Meritage Homes Corp (MTH) 2018 Q3 法說會逐字稿

Good morning, and welcome to the Meritage Homes Third Quarter 2018 Analyst Conference Call. (Operator Instructions) Please note, this event is being recorded.

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

Thank you, Jed. Good morning. Welcome to our analyst call to discuss our third quarter and year-to-date 2018 results. We issued the press release after the market closed yesterday, and you can find it along with the slides for this 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 the call as well as the press release and slides contain forward-looking statements, including our projections for 2018 operating metrics such as closings, revenue, margins and earnings. Those and other projections represent the current opinions of management, which are subject to change at any time, and we assume no obligations to update them.

Any forward-looking statements are inherently uncertain and actual results may be materially different than our expectations. We've identified the risk factors that may influence our actual results and listed them on this slide as well as in our press release and most recent filings with the SEC, specifically our 2017 annual report on Form 10-K and subsequent 10-Q for the second quarter of 2018.

We've also provided a reconciliation of certain non-GAAP financial measures referred to in our press release and 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 about an hour and a replay will be available on our website approximately an hour afterwards and it will remain active for approximately 2 weeks.

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

Thank you, Brent. I'd like to start off by thanking some of my peers who reported before us for taking some of the initial slings and arrows (technical difficulty) that we were initially expecting in light of the recent shift in the market. So we're going to try to keep this light and fun today.

So I'm going to start off on Slide 4. I'll begin with a few highlights of the quarter, then review our progress on the strategic shift we entered into a couple of years ago and finally discuss some recent market conditions.

First, we had another quarter of good earnings. We delivered double-digit closing and pretax earnings growth over last year in Q3. Our total home closing growth grew 10% over last year primarily due to an improved performance in the South and higher backlog conversion associated with our entry-level strategy. Combining the increased closes with the price increases we took earlier in the year, we were able to hold our home closing gross margins and overhead leverage stays despite significant cost headwinds, which Hilla will discuss in more detail later.

Pretax earnings increased 13% and net earnings increased 27%, benefiting from a lower statutory income tax rate this year. As a result, diluted earnings per share were up 30% year-over-year, which increased our earning book value per share to $42.51. Second, our East region contributed significantly to those year-over-year gains, with 32% more closings in the third quarter, which generated 31% greater home closing revenue over last year. The gross margin on those closings improved 160 basis points year-over-year, which greatly narrowed the gap between the East and our other 2 regions. Those improvements are mostly the result of some self-help measures we have implemented in the last couple of years as one of our strategic initiatives, and we want to recognize those employees who contributed to that success.

Now I'll turn to Slide 5. Third and most importantly, we continued our strategic investment, focused exclusively on the entry-level market and affordable first move-up homes. We believe this positions Meritage to address the largest group of homebuyers over the long term, namely millennials and baby boomers, as we exited out of the tougher second-time move-up and luxury markets. We opened 19 new entry-level communities during the quarter. More than half of the total new communities opened during the quarter continue on our expansion into the market. Entry-level communities made up 1/3 of our total active communities and 43% of our total orders for the third quarter, a significant increase over 2017, with entry level representing 33% of our total orders and much higher than our starting point of 24% in 2016.

Consistent with our last several quarters, approximately 80% of the lots we put under contract in the quarter were for entry-level homes. The demand in our entry-level communities continue to outperform our move-up stores. They not only sold at a much higher absorption pace than our move-up homes, but the margins were also slightly higher for the entry-level homes compared to move-up homes. As expected, just under half of our closes in the third quarter were from spec inventory. We're building mostly on a spec basis in most of our entry-level communities. Our third quarter's were 2% lower than last year's and our backlog was down 1% year-over-year, reflecting the recent softening in market demand. While this makes the short-term outlook less -- look less certain, we believe the long-term outlook for the housing market continues to be positive based on demographics and economic trends. Employment is high, wages are growing, consumer confidence is high and inventories of home are still low, especially for the affordable entry-level, single-family homes.

Our strategic shift anticipated slowing demand at the higher end of the market, and we've been pivoting to focus more on entry-level and more affordable first-time, move-up markets and have been purchasing land for these price points aggressively for the last couple of years. We believe that this is the right strategy for us, and we are confident that Meritage is well positioned for the long term as the market continues to shift that direction. However, the next several quarters may be choppy for our industry as buyers adjust their expectations for interest rates.

I'll now turn it over to Phillippe for some additional insights into our operational performance. Phillippe?

Thank you, Steve. I'll address our third quarter order trends as well as our outlook and plans at an operational level.

Slide 6. As others have reported already, market conditions have become more challenging over the last couple of months. We believe the third quarter order decline reflected a combination of normal seasonality, buyers hesitating as they digested the impact of higher home prices and interest rates and what they can afford and what they can expect in selling their existing homes. We saw that reflected in our overall order trends, which masked the positive impact that we'd otherwise be seeing from our shift to the entry-level market.

Despite the 2% decline in third quarter orders, we were encouraged that traffic and gross orders were both up year-over-year, though cancellations spiked at the end of the quarter. Our third quarter cancellation rate increased to 17% this year from 13% in 2017, indicating more buyers' uncertainty as well as an inability of some buyers to qualify at the lowest credit levels and delays in selling existing homes for move-up and move-down buyers. We also had some weather-related disruptions from Hurricane Florence in the Carolinas and unseasonably wet weather in Texas.

We expected to sell out of a number of communities during the quarter, which we didn't do. So our average active communities for the quarter of 2018 was up 2%, which was higher than we forecasted. The decline in orders and increase in average community count reduced our average orders per community, which was 7.1 this year compared to 7.4 in the third quarter last year. The slowing in move-up orders and higher volume cancellation masked the faster order pace per community from our higher absorption entry-level communities. We did see a decrease in our average sales price to approximately $391,000 compared to $408,000 a year ago as our entry-level communities became a greater portion of our volume and our California operations declined notably due to a limited community count.

Slide 7. Our East region orders were down 9% year-over-year in the third quarter after being up 12% last quarter. Slower sales were evident in the 14% decline in absorptions per store. Hurricane Florence was responsible for part of the declines in North and South Carolina as we lost about 2 weeks of activity due to the preparation and aftermath. Additionally, we saw few orders at move-up price points across the region, with a more broad-based slowing in Atlanta. With only about 1/4 of our communities based in the entry-level buyer in the East, we weren't able to offset declines in our move-up communities, with higher entry-level orders to the same effect as our other regions.

Slide 8. Moving to Slide 8, the central region continued to be our strongest performer. We've encountered some buyer resistance at higher price points in Dallas and to some degree in Houston more recently, but our Austin and San Antonio communities, which are predominantly entry level, continued to sell well as they are in the sweet spot of the market. Our 9% increase in order pace for the Central region more than offset a 2% decline in average community count compared to last year's third quarter.

Slide 9. Our orders in the West region were down 5% year-over-year, reflecting a 42% decline in our average community count in California and softening in the market from rising interest rates and affordability challenges. Despite a slight decline in our Arizona absorptions, we produced a higher -- highest orders per average community here for the quarter and we remain very positive due to our solid entry-level pricing as well as local demographics and economic trends. Colorado has been our highest absorption market in the company year-to-date. Our long-term outlook for the market remains very positive, though we saw an increase in cancellations in September, mostly at higher price points. We have recently introduced more affordable attached products and expect that these [dollar] performance from our new entry-level [flag] there.

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

Thank you, Phillippe. I'll provide some additional details on our P&L as well as covering the land and balance sheet metrics. Beginning on slide 10. Our home closing gross margin for the third quarter of 2018 was 18.1% and included a $2.6 million charge to write off assets associated with a purchase agreement in California that we entered into several years ago but decided to terminate since it wasn't consistent with our current strategy. The charge impacted our home closing margin by 30 bps, which otherwise would have been 18.4%, in line with our second quarter guidance.

This also impacted diluted EPS by approximately $0.05 per share. We did get some relief from lumber pricing that came down in the third quarter from the highly inflated levels we've seen for most of the year. That pickup will begin to benefit our closing margin at the tail end of this year and into 2019.

Total SG&A was relatively flat as a percentage of home closing revenue for the third quarter at 11% in 2018 compared to 10.9% in 2017. We incurred the charge to true-up our healthcare insurance reserves due to some rising costs and also decided to accelerate the reconfiguration of our move-up design studios and rollout of new technology for our entry-level sales centers. The total impact of these expenses on our SG&A was approximately 35 bps for the third quarter of 2018.

Our year-to-date net earnings are up 41% over last year and diluted EPS was up 45% year-over-year for the first 9 months of 2018, reflecting the higher closing volume, improved year-to-date gross margins and lower 2018 tax rate.

Turning to the balance sheet and cash flow items on Slide 11. Our net debt-to-cap ratio came down to 39.2% at September 30, 2018, from 41.4% at the end of 2017. We are comfortable dropping below our low 40s target as we evaluate the current positive market and may choose to either reinvest excess cash and land purchases as the market conditions stabilize or redeploy it into debt and equity repurchases if the recent pullback is more than temporary. We used $29.4 million of our $100 million share repurchase authorization to purchase and retire approximately 686,000 shares at an average price of $42.79 per share in the third quarter, and we're planning to repurchase additional shares this quarter. We expect to see the benefits to our EPS on a go-forward basis.

Total land and development spend was approximately $193 million in the third quarter of 2018 compared to $286 million in last year's third quarter. For the first 9 months of 2018, our total land and development spending is approximately $154 million the last year. We have terminated positions that are no longer aligned with our low price-point strategy and are being more conservative in our land underwriting, although we are still actively tying up lands that fits our strategy.

We added approximately 3,400 new lots under control during the quarter. 82% of the lots we've added under control year-to-date in 2018 were for entry-level homes. Our total lot supply at September 30 increased by approximately 1,100 lots year-over-year to about 34,400 lots. That translated to a 4.2-year supply based on trailing 12 month closings this year compared to 4.4-year supply at September 30, 2017. We owned about 66% of our total lot inventory, with the remainder under contract or option as of September 30, 2018.

Slide 12. Based on our softer orders in the third quarter in the first few weeks of October, we're adjusting our projection for full year 2018 home closings to approximately 8,300 to 8,500 homes, with total home closing revenue of roughly $3.375 billion to $3.475 billion. That's about 6% to 9% growth over 2017. We are also slightly adjusting our expectations for home closing gross margins to be about 18% for the full year compared to last year's 17.6% in anticipation of potential price pressures and reduced leverage. The net effect of those revisions reduces our pretax earnings expectations to roughly $265 million to $285 million for the full year. Our expected tax rate is expected to remain at 25% for the balance of 2018.

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

Thank you, Hilla. In summary, we are pleased with the earnings growth we delivered so far this year and believe we are well positioned in the market for the long term, with our focus on providing more affordable homes. We've been pivoting down in the price band for 2 years, and we believe this will be the best place to be as the market cycles, given the shortage of affordable single-family homes. Rising interest rates only intensify this shortage. We've been expecting interest rates to rise. We've had a 5% to 6% interest rate in mind as we evaluated new community positions. We're confident that our strategy is appropriate for these market dynamics and will serve us well over the long term.

Thank you for your support of Meritage Homes. We'll now open up for questions, and the operator will remind you of the instructions. Operator?

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

This is Elad on for Mike. You mentioned that 3Q cancellation rate increased, I think, to 17% versus 13% last year. Would you be able to provide that by month and where it ended the quarter?

No, we can't give that out by month, but within the quarter, it's 17%.

Okay. Was that a quarter-end number or is that for kind of the average over the quarter?

That's the average over the quarter, but it was probably a little higher than that in September.

Okay. Great. And then secondly, how did sales pace progress throughout the quarter? Maybe you could provide that on a month-to-month and then also just kind of year-on-year for those months. And what have you seen so far in October?

So without giving you specific numbers, I can tell you that July was weak. We started -- we had the 4th of July, which is in the middle of the week. A lot of people took off the entire week, so the first 2 weekends in July were pretty soft. But then in the later part of July, sales popped back. But for the whole month, we were down in our year-over-year comp. August was a good month. We had a double-digit increase in August from the prior year. But then in September things slowed down again, and we had a weaker September. We had more cancellations come in later in September. And October's been soft so far. So we still have another weekend left in October, but the first few weeks have been pretty soft. Our traffic has held up really well. Our traffic is in line with last year and even slightly up in some places. So it's not a question of whether people are interested in buying new homes. We believe that they are. We just think they're taking longer to make decisions and they're taking a bit of a pause to digest these higher prices and higher rates.

The next question comes from Stephen Kim with Evercore ISI.

On this cancellations issue, we typically like to look at it on a percentage of backlog because it's your backlog that cancels, not necessarily the orders you just took. And on that basis, your can rate as a percentage of backlog went up, but not very much. So I was wondering -- but obviously, your commentary suggested you did see something that was worth calling out. So I guess, I was wondering if you could put some perspective on what kinds of communities and what kinds of buyers were doing the canceling. Was this more higher-end folks with contingent sales? Was this more entry-level folks who had the rates move and just simply couldn't afford? Or if there's any other kind of qualitative perspective you can provide on the can rate?

It wasn't any one particular group, but I'd say it would tilt more towards the move-up people that were canceling that generally fell in the bucket of buyer's remorse. We didn't see a lot of people cancel because they couldn't qualify. We just -- from what we've heard from our backlog and our people we took -- we've talked to in exit survey when they canceled, it was -- they hadn't sold their home or they're concerned about the higher interest rate, what's it going to be versus the interest rate they have on their current home, and some of them just think, "Well, now's not a good time to buy." So -- and we didn't throw a lot of incentives at people to try to keep them in the backlog. So I think it's more of a psychological factor more than a qualification situation.

Okay. That's actually really important about the incentive comment, and that's actually where I was going to go next. So in general, we imagine builders move to pull the incentives lever first through the mortgage company and through increasing or giving away some options and so forth, so as to protect the ASP. You've been moving to a more standardized offering, obviously, recently with your strong pivot to the entry level. And I was curious as to whether you could comment on your decision maybe not to incentivize as much as you otherwise could have. Is that in part because it is more difficult to offer incentives in community -- entry-level communities where you have a more standardized product? Or was there a different element to your strategy that would have driven you to hold off incentivizing? And is there anything that you're contemplating right now, given what you've seen so far in October, that would cause you to make any shifts that we should know about?

Well, I'd say, first of all, I'd say we have increased our incentives primarily on spec homes that will close this year as most builders have done the same. And we've done that across the board, but we've had a stronger focus on increasing those incentives in 2 MU communities and communities that don't fit with our strategy. So we'd like to accelerate our shift to more entry level. And so those assets that don't -- that aren't quite in that niche, in that segment, we've offered more incentives. Although our incentives have increased a bit on the entry level, we're clearly feeling that market is better, and we don't feel like we have to give as much away to sell those homes.

Okay. So you don't have to incentivize as much?

Well, we have to give a little more incentive right now because the newspapers are reporting a lot of misinformation, but to that degree, certainly, there's more demand at the entry-level price point, so we don't have to give as much incentive there.

And Stephen, just to clarify, we're certainly offering incentives on Q4 possible closings on spec, and we're looking at every one of our communities, but there's no across-the-board massive discounting that we're giving, and thankfully, we're not really seeing other builders do the same. It's a targeted, strategic community-by-community review based on what's occurring in that market, and some are holding up very well and don't need additional incentives.

Yes. Just to underline that, I mean, it is market-by-market. We have certain markets that are -- require a lot less incentives and are much more stable than others. And I think it's been widely reported what those markets are. Certainly the higher price, less affordable markets are the most challenging of all the markets.

The next question will be from John Lovallo with Bank of America.

When you think about the first-time buyer, maybe a millennial specifically, I mean, do you think of this buyer as being kind of more need-based in nature, maybe having children or getting married, just kind of needing more space? And then on top of that, the fact that they don't need to sell a home, would you consider them to be somewhat less influenced by interest rates? In other words, if costs goes up a little bit, if rates go up a little bit or prices go up, maybe they buy less home, but they're going to buy a home. And if that's not how you guys feel, I mean, what would give you confidence with rates continuing to go up and no real relief on -- in supply on the near-term horizon, what will give you confidence that this buyer is going to remain strong?

Well, I think that's an accurate assessment, that they're not so much focused on the interest rate. They're focused on really what the payment is. And a lot of these millennials have been renting for a long time, for a lot -- for a longer period of time or living in their parents' home, for a longer period of time than the generation before them. And once they have children and they get married, they're going to move out to the suburbs and buy a home just like generations before them, but they're just going to have to buy that plan below. We have generally 6 to 8 plans in our lineup, and there's a reason we have that many because when interest rates are higher, they got to move down a plan or 2. And we have 4-bedroom plans at the smallest square footage just like we do at the largest square footage. So I think we move back-and-forth along that band based upon the interest rates.

Yes. That makes a tremendous amount of sense to me. Okay. And then you guys called out that the entry-level margins, I believe you called this out, the entry-level margins were slightly higher than that on the move-up, which was interesting to me. I mean, was this just better kind of efficiencies in the build process? Or was this partly due to higher incentives on the move-up product?

It's for a lot of reasons. I mean, some of those you mentioned, but probably most importantly is just the demand is stronger for that product. Which allows us or doesn't require us to do as much incentives, but it is more efficient for us to build. We're able to build it for a lower cost on a pound-for-pound basis. And our trade contractors like to build that better, and it's more efficient. And so for all those reasons, we're able to get a little bit better margin.

Our next question will be from Stephen East of Wells Fargo.

Yes, this is actually Paul Przybylski on for Steven. I guess, correct me if I'm wrong. but am I hearing it correctly, that you're still focused on price versus pace given your lack of incenting, I guess, your backlog and focus on just incentives on spec for the end of this year?

Well, I'd say certainly through the third quarter we were more focused on price than pace. As we rotate into the fourth quarter, we have to get pace. We still want to get price. We're not going to give the farm away, but we've got to get some pace. And so for that reason, we're increasing our incentives on spec homes that we can deliver this year and time's running out for that. We have a few weeks left, and then we're going to be selling into next year even if you buy a spec, we won't be able to have it finished in time. So just as all builders are doing, we're trying to finish off our year strong and get these homes that are done off the books.

Any color on what your gross margin is and backlog then versus what you recorded for the company this quarter?

I think it's pretty close to the same.

We're not expecting a deterioration throughout the year. Part of that is we have strong numbers coming into the quarter. We also have an incremental leverage in Q4 on higher volumes. If you kind of do the math and get to that 18-ish percent full-year guidance, the Q4 numbers have to come in a little bit at or a little bit better than what we get in Q3.

Okay. I guess, how long do you think it will take for you to completely move your offering base to entry-level and first move-up and then be completely done with second move-up in luxury?

Well, we're going to be about 35% right on target of communities that face the entry-level buyer. At the end of this year, we're going to be maybe another 10% higher or so. By the end of next year, they would be at 45%. Maybe with a little tailwind, we can be at 50% by the next year, but we're getting closer. And I think we'll be pretty much out of most of the 2 MU by the end of next year. We'll have a few stragglers, of course, so going into '20 but it'll become more of an irrelevant number as we get later into '19. And then when we think about the 1 MU market, we're really looking at all our land positions in the -- and the -- on the contracts on the land that we have tied up and really trying to focus on the 1 MU communities that are really more affordable at -- in the lower end of that bracket and that are really the more desirable 1 MU projects.

Our next question will be from Nishu Sood with Deutsche Bank.

This is actually Tim Daley on for Nishu. So my first question is -- this quarter saw the first share buybacks done in several years, so -- and it clearly was telegraphed with the discussion on the last call following the authorization. But just thinking about it, Steve, how should we interpret this move and then the statement in the press release and the prepared remarks regarding buybacks? Is this going to be more of a structured program or is -- are you going to be kind of attacking buybacks as a more opportunistic, I guess, style there?

Well, I think it's sort of both. It's structured for now. Certainly at these prices, it's attractive to us. We have a $100 million authorization, and we're going to continue to execute on that. And then as we go into next year, we'll see where we are. We have a Board meeting coming up in November. We'll certainly be talking about it there. But we actually had to stop buying back stock when we went into our blackout period, which was September 15. So all of the shares we bought were prior to September 15. And clearly, the prices are lower since then, and we'll get back into the market here as soon as we can.

Understood. Thanks for the color. I guess, and then the second question. So Hilla, you mentioned the headwind to SG&A this quarter from the reconfiguration of the move-up design centers as well as the improvement in the -- I guess it -- I think it was the technology in the entry-level sales centers. So could you just provide a bit more color on these changes? And then as well, if you can, some -- any kind of benefit or reversal of that headwind that I guess you guys quantified for us this quarter?

Sure. So I think we've talked about it previously that we're doing a change-up in how we sell options at the first time move-up. So there's some physical and technology changes that we need to do in order to get that new profit up and rolling. So that is underway. We have a couple of divisions already completed and we're rolling through the rest of the country. That cost will continue on, although at a more mitigated level going into '19. We're pretty much done with the rollout of our new sales process, the new technology upgrades in our entry-level communities, so that's behind us. I do think we're going to be able to see some additional leveraging of SG&A into Q4 and then rolling into 2019.

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

So if I look at Slide 11, I'm calculating your specs are up about 3% year-over-year and completed specs are up almost 50%, which I know a lot of that has to do with the shift to entry-level, but with your absorptions down a little bit here, it still seems like a really big increase. And Steve, I know you alluded to maybe increasing the incentives a little bit in October to get some year-end sales here. But reading between the lines, it doesn't sound like you had a big step-up in sales pace in October. So at what point does that number become concerning to you? And are you doing anything, either adjusting the construction start schedules or something else just to kind of really target that number? Or is it at an optimal level, in your opinion, even with that increase?

Well, as you know, Alan, we can do something really simple to have a big impact on that. We just don't start any new specs.

Right, so that's what I was getting at there. Is that something that you're really adjusting right now?

Oh, absolutely. I mean, we're not doing this in a vacuum. I mean, we're looking at that every week, every month. So I can promise you there won't be a lot of specs started in October in non-entry-level communities. So yes, we're very focused on managing that number. We think we have the appropriate amount. Maybe have a little too much here and not enough there, but it's a strategy we feel comfortable with. And we have inventory to close -- to sell that we can close this year and it could have an impact on the bottom line and we're comfortable with that. You know our conversion rate has steadily risen. And you know those builders that have a stronger presence at the entry-level like Horton and Lennar has a significantly higher conversion rate than we have, even though ours have moved up quite a bit versus some of our move-up peers and that's because that's the way you have to sell those homes to that buyer segment. And with interest rates continuing to rise, I don't think a lot of buyers are going to be excited about waiting 6 months for a new home that they'd like to move in right away. So I think this strategy will benefit us over the long term.

And then, Alan, just to clarify. The number of specs we have targeted for each community at the entry-level space is a function of a month's supply of sales. So if sales are ticking down, naturally our calendar for when to start new specs is going to tick down with it. So we're monitoring that with every week's new starts.

So, Hilla, that obviously impacts the new specs that are put on the ground, but I guess, just on the sale side, how -- we hear from some other builders, dynamic pricing, adjusting pricing every day based on the sales pace. How aggressive would you say you are in actually adjusting that pricing mechanism in order to keep that spec level optimal? Because you start -- changing your starts is going to take a little bit of a while to actually flow through the system there.

For sure. That's a fair point. I think as Steve mentioned before, the specs that can close in Q4 have the most aggressive incentive in the company currently. We're certainly looking to close out the year as strong as possible. And specs that are just natural specs and will close out in Q1, we're monitoring on a community-by-community basis.

Okay. I appreciate that. And second question if I could. With the shift to entry-level, I'm curious if you've run any analysis on your backlog, on your closings, et cetera. Just kind of trying to get at the sensitivity of your buyers to further moves in rates because obviously, these buyers are going to be a little bit more prone to affordability issues if there are some, I would imagine. So, have you stress tested your closings or backlog to determine what the fallout might be if rates were to go up another 50, 100 basis points, let's say, based on the current income profiles?

We're doing that right now. We're actually looking at new communities that we have in the pipeline compared to communities that we've been selling in to look at those buyers to see if they can afford a higher interest rate. And we're doing that on a -- just right now, as we speak, and we don't have all that data back yet. But we do believe overall that the people that are buying our homes today both in the entry-level segment and in the move-up segment are under leveraged compared to past cycles, and they could, if they chose, spend more money on their housing in the form of a higher payment if they wanted to. Within the last cycle, which you know 10 years ago, we still remember vividly, buyers were completely stressed, and they had really high ETIs and they had no room at all to afford a higher payment. But I think it's different this time, and we're keeping a close eye on that.

And Alan, just one more question.

Hey, Steve. Sorry, guys, it's Ivy. Just want to jump in there, Steve. If you can tell us in your affordable product offering what percent of those buyers are utilizing FHA lending criteria?

I can tell you that. Hilla, you have that?

Yes, I think it's about 17%. So It's not as much as you think, actually. So they're utilizing it where they can, but they're not -- that's not the only buyer target that -- or the buyer cohort that we're attracting into that pool. And just to clarify 1 more point, as we're looking at incentives, it's not always incentive dollars off the top. Alan, to your point, if we're finding that the stress is the ability to qualify with the interest rates, rate buydowns are certainly another lever we can pull in the type of incentives that we're offering this customer.

The next question will be from Susan Maklari with Crédit Suisse.

My first question is around -- you made significant progress in the East region, continuing to close the gap there from a margin perspective. I guess, how much more is there that you can realize? And does any of the current demand or the expected sort of demand trends change the trajectory of that?

Well, I can't quantify for you precisely how much more there is, but I can tell you there is significantly more in both margin and absorption, particularly in our 5 divisions in the South. And certainly, the demand situation there is no different than the rest of the country, although it's better than high-priced markets like California and Colorado. I'd say we're probably seeing a little bit more, a little more challenges in the Atlanta than we are in some of the other markets. Florida continues to feel pretty good. We're not in South Florida in a meaningful way. We hear the incentives are bigger down there, but they seem to be manageable in Tampa and Orlando, but we still have a lot of opportunity to improve our business in the East region and we're very focused on that.

Sorry, just a quick correction. So we're under 20% FHA buyer total. For the entry-level, it ticks a little bit higher than that. It's in the 20s, 30s depending on the division.

Okay. And then my second question is just around -- you mentioned in your remarks that you are taking a more conservative approach to your land underwriting. Can you just give us a little bit more color around that?

I mean, I think we're putting a higher emphasis on option deals and deals that require more capital. Maybe they run out longer or we're shying away from a little bit. We're probably ratcheting up our margin and ROA requirement on some deals in certain markets. Certainly, we're thinking about some of the incentives that are out there today in the fourth quarter and how those impact the pricing of our product and how they impact the margins and velocity of the deals that we have under contract and that we're looking at to purchase. So, we're taking a more conservative approach. We also want to bring our land spend down next year because we want to have liquidity available to pay down debt as we go into '20 and to buy back stock and potentially do other things. So we're just being more conservative on what we're buying and committing to.

The next question comes from Jade Rahmani with KBW.

This is actually Ryan Tomasello on for Jade. Just piggybacking off of the land question, I was wondering if you're seeing any changes in that market based on maybe competition or pricing that you're seeing, notwithstanding your underwriting.

Not yet.

And does that vary from market-to-market or any other color you can give there on a market basis?

I'd say it's across the board. There hasn't been any really change in any markets that's notable.

Okay. And then just given the near-term expected pressures on pricing and margins, I was wondering if you can give your updated thoughts on off-site solutions in terms of preconstruction fabrication for various aspects of the home construction process?

There's a lot of things going on out there in that area, a lot of talk, a lot of great ideas, but nothing's really come to fruition yet that we think is going to give that paradigm shift. We really believe that the opportunity is really more in precutting and panelizing houses, the framing area. If we can get to a place where we could precut -- have drywall precut and other items that go into a home precut, it'd eliminate waste and labor. We still think we're a long way from a completely modulized, component-ized home that's built in a factory and delivered to the job site. We don't -- I don't see that happening in the next few years. So we're keeping our eyes open. And we're also really focused on how we can make the sales process more efficient and how we can reduce our marketing cost and deliver a more technology-based, efficient process to the customer's purchase of a new home and the sale of their existing home.

The next question will be from Carl Reichardt with BTIG.

You answered my land spend question. But I wanted to ask you about the move-up lots. I think we're looking at, not too long ago, 15% to 20% of lots under control that were really designed for second time move-up. I just want to make sure I'm right in thinking that your expectation is to clear through those lots in the course of the next sort of 12 to 18 months, maybe 12 to 24 months. And so I'm curious. I know you're not giving guidance on '19, but what's your expectation on how that might impact margins if business continues to be slowish in that particular price point next year?

We'll tell you next quarter. It's too early to tell.

Okay. But just to clarify. I'm right that the process here is it's 15% to 20% of controlled lots. And the idea is that you want to work through them ASAP through that period?

Yes.

The next question will be from Scott Schrier with Citi.

Last quarter you talked about margin in the west improving due to pushing price in Arizona pretty hard. Now it looks like your community count's up there. ASP is down. I'm curious what the like-for-like pricing in Arizona might be and what you're now thinking in terms of the margin trajectory from [LS] in Arizona?

I mean, again, as I said earlier, I'm not going to give any margin guidance right now. I mean, we are -- we have increased our margins on our specs across the country, even in Arizona, but Arizona continues to be relatively strong. And we're getting a lot of action particularly on our entry-level communities in Arizona, which we have quite a few. I'd also say that one of our challenges has been, as you saw, our community count in California has dropped substantially over the last year. We expect that to start going the other direction in Q4. And we're opening quite a few communities in California and most of them are at the entry-level price point. So we think we're going to be able to deliver some desirable, affordable homes in California to satisfy the market out there. And I think, hopefully, over the Q4 and into Q1, that will help our -- rebalance our West Coast position.

We don't provide guidance by state, but look early next week for the filing of the 10-Q, and then you can see that margin by region.

Great. And then if I think about Texas, obviously, really strong absorptions there. Community count did a little bit. But when you're looking at your land spend, I mean, are you still looking to ramp up that community count in Texas?

Modestly so. I mean, we're -- our eyes are open to continue to grow our entry-level business there. We have a very strong entry-level business in Austin and San Antonio, a little less so in Houston. We want to get deeper down the price band in Houston, but definitely Dallas is the place where we're too much oriented on the move-up side of the business and we need to get down market and we're really focused on doing that. We have a lot of entry-level communities opening there that we've been working on for the last year to 18 months.

The next question is from James McCanless with Wedbush.

The first question I had. When we look at the inventories of existing homes for sale in several of the markets Meritage operates, we've seen inventories moving up on both a year-over-year basis, and we're seeing a sequential increase in periods where you should be seeing sequential decreases. Can you talk about what type of activity you're seeing along those lines in the field? And has that had an outsized negative impact on your move-up business? Is that the reason maybe that you're seeing a pickup in the cancellation rate on the move-up side?

Well, clearly, when there's less buyers, the inventory level calculation rises, right? So there's less people buying move-up homes today, whether it's used homes or new homes, because of the higher interest rates. A move-up home is more of a choice. It's more of an elective decision. Entry-level home is more of a need. And people are looking at their existing home and they're saying, well, I got a 3.5% or 4% interest rate here. Should I buy this new home and -- at a 5% rate and a higher price? And they're -- some are electing to stay put. And so that's not a news flash. That's what we've been talking about -- people have been talking about certainly over the summer and even in previous quarters. So that's why we're making the shift to the entry-level market and why we think that part of the market's going to do better.

And the second question to follow on that. Are you seeing any markets now where land prices are starting to come down either sequentially or on a year-over-year basis? And if so, does that maybe open up an opportunity for you guys to make an acquisition and accelerate that shift into entry-level?

No, we hit that before. We haven't seen any change in the land sellers' disposition across the country in any markets. That may change over the next couple quarters, but at the moment, nothing's really changed.

At this time, we have one further question in the question queue and that question comes from Alex Barrón with Housing Research Center.

I was wondering if you could comment on what form of incentives you feel have worked best for you so far. Is it like raising broker commissions or rate buydowns or offering more for closing costs or even cutting prices; anything that you feel is working right now?

Well, traditionally, when you're selling more build-to-suits, we offer incentives that people can use a design center. But now as we shifted to selling more spec homes, particularly in the fourth quarter, it's generally around closing costs and rate buydowns and just lowering the price, and a combination of the 3. We have not offered a lot of increased commissions. Some of our competitors use that strategy occasionally. We do it on a very limited basis. Not sure how effective it is. But we're using the kind of same toolkit of incentives that we've used before. Nothing's really changed.

Got it. And just to confirm -- so, it sounds like you guys are starting to reduce spec more in the move-up, but in the entry-level you're still doing the same spec starts?

That's correct. But we monitor on a weekly and monthly basis and if we don't sell a lot of houses this month in a certain community, we're not going to start as many spec homes next month. And it's really determined based upon what the sales activity is.

Okay, makes sense.

Okay, thanks, Alex. Is that our last call? I think that's our last question, so I appreciate everybody's participation in our call this quarter, and we'll look forward to talking to you again early February on our year-end results. Thank you very much.

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