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Meritage Homes Corp
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Good morning, and welcome to the Meritage Homes’ Fourth Quarter 2018 Analyst Conference Call. [Operator Instructions] Please note this event is being recorded.
I would now like to turn the conference over to Brent Anderson, Vice President, Investor Relations. Please go ahead.
Thank you, Danielle. Good morning and welcome to our analyst call to discuss our fourth quarter and full year 2018 results.
We issued the press release after market closed yesterday. You can find and the slides that we’ll be referring to during this call on our website at investors.meritagehomes.com, or by selecting the Investor Relations link at the bottom of our homepage.
I’ll refer you to Slide 2 and remind you that our statements during this call as well as the press release and slides contain forward-looking statements including projections for the first quarter 2019 operating metrics such as order trend closing, revenue, margins. Those and any other projections represent the current opinions of management, which are subject to change at any time, and we assume no obligation to update them.
And these forward-looking statements are inherently uncertain and actual results may be materially different than our expectations. We’ve identified risk factors that may influence our actual results and listed them on this slide as well as in our press release and most recent filings with the Securities and Exchange Commission, specifically, our 2017 annual report on Form 10-K and most recent 10-Q for the third quarter of 2018, which contain a more detailed discussion of the risks. We’ve also provided a reconciliation of certain non-GAAP financial measures referred to in our press release and presentation as compared to their closest GAAP measures.
With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage; Hilla Sferruzza, Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage.
We expect to conclude this call within an hour. And a replay will be available on our website approximately one hour afterwards and remain active for approximately two weeks.
I’ll now turn the call over to Mr. Hilton to review our fourth quarter and full year results. Steve?
Thank you, Brent. And welcome to everyone participating on our call today. I’ll begin on Slide 4.
We are pleased to report our full year results and strong earnings growth despite soft fourth quarter sales. The first after the year was good, followed by a choppy third quarter and a slower fourth quarter. Even so we met or exceeded the expectations we shared in our guidance at the beginning of 2018. For the full year our total home closings were up 11% year-over-year. We expanded our gross margin by 60 bips over 2017, despite continued cost pressure, correctors and the lack of pricing power in the last half of the year as we’re beginning to realize more operating efficiencies.
Earnings grew 14% before taxes and 59% after taxes due to a lower tax rate. And our diluted EPS was up 64% for the year after a reduction in our diluted share count from the repurchase program we completed in the fourth quarter. We repurchased and retired about 2.6 million shares for $100 million in total, at an average price of $38.71 per share, which was a good value considering our book value per share, which is now at $45.20.
We also strengthened our balance sheet during the year, ending the year with $141 million more cash than we had at year end 2017 and increased our stockholders’ equity by 9% even after the share repurchases. The net result is that we reduce our leverage in terms of both debt to capital and net debt to capital ratios.
Turning to Slide 5. Homebuilding activity slowed in the later part of the year, which comes as no surprise to anyone who follows the industry. We noted back in October when we reported our third quarter results that the market had soften, especially among move-up buyers who seem to be positive before committing to a home purchase. That continued through the end of the year, so the near term outlook is unclear. However, despite slower sales and an increase in cancellations during the fourth quarter, out total orders for the year, we’re up 2% over 2017.
I’ll note that our January orders are running slightly ahead of last year’s, but we wouldn’t read too much into that yet. Considering the price sensitivity of buyers we’re adjusting incentives as needed to maintain the pace that effectively leveraged their overhead. The margin improvements we’re achieving are due to operational efficiencies rather than holding onto prices.
We remain confident in the long-term opportunities for the home building industry, considering the underlying drivers for housing demand remains strong. Economic growth, household formations, more jobs and higher incomes, strong consumer confidence, combined with relatively low inventories and homes for sale and the prospects of interest rate stabilizing should continue to drive demand. With that as a backdrop in mind we will defer sharing our projections for the full year in 2019 until we report next quarter, after we can more adequately assess marketing conditions with the benefit of the spring selling season.
Turning to Slide 6. I’m pleased with our progress towards strategically repositioning our product to focus on the first time and first move-up buyers, as we believe they are the largest and most active sectors of the housing market today and will be for many years to come. As we already have a large first move-up business we’ve been actively growing our presence in the entry-level market and have acquired a significant new land positions, targeted those buyers over the last couple of years. 85% of the new lots we put in our control in 2018 were entry-level homes, and about one third of our active communities were classified as entry-level as of year-end 2018.
These communities made up 41% of our orders in 2018 since they’re selling at a faster pace than our move-up homes. Our order for entry-level homes grew about 25% in 2018, while first move-up was flat and second move-up and others decreased by 35%. That’s a significant shift from our traditional business, which was about 75% move-up homes just a couple of years ago, including first and second move-up and beyond. But our strategy goes far beyond simply purchasing less expensive lots.
We redesigned our homes to make them more affordable while still including the standard that Meritage features like our high energy efficiency and M.Connected Smart Home Suite, along with upgraded finishes and appliances to appeal to a broader range of buyers who are looking for more than just a basic no-frills starter home. We’ve simplified and streamlined our construction sales process to better serve our customers and to make it easier for our trades and suppliers to work with us. We believe the strategy provides a more efficient cost structure due to a less complex homes, fewer points of variations, or SKUs and starting more homes on a spec basis so that our trade partners can be more efficient.
It also enables buyers to move into their homes quicker. 56% of our closes in the fourth quarter were from specs, compared to 47% a year ago. And our backlog conversion rate hit a six-year high at 76%, compared to 68% in the fourth quarter of 2017. We’re also beginning to capture efficiencies in the back office as a result of simplifying and streamlining, which will help us reduce overhead costs and improve our SG&A leverage in the future, after incurring startup costs in 2018 related to the strategic conversion.
I’ll turn it over to Phillippe to discuss our sales trends in more detail by market. Phillippe?
Thank you, Steve and good morning. Slide 8. I will begin by recognizing the tremendous efforts of our teams to complete and close over 2,500 homes in the fourth quarter. That’s the most homes we’ve closed in a single quarter going all the way back to 2006. And an 11% increase over the fourth quarter of 2017. We are proud of the accomplishment and the differences that they made in those 2,500 families lives. We’re also proud to report that our customer satisfaction scores, as measured by total home buying experience reported by Avid, were up again in 2018 and remain among the best in the industry. We invest a lot of energy and money to deliver a positive home buying experience and buyers are obviously happy with the overall experience, in addition to getting beautiful new homes for their families.
Slide 9. It’s no secret that the fourth quarter was a more challenging selling environment than what we see for many years, especially in October, which was down 20%, compared to the fourth quarter of 2017, while November was up 1% year-over-year and December was just 4% lower than 2017, which was unusually strong.
After seeing home prices increase further through early 2018 and enduring several rounds of interest rate hikes, buyers thought to reassess whether this was the right time for them to purchase a new home. For some that was an issue of affordability, but for most it was a psychological reaction to price levels in an uncertain market. This was most apparent in California, Colorado and Dallas, where prices have risen the most in the past few years.
Our traffic levels remain healthy and even our gross sales were relatively consistent with the fourth quarter of 2017, indicating consumers are still interested in becoming homeowners. But we saw an increase in cancellations that reduced our net sales. That also meant that we didn’t close out communities as soon as we expected to, so our absorption pace was off even more significantly than our order numbers. Orders were up 8% year-over-year for the fourth quarter, but absorptions on average per community were 15% lower due to the distortion from these near closeout communities.
As we close out those communities in 2019, we would expect our total community count to decline somewhat through the year. The slowdown was most pronounced with higher priced homes in move-up communities, where buyers were nervous about selling their existing homes and stepping into a new home at a potentially higher mortgage rate.
With mix shifting more towards lower-priced homes, the total value of orders in the fourth quarter was 15% lower than a year ago. While it was a broad-based volume in the market overall, there were significant differences between markets. A view of the hottest markets last year fell back to more normal absorption pace while others remained relatively steady, which I’ll cover shortly. With most uncertainty comes more competition. And we must excel at delivering what our customers want, which is a quality home at a good value. As we adjust to changing conditions, we are focused on improving our overall execution at every level.
I will discuss our progress in each region, and provide a little more local color beginning with each region on Slide 10. Slide 10, after a 47 year-over-year increase in the fourth quarter of 27 [ph], our each region orders were 5% lower in 2018 and 6% less in total order value. This was primarily due to a 19% lower absorption pace for the region. Florida accounted for most of the year-over-year decline in the fourth quarter of 2018. Since the fourth quarter 2017 includes orders that had been delayed due to the hurricane in September but rebounded in the fourth quarter. That made for a difficult comparison in 2018. Outside of Florida, total orders for each region were flat in the fourth quarter. So tenancy absorption has softened more than others. Overall, the region showed solid growth for the full year.
We are confident in our product and locations and believe we have opportunities to continue to improve our sales execution, and reduce our cost and cycle times, expand our margins and get our performance metrics up to the levels we’re achieving in our other regions. We’re focused on continuing to make these improvements across the Board.
Slide 11, Central Region. Moving to Texas, the word I would use to describe it in general is steady. Orders increased 2% on flat absorption year-over-year. Austin, San Antonio and Houston continue to perform well. We still have quite a few second move-up communities in Dallas, but we have recently begun opening more LiVE.NOW.® communities which are seeing good demand.
Slide 12, West Region. Our West Region orders were down 19% year-over-year for the fourth quarter as declines in California and Colorado offset strength in Arizona. Arizona’s fourth quarter orders were 12% higher than 2017, reflecting strong demand for entry-level communities here. And we believe that got great growth potential for the next decade.
As most of you are aware, the California housing market chilled towards the end of last year, after producing among the highest absorptions in the company over most of the last seven years, as interest rate increase had a greater impact due to the higher average prices there. On top of these industry level issues, our average community count was down 30% year-over-year in California, resulting in a 56% order decline. We’re rebuilding our positions in California with more affordably priced communities that should experience high absorptions.
Colorado’s orders were down 10% year-over-year in the fourth quarter, as higher interest rates made high price homes unaffordable. It remains a strong market and we believe we are well-positioned there after opening many new affordable and well-located entry-level communities.
I’m now turning to Slide 11, direct cost savings. Finally, I would like you to take a moment and address our direct cost trends, specifically lumber, which was a big concern in the first half of 2018 and something, I think, we’ve managed well in the back half. The savings we’re capturing will help offset the impact of increased incentives in 2019. Overall, most components we purchased have remained steady and consistent in price, or dropped slightly over the last 90 days. There are a few specialty lumber components in the west that have increased, but those increases are minimal.
Since the market began to decline in August of 2018, we have recaptured all of the previous lumbar cost increases from January through July. The bulk of these cost reductions we’re negotiating Q2 – Q4 but the first closings to benefit from those cost savings will be in the first quarter of 2019 and should continue through the remainder of the year.
I will now hand it over to Hilla to review some additional details regarding our financial performance and our balance sheet. Hilla?
Thank you, Phillippe. I’ll cover our fourth quarter results in a little more detail and highlight the strength of our balance sheet, which has always been a primary focus for us and it’s been more important now if you’re uncertain about the near-term outlook for the housing market.
Slide 14. We generated strong earnings growth in the fourth quarter and for the full year of 2018, despite the tougher market conditions over the last couple of quarters. Our net earnings of $75.5 million or $1.91 per diluted share for the fourth quarter of 2018, more than doubled the prior year’s fourth quarter net earnings of $35.6 million and diluted EPS of $0.87. The 112% increase in net earnings and 120% increase in diluted earnings per share in the fourth quarter, resulted from 11% growth in home closing translating to an 8% increase in revenue with an 80 bip improvement in home closing gross margin.
Net earnings benefited from our lower tax rate and share repurchases accounted for $0.05 of an increase in our diluted EPS for the quarter due to lower dilution. We were able to offset the negative impact of the higher lumber cost that flowed through our fourth quarter closing through a combination of cost reductions in other areas, home price increases taken earlier in 2018 and a favorable mix shift towards entry level which has a higher average profit margin.
We lost some overhead leverage as closings were lower than we had initially anticipated due to slower sales in the fourth quarter. Where we hope SG&A to 10.6% of homes closing revenue in fourth quarter of 2018, compared to 10.4% in the fourth quarter of 2017. After year end, we made some personnel reductions to properly size the organization for current market conditions and eliminated manual or redundant processes as a result of streamlining and simplifying our business. We recorded charge in the first quarter of 2019 for these reductions but expect to experience lower costs for the remainder of the year due to these actions.
Land profit swung from positive $2.9 million in the fourth quarter of 2017 to an $825,000 loss in 2018, which includes $2.2 million of land of impairments. Our effective tax rate was 18% for the fourth quarter of 2018, compared to 58% in the fourth quarter of 2017. We incurred a charge in the fourth quarter of 2017 for the reevaluation of our deferred tax asset as a result of the lower tax rate enacted under the Tax Cuts and Jobs Act of 2017. Without that charge, the tax rate was 34% for the fourth quarter of 2017.
Our tax rate for the fourth quarter of 2018 was lower than the expected corporate blended rate of 24% to 25%, primarily due to two factors: first, the additional tax credits from 2015 through 2017 closings after an re-audit of our energy efficiency qualification; and second, a favorable adjustment from the true up of our DTA valuation. Our lower effective tax rate compared to our peer group is sometimes overlooked. But we want to emphasize that is the direct result of the way that we designed and build homes, as well as the diligence of our team to pursue the associated energy tax credits we earned. I commend them for their work and the results.
After repurchasing approximately 2.6 million shares of our outstanding stock with the 100 million authorized by our Board in the third quarter of 2018 our diluted share count for the fourth quarter was reduced to approximately 39.6 million shares, compared to 41.1 million shares in the fourth quarter of 2017. The full impact of the repurchases will be recognized in 2019 and beyond.
Slide 15. We ended the quarter with approximately $311 million of cash and nothing drawn against our revolving credit facility. The $141 million increase in cash over 2017 was the result of $262 million positive cash flow from operations, partially offset by the 100 million share repurchase. We had expected to be cash flow positive in 2019, which we’ve gotten down in 2018 is significant, especially considering that we maintained our lot supply and returned $100 million to our shareholders.
As a result, we reduced our net debt-to-capital ratio to 36.7% at December 31, 2018, compared to 41.4% at the end of 2017. We secured approximately 10,300 new lots in total during 2018, maintaining our lot supply consistent with 2017, but spent $209 million less on land and development in 2018 than we did in 2017 due negotiated land purchase terms and less expensive lots to supply our entry-level business. We expect to spend about the same amount on total land and development in 2019 as we did in 2018.
We ended the year with approximately 34,600 lots or 4.1 years supply of land, compared to 34,300 lots or 4.5 years supply of land a year ago. 85% of the newly controlled lots from our 2018 acquisitions are for entry-level communities. We ended the year with 2,500 specs completed or under construction, which was approximately 9.2 specs per community, compared to 2008 specs in average of 8.5 per community a year ago. Our Q4 personal comp was slightly lower than third quarter 2018, as we paired back spec charges based on market conditions. Approximately 32% of our total specs were completed as of December 2018 in line with 31% as of December 2017.
Slide 16. Considering that our backlog entering 2019 was 15% lower than our backlog entering 2018 and 18% lower in total value due to a reduction in our ASPs, our expectation for first quarter closings and revenue reflect these lower starting points. We expect to deliver it between 1,500 and 1,625 home closings in the first quarter of 2019, with an ASP of approximately 400,000 and home closing gross margin 50 bips to 75 bips lower than the first quarter of 2018, in anticipation of additional price incentive.
As we noted, we currently anticipate providing full year guidance when we report our first quarter 2019 results.
With that, I’ll turn it back over to Steve.
Thank you, Hilla. In summary, we are pleased with our 2018 results, despite the slowing market in the latter part of the year. And we are confident our strategy is focused on the entry-level and first move-up markets and simplify our operations to make us more competitive.
We are encouraged by the fact that demand for entry-level homes and our LiVE.NOW.® homes remain stronger than the higher end of the market, which we are reducing in favor of more entry-level focus. We are dedicated to our brand promise of delivering a life still better for all of our customers and we continued to innovate and focus on customer satisfaction, which we expect to drive additional growth and shareholder value.
Thank you for your support in Meritage Homes. Operator, we’ll open it up for questions. The operator will remind you of the instructions.
We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Michael Rehaut of JP Morgan. Please go ahead.
Mike you’re there?
Mike your line is open. Okay, we’ll go to the next question. The next question comes from John Lovallo of Bank of America. Please go ahead.
Hey guys, thank you for taking my questions. First question is you guys mentioned incentive activity picking up, that’s pretty consistent with what we’ve heard from everybody else, I mean through October, November and December. I guess the question is as we kind of went into January, did you see any ability to kind of reign back on some of the incentives? And how are you kind of thinking about things heading into the spring?
So we did pull back our incentives on our specs from the fourth quarter as we entered January. But we did have a very successful promotion last weekend, where we offered some incentives, some additional incentives on specs. And it seemed to work out well for us. I would say the incentives for entry-level homes are probably around $5,000 or less. And for move-up homes they may be around $8,000 to $12,000.
As Phillippe talked about earlier, we are going to be – going into this year with some lower costs that we got some money back from lumber, probably an average of about $2,500 a house. So we think the net impact will be minimal because of the additional leverage we’re going to get from these additional sales. I would say we did get some color that we think our orders are going to be pretty good at for January. I will give you a little more color on that. The month is not over yet, so we haven’t tabulated all of the orders. But from what we can see right now, we think we’re going to be up in January at least 5%.
That said February and March are going to be much tougher comps for us. And it’s still too early to tell what we can do against those comps for the rest of the quarter.
Okay. That’s really helpful. And then going back to the 56% of closings that were attributable to spec that’s a very solid improvement in our view. Where could that number trend over the near term? Where is maybe is the target level for you guys if there is a target?
We don’t have a specific target, but some of our bigger brother and who are more focused on the entry-level market are 80% or higher. So we definitely believe that we have more opportunity to increase that as a percentage which will increase our conversion ratio and reduce our cycle times.
Okay. Thanks very much guys.
Thank you.
The next question comes from Nishu Sood of Deutsche Bank. Please go ahead.
Thank you. I wanted to ask about the kind of monthly cadence over the last couple of months. Obviously there’s been a lot of interest in that. The weakness in October followed by the rebound in November, December is a little different than peers, I think, generally what folks have perceived is that there was a weakness that accelerated into November and then some stabilization for some folks in December and January. What might explain that, and I know obviously there can be a lot of volatility in these monthly numbers. There’s something timing of promotions, availability of inventory or community openings that might have influenced the difference in your trend versus the kind of general trend out there?
Well as you already articulated there’s a lot of variables that go into the year-over-year, monthly comps and that’s why we don’t really release those numbers every month. But we release them quarterly. But we do talk about it when we look back. And it does reflect communities opening, it reflects promotions reacting to the market, specific geographies, but as far as our numbers – our October last year was down 20%; November was up 1% for us and then December was down 4% and the cumulative of all that, as we’ve already stated, was negative 8% for the quarter. But again the month over month numbers I don’t think are really that meaningful because there’s a lot of variables that go into that.
Got you, got you. Okay. And then kind of continuing on that line, other folks have been talking about traffic picking up in December and January, don’t read too much into that. You folks are seeing an increase in signups, in orders year-over-year in January, but you’re still saying not to read too much into that. I think you addressed it somewhat, that the comps get a lot tougher, but just wanted to revisit that. I mean, it would seem we’ve obviously have much more positive indicator to have plus 5% orders in January versus simply traffic trends. So yes, just wanted to kind of get some further thoughts on that please.
I mean, I don’t know how much more, I could say the traffic has been pretty good this year, for the first month of the year. It’s just a function of being able to convert that traffic. Clearly there’s a difference between entry-level traffic and move-up traffic, move-up traffic is taking its time making that decision. But I want to say that we’re not going to like – all discussions from some of our peers who have already announced or maybe that were a month earlier in their quarter end about pace over price. And we’re not going to cede market share to them. And we’re going to be focusing on pace over price as well. I think we’ve demonstrated that in January.
We are cognizant about our margin and we’re going to be smart about it because our margins are a little bit lower than some of those peers. And we have to be sensitive to that, but the leverage of our overhead is really, really important. And we need to sell homes to be able to effectively drive the strategy that we’re focused on here.
Got it. Okay, thank you.
The next question comes from Stephen East of Wells Fargo. Please go ahead.
Thank you. And good morning to you all and nice quarter. Steve, you’ve been talking a little bit about what’s going on with a pace versus price, et cetera and that’s really helpful to us. I guess a few things around the gross margin. One, could you talk what the differences between finished spec gross margin and your unfinished since you carry about a third of your specs is finished. And then you all be pretty significantly on your gross margin. You were about 60 bps higher than last quarter. And yet last quarter you said you thought that the gross margin and the backlog was similar. So I am trying to understand what that driver was at that big beat and is that repeatable as we go through the first quarter?
I mean I would just say that – I will let Hilla jump on this one that in our entry-level segment pretty much always sell the specs. So there is no difference between specs and bills because our strategy for entry-level is exclusively sell specs because we believe that’s what those guys want and that’s where our competition is going and that’s how we have to compete.
So comparing margins for entry-level specs versus move-up specs, clearly, within the move-up segment we’re trying to get out of our 2MU segment we have 15% of our communities, which are in 2MU. And we’re going to be probably more aggressive this year than we were at last year to price that product to move. And that’s going to result in lower margins. But at the same time, the entry-level communities that we’re – we’ve been opening and we continue to open in the entry-level segment, the margins are good.
We did fall a little – it’s probably more information than you asked me for, but we did fall a little bit short in the number of entry-level communities or the percentage level of the entry-level communities of the total for the year. We’re at 33%. We expect it to be 35% to 40%, but we did hit our goal of opening 90 – of having 90 entry-level communities that challenge was some of the move-up communities didn’t close out as quickly, which slowed our community count and drove that percentage down. I would say that as we go into 2019, we expect to get that number from 90 up to about 115 communities at the end of the year. And as I said earlier, those communities have higher absorptions and for the most part better margins.
So just to tack on a little bit on that. On the margin side, you’ll see this when our K comes out in a couple of weeks, but if you’re looking across our regions, the reason why our margins improved, Texas held pretty steady, the West improved notably as did the east. And that’s really just for the West it’s a story of the entry-level product. It just has a better margin and it was a larger portion of the pie for the west and the east. All of these improvements that we’ve been working on are finally coming through.
So I think that we weren’t sure on the composition of the mix of homes closing when we guided last quarter as to where they were coming from. So we didn’t know how to break out the margin exactly. And we ended up pushing up to the positive. Both the east came in with a stronger performance and the 2,500 closing helped us leverage our overhead better with positive gross margin increase.
Okay, thanks a lot. And then – great to hear that you’re cash positive you think in 2019, I guess a couple things on that. You’re talking about land spend being a little bit less. Is that you all looking at the market and being less comfortable with it? Is it more optioning? Or is this something else? And then you have no debt coming due. So do you apply that to share repurchase? Do you sit on the cash? How are you all thinking about that?
Well, I would say it’s all the above. Certainly we’re well aware of what’s going on in the market and we’re keeping a steady eye on that. And we’re making decisions on a daily – on a monthly basis on where we see the market going. We’re continuing to pivot to more the entry-level communities. As we said earlier, 85% of the loss we bought for entry-level. We’re trying to be more mindful of using options. It’d be more capital efficient. We’re very much focused on improving our ROA and ROE, but we do have a debt – a note coming due next year, $300 million. So we’re – we don’t see any reason why we won’t be able to refinance that, but we’re keeping some liquidity aside for that.
And then we want to be – have liquidity available if certain opportunities arise. So we’re managing all of that. Regarding share repurchase, we completed the $100 million in one quarter. We’re continuing to evaluate whether we want to renew that and follow up with another authorization, but we want to get to this earnings announcement and we have a board meeting in a couple of weeks. I’m sure it’s something we’ll be discussing and we’ll go from there.
Just one other part, Stephen. I think it’s really important to know that because we’re shifting so dramatically to entry-level, the cost of lots is just cheaper. So we’re able to spend less money and still secure the same amount of lots.
Yeah, but the deals are a little bigger [indiscernible] but the absorptions are higher.
Yep.
Yep, got you.
All right, thanks a lot.
Thank you.
The next question comes from Michael Rehaut of JP Morgan. Please go ahead.
Thanks, good morning everyone. Sorry for the earlier issues with the phone. Yeah, first question, I just wanted to circle back to the gross margins you know an answer to your question. Steve, it sounds like the upside on 4Q is largely driven by mix, but you’d also talked about efficiencies that you’re starting to get in the east region. Looking into the first quarter guidance, you’re shifting – switching to solidly down year-over-year or moderately down year–over-year driven by the incentives. So just wanting to get a sense, when you think about going from up 80 bps to down 50 bps to 100 bps, I believe I’m sorry I don’t have the numbers right in front of me. Is that primarily driven entirely by incentives? And given the fact that incentives I would assume increased during the quarter could this lead to a wider year-over-year delta in 2Q?
So just sort of clarify that guidance was 50 bps to 75 bps. So that’s where we think, we’ll probably in that the first quarter and its partially incentive but it’s also partially low closing volume.
We entered 2019 with a much lower backlog than we did 2018 and is quite a bit of leveraging that occurred and kind of right at that sweet spot of 1,500 to 1,800 homes. So part of that loss a margin is actually leverage is not direct margin. So we don’t anticipate the same level of drag continuing for the rest of the year. Of course we don’t have a crystal ball we don’t really know what the rest of 2019 is going to look like.
But right now it’s primarily a function of incentive that we know that we’re planning to offer in the first quarter and the lower leverage.
Yes. I wouldn’t extrapolate that in the second quarter yet, because it’s still early and as I said earlier, orders for the first month are probably going to be up at least 5% and that’s going to help with the leverage. So that could turn around in the second quarter and beyond. I’m sorry, at the end of the first quarter’s numbers going into the second quarter.
Right. I appreciate that clarification. I guess, secondly, community count, if you could just kind of recap, obviously the change in order patterns with the higher can rates impacted community count in 4Q. You talked about that kind of evening out during 2019. If we have somewhat of, let’s say of a low–single-digit order growth type of year in 2019, what would you expect community count to be year-end 2019 versus year-end 2018 or at least some type of range?
The projection right now at this moment to be kind of flattish, so we can’t get better color on that, at the end of the year, I mean the next quarter, it could be slightly down, slightly up. The challenges at the end of the 2018, our community count was actually a little higher than we expected because we didn’t close out as many MU communities as we expected to which left the community go higher.
I believe we have like 32 or 35 communities that have less than 10 lots left in them and we’re trying to drive those to a completion, definitely helps with our overhead. So that will bear weight on the overall community count number for us. The number that we’re most interested in is the absolute number or the net number of entry level communities that we have opened.
As I said earlier, we have about 90 that we’ve seen in the last year and we expect to be open another 25 net by the end of this year to get us to about 115 and we expect that number to continue to rise every year for the next several years.
Thanks. One last quick one if I could and just wanted to also just clarify and make sure I understood right. Did you mention that you expect your order comps to get a little tougher in the next two or three months relative to January?
That’s correct. I mean our orders for last – Q1 last year were 2,358 and certainly the orders for February and March were substantively higher than they were in January. So market is going to get better, the really season kicks off on Monday after the Super Bowl this weekend for housing, but the comps gets tougher and we’re going to sell more homes to put up a positive number. But it’s like every year, we have a strategy, we have a series of promotions planned and we’re optimistic that we can continue the good start we’ve had with the year so far.
Great. Thanks Steve.
The next question comes from Susan Maklari of Credit Suisse. Please go ahead.
Thank you. My first question is just around some of the efficiencies that you’ve talked to earlier in your commentary. Can you just give us some sense of maybe how much more you can realize there and then with that, you’ve certainly done a lot of work with efficiency in the building process as you move down to more entry level product, can you talk about your ability to kind of continue to capture some of that and maybe what it could mean for you over time, especially as we do think about the margin progressions?
Well one of the major things we’re focused on is that drives efficiencies and absorptions. So as we get our builders or superintendents to be able to build more homes, I think in a lot of markets or smaller markets the absorption levels are not adequate and that allows us to really leverage our overhead.
As we continue to pivot more and more the entry level, we can leverage our overhead in so many ways, it’s our construction overhead, the models that we have, sales presentation, it’s our back office, the way we’re selling home, we have an initiative this year that we’re moving our sales office to less paper.
We’re not going to be handing out as much brochures and paper promotion materials, we’re doing more electronically that could save us $3 million a year. There are lot of things that we’re doing to save money and reduce overhead. Hilla, if you want to piggy back on that.
Yes. The East that I mentioned earlier, the east region has definitely improved their margins. As you guys have seen a couple of weeks when we published the regional results for the quarter. However, there’s still opportunity there, they’re not yet at the company averages and there is no reason why they shouldn’t be.
So we still have some ability to increase the margin for the east, which is about one-third of our total business. And then of course as we continue to LiVE.NOW.®, I’m not sure that there is significant efficiencies to continue to ring out of the entry level, but the entry level continues to become a larger portion of our business that will just mathematically become more impressive.
And then the lessons that we’re learning about how to be more efficient and how to streamline the whole production sales to close the process that we’re learning in entry level, we’re also planning it to first move up. So you’ll be able to start to see some of the efficiencies in the rest of our product line as well in 2019 and into 2020.
Okay. That’s helpful color. And then can you just – following up on that, talk a little bit about what you’re seeing in terms of some of the trades. Is there anything that’s changed there, especially maybe with some of the uncertainty in the market?
I wouldn’t say there’s any it’s really a monumental to discuss the trades. They read the papers too and they see what’s going on with the orders and the overall housing markets, I think price increases in general have been more modest and we’re not seeing, there is continuing price pressure and labor issues of course, but I think it’s moderated to some degree.
Okay. Thank you.
Thank you.
The next question comes from Alan Ratner of Zelman & Associates. Please go ahead.
Hey guys, good morning, a nice job in a difficult market. First question, Steve you mentioned the incentive environment, just to kind of play the flip side to that, curious are there actually any communities these days where you’re actually raising prices and maybe quantify that in terms of percentage of communities that maybe where you’re seeing stronger demand?
There are some that we are modestly raising prices. I can’t tell you how many of them there are, what percentage that is, but clearly we have some outliers where we have very, very strong demand and but we’re certainly not raising prices like we were in the first half of last year.
Got it. Second question, I think last quarter on the call, in response to my question you mentioned, if the softer demand environment continued the biggest lever you could pull is pulling back on a spec starts. And I believe Hilla made a comment that, that you did in fact pull back a little bit on the spec starts. I think spec accounts still up about 20% year-over-year and that’s I’m sure largely a function of more entry level mix. So recognizing you’re not giving kind of annual guidance and we fully understand that. How would you think about the current level of spec activity – spec starts that you’re running at today?
What type of annual closing volume would that roughly translate to recognizing you get close to about 8,500 homes last year and you’re clearly prioritizing a pace to a large extent right now to keep the machine running.
Yes, Alan, it’s just way too granular for right now. I mean I would tell you this, our total specs, at the end of the quarter were down a bit from the previous quarter. We had 2,507 specs at the end of 2018 versus 2,586 the previous quarter. I can tell you we’ve put a hard brake on move-up specs. We’re really trying to bring down our move-up specs to about one-third of our absorptions. We think that’s kind of the right number.
About 30% to 35% of our large sales in the move-up segment are going to be specs. So we’re really trying to make sure we have that number right sized in every one of our communities, but we’re continuing to evaluate on a monthly basis, how many specs we have in each entry level community as well and making sure that we have the right quantity to be also to not heard our sales, because we know those entry level buyers don’t want to wait for a home and they want to move in quicker and they don’t need to go to the design center. They’re happy to accept some of the great choices that we have for them for interior finishes and so forth.
So that strategy continues to work out well, but we’re very careful on how we approach the spec strategy and this is subsequently different per entry-level at least for move up.
So Alan, I think just a little bit more color. We’ve talked about this in another call that spec count for us in entry level is running about two–times the pace. That it’s running outside of the entry level and its function of month of supply and sales. So as the sales volume move up and down with the market, we’re not really we regulating how many specs we have started, which is why we started between Q3 and Q4. The market’s going to dictate how many specs we have and we’re not going to overbuild to a specific numbers as a function of sales.
Well that’s what I was really trying to get that Hilla is, what is that month’s supply number you’re targeting? Because if I look at the 2,500 specs embedded within that presumably is some expectation for what sales are going to look like over the next several months.
We can’t roll it out for you, but I can tell you let’s say for a spec, for entry-level community, if we’re planning to sell for a month, that’s been our history, our track record from the last couple of three quarters and based upon seasonality. We probably have 16 specs for that community, a four month supply, for a move-up community, for selling two a month, it’s a longer cycle time for those homes.
So for some are two a month and one-third of those are spec so it would be maybe three or four or five specs [indiscernible] 16 for an entry-level community.
And we’re making those decisions weekly when we schedule lot of starts. We’re constantly looking at our sales pace and expectations and adjusting, so we don’t have a magic number we’re trying to hit by the end of 2019. We’re making the decisions lie on the ground based on what we are seeing.
Yes, we’re not trying as we possessed in the ground to drive to a certain point where we’re putting the specs on the ground, based upon what the market has given us.
Okay, got it. Okay. I appreciate that. Thank you
Okay, next question comes from Scott Schrier of Citi. Please go ahead
Hi. Good morning. I wanted to ask a little bit about California and Colorado, obviously you’ve had significant declines in absorption rates there. Do you see opportunities for demand to pick up, but I know you’ve talked about how your product mix is changing there. Are rates and incentives enough to stimulate the demand and with that in mind are you changing how you think about whether it’s you’re the pace that you open communities there, meaning is the underlying demand there still very strong as long as you get to the right product mix?
Yes, I think that’s you’re hitting the nail on the head, I mean a lot of our issues in California and less than in Colorado are more our own execution than they are in the market. We have our lowest level of communities opened in California, we’ve had that long time and that’s because it’s taken us significantly longer to get our communities open. We have many communities that are more than a year delayed in California right now for a variety of different reasons.
I believe we only have 18 communities open in the whole state of California and we have like another 18 in the queue getting ready to open. So the new communities we’re going to be opening in California are priced lower, have lower ASPs and they’re more entry-level of focus. So we think that’s going to help us improve our numbers in California.
And I’d say the same for Colorado. We’ve stopped buying move-up communities in Colorado, quite some time and we have quite few communities that are scheduled open mostly focus to the entry-level market. So it’s really about the mix and the mix could help, both those markets California and Colorado, northern and southern California and Denver are very housing starved and if you can deliver appropriately priced product to the entry-level segment of the market, I think you can do well in both of those states going forward and that’s what we’re going to try to do.
Got it, thanks. Then my follow up, I wanted to ask a little bit about the land spend that I know for 2018 it was 85% of your newly controlled lots. We’re going toward the entry-level. Is that more of an effort to right size the book and we should see more diverse land purchasing in 2019 or would you expect also say an excess of 80% of your land acquisition in 2019 to be at the entry level also?
With both, we want to get our entry level segment to more than 50% of our total orders and 50% of our community is based on the entry-level segments. So we have to continue to spend there to balance that as you said right-size the book. At the same time, that’s what the strongest demand is right now for the foreseeable future.
Those people that are buying entry-level homes aren’t coming out of existing home where they have 3.5% to 4% mortgage, they are looking to move into a more expensive home with 4.5% or 5% mortgage. So they need a home. They’re starting families. They have to get their kids in school, their decision matrix in their mind is much different than the move-up buyer and they aren’t as persuaded by various markets. So they’re in the strongest segment we’re going after that.
Great. Thanks for taking my questions.
Thank you.
The next question comes from Carl Reichardt of BTIG, please go ahead.
Thanks. Good morning guys. Just a clarification, Hilla you talked about closings I think being below lower than you expected, which was part of the issue for the SG&A. I think I have this right is that closings where ahead of what your guidance was certainly but the street had. Is that really more an issue of the communities hanging in there longer than you’d anticipated and that was what drove the SG&A higher or is there something in the closings number I’m missing?
You’re right on both fronts. So number one, we have more communities opened I think Steve mentioned that was 32 communities that are open, that we were not expecting to be open in Q4. So that has an additional burden.
Not all, because they have less intense.
Yes, I agree. So they had a burden that we weren’t anticipating, which is part of the reason why our SG&A was higher and that was piece of it does, even though our numbers came in better than we had expected, they didn’t come in better than we had expected at the beginning of the year. So it takes a little while, check back, overhead reduction to get everything done. So we were running at a higher pace, which we are seeing adjusted in Q1.
Okay. That makes sense. Thank you. And then on your can rate, it’s about 500 basis points up, the mix shift might be part of that at least historically low end’s got somewhat of a higher can rate. Are you seeing, can rates change at different rates between the low end and in the move up and how much of that can rate was driven by mix versus same geographic market?
Well, clearly it was a mixed shift, you’re going to have higher cans at the entry level and you are at the move-up, more for mortgage qualification reasons those buyers are stretching a little bit more to qualify for a new home. But that said, in the fourth quarter we did have a considerable number of move-up buyers, got cold feet because of the gyrations in the stock market and some of the headlines and the interest rates and so forth. They just walked away and said, we’ll be back later. So, it was really both factors that play.
Okay, great. Thanks Steve. Thanks guys. Thanks.
Thanks.
The next question comes from Jade Rahmani of KBW, please go ahead.
Hi. Thanks for taking the question. I was wondering if you could provide your views on M&A and if you think in the current environment there should be industry consolidation amongst the public players to drive scale and efficiency gains?
I think, there always should be consolidation. I think there’s too many of us doing the same things that said, I’m not expecting a lot of M&A activity for a variety of reasons. I’m not going to articulate it right now. But I generally see more M&A when values are higher, and when builders are trading below book value. I think it’s hard to expect M&A to occur.
There was quite a bit of private builder M&A last year and I expect the same for this year. Public builders buying private builders, but I think public-to-public is going to be hitting us.
Thanks for that. And just secondly on SG&A for the first quarter, what’s a reasonable way to think about it, assuming that there’s negative operating leverage from the lower closings that you got into work?
We’re not prepared to discuss SG&A. It wasn’t part of our guidance and we’ll give you guys a little bit more clarity on that. Obviously on our first quarter earnings as we mentioned, we had some of right adjustments in our overheads in Q1 and we’ll be prepared to talk about that on next call.
Thanks very much.
Yes, thank you.
The next question comes from Stephen Kim of Evercore ISI. Please go ahead.
Yes, thanks very much guys. And sorry I had a lot of phone problems here. So, I want to just revisit the incentives comment. You’ve said a few things here, a lot of them seem important.
You mentioned that you did cut back on incentives in January, but last week there was a special promotion and you also said that you have a series of promotions planned in the spring selling season it sounds like. And Hilla’s comments on gross margin also said that you anticipate, I think she said increased incentives and so putting it all together, I’m curious, overall were these promotions are regular or planned well ahead of time because you’re talking about the spring selling season or a reaction to a continued sluggish environment?
And was the reaction to the January promotion that you did, that’s what you expected or was a little stronger than expected? And so kind of overall, are you seeing the need to maintain high levels of incentives versus a normal spring selling season or not?
The promotion that we had last weekend did a little better than we thought. And I think our mindset has maybe evolved a bit from last year that we cannot let market share get away from us. And we’re not going to let brand X, Y and Z take our buyers on price. So we’re going to have to – we’re going to have to make sure that we’re offering the right types of promotions and the right incentives to attract buyers to our product.
So, yes we were running a lot of promotions in the first half of last year. We were raising prices, right. So market – the environment’s changed and although the incentives have expanded a bit, the net impact hasn’t been as significant because of the lower costs that we have this year. And we’re continuing to drive costs lower as we optimize our plan offering, our plan line up and work with our trade partners and vendors to reduce costs.
At the same time, the overhead leverage becomes more and more important and, we’re very, very focused on that and want to keep this machine running, that has better offering with better efficiency levels.
You’ve been really clear about that. And so it sounds kind of like the level of incentives and the promotions that you’re kind of planning here, it sounds like you guys going on offense more than it is a sort of a defensive reaction to a weakening market trend. I suppose that’s a fair way to summarize it?
Yes, I would say that you hit it right on the head. I mean, we’re going to be very offensive over the next several months, maybe more or so than we were last year.
Steve, I can’t imagine you being perceived as offensive.
No, I would say like we’re going to have a stronger aerial attack and we’re just going to – we’re not going to be on the ground game. I think you know what I meant.
The second question I had relates to your land positions. So you’ve made this very significant and effective pivot to target the entry level with the LiVE.NOW.® and all the other things that you’ve been doing. But one of the questions that we’ve gotten from investors has to do with some of the land positions that may be associated with your previous strategy before you made this pivot. I am wondering whether or not there may be some risk that those kind of get orphaned on the balance sheet.
So I was wondering maybe if you could talk about what your approach is to dealing with some of these lot parcels, maybe you could size it up for us or just how you think about the game plan for what you might call legacy land positions
Price them to sell. I mean, I think as I said earlier, we have about 15% of our communities of 2MU and probably a little more aggressive this year than last year to get out of them quicker because I want to turn that capital around, potentially return it to shareholders, potentially use it to buy more entry level communities, potentially save it for a rainy day, but you know the opportunity for those communities do increase absorptions and raise prices is not that strong. So we need to move those assets and we’re focused on that in 2019.
Should we be thinking they are kind of book sales target or do you think it’s more just sort of building them out and just being aggressive on price?
Probably more built them out and being more aggressive on price. I mean, there’s an opportunity to sell them on a one-off basis to other builders. We’re definitely going to consider that and look at that, but there’s no grand strategy to move all those in bulk.
Got it. Okay, that’s helpful. Thanks very much guys.
Thanks.
The next question comes from Jay McCanless of Wedbush Securities. Please go ahead.
Hey good morning. So my first question just can you guys tell us what defines or what is the threshold for a community, is it five lots left to sell or how do you well define it?
If we have five lots left to sell, we counted as active. During the downturn if it was 10 lots and it wasn’t moving, we would also count it as inactive we’re certainly not in that same mind frame right now, which is why the communities have very, very few lots between five and 10 are getting counted as active. Some of them actually sold down to five and then had cancellations that brought them back up into the active category. That’s why that’s 32 community count challenges that kind of its just kind of cause, its causing such a big skew in our numbers.
I’d from the community, if we’ve make one sale, we have an active sales present which we counted as a community, even though it might not be fully running yet once we make a sale we will count that.
So if you back those out, you guys are essentially flat with last year’s community counts and should we expect that to come down through the year or are you all, do you believe you’re going to be able to open enough entry level communities to hold it steady or roughly like a 245 number?
Well, we finished the year with 264 – 274, again as I said, we’re not going to get as a really specific quarter-to-quarter guidance on that. You know, these numbers can go up or down every quarter, it’s based upon sales basis, a lot to do with it and not just getting communities open but actually, how we’re selling on the opening and the closing. But I think for the year it’s going to be pretty flat with that number and maybe potentially even down a bit.
And then the other question I had, in terms of the incentives and the co-broker stuff that you talked about, do you believe that your overall customer acquisition cost has got to go up from here in order to maintain the pace? Or do you feel like the current level is driving enough volume to meet your plan?
No, I think we’re getting more efficient with their marketing and marketing dollars and we’re not intending to spend substantively more money on marketing. We’re also not intending to increase commissions. You may pay some additional commissions on 2MU spec homes or something to move them off the books. But our strategy hasn’t changed around commissions and marketing spend. So, I do not expect changes in that area.
Then one other quick one, of the specs that you have now, how many is that 2,000 number move second move-up?
Don’t have that number. Hilla, do you have that?
I don’t have the number but I can tell you that on average we are keeping below the units per community on entry level than we do on the first move-up and spec, 2MU will be even lower than that, about a third. So that you can kind of do the mental math and get to those numbers.
Got it.
Thank you.
Thank you Mr. Hilton, we are at the end of our time should I take one more question?
I think we got one more in the queue, let’s take that and then I will wrap it up.
The next question is from Alex Barrón of Housing Research Center. Please go ahead.
Best of luck, Alex.
Sounds good Steve, thanks. I was just curious, I guess about your thoughts, you’re saying you’re not going to let other guys take market share and other guys say they are willing to sacrifice margins to outsell everybody. So I’m just trying to square those two comments, how competitive are you willing to be comment in terms of – are you also willing to take price margins just to keep up with those guys?
We’ll be more competitive than we have been in the past. Let me say that. And we will sacrifice some margin, but as we shift to more entry level, we think we’re able to close the cost gap with them. Our costs historically have probably been a wider than they should be and I think as we rationalize our product, our cost gap is hopefully is narrowing. And then combine that with the leverage from our overhead, by pushing through higher volumes.
We expect the impact on margin degradation is going to be not as much as people might think. So, we just can’t sit here and say we’re going to wait for the storm to pass because it’s not going to pass because they’re very, very focused on driving volume. And we’re going to ask to adapt and move more to that model if you want to be successful.
Got it. And as far as the tax rate that was pretty unusually low this quarter. So, what can we expect – I mean, I’m not sure if I missed your comment on what drove that, but what can we expect for next year?
So we covered it a little bit. The reason why that was still low in the quarter, a little bit of it is DPA revaluation which is just something that happens at the end of the year, but a big chunk of it was, we actually went back for energy efficiency targets, all of the homes that closed in 2015, 2016 and 2017, we were able to capture an additional pool of home.
There’s not been any action yet in Washington who approved the energy tax credit for 2018 or any subsequent year. But, obviously with the government shutdown, that wasn’t the number one priority. We’re still very actively pursuing it. If that comes to fruition, we’ll be able to see some savings again in 2019. If it doesn’t, we’ll continue to purse on some of the cooler tones for additional credits, but we’ll start to shift closer to the 24% to 25% blended tax rate.
Got it. Okay, well, best of luck. Thanks.
Thanks Alex and thank you everybody for your participation in our fourth quarter 2018 earnings call. That’s going to be wrap it up and we’ll look forward to talking to you again at the end of the first quarter. Have a great day.
The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect.