Meritage Homes Corp (MTH) 2018 Q1 法說會逐字稿

Welcome to the Meritage Homes First Quarter 2018 Analyst Conference call. (Operator Instructions) Please note, this event is being recorded.

I would now like to turn the conference over to Mr. Brent Anderson, Vice President of Investor Relations. Please go ahead.

Thank you, Phil. Good morning. Welcome to our analyst call to discuss our first quarter 2018 results. We issued the press release yesterday after the market closed and you can find it along with the slides that we'll be referring to during the 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 statements during this call as well as in our press release and slides contain forward-looking statements including projections for 2018, operating metrics such as community count, order trends, closings, revenue, margins and earnings in addition to expectations of our market trends. Those and 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 our actual results may be materially different than our expectations due to a wide variety of risk factors, which we have identified and listed on this slide as well as in our press release and most recent filings with the SEC, specifically our 2018 Annual Report on Form 10-K which contains a more detailed discussion of these risks. We've also provided a reconciliation of certain non-GAAP financial measures referred to in our release or presentation as compared to their closest GAAP measures. With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage; Hilla Sferruzza, Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage. We expect to conclude the call within an hour or maybe less and a replay will be available on our website approximately an hour after we conclude. It will remain active for approximately 2 weeks.

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

Thank you, Brent, and welcome to everyone participating on our call today. We appreciate your interest and I'll begin on Slide 4. We were pleased with our results for the first quarter of 2018. They demonstrated solid progress on our strategic initiatives in addition to generally healthy market conditions. We produced year-over-year growth in nearly all key metrics including 10% order growth, 9% increase in closings and a 10% increase in home closing revenue, a 90 basis point lift in our home closing gross margin plus a 30 basis point improvement in SG&A leverage. We also made significant progress in our East region performance. Turning to Slide 5. Those results were partially due to continued strength in the economy and the drivers of growth for the housing market, but much of the credit goes to our team who has been very focused on achieving our strategic initiatives.

With this all-hands operational focus, we expect continued improvements in these metrics throughout 2018 and beyond. The strategic initiatives I'm referring to include community count growth, home closing margin improvement, maximize overhead leverage especially through growth in our East region and our strategic focus on the entry-level segment. We grew our community count during the quarter back to 253 communities, about where it was a year ago. It's been a challenge to grow community count due to a combination of high demand in several markets resulting in the early close-outs of community as well as delayed openings. Our gross margin improved to 17.1% from 16.2% in the first quarter last year with much of the improvement due to our performance in the East region where home closing gross margin was up 260 basis points year-over-year.

As we noted last quarter, we made solid and sustainable gains in most of our markets in the east and believe we turned the corner there. We have more than offset rising costs with price increases in most of our communities across our markets, which helped our margins. We leveraged the 9% growth in closing volumes to reduce our SG&A ratio to 11.5% of total home closing revenue, down from 11.8% in the first quarter of last year. We expect to trend down throughout the year and we give you some positive year-over-year comparisons. Once again, much of the improvement in leverage was due to 29% year-over-year growth in closing volume in the east, which drove 25% home closing revenue growth for the region. Those margin improvements on top of 10% growth in home closings revenue were the primary reasons for a 33% increase in pre-tax earnings.

There were a few other unique items that Hilla will describe in more detail later on. Turning to Slide 6. Our strategic shift towards more entry-level homes is certainly helping to drive our growth. Orders for average community were up 10% year-over-year for the first quarter of 2018 marking our third consecutive quarter of positive year-over-year comps as partially the higher absorption pace in our entry-level communities and for the first quarter of this year, we averaged 4 orders per month for entry-level versus 2.8 for non-entry level homes. The last couple of quarters, 70% or more of our new lots under contract are for entry-level communities. Many will be opening in the next or 2. We have refined our entry-level track even further over the last couple quarters and expect to continue to drive construction and purchasing efficiencies while providing a quicker and less stressful home buying process for our customers.

We are closing in on our goal of having 35% to 40% of our communities spaced in the entry level market by the end of the year. We ended the first quarter of 2018 with approximately 32% of our communities classified as entry-level meaning that they have rates below local FHA loan limits.

Those communities drove 38% of our total orders in the quarter due to higher absorptions. As we expand the percentage ratio of communities, we expect to generate additional order growth beyond what we can achieve through community count growth and general market trends.

I'll turn it over to Phillippe to discuss some highlights of our sales trends. Phillippe?

Thank you, Steve. Demand remained generally solid through the first quarter of 2018 providing opportunity to take price increases through disciplined pricing management to help offset rising costs. Focusing on our sales performance and order trends, the East and Central regions drove our 10% order growth for the first quarter with particularly strong gains in the East due to our great community position, new product and improved execution. I'll discuss our progress in each region and provide a little more local color beginning with each region on Slide 7. Our East region orders were up 23% year-over-year in the first quarter with the most significant gains in Georgia and Tennessee. Georgia more than doubled its sales volume over the last year's first quarter. Florida and South Carolina also had strong double-digit increases in their absorption pace and order volumes for the quarter.

Our average sales price on orders for the East region was 4% lower in the first quarter of 2018 compared to 2017 demonstrating a mix of more entry-level homes relative to our previous move up concentration. We are confident in our product, community location and processes. While we're pleased with our first quarter results, we still have many opportunities to improve our execution, reduce our cost and cycle times, drive margin expansion and get our performance back up to how we underwrite land. Moving West, Slide 8. Texas continued its record of strong performance with another quarter of double-digit order growth. Total orders were up 17% for the first quarter and total order value increased 11% year-over-year as ASPs came down about 5% reflecting our success in the entry-level market.

We're seeing this especially in Austin where the entry-level communities we've opened are selling well. Our average community count in Texas was up 15% year-over-year in the first quarter and average absorptions also increased to 8.6% compared to 8.4% in the first quarter of 2017. We expect continued strength in Texas due to population and job growth in its major markets as we experienced the last several years and the pivot to the lower price band should help with potential pullback on demand at higher ASPs, which are nearing affordability limits. Slide 9, our orders in the West region were down just slightly despite a 14% decline in average community count as a 14% increase in order pace made up for few communities. High ASPs coupled with higher absorptions offset the community count decline maintaining total order value consistent with last year's first quarter.

The high level of demand in the West has made it difficult to replace communities starting up to keep up with the accelerated closeouts. We did open 7 new communities in Colorado during the first quarter, which helped drive a 22% increase in orders. While Colorado had a 13% decline in absorptions to most of those communities opening in the last few weeks of March, they still maintain the highest absorption pace in the company. We're planning to open up 10 net additional communities that will close out in the West region over the next 3 or 4 quarters increasing our total active communities in the region despite the accelerated sales pace.

I will now hand it over to Hilla to provide some more additional information. Hilla?

Thank you, Phillippe. I'll provide some more detail on our P&L results as well as land and operating metrics beginning with Slide 10. We generated nearly $49 million in pre-tax earnings for the first quarter of 2018, a 33% increase over $37 million for the first quarter of 2017 and our highest first quarter pre-tax earnings since 2006. Dissecting the $12 million year-over-year increase; approximately $3 million came from home closing revenue growth, another $7 million from the increase in home closing gross margin and an additional $2 million from lower SG&A as a percentage of home closing revenue. There are a couple of other items that largely offset one and another. Land closing gross profit swung from a positive $2.5 million last year to a negative $1.2 million this year. The net loss this year was primarily from our exit of one [lost cause] community in California partially offset by gains on a few small land sales.

That $3.7 million negative impact was offset by $4.3 million of incremental other income in 2018, which was mostly comprised of $4.8 million favorable legal settlement relating to an old joint venture in Nevada. We had a couple of issuances of new notes and a couple of retirements of existing notes since 2017's first quarter that impacted our total interest incurred. We issued $300 million in new 5 1/8 senior notes last June that we used to retire our 1 7/8 convertible note and repay borrowings under our credit facility at that time. We issued another $200 million of 6% senior notes in March this year and used the proceeds to repay borrowings under our credit facility that we had used to redeem $175 million 4.5% note in February of 2018. With those transactions completed, we have a well-laddered maturity schedule for our long-term debt with the next maturity not due until 2020.

The net effect of the higher rate issuances was an increase in our total interest incurred of about $3 million in the first quarter of 2018. However, most of that interest was capitalized to assets under development so our interest expense declined by approximately $700,000 year-over-year. Net earnings were 86% higher than last year's first quarter as our effective tax rate was just 10% of the first -- for the first quarter of 2018 compared to 36% a year ago. In addition to the lower statutory federal rate enacted late last year and commencing in 2018, we also benefited from a 1-year extension of energy tax credit for all qualifying loans closed in 2017. This benefit recorded in the first quarter of 2018 totaled $6.3 million. We expect our effective tax rate for the remainder of the year to be closer to 25% as we had indicated last quarter.

Slide 11, turning to balance sheet and cash flow items. We spent approximately $203 million on land and development in the first quarter of 2018, slightly lower than last year's first quarter of $207 million. Our total lot supply at quarter-end held steady at about 34,000 lots compared to 34,300 at year-end but reduced our lot supply to about 4.3 years from 4.5 years based on trailing 12-months closings. About 70% of total lot inventory was owned and 30% was optioned at March 31, 2018. Consistent with our strategy to increase our focus on entry-level market, we are building more spec homes in those communities. 51% of the quarter's closings were from spec inventory. We ended the quarter with a total of about 2,000 spec homes, which is an average of 7.9 specs per community compared to an average of 6.4 per community a year ago.

Approximately 1/3 of total specs were completed as of March 31, 2018. Turning to Slide 12. Based on our first quarter results and operating improvement especially in the East region as well as our expectation that housing-related economic indicators remain mostly positive, we anticipate additional earnings growth in 2018 particularly in the second half of the year. We are raising our expectations for total 2018 closings and home closing revenue to approximately 8,450 to 8,850 units of closings and $3.5 billion to $3.65 billion for home closing revenue. We are projecting a home closing gross margin of at least 18% for the year anticipating that we can offset cost inflation with price increases. The net effect is that we expect full year pre-tax earnings of $285 million to $305 million with a tax rate of 25% for the rest of 2018.

For the second quarter, we're projecting 1,850 to 2,000 closings for total home closing revenue of about $775 million to $850 million, a home closing gross margin in the mid 17%s range for the quarter and pre-tax income of roughly $55 million to $60 million. We are projecting a sequential ramp up in closings margin and profitability for the remainder of 2018 and we expect the year-over-year comparison to be stronger in the back half of the year. This year's second quarter is our most difficult year-over-year comparison to 2017. Gross margin will be impacted by a greater mix of closings coming from lower margin states than we had last year. We also anticipate some additional non-recurring expenses in Q2 2018 relating to our new strategic initiatives roll-out as well as compensation expense in the second quarter this year that we didn't have last year due to a change in our equity awards to a more advantageous tax structure for the company.

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

Thank you, Hilla. In summary, we were pleased with our first quarter results and the positive progress we delivered on nearly all key metrics. Demand for new homes remains healthy and we're especially pleased with the success of our LiVE.NOW homes. This is -- there's still a shortage of entry-level product for buyers who are looking for more -- a more affordable home that meet their needs and give them some extras to also satisfy a few of their wants. Meritage offers our industry-leading energy efficient, home automation, attractive and fresh designs in all of our homes along with a stress-free experience for buyers purchasing their first home. I'm proud of our entire Meritage team for putting our customers first and working hard every day to make the company successful. We're confident in our abilities to make the most of the opportunities ahead of us. We expect to continue to grow and deliver increased shareholder value.

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

Thank you, Steve. (Operator Instructions) Our first question comes from Michael Rehaut with JP Morgan.

First question I had was on the entry-level strategy. Steve, in your prepared remarks mentioned that this is something that you continue to refine and from what we understand and when we visited back with Hilla in Phoenix in mid-March, talking about more -- shifting even more of your product towards entry-level and with less customization, kind of more of a LiVE.NOW type of approach. So, just wanted to get your -- get kind of an overview of how the strategy has been refined over the last few quarters and what that could mean on an incremental level in terms of margins and returns?

Well, we never refine and we're talking more about the operational side of it. We're doing some things with technology on how we're selling those homes in the sales office and how we're dealing with customers and brokers on the pricing. Our spec home offering, the mix of the specs, the features we put into the specs, the upgrades we put into the specs is all part of the refinement to make sure we have the right inventory at the right time to capture the biggest pool of buyers that we can. So we continue to experiment, but to learn from the communities that we do have open and we're opening quite a few more what I call LiVE.NOW communities for the remainder of the year. And as you know when we came out here, those communities were primarily spec home driven.

This is Phillippe. We've gone, -- it's 100% spec, which is one of the biggest changes. So we only -- you can only buy a spec home, you cannot do a to be built. There is no design studio, you select your options right on site. We've aligned all of our options with our national trade contracts, which is allowing us to drive our costs down. Our cycle times are better. So, that's really what's driving the operational improvement and we're seeing that impact our margins and more importantly, just our ability to build homes at better costs and drive our cycle times down.

So just kind of working off of that then and just trying to understand how this is going to kind of work across the company more and more, can you give us a sense of how much over the next let's say 18 months, what percentage of closings the LiVE.NOW approach where you have no customization and more of a spec driven approach, what percent of closings or revenue this approach might account for?

Well, we previously stated that 35% to 40% of our communities will be entry-level by the end of this year. We think almost all of those will be -- not quite all of them, most of them will be LiVE.NOW and since the absorptions are higher in those communities than they are in our move up communities, that means there will be even a higher percentage of the total closings coming from entry-level communities. So, I think it'll be probably close to 50% by the end of next year if not sooner.

The next question comes from Alan Ratner with Zelman & Associates.

A couple questions on the land strategy. So if I look at your lot count, you've actually seen an uptick in the share of owned lots year-over-year about 500 basis points, 600 basis points versus optioned, which is a bit different than what other builders are seeing and talking about as far as trying to really push more optioned land off balance sheet to drive cash flow and returns higher. So, first question was maybe just talk a little bit about your strategy on the land front and why you're incrementally adding owned lots at this point in the cycle and whether that has anything to do with trying to drive the gross margin higher?

We don't have a conscious strategy to buy more land versus option more land. We just haven't found the opportunities to find land that we can buy under option in the markets where we need land or we want to buy land. To the extent those are available, we'd pursue them. We are trying to be mindful about our balance sheet and maintain our leverage and then over time even reduce it, but we just haven't found opportunities for option land that makes sense for us to the degree that we want to increase that ratio.

Alan, I think you're right though on bringing in third-party intermediaries to land sales to land bake for us. It's exactly for the reason that you noted. At this point in the cycle, we're hyper focused on increasing our margins and giving a piece of that upside to a land seller is not making sense for us.

Got it. That makes sense. And then second question, obviously the order patterns are very healthy and it seems like you guys and others are not seeing any impact from rates impacting demand at this point although, Phillippe, I did hear you mentioning affordability in some of the entry-level communities maybe pushing a little bit of a barrier there. So when you're underwriting land today presumably for community openings a year or 2 years down the road, what are the primary metrics you're looking at as far as really gauging whether it makes sense to kind of execute that land deal and are there any kind of yellow flags that are kind of being waved at this point that are giving you a bit more caution given the move-in rates and affordability that we've seen?

We're being extra careful in some of the markets that are not as affordable as other markets. I think you know what those markets are. We are continuing to underwrite to 20% plus gross margin and a 25% plus IRR. We're pushing more for entry-level. We're not buying anything above first mover, anything outside the conventional loan limits, jumbo loans we're not buying that type of land and our strategy has been pretty consistent for the last year plus.

Were there are any deals, out of curiosity Steve, that might have been under consideration that you decided not to move forward on in the quarter because of the move-in rates?

No. I think we've been more laser-focused on finding deals that have less risk. So around land development, around product, we want to really reduce the execution risk to improve the market risk. I think we can more easily quantify the market risk, but the other risk we want to try to avoid.

I think the size of deals is something we've been really thinking about too, making sure we're looking at how the deal fits into the market long term not just short term. So, we're going to spend a little more time on that as well.

The average size of our land acquisition has increased. That's because we'd rather focus on deals that have a longer runway and less turnover, particularly at the lower price points where we can get a good land buy.

So obviously, you think there's more runway to go in the cycle?

At the entry-level. So we're buying -- the entry-level deals we are buying little bit bigger positions on the first mover communities that are smaller. But for the entry-level, we are trying to have less turnover and more leverage of our overhead.

And I think we already stated that for us entry-level, the key underwriting criteria is that we're below the FHA limit. And we have to be able to stay there 2 years from now, we have to still be under -- meet the FHA limit.

And they have to be higher absorption communities for sure.

The next question comes from Stephen East with Wells Fargo.

If you look at LiVE.NOW, Steve, is this a case of -- can you get better gross margins out of this or is this more that the returns are a lot better because of your velocity out of that? And then along with that, this is -- as we toured that product, this is the one that really struck you as potentially having manufacturing opportunities and I know you all are probably on the forefront at looking at a lot of different options. But is manufacturing -- offsite manufacturing a real possibility with LiVE.NOW or is this just more a case of executing on spec and delivering the product?

I think it's more the case of executing on spec and delivering the product. We just think there's less operational risk on the LiVE.NOW than there is on the first move up or on any move up and the gross margins which we don't think are going to be necessarily better, but we have a higher probability of hitting our underwriting criteria we think with entry level and LiVE.NOW than we do at the higher price points, particularly if the interest rates rise. As far as manufacturing, more offsite manufacturing modular, it's just not there yet and there is a lot of talk about it and certainly I've been studying it and we have people on our team that have been out to some different parties who are doing some of the stuff, but I still think it's quite a ways away from coming into play for what we do. I think there's a lot of other things that can happen first around what I call pre-cut; pre-cut lumber, maybe pre-cut drywall, pre-cut everything to make the skilled labor become -- have less pressure on the manufacturing process onsite.

Okay. And then just as you all look at your costs nationwide, can you just give us an idea of what they're inflating at; maybe materials and then labor and land, if you will? And then I was interested in your lumber strategy, I mean how do you -- do you lock it in for 90 days or what's your strategy there?

This is Phillippe. So, our costs are up maybe 1% through the first 3 months, a lot of that's lumber which I'll get into. We think we've incurred about $1,500 a house on lumber since the beginning of the year. It's kind of moved around a little bit. We've seen OSB go down, but loose lumber go up. We kind of locked in thinking it was going to go down after the first quarter. That's what everyone believed it was going to do. It actually went up. Right now the sentiment is that it's going to go down again, we'll see if they're right. We have different locks throughout the country depending on how we build homes, right. I mean in Texas we stick bills in the West, we're turnkey so we have a little bit longer locks in the West. Our locks in Texas are very short so we can take advantage of lumber as it goes down. So, that's kind of the lay of the land for our cost through the first quarter of the year.

Okay. And what's your labor and land doing?

Labor has not gone up very much quite frankly and I think a lot of that's the fact that we're simplifying our business and we're getting some more efficiencies there. On land, the pricing on land isn't getting any cheaper. But I think we're seeing it come through our balance sheet a little bit lower just because of the entry-level exposure, but the stuff is not getting any cheaper.

The next question comes from Stephen Kim with Evercore ISI.

I appreciate all the information as usual. I wanted to ask a little bit about the LiVE.NOW. In particular I wanted to get a sense for how that product maybe -- you may be positioning it for the future where we may see a little bit more pressure on affordability. You talked about the FHA levels and that was very helpful about staying below that limit. But I wanted to ask within the LiVE.NOW range that you offer in your communities, are you seeing more buyer interest for the larger footprint within the LiVE.NOW range that you currently have or would you say it's pretty evenly distributed? And how much ability do you have to add smaller footprint homes or larger footprint homes for that matter within these communities that are slated to come out in the next year or 2 if you get a sense that maybe affordability is more than issue if rates move up, let's say can you slide in some smaller footprint homes within to extend your range lower basically?

Well, I'd say that we have a relatively wide band of products for most of our LiVE.NOW communities as low as 1,400 square feet. Actually, we just opened a community in Phoenix, I think that it's a 1,400 square foot plan and it sells for $180 -- close to $180,000 and some are far outskirts of Phoenix. Some of our LiVE.NOW communities go up to 2,800, 2,900 feet, but I don't think we're doing anything over that in most of our LiVE.NOW communities. So depending upon market conditions and buyer demand in those communities, our individual operators have the ability to bring more product in with lower square footage or more in a higher square footage. It's really based upon what the demand is at that location and who the buyers are. Some of the locations are really really young families and they're looking for smaller square footage, just trying to get in a bit more affordability and some are a little bit more mature families that wait longer to have kids and they need little bit more square footage. So it varies by community and by market, but we do have that flexibility for sure.

Second question I had sort of touches on your comment about using maybe more pre-cut lumber maybe being more focused on pre-cut lumber and drywall. I wanted to ask one of your -- I think one of the other builders this morning made mention that they thought that there was the potential for maybe some of the more sophisticated approaches to panelization and increased technology to add value going forward and they were looking at it hard. I know that you guys have also been very focused on exploring opportunities. I think you're the only ones that actually have a head of sustainability and innovation. So I was interested in your comments there and I was curious if you could give us a sense for the percent of your homes that you're building using this pre-cut lumber or even just panelization. If you could give us a sense for how involved you are already in that and how you see that changing over the next year or 2 years? And then as a side note, does using pre-cut lumber impact at all the way your lumber costs move with spot or not at all?

I don't think pre-cut has any bearing on the pricing, our ability to get the raw materials at a lower price. I would say pre-cut is a very small percentage of what we're doing. Unfortunately, I'd like to see it to be a much bigger percentage. Even panelization is probably a pretty small percentage, we're probably panelizing 20% of all of our homes. When you say I mean California, most homes in California have been panelized, certain markets in Texas we're doing more panelization; but beyond that, there's not much panelization going on but we are trying to increase that. But it's not easy, it's a challenge with some of our subcontractors, but it's definitely an area of focus. The move to pre-cut everything that goes into a home is really I think the wave of the future and I think it's going to come before modular building. So, that's kind of where we're focused.

The next question comes from Nishu Sood with Deutsche Bank.

This is actually Tim Daley on for Nishu. So, my first question is regarding the West Coast. So, strong demand out there this quarter and you're not the first builder to comment on that. Just thinking as builder with a strong entry-level and move up presence out West, could you help us understand the dynamics of the demand on the West Coast last quarter and kind of currently? Just curious about if there's been any sort of pull forward tax -- what happened with the tax rate, changes to the mortgage rates and particularly highlighting any sort of differences you're seeing between entry-level versus the move up demand? Thank you.

This is Phillippe. Generally demand in the West is really strong and we have communities, flags flying and we're seeing really strongest absorptions across the country. We have a lot of entry-level in Arizona and as we've said before, it's doing extremely well. We are starting to get much more in the entry-level space in Denver where affordability is really stretched and that's doing quite well. We don't have as many LiVE.NOW or entry-level communities in California although we are buying land for that space. So, we can't really contrast it to most of our California communities, our first move-up communities. But the demand in those communities is extremely strong. Supply conditions in those core markets in Northern California and Southern California is very strong and has been strong for a while.

And then apologies if I missed it. But are you still expecting the community count growth of 5% to 10% given there was a large push in 1Q higher than we had expected and then kind of contrasting that with the faster closeouts in the West Coast. Just trying to I guess better think about how the cadence of community count will go throughout the year and any sort of I guess kind of looks into '19 if you could provide that as well, it'd be very helpful.

The short answer is yes, but probably to the lower end of that range. And we're not ready to give any kind of guidance on 2019 community count growth yet.

The next question comes from John Lovallo with Bank of America Merrill Lynch.

First question is it does really seem like the East region has turned a corner here. Are you guys pretty confident that the management team you have in place in the region is now pretty much set or is there still a little bit of refining that you guys have to do?

This is Phillippe. Very confident in our management team in the East. We've made a couple of moves over the last 3 or 4 quarters that I think have really upgraded our leadership teams in those markets. We're always looking at our management team, evaluating them to make sure we have the absolute best people running each division. So I'm not just going to sit here and tell you that there aren't going to be changes over time as we assess that, but we've got -- we've made our team much stronger over the last few quarters and we're really excited about the progress that they're making.

Okay. And then maybe just going back to community count for one second. Is there anything you can help with just in terms of cadence over the next couple of quarters?

There's not going to be a lot of variability over the next couple of quarters, maybe up a couple, down a couple just kind of bumping along and then ending up the year. I see it within our guidance of 5% to 10%, but probably closer to the lower end.

Talking more about absorptions there. That's the cadence.

The next question comes from Susan Maklari with Credit Suisse.

My first question is thinking a bit bigger picture perhaps. As we get a rise in the rates and you get a move down in buyers towards more of your entry-level LiVE.NOW kind of product, do you think that you could perhaps see more upgrades that come in there driving a bit more gross margin expansion over time?

No, because that's not really the strategy for that product. Price is the #1 amenity have for the entry-level buyer and we're not sending him to the design center so we have to -- whatever upgrades we're going to put into those houses, they have to be pre-plotted or pre-planned. So, there's really not going to be an opportunity to get more option revenue for those in that niche of our business.

Well, Susan, I must say that our base spec level and the options that we're putting in are probably a notch above what you're going to see in traditional entry-level so there's still highly amentized homes for the entry-level space. And as interest rates increase and that second time move up, it needs to pivot down due to affordability, they will probably be attracted to our first time move up product meaning not so much our LiVE.NOW product, which still does have the ability to put options...

The opportunity is the fact that we don't have to build as many models so we don't have as much overhead because there's always standard the inventory for people to purchase and [inaudible] and we can do it with less construction overhead, less supervision like we can build more homes because we are line building and we can... As you've seen from some of the more dominant entry-level builders like ones that have reported today, their SG&A is very low and that's because that's their strategy. And I think we can push our SG&A down over time as we get bigger in the space.

Okay. And then can you just give us a little bit of color on what you're seeing in Texas. It seems like your order growth there has really held up pretty well. Just any color in terms of what's going on on the ground?

This is Phillippe, it's good, it's strong. I mean in all 4 markets we're seeing strong demand. We have different strategies in all 4 markets. We're very focused on the first-time home buyer in San Antonio and Austin and those segments are really strong and we've seen really positive conditions for those groups. And then we're more of a move up builder in Dallas and Houston and since the hurricane in Houston, demand has recovered very quickly and it's softer in Dallas at high price points, but we're positioning ourselves a little bit lower these days, more in the first move up space and we're seeing strong demand there. So, we're bullish on the economy and the housing market in Texas right now.

The next question comes from Alex Barron with Housing Research Center.

I wanted to ask about your pricing power and if you could make a comment about what you're seeing. I guess that the lower entry-level prices versus the move up, how much pricing power you have in each?

We have a lot of pricing power. We've take substantive price increases throughout the previous quarter and already into this quarter this month. We're hyper focused on margin here. We are really getting more involved at the corporate level in our pricing and taking everything the market will give us in every one of our communities across the country. So, that's going to be a big part of our margin story. I think we have -- we maybe could have done better on pushing up pricing, but that's not going to -- that's not to be the case for the remainder of this year.

Got it. And I also had a question related to the tax rate, I guess this quarter we saw bit of a catch up on the energy tax credits. How is that going to work going forward? Is that going to be something you get each quarter or just once a year? How is that going to work?

So, there was a one-time catch up for all of 2017 that was passed in the first quarter. So the way that the tax rules work, we took all of last year in the first quarter so the first quarter's tax rate is 10%. That's not going to be repeated throughout the rest of the year. The rest of the year is just going to be the regular tax rate with no energy tax credit reflecting in those and we -- I've noted that's going to be about 25% although we're still holding up hope that there may be an opportunity to get a similar extension for 2018, but we are certainly not modeling it.

If you recall under the previous administration like in '14 and '15, at the end of each year, they passed the energy tax credit bill and we got those credits right at year-end. And then in '16 and '17, they passed a bill for a 2-year period that was passed at the end of '15 for '16 and '17. That expired and then there was no energy tax credit passed at the end of '17 like we see normally. So, that [inaudible] went into January, February. Finally, they passed it. It was retroactive to last year, but we had already delivered our results for last year so we took it in the first quarter. Whether we're going to get it again this year, we don't know, but we're working hard lobbying Congress and the administrations to pass another one.

So at this point basically for the rest of the year, you don't expect to see it until maybe if a new law gets passed at the beginning of next year?

Who knows? It could come sooner or it could come later, but we're not banking on it. But we've gotten it every year, just comes at different times.

The next question comes from Carl Reichardt with BTIG.

I wanted to ask about, Hilla, your guidance for this quarter that you offer back in January for margin was mid-16%s and you did 17.1%. just internally, what were the positive surprises that led the performance to be so good relative to what you'd guided to in January?

I'll take that one. I'll say that I think 51% of the homes we closed were specs and we pushed prices hard on those throughout the quarter particularly earlier in the quarter and we got a handful of extra closings that really helped our leverage as well.

We also did some value engineering of our product. In the East if you guys remember, we had a new product library roll-out over the last couple of quarters and as we value engineered that product, as we started to build it, we were able to squeeze out a little bit of the cost as well as it went into production.

[inaudible] Q4 and early in the quarter.

Okay. And then on the East, I know we'll get your gross margins by region with the Q, but your Florida closings were a substantially higher percentage of what you did this year versus last, I'm not quite -- 50% I think versus the third. So how much -- and you mentioned the gross margins there being help to -- a helpful driver. So how much of the improved performance there was due to the mix shift in Florida relative to the rest of the markets, whether that's margin there or just you have the legacy assets there that you've done for a while or a better business there than the other parts of the East. I'm just trying to parse the difference between Florida contribution and then operational improvement in those markets that you bought into.

We don't break out the margin to anything lower than regional level. Although you are correct, there's a bigger concentration of the performance coming from Florida, part of that is, of course, the lag from the hurricane homes that we couldn't get closed in Q4. We were able to get closed in Q1. The performance in Florida is a bit stronger than the rest of the other markets although we saw improvement in all of the markets in the East.

The next question comes from Jade Rahmani with KBW.

With the 1Q spec sales being so successful, what's driving the lower backlog conversion expectation implied in your closing guidance for 2Q?

I'd have to look at that.

We had a little bit -- as we mentioned, there was a little bit of the hurricane catch up in Q1 that accelerated some of those closings. The homes are actually complete, we are actually just waiting on utility and municipal hookups. But we saw a little bit of a blip in Q1, Q2 we're kind of back to normalized volumes.

Okay. Can you give us a percentage cancellation rate in the quarter and if you're seeing any color and if you're seeing higher cancellation rates on the spec sales?

We have about a 14% cancellation rate for the quarter. I think last year's quarter -- first quarter we were at 12% so it picked up just a little bit. It's not actually on spec. It's due to the shift to entry level, which is very intentional. We're trying to get a wider population of folks to try to qualify and some do and some don't. But the bigger we make that funnel, we get folks in the door then more successful we'll be in the entry level space.

The cycle time on the specs is a lot lower. Most of the specs are being sold somewhere around brand new drywall. So cancellation rate really isn't anymore for specs than it is that for build. I'd probably argue that it might be less. So, we're going to keep an eye on it.

The next question comes from Jay McCanless with Wedbush.

The first question I had, you guys and the other builders have reported this week all took your gross margin guidance up for the year. What's changed in the last couple months either for Meritage or for the industry where everyone's a little more comfortable with their gross margin line?

Pricing power. Pricing power, refined execution. I think we're all executing better, at least I know we are. Pricing power and outside of lumber, better cost control.

Maybe a little bit of breathing room, as Phillippe mentioned, on labor.

The second question I had on call it your second move up all the way to your luxury product. What are you seeing for sales or what did you see for sales absorption in the quarter versus last year? And are you generally just seeing a better sell through of that product? Just trying to figure out why the ASP for the full year moved up, whether it's mix or you're seeing better sell through in those higher price points?

I wouldn't say it's better. We had some really, really high priced stuff in California that started influencing that. We had really good sales, actually opened some -- opened up a couple of communities with the sales out in California around -- the ASPs around $1 million and we're selling well there. It wouldn't be a luxury community in the other states. $1 million, it's probably a first move up in California in some of these markets that we're in; close to Silicon Valley and then not far from the water in Orange County. So, I think that's skewing the numbers a little bit, but I don't think it's a material directionally where we're heading.

And just to clarify. With our focus on LiVE.NOW and first time move up, our participation in second time move up and luxury is fairly limited and it's going to continue to decline over the next couple of years.

The next question comes from Dan Oppenheim with UBS.

Wondering about overhead leverage I guess as it relates to the community count in the West. Wondering if you -- how that impacts on the SG&A leverage as we go to the next couple quarters given sort of the declines in California with the higher price point and looks as though community counts sort of ended the quarter at a lower level than and was trailing lower as the quarter progressed and thinking about closings then over the coming quarters here.

Our leverage is actually still going down in the West and a lot of that's just driven by the high absorptions that we're seeing out of those communities. Obviously overhead is impacted when you're turning over communities, you always frontload overhead when you're opening up new communities so that's having a little bit of a drag on it. But we're getting such strong absorptions in the West on a per store basis that our leverage continues to trend in a positive way.

Okay. And then I guess there's been a couple questions in terms of the margins, but you'd also talked about how you've been refining what goes into the specs. Wondering how much of the margin improvement would you say is coming to sort of changes in what you've been doing with that versus just the move in the market?

I would say most of the margin in the short term is being driven by the pricing power in the market. I mean we've really focused getting everything we can from the market. In the first quarter, the market was strong, we had pricing opportunities. But we also are seeing margin on opportunities as we simplify our business, as we align what we're putting into the house with our national contracts and get more efficient with the way we're building houses. We are seeing better cost control and even opportunities to reduce our cost. But I would say again big part of the margin story is the pricing power.

So, I think that was our last question. We thank you for your interest and participation in our call this quarter and we look forward to talking to you on our next call. Thank you very much. Have a great day.

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