Meritage Homes Corporation
Q3 2013 Earnings Call Transcript

Published: 23 Oct 2013

[Operator:]

Good morning and welcome to the Meritage Homes Third Quarter Conference Call. All participants will be in listen-only mode. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Brent Anderson, Vice President of Investor Relations. Please go ahead.

[Brent Anderson:]

Thank you, Amy. Good morning, everyone. I’d like to welcome you to our analyst conference call today. Our third quarter 2013 ended on September 30. We issued our press release with the results before the market opened today. If you need a copy of the release or the slides that accompany our webcast, you can find them on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom-left of our home page. Turn to this Slide 2 in the presentation. Our statements during this call and the accompanying materials contain projections and forward-looking statements which are the current opinions of management and are subject to change. We undertake no obligation to update these projections or opinions. Additionally, our actual results may be materially different than our expectations due to various risk factors. For information regarding these risk factors, please see our press release and most recent filings with the Securities and Exchange Commission, specifically our 2012 Annual Report on Form 10-K and our second quarter 2013 report on Form 10-Q. Today’s presentation also includes certain non-GAAP financial measures as defined by the SEC, so to comply with SEC rules we’ve provided a reconciliation of those non-GAAP measures in our earnings press release. With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage Homes; and Larry Seay, our Executive VP and CFO. We expect our call to run about an hour and a replay of the call will be available on our website within an hour or so after we conclude the call and it will remain active for 15 days. I’ll now turn it over to Mr. Hilton to review our third quarter results. Steve?

[Steven J. Hilton:]

Thank you, Brent. Good morning everybody. We are pleased with our strong operating results for the third quarter of 2013. We achieved significant growth in closings, revenue, margins and earnings again this quarter. And we grew orders year-over-year despite headwinds from the significant increases in home prices and interest rates, as well as the recent turmoil caused by Washington. We believe the market tossed the long runway ahead for additional growth, and the somewhat slower sales pace we’re experiencing is actually healthy and it allows the market to return to more sustainable pace. Market fundamentals remain strong, so we are not overly concerned about the slowing and the pace of sales, but we do not accept to return to the same proxy sales base we saw earlier in the year. We are confident that we can continually grow our earnings through both top line growth and operating leverage. I’ll address our order trends and what’s behind those in a few minutes. But we’ll begin with the review of our operating results. We are now on Slide 4. We are at $0.99 per diluted share for the third quarter of this year, more than 5 times as much as last years $0.19 per diluted share for the third quarter. Net earnings were up 463% year-over-year. Home closing revenue increased 44% with an 18% increase in home closings and a 22% increase in average closing prices. This was our eight consecutive quarter of year-over-year growth in home closing revenues, and our seventh consecutive quarter of year-over-year earnings growth. Since we entered the quarter with a backlog value 65% higher than a year-ago, we expect to see substantial year-over-year growth in home closings again next quarter. Slide 5, because home pricing increases have exceeded the increases in our land and construction costs, our home closing gross margin increased by 420 basis points to 22.8% compared to 18.6% in the third quarter of last year. This may go marginally higher for a couple more quarters, but we expect gross margins to return to a more normalized level as demand and prices begin to stabilize. The margin expansion highlights the fact that we shifted our focus from volume growth to maximize the profitability of our assets over the last several quarters, and our earnings have grown accordingly. You can see that reflected in our year-over-year price and volumes comparisons by quarter. While our increases in average prices are partially due to our mix shifting towards higher price communities and states, the prices increases we took in communities generated much of the 22.8% home closing gross margin in the third quarter of this year, a 130 basis point improvement over the second quarter. Our operating leverage also contributed to our earnings growth, our total SG&A expenses dropped to 140 basis points year-over-year and interest expense dropped another 80 basis points from last years third quarter. Larry will go through more of these details in a bit. Slide 6. This is our tenth consecutive quarter of positive year-over-year growth in orders, though the 8% growth was less than previous quarters for several reasons. Year-over-year order comparisons were more difficult considering that orders were up 33% last year over 2011 third quarter, but there’s more towards in that. Low prices and low interest rates coupled with low inventories and homes available drove much of our sales growth last year and earlier this year. Since we are selling out communities faster than we can replace them, we raised prices repeatedly in the areas where demand was the strongest and so we reached a point where sales per community came down to a more normalized pace. Late in the second quarter, the sudden and steep rise in interest rates came just as the spring selling season was ending and we’re entering the seasonally slow summer months causing buyers to pause in their purchasing decisions. We believe the rapid price increases had more impact on buyers than interest rates and it may take some time for buyer to adjust to their expectations to current price levels. For Meritage, our average sales price on orders were up 20% in the third quarter of 2013 over 2012, which produced a 29% growth in total order value despite an only 8% increase in unit orders. We also added 14 net new communities during the quarter including three from Nashville as we opened 27 and closed out 13. Our average active community counter in the quarter was 13% higher than 2013 than it was in 2012, yet our average orders per community were only slightly lower this year than last year. We sold an average of 7.6 homes per community in the third quarter of this year compared to 7.9 per community in the third quarter of last year. Since the fourth quarters normally are our slowest selling quarter seasonally, we wouldn’t expect to see sales pick up until the spring selling season next year. However, we are planning to increase our active community count and are comfortable with our previous projection of 185 communities by end of the year 2013. We plan to go grow this by another 10% to 20% next year. Slide 7. We grew our total order value and backlog value across the Board except in California where orders and order value declined after we raised prices more significantly there. California had the highest average orders per community since early 2012. It was 12.7% in the third quarter of 2012 and 17.9% in the second quarter this year. We’ve been selling our communities in California faster than we can replace them, so our average community count was down 21% year-over-year and orders were down 33%. I will note that we did increase our community count in California by 5% from the second to third quarter as our recent land acquisitions are starting to come online. Our total order value in California was only down 11% due to a 34% increase in our average sales price. After running an unusually high sales pace for several quarters, we are getting back to more reasonable sales pace there as it was 10.6% this past quarter. California is achieving the highest returns in the company. As evident in our result, the strategy of focusing more on price and volume has been working. We are earning much more per home, so our gross profit has increased much faster than our Home closings have. This strategy results are similar in Colorado which had the second highest orders per community across the company in four of the last five quarters. Our average sales price in Colorado was 40% higher year-over-year in the third quarter. We took orders from eight homes per community there in the third quarter – two eight homes per community there in the third quarter, roughly in line with the company average. We also had a 50% more active communities in Colorado in the third quarter of 2013 to 2012. Orders were up 9% year-over-year and our ASP increased 40% driving a 53% increase in total order value. Arizona, the average community count was up 14% offsetting 10% decline in orders per community. So our net orders there increased 2%. Average sales prices were up 12% and our total order value in Arizona increased 15%. Demand remains strong at Phoenix, even after pushing prices aggressively there over the last year and is one of our most profitable markets. Our sales pace is lower in Tucson in the active adult markets, which brings the average for Arizona down though all of our Arizona markets are still producing very good margins. Turning to Slide 8. We were pleased with the growth we achieved in Texas during the third quarter where we grew orders by 28% year-over-year, primarily by increasing our average orders per community by 21% over the third quarter of 2012. Sales per community in Texas had lagged the rest of the company over the past several quarters, but we’re right in line with our company average this quarter, with a 16% increase in ASP on top of that order growth, we generated a 49% increase in total order value for the quarter in |Texas. Slide 9. We are growing our East Region through expansion into the new markets in the Carolinas and Tennessee, where we recently completed the acquisition of Phillips Builders, a long established builder with high quality reputation in the Nashville area. Florida is still growing strong. We've expanded our Carolinas operations significantly over the last year and ended the quarter with 15 communities there compared to seven last year. Since many of those communities were newly opened and not in full stride yet, our pace of sales were down in the Carolinas. Here we doubled our orders and total order values were up 128% from the year ago. Florida has quite a few new communities with deep law possessions that are remaining open longer. So new community opens there are increasing our store count. We ended the quarter with 27% more active communities in Florida than a year ago, which drove a 13% increase in orders. Florida’s average prices were up 33% and total order value for the quarter increased 51% over last years third quarter. With that, I’ll turn it over to Larry to review a few other highlights of the third quarter. Larry?

[Larry W. Seay:]

Thanks, Steve. Turning to Slide 10. In addition to the 500 lots that Steve noted from the Phillips Builders acquisition, we added approximately 3,700 new lots during the third quarter, which was the second highest number of lots we secured in the last two years after the fourth quarter of 2012. We secured some great possessions in highly desirable locations in our key markets including those in areas where demand has been the highest like California, Colorado and Arizona while solidifying our positions in the Carolinas and adding communities in some other best submarkets in Houston and Dallas Ft. Worth which are strengthening markets. We ended the quarter with approximately 25,000 total lots under control, 40% more than a year ago and about 2,400 more than were we finished the second quarter of this year. We now have the equivalent of approximately five year supply of lots based on our trailing 12 months closings. We invested approximately $167 million in land and land development during the third quarter of 2013 to continue to grow the business and have a healthy pipeline of potential new positions with all of our 2014 and more than 85% of our 2015 closings owned or under contracts. Slide 11. Total closing profit increased $51 million or 81% over the third quarter last year including approximately $3 million of land closing gross profit from the sale of excess lots in certain areas, in addition to the $48 million increase in home closing gross profit. We also increased financial services profit by a little over $1 million, primarily from increased closing volume. Commissions and other sales costs came down to 6.9% of home closing revenue, an 80 basis point improvement over the third quarter of 2012. G&A expenses were down 60 basis points year-over-year to 5.0% of total closing revenue. And interest expense was down $1.5 million or 80 basis points year-over-year. With that leverage, we generate an 11.5% pre-tax margin for the third quarter of 2013 compared to 2.0% for the third quarter of 2012. It was also a 300 basis point increase over the second quarter of this year. Our 2012 results included an $8.7 million charge to increase reserves surrounding litigation in the South Edge joint venture in Las Vegas. Our tax provision was $18.6 million in the third quarter of 2013 compared to just $202,000 for the third quarter of 2012. That’s an effective tax rate of about 33% for the third quarter of 2013, which is less than the statutory rate, partially due to energy tax credits we received. We project that our effective tax rate for the full year will end about 31% to 32% range. Moving to Slide 12, looking at our results year-to-date, we generated $78 million net earnings in the first nine months of 2013 compared to $10 million in the first nine months of 2012, a seven-fold increase. For the first nine months of the year, home closing revenue was 52% year-over-year with a 26% increase in home closing and a 20% increase in average closing prices. Home closing gross margin of 21.5% was 330 basis points higher than last year due to home price appreciation, better direct cost control and construction overhead leverage. Commissions and other sales costs were down 110 basis points. General and administrative expenses were down 90 basis points as we are leveraging our existing overhead platform over great revenues. And interest expense was down 130 basis points year-over-year as we are capitalizing a greater portion of interest incurred to additional inventory under development. Our pre-tax margin for the first nine months of 2013 improved 810 basis points to 8.7% compared to 0.6% in 2012. Orders were up 21% year-over-year for the first three quarters of the year and average sales prices were up 22% yielding a 48% increase in total order value over the first nine months of 2012. Slide 13. Our balance sheet is strong and we believe we have adequate capital and financing capacity to support additional growth. We ended the quarter with $311 million of cash and cash equivalents, restricted cash and securities, $16 million higher than our December 31, 2012 balance. Our net debt to capital ratio at September 30, 2013 was 38.1%, consistent with our year-end ratio. We also have a $135 million revolving credit facility and have borrowed nothing against that line to date. Our total real estate inventory rose to $1.4 billion at September 30, 2013 from $1.1 billion at the beginning of the year. More than half of that increase was from additional homes in construction under contract while most of the remaining increase was due to increased land under development. We had total 652 spec homes started, but not yet sold at quarter end of which 442 were other construction compared to 643 spec homes at December 31, 2012. With that, I’ll turn it back over to Steve before beginning Q&A.

[Steven J. Hilton:]

Thank you, Larry. We were pleased with the results for the third quarter, particularly our bottom line earnings growth, which demonstrates the success of our strategies. We’ve grown our top line by expanding into new markets, growing our community count and maximizing prices at a reasonable sales pace. We’ve managed to keep cost increases lower than the increase in our sales revenue which generated a 420 basis point improvement in our home closing gross margin, and we are driving greater earnings growth from every dollar increase in our gross profit through operating leverage. We expect to continue to grow our earnings with these strategies going forward and we manage a strong balance sheet while improving our credit metrics as we’ve grown and expanded our footprint. Most housing metrics have been moving in a positive direction over the last year albeit from historically depressed levels as the U.S. economy slowly improves and creates jobs, demand for new homes should remain strong specially in light of the shortage of the used home business for sale. We believe that Meritage is well positioned with highly desirable locations and distinctive energy efficient homes in many of the best housing markets in the country. Based upon our reported results year-to-date and assuming continued strength in our market we are projecting home closing revenue of approximately $1.8 billion for 2013, which projected earnings per diluted share in the range of $2.95 to $3.05 for the year. I thank you for your attention and we will now open up for questions. The operator will remind you of the instructions. Operator?

[Operator:]

(Operator Instructions) Our first question comes from Michael Rehaut of JPMorgan.

[Michael J. Rehaut:]

Thanks. Good morning and congrats on the quarter. The first question I had was on order trends, if you could – if it's possible to give us any granularity in terms of how they progressed throughout the quarter and in particular I'm interested in the company-wide sales pace per community. I would assume that perhaps the – with the down 5% on average for the quarter overall just trying to get a sense if it was perhaps worst at the beginning of the quarter and perhaps better the net average number at the end, and just to give us a sense because we've heard that in our own fieldwork that September was a little bit better than August. And just trying to get a sense if that’s what you saw?

[Larry W. Seay:]

For us it was a negligible difference month to month. August was actually our best month in the three-month period, but the differences were so slight it is really hard to put much into it. I mean we're talking less than 5% difference month to month, so I wouldn't read into that, it varied by region. I mean in Texas July, September were like bookings and August was a little weaker. It was a little weaker in the west in September, but it was a little stronger in the Southeast in September. So it was pretty flat throughout the entire quarter.

[Michael J. Rehaut:]

Okay. And in terms of the commentary around gross margins, you expect them to increase modestly I guess in the fourth quarter before beginning to normalize. How should we think about path to normalization and what would you think is more of a normal level, I mean in the late 1990s, early part of last decade, you are more or less right around 20% plus or minus pretty consistently, would we expect to get back to that 20% mark perhaps on a graduated page through the end of 2014 or would it be even more gradual than that given some of the land in your books that you already have locked up?

[Steven J. Hilton:]

I think we are going to have margins at or above where we are right now for the next two or three quarters. And then I think we will start to gradually go down probably more towards 21% than 20%, but it’s hard for me to pinpoint the exact rate of that descent. We’ll tell you more as we get into the next year. As our margins decline in California, they are pretty amazing right now, our margins are improving in other markets like Texas. So it’s tough to mitigate over themselves.

[Michael J. Rehaut:]

No, thanks. I just want to make sure to understand it, part of the confidence there that you’re still going to have pretty solid margins for two to three quarters in more of a gradual decline following that, is that due to perhaps the pricing and incentives remaining relatively firm throughout the third quarter with the slower pace of demand and maybe in general you could just talk about pricing and incentive trends over the last three or four months?

[Steven J. Hilton:]

We haven’t really increased our incentives that much. We have done it on a select basis. Over this last quarter, between 1% and 2%, where we think we needed it, and I don’t think we are going to be doing much more this quarter. So the gross margin picture, we’ll have to look at that more as we go into next year and as we see how the spring selling season plays out, but I think a bigger impact on the margins is really going to be land cost and as we move into more festive lands that will have the biggest impact.

[Michael J. Rehaut:]

Thank you.

[Operator:]

Our next question comes from Stephen Kim at Barclays.

[Stephen S. Kim:]

Thanks guys. First, great job in the quarter, really impressive. And yes, I am glad to hear you talk Steve about the fact that higher land costs are going to be coming through and making sure our expectations are probably on the margin trajectory going forward. I think most of your peers are going to wind up seeing the same thing, but I guess I wanted to ask you about your land spend strategy. One of the things I’ve been interested in is to observe that, relative to the size of your business, your amount of land sales this year has been on the lower end of your peer group when you adjust for the fact that you guys in general don’t have a particularly long land bank. So you kind of have been fairly moderate in your land purchases this year relative to peers and I was curious as to whether or not, you could comment on what you are seeing in the land market now and why you have generally felt it wasn’t the right strategy to be very aggressive in buying land over the last few quarters like some of your peers have?

[Steven J. Hilton:]

I think we were aggressive. This last quarter, we bought 3,700 lots.

[Stephen S. Kim:]

That was about 35%, you spend about 35% of revenues, which is pretty typical for builders going back over the last 20 years on average. Some of your peers are well up into the 40s or in some cases even above that. So as a percentage of the amount of land you are burning through, your replenishment rate was fairly normal.

[Steven J. Hilton:]

I don’t know, I mean, you are talking about when we’re actually spending cash or are we actually committed to spend?

[Stephen S. Kim:]

Your cash spend.

[Steven J. Hilton:]

Well, that’s not really that important. What’s really important is what we put under contract and what we committed to spend or we have under control and that’s that 3,700 lots I’m talking about. That was a super strong quarter for land purchases for us that we’ve proved and we’ll be purchasing over the next several quarters as these lands – as these lots come on line. So I don’t have the number in front of me. Larry, might have it, but year-to-date I believe we’ve purchased over 8,000 lots and so we’ve been fairly aggressive relative to our run rate on lot acquisition.

[Stephen S. Kim:]

Okay. So basically you believe that the time is right now to be tying up a lot of land. So although you’ve not been spending a lot in the way of cash, you’ve been tying up a lot of land in the way of options and things like that. Is that what you’re referring to?

[Steven J. Hilton:]

Well, I guess it’s a market-by-market situation. Certain markets like Phoenix, we’ve got a really big land book here. We’ve got a lot of great locations. We don’t need a lot of land. We bought land early here. I’d always like to have more land in California, but it’s hard to get. We’ve really bought some phenomenal positions in Houston. We’re really excited about our business down there. Other markets like Dallas, we’d like to buy more land, but it’s been hard to find land that works. So in some places I’m pulling back on the gas pedal, lifting up with the gas pedal. In other places I’m putting the foot down harder. So it’s a market-by-market strategy.

[Stephen S. Kim:]

Okay. Fair enough.

[Larry W. Seay:]

Steve, if I could add a couple of things here. We’ve put under control about 8,600 lots for the first three quarters this year, but we’re also, are auctioning more. Land banking is coming back. We’ve closed eight deals over the last couple of quarters for a total purchase price of lots of about $126 million. And we have now a little under 30% of our total lots under control controlled through purchase contracts or options. So that number is starting to come up and that is part of our long-term strategy of controlling some of our land off balance sheet through a non-recourse option. So you’re seeing us start to re-implement the strategy we used last cycle.

[Stephen S. Kim:]

Yes, and that worked well for you. What is your finished lot count?

[Larry W. Seay:]

Finished lot count it’s, I don’t have that off the top of my head. We have more lots under development today than we have – I think our finished lot counts are roughly in the kind of 30% to 40% range. I don’t have the specific number, but because we’ve been buying almost all raw land a lot of our lots are under development in some way or another and we are spending more in land development because of that.

[Stephen S. Kim:]

Got it. Thanks, guys.

[Operator:]

Our next question comes from Ivy Zelman at Zelman & Associates.

[Ivy Zelman:]

Thank you, and good morning. Congratulations on the quarter guys. Steve, you talked about margins over the next two quarters, showing a price at current level you’re running at. What are your assumptions in expecting the margins to decelerate in terms of expectations at home prices? Are you assuming that prices are going to be flat, so that obviously the lower cost or high cost land is not being offset with some price inflation?

[Steven J. Hilton:]

Well, I think margins are going to vary, our price are going to vary by market and I expect prices in California to continue to rise, maybe more in the 5% to 7% range and maybe Arizona and Colorado be more in the 3% to 5% range and then other markets closer to that number. But as I said earlier, I think the biggest impact for us, our margins going forward is going to be land cost, particularly in California. It’s going to be difficult for us to replace some of that land that we got at really good prices. That said, we had five communities we opened this quarter in California and we have more coming. It’s still at pretty good prices. So I don’t expect our margins are going to drop off the cliff. I think they’re going to gradually decline over the next year to two years.

[Ivy Zelman:]

And that post assumptions that you are underwriting to a 5% to 7% increase from the new land that you are buying for price inflation in California?

[Steven J. Hilton:]

No. We only underwrite with appreciation in select – few communities in California and in most cases it’s even less than that.

[Ivy Zelman:]

So then really your expectation is the backdrop inflation [ph] to offset the higher cost of land and yet you’re thinking that margins would be weaker as a result of that. So I guess I’m really confused. So if you’re…

[Steven J. Hilton:]

We don’t underwrite to the margins we’re achieving today. We underwrite right to more of a normal margin. Our margins in California, right now that we’re achieving are way above what we underwrite to. So just by the fact that we are going to have lower margins, just by the fact we’re cycling new lands through we are not going to get depreciation that we had last year.

[Ivy Zelman:]

Got it. And then secondly just to – I’m sorry. Go ahead, Larry.

[Larry W. Seay:]

I was going to say, Ivy the other thing is we typically don’t underwrite any inflation on the revenue or cost side and only in rare instances do we underwrite some revenue appreciation. So our strategy is to not expect appreciation that is more than cost. So if we get some it’s all greatly [ph] to us.

[Ivy Zelman:]

Got it. Now that makes sense. And with that as your community so you’ve been opening, maybe you can talk about some of these impediments that have been prevalent with respect to constrains on whether it would be local municipalities and utilities getting to drop size just the labor component and you sound like you’re on track to deliver where you expect it. So are those impediments for the most part starting to alleviate? And then when you open the new communities and we think about to outpace slower, are your new communities opening at the price points you expected or have you had the lower list price and how is then the overall reception to the new communities, is there a better performance on sale paced in those communities and are you at the original list price that you had expected to the opening of that?

[Steven J. Hilton:]

Okay. So I’ll take kind of a reverse order. I would say that almost all of our communities we opened over the last quarter or two; I hope [ph] that the prices that we performed were higher, in most cases higher, of course because we underwrite these communities at least a year ago if not more. And I would say that we will have the line of people to buy early in these communities that we had a few quarters ago, particularly in the west, but almost all of them opened to a good sales pace. I would say our biggest problem right now bringing communities online is not so much on the construction side with trades, buying trades to complete the work. I think we’ve kind of got that under control. The biggest challenge that we’ve faced is really more on municipalities and the delays we’re encountering getting communities through the entitlement and plan approval and permitting process. And it’s backing up at some locations, which is delaying us against our projections, our community openings, but we are managing to it.

[Ivy Zelman:]

And that’s why you might have that wide range of 10% to 20% because you want to be conservative given those delays?

[Steven J. Hilton:]

Yes.

[Ivy Zelman:]

Okay, thanks guys.

[Steven J. Hilton:]

Thank you.

[Operator:]

Our next question comes from Nishu Sood, Deutsche Bank.

[Nishu Sood:]

Thanks. I wanted to follow-up on the community count question. So the 185 communities by year end, you are still comfortable with that, now I know you haven’t given specific numbers for 2014 or 2015, but you did mention that you have most of the land under control for your deliveries in 2014 and 2015, so I was just wondering if you could talk directionally after this terrific year of community count growth you have, which has been very well timed, what we might be looking at directionally for 2014 and 2015?

[Steven J. Hilton:]

Yes, I am not prepared yet to give guidance on 2014. As far as revenues and orders and all that, I will try to do it next quarter, but I don’t – earlier want to say more other than community count it’s going to grow between 10% and 20%.

[Nishu Sood:]

Got it, okay. And also wanted to ask about your land spend, the quarterly profile of it. If you look at the last few years, it’s followed a seasonal trend where it’s lowest in the first quarter and then it rises through the rest of the year. Now you guys have done a great job of managing the balance sheet, so I was just wondering what’s been driving that seasonal profile, is it for example to do a development spend ahead of the spring selling season and how should we expect that to look going forward?

[Steven J. Hilton:]

Well, I think a lot of sellers want to get deals closed by year end, so we are pushing a lot of lot through the pipeline, they are getting closed by December and then we have a slowing of activity in Q1, it starts to build up again through the year. I wouldn’t put a lot of weight into that though, I don’t know that we’ll have a bigger land spend in Q4 of this year that we had in our land – maybe in our land spend lot of commitment in Q4 as we had in Q3. The spend might go up because we certainly probably go up because we have a lot of deals closing, but commitments may not increase, probably will actually decrease.

[Larry W. Seay:]

Yes, that’s not a metric we manage the business to and if there is some seasonal pattern that has developed, it’s not something that we are purposely managing and I don’t think it’s that significant in ruining the business properly.

[Nishu Sood:]

Got it. And just housekeeping ones, on the Phillips acquisition, how much of that add to backlog and orders in 3Q?

[Steven J. Hilton:]

Larry?

[Larry W. Seay:]

The backlog was around 40 or 45 units and it’s that it’s a small business deal, 100 units, 150 units that we planned to grow rapidly, it really provides us with a good platform and good connections in Nashville in which to deploy our excess cash.

[Nishu Sood:]

Okay, great. Thanks.

[Operator:]

Our next question comes from Stephen East at ISI Group.

[Stephen F. East:]

Thank you. Congratulations on the quarter guys. Steve, I don’t know maybe this is for Larry, but if you look at the incentive, you said they haven’t gone up much, I guess what I am interested in is, what type of incentives are you seeing consumers gravitate to and are you seeing differences geographically in the amount of incentives you have to use and also between different buyer profiles, first move up, second move up and I know you do just a little bit of entry-level, but if you can just give us some more color around all of that issue.

[Steven J. Hilton:]

Well, I can tell you what they’re not buying on is interest rate related incentives like buy downs. We’ve kind of experimented with those and they haven’t really made any much of a difference. So it’s kind of stopped, trying to put those out there. I mean the typical incentives are pretty much what we’ve always been using, which is towards options, money to use towards upgrades and options and we kind of change that around a little bit sort of a little bit – little secret sauce formula, but it’s all option related and I would say there’s not much difference between first and second move up. It’s pretty much the same. Certainly, we’re using less incentives in California than we are probably in other places, but there’s not a very wide difference by geography.

[Stephen F. East:]

Okay. That’s helpful. Not having buy downs and is that selling you then that you think the consumer is buying on affordability in that type of thing and maybe just a bit more sticker shock that they have to work through?

[Steven J. Hilton:]

Yes, I’d say it’s 70% to 80% sticker shock and headline shock and I think this Washington thing is really having an impact on the most recent sales and I don’t think it’s interest rates.

[Stephen F. East:]

It’s okay. All right, thanks. And you all have talked a lot about gross margin, I guess while that’s important, I guess I’m a bit more focused on what your ultimately your operating margin would be as you move forward in time. So I’m wondering a few things there. What type of leverage do you think you have on your SG&A? You all moved that lower as a percentage of sales faster than I thought you would. And where do you think SG&A goes up, margin goes? And then also embedded right now, what do you think your true ASP in price increases versus mix in the quarter that just ended?

[Steven J. Hilton:]

I’m going to pump that over to Larry. Larry?

[Larry W. Seay:]

Well, I’d answer the first question. We are hopeful that in growing the top line even though over the next few quarters margins may start to contract a little bit that we’re growing the top line, can continue to leverage our overhead and we can continue to bring down commissions and other selling costs and about half – half of that number is more fixed selling costs than commissions. So there is ability to leverage that and we should be able to leverage with a G&A number. I’m not prepared to tell you how much on a percentage basis, but we are hopeful of that. We’ll help maintain the bottom line pretax margin even though gross margins might erode a bit. What was the second question?

[Stephen F. East:]

If you look at your ASPs, how much have they gone up, how much of that is true pricing versus mix?

[Larry W. Seay:]

Yes, the last couple of quarters, the actual true price increase has been two-thirds to three-quarters of the change and it hasn’t been as much mix related as it was a year or so ago.

[Stephen F. East:]

Okay, all right, that’s helpful. And then just one last question along those lines. You’ve talked about your land cost. What’s going on, on the construction side? I’m thinking about. Everybody has talked about labor. Is labor changing any and are you seeing any of the materials start to move meaningfully one direction or another?

[Steven J. Hilton:]

It’s not having the impact that we saw a couple – few quarters ago. We got it under control. Not to stay it’s still not an issue that we are managing everyday. We have challenges in different areas, whether it’s brick masons or framers or whatever it maybe, but we have to manage to it and it’s a market-by-market situation. So I’m not going to put that out there as an excuse today for future results, but it’s under control for now.

[Stephen F. East:]

Okay. Thanks a lot, guys.

[Steven J. Hilton:]

Thanks.

[Larry W. Seay:]

Thank you.

[Operator:]

Our next question comes from David Goldberg at UBS.

[David Ira Goldberg:]

Thanks. Good morning, everybody.

[Steven J. Hilton:]

Good morning.

[David Ira Goldberg:]

I wanted to follow-up on the earlier question. I think it was Steve’s question on land banking, and I wanted to talk about how you guys are seeing the markets, the land banking evolves as we move through the downturn and if it’s through the upturn here and now there’s little bit of a pause. Are you seeing the availability of dollars for land banking and off balance sheet range change significantly? And do you think that’s an opportunity to change the trajectory of your growth as you’re reporting, and I think you talked in the past you don’t think it’s going to be where it was certainly in 2004 and 2005, but how much are we losing in terms of the availability of credit there?

[Steven J. Hilton:]

Well, a year ago it was like zero. So anything above zero is good. There is a few big players that have entered the space and are doing quite a few deals. I don’t know how deep those pockets are and how long they are going to be in it, but while it’s available to us we’re going to be aggressively pursue it. I don’t think it’s going to return anywhere near to where it was in the previous cycle, because there just isn’t the capacity there that we saw before. But I still think it’s some that makes a lot of sense and will really help drive our growth.

[David Ira Goldberg:]

And just together – sorry, go ahead.

[Steven J. Hilton:]

There is probably about 10 people we’re talking to that we’ve either done business with or are talking about doing business with. So and those are not like there are tens or hundreds, but there is certainly a group and it’s growing. So I see our ability to use this going forward as something that we can continue to do and grow. Again it’s not going to be what we were at last cycle, but it should be very meaningful and helping us provide off balance sheet capital to grow our business.

[David Ira Goldberg:]

And just as a [indiscernible] with that, is the cost of that capital is pretty comparable or relative to last cycle?

[Steven J. Hilton:]

It’s a touch higher than it was before in the previous cycle, but not that much and it’s pretty much the same program that we were operating under previously.

[David Ira Goldberg:]

And then just as a follow-up question. Steve, I know you said you don’t want to use this as an excuse in terms of labor market and labor shortages and then it feels a little more controlled now certainly than it was nine months. What I wanted to kind of talk about we’ve heard a lot of debate about labor in this cycle generally and I’m just wondering if you kind of think about your experiences up cycle, has there been a fundamental change in labor pool because of changes in immigration policy because of training for skilled labor and maybe having happened in the last three or four years. Do you think through this cycle labor shortages are fundamentally going to be a bigger or more significant or different kind of bump than they have been before or is it just kind of another up cycle to you?

[Steven J. Hilton:]

No, I think there has been some fundamental changes for all the reasons you mentioned. It’s going to depend on what our government’s policy is with regard to that going forward and then how efficient we can become. I think we are constantly searching for methods to build our houses that require less labor and we’re experimenting with a couple of those right now. But it’s a long-term challenge for the industry. There’s not a lot of people that want to pour concrete and frame houses. So some we think about it everyday and we’re working towards managing it better.

[David Ira Goldberg:]

Got you, and then thanks Steve. One more, Larry on the tax rate and the lower kind of tax rate for the year 31%, 32% I think you said. Is that going to be persistently lower tax rate at the time being just given energy, credit and everything or is that going to be kind of a 2013 event that will scale-off as we move into 2014 and 2015?

[Larry W. Seay:]

Well, next year we’ll probably be a bit higher, but it will continue to be lower than the statutory rate. This year we had some catch up things, some discrete one-time items that we booked from last year, because of changes in tax laws. And those are kind of fixed in as we’ve gone through the year, those numbers as a percent of the total pretax income has reduced and that's why the tax rate gradually gone up. But when you get to next year you won't have those, but you will still have the ongoing energy tax credits Section 199 deductions, maybe reversals of state Arizona and California State DPA’s that haven't yet been booked. So you will have some of those things continuing to bring the tax rate down some.

[David Ira Goldberg:]

Got it. I appreciate you guys. Thank you.

[Operator:]

…Credit Suisse.

[Unidentified Analyst:]

Thanks very much. I was wondering if you can talk a little bit about the comment, in terms of how the prices have the greater impact in terms of the variable trends here in the Golden State crew [ph], there have been increases in terms of pricing, and then saw a first line lower absorption during the quarter, but you’re still expecting a 5% or 10% increase in terms of pricing over time. Is this just to reveal this, certainly the third or fourth innings stretch that we’re going through right now and that in a sense doing much in the way of incentives and try to put that, do you think the pricing is going to come back over the next few months here and then into 2014?

[Steven J. Hilton:]

Yes, I mean you pretty much said it right. I think we still have a lot of the factors that pretend to a good housing market, very limited supply of resale homes, tight land conditions, high affordability and all these factors or even more so in California and are going to lead to better appreciation in California than other markets around the country. So we’re going to be very careful with our incentives and we’re going to do it – we’re going to use incentives strategically. We certainly want to protect our backlog and we want to maintain our margins to the best that we can.

[Unidentified Analyst:]

Okay. And then secondly I guess you commented that there has been a response related to confidence around the government shutdown and such, and those are real impact some of the most recent sales. Anything you can say in terms of the best periods of October here, anything regionally in terms of just how you’re seeing those having impact.

[Steven J. Hilton:]

Overall, it’s been pretty sluggish in October. I think we are going finish October with less sales than we had in September. Seasonally, that’s generally the case, but let’s go on and watch and it certainly hasn’t helped our business at all.

[Unidentified Analyst:]

Okay. Thank you.

[Operator:]

Our next question comes from Adam Rudiger at Wells Fargo.

[Adam Rudiger:]

Hi, good morning. Thank you. Most of my questions have been asked. So Steve, I’ll ask you kind of a big picture crystal ball type question. Something I’ve been struggling a little bit as we’re hearing common themes from you and a lot of the others builders talking about distinct this temporary blips or bumps on the road or kind of a choppy market in terms of a longer term improvement. I think we’d all agree that longer term supply demand is pretty favorable, couple of years out. But what gives you the confidence or the visibility as you see the next six to nine months maybe that this isn’t the sluggishness or sort of molasses [ph] we’ve seen isn’t kind of just going to continue? How do you think about the next six months, I guess?

[Steven J. Hilton:]

Well, we still have pretty good traffic in our communities. We just don’t see the urgency from buyers. We talk to buyers everyday. I mean I go out to sales offices myself. I talk to buyers and I know there’s still a deep pool of people out there that want to buy a house. But the memories of what happened in 2005 and 2006 is still fresh in people’s minds and they saw prices shoot up very quickly and then they saw them go down very quickly and it was painful for a lot of people. So people want to make sure that this new level of pricing that we’ve achieved is going to stick. So they are going to wait two or three or four months before they pull the trigger and see what builders are going to do and what sellers are going to do and if there is going to be a flood of houses in the market, they are going to drive prices down. I don’t see that happening and I see buyers looking over the next several months okay it’s safe, prices are steady. I’m going to buy a house and I think by the time we get to February or so we’ll have four, five, six months of this behind us and people will start buying again at a higher pace. It’s not like we’re not selling any houses right now. We are still selling houses, but just the pace has cooled off a little bit. So I think just being out in the field, talking to potential customers and looking at traffic really makes us more positive.

[Adam Rudiger:]

I think you’ve mentioned that you talk to buyers and they want to buy a house and there is a difference between wanting to buy house and actually buying house or being able to buy a house as there – so moving into I guess mortgage financing and mortgage availability, what have you guys picked up on in terms of the ability of your buyers to qualify, how is that been changing and if at all?

[Steven J. Hilton:]

It hasn’t really changed that much. I would say there’s been more shift towards the conventional financing from FHA and DA. I think, correct me if I’m wrong Larry, 75% of our buyers, they are using conventional financing. I think that was a little bit more closer to 60% in quarters past. And our down payments have actually risen from 11% to about 15% and credit scores have actually risen a little bit. So again we’re not very big in the entry-level space. So we’re not a very good barometer for what’s happening there. But we’re now finding a lot of buyers that are looking to buy – move homes from us having mortgage issue per se.

[Adam Rudiger:]

Okay, great. Thanks for taking my questions.

[Steven J. Hilton:]

Thank you.

[Operator:]

Our next question comes from Eli Hackel with Goldman Sachs.

[Eli C. Hackel:]

Thanks. Just two quick questions; one, have you seen any impact in relation to loosening of lending standards, and then just on the municipalities that you said you’re seeing some backup, is that thing getting worse over the past couple of quarters and is that being concentrated in any regions around the country? Thanks.

[Steven J. Hilton:]

Again, we haven’t seen much change in the mortgage markets for our buyers. I’d say yes, it has been getting a little bit worse over the last couple of few quarters, dealing with cities and towns has become a bigger problem, certainly in the west than other parts of the country.

[Eli C. Hackel:]

Okay, thank you very much.

[Steven J. Hilton:]

Okay.

[Operator:]

Our next question comes from Will Randow with Citi.

[Will Randow:]

Hey, good morning and thanks for taking my question.

[Steven J. Hilton:]

Good morning.

[Will Randow:]

Just two follow-up questions from the board, in terms of lot prices, we have been hearing, they are starting to plateau, in areas like the Inland Empire, are you seeing that at all?

[Steven J. Hilton:]

Yes, I think that’s a safe assumption.

[Will Randow:]

And I guess which areas in particular?

[Steven J. Hilton:]

I would say, across the country. I’d say pretty much everywhere.

[Will Randow:]

It makes sense. And I guess in regards to the government shutdown, were you seeing any hiccups or slowdown in FHA or FHFA insured mortgages for the first few weeks of October?

[Steven J. Hilton:]

Larry, do you hear anything on that, I didn’t really – we heard that it was going to be potentially a problem if it lasted longer. I think we were right on the precipice of it, if it impacting us, but I don’t think we really felt much of an impact. Is that correct, Larry.

[Larry W. Seay:]

Yes, the mortgage companies were closing with maybe a couple of two cum [ph] items and they were willing to take that – we open that investors are willing to take a risk until the government open backup and at some point, they would have stopped taking that risk, but it was a short enough period that it’s going to affect our buyers ability to close.

[Will Randow:]

Innovation, you haven’t talked all that much about it, I know you’ve mentioned on a few calls, can you talk about the cost benefit and how that improves the buyer demand if that is the case over production time?

[Steven J. Hilton:]

It’s still in the testing phase and we are still experimenting with it. So I really wouldn’t want to give any more information about it yet. We will certainly know more in the next couple of quarters and we could talk more about it then, but not really prepared to get into it too much more than we already have in previous quarters.

[Will Randow:]

Thanks again guys and congrats on the quarter.

[Steven J. Hilton:]

Okay, thank you.

[Larry W. Seay:]

Thank you.

[Operator:]

Mr. Seay and Mr. Hilton, we are turning up to the hour point, we do have several more questions in the queue, would you like to continue?

[Steven J. Hilton:]

Yes, we will take a few more. We’ll keep going.

[Operator:]

Then our next question comes from Jay McCanless with Sterne Agee.

[Jay C. McCanless:]

Hi, good morning everyone. First question I had on taking the gross margin question different way, if you look outside the California, with the acquisitions you have done in the neighborhood that you are opening, are you still seeing trends in the houses and what the buyers want in terms of larger square footage, higher amenities that might reverse the outlook you gave for gross margins?

[Steven J. Hilton:]

Yes, I don’t think it’s going to have that much impact on gross margins. I think as interest rates rise, if they rise it’s going to have more of an impact on size than actual buying decision. And so at these lower rates, people still wants the big houses and we’re selling at the larger end of our lineup in most communities, and they want their options and upgrades. So I haven’t seen, much of a change in that area either. And we certainly didn’t experience a lot of change around the option strategy in the last cycle, until things really fell off the cliff. So I expect it to remain pretty steady this cycle as well.

[Jay C. McCanless:]

Okay, second question is on active adult, and you made a comment early in the call about Tucson, what are you hearing from the field and what are your people in the field telling you about higher demand and why we haven’t seen active adult maybe pick up as quick as some people have anticipated?

[Steven J. Hilton:]

I wish I knew the answer of that, I certainly have my own theory on why active adult is not stronger and I think it’s certainly because that passive income that a lot of active adult buyers depend upon is much lower than it’s been, because of the low interest rates and lower savings return rates, and they don’t have the disposable income to buy a new home like they had in the last cycle. So that’s the impact, it’s a very, very small piece of our business and so it’s really not that material for us. But I’d certainly like to see they improve and maybe they will improve as we get into during next year. Yes, Tucson is a relatively good market. It’s not quite as strong as Phoenix; the north side has performed better than the south side, but we still have very positive plans for Tucson going forward.

[Jay C. McCanless:]

Okay, great, thank you.

[Operator:]

Our next question comes from Alex Barron at Housing Research Center.

[Alex Barron:]

Hi, good morning, good quarter guys. I wanted to ask you Steve, in terms of the communities that you guys are raising prices, or not raising prices, what’s the criteria for deciding whether to raise them or not. And also what percentage of your communities would you say, you did raise prices this quarter versus what percentage should we keep on flat and where there any – where you actually had to increase incentives or cut prices?

[Steven J. Hilton:]

I don’t have the answer to the second part of your question, and I don’t know if Larry wants to comment, but the first part I guess is purely on what demand is and sales pace so. If sales pace is exceeding 3 to 4 homes per months. We’re going to try to push prices and if we have a lot of demand and a deep pool of buyers that want our homes, then we will try to get a little more price out of it. I’d say we also look at the competition to see how we price that against them. We certainly don’t want to kill demand by over pricing our product and we’re looking at what spread is between our homes and the resale homes in our area where we are building. So there is lot of things that go into the decision whether to raise prices or not, but it’s mostly around demand. Larry, do we have any stats on how many communities we raised prices in and what are un fed, I don’t know if we want to get too much on the incentives.

[Larry W. Seay:]

Yes. I don’t think we have any hard percentages. I would just say that price increases were much more modest the last few months and so we don’t have huge price increases like we were having for quarters before that. And then incentives, I don’t think we really had any places where we had huge incentive increases. It’s more of a modest incentive increase of 1% or 2% in a few or certainly it wasn’t across the board kind of incentive increase. So I think price increases were more modest and incentives were fairly modest where they were used.

[Steven J. Hilton:]

Thanks. Operator, this will be our last question.

[Operator:]

Our last question comes from Jade Rahmani of KBW.

[Jade J. Rahmani:]

Thanks for taking the question. Just wanted to ask about backlog conversion, I think in the past last quarter, I think you said in the high 60s and you would like to keep it above 70%. What do you think a normalized rate is for your business, say going into next year?

[Steven J. Hilton:]

Well, Larry and I’ve been arguing about this a little bit because Larry is little more conservative than I am and he believes this is going to fall more. I’d like to see it stay higher. I think a lot of it has to do with how many specs we have available and we haven’t been able to put as many specs out there over the last couple of quarters because demand for dirt sales as we call them or new builds has been very strong, but I think as things cooled off a little bit this last quarter, we’ll be able to get some more specs on the ground and that will help drive a better conversion rate in quarters to come. And it’s also been a challenge getting permits in some places, which has slowed things down as well. So it’s probably going to be tough to get back to 70%, but I hope we can keep it about 60%.

[Jade J. Rahmani:]

Okay, great. And from the SG&A, I think on the commission percentage, I was wondering if there’s a potential for that percentage to tick up based on higher payouts to the sales people or increased marketing expense.

[Steven J. Hilton:]

It might tick up as such. We’ve been using commissions as a little bit of a tool to sell some house this last quarter. So there could be a small tick up there, but I don’t think it’s going to be that meaningful.

[Jade J. Rahmani:]

Great. Thank you.

[Steven J. Hilton:]

Okay. Well, thank you everybody. We’ll look forward to talking to you again next quarter. I appreciate your time and support. Good day.

[Operator:]

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