Meritage Homes Corp (MTH) 2013 Q3 法說會逐字稿

Good morning, and welcome to the Meritage Homes third-quarter conference call.

(Operator Instructions)

Please note this event is being recorded. I would now like to turn the conference over to Brent Anderson, Vice President of Investor Relations. Please go ahead.

Thank you, Amy. Good morning, everyone. I'd like to welcome you to our analyst conference call today. Our third-quarter 2013 ended on September 30th. 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, you can find them on our website at investors.meritagehomes.com, or by selecting the investor relations link at the bottom left of our homepage. Turn to slide 2 in the 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 these risk factors, please see our press release and most recent filings with the Securities and Exchange Commission, specifically our 2012 Annual Report on Form 10-K, and our second-quarter 2013 report on Form 10-Q. Today's presentation also includes certain non-GAAP financial measures as defined by the SEC, so to comply with SEC rules, we provided a reconciliation of those 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 VP and CFO. We expect our call to run about an hour, and our replay of the call will be available on our website within an hour or so after we conclude the call, and it will remain active for 15 days. I will now turn it over to Mr. Hilton to review our third-quarter results. Steve?

Thank you, Brent. Good morning, everybody. We were pleased with our strong operating results for the third quarter of 2013. We achieved significant growth in closings, revenue, margins, and earnings, again this quarter, and we grew orders year over year despite headwinds from the significant increases in home prices and interest rates, as well as the recent turmoil caused by Washington.

We believe the market still has a long runway ahead for additional growth, and that somewhat lower sales pace we are experiencing is actually healthy, and allows the market to return to a more sustainable pace. Market fundamentals remain strong, so we are not overly concerned about the slowing and the pace of sales, but we do not expect to return to the same frothy sales pace we saw earlier in the year. We are confident that we can continue to grow our earnings through both top-line growth and operating leverage.

I will address our order trends, and what's behind those, in a few minutes, but we will begin with a review of our operating results. We are now on slide 4. We earned $0.99 per diluted share for the third quarter of this year, more than 5 times as much as last year's $0.19 per diluted share for the third quarter. Net earnings were up 463% year over year.

Home-closing revenue increased 44%, with an18% increase in home closings, and a 22% increase in average closing prices. This was our 8th consecutive quarter of year-over-year growth in home-closing revenues, and our 7th consecutive quarter of year-over-year earnings growth. Since we ended the quarter with a backlog value of 65% higher than a year ago, we expect to see substantial year-over-year growth in home closings again next quarter.

Slide 5. Because home price increases have exceeded the increases in our land and construction costs, our home-closing gross margin increased by 420 basis points to 22.8% compared to 18.6% in the third quarter of last year. This may go modestly higher for a couple more quarters. We expect gross margins to return to a more normalized level as demand and prices begin to stabilize.

The margin expansion highlights the fact that we shifted our focus from volume growth to maximize the profitability of our assets over the last several quarters and our earnings have grown accordingly. You can see that reflected in our year-over-year price and volume comparisons by quarter.

While our increases in average prices are partially due to our mix shifting towards higher-priced communities and states, the price increases we took in many communities generated much of the 22.8% home-closing gross margin in the third quarter of this year -- a 130-basis-point improvement over the second quarter. Our operating leverage also contributed to our earnings growth, our total SG&A expenses dropped 140 basis points, year over year, and interest expense dropped another 80 basis points from last year's third quarter. Larry will go through more of these details in a bit.

Slide 6. This was our 10th consecutive quarter of positive year-over-year growth in orders, though the 8% growth was less than previous quarters for several reasons. Year-over-year order comparisons were more difficult, considering that orders were up 33% last year over 2011's third quarter, but there's more to it than that.

Low prices and low interest rates coupled with low inventories of homes available, drove much of our sales growth last year and earlier this year. Since we are selling our communities faster than we can replace them, we raised prices repeatedly in the areas where demand was the strongest until we reached a point where sales per community came down to a more normalized base.

Late in the second quarter, the sudden and steep rising interest rates came just as the spring selling season was ending and we were entering the seasonally slow summer months, causing buyers to pause in their purchasing decisions. We believe the rapid price increases had more impact on buyers than interest rates, and it may take some time for buyers to adjust their expectations to current price levels.

For Meritage, our average sales price on orders were up 20% in the third quarter of 2013 over 2012, which produced a 29% growth in total order value, despite an only 8% increase in unit orders. We also added 14 net new communities during the quarter, including 3 from Nashville, as we opened 27 and closed out 13. Our average active community count during the quarter was 13% higher than 2013 than it was in 2012, yet our average orders per community were only slightly lower this year than last year.

We sold an average of 7.6 homes per community in the third quarter of this year, compared to 7.9 per community in the third quarter of last year. Since the fourth quarter is normally our slowest-selling quarter seasonally, we expect to see sales pick up -- we wouldn't expect to see sales pick up until the spring selling season next year. However, we are planning to increase our active community count and are comfortable with our previous projection of 185 communities by end of the year 2013. We plan to grow this by another 10% to 20% next year.

Slide 7. We grew our total order value and backlog value across the board, except in California, where orders and order value declined after we raised prices most significantly there. California had the highest average orders per community since early 2012 -- it was 12.7% in the third quarter of 2012 and 17.9% in the second quarter this year.

We have been selling out communities in California faster than we can replace them, so our average community count was down 21% year over year, and orders were down 33%. I will note that we did increase our community count in California by five from the second to third quarter, as our recent land acquisitions are starting to come online.

Our total order volume in California was only down 11%, due to a 34% increase in our average sales price. After running an unusually high sales pace for several quarters, we are getting back to a more reasonable sales pace there, as it was at 10.6% this past quarter. California is achieving the highest returns in the Company.

As evident in our results, the strategy of focusing more on price and volume has been working. We are earning much more per home, so our gross margin -- our gross profit has increased much faster than our home closings have.

This strategy and results are similar in Colorado, which had the second-highest orders per community across the Company in 4 of the last 5 quarters. Our average sales price in Colorado was up 40% higher -- was 40% higher year over year than the third quarter, when we took orders from eight homes per community there in the third quarter -- to eight homes per community there in the third quarter, roughly in line with the Company average.

We also had a 50% more active communities in Colorado in the third quarter of 2013 than 2012. Orders were up 9% year over year, and our ASP increased 40%, driving a 53% increase in total order value.

Arizona's average community count was up 14%, offsetting a 10% decline in orders per community. So our net orders there increased 2%. Average sales prices were up 12%, and our total order value in Arizona increased 15%.

Demand remains strong in Phoenix, even after pushing prices aggressively there over the last year, and is one of our most profitable markets. Our sales base is lower in Tucson in the active-adult markets, which brings the average for Arizona down, though all of our Arizona markets are still producing very good margins.

Turning to slide 8. We are pleased with the growth we achieved in Texas during the third quarter, where we grew orders by 28% year over year, primarily by increasing our average orders per community by 21% over the third quarter of 2012.

Sales per community in Texas had lagged the rest of the Company over the past several quarters, but we are right in line with our Company average this quarter. With a 16% increase in ASP, on top of that order growth, we generated a 49% increase in total order value for the quarter in Texas.

Slide 9. We are growing our East region through expansion in new markets in the Carolinas and Tennessee, where we recently completed the acquisition of Phillips Builders, a long-established builder with a high-quality repetition in the Nashville area. Florida is still growing strong.

We have expanded our Carolina operation significantly over the last year, and ended the quarter with 15 communities there, compared to 7 last year. Since many of those communities were newly opened and not in full stride yet, our pace of sales were down 15% in the Carolinas, yet we doubled our orders, and total order values were up 128% from a year ago.

Florida has quite a few new communities with deep [block] positions that will remain open longer, so new community opens there are increasing our store count. We ended the quarter with 27% more active communities in Florida than a year ago, which drove a 13% increase in orders. Florida's average prices were up 33%, and total order value for the quarter increased 51% over last year's third quarter.

With that, I will turn it over to Larry to review a few other highlights of the third quarter. Larry?

Thanks, Steve.

Turning to slide 10. In addition to the 500 lots that Steve noted from the Phillips Builders acquisition, we added approximately 3,700 new lots during the third quarter, which was the second highest number of lots we have secured in the last 2 years, after the fourth quarter of 2012.

We secured some great positions in highly desirable locations in our key markets, including those in areas where demand has been highest, like California, Colorado, and Arizona, while solidifying our positions in the Carolinas and adding communities in some of the best sub-markets in Houston and Dallas-Fort Worth, which are strengthening markets. We ended the quarter with approximately 25,000 total lots under control, 40% more than a year ago and about 2,400 more than where we finished the second quarter of this year.

We now have the equivalent of approximately five years' supply of lots, based on our trailing12-months closings. We invested approximately $167 million in land and land development during the third quarter of 2013 to continue to grow the business and have a healthy pipeline of potential new positions, with all of our 2014 and more than 85% of our 2015 closings owned or under contract.

Slide 11. Total closing profit increased $51 million, or 81% over the third quarter last year, including approximately $3 million of land-closing gross profit from the sale of excess lots in certain areas, in addition to the $48-million increase in home-closing gross profit. We also increased financial services profit by a little over $1 million, primarily from increased closing volume.

Commissions and other sales costs came down to 6.9% of home-closing revenue, an 80-basis-point improvement over the third quarter of 2012. G&A expenses were down 60 basis points year over year to 5% of total closing revenue. And interest expense was down $1.5 million or 80 basis points year over year.

With that leverage, we generated an 11.5% pretax margin for the third quarter of 2013, compared to 2% for the third quarter of 2012. It was also a 300-basis-point increase over the second quarter of this year.

Our 2012 results included an $8.7-million charge to increase reserves surrounding litigation in the South Edge joint venture in Las Vegas. Our tax provision was $18.6 million in the third quarter of 2013, compared to just $202,000 for the third quarter of 2012. That's an effective tax rate of about 33% for the third quarter of 2013, which is less than the statutory rate, partially due to energy tax credits we received. We project that our effective tax rate for the full year will end about 31% to 32% range.

Moving to slide 12. Looking at our results year to date, we generated $78 million net earnings in the first 9 months of 2013, compared to $10 million in the first 9 months of 2012, a sevenfold increase. For the first 9 months of the year, home-closing revenue was up 52% year over year, with a 26% increase in home closing, and a 20% increase in average closing prices.

Home-closing gross margin of 21.5% was 330 basis points higher than last year, due to home-price appreciation, better direct cost control, and construction overhead leverage. Commissions and other sales costs were down 110 basis points. General and administrative expenses were down 90 basis points, as we are leveraging our existing overhead platform over greater revenues, and interest expense was down 130 basis points year over year, as we are capitalizing a greater portion of our interest incurred to additional inventory under development.

Our pretax margin for the first 9 months of 2013 improved 810 basis points to 8.7% compared to 0.6% in 2012. Orders were up 21% year over year for the first 3 quarters of the year, and average sales prices were up 22%, yielding a 48% increase in total order value over the first 9 months of 2012.

Slide 13. Our balance sheet is strong and we believe we have adequate capital and financing capacity to support additional growth. We ended the quarter with $311 million of cash and cash equivalents, restricted cash and securities, $16 million higher than our December 31, 2012 balance.

Our net debt-to-capital ratio at September 30, 2013, was 13.1% -- excuse me, 38.1%, consistent with our year-end ratio. We also have a $135 million revolving credit facility and have borrowed nothing against that line to date.

Our total real estate inventory rose to $1.4 billion at September 30, 2013, from $1.1 billion at the beginning of the year. More than half of that increase was from additional homes in construction, under contract, while most of the remaining increase was due to increased land under development.

We had total 652 spec homes started but not yet sold at quarter end, of which 442 were under construction, compared to 643 spec homes at December 31, 2012. With that, I will turn it back over to Steve before beginning Q&A.

Thank you, Larry. We were pleased with our results for the third quarter, particularly our bottom-line earnings growth, which demonstrates the success of our strategies. We have grown our top-line by expanding into new markets, growing our community count, and maximizing prices at a reasonable sales pace.

We have managed to keep cost increases lower than the increase in our sales revenue, which generated a 420-basis-point improvement in our home-closing gross margin. And we are driving greater earnings growth from every dollar increase in our gross profit through operating leverage. We expect to continue to grow our earnings with these strategies going forward. And we've managed a strong balance sheet while improving our credit metrics, as we have grown and expanded our footprint.

Most housing metrics have been moving in a positive direction over the last year, albeit from historically depressed levels. As the US economy slowly improves and creates jobs, demand for new homes should remain strong, especially in light of the shortage of used homes listed for sale.

We believe that Meritage is well positioned, with highly desirable locations and distinctive energy-efficient homes in many of the best housing markets in the country. Based upon our reported results year to date, and assuming continued strength in our markets, we are projecting home-closing revenue of approximately $1.8 billion for 2013, with projected earnings per diluted share in the range of $2.95 to $3.05 for the year.

I thank you for your attention, and we'll now open it up for questions. The operator will remind you of the instructions. Operator?

(Operator instructions)

Please limit yourself to one question and one follow-up. If you have further questions, you may reenter the question queue.

Michael Rehaut, JPMorgan.

Thanks. Good morning, and congrats on the quarter.

The first question I had was on order trends. If it's possible to give us any granularity in terms of how they progressed throughout the quarter, and in particular, I'm interested in the company-wide sales pace per community. I would assume that perhaps with the down 5% on average for the quarter overall, I'm just trying to get a sense of if it was perhaps worse at the beginning of the quarter and perhaps better than that average number at the end.

Just to give us a sense, because we've heard that in our own fieldwork, that September was a little bit better than August. And just trying to get a sense if that's what you saw.

For us, it was a negligible difference month to month. August was actually our best month of the 3-month period, but the differences were so slight, it's really hard to put much mud into it. I mean, we're talking less than 5% difference month to month.

So I wouldn't read into that, it varied by region. In Texas, July and September were like book ends, and August was a little weaker. It was a little weaker in the West in September, but it was a little stronger in the Southeast in September. So it was pretty flat throughout the entire quarter.

Okay. And in terms of the commentary around gross margins, you expect them to increase modestly in the fourth quarter before beginning to normalize. How should we think about that path to normalization, and what would you think is more of a normal level?

In the late 1990s, early part of last decade, you were more or less right around 20%, plus or minus, pretty consistently. Would we expect to get back to that 20% mark perhaps on a graduated pace through the end of 2014? Or would it be even more gradual than that given some of the land in your books that you already have locked up.

I think we're going to have margins at or above where we are right now for the next 2 or 3 quarters. And then, I think we will start to gradually go down probably more towards 21% than 20%. But it's hard for me to pinpoint the exact rate of that descent, but I will tell you more as we get into next year.

As our margins declined in California, they are pretty amazing right now. Our margins are improving in other markets like Texas. So I expect (multiple speakers) mitigate them over themselves.

Thanks. I just want to make to understand. As part of the confidence there that you are still going to have pretty solid margins for 2 to 3 quarters and more of a gradual decline following that? Is that due to perhaps the pricing and incentives remaining relatively firm throughout the third quarter with the slower pace of demand? And maybe, in general, you could just talk about pricing and incentive trends over the last 3 or 4 months?

We haven't really increased our incentives that much. We've done it on a select basis, over this last quarter between, 1% and 2%, where we needed it. And I don't think we're going to be doing much more this quarter. So the gross margin picture, we'll have to look at that more as we go into next year, and as we see how the spring selling season plays out. But, I think a bigger impact on the margins is really going to be land costs. And as we move into more expensive land, that'll have the biggest impact. So --

Thank you.

Stephen Kim, Barclays.

Thanks, guys. First, great job in the quarter. Really impressive. And yes, I'm glad to hear you talk, Steve, about the fact that higher land costs are going to be coming through and making sure expectations are set properly on the margin trajectory going forward. I think most of your peers are going to wind up seeing the same thing. But, I wanted to ask you about your land spend strategy. One of the things I've been interested in is to observe that relative to the size of your business, your amount of land sales this year has been on the end of your peer group, when you adjust for the fact that you guys, in general, don't have a particularly long land bank.

So you have been fairly moderate in your land purchase this year relative to peers. And I was curious as to whether or not you could comment on what you are seeing in the land market now? And why you have generally felt it wasn't the right strategy to be very aggressive in buying land over the last few quarters like some of your peers have.

I think we were aggressive this last quarter. We bought 3,700 lots.

You spent about 35% of revenues, which is pretty typical for builders going back over the last 20 years on average. Some of your peers are well up into the 40%s, or in some cases even above that. So, as a percentage of the amount of land your burning through, your replenishment rate was fairly normal.

You're talking about what we actually spent in cash, or what we actually committed to spend?

Your cash spend.

Well, that's not really that important. What's really important is what we put under contract, and what we committed to spend, and what we have under control. And that's that 3,700 lots I'm talking about. That was a super strong quarter for land purchases for us, that we approved. And we'll be purchasing, over the next several quarters as these lots come online. I don't have the number in front of me, Larry might have it, but year to date, I believe we've purchased over 8,000 lots. So we've been fairly aggressive, relative to our run rate on lot acquisitions.

Okay. So basically you believe that the time is right, now, to be tying up a lot of land. So, although you've not been spending a lot in the way of cash, you've been tying up a lot of land in the way of options and things like that. Is that what you are referring to?

Well, it's a market by market situation. Certain markets like Phoenix, we've got a really big land book here. We've got a lot of great locations. We don't we need a lot of land. We bought land early here. I'd always like to have more land in California, but it's hard to get. We've really bought some phenomenal positions in Houston. We are really excited about our business down there. Other markets like Dallas, we'd like to buy more land, but it's been hard to find land that works. So, in some places, I'm pulling back on the gas pedal, lifting the foot off the gas pedal. In other places, I'm putting the foot down harder. So, it's just a market by market strategy.

Okay. Fair enough.

Steve, if I can add a couple of things here. We put under control about 8,600 lots for the first three quarters this year. But we're also, are optioning more. Land banking is coming back. We have closed eight deals over the last couple of quarters for a total purchase price of lots of about $126 million. And we have now a little under 30% of our total lots under control, control through purchase contracts or options.

So that number is starting to come up, and that is part of our long-term strategy of controlling some of our land off balance sheet through nonrecourse options. So, you are seeing us start to reimplement the strategy we used last cycle.

Yes, and that worked well for you. But what is your finish lot count?

Finished lot count, I don't have that off the top of my head. We have more lots under development, today, than we have, I think, our finished lot count is roughly in the 30% to 40% range. I don't have a specific number. But, because we have been buying almost all raw land, a lot of our lots are under development in some way or another. And we are spending more in land development because of that.

Got it. Thanks, guys.

Ivy Zelman at Zelman and Associates.

Thank you, and good morning. Congratulations on the quarter, guys. Steve, you talked about margins over the next few quarters, showing approximately the current level you're running at. What are your assumptions in expecting that margins to decelerate in terms of expectations in home prices? Are you assuming the prices are going to be flat? So that, obviously, the high-cost land is not being offset with home price inflation.

Well, I think prices are going to vary by market, and I expect prices in California to continue to rise, maybe more in the 5% to 7% range. And maybe Arizona and Colorado will be in the 3% to 5% range. And other markets closer to that number.

But, as I said I said earlier, I think the biggest impact for us, our margins, going forward is going to be land cost. Particularly in California, it's going to be difficult for us to replace some of that land that we got at really good prices. That said, we had five communities we opened this quarter in California, and we have more coming, still at pretty good prices. So, I don't expect our margins are going to drop off the cliff, I think they're going to gradually decline over the next year to 2 years.

And that price assumption is that you're underwriting to a 5% to 7% increase on the new land that you're buying for price inflation in California?

No -- yes, we only underwrite with appreciation in a select few communities in California, and in most cases, even less than that.

So then, really, your expectation is to not get inflation and offset the higher cost of land, and yet you're thinking that margins would be weaker as a result of that? So, I guess, I'm a little confused. So if you're not underwriting -- (multiple speakers)

No, I'm sorry. We don't underwrite to the margins we are achieving today, we underwrite to more of a normal margin. Our margins in California right now that we are achieving are way above what we underwrite to. So, just by the fact that we are going to have lower margins, just by the fact that we're cycling new land through, that we're not going to get the appreciation that we had last year.

Got it. And then secondly -- I'm sorry, go ahead, Larry.

I was going to say, Ivy, the other thing is we typically don't underwrite any inflation on the revenue or cost side, and only in rare instances do we underwrite some revenue appreciation. So, our strategy is to not expect appreciation that is more than costs. So if we get some it's all gravy to us.

Got it. No, that makes sense.

And within the new communities that you've been opening, maybe you can talk about some of the impediments that have been prevalent with respect to the constraints on whether the local municipalities and utilities getting to job sites, or just the labor component? And you sound like you are on track to deliver where you expected. So, are those impediments, for the most part, starting to alleviate?

And then, when you open the new communities, and we think about sales pace slower, are your new communities opening at the price point you expected or have you had to lower list price, and how has been the overall reception to the new communities? Is there a better performance on sales pace in those communities? And are you at the original list price that you had expected to be opening at?

Okay. So I will take, in reverse order. I would say that almost all of our communities, we opened over the last quarter or two, have opened at the prices that we pro forma or higher. In most cases higher, of course, because we underwrote these communities at least a year ago if not more.

I would say that we don't have the line up of people to buy early in these communities that we had a few quarters ago, particularly in the west. But, almost all of them have opened to a good sales pace. I would say our biggest problem, right now, in bringing communities online, is not so much on the construction side with finding trades to complete the work. I think we've got that under control. The biggest challenge we face is really more with municipalities, and the delays we are in encountering getting communities through the entitlements, and plan approval, and the permitting process. And it's backing up in some locations, which is delaying us against some of our projections or community openings. But, we are managing to it.

That's why you might have that wide range of 10% to 20%, because you want to be conservative, given those delays?

Yes.

Okay. Thanks, guys.

Nishu Sood, Deutsche Bank.

Thanks. I wanted to follow-up on the community cap question. So, the 185 communities by year end, you are still comfortable with that. Now, I know you haven't given specific numbers for 2014 or 2015, but you did mention that you have most of the land under control for your deliveries in 2014 or 2015. So, I was just wondering if you could talk directionally, after this terrific year of community count growth you have, which has been very will timed, what you might be looking at directionally for 2014 and 2015?

I'm not prepared, yet, to give you guidance on 2014 as far as revenues, and orders and all that. I will try to do it next quarter. But, I don't really want to say anymore than community count is going to grow between 10% and 20%.

Got it. Okay. And I also wanted to ask about your land spend, the quarterly profile. But, if you look at the last few years, it has followed a seasonal trend where it is lowest in the first quarter, and then it rises through the rest of the year. Now, you guys have done a great job of managing the balance sheet. So, I just wondering what is been driving that seasonal profile? Is it, for example, to do with development spend ahead of the spring selling season? And how should we expect that to look going forward?

Well, I think a lot of sellers want to get deals closed by the year end. So you are pushing a lot of lots through the pipeline to get them closed by December, and then we have a slowing of activity in Q1. It starts to build up again through the year. I wouldn't put a lot of weight into that, though. I don't know that we'll have as big a land spend in Q4 as we had -- maybe not land spend -- land commitment in Q4 as we had in Q3. The spend might go up because -- it will certainly probably go up because we have a lot of deals closing. But the commitments may not increase. It probably will actually decrease.

That's not a metric we manage the business to. And if there is some seasonal pattern that has developed, it's not something that we are purposely managing. And I don't think it's that significant in running the business properly.

Got it. And just housekeeping wise, on the Phillips acquisition, how much did that add to backlog and orders in 3Q?

Larry?

The backlog was around 40 or 45 units. It's a small business doing -- 100 units, 150 units that we plan to grow rapidly. It really provides us with a good platform and good connections in Nashville in which to deploy our excess cash.

Okay, great. Thanks.

Stephen East, ISI Group.

Thank you. Graduations on the quarter, guys. Steve, and, I don't know, maybe this is for Larry, but if you look at the incentives you said they haven't gone up much. I guess, what I'm interested in is what type of incentives are you seeing consumers gravitate to? And are you seeing differences geographically in the amount of incentives you have to use? And also between different buyer profiles -- first move up, second move up, and I know you do just a little bit of entry level. But if you can just give us some more color around all of that issue.

Well, I can tell you what they are not biting on is interest-rate related incentives like buy downs. We experimented with those, and they haven't really made much of a difference. So we stopped trying to put those out there.

I mean, the typical incentives are pretty much what we've always been using, which is towards options. Money to use towards upgrades and options. And we changed that around a little bit, a little bit of a little secret sauce formula. But, it's all option related. And I would say there's not much difference between first and second move up. It's pretty much the same. Certainly, we are using less incentives in California than we are probably in other places. But, there's not a very wide difference by geography.

Okay. That's helpful. So, by not having buy downs, is that telling you, then, that you think the consumer is fine on affordability, and that type of thing, and maybe just a bit more sticker shock that they have to work through?

Yes, I would say it's 70% or 80% sticker shock, and headline shock, and I think this Washington thing is really having an impact on the most recent sales. And I don't think it's interest rates.

Okay, all right, thanks. You all have talked about the gross margin. I guess, while that's important, I'm a bit more focused on what your ultimately your operating margin will be as you move forward in time. So, I'm wondering a few things there. What type of leverage do you think you have on your SG&A. You all have moved that lower as a percentage of sales faster than I thought you would. Where do you think SG&A goes, up margin goes? And then also, embedded right now, what do you think your true ASP price increases versus mix in the quarter that just ended?

I'm going to bump it over to Larry. Larry?

Well, to answer the first question, we are hopeful that, in growing the top line even though over the next few quarters margins may start to contract a little bit, that through growing the top line can continue to leverage our overhead. And we can continue to bring down commissions and other selling costs.

And about half of that number is more fixed selling costs than commissions. So, there is an ability to leverage that, and we should be able to leverage the G&A number too. I'm not prepared to tell you how much on a percentage basis, but we are hopeful that, that will help maintain the bottom line pre-tax margin, even though gross margins might erode a bit. What was the second question?

If you look at your ASP, how much they've gone up, how much of that is true pricing versus mix?

The last couple of quarters, the actual true price increase has been two-thirds to three-quarters of the change, and it hasn't been as much mix related as it was a year or so ago.

All right. That's helpful. And then, just one last question along those lines. You've talked about your land costs. What's going on, on the construction side? I think that everybody has talked about labor. Is labor changing any, and are you seeing any of the materials start to move meaningfully one direction or another?

It's not having the impact that we saw a couple few quarters ago. We got it under control. Not to say it's still not an issue that we are managing everyday. We have challenges in different areas, whether it's brick masons or framers or whatever it may be, but we have to manage to it. And it's a market by market situation. So, I'm not going to put that out there as an excuse, today, for future results. But it's under control for now.

Okay. Thanks a lot, guys.

David Goldberg, UBS.

Thanks, good morning, everybody. I wanted to follow-up on the earlier question, Steve's question on land banking. I wanted to talk about how you guys are seeing the market for land banking evolve, as we have moved through the downturn and through the upturn, now there's a little bit of a pause.

Are you seeing the availability of dollars for land banking and off balance sheet change significantly, and do you think that's an opportunity to change the trajectory of your growth, as you move forward? I think, you've talked in the past you don't think it's going to be where it was, certainly, in 2004 or 2005, but how much are we losing in terms of the availability of credit there?

Well, a year ago it was like zero. So anything above zero is good. There are a few big players that have entered the space and are doing quite a few deals. I don't know how deep those pockets are and how long they are going to be in it, but while it's available to us, we are going to be aggressively pursue it. I don't think it's going to return anywhere near to where it was in the previous cycle, because there just isn't the capacity there that we saw before. But, I still think its something that makes a lot of sense, and will really help drive our growth.

(multiple speakers) I'm sorry, go ahead.

There's probably about 10 people we are talking to that we have either done business with or are talking about doing business with. So, it's not like there's tens or hundreds, but there's certainly a group, and is growing.

So, I see our ability to use this going forward as something that we can continue to do and grow. Again, it's not going to be what we were at last cycle, but it should be very meaningful in helping us provide op balance sheet capital to grow our business.

And just as a tack on with that, the cost of that capital is pretty comparable relative to the last cycle?

It's a touch higher than it was before in the previous cycle, but not that much. It's pretty much the same program that we were operating under previously.

And then just as a follow-up question. Steve, I know you said you didn't want to use as an excuse in terms of the labor market and labor shortages, and that it feels a little bit more under control now, certainly than it was 9 months ago. What I want to talk about, we've heard a lot of debate about labor in this cycle generally. And, I'm just wondering if you think about your experiences in up cycles, has there been a fundamental change in the labor pool because of changes in immigration policy, because of training for skilled labor, that maybe hasn't happened in the last 3 or 4 years? Do you think through the cycle, labor shortages are fundamentally going to be a bigger or more significant or different kind of problem than they've been before? Or is this just another up cycle to you?

No, I think there has been some fundamental changes for all the reasons you mentioned. It's going to depend on what our government's policy is with regard to that going forward, and then how efficient we can become. I think we are constantly searching for methods to build our houses that require less labor. And we are experimenting with a couple of those right now. But it's a long-term challenge for the industry. There's not a lot of people that want to pour concrete and frame houses. So, its something we think about everyday, and we're working towards managing it better.

Got you. And can I just sneak one more in? Larry, on the tax rate and the lower tax rate for the year, 31%, 32%, I think you said. Is that going to be persistently lower tax rate for the time being, just energy credits and everything? Or is that going be a 2013 event that will tail off as we move into 2014 and 2015?

Next year will probably be a bit higher, but it will continue to be lower than the statutory rate. This year, we had some catch-up things, some discrete one-time items that we booked from last year because of changes in tax laws. And those are fixed, and as we've gone through the year, those numbers, as a percent of the total pretax income has reduced, and that's why the tax rate's gradually gone up. But, when you get to next year, you won't have those, but you will still have the ongoing energy tax credit, section 199 deductions, maybe reversals of Arizona and California state DPAs that haven't yet been booked. So, you'll have some of those things continuing to bring the tax rate down some.

I appreciate that. Thank you.

Dan Oppenheim, Credit Suisse.

Thanks very much. I was wondering if you could talk a little bit about coming to terms of how the prices have had the greater impact in terms of the available trends here in the Golden State. Clearly, there have been big increases in terms of pricing. And then, you saw, of course, running lower absorption during the quarter, but you are still expecting a 5%, or a 7%, increase in pricing over time.

Is it just your view that this is, essentially, the third or fourth inning stretch that we're going through right now, and that no sense of doing much in the way of incentives to drive it? But that you think the pricing is going to come back over the next few months here, and then into 2014?

Yes, I mean, you pretty much said it. I think we still have a lot of the factors that portend to a good housing market, very limited supply of resale homes, tight land conditions, high affordability, and all these factors are even more so in California. And are going to lead to better appreciation in California than in other markets around the country. So, we're going to be very careful with our incentives, and we are going to use incentives strategically. We certainly really want to protect our backlog, and we want to maintain our margins to the best degree that we can.

Okay. And then secondly, I guess you had commented that there's been a response as it relates to confidence around the government shutdown and such. And there's a real impact in terms of the most recent sales. Anything you can say in terms of the first couple of weeks -- first 3 weeks of October, anything regionally in terms of just how you are seeing those having impact?

Overall, its been pretty sluggish in October. I think we're going to finish October with less sales than we had in September. Seasonally, that's generally the case. But, what's going on in Washington certainly hasn't helped our business at all.

Okay. Thank you.

Adam Rudiger, Wells Fargo.

Good morning. Thank you. Most of my questions have been asked, so Steve, I will ask you a big picture, crystal ball type question. Something I've been struggling with a little bit is we're hearing common themes from you, and a lot of the other builders, talking about this being temporary blips or bumps in the road or a choppy market in terms of a longer-term improvement. I think we'd all agree that the longer-term supply/demand is pretty favorable a couple of years out.

But what gives you the confidence of the visibility as you see the next 6 to the 9 months, maybe, that this isn't, the sluggishness of this malaise you've seen, isn't just going to continue? How do you think about the next 6 months?

Well, we still have pretty good traffic in our communities. We just don't see the urgency from buyers. We talk to buyers everyday.

I mean I go out to sales offices myself, and I talk to buyers. And, I know there's still a deep pool of people out there that want to buy a house. But the memory of what happened in 2005 and 2006 is still fresh in people's minds. They saw prices shoot up very quickly and then they saw them go down very quickly, and it was painful for a lot of people. So, people want to make sure that this new level of pricing that we've achieved is going to stick. So they are going to wait 2, or 3, or 4 months before they pull the trigger and see what builders are going to do, and what sellers are going to do, and if there's going to be a flood of houses on the market that are going to drive prices down.

I don't see that happening, and I see buyers over the next several months say, okay, it's safe. Prices are steady, I'm going to buy a house. And I think by the time we get to February or so, we'll have 4, 5, 6 months of this behind us, and people will start buying again at a higher pace. It's not like we're not selling any houses right now. We are still selling houses. But just the pace has cooled off a little bit. So, I think just being out in the field talking to potential customers and looking at traffic really makes us more positive.

I think you have mentioned that you've talked to buyers and they want to buy a house. I think there's a difference between wanting to buy a house and actually buying a house -- or being able to buy a house. So, moving into mortgage financing or mortgage availability, what have you guys picked up on, on terms of the ability of your buyers to qualify? How is that been changing, and if at all?

It hasn't really changed that much. I would say there's been more of a shift towards conventional financing from FHA and VA. I think, correct me if I'm wrong Larry, 75% of our buyers today are using conventional financing. I think that was a little bit more close to 60% in quarters past. And our down payments have actually risen from 11% to about 15%. And credit scores have actually risen a little bit.

So, again, we're not really big in the entry-level space, so we are not a very good barometer for what's happening there. But we're not finding a lot of buyers that are looking to buy [MULA] homes from us having mortgage issues, per se.

Great. Thanks for taking my questions.

Eli Hackel, Goldman Sachs.

Thanks. Just two quick questions. One; have you seen any impact in relation to loosening the lending standards? And just on the municipalities, that you've seen some backup. Has that been getting worse over the past couple of quarters, and has that been concentrated in any regions around the country? Thanks.

Again, we haven't seen much change in the mortgage markets for our buyers. I'd say yes, it has been getting a little bit worse over the last couple few quarters, dealing with cities and towns. And it's become a bigger problem, certainly in the West, than other parts of the country.

Okay. Thank you very much.

Will Randow, Citi

Thanks for taking my question. Just two follow-up questions from before. In terms of lot prices, we've been hearing they're starting to plateau in areas like the Inland Empire. Are you seeing that at all?

Yes, I think that's a safe assumption.

And I guess, which areas in particular?

I'd say across the country. I'd say pretty much everywhere.

Makes sense. And in regards to the government shutdown, were you seeing any hiccups or slowdown in FHA or FHFA in term mortgages for the first few weeks of October?

Larry, did you hear anything on that? We heard that it was going to be potentially a problem if it lasted longer. I think we were right on the precipice of it impacting us, but I don't think we really felt much of an impact. Is that correct, Larry?

Yes. The mortgage companies were closing with maybe a couple of [two-come] items, and the ultimate investors were willing to take the risk until the government opened that back up. And at some point they would have stopped taking that risk. But it was a short enough period that it didn't affect our buyers abilities to close.

And if I can just sneak this last one in, your HercuWall innovation, you haven't talked all that much about it. I know you mentioned it on a few calls. Can you talk about the cost benefit and how that improves buyer demand, if that is the case, or production time?

It's still in the testing phase. And we are still experimenting with it. So I really wouldn't want to give any more information about it yet. We will certainly know more in the next couple of quarters and we can talk more about it then. But I'm not really prepared to get into it too much, more than we already have in previous quarters.

Thanks again, guys, and congrats on the quarter.

Mr. Seay and Mr. Hilton, we are coming up to the hour point. We do have several more questions in the queue. Would you like to continue?

Yes, we will take a few more. We'll keep going.

Jay McCanless at Sterne, Agee.

First question I had on taking the gross margin question a different way. If you look outside California, with the acquisitions you've done and the neighborhoods that you are opening, are you still seeing trends in the houses and what the buyers want in terms of larger square footage, higher amenities, that might reverse the outlook you gave for gross margins?

I don't think it's going to have that much impact on gross margins. I think as interest rates rise, if they rise, it's going to have more of an impact on size than actual buying decisions. And so, at these low rates, people still want the big houses, and we're selling at the larger end of our lineup in most communities. And they want their options and upgrades. So we haven't seen much of a change in that area either. And we certainly didn't experience a lot of change around the option strategy in the last cycle until things really fell off a cliff. So, I expect it to remain pretty steady this cycle as well.

Okay. Second question is on active adult, and you made a comment early in the call about Tucson. What are you hearing from the field and what are your people in the field telling you about buyer demand? Why we haven't seen active adult maybe pick up as quick as some people had anticipated?

I wish I knew the answer to that. I certainly have my own theory on why active adult's not stronger. I think it certainly is because that passive income that a lot of active adult buyers depend on is much lower than it's been because of the low interest rates and low savings return rates. And they don't have the disposable income to buy a new home like they had in the last cycle. So that's impacted. It's a very, very small piece of our business, so it's really not that material for us. But I'd certainly like to see it improve and maybe it will improve as we get into next year.

Tucson is a relatively good market. It's not quite as strong as Phoenix. The north side has performed better than the south side. But we still have very positive plans for Tucson going forward.

Okay, great. Thank you.

Alex Barron at Housing Research Center.

Hey, good morning. I wanted to ask you, Steve, in terms of the communities that you guys are raising prices -- or not raising prices, what's the criteria for deciding whether to raise them or not? And also, what percentage of your communities would you say you did raise prices this quarter versus what percentage did you keep them flat? And were there any where you actually had to increase incentives or cut prices?

I don't have the answer to the second part of your question, and I don't know if Larry wants to come at it. But the first part is purely on what demand is and sales pace. So, if sales pace is exceeding three to four homes per month, we're going to try to push prices. And if we have a lot of demand, deep pool buyers, that want our homes, then we are going to try to get a little more price out of it.

I'd say we also look at the competition to see how we price out against them. We certainly don't want to kill demand by over pricing our product, and we are looking at what the spread is between our homes and the resale homes in our area where we are building. So, there's a lot of things that go into the decision whether to raise prices are not. But it's mostly around demand. Larry, do we have any stats on how many communities we raised prices in? I know we don't want to give too much on the incentives.

I don't think we have any hard percentages. I would just say that price increases were much more modest the last few months. And so we didn't have huge price increases like we were having for quarters before that. And then incentives, I don't think we really had any places where we had huge incentive increases. It's more of a modest incentive increase of 1% or 2% in a few -- it certainly wasn't across the board incentive increase. So, I think price increases were more modest and incentives were fairly modest where they were used.

Thanks.

Operator, this will be our last question.

Jade Rahmani, KBW.

Thanks for taking the question. I just wanted to ask about backlog conversion. I think in the past, last quarter I think you said, in the high 60%s and you would like to keep it above 70%. What do you think a normalized rate is for your business say going into next year?

Well, Larry and I have been arguing about this a little bit. Because Larry is a little more conservative than I am, and he believes it's going to fall more. I'd like to see it stay higher. I think a lot of it has to do with how many specs we have available, and we haven't been able to put as many specs out there over the last couple of quarters because demand for dirt sales -- as we call them or new builds, have been very strong.

But I think as things cooled off a little bit this last quarter, we'll be able to get some more specs on the ground, and that will help drive a better conversion rate in quarters to come. And it's also been a challenge getting permits in some places, which has slowed things down as well. So it's probably going to be tough to get back to 70%, but I hope we can keep it above 60%.

Okay, great. And on the SG&A, I think on the commission percentage, I was wondering if there's a potential for that percentage to tick up based on higher payouts to salespeople and increased marketing expense?

It might tick up a touch. We've been using commissions as a little bit of a tool to sell some houses this last quarter. So there could be a small tick up there, but I don't think it's going to be that meaningful.

Great. Thank you.

Okay. Well, thank you very much, everybody. We'll look forward to talking to you again next quarter. Appreciate your time and support. Good day.

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