Meritage Homes Corp (MTH) 2018 Q4 法說會逐字稿

Good morning, and welcome to the Meritage Homes Fourth 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, Danielle. Good morning, and welcome to our analyst call to discuss our fourth quarter and full year 2018 results. We issued the press release after the market closed yesterday, and you can find it and the slides that we'll be referring to during this call on our website at investors.meritagehomes.com, or select the Investor Relations link at the bottom of our homepage.

I'll refer you to Slide 2 and remind you that our statements during this call as well as the press release and slides contain forward-looking statements, including projections for the first quarter of 2019 operating metrics, such as order trend, closing, revenue, margins. Those and any other projections represent the current opinions of management, which are subject to change at any time and we assume no obligation to update them.

Any forward-looking statements are inherently uncertain and actual results may be materially different than our expectations. We'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 Securities and Exchange Commission, specifically our 2017 annual report on Form 10-K and most recent 10-Q for the third quarter of 2018, which contain a more detailed discussion of the risks.

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

With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage Homes; Hilla Sferruzza, our 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 about -- approximately 1 hour afterwards and remain active for approximately 2 weeks.

I'll now turn the call over to Mr. Hilton to review our fourth quarter and full year results. Steve?

Thank you, Brent, and welcome to everyone participating on our call today. I'll begin on Slide 4. We are pleased to report our full year results and strong earnings growth despite soft fourth quarter sales.

The first half of the year was good, followed by a choppy third quarter and a slower fourth quarter. Even so, we met or exceeded the expectations we shared in our guidance at the beginning of 2018.

For the full year, our total home closings were up 11% year-over-year. We expanded our gross margin by 60 bps over 2017 despite continued cost pressures and the lack of pricing power in the last half of the year as we are beginning to realize more operating efficiencies.

Earnings grew 14% before taxes and 59% after taxes, due to a lower tax rate. And our diluted EPS was 64% -- up 64% for the year after a reduction in our diluted share count from the repurchase program we completed in the fourth quarter.

We repurchased and retired about 2.6 million shares -- $100 million in total, at an average price of $38.71 per share, which was a good value considering our book value per share is now $45.20.

We also strengthened our balance sheet during the year, ending the year with $141 million more cash than we had at year-end 2017, and increased our stockholder's equity by 9% even after the share repurchases.

The net result is that we reduced our leverage in terms of both debt-to-capital and net debt-to-capital ratios.

Turning to Slide 5. Homebuilding activities slowed in the later part of the year which comes as no surprise to anyone who follows the industry. We noted back in October when we reported our third quarter results that the market had softened, especially among new buyers who seemed to be pausing before committing to a home purchase.

That continued through the end of the year so the near-term outlook is unclear. However, despite slower sales and an increase in cancellations during the fourth quarter, our total orders for the year were up 2% over 2017.

I'll note that our January orders are running slightly ahead of last year's, but we wouldn't read too much into that yet. Considering the price sensitivity of buyers, we're adjusting incentives as needed to maintain a pace that effectively leverages our overhead.

The margin improvements we're achieving are due to operational efficiencies rather than holding onto prices. We remain confident in long-term opportunities for the home building industry, considering the underlying drivers for housing demand remained strong. Economic growth, household formations and more jobs at higher incomes, strong consumer confidence, combined with relatively low inventories in homes for sale and the prospect of interest rates stabilizing should continue to drive demand.

With that as a backdrop in mind, we will defer sharing our projections for the full year of 2019 until we report next quarter, after we can more adequately assess market conditions with the benefit of the Spring selling season.

Turning to Slide 6. I'm pleased with our progress towards strategically repositioning our product to focus on the first-time and first move-up buyers as we believe they are the largest and most active sectors of the housing market today and will be for many years to come.

As we already had a large first move-up business, we've been actively growing our presence in the entry-level market, and have acquired a significant new lands divisions targeted at those buyers over the last couple of years.

85% of the new lots we put under control in 2018 were for entry-level homes, and about 1/3 of our active communities were classified as entry-level as of year-end 2018.

These communities made up 41% of our orders in 2018 since they're selling at a faster pace than our move-up homes. Our orders for entry-level homes grew about 25% in 2018 while first move-up was flat and second move-up and others decreased by 35%. That's a significant shift from our traditional business, which was about 75% move-up homes just a couple of years ago, including first and second move-up and beyond.

But our strategy goes far beyond simply purchasing less expensive lots. We redesigned our homes to make them more affordable while still including the standard Meritage features like our high energy-efficiency and M Connected smart home suite, along with upgraded finishes and appliances to appeal to a broader range of buyers who are looking for more than just a basic no-frills starter home.

We've simplified and streamlined our construction sales process to better serve our customers and to make it easier for our trades and suppliers to work with us. We believe this strategy provides for a more efficient cost structure due to a less complex homes, fewer plans and variations or SKUs, and starting more homes on a spec basis so that our trade partners can be more efficient.

It also enables buyers to move into their homes quicker: 56% of our closings in the fourth quarter were from specs, compared to 47% a year ago, and our backlog conversion rate hit a 6-year high at 76%, compared to 68% in the fourth quarter of 2017.

We're also beginning to capture efficiencies in the back office as a result of simplifying and streamlining, which will help us reduce overhead costs and improve our SG&A leverage in the future after incurring start-up costs in 2018 related to the strategic conversion.

I'll turn it over to Phillippe to discuss our sales trends in more detail by market. Phillippe?

Thank you, Steve and good morning. Slide 8. I will begin by recognizing the tremendous effort of our teams to complete and close over 2,500 homes in the fourth quarter. That's the most homes we've closed in a single quarter going all the way back to 2006, and an 11% increase over the fourth quarter of 2017.

We are proud of the accomplishments and the differences that they made in those 2,500 families' lives. We're also proud to report that our customer satisfaction scores, as measured by total home buying experience reported by Avid, were up again in 2018 and remain among the best in the industry.

We invest a lot of energy and money to deliver a positive home buying experience, and buyers are obviously happy with the overall experience in addition to getting beautiful new homes for their families.

Slide 9. It's no secret that the fourth quarter was a more challenging selling environment than what we've seen for many years, especially in October, which was down 20% compared to the fourth quarter of 2017, while November was up 1% year-over-year and December was just 4% lower than 2017, which was unusually strong.

After seeing home prices increase further through early 2018 and then during several rounds of interest rate hikes, buyers paused to reassess what whether this was the right time for them to purchase a new home.

For some, that was an issue of affordability, but for most, it was a psychological reaction to price levels in an uncertain market. This was most apparent in California, Colorado and Dallas, where prices have risen the most in the past few years.

Our traffic levels remain healthy and even our gross sales were relatively consistent with the fourth quarter of 2017, indicating consumers are still interested in becoming homeowners, but we saw an increase in cancellations that reduced our net sales.

That also meant that we didn't close out of communities as soon as we expected to, so our absorption pace was off even more significantly than our order numbers. Orders were off 8% year-over-year for the fourth quarter, but absorptions on average per community were 15% lower, due to the distortion from these near close-out communities.

As we close out those communities in 2019, we would expect our total community count to decline somewhat through the year. The slowdown was most pronounced with higher-priced homes in [newer communities] where buyers were nervous about selling their existing homes and stepping into a new home at a potentially higher mortgage rate.

With our mix shifting more towards lower-priced homes, the total value of orders in the fourth quarter was 15% lower than a year ago. While it was a broad-based slowing in the market overall, there was significant differences between markets. A few of the hottest markets last year fell back to more normal absorption pace while others remained relatively steady, which I will cover shortly.

With most uncertainty comes more competition, and we must excel at delivering what our customers want, which is a quality home at a good value. As we adjust to changing conditions, we are focused on improving our overall execution at every level.

I'll discuss our projects -- progress in each region and provide a little more local color, beginning with the East region on Slide 10. Slide 10. After a 47

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year-over-year increase in the fourth quarter of 27 (sic) [2017], our East region orders were 5% lower in 2018 and 6% less in total order value.

This was primarily due to a 19% lower absorption pace for the region. Florida accounted for most of the year-over-year decline in the fourth quarter of 2018 since the fourth quarter of 2017 includes orders that had been delayed due to the hurricane in September but rebounded in the fourth quarter.

That made for a difficult comparison in 2018. Outside of Florida, total orders for the East region were flat in the fourth quarter, though Tennessee's absorption has softened more than others. Overall, the region's slow -- showed solid growth for the full year.

We are confident in our product and location and believe we have opportunities to continue to improve our sales execution and reduce our cost and cycle times, expand our margin and get our performance metrics up to levels we're achieving in our other regions. We're focused on continuing to make these improvements across the board.

Slide 11, central region. Moving to Texas, the word I would use to describe it is generally -- in general, is steady. Orders increased 2% on flat absorptions year-over-year. Austin, San Antonio and Houston continued to perform well.

We still have quite a few second move-up communities in Dallas, but we have recently begun opening more LiVE. NOW. communities, which are seeing good demand.

Slide 12, West region. Our West region orders were down 19% year-over-year for the fourth quarter, as declines in California and Colorado offset strengths in Arizona. Arizona's fourth quarter orders were 12% higher than 2017, reflecting strong demand for entry-level communities here, and we believe that spells great growth potential for the next decade.

As most of you are aware, the California housing market chilled towards the end of last year after producing among the highest absorptions in the company over most of the last 7 years, as interest rates increase had a greater impact due to the higher average prices there.

On top of these industry-level issues, our average community count was down 30% year-over-year in California, resulting in a 56% order decline. We're rebuilding our positions in California with more affordably-priced communities that should experience higher absorptions.

Colorado's orders were down 10% year-over-year in the fourth quarter, as higher interest rates made high-priced homes unaffordable. It remains a strong market and we believe we are well-positioned there after opening many new affordable and well-located entry-level communities.

I'll now -- turning to Slide 11, direct cost savings. Finally, I would like to take a moment and address our direct cost trends, specifically lumber, which was a big concern in the first half of 2018 and something I think we've managed well in the back half.

The savings we're capturing will help offset the impact of increased incentives in 2019. Overall, most components we purchase have remained steady and consistent in price or dropped slightly over the last 90 days.

There are a few specialty lumber components in the West that have increased, but those increases are minimal. Since the market began to decline in August of 2018, we have recaptured all of the previous lumber cost increases from January through July. The bulk of these cost reductions were negotiated in Q4, but the first closings to benefit from those cost savings will be in the first quarter of 2019 and should continue through the remainder of the year.

I will now hand it over to Hilla to review some additional details regarding our financial performance and our balance sheet. Hilla?

Thank you, Phillippe. I'll cover our fourth quarter results in a little more detail and highlight the strength of our balance sheet, which has always been a primary focus for us and is even more important now if you're uncertain about the near-term outlook for the housing market.

Slide 14. We generated strong earnings growth in the fourth quarter and for the full year of 2018 despite the tougher market conditions over the last couple of quarters. Our net earnings of $75.5 million, or $1.91 per diluted share, for the fourth quarter of 2018 more than doubled the prior year's fourth quarter net earnings of $35.6 million and diluted EPS of $0.87. The 112% increase in net earnings and 120% increase in diluted earnings per share in the fourth quarter resulted from 11% growth in home closings, translating to an 8% increase in revenue with an 80 bps improvement in home closing gross margin.

Net earnings benefited from our lower tax rate and the share repurchases accounted for $0.05 of the increase in our diluted EPS for the quarter due to lower dilution. We were able to offset the negative impact of the higher lumber costs that flowed through our fourth quarter closings through a combination of cost reductions in other areas, home price increases taken earlier in 2018 and the favorable mix shift towards entry-level, which has a higher average profit margin.

We lost some overhead leverage as closings were lower than we had initially anticipated due to slower sales in the fourth quarter, but when we held SG&A just 10.6% of home closing revenue in the fourth quarter of 2018 compared to 10.4% in the fourth quarter of 2017.

After year-end, we made some personnel reductions to properly size the organization for current market conditions and eliminated manual or redundant processes as a result of streamlining and simplifying our business. We recorded a charge in the first quarter of 2019 for these reductions, but expect to experience lower costs for the remainder of the year due to these actions.

Land profit swung from positive $2.9 million in the fourth quarter of 2017 to an $825,000 loss in 2018, which includes $2.2 million of land impairments.

Our effective tax rate was 18% for the fourth quarter of 2018 compared to 58% in the fourth quarter of 2017. We incurred a charge in the fourth quarter of '17 for the revaluation of our deferred tax asset as a result of the lower tax rate enacted under the Tax Cuts and Jobs Act of 2017. Without that charge, the tax rate was 34% for the fourth quarter of '17.

Our tax rate for the fourth quarter of 2018 was lower than the expected corporate blended rate of 24% to 25% primarily due to 2 factors: first, the additional tax credit from 2015 through 2017 closings after a re-audit of our energy efficiency qualifications; and second, a favorable adjustment from the true-up of our DTA evaluation.

Our lower effective tax rate compared to our peer groups is sometimes overlooked, but we want to emphasize that it is the direct result of the way that we design and build homes as well as the diligence of our team to pursue the associated energy tax credits we earn. I commend them for their work and the result.

After repurchasing approximately 2.6 million shares of our outstanding stock with the $100 million authorized by our board in the third quarter of '18, our diluted share count for the fourth quarter was reduced to approximately 39.6 million shares, compared to 41.1 million shares in the fourth quarter of 2017.

The full impact of the repurchases will be recognized in 2019 and beyond.

Slide 15. We ended the quarter with approximately $311 million of cash and nothing drawn against our revolving credit facility. The $141 million increase in cash over 2017 was the result of $262 million positive cash flow from operations partially offset by the $100 million share repurchase.

We expected to be cash flow positive in 2019, but to have gotten down 27 -- 2018 is significant, especially considering that we maintained our lot supply, and returned $100 million to our shareholders.

As a result, we reduced our net debt-to-cap ratio to 36.7 by December 31, 2018, compared to 41.4 at the end of 2017. We secured approximately 10,300 new lots in total during 2018, maintaining our lot supply consistent with 2017, but spent $209 million less on land and development in '18 than we did in '17 due to negotiated land purchase terms and less expensive lots to supply our entry-level business.

We expect to spend about the same amount on total land and development in 2019 as we did in 2018. We ended the year with approximately 34,600 lots or a 4.1 year supply of land, compared to 34,300 lots or 4.5 years' supply of land a year ago. 85% of the newly controlled lots from our 2018 acquisitions are for entry-level community.

We ended the year with 2,507 specs completed or under construction, which was approximately 9.2 specs per community, compared to 2,086 specs, an average of 8.5 per community a year ago, though our Q4 per-store count was slightly lower than our third quarter '18, and we pared back spec starts based on market conditions.

Approximately 32% of our total specs were completed as of December of 2018, in line with 31% under December of 2017.

Slide 16. Considering that our backlog entering 2019 was 16% lower than our backlog entering 2018 and 18% lower in total value due to our reduction in our ASPs, our expectation for first quarter closings and revenue reflect these lower starting points.

We expect to deliver between 1,500 and 1,625 home closings in the first quarter of 2019, with an ASP of approximately $400,000 and home closing gross margin 50 to 75 bps lower than the first quarter of 2018 in anticipation of additional price incentives.

As Steve noted, we currently anticipate providing full-year guidance when we report our first quarter 2019 results.

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

Thank you, Hilla. In summary, we are pleased with our 2018 results, despite the slowing market in the latter part of the year, and we are confident in our strategy focused on entry-level and first move-up market and simplify our operations to make us more competitive.

We are encouraged by the fact that demand for entry-level homes and our LiVE. NOW. homes remains stronger than the higher-end of the market, which we are reducing in favor of more entry-level focus. We are dedicated to our brand promise of delivering a life built better for all of our customers, and we continue to innovate and focus on customer satisfaction, which we expect to drive additional growth and shareholder value. Thank you for your support in Meritage Homes.

Operator, we'll now open it up for questions. The operator will remind you of the instructions.

(Operator Instructions) The next question comes from John Lovallo of Bank of America.

First question is, you guys mentioned incentive activity picking up, that's pretty consistent with what we've heard from everybody else, I mean through October, November and December. I guess the question is, as we kind of went into January, did you see any ability to kind of rein back on some of the incentives? And how are you kind of thinking about things heading into the Spring?

So we did pull back our incentives on our specs from the fourth quarter as we entered January, but we did have a very successful promotion last weekend where we offered some incentives, some additional incentives, on specs and it seemed to work out well for us. I would say the incentives are -- for entry-level homes -- are probably around $5,000 or less. For move-up homes, they're maybe around $8,000 to $12,000. As Phillippe talked about earlier, we are going to be -- going into this year with some lower costs, that we got some money back from lumber, probably at an average of about $2,500 a house, and so we think the net impact will be minimal because of additional leverage we're going to get from these additional sales. I would say we did get some color that we think our orders are going to be pretty good in January. I'll give you a little more color on that. But the month is not over yet so we haven't tabulated all of the orders. But from what we can see right now, we think we're going to be up in January at least 5%. That said, February and March are going to be much tougher comps for us and it's still too early to tell what we can do against those comps for the rest of the quarter.

Okay, that's really helpful. And then going back to the 56% of closings that were attributable to spec. That's a very solid improvement in our view. Where could that number trend over the near term? And where is maybe the target level for you guys, if there is a target?

We don't have a specific target, but some of our bigger brethren who are more focused on the entry-level market, are 80% or higher. So we definitely believe that we have more opportunity to increase that as a percentage, which will increase our conversion ratio and reduce our cycle times.

The next question comes from Nishu Sood with Deutsche Bank.

I wanted to ask about the kind of monthly cadence over the last couple of months. Obviously, there's been a lot of interest in that. Your -- the weakness in October followed by the rebound in November, December is a little different than peers. I think that generally what folks have perceived is that there was weakness that accelerated into November and then some stabilization for some folks in December and January. What might explain that? And I know, obviously, there can be a lot of volatility in these monthly numbers and -- or is there some timing of promotions or availability of inventory or community openings that might have influenced the difference in your trend versus the kind of general trend out there?

Well, as you already articulated, there's a lot of variables that go into the year-over-year monthly comps, and that's why we don't really release those numbers every month, but we release them quarterly. But we do talk about it, we look back, and it does reflect communities opening, it reflects promotions, reacting to the market, specific geographies. But as far as our numbers, our October last year was down 20%, November was up 1% for us and then December was down 4%, and the cumulative of all that, as we already stated, was negative 8% for the quarter. But again, the month-over-month numbers, I don't think are really that meaningful because there's a lot of variables that go into that.

Got you. Okay. And then kind of continuing on that line, other folks have been talking about traffic picking up in December and January, don't read too much into that. You folks are seeing an increase in sign-ups and orders year-over-year in January, but you're still saying not to read too much into that. I think you addressed it somewhat, that the comps get a lot tougher. But yes, I just wanted to revisit that, I mean, it would seem to be, obviously, a much more positive indicator to have plus 5% orders in January versus simply traffic trends. So yes, just wanted to kind of get some further thoughts on that, please.

I mean, I don't know how much more I can say, the traffic has been pretty good this year for the first month of the year. It's just a function of being able to convert that traffic. Clearly, there's a difference between entry-level traffic and move-up traffic. The move-up traffic is taking its time making that decision. But I want to say that we're not going to, like -- there's a lot of discussion from some of our peers who have already announced -- maybe that were a month earlier in their quarter-end -- about pace over price, and we're not going to secede market share to them, and we're going to be focusing on pace over price as well. I think we've demonstrated that in January. We are cognizant about our margin, and we're going to be smart about it because our margins are a little bit lower than some of those peers, and we have to be sensitive to that, but the leverage of our overhead is really, really important, and we need to sell homes to be able to effectively drive the strategy that we're focused on here.

The next question comes from Stephen East of Wells Fargo.

Steve, you've been talking a little bit about what's going on with pace versus price, et cetera, and that's really helpful to us. I guess a few things around the gross margin: one, could you talk what the difference is between finished spec gross margin and your unfinished since you carry about 1/3 for your specs as finished? And then, you all beat pretty significantly on your gross margin. You were about 60 bps higher than last quarter, and yet last quarter you said you thought that the gross margin and the backlog was similar. So trying to understand what that driver was or that big beat and is that repeatable as we go through the first quarter?

I mean, I would just say that -- I'll let Hilla jump on this one -- that in our entry-level segment, pretty much all we sell is specs, so there is no difference between specs and builds, because our strategy for entry-level is to exclusively sell specs; we believe that's what those clients want, and that's what our competition is doing and that's how we have to compete. So comparing margins for entry-level specs versus move-up specs -- clearly, within the move-up segment, we're trying to get out of our 2MU segment. We have 15% of our communities which are in 2MU. And we're going to be probably more aggressive this year than we were last year to price that product to move, and that is going to result in lower margins. But at the same time, the entry-level communities that we're -- we've been opening and we continue to open in the entry-level segment, the margins are good. We did fall a little -- this is probably more information than you asked me for -- but we did fall a little bit short in the number of entry-level communities -- or the percentage level of the entry-level communities of the total for the year. We're at 33%, we expected to be at 35% to 40%. But we did hit our goal of opening 90 -- of having 90 entry-level communities, but the challenge was some of the move-up communities didn't close out as quickly, which swelled our community count and drove that percentage down. I would say that as we go into 2019, we expect to get that number from 90 up to about 115 communities at the end of the year, and as I said earlier, those communities are higher absorptions and, for the most part, better margins.

Yes, just to tack on a little bit on that on the margin side -- you'll see this when our K comes out in a couple of weeks -- but if you're looking across our regions, the reason why our margins improved, Texas held pretty steady, the West improved notably, as did the East, and that's really just -- for the West, it's a story of the entry-level product. It just had a better margin and it was a larger portion of the pie for the West. In the East, all of these improvements that we've been working on are finally coming through so I think that we weren't sure on the composition of the mix of home closing when we guided last quarter as to where they were coming from, so we didn't know how to break out the margin exactly and we ended up plussing up to the positive so the East came in with a stronger performance and the 2,500 closing helped us leverage our overhead better, which caused a gross margin increase.

Okay. And then, great to hear that you're cash positive, you think, in '19. I guess a couple of things on that. You're talking about land-spend being a little bit less. Is that you all looking at the market and being less comfortable with it? Is it more optioning or is it something else? And then you have no debt coming due, so do you apply that to share repurchase? Do you sit on the cash? How are you all thinking about that?

Well, Steve, it's all of the above. Certainly, we're well aware what's going on in the market and we're keeping a steady eye on that and we're making decisions on a daily and a monthly basis on where we see the market going. We're continuing to pivot to more entry-level communities, as we said earlier, 85% of lots we bought are for entry-level. We're trying to be more mindful of using options to be more capital efficient. We're very much focused on improving our ROA and ROE and -- but we do have a debt -- a note coming due next year, $300 million, so we're -- we don't see any reason why we won't be able to refinance that, but we're keeping some liquidity to that and then we want to be -- have liquidity available if certain opportunities arise, so we're managing all that. Regarding share repurchase, we completed the $100 million in 1 quarter. We'll continue to evaluate whether we want to renew that and follow up with another authorization, but we want to get through this earnings announcement, and we have a board meeting in a couple of weeks. I'm sure it's something we'll be discussing and we'll go from there.

Just one other point, Stephen, I think it's really important to note that because we're shifting so dramatically to entry-level, the cost of lots is just cheaper. So we are able to spend less money and still secure the same amount of lots.

The deals are a little bigger, they're larger, but absorptions are higher.

Yes.

The next question comes from Michael Rehaut of JPMorgan.

First question, I just wanted to circle back to the gross margins. In answer to your question of Steve, it sounds like the upside on 4Q was largely driven by mix, but you'd also talked about efficiencies that you're starting to get in the East region. Looking to the first quarter guidance, you're shifting -- switching to solidly down year-over-year or moderately down year-over-year, driven by the incentives. So just wanted to get a sense, when you think about going from up 80 bps to down 50 to 100, I believe -- sorry, I don't have the numbers right in front of me -- is that primarily driven entirely by incentives? And given the fact that incentives, I would assume, increased during the quarter, could this lead to a wider year-over-year delta in 2Q?

So just to clarify that. Guidance was 50 to 75 bps, so that's where we think we'll probably end up for the first quarter, and it's partially incentive but it's also partially lower closing volume. We entered '19 with a much lower backlog than we did '18 and it was quite a bit of leveraging that occurred kind of right at that sweet spot of 16 bps -- 1,500 to 1,800 homes. So a part of that lost margin is actually leverage, it's not direct margin, so we don't anticipate the same level of drag continuing for the rest of the year. Of course, we don't have a crystal ball, we don't really know what the rest of '19's going to look like, but right now, it's primarily a function of incentives that we know that we're planning to offer in the first quarter and the lower leverage.

I wouldn't extrapolate that into the second quarter yet because it's still early and, as we said earlier, our orders from the first month are probably going to be up at least 5% and that's going to help with the leverage. So it could be -- that could turn around in the second quarter and beyond. Or -- I'm sorry -- at the end of the first quarter's numbers and into the second quarter.

Right. I appreciate that clarification. I guess, secondly, community count, if you could just kind of recap -- obviously, the change in order patterns with the higher CAN rates impact the community count in 4Q. You talked about that kind of evening out during 2019. If you have somewhat of a, let's say, the low- single-digit order growth type of year in 2019, what would you expect community count to be year-end '19 versus year-end '18 or at least some type of range?

We're projecting right now, at this moment, it to be kind of flattish until we can get better color on that at the end of the year -- or at the end of this quarter. It could be slightly down to slightly up. The challenges in the -- at the end of 2018, we -- our community count was actually a little higher than we expected because we didn't close out as many MU communities as we expected to, which left the community count higher. I believe we have like 32 or 35 communities that have less than 10 lots left in them, and we're trying to drive those to a completion. Definitely helps with our overhead, so that will bear weight on the overall community count number for us. The number that we're most interested in is the number -- the absolute number, or the net number of entry-level communities that we have open. As I said earlier, we had about 90 at the end of last year and expect to be -- open another 25 net by the end of this year to get us to about 115, and we expect that number to continue to rise every year for the next several years.

Okay, one last quick one if I could. I just wanted to also just clarify, to make sure I understood right. Did you mention that you expect your order comps to be a little tougher in the next 2 or 3 months relative to January?

That's correct. I mean, our orders for last -- for Q1 last year were 2,358, and certainly the orders for February and March were substantively higher than they were in January. So the market is going to get better, the real season kicks off on Monday after the Super Bowl this weekend for housing, but the comps get tougher, and we're going to have to sell more homes to put up a positive number, but it's like that every year. We have a strategy, we have a series of promotions planned, and we're optimistic that we can continue the good start we've had to the year so far.

The next question comes from Susan Maklari with Crédit Suisse.

My first question is just around some of the efficiencies that you talked to earlier in your commentary. Can you just give us some sense of how much more you can realize there? And then with that, you've certainly done a lot of work with efficiency in the building process. As you move down to more entry-level product, can you talk about your ability to kind of continue to capture some of that and maybe what it could mean for you over time, especially as we do think about the margin progressions?

Well, one of the main things we're focused on is -- that drives efficiencies -- is absorptions, so if we can get our builders, our superintendents to be able to build more homes. I think in a lot of markets, our smaller markets, the absorption levels are not adequate, and that allows us to really leverage our overhead, and as we continue to pivot more and more to entry-level, we can leverage our overhead in so many ways: it's our construction overhead, it's the models that we have, it's the sales presentation, it's our back office, it's -- there's a lot of -- the way we're selling homes, we have an initiative this year that we're moving our sales offices to less paper. We're not going to be handing out as much brochures and paper promotion materials. We're doing more electronically. That could save us $3 million a year. There's a lot of things that we're doing to save money and reduce overhead. Hilla, I don't know if you want to piggyback on that.

Yes, the East, as I mentioned earlier, the East region has definitely improved their margins, as you guys will see in a couple of weeks when we publish the regional results for the quarter. However, there's still opportunity there. They're not yet at the company averages and there's no reason why they shouldn't be. So we still have some ability to increase the margins for the East, which is about 1/3 of our total business. And then, of course, we continue to roll LiVE. I'm not sure that there's significant efficiency to continue to wring out of the entry-level but if entry-level continues to become a larger portion of our business, that will just mathematically become more impressive. And then the lessons that we're learning about how to be more efficient and how to streamline the whole production sales-to-close process that we're learning in entry-level, we're also carrying into first move-up. We'll be able to start to see some of to see some of those efficiencies in the rest of our product lines as well, '19 and into '20.

Okay, that's helpful color. And then can you just -- following up on that, talk a little bit about what you're seeing in terms of some of the trades. Is there anything that's changed there, especially with some of the uncertainty in the market?

I wouldn't say there's anything really monumental to discuss with the trades. They read the papers, too. They see what's going on with orders and the overall housing market, so I think price increases in general have been more modest and they're not -- we're not seeing the -- there's continual price pressure and labor issues, of course, but I think it's moderated to some degree.

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

First question, Steve, you mentioned the incentive environment, just to kind of play flip side to that. Curious, are there actually any communities these days where you're actually raising prices and maybe quantify that in terms of percentage of communities maybe where you're seeing stronger demand?

There are some that we are modestly raising prices. I can't tell you how many of them there are, what percentage that is, but clearly, we have some outliers that we have very, very strong demand. And -- but we're certainly not raising prices like we were in the first half of last year.

Got it. Second question, I think last quarter on the call, in response to my question, you mentioned if the softer demand environment continued, the biggest lever you could pull is pulling back on spec starts. And I believe Hilla made a comment that you did, in fact, pull back a little bit on the spec starts. I think your spec count's still up about 20% year-over-year, and that's, I'm sure, largely a function of more entry-level mix. So recognizing you're not giving kind of annual guidance -- and we fully understand that -- how would you think about the current level of spec activity -- spec starts that you're running at today? What type of annual closing volume would that roughly translate to, recognizing you closed about 8,500 homes last year and you're clearly prioritizing pace to a large extent right now to keep the machine running.

Yes, Alan, it's just way too granular for right now. I would tell you this: our total specs at the end of the quarter were down a bit from the previous quarter. We had 2,507 specs at the end of '18 versus 2,586 the previous quarter. I can tell you we put a hard brake on move-up specs. We're really trying to bring down our move-up specs to about 1/3 of our absorptions. We think that's kind of the right number, about 30%, 35% of our sales in the move-up segment are going to be specs. So we're really trying to make sure we have that number right-sized in every one of our communities, but we're continuing to evaluate on a monthly basis how many specs we have in each entry-level community as well, and making sure that we have the right quantity to be able to not hurt our sales, because we know those entry-level buyers don't want to wait for a home and they want to move in quicker, and they don't need to go to the design center. They're happy to accept the -- some of the great choices that we have for them for interior finishes and so forth. So that strategy continues to work out well, but we're very careful on how we approach the spec strategy and it is substantively different for entry-level as it is for move up.

Alan, I think -- just a little bit more color, we talked about this on other calls, the spec count for us in entry-level is running about 2x the pace that it's running outside of entry-level. And it's a function of months supply to sales, right? So as the sales volumes move up and down with the market, we're naturally regulating how many specs we have started, which is why you saw the drop between Q3 and Q4. The market's going to dictate how many specs we have, and we're not going to over-build to a specific number, it's a function of sales.

Well, that's what I was really trying to get at, Hilla, is what is that months supply number you're targeting, because if I look at the 2,500 specs, embedded within that, presumably, is some expectation for what sales are going to look like over the next several months.

That...

I can't roll it up for you, but I can tell you, let's say for entry-level communities, we're planning to sell 4 a month. That's been our history, our track record for the last couple, few quarters, and based upon seasonality, we probably have 16 specs for that community, a 4-month supply for a move-up community, for selling 2 a month. It's a longer cycle time for those homes. So if we're selling 2 a month, I mean 1/3 of those are spec, so it will be maybe 3 or 4 or 5 specs in those communities versus 16 for an entry-level community.

And we're making those decisions weekly when we schedule out our starts. We're constantly looking at our sales pace and expectations and adjusting, so we don't have a magic number we're trying to hit by the end of 2019. We're making those decisions live on the ground, based on what we're seeing.

Yes, we're not driving -- putting specs on the ground to drive to a certain point, we're putting specs on the ground based upon what the market has given us.

The next question comes from Scott Schrier of Citi.

I wanted to ask a little bit about California and Colorado. Obviously, you've had significant declines in absorption rates there, do you see opportunities for demand to pick up? And I know you've talked about how your product mix is changing there. Are rates and incentives enough to stimulate the demand? And with that in mind, do you -- are you changing how you think about whether it's your -- the pace that you open communities there, meaning is the underlying demand there still very strong as long as you get to the right product mix?

Yes, I think that's -- you're hitting the nail right on the head. I mean, a lot of our issues in California, and less so in Colorado, are more our own execution than they are the market. We have our lowest level of communities open in California than we've had a long time, and that's because it's taken us significantly longer to get our communities open. We have many communities that are more than a year delayed in California right now for a variety of different reasons. I believe we only have 18 communities open in the whole state of California and we have like another 18 in the queue getting ready to open. So the new communities we're going to be opening in California are priced lower, have lower ASPs and they're more entry-level focused, so we think that's going to help us improve our numbers in California, and I'd say the same for Colorado. We've stopped buying move-up communities in Colorado quite some time, and we have quite a few communities there scheduled to open, mostly focused on entry-level market, so it's really about the mix and the mix can have a -- both those markets, California and Colorado, North and Southern California, and Denver are very housing-starved. And if you can deliver appropriately priced product to the entry-level segment of the market, I think you can do well in both of those states going forward, and that's what we're going to try to do.

Got it. And then my follow-up, I wanted to ask a little bit about the land-spend, that I know for '18, it was 85% of your newly controlled lots were going toward the entry-level. Is that more of an effort to rightsize the book, and we should see more diverse land purchasing in '19? Or would you expect also say, in excess of 80% of your land acquisition in '19 to be at the entry-level also?

Well, it's both. We want to get our entry-level segment to more than 50% of our total orders and we want our -- 50% of our communities facing the entry-level segment. So we have to continue to spend there to balance that and, as you said, rightsize the book. At the same time, that's where the strongest demand is right now and for the foreseeable future. Those people that are buying entry-level homes aren't coming out of an existing home where they have a 3.5% or 4% mortgage and looking to move into a more expensive home with a 4.5% with 5% mortgage. So they're -- they need a home, they're starting families, they're -- they have to get their kids in school. Their decision matrix in their mind is much different than the move-up buyer, and they aren't as persuaded by the vagaries of the markets so they're the strongest segment, and we're going after that.

The next question comes from Carl Reichardt of BTIG.

Just a clarification. Hilla, you talked about closings being below -- lower than you expected, which was part of the issue for the SG&A. My read -- I think I have this right -- is that closings were ahead of what your guidance was, and certainly what the Street had. Is that really more an issue of the communities hanging in there longer than you'd anticipated and that was what drove the SG&A higher? Or is there something in the closings numbers I'm missing?

You're right on both fronts. So number one, we had more communities open, I think Steve mentioned it was 32 communities were opened that we were not expecting to be opened in Q4, so that has additional burdens.

Not all of them, I'd say less than 10.

Agreed, so they had a burden that we weren't anticipating which is part of the reason why our SG&A is higher. Another piece of it, though, is even though our numbers came in better than we had expected, they didn't come in better than we had expected at the beginning of the year. So it takes a little while to effect overhead reductions and to get everything done, so we are running at a higher pace, which we've since adjusted in Q1.

Okay, that makes sense. And then on your CAN rate, about 500 basis points up, the mix shift might be part of that, at least historically, low-end's got somewhat of a higher CAN rate. Are you seeing CAN rates change at different rates between the low-end and the move-up, and how much of that CAN rate was driven by mix versus, say, geographic market?

So it clearly is a mix-shift. You're going to have higher CANs at the entry-level than you are at the move-up, more for mortgage qualification reasons. Those buyers are stretching a little bit more to qualify for a new home. But that said, in the fourth quarter we did have a considerable number of move-up buyers got cold feet because of the gyrations in the stock market, some of the headlines and the interest rates and so forth, and they just walked away and said, we'll be back later. So it was really both factors at play.

The next question comes from Jade Rahmani of KBW.

I was wondering if you could provide your views on M&A and if you think, in the current environment, there should be industry consolidation amongst the public players to drive scale and efficiency gains?

I think there always should be consolidation. I think there's too many of us doing the same thing. That said, I'm not expecting a lot of M&A activity, for a variety of reasons I'm not going to articulate right now. You generally see more M&A when values are higher, and when builders are trading for below book value I think it's hard to expect M&A to occur. There was quite a bit of a private builder M&A last year, and I expect the same for this year, public builders buying private builders, but I think public-to-public is going to be hit and miss.

Just secondly, on SG&A for the first quarter, what's a reasonable way to think about it, assuming that there's negative operating leverage from the lower closings that you guided toward?

We're not prepared to discuss SG&A yet. It wasn't part of our guidance and we'll give you guys a little bit more clarity on that, obviously, when we report first quarter earnings. As we mentioned, we had some right adjustments in our overhead in Q1 and we'll be prepared to talk about that on the next call.

The next question comes from Stephen Kim of Evercore ISI.

I want to just revisit the incentives comment. You've said a few things here, a lot of them seem important. You mentioned that you did cut back on incentives in January but last weekend there was a special promotion, and you also said you have series of promotions planned in the Spring selling season, it sounds like. And Hilla's comments on gross margin also said you anticipated also, I think she said, increased incentives. So putting it all together, I'm curious, overall, were these promotions regular or planned well ahead of time that you're talking about in the Spring selling season, or a reaction to a continued sluggish environment? And was the reaction to the January promotion that you did about what you expected, or was it a little stronger than expected? So kind of overall, are you seeing the need to maintain high levels of incentives versus the normal Spring selling season or not?

The promotion that we had last weekend did a little better than we thought, and I think our mindset has maybe evolved a bit from last year -- that we cannot let market share get away from us, and we're not going to let brand X, Y and Z take our buyers on price. So we're going to have to make sure that we're offering the right types of promotions and the right incentives to attract buyers to our products. So yes, we weren't running a lot of promotions in the first half of last year. We were raising prices, right? So the market -- the environment's changed, and although the incentives have expanded a bit they haven't -- the net impact hasn't been significant, because of the lower costs that we have this year. And we are continuing to drive costs lower as we optimize our plan offering, our plan line-up, and work with our trade partners and vendors to reduce costs. And at the same time, the overhead leverage becomes more and more important, and we're very, very focused on that and want to keep this machine running, at better operating -- better efficiency levels.

You've been really clear about that, and so it just -- it sounds kind of like the level of incentives and the promotions that you're kind of planning here, it sounds like you guys going on offense more than it is sort of a defensive reaction to a weakening market trend. I suppose that's a fair way to summarize it?

Yes, I would say -- you hit it right on the head. I mean we're going to be very offensive over the next several months, maybe more so than we were last year.

Steve, I can't imagine you being perceived as offensive, so...

No, I would say, like, we're going to have a stronger aerial attack and we're just going -- we're not going to be on the ground game as much as last year, but -- I'm sorry, I think you know what I meant.

Right. The second question I had relates to your land positions. So you've made this very significant and effective pivot to target the entry-level with LiVE. NOW. and all the other things you been doing. But one of the questions that we've gotten from investors has to do with some of the land positions that may be associated with your previous strategy, before you made this pivot. Wondering whether or not there may be some risk that those kind of get orphaned on the balance sheet. So I was wondering maybe if you could talk about what your approach is to dealing with some of these lot parcels, maybe you can size it up for us or just how you think about the game plan for the -- what you might call legacy land positions.

Price them to sell. I mean we have -- I think I said earlier, we have about 15% of our communities are 2MU -- and probably a little more aggressive this year than last year to get out of them quicker, because I want to turn that capital around potentially return to shareholders, potentially use it to buy more entry-level communities, potentially save it for a rainy day. But those -- the opportunity for those communities to increase absorptions and raise prices is not that strong, so we need to move those assets, and we're focused on that in 2019.

Should we'd be thinking they are kind of bulk sales targets? Or do you think it's more just sort of building them out and just being aggressive on price?

Probably more building them out and being more aggressive on price. I mean if there's an opportunity to sell, sell them on a one-off basis to other builders, we're definitely going to consider that and look at that, but there is no grand strategy to move all those in bulk, so...

The next question comes from Jay McCanless from Wedbush Securities.

So my first question, just -- can you guys tell us what defines or what is the threshold for a community? Is it 5 lots left to sell, or how do you all define it?

If we have 5 lots left to sell, we count it as active. During the downturn, if it was 10 lots and it wasn't moving, we would also count it as an active. We're certainly not in the same mind-frame right now, which is why communities with very, very few lots -- between 5 and 10 -- are being counted as active. Some of them actually sold down to 5 and then had cancellations that brought them back up into the active category. That's why that 32 community count that's kind of just on the cusp is causing such a big skew in our numbers.

And the other side of that is when we -- opening a community, if we've made 1 sale and we have an active sales presence, we count it as a community even though it might not be fully running yet. Once we make a sale, we count it.

So if you back those out, you guys are essentially flat with last year's community count? And should we expect that to come down through the year? Or are you all -- do you believe you're going to be able to open enough entry-level communities to hold it steady at roughly like a 245 number?

Well, we finished the year at 2 -- was it 264? 274?

(inaudible)

Again, as I said, we're not going to get into really specific quarter-to-quarter guidance on that. These numbers can go up or down every quarter. It's based upon -- sales pace has a lot to do with it, not just getting communities open, but actually how we're selling on the opening and on the closing. But I think for the year, it's going to be pretty flat, that number, maybe potentially even down a bit.

And then the other question I had in terms of the incentives and the co-broker stuff that you talked about, are -- do you believe that your overall customer acquisition cost has got to go up from here in order to maintain the pace? Or do you feel like the current level is driving enough volume to meet your plan?

No, I think we're getting more efficient with our marketing and marketing dollars, and we don't have -- we're not intending to spend substantively more money on marketing. We're also not intending to increase commissions. We may pay some additional commissions on 2MU spec homes or something to move them off the books, but our strategy hasn't changed around commissions and marketing spend. So I do not expect changes in that area.

And one other quick one: of the specs that you have now, how many of that 2,000 number are second move-up homes?

We don't have that number -- you have that?

I don't have that number, but I can tell you that, on average, we are keeping double the units for community entry-level that we do on first move-up in spec and 2MU is even lower than that, about 1/3. So you can kind of do the mental math to get to those numbers.

The next question is from Alex Barrón of Housing Research Center.

I was just curious, I guess, about your thoughts, so you're saying you're not going to let other guys take market share and other guys say they're willing to sacrifice margins to outsell everybody, so I'm just trying to square those 2 comments. How competitive are you willing to become in terms of are you also willing to sacrifice margins just to keep up with those guys? I mean…

We'll be more competitive than we have been in the past, let me say that. And we will sacrifice some margin, but as we shift to more entry-level, we think we're able to close the cost gap with them. We -- our costs historically have probably been wider than they should be. And I think we're -- as we rationalize our product, our cost gap, hopefully, is narrowing, and then combine that with the leverage from our overhead by pushing through higher volumes, we expect that the impact on margin degradation is going to be not as much as people might think. So we just can't sit here and say we're going to wait for the storm to pass, because it's not going to pass, because they're very, very focused on driving volume, and we're going to have to adapt and move more to that model if we want to be successful.

Got it. And as far as the tax rate, it was pretty unusually low this quarter, so what can we -- I mean, I'm not sure if I missed your comment on what drove that, but what can we expect for next year?

So we covered it a little bit. The reason why it was so low in the quarter, a little bit of it is DTA revaluation, which is something that happens at the end of the year but the big chunk of it was we actually went back and reaudited for energy efficiency credits, all of the homes that closed in '15, '16 and '17, we were able to capture an additional pool of homes. There's not been any action yet in Washington to approve the energy tax credits for 2018 or any subsequent year, but obviously, with the government shutdown, that wasn't the #1 priority. We are still very actively pursuing it. If that comes to fruition, we'll be able to see some savings again in '19. If it doesn't, we'll continue to push on some of the closed homes for additional credits. But we'll start to shift closer to the 24%, 25% blended tax rate.

Thanks, Alex, and thank you, everybody, for your participation in our fourth quarter 2018 earnings call. That's going to wrap it up, and we look forward to talking to you again at the end of the first quarter. Have a great day.

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