Meritage Homes Corp (MTH) 2017 Q2 法說會逐字稿

Good morning, and welcome to the Meritage Homes Second Quarter 2017 Analyst Conference Call. (Operator Instructions) Please note this event is being recorded.

I would now like to turn the conference over to Brent Anderson, VP, Investor Relations. Please go ahead, sir.

Thank you, Chad. Good morning. Welcome to our analyst call to discuss our second quarter and year-to-date 2017 results.

We issued a press release before the market opened today, and you can find it along with the slides that we'll refer to during our call on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom of our homepage.

I'll refer you to Slide 2 and remind you that our statements during this call as well as the press release and slides contain forward-looking statements, including our projections for 2017 operating metrics such as community count, order trends, closings, revenue, margins and earnings.

Those and any other projections represent the current opinions of management, which are subject to change at any time, and we assume no obligation to update them.

Any forward-looking statements are inherently uncertain, and actual results may be materially different than our expectations. We have identified risk factors that may influence our actual results and listed them on the slide as well as in our press release and most recent filings with the Securities and Exchange Commission, specifically our 2016 annual report on Form 10-K and subsequent 10-Q for the first quarter of 2017, which contain a much more detailed discussion of those risks.

We've also provided a reconciliation of certain non-GAAP financial measures referred to in our press release or presentation as compared to their closest related GAAP measures.

On Slide 3. With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage Homes; Hilla Sferruzza, Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage Homes.

We expect to conclude the call within about an hour, and a replay will be available on our website approximately 1 hour afterwards and remain active for approximately 2 weeks.

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

Good morning. Thank you, Brent, and welcome to everyone participating on our call today. I'll begin on Slide 4. We had another solid quarter with strong order growth in Texas and Arizona, good earnings growth and further progress on our strategic initiatives. After years of constrained housing starts due to labor shortages, a lack of inventory and rising home prices, demand for new homes continues to be strong. More entry-level buyers are in the market, and we anticipate plenty of opportunities for further growth as we expand our offerings for this segment across many of the best markets in the U.S. for employment growth and homebuilding.

While we're facing a difficult -- while we were facing a difficult comparison to last year's second quarter, considering that we generated 37% net earnings growth, a 25% increase in home closings for the second quarter of 2016 over 2015, yet we still improved our pretax earnings by 7% year-over-year in the second quarter of 2017. We delivered slightly higher revenue on fewer home closings during the second quarter this year than we did last year due to an increase in our average home closing prices.

Although our closings were 2% lower than last year's second quarter, we were able to overcome cycle time expansion from tight labor supply by selling and closing more spec homes during the quarter. And in a rising cost environment, we priced our homes appropriately to more than cover the cost increases and improved our home closing gross margin.

Turning to Slide 5. Our performance during the second quarter reflects further progress on our strategic initiatives, building on what we accomplished from the first quarter. We are focusing on 3 primary metrics for earnings expansion: community count growth, gross margin improvement and overhead leverage.

Turning to Slide 6. After expending our community count in the first quarter of this year and maintaining that in the second quarter despite 25 community closeouts, we ended the second quarter with 7% more active communities than we had a year ago. The communities we were able to open in Q1 began delivering sales in Q2 and will benefit closings in revenue in the back half of 2017.

We not only replenished but expanded our lot supply during the second quarter, securing more lots than we have in any quarter since the cycle began, with the vast majority of lots starting in the growing entry-level market.

Turning to Slide 7. Our second strategic initiative is to improve our gross margins, which have been lower than our underwriting target since last year due to sharply rising land and labor costs combined with negative leverage in our newer markets due to lower closing volumes.

We were pleased to achieve year-over-year and sequential margin improvement in the second quarter. Our home closing gross margin of 17.7% was 40 bps higher than the second quarter of '16 and 150 bps higher than the first quarter this year. Margin improvement was due to pricing power, better margins on specs and improved operating leverage.

In markets where demand was strong, we were able to raise prices to more than cover cost increases. We also produced better margins on spec sales where our costs are more manageable and predictable. And our margins improved in general as we achieved better leverage of construction overhead with higher closing volumes in Q2 over Q1.

Lumber prices spiked in the first quarter in anticipation of higher tariffs on Canadian lumber, where we locked in pricing to mitigate the incurrence of those cost increases. The massive forest fires in Eastern Canada recently are threatening to drive lumber prices even higher, which is a potential headwind facing the industry and something we're working to minimize.

Turning to Slide 8. Moving to our third strategic initiative of improved overhead leverage, our selling, general and administrative expenses have improved year-over-year in the first 2 quarters of this year, and we are pleased with our 10.6% SG&A for the second quarter of 2017.

Most of the gains were in commissions and other selling expenses, which we reevaluated last year and implemented changes at the beginning of 2017 to bring those costs down. We also implemented other cost-cutting initiatives throughout the organization. As a result of the improvements in margins on slightly higher revenue, we generated $63 million in earnings before tax for the second quarter, significantly better than the $45 million to $50 million we projected last quarter.

I'll now turn it over to Phillippe Lord to provide some additional color on the trends in our various markets. Phillippe?

Thank you, Steve. Generally speaking, we have enjoyed solid demand so far this year. We produced 4% order growth for the second quarter of 2017 over the second quarter of 2016, primarily due to strong demand in Texas and Arizona with moderate growth also in Florida.

I'll direct you to Slide 9. Orders increased 2% in the West on a 4% increase in absorptions that was mostly offset by a 3% decline in average community count. I'll hit some of the highlights for you to provide some color on the reported statistics by state.

Almost all the growth in the West was in Arizona, particularly in Phoenix, which continues to be very strong. We are benefiting from our aggressive pivot into the more entry-level product, which is driving significant growth. We are well positioned here with many communities priced under the FHA loan limits, and there are more in the pipeline. And we have a long supply of lots to meet the demand for the current pace for selling.

After a strong first quarter, orders were down from 2016 in California, where demand was particularly strong last year and were down to a few lots in a number of communities in Northern California. We reloaded our lot supply and made some good acquisitions there in the second quarter, though some community openings were delayed due to heavy spring rains.

We have a similar situation in Colorado, where demand is strong and we're closing out many communities earlier than projected but are in the process of reloading our pipeline. We have a solid pipeline of new communities that we're planning to open over the next several quarters.

Slide 10. Texas, which makes up our Central region, continued to experience solid to strong demand across all of our markets there. Orders increased 30% over the second quarter of 2016 in Texas as a result of a 24% increase in average active communities during the quarter and a 5% increase in absorptions, orders per average community. We've made a strong pivot toward more entry-level product, which is paying big dividends for us in Austin and Houston, where there is strong demand at lower price points.

Our sales year-to-date in Austin are up more than 80% over last year with only 40% more communities. Dallas and San Antonio are also seeing strong demand at lower prices, and we plan to open more communities to meet that demand. We've been aggressively securing new positions for that product and have contracted for approximately 1,900 new lots in Texas during each of the first 2 quarters of 2017.

Slide 11. Our East region orders were down 13% compared to the prior year second quarter, primarily due to a 12% decline in absorptions. While we're not satisfied with our progress to date in this region, we're beginning to see some success from our new product rollout as it has been well received by buyers, and we will continue to focus on opening new communities, intensifying our market efforts and increasing absorptions.

Lower community counts in many of our markets there over the last several quarters have resulted in year-over-year declines in orders. Our primary focus is rolling out new products in our -- to our new and existing communities.

Florida has had a nice bounce back, driven by our affordable bungalow product and new communities in A locations. We're doing well despite there being fewer South American buyers than we had seen in the recent years, which drove some of our higher ASP order growth and will be bringing on more affordable price communities in the future.

Overall, we're excited -- we're executing well on our plan to capture a large portion of the entry-level market and are achieving a higher sales pace and good margins in many of our entry-level plus and LiVE.NOW communities.

I will now turn it over to Hilla for some additional details on our financials. Hilla?

Thank you, Phillippe. I'll review some additional details from our income statement, key land and balance sheet metrics and our third quarter and full year outlook.

Starting on Slide 12 with our year-to-date results. We generated $65 million in net earnings for the first half of 2017, a 7% increase over the first half of 2016. Our performance was primarily driven by a 5% increase in home closing revenue and a 50 bps improvement in overhead leverage, though partially offset by lower gross margins and a higher effective tax rate of 35% compared to 31% in the first half of 2016.

On a pretax basis, our earnings were up 14% year-over-year. Our average closing price was $418,000 in the first half of 2017, continuing its upward path over the last several years, though ASP growth is moderating in our backlog.

While we're successfully signing more entry-level homes, the majority of our business is still move-up and prices in general have continued to rise. Our first half home closing gross margin in 2017 was 30 bps lower than the first half of 2016 due entirely to the first quarter since the second quarter gross margin was 40 bps higher than 2016.

We expect home closing gross margins to be higher in the second half of '17 than they were in the first half, anticipating increased closing revenue, which will drive improvement in construction overhead leverage and higher margin from price increases we've taken over the last couple of quarters.

We brought our SG&A expenses down to 11.1% of home closing revenue in the first half of '17 from 11.6% in the first half of 2016. We expect to reduce our SG&A percentage further in the back half of the year, though we may see a slight uptick in the third quarter due to the timing of certain expenses.

We achieved our 2017 target of 10.5% to 11% SG&A leverage in the second quarter of '17 with SG&A of 10.6%, and we're approaching our long-term goal of 10% to 10.5% SG&A leverage.

Our interest expense for the first half of '17 was down 51% year-over-year due to greater capitalized interest on a larger amount of assets under development, where we anticipate higher interest expense in the back half of the year from the additional interest on our new senior notes.

Slide 13. We issued $300 million of new 5 1/8% senior notes due 2027 and used the proceeds to pay off our borrowings under the credit facility, and we purchased $52 million of our convertible senior notes in privately negotiated transaction. The first call date on the convertible notes is September 20 of this year, and we intend to issue an official notice to holders soon announcing our intent to redeem the remaining notes for cash at the call date.

We ended the quarter with $217 million of cash and nothing drawn against our credit facility. Our cash balance increased by a net $85 million from the end of last year after we invested in additional lots to support organic growth and increase our inventory of spec homes in order to meet continuing strong demand for homes that can be delivered faster.

We also amended our revolving credit facility in the second quarter of '17 to increase the available commitment to $625 million from $540 million, increase the accordion feature and extend the maturity to 2021.

Our net debt to cap ratio remained within our target range of low to mid-40%, ending at 43.3% at June 30, 2017, compared to 41.2% at year-end 2016 and may increase a little during the year to support the acquisition of more land, but we expect it to remain within our comfort zone of low, mid-40s.

61% of our closings in the second quarter of '17 were from spec inventory compared to 42% in the second quarter of '16, reflecting more spec sales within our entry-level and LiVE. NOW communities. We ended the second quarter with 1,790 specs completed or under construction, which was approximately 7 specs per community compared to 1,270 a year ago or an average of 5.3 per community in last year's second quarter. Approximately 28% of total specs were completed at the end of June '17 compared to 21% at June 2016.

Turning to Slide 14. We continued to direct the bulk of our investment in new lots and communities towards the entry-level market where demand is greatest. We secured more than 4,000 additional lots in the second quarter, more than any other quarter since the beginning of the cycle and spent $279 million on land and development during the quarter.

We have invested almost $1.4 billion in total land and development since the beginning of 2016 with the majority of that being in entry-level communities, and we currently have more than 150 new communities in the pipeline.

Our total lot supply increased to about 33,500 lots at quarter end, which equates to approximately 4.5-year supply of lots based on trailing 12 month closings, with 2.7-year supply of home lots.

Slide 15. Based on our performance in the first half of '17 and our continued positive outlook for the remainder of the year, we are updating our targets for full year 2017. We are on target to deliver approximately 7,600 to 8,000 homes for an estimated total closing revenue of $3.15 billion to $3.35 billion for the year. We believe we can maintain gross margins consistent with 2016 as we were able to increase home prices to at least absorb the costs we've -- we're experiencing.

While the opportunity exists for potentially higher gross margin in the back half of the year that could translate to upside to our forecast, we are cautious due to potentially rising lumber prices that could pressure margins and the continued tight labor supply.

In addition to our anticipated revenue growth, we expect to combine continued cost management and improved operating leverage in the second half of 2017 to generate approximately $230 million to $250 million in pretax earnings for the year, which takes into account the additional interest expense in the third and fourth quarters for the notes issued in June this year.

Within that full year guidance, we are projecting approximately 1,875 to 1,975 home closings in the third quarter for home closing revenue of $780 million to $830 million and pretax earnings of approximately $53 million to $58 million with strong growth in our fourth quarter closings, revenue and earnings.

With that, I'll turn it back to Steve.

Thanks, Hilla. In summary, we were pleased with our results for the second quarter of 2017 and the progress we've made on our strategic initiatives, which are designed to deliver long-term growth and shareholder value.

Housing market conditions remain healthy in general, and Meritage is well positioned in many of the best markets for homebuilding in the country. We believe that strong growth will continue, and we are prepared to take advantage of it.

We've developed new product that we can deliver at lower price points to meet the growing demand for first-time buyers, and we're successfully executing our strategy to increase the number of communities for that growing segment to 35% to 40% of our total communities by the end of next year.

We are dedicated to our brand promise of delivering a life built better for all of our customers, which we demonstrated by rolling out our M.Connected Home automation suite recently. We continue to innovate and focus on customer satisfaction, which we expect to drive additional growth and shareholder value.

Thank you for your interest in Meritage Homes and for supporting our growth and success. We'll now open it up for questions, and the operator will remind you of the instructions. Operator?

(Operator Instructions) The first question today will come from Michael Rehaut with JPMorgan.

The first question I had was on the land investment and some of the progress that you're making additionally in the East region and all the talk around focus on entry-level and the transition that, that -- in particular, you're focusing on the East as well as continued executing like Texas, where you're focusing more and more on the entry level. So my question is just around how, perhaps, to start to think about 2018. Obviously, guidance is tough enough when you typically introduce it later this year. But if there's any kind of thoughts around, directionally at least, community count growth. And with the impact that more and more entry level might have on sales pace -- average sales pace relative to where you are today as well as ASPs, that would be very helpful.

Well, we're not really prepared yet to give guidance for 2018, Mike. But I can tell you that our ASPs are going to flatten and expect next year that it will slightly decline. I don't think they're going to decline dramatically, but I think they are going to decline. 70% of the lots we bought in this last quarter were for entry level. But on the same token, we did buy some communities in California that I believe are kind of shovel-ready. It will deliver -- impact our 2018 results. I would say almost everything that we bought in this last quarter will produce sales in 2018. Also that will be late in '18, but we tried to stay away from anything that's really long term. I mean, we did buy a couple of larger positions, but they're going to be opening sooner than later. I'll let Phillippe make some comments about the South region and what we're expecting there and how we think about that going into 2018.

Thanks, Steve. So we have 90 active communities opened in the South region at the end of June, 60 are outside of Florida, which is performing well relative to others. 12 of those 60 were opened in the first 6 months this year and 30 more are scheduled to open over the next 6 quarters, replacing many of our existing...

38 more.

38 more are scheduled to open over the next 6 quarters, replacing many of our existing communities that have older, slowly moving and less profitable homes. The new communities that we are opening in the East are in A locations. They will have our new product, and we believe they will produce significantly better margin absorptions based on our new experience with that product. So we think the East is going to get a lot better as we roll this out and we open up these new communities in the East region, which makes up the South region.

Mike, just one quick follow-up, you had a question about general absorption trends for entry level. They're running at about 1.5 to up to 2x the absorption pace of the traditional move-up product that we have. So as Steve mentioned, the ASP is going to decline some, but the quicker absorption pace and increased closings will more than offset the decline.

No, I was just -- I just wanted to extrapolate from that. And when you talk about the improved sales pace, therefore, if you could just remind us on average kind of what your mix of the new entry-level product will be in 2018 versus 2017.

Well, we're targeting 35% to 40% of our communities to be entry-level facing. I expect that we'll have more than that actual entry-level buyers because some entry-level buyers are still buying the move-up communities due to low interest rates, but that's what we're looking at going forward.

And currently, we're in the mid to high-20s, so there'll be some incremental growth between the '17 and '18 percentage of entry level.

The next question will be from Alan Ratner with Zelman & Associates.

My question is if I look at the guidance for the back half of the year on gross margin, you obviously hit your target probably a quarter or 2 earlier than maybe you signaled last quarter. The guidance kind of implies that it's going to flatline a little bit from here, maybe tick a little bit higher but not improve materially. And I know, Hilla, you mentioned there might be some conservatism factored into that guidance. But I'm just curious, as you talk about price increases and the idea that pricing power is outpacing the cost inflation you're seeing, are you seeing any resistance at all, especially in some of these newer entry-level communities, where affordability, of course, is more of a concern there? Do you feel like the market still has a lot of runway to go in terms of potential price increases, if the cost environment remains inflationary like it is today? Or are you starting to bump up against a little bit of resistance there?

I think it's a market-by-market situation. Certainly, there are some markets like Northern California and Dallas where there is some headwinds on the higher-priced homes. There's resistance from buyers. But on the other side of that, the entry-level homes are selling really, really well, and there's opportunity to get some pricing power on that. But for the first-time homebuyer, they're a lot more price sensitive. So we're not -- we'd probably be more focused on driving volume for the entry level once we achieve our underwritten margin or better and try to get more margin back on the move-up homes where we can get it. But again, it's different in every city, in every submarket within a city, so it's hard for us to give you a general answer to that.

Okay, that's helpful. Hilla, just a clarification. You mentioned higher interest expense a few times in the back half of the year from the debt deal. Is that flowing through your gross margin line in terms of capitalized interest? Or do you expect the actual direct interest piece to move higher? And if you could parse that out for us, that would be helpful because just trying to figure out -- based on your 3Q guidance, it does look like you're going -- you might see some deleveraging on the margin side with revenue growing more than your pretax income. So I'm just trying to figure out what the drivers of that are.

Sure. Very, very minimally the interest expense is going to be capitalized, going to be affected by the new debt. Since we already are breaking on the interest expense, any the incremental interest will flow through to the P&L. So you can kind of back into it, knowing that we're taking out the converts and putting in this debt in place, what the incremental break will be, and most of that is going to flow through to the P&L as an expense.

So in terms of thinking about the pretax profit guidance of, I guess, down 2 to up 7, so it sounds like EBIT margin, you still expect to see some positive year-over-year comp, but the interest expense is going to drag that lower?

That's fair.

The next question is from Stephen East of Wells Fargo.

I agree with Alan on the gross margin there. Steve, you talked about specs and ramping up the specs. I guess, with entry level, what percentage of specs are you targeting for your quarterly closings? And what type of gross margin delta do you see in your specs versus your build-to-order on that? And I was a little surprised that your finished specs where as high as they were. Is that the type of level you want to run with, with entry level or just maybe some thoughts around that?

Well, we had 51% of our sales -- I'm sorry, closings for the quarter were specs. I think that's probably the highest it's ever been for us, at least in this cycle. Maybe in the last cycle, it was higher, at least the highest I can remember. I think that's a good thing. I'd like to see it potentially even a bit higher than that because I think for the entry-level market and for the first-time move-up, that's what those buyers want. Our competition, without naming any names, is doing well, is doing that, and they're having lots of success with it. So I'm not afraid to build more specs. We've got to be careful about it and do it in the right places at the right time. We're going into the slower time of the year right now, so we're going to manage those more carefully. I'd also say, without being too specific, that the margin delta on specs versus new builds has narrowed quite a bit. And it's as tight as I can remember. So we're not really giving up much for selling the spec versus the new build. And some of our entry-level LiVE. NOW communities -- we don't have a lot of them yet, but those that we have, we don't even offer new builds -- we don't offer a build job site. All we have is specs because we want to reduce the cycle time, and we want to increase the backlog conversion. We want to get people in the home quicker. So that's all part of our strategy.

All right, fair enough. That helps me. And then as you're making this big pivot toward entry level, in the past, you talked about what you thought was a normalized gross margin for your business. Does that normalized target come down any with the entry-level pivot? Or is it a similar margin profile as the rest of your business?

No, it's a similar margin profile. And we're still targeting 20% -- 19% to 20% gross margin. And we expect still to get back there over time even with more specs and with entry level. So that doesn't change.

Our next question is from Nishu Sood with Deutsche Bank.

I wanted to follow up on the questions about the entry level, the way you described it in your press release and I think in your comments as well. Obviously, you're seeing strong demand there. And you mentioned particularly in markets where you've expanded your entry-level effort significantly, and obviously you're going to keep doing that. I wanted to ask, are you trying to point out the broader market conditions? Or are you trying to point out the success of your particular efforts? Obviously, I know those 2 will partially go hand in hand. Just trying to understand particularly what you're trying to get across there?

Well, it's both. Phoenix, if you look at Phoenix as a market, I think it's broadly improved at both the entry level, the move-up and even arguably the luxury price points. But you could say the entry level is certainly leading the market substantively better than the rest of the segments. I'd say Austin, a little bit different. If you look at that market, it's very much entry level driven and not very much move-up driven. It's actually a little softer on the move-up side. So for us, as we pivot really hard enough to the more entry level, it's really paid big dividends for us. Other markets, we haven't been able to move as quickly into the entry-level niche, so we're not really prepared to brag about them per se. But some of those results will come later. Like in Denver, we have several entry-level communities coming. We have some duplex communities that are more infill coming, that are more positioned to the entry-level buyer. But we haven't got them opened yet. And same story for Dallas. We're going to be building a lot more bungalows, which will appeal to more entry-level buyers, but we don't have those communities opened yet to the degree that we want. So I think it's the combination that many of the markets we're in are doing well, and they're getting stronger at the entry-level price point. And our strategy of building more entry-level homes is working as well. Big challenge for us is we've got to get the South online. South is not performing up to our expectations. We've got to fix that. We're keenly aware of it. We're focused on it. As our new product rolls out there, we think that will have a big impact on our results along with other tweaks and changes that we're making in our operations in those markets.

And Nishu, just one follow-up on the entry level. While it's certainly a strong segment for all the builders, we feel like our strategic process to roll out entry level with the spec levels, with the elimination of the design studio, with the simplification of the process maybe give us an edge over some folks that haven't made the full pivot to building entry level, they're just building homes at a lower price point.

Got it. All that's very helpful. So clearly, the increase in your investment into the entry-level speaks to a broadening of entry-level demand. Earlier in the recovery, it seemed to be concentrated in a few markets, mainly in Texas. Let me ask the question this way, are there any of your markets -- and obviously, recognizing that you have a pretty attractive small-market footprint. Are there any markets where you have not seen that broadening of the entry-level demand -- market demand? Again, I'm distinguishing between your products and the market-level demand. Any markets where you have not seen that of the ones you operate in?

I would say no, but I would say -- I qualify that we haven't been able to penetrate entry-level positions in all of our markets. So we haven't put a lot of entry-level communities on the ground in California, for example. So we can't -- I can't really speak to that. But I could see from integral evidence from some of our competitors, they're doing really well in the Inland Empire who bought more entry-level communities or in Sacramento or further Inland in California. So -- but a lot of our entry-level positions that we purchased there are not open yet.

Yes. I mean, affordability is a challenge in a lot of markets. It continues -- home pricings continue to go up, which naturally creates the case for our stronger entry-level segment, both people who are getting priced out of the market and then there's just more entry-level buyers in all of these markets. They become more active, engaged in buying houses. So there's a lot of things that are driving the strength and the broad recovery of the entry-level price segments and product segments.

And that's why we think this cycle will differ -- we kind of think this cycle is a little different than previous cycles because as I think you heard about this in others, the entry-level recovery has been kind of late. We're 7, 8 years into this recovery, and it's just really started in the last year or so. So we think that gives the cycle a lot more legs.

Right. And a quick clarification as well. The press release has revenue guidance up, I think, $3.2 billion to $3.4 billion. The slides still say $3.1 billion to $3.3 billion. I'm assuming the press release is what we should be looking at?

Are you talking about revenue dollars or units?

Dollars.

Dollars.

Dollars. For the full year, it's $3.15 billion to $3.35 billion. We just rounded it to 1 decimal point.

The next question will be from Stephen Kim with Evercore ISI.

Wanted to start off with a question about land spending cash flow. Your land spend increased about 35% of revs. If we use this rate going forward, assuming about $1.2 billion or something like that on land spend next year, I'm looking in my model that you probably aren't going to generate positive cash flow next year. And so I'm just wondering whether you think -- when you think you might be able to generate positive cash flow, if you have a target for that, and if you think that's even a worthwhile metric to focus on at this point in the cycle or not.

It's not a metric that I'm interested in right now. We're still in the growth mode. So we're putting money back into the business. We still have many markets where we think we can get market share gains, particularly in some of our smaller markets in the South, where we want to do a better job leveraging our overhead. So I'm not in the mode yet of harvesting cash.

Just one point of clarification. Yes, one point of clarification. We're definitely not -- we don't run the metrics exactly the same way as the analysts look at then as to how the cash flow is working. But '16 and '17 were years where we are trying to catch up from under-purchasing lots. So there was maybe a disproportionately high dollar amount as a percentage of...

'15 and '16.

'15, we slowed down. '16 and '17, we were catching up. So while we're still going to acquire lots for growth, we don't have to refill a depleted pipeline. We just need to fund the incremental growth. So the percentages might be a little bit different than how you're modeling.

Perfect. Okay, that's helpful. And then regarding gross margins. I know that there's been a lot of talk about this already, but -- and you've been very helpful with your comments. I believe you mentioned that the back half margin profile could -- or rather the back half margin could come in maybe a little better than what you're modeling. But you want to -- you make allowances for lumber in light of the British Columbia fires and whatnot and tight labor supply continuing to be a headwind. You didn't mention the West Coast. But I was curious whether or not the West region -- you did talk about a pause in community count. I'm wondering whether or not that has a gross margin impact of a temporary nature that could also be somewhat of an offset temporarily in the back half, if that sort of factors into your thinking as well or not.

No.

No, no. I wouldn't say it's anything to do with any geography.

Right. Just we've been focused so much on the second quarter, which was a very significant growth over last year at 17.7%. But because of the first quarter performance, our blend for the year is only 17%. So to reach our guidance, we would still need to expect -- we expect to see noticeable improvements in the back half of the year to bring the full year average to where we were in '16. So we're absolutely modeling improvements in the back half of the year to bring the total back up to that mid-17 range.

Yes. I mean, so we had big community count growth in the first quarter, flattish in the second quarter. The third quarter is going to be flattish, maybe down a little bit in communities and then bouncing back up in the fourth quarter. But it's going to be -- still going to finish the year right around where we are right now, give or take a couple of few communities in the direction.

Next is John Lovallo with Bank of America.

The first question, Steve, you made an interesting comment about how the reemergence of the entry-level buyer could give the cycle more legs, and I would certainly agree with that. But would you say -- I mean, could you -- could we actually see the rate of industry growth accelerate given the size of this millennial cohort and kind of the first-time buyer cohort in general?

I think we could. I mean, I'm not the person to ask about that kind of question. But yes, I think the entry-level segment is still at a much lower percentage of the total housing starts than what you'd see in a normal market. So if we could just get back to a little bit more normal, in 2004, '05 and '06, we had 40%-plus entry-level communities and our absorptions were over 4 a month on average. Today, they're around -- less than 3. So I am optimistic that this millennial demand is sustainable and it's going to drive a better housing market.

Okay, that's helpful. And then, I guess, my second question would be Houston. If you could just remind us of your exposure there. And did you see volatility in the quarter given kind of the pullback in oil prices? Or do you think that market is kind of getting used to some volatility there in oil?

No. I think the market in Houston is stabilized, to starting to begin to improve a little bit. We're really comfortable with the Houston market now, albeit we're really focusing on more entry-level communities, more on the south side of the town, which is more petrochemical driven, health industry driven. The port down in Houston is experiencing some phenomenal growth, and all of our communities that are in -- within a reasonable commute to the port are doing extremely well. The north side is a little -- is certainly softer, so we're being careful up north. But the Houston market has definitely stabilized to beginning to start to do better.

The next question will come from Mike Dahl of Barclays.

Steve, I wanted to follow up on some of the comments around absorption and specifically relating to some of your product types. And I think at the Investor Day, you laid out you're targeting 3 a month or so for traditional move-up, 4-plus for entry-level plus and greater than 5 for ELP. And just since you're still running a little below 3 a month, could you give us an update on where you stand on those major product segments, how you're absorbing today and what the plan is to, I guess, migrate those north?

So for this last quarter, I'll give you some stats by segment. Our entry-level communities generated 3.9 sales per month. Our first move-up were 2.8. Our second move-up were 2.2. Active adult was 2.2 and semi-custom and luxury was 1.1, so for a total of 2.8. So that's right in line with what we were kind of expecting -- what we're targeting. It's 4 a month or better for entry level and 3 a month for move-up. We've got some a little work to do to get a little bit better than that, but that's what we're shooting for. And I think as we get more entry-level communities opened, that number will only get better. And also, as we get the South region to where we want it to go, it's going to help those numbers also.

Okay. That's helpful. And then, actually, just dovetailing on that on the South region. I noticed that you had a change in the South Carolina division. And I know, obviously, this is kind of a turnaround that's been in progress for a while now. It sounded like you were encouraged about some of the new product launches and -- or the conversion of old product to newer product that's coming up over the next handful of quarters. So just curious, just in light of some of the optimism around getting that back on track, could you comment around the change in management there?

We had a management change in Greenville. I'll let Phillippe talk about it. Maybe you want to give some more color on the South, Phillippe.

Yes, absolutely. We did have a management change in Greenville, an internal promotion that we're excited about, really came from Meritage. And we think he's going to drive some great improvement there. As it relates to the product, we're getting a lot of good read from the market on the new product, where we have rolled it out. It's going a little slower than we'd like as the new management gets their arms around all these new communities and we try to get them open on time and clean. But the new product's being well received, and we think it's going to absolutely improve our results out of South, along with the new management that we have in place. So we're excited about the future there. These markets are incredibly strong. And it's all about our execution, and that's what we're focused on right now is getting the South to operate at the same level our other regions are.

And if I could just make a quick follow-up to that. Just as you think about land investments, since it seems like there's still been a little less directed towards that region, are we at a point where you're like more likely to see increased investment in some of those markets?

We've actually bought quite a bit of land in the South which is while those new communities that we discussed earlier are going to be opening here over the next few quarters. So we feel pretty good about our land investment. It's about getting those communities open with our new product. And we continue to invest in those markets because they're very strong. Charlotte and Atlanta are markets that we're still focused on growing. But we have a pretty good land book in the South, and we've made a pretty big investment. And it's all about getting it open and performing.

Our next question is from Michael Rehaut with JPMorgan.

Just wanted to again just maybe get a little more granular, fine-tune in the back half, make sure I'm understanding the guidance correctly. In terms of gross margins and SG&A, Hilla, to hit the 17.6% from last year on the gross margins, it would point to second half gross margins around 18%, maybe a touch above 18%. Just want to make sure I have that right. And also if you were mentioning SG&A maybe being a little bit above last year's level and then maybe I'd expect a little bit of leverage in the fourth quarter, it would push that SG&A ratio to right around the high end of the guidance range. I just want to make sure I'm doing the math right on both of those accounts.

Mike, we can definitely -- if you want to walk through all the numbers, we can do so offline. But I don't think the math is working right. The SG&A leverage is not going up in the back half of the year. So maybe it's the interest component that's causing a little of an issue in the math. And we're certainly expecting the back half of the year to be stronger on the gross margin side. But also don't forget, it's disproportionately weighted in volume. So you don't need it to be -- it's not 17% in the first half, 18% in the second half, blending to 17.5%. You can have a kind of range around in there because the volume is greater. It's going to disproportionately impact the full year numbers, but we can definitely review it in more detail, if you'd like, offline.

Yes, that would be great. I thought you had said SG&A would be up year-over-year, maybe in dollars instead of ratio, I don't know, for the third quarter. But yes, we can follow up offline.

Yes. The third quarter ticks up a little bit every year based on the timing of certain expenses. So there's just a slight uptick, just like there was last year's third quarter. Not necessarily higher than last year, just the way that our curve works on the SG&A is a slight uptick in Q3 and then a significant reduction in Q4.

Our next question is from Susan Maklari with Credit Suisse.

On the SG&A front, can you talk a little bit about your ability to kind of control those costs? And where you think that can get to over time, especially as maybe you do focus on more growth within that entry-level, first-time kind of buyer segment?

Well, a lot of those costs are somewhat fixed. A lot of them are related to models, carry models, decorating models, marketing costs. We have a new website we've invested quite a bit of money on. It's going to be coming out in the next week or so. Corporate overhead. But I'd say as we move into entry level, we'll probably have less models, we'll spend less money on merchandising. Our commission structure will be streamlined. And so you get a lot of leverage of the SG&A in the entry level that you don't get as much in the move-up space. So I think as we get more entry-level communities opened, it will be easier for us to control our SG&A. You want to add to that, Hilla?

Sure. So I think we've said it, but maybe I'll clarify. Even though our ASP will decrease, it will be more than offset by the faster pace from entry level as we make a stronger shift into the entry level being a larger portion of our total closings. So we will see an increase in revenue even though the ASP will decrease due to higher volume of closings. So we will be able to leverage it on simpler operations in ELP. But also just on flat dollars, those fixed costs will just go further.

Okay, that's very helpful. And then just thinking about demand really broadly. As we sort of see affordability in the entry level or the younger buyers sort of become more squeezed whether from rising home prices, affordability, those kinds of things, are you seeing an increased interest -- or willingness rather among the buyer to sort of move further out, maybe more driving to qualify? Are you getting any sense if that's coming together at all?

Yes. Yes. I mean, certainly, there's a preference among the millennials to live closer in. But when they start to think about having a family and schools and backyard and larger house, they have more propensity to move into the suburbs and they're willing to go farther out. So there's a lot more activity on the periphery today than there certainly was a few years ago.

The next question will be from Jade Rahmani of KBW.

This is Ryan Tomasello on for Jade. Regarding the land market, what are return targets and have those changed at all? And what are the typical durations of the products that you've been investing in? And are you seeing potentially more option deals available?

We haven't seen more option deals, although we'll be sending a press release on a large deal that we just closed yesterday in Florida that was on a land bank option. But the deals really haven't changed from our historical land-buying habits. Generally, communities that we can absorb in 3 to 4 years, they generally have 1 to 2 years to get them on the ground and opened up and then a sellout period of 2 to 3 years.

If you look at our year supply of lots, we kind of always ping back and forth between 4 and 5 years. That's a comfortable place for us. As Steve mentioned, 1 year to 2 of development and 3-ish years to close out the communities, that's our comfortable place. And we're not speculative, trying to time the market up or down. That's kind of where we stay, so that hasn't changed.

And is there any interest in doing deals with any of the single-family or rental companies at either at the front or back end of any of your communities? We've heard some of your peers talking about seeing incremental opportunity in that space.

We've talked to some of them about different opportunities in communities but haven't been able to make any really work for them and for us.

The next question will be from Ryan Gilbert with BTIG.

I was wondering if you could quantify or at least kind of rank order on how much your gross margin benefited this quarter from pricing power versus operating leverage or the improvement in spec margins?

I don't know if we have the detail parsed out to that level of detail, although we do say that throughout the year, it's not necessarily just Q1 through Q2, but Q1 through Q4, there's about 100 bps that we pick up in leverage. So not all of that was in Q1 to Q2 but a portion of that.

Okay, great. And I guess, a follow-up to that. Is there any segment of your cost of sales where you're seeing particular moderations either in land, labor or materials?

Where we're seeing moderation? I mean, I think we're -- I think prices are outpacing cost increases. And I think that generally across the board, cost increases, although they're still substantive, they're less than they were a year ago.

The next question will be from Alex Barrón of Housing Research Center.

I wanted to ask if there's going to be any impact on the share count from the convert going forward and how much that would be. And then my second question was on the entry level, are you guys doing entry level that's primarily specs, kind of like some of the other entry-level competitors? Or is there still some element of build-to-order in your operation there?

Alex, I'll take the share count question. So we've already purchased $52 million back of the convert, but it happened in the last couple of days of the quarter. So you'll see that impact, about 500,000 shares, for all of Q3. Q3, we're going to go ahead and call the notes -- the remaining notes, which is about another 1.7-ish million shares. But that's happening September 20, so there's not really going to be an impact in Q3 since the way that the math works is within our relative share saves. But you will see the full impact of that in Q4.

So on the spec question, within the entry-level segment, we definitely have more specs per community, and we encourage our buyers to buy specs versus build jobs. But also within the entry-level segment, we have a segment within the segment called LiVE. NOW, which is our spec-only strategy, no designs that are -- program where it's all spec driven. And that is -- we have a handful of communities around the country that are designated LiVE. NOW that are in that situation.

Okay. And so Hilla, the full impact will be, what, how many shares?

The full impact in Q4 is, I think, I believe, 2.1 million or 2.2 million shares in total. That we will be out fully in Q4 and obviously going into '18.

Got it. And Steve, if I could ask again on the entry-level communities. As far as the land for entry level, are you guys still finding finished lot opportunities out there that were left from the downturn? Or are you guys having to develop your own land?

Almost all of it we're having to develop. Yes, there's no -- not much finished lot opportunities left.

Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Steve Hilton for any closing remarks.

Thank you very much for your attention and participating on our second quarter conference call, and we look forward to talking to you again next quarter. Have a great day.

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