise -- the improvement there -- have those shown up yet in the overall company margins, or is that when you're talking about -- (multiple speakers).

They are coming. A lot of it is coming. Phoenix and California is coming over the next quarter or two because these are sales that happened in May, June, July, through the summer. Some of these homes we have not delivered yet. Particularly in the newer communities, we have sold homes and we are just bringing them online. It is coming.

Okay. That's all I had.

Joel Locker, FBN Securities.

Is this our last question, operator?

Yes, sir. It does appear to be the last question.

Just was curious, on the gross margins, if you said you were up on your orders 11% year to date in Arizona and in California? I do not know what it is exactly, but once you -- if you look at your blend of reported gross margin, say from the fourth quarter of 2011 and first quarter 2012 before price increases really started hitting on the orders, you get to around 18% gross margin. Say, give you another 100 basis points for the fourth quarter and first quarter of 2013, you get up to 19.7%. That is 170 basis-point increase. But, how much of that, is that 400 basis points in actually order price increases once all of these orders close, versus, say, a 230 basis-point increase in direct cost? Or how would you quantify that or break that down, because based on if you are hearing 10% or 11% order price growth in, say, Phoenix versus maybe the company is a lot less or maybe Texas is flat, and some of the other areas --

It is hard for us to pinpoint that for you, but I can tell you that in Texas and the Southeast, it is very nominal price appreciation. There has been cost increases that have mitigated most of the price appreciation that we have had in those markets, so they are not helping us on the gross margin front. Where we are going to get the gross margin lift is really out of the West, of California, Arizona, and Colorado. As I said before, expect that to come through in the next couple quarters.

Right. But would you say that direct costs are going up relatively high in California and Phoenix just on labor and the material front, just because it seems like your margins might be closer to 21% based on the blended mix because --

At least half, if not more, of the price increases are being eaten up by construction cost increases and land cost increases.

Right. How much would you say your order prices, if they are up 11% in Phoenix year to date on orders, what kind of order increase did you get in California?

What kind of price increases have we got California?

Yes, just organically, not including mix or anything like that, but just on --

Our price increases for the last two quarters in northern California have been up about 7%, and in southern California have only been up about, maybe 2%.

Right.

The blend for the last quarter is like 4.5%.

4.5%.

All right.

Steve, can I comment on the conversion of the convertible notes? The conversion calculation on the convertible notes was anti-diluted this quarter, so therefore, the additional shares are not in the EPS calc, because they were anti-diluting some.

Okay. Thanks for clarifying that. Thank you for participating in our call this quarter. We will look forward to talking to you again with our fourth quarter results in January. Thank you very much.

We thank you, sir, and to the rest of management for your time. The conference has now concluded. We thank you all for attending today's presentation.