Meritage Homes Corp (MTH) 2013 Q2 法說會逐字稿

Good morning, and welcome to the Meritage Homes second-quarter, 2013 earnings 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 would now like to turn the conference over to Brent Anderson, VP of Investor Relations. Please go-ahead.

Thank you Emily. Good morning, everyone.

I'd like to welcome you to our analyst conference call today. Our second quarter of 2013 ended June 30, and we issued our press release with the results before the market opened today. If you need a copy of the release or the slides that accompany our webcast today, you can find them on our website at investors.meritagehomes.com, or by selecting the investors-relations link at the bottom left side of our homepage.

If you turn to slide 2 of our presentation, 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 2012 annual report on form 10-K and our first-quarter 2013 report on 10-Q. Today's presentation also includes certain non-GAAP financial measures as defined by the SEC. To comply with the SEC rules, we have provided a reconciliation of these non-GAAP measures in our earnings press release.

Turn to slide 3. 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 run about and hour, and a replay of the call will be available on our website within and hour or so after we conclude the call. It will remain active for 15 days.

I'll now turn it over to Mr. Hilton to review our second-quarter results. Steve?

Thank you, Brent, and welcome to our call today.

Second quarter of 2013 was another quarter of strong growth, with continued significant improvements across our operating metrics. We earned $0.74 per diluted share, more than three times our second-quarter 2012 earnings per share. Our net earnings were up 252% year-over-year, a 27% increase in home closings and a 55% in home-closing revenue.

This was our seventh consecutive quarter of year-over-year growth in home-closing revenue. We continued to raise prices, which improved our home closing gross margin by 300 basis points, and leveraged our overhead expenses to drive earnings growth at a faster pace than our closing or revenue growth.

The margin expansion highlights our shift to focus more on increasing prices and margins over volume growth, as demand continued to be strong. We saw that reflected in our year-over-year price and volume comparisons for the second quarter relative to our first-quarter year-over-year comparisons. Average closing prices were up 22% in the second quarter, higher than the 17% increase we saw in the first quarter. Our closing volumes were up 27% in the second quarter, less then a 39% increase in the first quarter.

While our increases in average prices are partially due to our mix shifting towards higher-priced communities, the increases we took generated much of the 21.5% home closing gross margin in second-quarter, a 200 basis point improvement over the first quarter.

Turning to slide 5, this was our ninth consecutive quarter of positive year-over-year growth in orders, and we went into the quarter with a backlog value 76% higher than a year ago. However, our year-over-year order comparisons are becoming more difficult as seen with this quarter's 21% growth in orders compared to our 49% order growth than last year second quarter. Consistent with our strategy to maximize the value of our live inventory while demand is high, our average sales prices on orders increased by 23% in the second quarter of 2013 over 2012, and produced a 49% increase in total order value for the quarter.

Our average community count in the second quarter was 11% higher in 2013 compared to 2012, and just slightly lower than at the end of the first quarter, consistent with our indication on last quarter's conference call. We opened 27 new communities in the second quarter, and closed out of 30. We are maintaining our projection for active community count of around 185 by the end of 2013.

We sold an average of 9.8 homes per community in this year's second quarter, compared to an average of 9.0 in the second quarter last year. We are satisfied with the pace at or above three homes per community per month while we are taking price increases and growing margins.

Turning to slide 6, we grew our total order value and backlog value across the board in every state but Nevada, where we ceased operations. To provide a little more color I will briefly address each state.

Arizona increased across all sales metrics. Average community count was up 19%, orders per communities were up 9%, net orders were up 27%, ASPs up 17%, and total order value was up 50%. Demand remains strong here, and we have some of the best community locations in the Phoenix area. Prices have increased rapidly as this market has been recovering, but are still well below peak levels.

California -- California has been turning in the highest growth rates for the last couple of years, and had by far the highest orders per community again in the second quarter. Because we've been selling out communities quicker than planned, our average community count there was down 32% year-over-year. However, orders were down only 10%, and total order value was up 13% due to a 26% increase in average sales prices. We have secured several new positions in some highly sought-after areas in Northern California over the last few quarters, and we expect to open them by year-end.

Colorado has 44% more active communities on average during the quarter than a year ago, and maintained nearly the same sales pace to generate a 39% year-over-year order growth for the quarter. In addition, our ASP increased 33%, driving an 85% increase in total order value. Our team in Denver has done an excellent job, and is highly regarded in that market.

Texas. We were pleased with the growth in Texas achieved in the second quarter, growing orders by 33%, primarily by increasing our average orders per community by 30% over the second quarter of 2012. With an 18% increase in ASPs we generated a 57% increase in total order value for the quarter. Some of our newer communities have kicked in and our sales teams are having good success in selling homes in Texas.

The Carolinas. We have expanded our Carolinas operation significantly over the last year, and ended the quarter with 13 communities, compared to five last year. As many of those communities were newly opened and not at full stride yet, our pace of sales was down in the Carolinas, yet still nearly double our orders, and total order values were up 125% from year ago.

Florida. We have opened quite a few new communities here, eight since the beginning of the year. Many of our communities there have also -- also have deep block positions and are remaining open longer. We ended with 31% more active communities in Florida than a year ago, which drove a 22% increase in orders.

We have been raising prices and selling homes in more high-value communities, so Florida's average prices were up 41%, and total order value for the quarter increased 72% over last year's. Our overall ASP for the Company was up 23%, largely due to selling more homes in higher-priced communities, as we have been increasing prices broadly for several quarters now. A larger portion of that increase in ASPs is actual price appreciation.

Turning to slide 7, we have successfully acquired many new land positions, and added approximately 3500 new lots from the second quarter, which was the second-highest number of lots we secured in our last six quarters. These lots are in very desirable locations in our key markets, especially in some of those areas where demand has been the highest, as in California, Colorado, and Florida, while further solidifying our position in Raleigh and adding several communities in some of the most promising areas of Texas, particularly in Houston.

We knew the quarter was over 22,600 total lots in our control, 29% more than a year ago, and about 1600 higher than where we started in the second quarter. We now have the equivalent of approximately 4.7 years of supply of lots based on trailing 12 month closings. We invested approximately $156 million in land and development during the second quarter of 2013 to continue to grow the business and have a healthy pipeline of potential new positions.

With that I will turn the call over to Larry to review a few of the highlights for the second quarter. Larry?

Thanks, Steve.

Turning to slide 8, the vast majority of our increased profit for the second quarter was due to higher home closing revenue and gross margins. In addition to the $42 million increase in home closing gross profit over the prior year second-quarter, we added approximately $2 million of land-closing gross profit from the sale of excess lots in certain areas, and another $2 million for financial services profit, primarily from increased closing volume through our mortgage joint ventures. We leveraged our overhead to generate a $36 million increase in pretax earnings on the $45 million increase in total profit before overhead expenses, resulting in a 750 basis point improvement in pretax margin, which increased to 8.5% in the second quarter of this year.

Commissions and other selling costs were down 100 basis points as a percent of home-closing revenue. General and administrative expenses were down 90 points as a percent of total closing revenue. Interest expense was also down 120 basis points. Together these accounted for 310 basis points of the total improvement in our pretax margin. As we indicated on our April call, we incurred a $3 million loss on early extinguishment of debt in the second quarter of this year, and had a similar type loss of approximately $6 million last year.

The second quarter of 2012 net earnings also included a $5 million benefit, resulting in a $6 million swing from last year to this year's quarterly net earnings, due to tax changes. Our effective tax rate was 27% for the second quarter, due mainly to energy tax credits and a parcel reversal of our deferred tax asset valuation allowance in California. We now project that our effective tax rate for the year could be in the range of 31% to 32% range.

Moving to slide 9 -- looking at our operating results year-to-date, we generated $40 million net earnings in the first half of 2013, compared to $3 million in the first half of 2012. The first six months of the year, home-closing revenue was up 58% year-over-year, with a 32% increase in home closing, and a 20% increase in average closing prices.

Home closing gross margin of 20.6% was up 270 basis points over 2012 due to home price appreciation, better direct cost control and construction overhead leverage. Commissions and other sales cost were down 130 basis points. General administrative expenses were down 100 basis points, both growing slower than revenues. And interest expense was down 160 basis points year-over-year as we capitalized more interest inventory under development. Our pretax margin for the first six months of 2013 improved 740 basis points to 7.0% compared to a negative 0.4% in 2012.

Moving to slide 10. Turning to our balance sheets, we ended the quarter with $353 million in cash and cash equivalents, restricted cash, and securities, a $140 million increase over $205 million at June 30, 2012. About half of that increase was from issuance of our $175 million, 4.5% note due in 2018, and the retirement of our $100 million, 1.731% notes due in 2017.

Our net debt-to-capital ratio at June 30, 2013 was 37.2% compared to 38.1% at December 31, 2012, and 44.1% a year ago at June 30, 2012. With that amount of cash and a relatively low leverage ratio, we believe we have adequate capital and financing capacity for additional growth. With that I will turn it back over to Steve before we begin the Q&A.

Thank you, Larry.

We were pleased with our results for the second quarter, particularly our 300 basis point improvement in home closing gross margin, and our operating leverage that drove ourearnings growth far higher than our growth in revenue. We expect to continue to grow and increase our earnings throughout the remainder of 2013.

Most housing metrics have been moving in a positive direction over the last year albeit from historically depressed levels. As the US economy improves and creates jobs, demand for new homes should remain strong, especially in light of the shortage of used homes listed for sale. Nearly every major housing market is experiencing price appreciation, which is good for both existing homeowners and home builders, is helping to drive our revenue growth well in excess of our growth in orders in closings.

While buyers may conclude that they missed the absolute bottom of the market in terms of price and interest rate, they also recognized that both are still a bargain in terms of the amount of house you can buy at a given income level. Assuming continued growth in the market due to those factors, based on our better-than-expected performance year to date in 2013, we are now projecting approximately $1.7 billion to $1.8 billion in home-closing revenue for 2013 and are increasing our guidance for projected earnings per diluted share to $2.65 to $2.85 for the year.

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

Thank you. We will now begin the question-and-answer session.

(Operator Instructions)

Michael Rehaut of JPMorgan.

Thanks. Good morning, everyone, and congrats on a great quarter, and particularly all the progress on the gross margins. The first question I had was -- I think what is on everyone's minds today is the impact of rising rates and, Steve, I know you mentioned in the press release and your prepared remarks that despite the rise in rates, demand remains strong in your markets. But I was hoping you can give us a little more granularity, particularly as the quarter progressed, how you saw trends, if you are able to give us some color -- April versus May versus June. If you saw any slowing momentum in terms of sales pace, or price increases for that matter, and if any markets stood out in particular?

No, I would say we finished June strong. And we had -- May was the peak for the quarter, obviously due to seasonality; as we roll into summer, demand does start to wane a bit. But I didn't see demand really retreating due to interest rates.

We have seen a little bit of cooling in July. Again, it is hard to tell whether that is from the summer seasonality or from demand. Our traffic remains significantly stronger than it was last July. But I have heard anecdotally from some people that -- some of our customers that they may sit out for a month or two, thinking that rates may actually go back down.

I think people were a bit surprised by the speed of the increase in rates, and it took a little people by -- shocked a few people. But I don't think those people are not going to buy a home. It's just a function whether they buy it this month or next month or the month after. They're going to buy a house. So we don't have a lot of concern, particularly in the short term, from the rising rates.

Okay, that is helpful, I appreciate that. I guess the second question, kind of following on in terms of pricing trends, and as it particularly relates to gross margins, I believe you said that most of the sequential improvement was due to the price increases you were able to implement over the last couple of quarters. The level of gross margins -- I assume that the raised guidance -- maybe you could correct me if I'm wrong -- is baking in a gross margin similar to what 2Q demonstrated? And I guess the question is -- is that correct? And to the extent that you have had some price increases, even perhaps throughout the second quarter, maybe they moderated as rates went up. Would you expect the gross margins to more or less hold, or would there be a little bit more upside or even downside if the pace of increase perhaps has slowed a little bit?

I don't want to get too granular on that. But I can tell you that we don't bake a lot of appreciation into our internal forecasting. I do think the pace of price increases will start to decline. I think we still have pricing power, but I'm not expecting a 300-basis-point increase in gross margins over the next 12 months like we saw over the last 12 months.

But that said, certainly there is a possibility that we can improve upon those numbers. But I don't want to stick my neck out right now and promise that. It's very hard to tell what we are going to see over the next several months as far as pricing. Pricing is particularly strong in the west. It is strong in other markets, but we have a lot of new communities opening up in the back half of the year. We will just have to see how those are accepted and how well they do.

Right, right. Just lastly, to finish this off, last quarter you said by the end of the year gross margins should exceed 20%. Against those previous comments in terms of the guidance, again, is it safe to say that -- sorry to push this, but that the 21.5% should -- is what is the new year-end type of goal? Or should we not draw that conclusion?

Larry, tell me if I am sticking my neck out too far here, but I think roughly 21% for the year is --

I would add that we don't see -- we see sales prices continuing to increase. We probably don't see them increasing at the same rate of increase that we have seen the last couple of quarters. And that would imply that we really don't expect margins to go down. We expect them to continue to increase, but at a more moderate rate than maybe you saw the last quarter, so that the average that Steve is talking about is certainly higher than that 20%, maybe in the more 21% range, but we expect the back quarters' margins to continue to be strong, and hold at least where they are now or around that point, and maybe increase a bit.

Great. Very, very helpful. Thanks, guys.

Thank you.

Stephen East of ISI Group.

Thanks. Nice quarter, guys. Steve, if I could just follow on that line of questioning a little bit. When you talk about pricing will moderate, is it more you all are taking -- you all will take what the market gives you, or will this be more of a strategy change for you? I know in the past you had talked about -- you worried about, in rising rates, that the consumer might try to trade down in product, that type of thing. I'm curious about how the strategy might change. And along with that, whether you consciously change your mix even more away from entry level to move up, second move up, et cetera?

Over the last couple of years we have certainly changed -- tried to focus more on the move-up market. We were never a big entry-level builder. But we became even more of a move-up builder the last couple of years. I still believe, over time, buyers will slide down the price band as rates go up. You certainly can't buy as much house at 4.5% as you could at 3.5%.

In answer to your first part of the question, we'll just take what the market gives us. We want to achieve an absorption of three to four sales per month in every one of our communities. To the extent that we can maintain that volume and push prices, that's what we will do, and that is what we have been doing. I don't see any change going forward.

Okay. And then, if we look at your land acquisition strategy, a couple different things here. One, when you look forward on your buying, what percentage of land do you want to bring onto the balance sheet versus putting into land banking? And then, of course, we have heard a lot over the last several months that in the hotter markets like California, that most builders are having to build in price appreciation and make the deals where -- your commentary and thoughts on that.

The land banking door has opened up, albeit in a small way. There have been a few land bankers of significance that have entered the market. I think we did -- over the last four months or so, about $50 million in land bank deals.

Does that sound right, Larry?

Yes, about a handful.

About $50 million, which is significant. And we are going to continue to do those to the extent that they are available, because we think that allows us to grow quicker, and leverage our balance sheet and minimize our risk. So we will keep land banking. (multiple speakers)

Stephen, If I could add, the percent of lots we have under contract versus owned has been increasing. And it was hovering around 15%, but over the last couple of quarters, it's bumped up to around 25%. And I think we have an internal goal of maybe trying to land bank 20%, 25%, 30% of going-forward acquisitions. Of course, it depends on availability of land banking.

That is great. That is helpful. And what you all are seeing in the markets like California for the pricing of the deals, et cetera?

Pricing of land?

Yes, whether -- we have heard a lot over the last six months where the builders are having to put in price appreciation to make the deals work. Just what you are seeing, what you all are doing, and what you think about that market from a land perspective?

Yes, certainly deals in the west, and particularly not so much in the other half of the country, you're going to have to put a little price appreciation there to make them work. But it would be naive to think there is not going to be any price appreciation. We just want to be conservative about that, and not be too aggressive. But yes, if you want to buy any land today in California, not going to pencil it at today's house price.

Okay, thanks a lot.

Alan Ratner of Zelman & Associates.

Congrats on the quarter. Steve, kind of adding onto your comment about the absorption pace and targeting that three to four sales a month pace. You were at about 3.3 sales a month in the second quarter. And I know you have plans to increase your community count sequentially in the back half of the year. So reading through your comments on July, and the fact that it's softened a little bit, and understanding that it is -- might not be clear at this point whether that is normal seasonality or the impact from higher rates -- at what point do you see that absorption rate, and decide that you need to either increase incentives, slow down the price increases, stop price increases in order to get that rate back up? Or are you comfortable for the next several months that absorption pace maybe dropping below that three- to four-month range, if you do think that this is more of a temporary blip.

It's too hard to tell right now. It is still early, and again, we are in the middle of the summertime. So it is hard to gauge demand when a lot of people are away on vacation. That said, I don't expect -- maybe in the third quarter, we're closer to three versus closer to four, and because of seasonality, I expect things to continue to be strong into the fourth quarter.

It is a community-by-community strategy, a market-by-market strategy. Some communities will be pushing prices harder, particularly in California and some better located communities in Arizona, and we won't retreat from that strategy. And other places we will have to give a little bit to keep demand up. I'm hesitant to paint it with a broad brush. And I think the other factor is we have a lot of new communities opening up in the next couple of quarters, and I think that will help us to maintain a pretty healthy absorption rate.

Just to be clear, then, based on your comments on July, it would be your expectation that even with that seasonal slowing you would still be pretty close to the low end of that range? We are not talking about absorptions going -- cut in half or anything like that?

Absolutely not. (multiple speakers)

Okay. And then, if I could just ask one more -- a number you provided in the past. Do you have at your fingertips the quarter -- the change in apples-to-apples pricing versus what your cost inflation was? I think you've provided that previously.

Larry, do you have that handy?

Sure. We have not updated that real recently, but we have made general comments. We haven't been real specific about that, but our general comments come from last quarter remain this quarter, which is, we think about 50% to a little more than 50%, maybe as much as two-thirds of the price increase you are seeing is real price increase and not mix or other kinds of changes. So pricing during the quarter and our ability to increase pricing remain pretty strong.

I think Alan was asking more on the cost side.

I was asking both. But that is helpful on the price versus mix. If you have the cost increases as well, that would be helpful.

I was going to say -- that is the revenue side of it. And I think we have done a better job the last couple of quarters, or three quarters, managing construction cost increases. So our construction cost increases have been more moderate, down in the -- as far as eating up as a percentage of sales price, maybe only eating up one-third of the sales price. So the difference there is the margin expansion you were seeing.

Does that already reflect the relief we've seen on lumber costs, or do you expect a lag there in terms of that flowing through on the margin?

I can't answer that question; I am not involved in the details enough to answer a specific question about a particular component.

Certainly though the lumber price declines we have experienced have not flown through the income statement yet to much of a degree. We will see some of that in the third quarter. And that will mitigate certainly some of the other price increases that we are taking.

Great, thanks a lot, guys.

Thank you.

Stephen Kim of Barclays.

Thanks guys, strong quarter. That's encouraging about the lumber margin, then, if it may be in the future.

You had made a comment about California, 30% fewer communities, and you hope to replenish that by year end. With all the attention California has gotten, and how strong a market that has been, I was wondering if you could be a little bit more specific about to what degree you think that may represent a little bit of a drag to your -- both your average price as well as your orders? Is that something that we think is measurable enough for us to talk about today?

No, I am not concerned that it's going to drag our orders or our earnings growth down because we have -- I don't know the exact number, but probably six or seven new communities opening up, particularly in northern California in the next several months, and we have a strong interest list in all of those communities. A lot of them are focused over towards Sacramento, and the market is very strong there. So, we expect to get a pretty good pop in those communities in the third and fourth quarter to mitigate the declining community count that we have seen there in California.

Sure, okay, that is great, good to hear.

Secondly, with respect to the interest rates -- it was interesting, Realogy made a comment on their call that, basically, we're not seeing an increase in cancellations in the existing home sales that are pending. And I would imagine that maybe the most forward-looking indicator for rate impact for you guys might be a change in the way buyers are upgrading their homes. Can you comment at all about what you are seeing, real time, on the willingness of folks to spend on upgrades?

I haven't seen any change yet. Absolutely haven't seen anything -- any change in behavior there.

Great. That is very encouraging. One data point -- finished lot counts. Do have that number?

Larry, you got that?

The finished lot count versus the total lot count?

Correct. Of the owned, what percent are finished?

That number, I do not have the exact number, but it is around about 40% now of finished lots, maybe a little less. We bought a lot of lots that were undeveloped lots, so we have a lot of lots that are under development, and are developed enough to be building houses on, but they are not completely finished. Our percentage of finished lots has decreased though, it's down in the 30% to 40% range, because so much of it is under development. Although, again, I want to emphasize we are able to build lots, or houses on a lot of those lots that are still technically under development because they are complete enough to do so.

Okay, great, well, thanks very much, guys, great quarter.

Thank you.

Dan Oppenheim, Credit Suisse.

Thanks very much. I was wondering -- you talked about some of the trends in July, a bit of cooling there. Wondering how much of that you are seeing in terms of differences at price point? Any more in terms of that customer sitting out where it is more rate-sensitive in terms of the first-time buyers at the lower end or roughly consistent across price points there?

Again, we just don't have that many first-time communities. I think we only really count about 12 of our communities as first-time. So we are not a really good gauge of what is happening there. But again, in the move-up market where we play, we just haven't seen that much change, other than hearing from the few instances the buyers are taking a little bit of a pause just to see if rates may go back down before they go up.

Sure. And then, in terms of some of the communities coming on in California, you talked a lot [around] Sacramento and stuff, are you focusing a bit more inland in terms of trying to focus on the slightly more affordable, and where we haven't seen land prices escalate quite as much as they have sort of on the -- along the coast there? How are you thinking about where you are looking at new communities that will be coming on over the next year or so?

Well, two things. Number one, we don't really operate on the coast very much. Most of our communities are inland, either in northern California, the East Bay of San Francisco or in Sacramento. And in southern California, we are primarily in the Inland Empire, although we have one community in Orange County and one down in Oceanside. We are primarily an inland builder. I would also say that prices have gone up just as much inland as they have on the coast. So the pricing pressure is pretty consistent across the whole state.

Great, thank you.

Will Randow of Citi.

Good morning, and thanks for taking my question. On the Texas market, we have seen some acceleration -- and I apologize if this has already been asked, in the DFW market -- I realize you're showing all of Texas in your order numbers, as well as your price numbers. Could you talk about pricing per square foot, and your orders that you are seeing in the DFW area?

Our business in DFW has strengthened every month throughout the entire year. Every month has been better than the previous month. And July is looking like a very strong month in DFW as well, right up there with what we saw in May and June. We have been pushing prices there, but absorptions have continued to remain strong, so I'm very bullish on DFW.

Thanks for that. One last one. When I'm thinking about the Phoenix market, how comfortable are you with current land prices? Do you think there is potential that you may be overpaying? And lastly, are you purposely augmenting your footprint to hedge that risk by growing in the Carolinas?

Land prices in Phoenix have gotten pretty high and -- but I would say that we have not been buying much land in Phoenix over the last few quarters. We bought a lot of land in Phoenix in 2011 and early in 2012. Our land position here is pretty solid, and we don't feel compelled that we have to pay up for a lot of these positions that people are buying right now. That is not to say we're not buying anything, we are just buying few and far between, being very selective. But the land price certainly has gotten pretty [frothy] here.

Thanks for that. Good quarter, guys.

Sure.

Nishu Sood at Deutsche Bank.

This is Rob Hansen on for Nishu. I just wanted to ask about mortgage rates. Again, in terms of -- you mentioned limiting the purchasing power -- and Larry, I think at our conference you mentioned that it would have a real impact when mortgage rates hit the 5.5% to 6.5%. I wanted to see if you could talk about what actions you would take if that were to happen, and really how quickly it would take you to take those actions so it would limit the impact on your results?

As rates rise, we will endeavor to purchase more land that accommodates smaller product. And we will probably be purchasing smaller lot sizes. We will start to design more product that's in the smaller end of the band than we are operating at now. I don't have our average square footage, but I would venture to say that it's probably close to 3,000 feet right now, and historically it has been 10% to 15% less than that. I expect that we will -- as rates rise, and I think it is too early to change strategies on this, but we will be focused more on smaller product.

Okay, and then you mentioned also managing the direct cost this quarter to help your gross margins there. And I think you mentioned lumber prices, but that's going to roll in the future. What other costs this quarter were you able to keep a lot lower to help provide a lot of that upside in the gross margin this quarter?

I think we talked about SG&A and those costs, leveraging our interest expense. All those costs that we are focused on, and we continue to be very focused on construction costs, and try to mitigate, to the extent that we can, the price increases that we are seeing in markets by building relationships with more vendors and more contractors to get our homes built to keep that competitive pricing pressure in the market.

I think we are doing a much better job this year than we did last year. And I think the margins speak to that, that you see in the second quarter. It's not just about -- it's not just about price increasing, it's about managing all of our costs.

All right, thank you very much.

Thank you.

Eli Hackel at Goldman Sachs.

Thank you. Good morning. Just wanted to talk about the Carolinas market. Obviously, you mentioned some of your communities haven't yet hit full stride there -- clearly a growth point for you. Just wondering if you could give some more oversight, or overview in terms of what is going on in those broader markets, and the strength of those markets as you grow into them? Thank you.

We're still relatively new in the Carolinas -- a little more seasoned in Raleigh. We've got a good platform in Raleigh. We're profitable there. We are continuing to grow; we're going to be building our first townhouse community there. And in Charlotte, we're still in our first full year of operation right now, so it's really too early to give too much color. But we are continuing to buy land in both of those cities, and we feel very confident in the long-term prospects for those markets.

Good, thank you.

Joel Locker of FBN Securities.

Hi, guys, nice quarter.

Thank you.

Just on a can rate, 11%, obviously it's historically low, and wanted to see if you saw any signs of that in July getting back to more normalized level of, say 20% --

No, it has not changed really at all in July.

Hasn't changed at all? And just -- going to absorption, your absorptions, going for the second or third quarter, used to be 10% to 15%, and they have been less in the last couple of years. And just with the -- the softening in July that you mentioned, do you expect that to return to more of a seasonal -- historical seasonal basis? Or do you expect it to still be less strong, near second-quarter levels like it's been the last couple of years?

I think over time it's going to become more seasonal. I don't know if we are going to see that much of that this year. But certainly there's seasonality in our business.

And I don't want to read -- I don't want people to read too much into my comments about softening in July. I'm not saying that we are seeing widespread softening. We just noticed -- in some communities, we have seen a little bit of a pause from buyers postponing their decision potentially a month or two to see what happens with rates. In no way, shape or form do I think these people are not buying houses. I don't see it as a concern for us.

Right. A last one on the specs, what was your total spec count and finished specs at the end of the quarter?

We had total specs as a percent of work-in-processes around 24%, and about one-third of those were completed and about two-thirds of those were under construction.

All right, thanks a lot, guys.

Thank you.

Jade Rahmani of KBW.

Thank you for taking the question. You commented on the focus on price over volume. Do you expect backlog conversion to moderate going forward, or stay similar to the level of -- seen in this quarter?

I expect it to -- what was our backlog conversion, Larry?

About 67%, 68% this quarter.

I would like to try to keep it above 70%; it was actually a little bit lower than we thought, but with the strong increase in sales, it's been harder to keep that up. But I'm not expecting it to decline from here.

Okay, great. And just on the G&A side, commission costs continued to decline as a percent of revenue. Could you speak to what is driving that, and if there is any permanent changes that you have made, or if you would expect that ratio to pick up as volume and competition picks up?

No, I expect it to stay pretty much where it's at, right around here. Obviously, we don't have to incentivize specs as much as we did previously, when the market gets stronger. The commission costs generally decline. I think our co-book rate has remained relatively constant. So I am not foreseeing any real change there.

There is about two-thirds of that commissions number you see is actual commissions, and the other one-third is model office costs and project marketing and advertising and sales G&A. So there is a bit of a fixed component to that other one-third. That is more of the leverage you are seeing in that number than actual commissions.

Okay, thanks for that. A final clarification -- on your balance sheet, the mothballed communities balance modestly increased quarter over quarter. Can you explain that?

Steve, do you want to take that, or do you want me to take it?

No, go ahead, Larry.

We had one small community in an outlying area in Tucson that we decided to mothball. But it's not a significant community, but a very slight, slight increase.

Thanks a lot.

Thank you.

David Goldberg of UBS.

Good morning. Thanks for taking the call. I wanted to follow-up on one of the earlier questions -- it might have been from Mike, earlier. But it was about what happens to margins as home price appreciation growth rates moderate, so not go down, but just moderate in terms of growth. And if I understood, you guys said that in the short term, margins would still expand just at a slower rate. I'm wondering if you think about a little bit longer term -- that makes sense for the next six months or nine months, but if you think about it a little bit longer term, if the rate of price appreciation moderates, is there a reason to think that you would feel margin pressure? Or would margins plateau? Or do you think they would expand further? Maybe just some color on that.

It's fairly obvious that trees don't grow to the sky, and you can't continue to raise prices, certainly at the rate we are raising them now, forever. To pinpoint exactly when these price increases are going to moderate is pretty hard to do. But it is certainly tied to interest rates, and tied to growth in the economy and jobs and all the other macroeconomic factors. But we still have a lot of land on our books that we got at very nice prices, and as long as that land flows through over the next several years, it should allow us to keep margins pretty high. I am expecting very good margins for quite some time. Certainly, it's going to be hard to keep them this high, on this trajectory forever. Your guess is as good as mine there I think.

I appreciate the color. My other question was on land banking. You mentioned trying to increase the amount of lots you are taking on through land banking as we look forward. And if you think about cost of land banking today, where that is relative to last cycle, and margin impact -- if you guys decide to take land on balance sheet and develop it yourself, and go through the process yourself, versus using a land banker, and what you have to pay for that? Just some more color would be helpful as we look forward.

Without getting too specific, the cost is very much in line with what it was last cycle. We made an internal decision not to do land banking if the cost was not reasonable, but it's very much in line with what we paid last time. And we think it is a smart strategy, it allows us to grow our earnings quicker, we get a higher ROA and ROE when we use land banking. And as I said earlier to the extent it is available, we are going to continue to pursue it.

And in terms of the margin impact? Maybe give us kind of an idea of what the spread would look like, if you guys develop something internally versus using a land banker?

It's a couple points to the margin. But again, it is such a small piece of our land acquisition strategy right now, I don't -- impact margins really at all.

Thank you for the color, I appreciate it.

We do have two more questions in the queue if you would like to take them now?

Sure.

Jay McCanless of Sterne Agee.

Good morning, everyone. First question is on direct labor cost. Could you talk about how that trended during the quarter, and what you're expecting going into year end?

I don't have any specific numbers on that, but from what I understand, they remain steady through the quarter. And I don't see much of a change for the rest of the year.

Okay. On cycle times, where do you estimate cycle times are now, and with the new communities that you are bringing online, where do you think those could go?

Well, they've been increasing just primarily due to the fact that we are doing more land development, and it is taking longer to get land developed. And it has been more difficult to -- over the last year to get labor to get these houses built. So as we talked about on previous calls, our conversion rate went below 70%. And I think that is primarily due to the fact that we are building less spec homes because we have more demand for what we call dirt sales. So cycles have certainly increased, but I don't have any specific numbers as to exactly where they are and where they are going.

Yes, Steve, our cycle times now are generally from sell to close, generally running in the 150-day range, maybe a little bit higher, and that is a small increase, maybe a 5% or 10% increase from the last -- over the last few quarters. It is not a large increase. We have been keeping a pretty good handle on cycle times, although it has expanded a bit.

Okay, great, thank you.

Alex Barron of Housing Research Center.

Hi, guys, thanks a lot. I wanted to ask you if you can quantify what incentives were a year ago versus this year? That is my first question. And second question was -- your thoughts on maybe issuing some debt here versus issuing some equity?

Larry, why don't you take the incentives?

Incentives really haven't been increasing at all. In fact, they have been going down. We're at the point now where our incentives are running about where they should be on a normalized basis. We don't have any concern on incentives affecting margins. If anything, they have been having a positive impact on margins by continuing to reduce some of that.

Steve, do you want me to handle the debt question, too?

Sure.

We look at managing the net-debt-to-capital ratio, and we have said many times that we are looking at a 40%, 45% net-debt-to-capital ratio as a target. We have been operating below that in the high-30%s. I don't really see the need to be issuing debt in the near future. Who knows what may be farther out?

And on the equity side, we've been opportunistic about that, and could do something, but again, at the current leverage ratio where we are at, it is certainly not something we need to do. That is something that we would do just on an opportunistic basis.

Okay, got it. On the incentive question, I know incentives have been going down. I was just trying to get a feeling for what the impact to the gross margin has been from the benefit of the declining incentives?

We look at that on a net basis.

Steve, go ahead.

It is a mix of reducing the incentive and raising the price. In some communities, the price increase will be smaller but the incentive decrease will be greater, and vice versa in other communities. We look at it as one and the same.

Okay, thanks a lot, guys.

Okay. Thank you. I think that -- sorry, operator. Go ahead.

Showing no further questions. This concludes our question-and-answer session. I'd like to turn it over -- back to Mr. Hilton for any closing remarks.

Thank you very much for your participation and attention this quarter, and we'll look forward to talking to you next quarter. Have a great day.

Thank you.

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.