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Meritage Homes Corp
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Good morning, and welcome to the Meritage Homes Fourth Quarter 2017 Analyst Conference Call. All participants will be in a listen-only mode. [Operator Instructions]. Please note this event is also being recorded.
I would now like to turn the conference over to Brent Anderson, Vice President of Investor Relations. Please go ahead, sir.
Thank you, Laurel. Good morning and welcome to our analyst call to discuss our fourth quarter and full year 2017 results. We issued the press release before the market opened today and you can find it along with the slides that we'll be referring to during this call, on our website at investors.meritagehomes.com, or you can select the Investor Relations link at the bottom of our homepage.
I'll refer you to slide two and remind you that our statements during this call as well as the press release and slides contain forward-looking statements, including our projections for 2017 operating metrics, such as community count, order trends, closings, revenue, margins, and earnings. Those and 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 made be materially different than our expectations. We have 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 2016 Annual Report on Form 10-K and subsequent 10-Q for the third quarter of 2017, 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 release or presentation as compared to their closest related GAAP measures.
With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage; Hilla Sferruzza, Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage Homes. We expect to conclude this call in about an hour and a replay will be available on our website approximately an hour afterwards and remain active for two weeks.
I'll now turn it over to Mr. Hilton to review fourth quarter results. Steve?
Thank you, Brent and welcome to everyone participating in our call today. I'll begin on slide four. We ended the year on a positive note with strong fourth quarter results, making 2017 our seventh consecutive year of annual order growth and our highest pretax earnings in over a decade.
We sold 20% more homes than we did in the fourth quarter of last year and increased home closing by 6%, generating 5% growth in home closing revenue for the quarter. We leverage the topline growth with an improved home closing gross margin combined with additional overhead leverage to drive a 10% increase in pretax earnings for the fourth quarter and contributing to a 14% increase in pretax earnings for the full year 2017 and we achieved those results despite the challenges from weather and rising costs during the year.
Turning to slide five. A key strategic driver of our growth has been our successful pivot to the entry-level market. There is a significant long-term opportunity with this buyer demographic as millions of millennials will be purchasing their first homes over the next decade.
In addition to the even larger number of baby boomers who may become move down buyers and there continues to be an extreme shortage of affordably priced homes available for sale to this demographic.
Over the last couple of years we've been executing a strategy to address the demand by acquiring land for communities and designing homes that can be delivered at a lower cost by simplifying our product and construction processes, starting more safe homes and making the entire home buying experience easier and better for our customers.
By doing that we'll include Meritage's Signature Energy Efficiency, our new M.Connected Home Automation Suite and many features not found in your typical entry-level home, delivering our brand promise of Life. Built. Better.
Our stated target was to have 35% to 40% of our communities to entry-level market by the end of 2018. We're already at about 30% and our absorption rate in those communities are higher, resulting in about one-third of our 2017 orders coming from entry-level homes geared to the first-time homebuyers, up from less than one quarter in 2016.
We've been investing heavily to grow that business. We spent over $1 billion in total land development during 2017, securing more than 30,300 new lots in total and almost 70% of those are for the entry-level communities.
We intend to build entirely on a spec basis in these communities making them more efficient for us to build through, while also allowing buyers to moving quickly in choosing their new home.
As a result of our strategic pivot to entry-level with more specs, our total closings from spec homes increased to 49% in 2017 from approximately 41% in 2016. We also achieved the highest customer satisfaction scores in our history last year. Our total home buying experience score reported by Avid was about 90 for 2017, several points higher than the industry average for large volume builders surveyed by Avid.
Clearly our entry-level home and customer interaction are meeting the needs and desires of our buyers. I'm proud of the efforts of our entire Meritage team that resulted in our growth and improve profitability this year and we're looking forward to continued growth and even better year in 2018.
I'll now turn the call over to Phillippe to discuss our sales trends in more detail by market.
Good morning. Thank you, Steve. Demand for new homes was solid throughout 2017. All three regions contributed to 20% order growth we achieved in the fourth quarter with particularly strong order growth in our East region. In East region, we have focused on improving our community positions, rolled out new products designs specifically for that region and improved our overall execution.
I'll discuss our progress in each region and provide a little more local color beginning with East region on slide six. Our East region orders were up 47% year-over-year in the fourth quarter and up 33% in total order value, with significant gains in every market. This was primarily due to a 48% increase in absorption pace for the region.
One of our strategic objectives in 2017 was to improve our performance in East region. We have dedicated a significant amount of energy and resources to that end throughout the year and those efforts are starting to show meaningful results. This was the best quarter for year-over-year performance improvements in East region all year and I believe we can say we're turning the corner and are adding inflection point there.
We nearly quadrupled orders in Georgia with more than a 250% increase in ordered per average active community on top of a 6% increase in average community count. Florida orders rebounded following the hurricane in September and we're up 36% year-over-year for the fourth quarter with a 27% increase in absorption. Florida ended the year with a 17% increase in orders and 18% increase in order value for 2017.
North Carolina, South Carolina, and Tennessee produced solid double-digit increases in orders despite lower average active communities. Absorption were up 52% in Tennessee, 37% in North Carolina, and 23% in South Carolina.
Average sales prices on orders for the region as a whole were 10% lower in the fourth quarter of 2017 compared to 2016, demonstrating the beginning of our transition to more entry-level homes for the first-time homebuyers in the East region.
We're confident in our product and locations and very pleased with our fourth quarter results, but I still believe we still have opportunities to improve our sales execution, reduce our cost in cycle-times, expand our margins, and perform metrics in East region up to the level we're achieving in our other regions. We're very focused on continuing to make these improvements across the Board.
Slide seven, Central region. Moving West, Texas continued its record of strong performance with another quarter of double-digit order growth. The total orders were up 19% for the fourth quarter and total order value increased 14% year-over-year. As with the East region, our ASP in Texas were 4% lower, reflecting our success in the entry-level market, especially in Austin and San Antonio, which are heavily-oriented towards entry-level buyers.
Demand was also strong in Houston, which we valued surprisingly quickly after the hurricane in August. We opened 30 new communities in Texas during 2017 due to strong demand there and our average community count was up 20% year-over-year in the fourth quarter. We expect continued strength in Texas due to population and job growth in its major market, which has been among the best markets in the nation for the last several years.
Slide eight, West region. Our sales teams in the West produced 5% growth over 2016's fourth quarter orders, despite an 11% decline in average community count for the fourth quarter of 2017 compared to 2016. This was attributed to a 17% increase in orders per community on average.
As we noted last quarter, heavy spring [rates] [ph] delayed community openings in Northern California. We are on plan to open several communities there over the next few quarters. California and Colorado, again, produced the highest average orders per community [count] [ph] during the fourth quarter as well as for the entire year in both 2017 and 2016. Demand was particularly strong in California where average absorptions increased 71% to offset a 23% decline in average community count.
In Colorado, our fourth quarter orders were 11% higher than last year, partially due to the success of new entry-level communities which also resulted in an average order price in Colorado coming down 4% from a year ago.
Arizona's fourth quarter 2017 orders were 14% lower than 2016. Since we experienced more typical seasonality in 2017 and were selling from fewer average communities than a year ago in Phoenix.
We continue to see strong interest in our entry-level communities there and we plan continue to focus on that segment which we believe offers a greatest growth potential for the next decade.
I'll now hand it over to Hilla to review some additional details regarding our financial performance and balance sheet. Hilla?
Thank you, Phillippe. I'll recap for our full year results as well as key land and balance sheet metrics beginning with slide nine. We generated $247.5 million in pretax earnings in 2017, a 14% increase over 2016. Most of the increase was driven by our 6% topline growth in home closing revenue and the associated overhead leverage that provided.
Our full year 2017 home closing gross margin was in line with 2016 as we expected due to the general cost inflation as well as supply disruptions from the hurricane during the third and fourth quarters.
We were able to offset cost increases through efficiency gains and home price increases, but the net effect limited our ability to improve home closing margins in the short-term. Greater leverage and companywide cost control initiative resulted in lower SG&A percentage in 2017.
We held those expenses to 10.4% of home closing revenue in the fourth quarter and 10.8% for the full year, which represented reduction of 10 and 50 bps respectively over 2016. Our long-term goal is to reduce total SG&A expense to 10.5% of home closing revenue and we expect to make further progress towards that goal in 2018.
Our effective tax rate before the DTA revaluation charge was 34.2% for 2017 compared to 31.4% in 2016 due to the expiration of the energy tax credit that reduced our 2016 tax rate.
Our fourth quarter 2017 tax expense includes a $19.7 million DTA revaluation charge, which further reduced our net earnings per diluted share by $0.47 compared to 2016. However, we expect the benefit going forward with a reduction in corporate tax rate. We're projecting an effective tax rate in 2018 of about 25%, which will benefit our 2018 net earnings significantly compared to 2017.
Slide 10. After retiring the last of our $126.5 million convertible senior notes in September, our diluted share count for the fourth quarter of 2017 was reduced to approximately 41.1 million shares compared to 42.7 million shares in the fourth quarter of 2016.
We ended the quarter with approximately $171 million of cash and nothing drawn against our revolving credit facility. Our net debt to cap ratio remain relatively stable and is well within our target range of low to mid-40%. We ended the year at 41.4% compared to 41.2% at year-end 2016.
Our total lot supply of approximately 34,300 controlled lot at quarter end equates to about 4.5 years supply of lot based on trailing 12 months closing with approximately three years supply of owned lot. This metric is also within our comfort zone of a four to five years supply of controlled lots.
As Steve explained, we are building more spec home as part of our strategy to focus on the growing entry-level market. We ended the year with 2,086 spec completed or under construction, which is approximately 8.5 spec per community compared to 1,682 a year ago or an average of seven per community in last year's fourth quarter. Approximately 31% of total specs were completed at the end of December 2017 compared to approximately 29% at December 2016.
Moving to slide 11. Housing related economic indicators remain positive, pointing to further growth in new home sales for the next several years. With that in mind and building on our strong quarter growth volume we achieved in the fourth quarter, we anticipate additional earnings expansion in 2018. We expect to deliver approximately 8,350 to 8,750 home closings in 2013 for total home closing revenue for approximately $3.4 billion to $3.6 billion, which should drive the 6% to 13% increase in pretax earnings.
At this time, we're projecting an annual home closing gross margin of 17.5% to 18% compared to the 17.6% we achieved in 2017. We also have opportunities for additional overhead leverage, which together with lower effective tax rate and lower share count will benefit our net earnings comparison in 2018.
First quarter results will be the low point of the year consistent with historical seasonality and we are forecasting 1,550 to 1,750 home closing and home closing revenue approximately $650 million to $750 million. With the home closing margin in the mid-16% range, we expect our 2018 first quarter pretax income to be 5% to 10% higher than 2017.
With that, I'll turn it back over to Steve.
Thank you, Hilla. In summary, we were pleased with our fourth quarter results and positive progress in nearly all the metrics during 2017. Demand for new homes continues to be healthy, especially for entry-level Live Now homes. We're 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 of Meritage Homes and we'll now open it up for questions. Operator?
Thank you. We will now begin the question-and-answer session. [Operator Instructions]
The first question will come from Stephen King -- Kim I'm sorry of Evercore ISI.
Yes, thanks very much guys. Strong quarter. Wanted to, sort of, talk a little bit about your entry-level focus here, which, obviously, I think it's really where you should be focusing. But one of the things that we've been curious about is the ability to raise price at that -- for that kind of buyer, particularly in the light of the potential for rates to maybe move up here.
Can you talk a little bit about what kind of resistance you are seeing maybe in pushing through price increases? And what your expectations might be for that as you go forward if rates were to move up, I don't know, let's say, call it 30, 40, 50 basis points from here?
We do believe we have pricing power in the entry-level segment. Clearly, if we stay below the FHA loan limit, I think we're okay. We think as rates move up, we may see buyers move down. Clearly, we're seeing more -- as prices get higher, we're seeing more buyers that were in the move-ups space moving into our entry-level plus community. So, I do believe we have pricing power there.
And we have a wide -- not as wide array of floorplans in the entry-level as we do in the move up, but we do have many choices for buyers. So, they can go small, they can go medium, and they can go a little bigger. And I think we have a product that appeals to many different buyers in a rising rate environment.
Okay. Yes. And as it relates to the breadth of offering, I wanted to talk a little bit about standardization. And I think last time we spoke a couple of months ago, that was an area that you were very focused on in terms of driving greater efficiencies. And I think that you had suggested that you were going to be rolling out maybe more clear -- good, better, best kind of a marketing or merchandising approach within your communities.
And then also you were amenable to the idea of moving into larger communities overall. And I was just wondering if you could sort of tie those two together under the header of your attitude towards standardization in terms of how you look for that to affect your business going forward versus what you had been doing in years past?
So, I'll let Hilla, I think she might have a number on what average lot size or quantity is for our land buys in the quarter. I mean you guys can look for that. I know we're buying larger communities. Coming out of the cycle, we're buying small 50, 60, 70-lot communities. And now today the average is larger so -- because we expect absorptions to be higher and we want a longer runway in entry-level communities. So, we'll give you that number in a moment.
But I would say that as we continue to pivot into entry-level particularly in our Live Now product series, this is almost a 100% spec strategy. We do have options in these communities, but they are preplanned. These buyers don't go to the design center.
The strategy is to have product on the shelf for people who want to move quickly, particularly from apartments and don't have a home to sell and we think there's a big market segment that that appeals to and it's a proven itself in the Live Now communities we have opened today because as absorption in those communities are higher.
So, just to follow-up on what Steve mentioned. Last quarter was our record average since the downturn at 116 average per community. This quarter we busted through that average at 153 lots per community and what we put under controlled, so we're definitely increasing the size of our communities very notably.
And then what that will do is reduce our community turnover. We churn a lot of communities, we open communities, we closed communities and will allow us to stabilize our community count number and we will steadily grow that number over the long-term.
And allows our [Indiscernible] to be more efficient as well.
Yes.
Right, right. Excellent. Okay. Thanks very much guys. appreciate it.
Thanks Stephen.
Our next question will come from Michael Rehaut of JPMorgan.
Thanks. Good morning everyone. I -- first question and then I have a follow-up on some modeling oriented details. But first question, kind of bigger picture, recently, you've done some work on ROE and components of ROE from a DuPont perspective. And it's clear to us at that two key drivers I think for different companies are improved margins and maybe a little bit less so for some of the larger accounts I think in your example.
There's still some good margin upside opportunity as well as turnover. And I wanted to focus on asset or inventory turnover for a moment. Right now, you are around one times and with a clear focus that you have been describing on the first time segment with the higher sales pace and absorption, I was wondering if that's a metric that you look at and where that might go over the next couple of years.
And kind of a separate part to that is with the margin mix, your margin guidance was a touch below what we are looking for, but not too far off. And I was wondering on the flipside, the first time shift, what type of dampening or negative impact that might be having on the margin outlook for the upcoming year?
Well, first off, I would say that our entry-level shift has had no negative impact on our margins. We think it's actually quite to the contrary. Some of our move-up communities, we've had some trouble with. Land [indiscernible], slow absorptions, stiff competition, they haven't performed as well as they should have, and that's why our margins aren’t where we want them to be.
But all of our entry-level communities we opened so far, for the most part, performed very close, if not better, than our underwriting standards. I would -- I can't give any guidance on ROE and ROA, but I can tell you, it's going to go north.
And I can tell you that, as we improve our margins in the South or in the East that will help our ROE and ROA and as we improve our absorptions in those markets, it's also -- it will improve our ROE and ROA. So, I expect better things ahead, but it's going to be a gross margins and absorptions first.
One other quick comment, Mike, on the asset turn. So, even though the size of the communities in the lots we are putting under control for the entry-level is larger, the per lot cost is smaller. So, obviously, the net-net amount is about the same or lower than what we were previously putting under contract, but the churn on those assets is significantly faster.
Our absorptions and closing pace is accelerated versus our move-up products, so you're actually going to see a quicker asset churn on about the same asset base, so we are going to see some improvement on that part of the equation as well.
Appreciate that, that's good to hear. Thanks Hilla and Steve. Yes, secondly, just some modeling oriented questions. How should we think about the interest expense line for 2018? Once again, there was seasonality in -- towards the end of this year, similar to last year. But I think you ended interest around $4 million for 2017, how should we think about that for 2018?
And also, if you could just provide a little -- what your ending share count was, obviously, went down by about 1 million the fourth quarter but I think that was still on average. How should we think about, as of today going forward, where the fully diluted share count is?
So, on the interest, I would model it up just a bit. We had the new debt issuance mid-year through the year, and we're going to have that higher outstanding debt amount and interest rate in all of 2018. So, it models a little bit north of where we ended the year for 2017.
And then on the share count, I think it's fair to assume 300,000 to 400,000 incremental shares during the year from additional issuances on a weighted average basis. So, the ending amount at the end of 2018 is not going to be too far north of where we saw at the end of 2017.
And is the end of 2017 equal to the average of the fourth quarter, that's what I was just trying to get at?
The weighted average for the fourth quarter is clean, it doesn't have any convert in it. The full year is not clean, it's got three quarters of convert. If you look at the fourth quarter average and then maybe add 300,000, 400,000 shares to get to the full year 2018 diluted count.
Okay. All right. Thank you.
Thank you.
And the next question comes from Stephen East of Wells Fargo.
Thank you. This is actually Paul Przybylski on for Stephen. I guess my first question I guess, Steve, the industry has been reporting some pretty strong order growth this quarter and in the not-too-distant past, chatter was that 10% growth was about all the industry can handle with that already stressing a strained labor pool.
How do you feel the industry is positioned today, given the stronger growth rates being reported? And do you think that's going to cause backlogs to become extended? Or are we going to see some more acceleration in labor cost going forward?
Well, with the pivot to entry-level allows us to keep up with stronger order growth because we're building more efficiently, we're line building this year for trading partners, that's really the key to be able to keep up with demand is moving our --- making our product easier to build and simplifying everything and moving to the entry-level.
Okay. Thank you. And then with respect to your gross margin guidance, what are the assumptions? Or how should we think about that regarding you hitting lower or higher end of that guidance range?
I think it's too early for the year for us to get that specific, trying to give ourselves a little bit of cushion. I hope it's higher, not lower, but it's just too early to pin that down.
All right. Thank you. Appreciate it.
And next we have a question from Alan Ratner of Zelman and Associates.
Hey guys, good morning. Nice quarter. So, my question is related to the tax reform, and I'm just curious, I think, Hilla, if I remember correctly it was at your Analyst Day where you had some interesting analysis on all of the initiatives you've done on the energy efficiency and kind of walking through the math behind how the added cost associated with making your homes more energy-efficient is made up for through energy tax credits and when you think about it from an after-tax return perspective, it made sense to make those investments.
And now, with tax reform, obviously, everybody's corporate rate is lower. The energy incentive is really no longer there. So, I am curious how you think about that part of your business today and really, I guess this could extend through all parts of your business, including land underwriting, et cetera.
Are you looking to may be shift those strategies in terms of maybe reducing your costs a little bit less of a focus on the energy efficiency to drive the margin higher, now that the tax incentive is no longer there? And on the land side as well, how are you thinking about underwriting between pretax and after-tax returns, given the lower tax rate? Thank you.
So, the short answer is no. We're continuing with our energy efficiency strategy. I would say that the gap between us and others is narrowing, because we're doing a very good job of reducing the cost energy efficiency, getting more competitive pricing from our trade partners who are active in that part of the construction of the house and installation of the windows.
And then the bar for energy efficiency has been raised all over the country. Many states are now -- it seems they are requiring more energy efficiency than they were a year or two ago. So, what we're doing is ahead of the minimum requirements, but the gap is closing, so the cost gap between us and brand X, Y and Z is going to be relatively narrow.
But energy efficiency is a big part of our brand and who we are and is part of our marketing. And we don't make -- have any ideas about retreating from that and every home that we build, comes married state-of-the-art energy efficiency, installation and our Internet, home automation as well.
And just one last point, Alan. Certainly, the energy efficiency of the tax credits have not been renewed, although there is some talk of potentially having them be attached in extender bill, so we're not modeling that. We are not expecting that, but we're continuing to very aggressively push behind the scenes in Washington to get that back that, to get that back up in the tax code.
But as Steve mentioned, it's a differentiator for us so even when the tax rate isn't there in the bottom-line, we're going to continue to pursue it although at a more cost efficient basis.
And the lower tax rate has not changed our underwriting, we're going to save $20 million or $25 million in taxes in 2018, that capital will just go back into the business. It allows us to do four, five, six more communities, help us with our growth and employ more people and take more advantage of this healthy housing market.
Great. Thanks for all the detail there guys. And I guess just a follow-on in terms of your comments Steve on the cost and kind of narrowing that gap, can you give us an update on where your cost inflation currently is on sticks and bricks? And how that compares to price per square foot trend, if your pricing power is currently exceeding your cost inflation? Thank you.
Most of our inflation is in lumber and concrete. I really don't want to give specific percentages or dollars right now. But I think we're managing well most of the other components of the home, but areas that are challenging right now are really lumber and concrete.
And [Indiscernible] Alan that, obviously, still tightening is the labor pool but feels either pulling steady or a little lesser than it's been in the last couple of years and as Steve mentioned previously with the high volume of specs, we're able to manage through that more efficiently than we have been in the past.
Okay, great. Thanks a lot. Good luck guys.
Thank you.
And next we have a question from Nishu Sood from Deutsche Bank.
Thank you. Steve, I want to ask your thoughts about the -- in some of the recent mergers there, one of the main lines of thinking behind them has been that in today's building market, you need to be top three, call it, in the market to have the right access to deals, the labor, maybe even on the materials, to some extent, which would imply, obviously, for smaller and mid-size builders some pressure or need to consolidate. What -- I wanted to ask your opinion, what do you think of that line of argumentation?
I agree and disagree. Clearly, bigger is better. You get more access to trades and land and everything that you need. But we don't have to be the biggest. I kind of look at the top five. We aspire to be top five in every markets that we are in. And those that we're not top five, we are incentivizing our leaders to get there, but we can't trade market share for risk and profitability. You don't want to be chasing market share and taking on new risk. So, I think you have to be balanced. And there's a time to have your foot on the gas pedal and a time not to.
You don't want to have your foot on the gas when the market is cooling and you're chasing market share. So, I do think that in this market that we're in right now, there's an advantage to being bigger.
Got it. Appreciate your thoughts. And second question, on the entry-level buyer, you folks were pretty early in putting together a strategy, I think it was mid-2015 or early 2015 when you first began to kind of formulate your strategies.
Early on -- and that like 2016 and even in the early part of 2017, there's still this thinking that the trade-offs for entry-level buyers just weren't happening, happening to move out, to find lower price points or maybe lesser amenitized locations, lower quality locations.
Now that we are here with, I think a little over 30% of your orders, and, obviously, the momentum clearly coming out of the segment, what changed? What -- how was that resolved? I mean, the entry-level buyers just kind of bite the bullet and say we want to get into the market then we have to go to the further out location, lesser amenitized. Did you start buying different types of parcels at some stage? Or what trade-off ended up happening to kind of really facilitate it as you see it across you operations?
Well, I think, hindsight is always 20-20. But looking back, we were a little tentative in our early execution of the entry-level strategy. And I wish we would have been more aggressive sooner and bought more land earlier for entry-level and made that pivot stronger.
Clearly, a couple of our larger competitors have been exploiting that segment now for a couple a few years, if not even more, for some of them. And it's really working out to their favor.
So, I just think being -- traditionally being a move-up builder, we had more entry-level in the last cycle, but we don't have much entry-level in this cycle, made us a little more cautious about moving into that space but it's full swing right now, and we have a lot of success, and we expect that to continue to have success going forward.
Our business is completely aligned around the strategy and even though those farther out communities that where may be we are afraid a few years back are doing really well right now.
And I'll just add, this is Phillippe. Really few things change and they always have are related to demand and affordability effect until the end markets got less affordable and people are pushing out into the tertiary market. And then demand just started growing and so you could underwrite the higher absorptions in these other markets, which makes the entry-level business work for us economically. So, demand changed.
Got it. Was that -- was the spec aspect of it, the kind of critical part of your strategy shift? Or was that just one part?
Yes, it was really -- there are multiple parts but the spec strategy, number one, that's what buyers are looking for. They need to move quickly. And that's the kind of the home buying experience that they are looking for.
And then number two, it's the effective way to keep the cost down. And prices, the ultimate amenity for first-time homebuyer and so it allows you to keep your cost down and see that price point you need.
Great. Thank you.
Thank you.
And the next question comes from John Lovallo of Bank of America Merrill Lynch.
Hey guys thank you for taking my question. Maybe I'll dovetail off the last question and 49% spec, I think was the number in the quarter, which I think makes a lot of sense given your increased focus on entry-level. Where do you think that, that could actually trend to as Live Now and other portions of the entry-level business become more prevalent?
I think we could end up in the 60s, approaching 70%. Not in the next couple of quarters but over a long-term, they could end up there.
Okay, got it. That's helpful. And then I guess in terms of community count in 2018, any thoughts around how we should be thinking about that from a modeling perspective and maybe in terms of cadence?
I'm waiting for someone to ask me that, so congratulations. We expect to be up between 5% and 10%, yes, throughout the year, by year-end to be up between 5% and 10% from where we've finished.
Okay, that's great. Any thought on how is that going to work quarterly?
The first quarter will be flattish. The second quarter will be up and it will continue to rise for the balance of the year.
Perfect. Thanks very much.
Thanks.
The next question comes from Jade Rahmani of KBW.
Good morning. This is actually Ryan Tomasello on for Jade. Just regarding the land, how does the acquisition pipeline look? And what's the targeted land spend in 2018? Are you seeing any material changes in pricing, deal flow or the mix of deal types, like JVs or option deals?
So, we have all the land that we need to meet our internal 2018 projections. We have almost all the land that we need to meet our internal 2019 growth projections. I expect that we'll buy a little bit less land in dollars in 2018 than we did in 2017. And then maybe a little less in 2019 than we did in 2018. What was the other part of the question?
The option?
Yes, nothing's really changed on the option front. The cost of bringing in third-party land bankers to controllable land, for us end up own the land is still too high for us to do that in a large way.
And we're not seeing a lot of a lot of developer options although there are some of that are some markets more in the South and other places, but we don't see how any of them at all in the West and much fewer in Texas than we saw the last cycle for sure. So, there's no real news in that, on that front.
And then could you give your updated thoughts on integrated offsite solutions in terms of preconstruction fabrication of various aspects of the home? What opportunities do you see that having and what areas do you see the impact of being the greatest? And how long do you think it could take for this type of construction to become a more meaningful parts of the homebuilding business model?
We're looking at things all the time. We have dedicated people on our team here that are focused on that, trying to figure that out. There is nothing on the horizon, I think it's eminent that we can componentized the home, build it offsite. I think transportation is still a big impediment to doing that. You have to shift those features to the job sites, you to have factories close by.
I do think though that when you look at the framing piece of it, the lumber and the carpentry, there's going to be more and more panelization and trusting and panelization, precut lumber, I think that's going to be a bigger part of the business. And I think that will help us mitigate some of the rising costs in the rough carpentry area.
And there's things happening inside the home too, with regard to plumbing and [Indiscernible] cabinetry that are also making some of those products more efficient. But as far as the massive componentization, there's a couple of companies out there that are pioneering in the apartment space. We'll see the results of that I think in the next year or two, but we're just not there yet for potential single-family houses. Okay? next question operator.
Sure. Next question will come from Alex Barrón of Housing Research Center.
Hey guys congratulations on the strong quarter. I wanted to ask if you guys could comment on how orders are doing or did in January? And also in your fourth quarter orders, curious what the percentage was what you guys define as entry-level or Live Now versus a year ago?
So, the quarter just ended -- or the month, I should say, just ended yesterday, so we're still kind of tabulating what our exact orders are for January, so I can't give you that precise number but I can tell you based upon what I saw last night, it should be up at least 10% year-over-year for January.
And we continue to have strong orders in the East, much like in South in the fourth quarter and also say that Phoenix looked exceptionally strong. Maybe the best month we haven't had in Phoenix in a long, long, long time. So, very impressive with Phoenix January orders and what we saw in the East.
For the fourth quarter, the percentage of entry-level is pretty similar to what it was in the full year, so around the mid-30s. It's increasing throughout the year as additional entry-level communities have come to the pipeline.
Got it. And -- where do you guys see the percentage going over the next year or two? And with regards to the January orders, is it your sense that people are just rushing now because they think rates are going higher or not really?
I don't know that -- that's really the case because certain markets were stronger than others. I think in Phoenix, we have a big entry-level presence and looking at a few of our competitors who are here, where their strength is, it's in the entry-level segments.
So, I just think that segment of the market is really picking up steam. And it's driving the orders more than the entry trades. We're producing a lot of jobs in the Arizona particularly at the lower end of the wage spectrum, and those people are buying houses now.
That's great. How about the trend in the entry-level as a percentage of your business?
We publicly say that we should be at 35% to 40% by the end of this year.
Of communities.
Of communities. And then actual orders will be higher than that because we do have some entry-level buyers in our move-up communities. And I stand by that, and we think that's -- this could be the number, if not better.
Probably closer to 45% to 50%, if the community count is going to be 35% to 40% since they have a stronger absorption pace than the traditional community.
Okay. And best wishes for the year. Thanks.
Thanks Alex.
And our next question will come from Mike Dahl of Barclays.
Thanks for taking my questions. Just interesting comments about your land positioning and how you think you have essentially all the -- or almost all the land you need through 2019.
I was curious to -- if you think about that land spend incrementally over the course of 2018, 2019 being a little lower, where, regionally, do you still have the kind of like pockets to fill or backfill on meeting your plan for 2019 and beyond?
Well, it's quite a mix of -- I can't -- I can tell you every market we are looking at land, we need land Charlotte, we need some land in California, we're buying land in Phoenix. There's couple of places in Texas where we're looking for more entry-level land. South Florida, we're growing. Tampa, we're growing, we have land there.
So, I mean, we're buying land, to some degree, everywhere, some places more, some places less. And a big part of our land spend for 2018 is land we already committed to in 2017, but we just haven't close on yet, waiting for the entitlement process and then half of our land spend is for development. So, projects that we already bought in 2016 -- 2015, 2016, 2017 that we're developing in 2018 as part of our land spend also. A big bulk of that number is already committed.
Yes, just to clarify that, the 2018 land spend is going to be pretty close to the 2017 land spend, right around that $1 billion mark. It's going to drop in 2019. So, the number of lots that we'll be putting under contract may pull back a bit since we sold our pipeline where we have a hole from prior years, but the spend to continue to do land takedowns and continue development on the lots that we put under contract over last 24 months we plan to continue throughout 2018.
Okay, got it. And along the lines of the discussion around entry-level mix, 35% to 40% of the communities by year-end, if you look at the commitments you just discussed and targets for the incremental acquisition spend, how should we think about what percentage of the incremental spend will be dedicated towards entry-level?
It's similar to what we did last year. 70% -- 60%, 70% of the dollars that we're going to spend will be focused on entry-level until we get to that 40% to 50% of our total sales.
Yes, we have strong move-up land positions in most of our markets, so we are trying balance the energy level of our acquisitions.
Okay. Thank you.
The next question comes from Will Randow of Citi.
Hey, good morning and congratulations. I guess just to piggyback on some of the prior questions in terms of working capital, with 5% to 10% growth in active communities and spec home growth, how should we think about, I guess, one, working capital; and two, free cash flow conversion relative to net income over the next couple of years?
We don't usually give projections beyond the next 12 months, although with us indicating a 2019, we're going to feel back a bit on the cash spend. We're going to start to harvest cash in 2019, in anticipation of a potential 2020 pay down on the notes that are due that year, obviously, we're going to adjust that as we see, even if the market strengthening or weakening we'll make adjustments in 2019.
But for 2018, we're expecting to remain relatively consistent with what we did in 2017, so spending about $1 billion of land spend like we did in 2018 except that we are going to have higher volume of net income as we telegraphed. So, I think you're going to be able to model kind of looking at all of those numbers together a slight improvement on cash.
And then do you have any market specific, in terms of use, you indicated some level of inflection, which we've heard from others. I guess from a gross margin perspective, I imagine Houston is still higher than company average and can you talk about pricing net of inflation in that market recently?
Yes, on the margins being higher than the company average. We experienced some cost inflation after the hurricane. So, some of that is still in place and it's subsiding a little bit. But I would say over the last -- since the hurricane, costs have gone up slightly higher than our prices and the margins have come down a little bit from the impact of the hurricane, but we expect that to sort of again, subside over the next two quarters and our margins are still healthy there.
And if I could just slip one last one in, in terms of lumber prices, are you baking in current spot prices, for example, for the random [Indiscernible] index? Are you expecting some easing in lumber prices? Or stated differently, could we be surprised, one way or another?
We are modeling our current loss. And our sense right now is that we think they are going to come down a little bit. But we've been surprised, but we think they are going to come down as of right now.
Just to be specific, so you're modeling lumber prices from 90 days ago from your current lock.
Correct.
Okay. Thank you. Good luck.
Thank you.
And next we have a question from Dan Oppenheim of UBS.
Thanks very much. I was wondering in terms of the entry-level, you talked about the order trends and absorption there. But can you talk about what's happened in terms of the conversion as the traffic comes through and the new products and the specs? How is that conversion relative to what you've seen in other communities?
Well it converts faster. I mean, the entry-level buyer doesn't have a house to sell, generally, and a little bit of the rental and we're selling more specs. It's got a little higher can rate, of course, but there is much faster conversion and faster cycle-time. I don't know the specific numbers to give you around that today, but believe me, it's a faster process.
Great. In terms of the past, wondering about that some of the a lot of entry-level communities out here in the West often strategies to shift to more in land I think what you are doing some of the upfront communities [Indiscernible] is very good location, strong locations with more density there.
How do you think about the potential for absorption in the asset turnover with those communities as you is that going to be a strategy in general in general in terms of great just greater density to bring down the price point as opposed to going in land?
Well, we're doing both. I mean, clearly the in land empire in Southern California and the bedroom communities in Phoenix are doing a lot better, there's tremendous amount of growth in those areas that's where the entry-level buyers buy in.
There are some infill opportunities, of course, where we are doing more density in California and the other markets in the West. But that's not a primary strategy, that's additional strategy.
Great. Okay. Thank you.
The next question comes from Carl Reichardt of BTIG.
Hi guys. Phillippe, last quarter and I think quarter before, you talked a lot about the importance of getting up to scale in the East to start to guide margins, and now, the East is, I think 35% of your unit backlog and orders are terrific. What's your thought process on the ability to drag, let's call them operating margins up in that region over the course of this year?
I mean, I think they are going to go up. We have better backlog, and we are selling more houses we are going to get leverage out of our DNA out there. And we are opening up new communities because you know we open up a new community will have a lot of leverage to get it going, but you started the leverage we are getting our new communities opened getting leverage on the community level, and therefore, the division level. So, like I said, in the beginning, we feel like we're an inflection point and the operating margins, and we expect them to go up.
We still have significant amount of older product communities and older lower-margin assets to burn through, but you are accelerating that burn in getting through that and that's holding margins down a bit, but the newer communities as you said are going to have higher margins with the newer product and better absorption. So, out with old, in with the new is the motto in the South and that will drive higher margins.
We saw improvement in margin in the region in the fourth quarter versus the third quarter and we expect that trajectory to continue into 2018.
Okay. Thank you. That's helpful. So, still a drag but not nearly as much of a drag and overall margin is how you're thinking about it?
Right.
Okay. Thank you. I allude one more question just on the math -- on your guidance. And so we're looking at 5% to 10% community count with a mix shift to entry-level, where absorption should be higher. I'm trying to square that plus the backlog that you've got now with sort of only an 8% to 14% delivery unit delivery growth.
And so I'm -- it just seems like on the method of these ought to be higher than that. Do you feel better towards the higher end of that range? Or what's your sense of your ability to better that?
It's still January -- February today. It's just too early. Selling season starts Monday and I know you'd like us to give you a little more color on those numbers and help you with come to a number, but still it's early, we've got the give our self a still wider birth.
And also don't forget the five to 10 community count growth, that's going to be our year-end number, it's going to grow throughout the year, but we're not going to have all the communities on day one, and then we have to sell and then we have to close the home. So, there is a little bit of a delay in when you're going to see those communities come on, sell-through and then close until it hits our P&L.
Community count growth was absolutely a struggle for us in 2017. We expect that we'll end the year with a more communities than we did for a whole variety of reasons. So, we think we'll do better on that this year. But there's a lot of variables that come into play the opening communities. So, I would focus more on the closing number that we gave you on the community count.
Okay, guys. Thanks a lot as always.
Thank you.
And next we have a follow-up question from Michael Rehaut of JPMorgan.
Thanks. A couple of just a clarification additional clarifications, I guess. So, Hilla, when thinking about the gross margin guidance and kind the following-up on my earlier question around makes and different factors that will drive that improvement.
Steve, you said that the newer communities are coming in a little better than the older ones because of some challenges you had, I guess, some positioning competitive positioning for some of the move-up communities. But how should we think about what's driving the improvement in 2018 versus 2017? Is it just a better seasoning up with those newer communities that are coming in better than we did closer to the underwriting that you have done? Or is it also just that continued improvement in the East or other factors?
All of the above. I mean, it's in the East. I don't think we're projecting our margins in the West or in Texas go any higher. I think we're projecting it to be pretty stable, but we get some improvements in the South and in the use.
And community count growth there as well an better absorptions from our existing communities as we continue to ramp-up the entry-level, which is observed at a higher pace than move-up communities and so it's a variety of things that are driving the growth.
Right. Okay. Thanks Steve. And I guess circling back, I want to make sure I understand on the interest expense line. Hilla, when you mentioned that you expect that to go up a little bit in 2018, I just wanted to be clear that that's what can't be amortized through COGS, this is on the separate line item and if that's the case, if it was around $4 million in 2017, what might not -- that number be or at least kind of a rough range in 2018?
We've got a couple million higher, will probably be a good place to model.
Okay, great. Thanks again.
Thank you.
Thank you.
Well, that concludes all of our questions today and comments on our fourth quarter 2017 call. We appreciate your support and following Meritage Homes and we look forward to talking to you again next quarter. Thank you.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.