Meritage Homes Corp (MTH) 2014 Q3 法說會逐字稿

Good morning and welcome to Meritage Homes third-quarter 2014 earnings conference call.

(Operator instructions)

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

Thank you, Amy. Good morning. We issued our press release with our third-quarter 2014 results before the market opened today, so if you need a copy of the release or 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 home page.

If you'll look at slide 2 of our presentation, I'll review the customary cautionary language. Our statements during this call and the accompanying materials contain projections and forward-looking statements, which are the current opinions of management and subject to change. We undertake no obligation to update these projections or opinions.

Our actual results may be materially different than our expectations due to various risk factors, which are listed and explained in our press release and our most recent filings with the Securities and Exchange Commission, specifically our 2013 annual report on Form 10-K and our subsequent quarterly reports on forms 10-Q. Today's presentation also includes certain non-GAAP financial measures as defined by the SEC. We have provided a reconciliation of those non-GAAP measures to the closest GAAP figures within our earnings press release.

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

I'll now turn the call over for Mr. Hilton to review our third-quarter results. Steve?

Good morning. Thank you, Brent, and welcome to everyone on our call today. Before we review our quarterly results, I would like to review our long-term strategy with regards to capital allocation.

Please turn to slide 4. We started out as a one state home builder only in Arizona. When we went public at the beginning of 1997, we were not yet on the list of the top 20 home builders in the United States. Our strategy was to grow and diversify geographically.

Through a series of acquisitions and start ups, we expanded into Texas, California, Colorado, Nevada, and Florida during the growth cycle that ended in 2006. We went into the downturn with operations in six states. The additional diversification we achieved served us well as various markets outperformed while others underperformed at different times.

As we emerged from the downturn and started the next growth cycle, we made the decision to pursue even greater diversification and concentrated our focus on the Southeastern United States where we had identified many opportunities. Since 2011, we have entered six more markets and completed two acquisitions. Each has required a significant initial investment in land, management, facilities, and start-up expenses, well in advance of producing sufficient revenues to offset these costs, which has had a temporary dampening effect on our overhead leverage, operating margins, and shareholder returns while those markets develop. However, we believe each of these new markets offers excellent long-term growth potential and return on investment as well as the benefits of additional diversification.

We are confident in the long-term growth potential of each of our existing markets. Understand that each market will go through short-term cycles at various times. Today, we are the ninth largest US home builder operating in nine states, in 14 of the top 20 home building markets, and we believe we can continue to grow and gain market share. While dividends or share buybacks may be appropriate for some builders who are already in many more markets, we believe we can still provide the best returns for our shareholders by continuing to invest in the best long-term markets for home building.

While we do take current conditions into account relative to timing, these strategic decisions are based on our expectations for long-term returns. With that, let's turn to slide 4, I'm sorry, slide 5, to begin. We are pleased to achieve year-over-year growth in closings, revenue, orders, and backlog for another quarter. Closings were up 7%, orders were up 15%, and backlog was up 24%, higher than our third quarter last year. Additionally, with a 5% increase in our average sales price, third-quarter closing revenue was up 13%, total order value was up 21%, and backlog value was up 30% over last year.

This growth was primarily driven by our Central and Eastern regions, due to strong economic conditions in Texas and our strategic expansion into the Southeastern United States. Home closing revenue in Texas was up 31% and the Eastern region increased 53% over 2013. We closed on our acquisition of Legendary Communities in August, so our third-quarter results include 81 closings and 87 orders for the last two months of the quarter from the 32 communities that we got in Legendary.

In our West region, Colorado achieved growth across the board in orders, closings, and backlog; both in units and total order value, including a 16% increase in home closing revenue, 59% increase in orders, and a 48% increase in ending backlog value. Our third-quarter 2014 orders and closings were lower than 2013 for California, though market conditions remain quite favorable, especially in the coastal communities, which sales have generally outperformed the inland communities. In fact, California orders were off just 5% and order value was up 3% over 2013's third quarter.

In contrast, market conditions in Arizona, particularly in Phoenix, have been softer since the second half of the year, resulting in year-over-year declines in orders and closings there. We remain committed to our Arizona markets, despite the short-term softness, and we believe we'll be rewarded for these investments we made in these markets over the next several years.

Turning to slide 6. Our total home closing gross profit was relatively flat year over year, though our home closing margin was reduced to 20.4% in the third quarter of 2014 from 22.8% in the third quarter of 2013, mostly due to lower margins in California and Arizona, which reflected higher land costs and increased incentives in Arizona.

Our margins in California are still above average, but off from their abnormally high levels in 2013, as the demand there has returned to more normal levels. We also took a small $1 million impairment on two older vintage communities in Tucson, and the short-term effect of purchase accounting reduced our margins on home closings from Legendary after we closed that acquisition in August.

Together, those two items impacted our home closing gross margins by about 60 basis points in the third quarter. We have been projecting home closing gross margins to decline through 2014 since the end of last year and are now forecasting closer to 21% for the year compared to 22% gross margin for the year in 2013.

The 21% for the full year 2014 includes approximately 30 to 35 basis points impact from the Legendary purchase accounting and the Tucson impairment. We reported net earnings of $32.6 million for the third quarter, compared to $38.2 million for the third quarter of last year.

Turning to slide 7. I'm proud of the excellent job our divisions did in getting new communities open during the quarter. We opened 36 new communities during the quarter to bring our total to 193 within our existing markets before adding Legendary. That was slightly ahead of our projection last quarter of 190 by our third-quarter end.

Adding an additional 32 communities from the acquisition of Legendary Communities, our total community count at September 30, 2014, expanded to 225 active communities from 175 at the beginning of the quarter, for a year-over-year increase of 26% compared to September 30, 2013. We are forecasting the addition of another five to 10 net new communities in Q4 to end the year at approximately 230 to 235 communities.

We are enthusiastic about the opportunities for continued growth represented by these additional communities. Even as we are expanding our total community count, our sales pace kept up, and we achieved increase in orders per average community in all states but California and Arizona.

In fact, some of our newer divisions had excellent improvement in their sales pace. North Carolina increased from 5.1 last year's third quarter to 7.8 this year. Tennessee increased their sales base to 10 per average community from last year's 7.3.

Both of those increases were due to opening some great new communities with long interest lists that produced good order volumes right out of the box. The sales for average community in Georgia and South Carolina Legendary markets are lower than the average of our markets, due to the fact that our orders there only represent two months of the quarter.

Additionally, Legendary has a slightly different operating model than Meritage as they manage several smaller communities in close proximity to one another with one shared sales office, one set of models, and fewer building superintendents. By sharing those overhead costs, they can operate profitably at lower absorption levels. Excluding Legendary markets, our average orders per community would have shown an increase over last year.

Turning to slide 8. We are also pleased with our results on a year-to-year or year-to-date basis. Home closings, average closing prices, and total home closing revenues for the first nine months of the year increased 5%, 10%, and 16%, respectively, over 2013. Our year-to-date home closing gross margin was flat coming in at 21.6% for 2014, compared to 21.5% in 2013. And net earnings for the first three quarters of 2014 increased 19% to $93 million over $78.4 million for the three quarters of 2013.

With that, I'll turn it over to Larry to review a few other highlights of our third-quarter and year-to-date results. Larry?

Thanks, Steve, and good morning, everyone. I'll provide some additional detail to help explain our third-quarter operating results. So let's turn to slide 9.

As Steve noted, part of the explanation for our margin this quarter was due to the impact from purchase accounting on standing home inventory acquired from Legendary. And purchase accounting lot and land inventory is recorded at market value, while standing home inventory is recorded significantly above market value, producing substandard margins under the assumption that a large percentage of the earnings process has already been completed prior to the acquisition.

That will negatively affect our home closing gross margins for a couple of more quarters until all of those homes acquired are closed. We estimate the impact will be approximately 40 to 55 basis points on fourth-quarter home closing gross margin, and approximately 20 to 35 basis points in the first quarter of 2015.

We had a negative swing in land closing gross profit of $3.3 million for the third quarter and $5.9 million year to date for 2014 compared to 2013. The $0.5 million loss on land closings in third quarter of 2014 resulted from the sale of our last remaining parcel of land in Nevada where we discontinued operations in 2012. In fact, almost the entire $1.5 million loss on land sales year to date in 2014 has been from sales to help us fully exit the Las Vegas market.

Commissions and other sales costs were 7.4% of home closing revenue in the third quarter of 2014, compared to 6.9% in 2013, primarily due to our success in getting 36 new communities open. While that was quite an accomplishment, the initial revenues from those communities were not yet sufficient to offset those costs associated with opening those communities.

Our general administrative expenses increased slightly to 5.2% of total closing revenue in 2014, compared to 5% in 2013. The year-over-year increase of $4.8 million included approximately $2.3 million related to the acquisitions of Phillips Builders and Legendary Communities. Approximately $1 million is non-reoccurring.

We expect to gain more leverage of our overhead expenses going forward as we eliminate some of those one-time items and grow our revenues. We are capitalizing essentially all of our interests to assets in development now, so our interest expense dropped by $3 million from 2013's third quarter.

Our effective tax rate was 30.7% in the third quarter of 2014, compared to 32.7% in 2013, which brought our year-to-date rate to approximately 34.5%. That is lower than our normalized rate of approximately 36% and the rate we would expect going forward due to an energy credit true up in the third quarter of approximately $2 million that was the result of a detailed study of the actual energy savings on our 2012 and 2013 home closings, which allowed us to receive a greater tax credit than was initially estimated.

Moving to slide 10. We put approximately 5400 new lots under control in the third quarter, including approximately 4000 from Legendary.

We ended the quarter with approximately 29,500 total lots under control, an 18% increase year or year. That represents approximately 5.4 year supply of lots relative to our trailing 12-month closings.

Our total spec inventory was 1311 with two-thirds of those specs under construction. We have seen the market change with more buyers seeking finished or nearly finished homes; and therefore, we intend to maintain a higher number of specs than we have historically, based on market conditions.

In order to position ourselves for the 2015 spring selling season, we have more than doubled the number of spec homes started and increased our average spec per community to 5.8 at the end of the third quarter of 2014 from 3.6 a year ago. We invested approximately $183 million in land and land development during the third quarter, excluding the acquisition of Legendary.

Moving to slide 11. We ended the quarter with approximately $94 million in cash, cash equivalents, and securities, compared to $364 million at the year end of 2013.

The balance was down this quarter after our purchase of Legendary Communities and other investments in real estate, which include homes under contract, under construction, and spec homes, which increased by a total of $313 million, where our home sites, either finished or under development, increased by $128 million over our year-end 2013 balances.

Additionally, we have $375 million available under our $400 million in revolving credit facility at the end of this quarter. Our net debt to capital ratio at the end of September 30, 2014, was 43.4% compared to 39.1% at December 31, 2013, and 38.1% a year ago at September 30, 2013.

Moving to slide 12. I'll briefly recap a few statistics from our mortgage company as of the end of the third quarter, since we typically get a few questions on this. The credit statistics of our buyers have improved as we have been selling to a higher move-up segment in the last couple of years.

The average credit score of our buyer is now 745, with 79% over 700 and only 1% below 620. 82% of our buyers make at least a 5% down payment on the purchase of their home and nearly half put down 20% or more.

76% finance with a conventional qualifying mortgage and 24% with FHA, VA, or USDA loans. With that, I'll turn it back over to Steve before we begin Q&A.

Thank you, Larry. Overall, we were pleased to achieve year-over-year growth in closing, closing volumes, orders, and backlog for the quarter, and believe that our investments in new and existing markets have positioned us well for continued revenue growth and improved earnings leverage in 2015 and beyond.

We currently project fourth-quarter home closing revenue of $700 million to $735 million and diluted earnings per share of $1.00 to $1.05. Even with no improvement in marketing conditions or additional community count growth in 2015, our current community count suggests the potential for greater than 20% growth in 2015 orders, closing, and revenues; and we believe our earnings growth should exceed our top-lying growth.

While an improving economy and employment growth, coupled with relatively low inventories of homes for sale and low interest rates, the US housing market can continue to improve overall and we are confident in our ability to leverage our strengths in the Meritage Homes brand to further develop our existing markets and penetrate additional markets where we see promising opportunities.

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

Thank you.

(Operator Instructions)

Michael Rehaut from JPMorgan.

Thanks. Good morning, everyone. First question I had was on the gross margins, and appreciate the detail on the regional level.

And with Arizona and California having some negative drag, I guess, due to the higher lot costs, I wanted to get a sense of as you look into your backlog, if that drag should continue to the downside or perhaps stabilize in the next quarter or two?

We feel pretty confident that our margins are going to stabilize about where they are right now. In that 20.5% to 21% range, excluding purchase accounting adjustments, so I don't see additional downward pressure overall on our margins. You agree with that Larry?

Yes. Agreed. You have to really look at the California margins were just really super high last year. And they have really come down to more normalized levels. The California market is still pretty strong.

Right. No, I guess, specifically, I was asking, not on overall margins, but just on California and Arizona. If you think that adjustment perhaps back to normal has run its course, but there isn't any incremental downside from here?

I don't think so. I mean, certainly, there is potential for those margins in the inland California markets and Arizona to get worse. But I also think some of our other markets are going to improve. Margins are getting better in some of those places and would actually offset that, so not --

Right. But potential aside, Steve, I guess, in terms of what you have -- and maybe Larry can speak to this, what you actually have in your backlog?

Well, I think what you're asking is there continued pricing pressure to increase incentives that would affect margins in those markets? And I would say, probably not. I think our pricing is stabilized.

Whether we have some minor additional downward pressure on margins in California and Arizona in our backlog, yes, possibly. But again, without getting that granular, I don't believe it's going to have an impact on our overall margins.

No, that's helpful. Thank you. And, just the second question on spec per community. You highlighted that as you have a higher level now, versus a year ago going into the upcoming spring eventually or positioning.

Did you feel that perhaps you lost some sales this past year because you didn't have enough spec? And do you feel that with the greater amount of spec that you are carrying now, does that potentially place you in any undue risk if demand doesn't materialize the way you are expecting?

No. I think I look carefully, at some of our competitors are having some very good success. I won't mention their names, but some of the competitors have the strongest order growth, are building more specs than we are, and I think, some of their order success relative to the peers is due to their spec strategy. And we are very close to our customers, and we hear what people are looking for when they come through our communities. And realtors and prospects want to find homes that are ready to move into quickly.

So we expect our spec strategy to help us, certainly, in the later parts of this year as we go into the fourth quarter; sell more homes that we can deliver quickly to increase our conversion ratio, and will also help us in the spring selling season. I certainly don't see the market weakening where we have these specs. If anything, I expect it to improve. And I think the strategy is going to benefit us. So let's move onto the next, thank you, Michael, let's move onto the next caller.

Ivy Zelman of Zelman & Associates.

Hey, guys, it's is actually Alan on for Ivey, good morning. Steve, I was hoping to dig in a little bit more on California. Because when you look at your community count there, it was by far the strongest growth of the states in the quarter, obviously aside from the Legendary markets.

And you mentioned a lot about the higher lot costs and some of the demand trends you are seeing there. But if you look at your website, it looks like the majority of your growth, really, is coming from the Inland Empire, maybe Sacramento to a lesser extent.

Was curious if you could talk specifically about, A, the margin differential on those markets versus the coastal markets, which was probably representing a greater percentage of your orders and deliveries there over the last year or two; and B, just talk a little bit about how you see that market unfolding because other builders, I think, have been more reluctant to make a heavy bid on the inland markets?

Well, we'll look at Northern California first. We have a few new communities we opened up in the South Bay area of Morgan Hill and Gilroy, and we have a few more to open up there that have tremendous demand. You are going to have really high margins, going to really help us going into 2015.

Certainly, we opened several communities in that Sacramento area of Roseville and Lincoln and they're not doing as well; demand is weaker, competition is higher. Margins aren't so good there.

And then we have some stuff in between those two points that are sort of in between on the margin and absorption scale. So, it's kind of a mixed bag at Northern California. We've got some of both.

Certainly, down south, in Southern California, our emphasis is more on the Inland Empire. We only have one Orange County community open right now in Rancho Mission Viejo. But we're going to be opening two more next year, so we're excited about that. We think that is going to have a positive impact on margins there.

But certainly, our Inland Empire communities' sales pace and pricing is weaker. It's not as weak as it is in Arizona, but certainly a lot weaker than it is on the coast.

Got it. That is helpful. And then just a follow up in a similar vein.

Earlier this year, I think you guys highlighted some numbers regarding the reduction in the FHA loan limits and how that impacted you in the markets like Phoenix and the Inland Empire. And obviously, had a big impact given your price points in those markets. With the FHFA news that they're going to be launching a new 97% program, which presumably would have higher loan limits than the FHA current limits, I was curious if you have done any work in understanding what impact that might have on your activity in those markets and what your people in the field are saying?

Well, we haven't done any precise calculations, but I can tell you the lowering of the FHA loan limits really hurt us in Arizona, in particular. I mean, I think it hurt us in other places as well, but had a bigger impact in Arizona. And if the FHA increases those limits back to where they were before, somewhere in between, I think it will be helpful.

Down payment is an issue as well, but I think it's the loan limits are even a bigger issue. You can see our FHA, VA, and USDA loans are 24% of the total, I think they were closer to 40% a year ago. So, I certainly welcome FHFA stepping in and making some adjustments. We'll see how fast they come.

Thank you.

Stephen East at ISI group.

Thank you. Good morning, guys. Steve, you talked about California and Arizona. Can you talk about what you are seeing in the other markets and as far as demand? And to follow along on the prior question about whether the government actions would help, whether you see any of those markets, in particular, that would get a nice bump from it?

I think it's going to help everywhere. I mean, I think there is perception and reality. And perception is that financing is hard to get and it's cumbersome and it's difficult. And reality is that it is tougher to get and you have to have higher credit and higher down payment.

So, yes, I mean, there is not a builder out there that is going to tell you that it's not going to help. It's going to help a lot. And not just in the west, but in markets across the country.

So, I think you have more boomerang buyers out here, you have more buyers that have been waiting for the equity to return to their homes before making a decision to buy. And you have more people that are tepid about the market because the downturn was greater, certainly in Arizona and parts of California than it was in other places. Market confidence of financing is probably a bigger deal in the west than it is in other places.

Sure, I got you. And if you look at the other markets, what are you seeing out there? Which markets are you still seeing pricing power? And I'm also interested in, after that, just what you are seeing on the construction cost side?

We have pricing power in Colorado, we have got pricing power in Texas. We have pricing power in many of our Southeast markets.

So, I mean, it's more normalized pricing power in that 2% to 5% range. It's not the real high pricing power that we saw in the first half of 2013, but there's still pricing power.

As far as material costs, I mean, things are relatively stable. There's nothing that's really jumping out this quarter from quarters past. If anything, we're having some success in maybe reducing some of our cost out west.

Okay, I got you. And just very quickly on the commissions, are you seeing the co-broke fees ramping up? Or is this just really isolated to you all, trying to get your communities open, et cetera?

I don't see co-broke fees changing. I mean, certainly, sometimes we have an unusual situation or a spec we want to sell, we might offer a little higher commission. But I think it's an aberration and I don't expect this to be a long-term trend.

Okay, thanks.

Adam Rudiger at Wells Fargo.

Hello, thanks for taking my question. The first one is, if I look at the fourth-quarter commentary you gave on the revenue and earnings range, on my math, if I just stick current trends in there, I'd get to a higher earnings number than $1, $1.05.

My question is, is that just a conservative number? Or is there anything funny in there that might be impacting things?

Yes, there's not anything unusual in there, obviously. We got a factor in the purchase accounting which we gave the items and how much in basis points that that would affect the margin. But these estimates are some what broad estimates and the math doesn't always work precisely from revenue to EPS. So, that's currently where we think we'll wind up. But the math won't work exactly.

Okay. And then second question was, I was wondering if you are willing to share any of your thoughts on what you have seen in October so far?

I think October is looking pretty much like we saw in Q3. The 15% order growth is trending similar in October. Certainly, we are getting some of that from the Legendary acquisition, but I feel pretty good about that number, if not higher, going through the fourth quarter and into next year.

Great. Thanks for taking my questions.

Nishu Sood at Deutsche Bank.

Thanks. I wanted to delve into the Legendary acquisition a little bit. Some pretty important differences it seems like from the traditional Meritage operations.

Higher option, proportion of land, you talked about smaller communities. But lower overheads and lower absorptions. I would imagine there might be some slightly lower gross margins as well, that might be mixing in there.

I just wanted to get your thoughts on as you've looked at that model, how is it integrating? And whether those effects I'm discussing, particularly in the gross margins, might be felt in the next couple of quarters?

Well, I'll let Larry speak to the gross margins and I'll talk about the land and product strategy. I would say, they were very successful at tying up a lot of distressed lots coming out of the downturn on relatively soft terms. Most of the 4000 lots that we acquired were on option. And certainly that's how they built the company. Their product was very much in line with what we built, of course, catering to that move-up market, high-value proposition.

And so, we are very much in alignment on the land that we are looking for, the product that we are building. Certainly, I don't expect to be able to continue getting lots, almost 100% of our lots in Atlanta and Greenville on option.

But that said, we still think we can get a lot of options, but maybe not quite the percentage that they were getting. And so, in margins, Larry?

Yes. Well, in purchase accounting, we wrote to our standard, average margins. So that 21% margin that were -- 21.5%, or 20.5% to 21% is kind of what we did our purchase accounting to.

So all of the lots that we got control of in the Legendary account were either written up or down to that gross margin. So I would expect that that would track.

And going forward, we're going to be tying land up that meets our minimum underwriting standards. Again, that's right around that gross margin level. So, we don't expect it to be impacting our margins negatively at all.

Got it. Very helpful. And, Steve, a bigger picture question. Investors, as they look at your results, the gross margin pressures you've seen, the weakness you cited in some of the most important markets like Arizona and California, the flat absorptions year over year.

So investors look at all of that and see, let's call it, flashing yellow signals. And yet, if I look at what you folks are doing, community count increases still very strong, I think you mentioned even 20% pace for next year, the $185 million of land spend. The Legendary acquisition that says, internally, it's still full speed ahead.

So I was just wondering if you could reconcile the two? How can we have these cautionary bigger trends, but on the ground you are still seeing a lot of significant opportunity?

Well, I think you have got to pay real close attention to what we said and how we opened up the call. Certainly, we've entered six new markets, we're very small in a lot of these markets but we're growing rapidly. There's a cost to that.

We're not getting the returns that we need out of those markets. We have had an increased G&A. We're not operating out of a trailer, we put a full management team in place in all of these markets so that we can ramp up our business quickly and successfully.

You really have to look at our community count and our absorption pace going into next year. And if you believe that the housing market is going to be relatively stable, if not improving, the 20% growth in orders and revenues should be a very conservative estimate for us going into next year.

So, yes, we've had a bumpy year in 2014, held down by what's happened in Arizona and the inland markets in California, that we didn't foresee and we didn't expect. But we're still very well positioned because of our diversity, with our Texas business and other markets that I've already mentioned to really have a great year in 2015.

And if the credit markets loosen a little bit and we continue to have good job growth, which I expect, and the lag effect kicks in from household formation and people coming out of the boomerang situation; I'm pretty bullish on next year and beyond and how we're positioned.

Okay. Thanks for the color.

Stephen King at Barclays.

Thanks, guys. Steve Kim from Barclays. Steve, I was wondering if we could talk a little bit from a high level on the spec strategy?

I guess my first -- my question basically is if you are using the spec strategy, primarily to be more competitive relative to other builders, and you were pointing to their success, I was curious why this won't ultimately lead to maybe some more pricing pressure? If we assume that building a spec home is irrelevant if a buyer is not -- unless somebody is actually looking to buy a home, right? You're not going to create a home purchase decision by building a spec home.

The only way I could see a spec strategy really helping you and not adding more pressure on the new home market is if you are looking to take share from resales. And so, I wanted to understand, specifically, how do you envision this spec strategy benefiting you without putting more pressure in the market?

And then the second half of that question is, why now? Because we haven't even had any -- up here, it is like barely fall, let alone spring. So, isn't this a little early to start this?

Well, first of all, I'll answer the later part first. This is a strategy that has been evolving over more than a year. So, it is not something we just decided to do last quarter. We've been growing our spec count for quite awhile now.

Number two, we are not taking a lower margin on specs, as you would traditionally expect, than build-to-order jobs. Our margin on specs is pretty much the same, which makes me quite happy. Because that historically has not been the case. But we have been seeing now for over a year that the margins for spec is the same.

There's people that come into our community, they're looking at both new and used homes. And they want a home, they don't want to wait six months or long, or five months for a home. And the part of their decision whether they are going to buy from us is based upon what inventory we have available and how quickly we can deliver it. So it helps us to compete both with the resale market and with some of our competitors.

We have a lot of new home competitors in a lot of our communities, and if they have a spec home and we don't, we may lose the sale to them. So, I'm not that concerned that it's going to drive our pricing down. I think it's going to open up more opportunities for us to be more competitive.

Okay. Great. Thanks for that. And then, I guess, my second question relates to land spend. Do you have any forecast or target range of land spend next year? And is there any, or even if whether you do or you don't, if you could talk a little bit about where you anticipate regionally emphasizing or focusing your land spend, that would be great? Thanks.

Yes, well certainly, we have a forecast that we have internally for where we want to spend our money next year and we have a very sophisticated capital allocation process. But I don't really want to share those with everybody, because I don't want people to come back and say, well, you said you were going to spend this much, you only spent that much. So, I don't want to put those numbers out there.

But I'll tell you the Southeast is a big part of our strategy. And we are going to spend more money on land there than certainly in other regions.

I mean, I don't see us buying any land in Arizona. I don't seeing us buying land in the inland markets of California, although if we can find opportunities in coastal markets, we're certainly going to pursue those.

Probably spend a little bit more money in Denver, we've got a good position up there already. We always have the green light on for land in Texas. And we are looking at some other potential opportunities for land acquisitions in Florida certainly, and in the rest of the Southeast.

Yes, I could give you a little bit of historic detail on land spend, including option deposits. We spent just a little under $600 million in 2013, and this year so far we spent about $515 million.

So it would be a safe bet that, and that was a $200 million including Legendary for it for the third quarter. And the second quarter was about $150 million.

So if you assume somewhere between $150 million to $200 million and add it to the $514 million, that's what our spend would be for 2014. And you could look at that trajectory and say that we are going to continue to grow the business.

Although probably, we are going to be a little more cautious about buying land and may temper our land buying and make our divisions do more with the same amount of land they have now, and try to get our absorption pace up and our return on asset up, by holding our land spend a bit. But that gives you a general idea.

Great. Yes, that is pretty much in line with what we have been modeling for you guys and that's great. Okay. Thanks, guys.

Thank you.

Michael Dahl at Credit Suisse.

Hello, thanks. Appreciate all the detail you are providing, Larry.

I wanted to go back to the question on the 4Q guidance. I understand that there are some puts and takes that you have that we don't have, but at the same time this is formal guidance you're providing. And if we just back into what some of the biggest levers are, it seems like you're suggesting gross margins could fall closer to 20%, potentially even sub-20%.

So just wondering, are we missing something? Or could you help reconcile that between with the comments that we should stabilize in the 20.5% to 21% range?

Yes, I think what you're missing is we said that the purchase accounting on standing inventory for Legendary housing, that's going to have, I think the number I read off was like a 35 to 50 basis point difference. So, it's somewhere around 40 to 50 basis points. Well, that is that differential from 20.5% down to 20% So, I think if you factor that in, that will make up a big part of the item you are trying to reconcile.

I guess the sequential impact of that headwind seems pretty similar because it impacted 3Q by 40 basis points, also. If you are saying 40, 45 basis points in 4Q, it still seems like there's a difference to get down to where the 4Q margin guidance would be?

Yes, you also have to realize we're not factoring in that tax benefit we got in the third quarter -- in the fourth quarter. So there is some difference there, too, you have to factor in with the tax rate being higher.

Got it. Okay. And then, second question, I guess, starting at that point and recognizing that there's still going to be some headwind from, if nothing else, in purchase accounting in the first part of 2015, that you're starting at a lower margin point than we have run for most of 2014. So, trying to understand where the -- if you are getting 20% top-line growth, why we would see greater than 20% bottom line growth if we are starting at the lower margin point?

Is this a question for 2015 you're saying?

Correct. The comment, I think Steve made the comment that earnings growth could exceed top-line growth. And, I guess, if we are starting at lower margins, just wondering where the confidence is on that?

Yes, I think that differential comes from leveraging overhead. And again, I think we've been trying to say that, in 2014, we've been adding a lot of communities. We've had not the full positive impact of some of the newer divisions we've started because we haven't gotten to the scale there we'd like. So as we get to better scale in those newer divisions, we're going to be better able to leverage our overhead and that improvement in bottom line is going to come from that.

Got it. Okay. Thank you.

Eli Hackel at Goldman Sachs. Mr. Hackel, please go ahead with your question. Okay, we'll move onto Joel Locker, FBN Securities.

Hello, guys. Just wanted to get a little more in depth on Colorado. And just see where your gross margins are versus the Company right now and where you see that trajectory going forward? As in, backlog margins versus third-quarter deliveries?

Correct me if I'm wrong, Larry, but I think they're slightly ahead of the Company average. And I expect them to stay there. We have no pressure on margins in Colorado. If anything --

We tend to have a little bit lower than average gross margin there, but we have a very lean operation on the SG&A side and we make it up so the net margin from Colorado winds up being above average.

Yes, sorry, that is what I meant. I meant our net contribution from Colorado is a little bit better than the Company average, but our gross margins are actually a touch lower, but --

Got you. And just a follow-up question on G&A going forward. First of all, were there any acquisition costs that were in the third quarter of G&A, the $29.2 million?

And where do you see the run rate of that going forward, now that you have Legendary?

Well, again, I think in the press release or on the script, we said it was about $1 million of non-reoccurring cost. And these are legal costs and things like that relating to the actual acquisition that won't be reoccurring.

On the other hand, both Legendary and Phillips Builders have G&A, which creates a higher standard level of G&A that we'll have going forward. So, we don't see G&A shrinking going forward. We see it staying about the same, maybe growing a little bit of sales growth. But again, where the big story is for 2015 is that we are going to be better leveraging the same amount of G&A with higher revenue.

All right. Thanks a lot, guys.

Thank you, Joel.

David Goldberg at UBS.

Thanks, good morning. My first question was, I wanted to revisit the spec strategy and I wanted to talk about it in the guise of energy efficiency. And you guys, I think, correct to say have been the leaders in energy efficiency in the industry.

How do those two things go together? What kind of energy efficient options do you put in houses? Are the buyers who want spec homes, are they more prone to buy them because of the energy efficiency? Is it something they don't care as much about? Do they want choice? So if you could just talk about how those two things go together and how we should think about them, I think that would be helpful for us?

Yes, I don't think there is a direct tie between specs and energy efficiency. I think our energy efficient program is really about including the energy efficient features in the home as a standard.

We don't option anything to make it more energy efficient, other than solar. And in markets outside of California, we have communities where we include some solar. But most areas, solar is an option.

And everywhere we build, except Nashville and the new Legendary acquisition, we have a very robust, standard, energy efficient package. So certainly, we believe it sets us apart from not only the resale homes, the used home market, but also from a lot our competitors. And we think it gives us an advantage.

And certainly, when a buyer is looking at our spec home versus somebody else's spec home, it'll make a difference. But that would be the same for a new build as well.

That's really helpful. And then, if we could revisit on the Legendary acquisition, Nishu asked a question about integration. I want to ask it from a little bit different perspective.

Steve, I thought it was really interesting when you talked about their sales models and selling from multiple communities, from a single model home or one group of model homes for multiple communities. What are you guys learning from them operationally that you think might be transferable to what you're doing? It seems like they have a pretty good low overhead model that way?

Is that transferable to any of your markets? Are you picking up any thing from them you think might be in Meritage more broadly as we move forward?

Well, I think that's a little bit, their strategy is a little bit of byproduct of the market there, and a byproduct of the circumstances coming out of the downturn. Atlanta was a market that was very fragmented. There was a lot of what I would call, cul-de-sac builders. Guys that would have five or ten lots, here and there. And there were small private builders that were building in locations, or not locations, but in small quantities that public builders wouldn't do.

A lot those guys went out of business and those lots went back to the banks and these are the lots that Legendary now has under their control. They got these lots very inexpensively and they are able to deliver a phenomenal value to their customers.

So they've been very opportunistic and entrepreneurial and figured out how to cobble together a lot of those positions to offer lots of choices to buyers. And they can manage them efficiently because they're close by and they can share superintendents and sales people.

That's a strategy going forward. It is only going to last so long until those lots are fully absorbed. It's going to be awhile, certainly. And certainly, they will be able to continue to do some of that in Atlanta, just because that's the way the market is. But long term, it's going to become more like a lot of the other markets.

Not only in the Southeast, but across the country, where we'll have to develop some lots ourselves or have somebody develop the lots for us.

And just to make sure I understand, the geographic diversification within a market would make it less feasible to have single models from multiple communities if your land is spread out more, essentially?

Yes.

Okay.

But again, these little cul-de-sacs won't, when supply of those is exhausted, we'll have to be building more traditional 50- to 100-lot communities versus 5 or 10 lots here and there.

Got it. That is really helpful. Thank you very much.

Thank you.

Michael Roxland at Bank of America Merrill Lynch.

Thanks very much. Last quarter, Steve, this about SG&A. I think you mentioned, and the terms you used were, that SG&A was frustratingly high. This quarter, SG&A also seems to be a headwind. And I do realize that some of this is from the new communities and the fact that they have yet to generate any sales, but are there any specific cost actions that you've taken or you plan to take to drive the absolute level of SG&A dollars lower? And is there anything that can be done as you get -- ? Okay, got it.

No, I mean, it's still frustratingly high. And it's for the reasons I articulated in my opening remarks. Because we have these small markets, particularly like Nashville, like Tampa, like Charlotte to some degree, that we have not been in for that long, and we have a President, a Vice President of Sales, Vice President of Land Acquisition, we have the full management team. Because we wanted to invest in the market because we want to be a player in the market, we want to be relevant, quicker, sooner than later. And the overhead in those markets is a drag because we just don't have the volumes up yet.

But as we get into next year, we are going to be bigger in a lot of these markets and we're going to be at a point where we can cover the overhead. And we're going to be able to leverage that overhead, not only within the market, but across the country. So yes, it doesn't look very pretty right now, but it's an investment in the future and I think it's going to pay off for us next year and the years beyond.

Got it. Appreciate the color there. Then last question. Heard some comments, recently, that Texas is slowing from the torrid pace that we have seen in the last few years. Have you looked at your Q3 results, orders did decline about 1% year over year.

What drove the weakness in the quarter? Are there any particular areas within Texas or any cities that have softened a little more than the others? Anything that you are monitoring right now relative to the border state?

I don't see any slow down in Texas. I just see it as a mix issue and a timing issue of communities opening and closing out.

I'm really bullish about our business in Austin. I expect it to continue to get even stronger. Some our new land positions there are very exciting.

I would say the same about DFW and San Antonio. Certainly, there has been a lot of commentary about the oil industry and what impact it is going to have on Houston, but I haven't seen any impact yet for sure. There's still 10,000 people a month moving to Houston and it's absolutely the most dynamic market in the entire country.

So if oil drops a lot farther, I think it would be certainly something to be concerned about. But at this price level, most people I talk to in Houston think it's going to be business as usual.

Got it. Good luck in the quarter.

Thank you.

Will Randow at Citi.

Hello, good morning. This is Scott Schroetter in for Will. First, on some regional trends. I know you had talked about North Carolina and Tennessee where you were opening up newer communities and you saw strong absorptions. Do you expect that to continue? Or are those absorption paces that you had this quarter, is that maybe a little bit of a positive that might slant a little bit?

No, I think we're going to continue throughout next year to have strong absorptions in those markets. Because we have high quality land positions that we've secured. And in great locations that I expect that they're going to deliver us good results on both top line and bottom line.

And then on the balance sheet, and you opened the call talking about your strategy about continuing to invest in the divisions, and the net debt to capital has ticked up. And just wanted to see how you think about that and where you are comfortable being leveraged to?

It's a little higher than we'd like it to be right now. I expect that it hopefully will come down a little bit next year.

We like to be in the low 40%s, we are 43% and change. But may get it down 1 point or 2. And that's where I feel the most comfortable.

Yes, this level was not unexpected. We did the Legendary acquisition knowing we'd be at this point with the plan to, as we earn more money over the next few quarters, to gradually bring that leverage back down.

Great. Thank you.

We do have additional questions, would you like to continue?

We'll take a couple more.

Michael Rehaut from JPMorgan.

Thanks. Appreciate the follow up. Just wanted to clarify, I guess, and go back on the spec question and recognize there was the prior question on potential, perhaps competitive pricing pressure.

But just from the actual standpoint of the margins that you currently generate on spec versus build-to-order. Just wanted to know if there was any material difference there as certain builders talk about differences at points in the cycle that wax and wane? But currently, where is that difference, if anything, and would that have a potential negative impact from a mix standpoint on margins next year?

Certainly, over my 30-year career, there's always been a difference in margin on a spec home versus a new build. Buyers believe they should be able to get a discount for a spec home. But I've not seen that in our numbers over the last couple years.

I've actually seen the people have more desire or are more interested in getting a spec than they are a new build, because as tepid as the overall market is, people don't want to take the risk of selling their house after they have already purchased the new home. They want to sell their house first. They generally make an additional move, they move into a rental.

And so, they want to get into a house right away. And so, there's a lot of demand for, much more demand for spec homes today than there were in prior cycles.

And I think we have to understand what our buyers are looking for and we have to be prepared to have the inventory to satisfy that need. And I think some of my larger competitors, who put up some pretty good results, have already demonstrated the success of that strategy.

So then, that sounds good. So then, basically what you are saying is, you wouldn't expect any incremental negative pressure on margins from a little bit more spec?

No, absolutely not.

Great. Thank you.

Thank you.

Alex Barron in Housing Research Center.

Hey, thanks, guys. Steve, I was hoping you could elaborate a little bit on the comment regarding the boomerang buyers? What has been your experience this year versus, say, the last couple of years? Are you guys tracking that? Like what percentage of the buyers are boomerang buyers? And has that been increasing? What states are you seeing that more in? Can you just give more color on that?

Well, I mean, it was bigger probably a few quarters ago. The FHA was more lenient on when a boomerang buyer could come back and buy a home after a foreclosure or short sale than the Fannie Mae and Freddie Mac rules. But when the FHA lowered their loan limits, it knocked a lot of those people out who wanted to buy a move-up home.

It had a disparity impact on those buyers, more than other buyers, when the FHA loan limits came down. Particularly, in the west. So, I think it's about 15% of our overall market, maybe a little higher in the west, but it's right around that number.

Okay. And my other question, I guess, for either you or Larry. So I was looking at the backlog conversion rate for Texas and Colorado and California, it looks like it's lower, it's been lower this year than last year. Your guidance for fourth quarter would imply that we are going to see a lot of deliveries coming through in the fourth quarter.

So, is there something that is changing there? Or what would you attribute to the lower backlog conversion over the last three quarters?

It is taking a little longer to get homes built in Colorado and in parts of Texas. Certainly, some of the trades have been harder to get because of the competition with the oil industry.

And then, of course, the new communities have hurt the absorptions. Again, these new communities online, in open, and delivering homes. But I expect our conversion rate to improve in Q4 and beyond because of the spec strategy and because of the position that we have going forward.

Okay. Thanks a lot.

Thank you. Operator, do we have any more questions.

There is one more in the queue. Would you like to take it?

Yes, we'll take one last one.

Timothy Jones from Moloney Securities.

Good morning, been a long time since I have been on. Couple of questions. First of all, could you give us a breakdown of your California markets?

I mean, what percentage is Inland Empire, or Southern California, Northern California, and the other markets? Could you give us an idea of the relative size of each?

Well, I don't have the exact numbers in front of me.

No, just a rough number.

I could tell you, if you look at all of our Southern California communities, they're all in Inland Empire except for a couple of them. We have one in Rancho Mission Viejo in Orange County, and we have one down in North San Diego that we are finishing up. I would say, Northern California, a third of them are in Sacramento, a third of them are in, quote, the Bay Area, the South Bay, and the East Bay, and a third of them are probably in between those two areas.

So we are a little more coastal oriented in Northern California than we are in Southern California. But certainly, California, in general, I would say, more than half to two-thirds of our communities are inland.

That is different than a lot of builders. I went out with Kaufman and Broad back in 1970. Is the Inland Empire building up so that they have people, jobs out there, rather than having to do the long commute into Los Angeles?

Well, most buyers of the Inland Empire still commute either into Orange County or they commute into some of the markets. They don't commute into downtown L.A., but they commute into Ontario. And some of the jobs between the Inland Empire and downtown L.A.

It is a heavy commuter market, but there are jobs moving out into those areas. And certainly, you referred to KB and other builders that maybe build more attached product. That have a longer history in California that have more of a strategy designed to be more coastal.

We are working to try to become more infield and more coastal as well. But traditionally, we've been a suburban builder in California.

Stated Naples, Florida, my ears perked up when you said you were going to increase your investments, substantially, in basically the Southeast and Florida. Can you give me an idea of which markets you are really interested in?

Well, we have a dominant position in Orlando. We're going to continue to hold our market share there, and continue to grow with that market. Certainly, Tampa is a new market for us, and we're working to get some scale in Tampa.

I certainly don't see us going into the Southwestern markets in Florida, and Naples and Fort Meyers is not on our radar. But I do, potentially, see us moving south and southeast into some of those markets down there where we have been studying as well, and to grow into that area; and maybe Broward County, and Ft. Lauderdale and the Boca area we see some opportunities. But nothing is imminent there.

Thank you very much, Tim, for your call. And appreciate it. I think that concludes all of our comments and questions on the third quarter. I appreciate everybody's participation. And we'll look forward to talking to you again next quarter. Have a good day.

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