Meritage Homes Corporation (MTH) Q1 2017 Earnings Report, Transcript and Summary

Good morning and welcome to the Meritage Homes First Quarter 2017 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 of Investor Relations. Please go ahead.

Thank you, Kate. Good morning and welcome to our analyst call to discuss our first quarter 2017 results. We issued the press release before the market opened today and you can find it along with the slides that we will 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 will 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 our projections for 2017 operating metrics such as community account, order trends, closings, revenue, margins and earnings. Those and other projections represent the current opinions of management, which are subject to change at anytime and we assume no obligation to update them. Any forward-looking statements are inherently uncertain and actual results maybe materially different than our expectations. We have identified risk factors that may influence our actual results and listed them on this slide as well as in our press release and our most recent filings with the Securities and Exchange Commission, specifically our 2016 annual report on Form 10-K, which contains a much more detailed discussion of those risks. We have also provided a reconciliation of certain non-GAAP financial measures referred to in our press release or presentation as compared to their closest related GAAP measures. With me today to discuss our results today are Steve Hilton, Chairman and CEO; Hilla Sferruzza, Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage Homes. We expect to conclude the call in about an hour and a replay will be available on the website approximately an hour afterwards and remain active for approximately 2 weeks. I will now turn it over to Mr. Hilton to review our first quarter results. Steve?

Good morning. Thank you, Brent and welcome to everyone participating on our call today. I will begin on Slide 4. We delivered solid results in the first quarter of 2017 and are well on our way to achieving our plans for the year. We produced year-over-year growth in key operating metrics, including a 7% increase in orders, a 6% increase in closings, 11% increases in both home closing revenue and order value, and a 27% increase in pre-tax earnings, which yields a 12% increase in our diluted EPS over last year’s first quarter. In addition, we grew our community count and lot supply and made progress on expanding our communities for the entry level and first-time homebuyer segment, which represents a tremendous growth opportunity. Turning to Slide 5. I am pleased with the progress we made on our strategic initiatives, which we discussed on last quarter’s call and reviewed in more detail during our Analyst Day meeting last month. If you weren’t able to attend that event, you could find a replay of the presentations on our website. We are focused on three strategic initiatives to drive long-term earnings expansion: community count growth, gross margin improvement, and managing our overhead expenses to leverage top line growth for greater earnings power. Slide 6. Regarding our first initiative, we delivered 5% community count growth as of the end of the first quarter, which was the increase we have projected to reach by year end. We are opened – we were able to open many communities in March that were expected to come online in the second quarter, so they will be active doing more of the critical spring selling season. We also expand our lot supply during the quarter, which will translate into additional community count growth over the next several years. Approximately two-thirds of the new lots and communities we secured during the first quarter were for entry plus or LiVE.NOW communities homes. Turning to Slide 7. Our strategic initiative is focused on improving our gross margins, which is being compressed over the last couple of years due to the rising costs and a lack of leverage in our newer decisions. As most of you know, the cost of lumbar has increased by high single-digit – digit percentages at the beginning of the year in anticipation of the Canadian tariff announced earlier this week. While we have little control over the price of labor materials, we are able to raise prices enough to offset the cost of those increases. We have also been focused in our operational improvements such as simplifying our plan library in the east, reducing variations and starting homes on an even flow basis, which we expect will benefit our gross margins over the next several quarters. Our home closing gross margin for the first quarter of 2017 was in line with our internal plan is expected to be the low watermark for the year as we are projecting gross margins to move higher for the remainder of 2017. Hilla will discuss those in more detail later. Turning to Slide 8. Lastly, we are pleased with the 90 basis point improvement in our SG&A leverage compared to last year’s first quarter and made good progress towards our long-term goal of 10% to 10.5%. We are able to better leverage first quarter revenue growth as a result of cost controls and productivity gains over last year. Turning to Slide 9. We produced 7% order growth for the first quarter of 2017 over the first quarter of 2016, with a strong and steady improvement each month through the quarter. We expressed that March 2016 would be a difficult comparison since it was so strong last year, but we topped it with another strong March in 2017. Our sales base also improved for the first quarter, with an 8% year-over-year increase in average community absorptions, which is impressive considering that about half of the new communities were opened during the first – first quarter of 2017 were only opened for a few weeks. So, they had minimal impact in the first quarter orders. We have seen significantly higher sales base on our entry-level plus and LiVE.NOW communities than our traditional move-out communities. We expect that to continue as this customer segment becomes a larger part of our mix. Turning to Slide 10. We have increased our investment in new lots and communities targeting first-time buyers. We spent $207 million on land and development in the first quarter of 2017 securing more than 3,600 additional lots, more than any other quarter since the beginning of this cycle, with the exception of the acquisition of communities in the third quarter of 2014, then increased our whole lot supply to more than 31,300 lots at quarter end. Based on positive economic drivers for homebuilding as well as Meritage’s position in many of the best markets and our distinctive product offerings, we are confident in our opportunities for continued growth and we are continuing to invest in new communities to take advantage of those opportunities and deliver additional value for our shareholders. I will now turn it over to Phillippe to provide some additional color on the trends in our various markets. Phillippe?

Thank you, Steve. I will begin on Slide 11. Generally speaking, we continued to experience solid demand, which was evident across our Western and Texas markets, offsetting our slower performance in each region, which I will point shortly. Slide 11. The West region had the strongest order comps in the first quarter this year. Total orders for the region were up 25% over the prior year in the first quarter of 2017, led by a 56% increase in Arizona, which was almost entirely due to increased sales per community in the Phoenix marketplace. Phoenix has had a very strong spring selling season and we are well-positioned there with many of our new communities targeted to our first-time buyers, including our new LiVE.NOW homes. Our average selling price in Phoenix has come down about 10% in the last year, while Arizona as a whole was 5% lower year-over-year. A greater percentage of orders were for entry-level homes in those lower priced communities. We expect those trends to continue as we have had a long – as we had a long supply of lots in most of our new communities here to meet the current pace of demand. California is also having a strong strength. The heavy rains there didn’t seem to impact sales demand. They will increase our cycle time and delay some closings into later this year. We had a 6% increase in our ASP there, along with 21% order growth year-over-year in the first quarter of 2017. We have been acquiring additional lots in California and we were able to open more communities during the first quarter translating to a 19% increase in our average community count year-over-year. We are selling almost 1 home per week per community in California, which is the second highest sales state in the company, following Colorado. Despite very strong demand, our Colorado orders were down 15% due to a lower community count. We had one-third new communities on average in Colorado during the first quarter of 2017 than we had in the first quarter of 2016. However, our average sales pace was almost five per month during the first quarter of 2017, 27% higher than last year’s first quarter and the highest in the company. Demand in Colorado has been so strong, that we are selling out communities faster than we can open new ones. We have been in the process of reloading and we contracted for over 400 additional new lots in the first quarter of 2017, combined with the 1,000 lots contracted for in 2016 that represents 16 new communities expected to open in Colorado over the next 1 year or 2 years. As a consequence of strong demand in the Western markets, labor shortages are elongating our cycle times. While that will now result in later closings – while that will result in later closings, we do not expect to see increased cancellations rates due to those delays. Slide 12, demand in our Texas market continues to be solid, especially in Austin and Dallas- Fort Worth. We increased our first quarter orders in Texas by 17% in 2017 over 2016, primarily related to additional communities that we added to serve the Austin and Dallas markets. We will soon have six new bundle communities for the first time buyer in the DFW area. And about half of our communities in Austin are already selling to that segment of buyers. Austin, like Phoenix is another market where we have made a significant shift from high end mover communities to more affordable communities that are selling well. Houston and [indiscernible] were consistent with last year’s first quarter. Last year was a record year for San Antonio, so were pleased with similar performance there this year. Our order volumes in Houston has held steady as oil prices have stabilized and we believe there is an opportunity for growth there at lower price points. We have secured some great new communities to meet the demand and are excited about opportunities they present for us. Turning to the East region, Slide 13, our first quarter orders were 19% lower than last year in the East region, where our average community count was down 9% and absorptions were down 10% from the region as a whole. While we opened 11 new communities in East during the first quarter of 2017, almost half were opened in the last two weeks of the quarter. So they didn’t contribute even a full month of orders, However, they increased our average community count, which artificially decreased our absorption pace in North Carolina and South Carolina, Georgia and Tennessee. Demand is strong in those markets, but as we mentioned last quarter, we are rolling out new products there, which lowered community count growth in Georgia, the Carolinas and Tennessee. That trend will reverse over the remainder of this year as the product redesign is now behind us and as new communities will be featuring the new products as they open. Florida was the only East region state that increased community count and orders during the first quarter of 2017 by comparison to 2016. We are expanding our presence it’s a great – A locations in Orlando and are adding six new entry level plus communities there this year. Overall, we are bullish on our new positions in the East and are projecting strong order growth as we open new communities with new products during the first half of this year. I will now turn it over to Hilla for some additional details on our financials.

Thanks Philippe. I will review some additional details from our income statement, key land and balance sheet metrics and our second quarter outlook. Starting on Slide 14, we generated a 12% increase in net earnings for the first quarter of 2017 over the first quarter of 2016, which was primarily driven by higher closing revenue and greater overhead leverage but partially offset by lower home closing gross margin and higher effective tax rate. On a pretax basis, earnings were up 27% year-over-year, which is a better indication of our earnings performance for the quarter. First quarter home closing revenue increased 11% year-over-year on a 6% increase in volumes and a 4% increase in average closing price. We saw positive contributions from all regions, particularly Arizona, Texas and the Carolinas. Our average closing price was $418,000 in the first quarter of ‘17, continuing its upward trend over the last several years. We did see our ASPs and backlog begin to trend down this quarter from $432,000 at year end to $430,000 at March 31, 2017. Something we expect to happen gradually, as we sell a greater percentage of homes and our lower priced communities for entry level and first time buyers. We also had a $2.5 million gain on land on sales during the first quarter of ‘17, which was primarily generated by one parcel in Southern California. Our first quarter home closing gross margin was 120 bps lower than the first quarter of ‘16, but was in line with our internal expectations. I will come back to that in just a minute. We brought our SG&A expense down to 11.8% of home closing revenue in the first quarter of ‘17, down from 12.7% in the first quarter of ‘16 and expect that trend to continue as we progress throughout the year with higher closing revenue. We are targeting 10.5% to 11% SG&A as a percentage of home closing revenue for the full year ‘17 with a longer term goal of 10% to 10.5%. Financial services profit increased 6% in the first quarter of ‘17 over ‘16, nearly driven by increased home closing volumes. We have less than $1 million of interest expense for the first quarter of ‘17, which was $2.5 million lower than the first quarter of ‘16 as we capitalized nearly all interest incurred traditional land and homes under development. We expect to increase our credit facility usage throughout the year to finance additional land and development expenditures, which we anticipate will result in higher interest expense for the remainder of the year. This Congress hasn’t yet re-authorized energy tax credits for 2017. Our effective tax rate was 36% this quarter compared to 27% in the first quarter of 2016. In all past years, except for 2016, these credits weren’t renewed until late in the year. If that happens this year, it will reduce our full year effective tax rate at that time. Maybe helpful to review the short-term impact and longer term opportunities to improve our gross margin. Turning to Slide 15, our 2017 margins included several components. First, we incurred approximately $2 million of real estate impairments in write-offs during the first quarter of ‘17, which reduced gross margin by 30 bps, consisting – consistent with 2016 Q1. Second, the additional construction overhead expenses associated with the large number of new communities we opened in the first quarter or will be opening soon increased our first quarter 2017 cost of sales without any corresponding revenue from those communities. We expect that revenue to come in the latter half of ‘17 to offset the overhead burden. Third, as you know and as we have previously discussed, land costs have continued to increase, which together with labor material pressures have been absorbing the price increases we have been able to capture, limiting our ability to grow our margins. And fourth, as we increase the mix of closings from entry level plus communities, we are experiencing slightly lower gross margins from these closings, but higher absorption and IRRs than our move-up communities. This net positive trade-off is noted as our cost of sales increases our company by improved SG&A leverages. These factors are limiting margin expansion in the short-term, so we are projecting flat home closing margins for full year 2017, with increasing margins in the back half of the year. We expect better margins next year as those headwinds ease and we see more benefit from our new committees due to simpler products and greater closing volumes to leverage community level costs. And finally, past 2017, the closing out of the communities impacted by the reduction in FHA loan limits will also help our margins once we eliminate that the 30 bps drag projected for full year 2017. Turning to Slide 16, we ended the quarter with $86 million of cash and $60 million drawn against our revolving credit facility. Our cash balance declined $46 million from last year, as we invested in lots to support organic growth and increase the inventory of homes under constructions or completed for sale. Our total real estate inventory increased by $91 million during the first quarter of ‘17. 47% of our closings in the quarter were from spec inventory compared to 39% in the first quarter of 2016, reflecting more spec sales within our first time buyer and LiVE.NOW communities. We ended the first quarter with 1,633 specs completed or under construction, which was approximately 6.4 specs per community compared to 11.55 a year ago or an average of 4.8 per community in last year’s first quarter. Approximately 32% of our specs were completed at the end of March ‘17 compared to 35% in March ‘16, indicating our ability to sell specs earlier in the construction process. Net debt-to-cap ratio remained within our target range of low to mid-40s percent, ending at 42.8% at March 31, 2017, compared to 41.2% at year end 2016. And the increase [indiscernible] during the year support the acquisition of more land will remain within our comfort zone of low-to-mid-40s. With a successful first quarter behind us and a positive outlook for continued strong demand through the spring selling season, we remain comfortable with our full year projections for 2017 beginning on Slide 17. Since we push for open communities on an accelerated pace for the spring selling season, we reached our expected year end community count for 2017 early. We are expecting to open dozens more communities this year, but they will replace communities that we project will be closing out. So our quarterly community count we move up or down a little for the remainder of the year, where we don’t expect additional net growth in community count in 2017. We are projecting deliveries of approximately 7,500 to 7,900 homes for estimated home closing revenue of $3.1 billion to $3.3 billion for the year, with the large ramp up in the second half of the year as we closed homes from the new additional communities. A large number of our closings came from spec inventory in the first quarter, resulting in a high backlog conversion rate. With the shortage of labor and expected delays in closing due to expected rain in California, we are projecting a lower conversion rate for the second quarter, anticipating those closings will come in the latter half of the year. While we are mindful of labor and material cost pressures, we believe we can maintain gross margins consistent in 2016, while generating a 6% to 12% increase in pre-tax earnings through a combination of cost management and additional operating leverage with our anticipating revenue growth. For the second quarter of 2017, we are projecting approximately 1,750 to 1,850 home closings, with closing revenue of $735 million to $785 million for projected pre-tax earnings of $45 million to $50 million. With that, I will turn it back over to Steve.

Thank you, Hilla. In summary, we were pleased with our results for the first quarter of 2017 and the progress we have made on our strategic initiatives, which are designed to deliver long-term growth and shareholder value. The key drivers for the housing market remained positive, including job growth, consumer confidence, increasing household formations, low interest rates and good affordability in most areas. We are well-positioned in our markets and developed new product that we can deliver our lower price points to meet the growing demand for first-time buyers and we are successfully executing on our strategy to increase the number of communities for that growing segment to 35% to 40% by the end of next year. We are dedicated to delivering a life built better for all of our customers as our brand promise says and we do our best to provide that by continually innovating and selecting great locations for our communities. Thank you for your interest in Meritage Homes and for supporting our growth and success. We will now open it up for questions. And the operator will remind you of the instructions. Operator?

[Operator Instructions] The first question comes from Stephen East of Wells Fargo. Please go ahead.

Thank you. Congratulations on a good start to the year here, Steve and team. Steve, maybe I will ask you, you had some great order growth in the West and Central. The East is sort of playing out like you all thought. As you look at – as you roll your new product introductions through the East and you cycle through the old communities into the new communities, are you expecting that these communities – that these markets can perform like you are seeing in the Central and West or would you expect some slower, faster maybe some ketchup coming through these just sort of how you all are thinking of it, not only in magnitude, but sort of in timeline as well?

Well, they are certainly going to perform a lot better when we get our new communities opened with our new products. And as we continue to work through some execution issues, we think that will have impact on their performance as well. I mean, the West and a couple of markets in Texas are very, very strong right now. So, I don’t expect them to match the performance in those markets. But if you expect a much better performance and I do expect the market is there to be more in line with many of the other markets and the rest of the company. So, I think that’s a big story for us for later this year and into next year.

Alright. Fair enough. Hilla, you gave several – Slide 15, several drivers of the gross margin. Could you help us out a little bit other than the impairment, could you rank order those and just give us some idea of how much they are pushing against your gross margin right now and maybe again sort of the same thing the timeline of how you think those will ease as we go through the year?

Yes. I can try to give some high-level quantification though as you mentioned real estate impairments is certainly not something we are forecasting on a go-forward basis, those are 30 bps, so hopefully one and done in the first quarter. On the construction overhead, that one is a little bit tougher to quantify. We have had a lot of overhead reduction. So all things being equal, Q1 over Q1, ‘17 over ‘16, we should have seen a decline, but we actually saw our overhead component that the variable piece based on employees and swept and community maintenance increased – not to put, to find a point on it, tough to quantify when you had overhead count being different, but we would probably expect something maybe in the neighborhood of 20 to 50 bps range from that as new communities come on and come off throughout the year, not including just the general leverage that you would get improvement over the year with higher revenue volumes. On the land cost, the land and materials and the labor cost, we have actually been able to keep steady with that. On the price increases we are not seeing a margin deterioration although some of the increases in margins that we should have been able to capture from the pushing up the pricing on how to get materialized to the degree that we have expected from knowing that we have its pricing power. And then the entry level story, I think it’s really just a shift on geography, on the P&L despite increases we are seeing on the margins are coming back, maybe even more so in savings on the SG&A. So, all-in it’s a watch on a bad day and probably some pickup in the leverage on a good day.

Okay, got it. Steve, I forgot to ask on the East, are there any mileposts you are looking at for Atlanta, Nashville, Greenville that you all are sort of using to judge this?

I will point that over to Phillippe.

Yes, I assume. When you say mileposts, you are indicating sort of what period of time we are looking for things doing flat.

Exactly.

Yes. Why does it had to do with just the new communities opening up. So, I mean, we have as we reported in our Analyst Day meeting, we have a bunch of communities opening up in Raleigh this year, with a bunch of communities opening up in Atlanta this year, with a bunch of communities opening up in Nashville here. So, we really feel the benefit of those you develop in Q4 fully. Charlotte will get little bit later…

Just on the Q3?

Yes. You will see marked improvement throughout the year, but we really feel like the full weight that will be in Q4 and the communities – the communities that we did open up this quarter in the South did well again over the last few weeks of the month, but it did do well.

Got it. Thank you all.

Thanks, Stephen.

The next question is from Alan Ratner of Zelman & Associates. Please go ahead.

Hey, guys. Good morning. Nice quarter. Following on the margins so the guidance obviously implies a pretty significant ramp through the year. And I know you have talked about the de-leverage there, it sounds like you guys were successful in bringing forward some of those community openings and I recognized it didn’t really show up in the quarter, because it happened late in March. But now that you are 4, 5, 6 weeks into having these communities open, I was hoping you could give us a little bit of an update on how those communities are faring, maybe you talk about the absorptions there, but more specifically, how do the margins look on those homes in backlog today as of late April versus what you have been delivering over the past few quarters, because on the surface, it seems like the margin improvements really dependent on a lot of things going right, but if you could give a little bit more data that would show some of that margin improvements already baked in backlog based on these communities you have opened up here over the last month or 6 weeks that would be helpful in providing some consonance there? Thank you.

Sure. I mean, we haven’t closed any of those houses yet. So, we don’t have the final numbers, but I can certainly tell you that our pro forma show us that all of those communities that we opened in the last 6 or 7 weeks have good margins more in line with our underwriting and the overall margins for the company that we expect. I would also tell you that the numbers show me that we have been able raise prices, modestly more than the cost of increase. So I think that is also going to help us lift our margins through the remainder of the year and that’s why the margin ramp is so back end loaded because homes that we are selling in this quarter are going to be begin to close next quarter and the quarter after. And we are selling more specs than we have ever had before. That will also help the margin increases come sooner. So I think there is a lot of – there is a lot of positive things happening on the margin front, that I am very encouraged about. But there is also some things I am worried about as far as additional lumber increases that could have an impact as well. But overall, I am feeling pretty bullish about getting those increases that we are projecting for the second half of the year that will get us in line with last year’s margin.

Just to echo what Steve said, the projections that we provided today have obviously, some underlying assumptions based on those new communities, even though very preliminary six to seven weeks in the life of the sold home is not too far of a development, their costs are tracking in mind with the underwriting performance that we used in the forecast, so far averaging we are seeing is trending in line with our expectations. And then, sometimes we get questions about what is the best margin since we are selling a higher percentage of our homes and specs got it, whether the spec margins are trending something lower than our [indiscernible] and they are not. So at this point in time, the spec margins that we closed in the first quarter were in line with our gross [ph] margin.

Thank you for that Steve and Hilla. So you mentioned the pricing power running a little bit above the cost inflation, do you have those numbers in terms of what your apples-to-apples pricing is up year-over-year versus costs and maybe talk about how that compares to a year ago when presumably your costs were outpacing that price depreciation? Thank you.

The only number I can really give you is I am thinking is about 50 bps. So the net difference between prices and costs in Q1 is about 50 bps.

Just under…

Last year, I think it was negative, it was going in the other direction. But this year, I think prices are increasing over cost about 50 bps.

Just understand that then so eventually that’s the type of year-over-year spread you should expect to see on your margin or are there other pieces there that we need to consider?

Over time, that’s not going to be the ‘17 over ‘16 spreads, we are projecting margins to be consistent. But that performance that we are modeling now for new communities that are opening up that won’t be closing into latter ‘17 into ‘18 have that spread.

It’s a combination of things happening. Newer communities with better margins, because of more efficient product, because of better land buys, because of better operations and then just pure price appreciation over cost, escalation of about 50 bps, the two of them combined is going to raise our margins for the remainder of the year to get back to the number that we had last year. Where we go beyond that, it’s hard to tell, but I am also feeling like we are going to have even better margins next year. But we can give you a lot more clarity on that next quarter’s call.

Great. Thanks guys. Good luck.

Thanks.

Our next question is from Michael Rehaut of JPMorgan. Please go ahead.

Good morning. It’s Jason in for Mike. The first question in on cycle times, so your closings in the quarter came in above – nicely above where your guidance was, I just wanted to see if maybe there is an improvement in cycle times that you have seen recently maybe across the footprint. And then the other part to that I guess is in terms of labor availability, I wanted to see if has varied much as you look across the different geographic regions?

I don’t think cycle times necessarily improved, which drove more closings. It’s actually to the contrary, cycle times are elongating, which is going to impact our second quarter closings, particularly in California, where we had a lot of rain. And in Arizona and Colorado, where activity is super strong and it’s becoming more challenging to get our homes completed on time. So I can’t tell you that’s the reason why we closed more homes because of the cycle times, maybe our guidance was just a little conservative going into the year.

Because we sold a lot more specs…

Yes. We sold more specs, we sold 47% specs in Q1, which was a high watermark for us on that metric. But I can tell you, labor is tough in California, labor is tough I mean everywhere in the West. And in some markets, in Texas, labor is challenging and even a little bit in Florida, but we are doing our best to manage to it and making a lot of strategic moves in the way we build homes, which we talked about at our Analyst Day and earlier in the call, building more specs, doing more line building, more unit flow and I think all of that’s in the tail-off.

We entered Q1 with the highest spec per community we have ever had. So we were able to translate that. Now we are still entering Q2 with the high number of specs, but it’s down a bit for communities than Q1 and you will see that a little bit in the conversion rates.

Okay, great. Next question, just going back to the SG&A for a minute, so you got some really nice leverage in the quarter, I think more so than what we were looking for, I think more so than what we have seen over the last few quarters. I wanted to see if there is anything specific to call out there that was may be one-time in nature and if not, how we should think about what could get you to the lower end of the SG&A range as you progress through the year, aside from getting to the high end of the revenue range?

We will hold the line on our overhead. We have made some adjustments in the fourth quarter. And we are really trying to do more with less right now. And I think we have guidance that SG&A would be 10.5% to 11% for the year and we feel really very positive that we are going to be there.

There were no unique one-time items in the current quarter or the prior year’s first quarter for comparison. So this is our new – this is our new trend line. We touched it a little bit earlier that the – what you are giving up a little bit on margin on the entry level products, you should be coming back to you on the leverage, on the overhead and that’s exactly what’s happening.

Great. Thanks.

Your next question is from Stephen Kim of Evercore ISI. Please go ahead.

Hi guys. It’s Stephen Kim. Thanks for all the detail. I just had one question, we have recently seen your – some of your products down so we are pretty impressed with it and we are curious as to the ability to build that product of specifically the bungalow product, but also you can provide us to make the LiVE.NOW and some generally some of the newer products that you have been introducing to the market, what is your ability to build those on the existing land portfolio that you had maybe you can just give us a sense from what are the – some of the – what’s the ability to sort of proliferate this more quickly than it would otherwise be if you had to buy the land the spoke [ph] for it?

Yes. We can’t really build any of that product on the existing lots. We have to buy new lots for that land and that’s why it takes a couple of years to make that shift, because you got to get the land and make sure it’s entitled, developed, build model, frame the market. But as we have said, in the script here, we bought many communities already in Dallas, I think we have bungalow communities opening up here in this year. We have six LiVE.NOW communities in Arizona already opened which are predominantly selling specs. We are opening LiVE.NOW communities in other markets, we have a few opened in Houston, a few in Orlando. So we have been buying two-thirds of the lots we bought in the quarter were for entry-level plus communities and LiVE.NOW communities and we are continuing to buy for that segment. And that’s where we are seeing the greatest demand and we are also seeing the best way for us to manage our costs. We are able to drive the costs down in those communities because of the more simpler process, less upgrades, there is no design center and line and even flow building helps both of those product series and so that’s a big – you haven’t got already, that’s a big push where we are heading.

No doubt. I guess I was wondering about ways that we could maybe accelerate the process. So how about land sales, because I imagine that a lot of the land you have is certainly something particularly wrong with it. It’s just that it’s not necessarily in the direction that you are headed. Have you contemplated accelerating your land sales or doing more land swaps with other builders if you could just comment on that opportunity?

No. I mean, we don’t really have anything to sell. I mean, we are not – certainly not abandoned in the move-up market. I mean, that’s still are going to be more than half the business that we are in. We are pretty land light builder relative to our production. We don’t have a lot of excess land. So, it is not really anything to sell, but I do believe that our asset turns will increase as we get rid of – we get rid of some of these older FHA impacted communities at higher price points moving to these lower price points, ROA and ROE is going to increase. And terms are going to increase and I am feeling like we have got a really good pipeline of entry level land coming into production.

Okay, great. Thanks very much, guys.

The next question is from Nishu Sood of Deutsche Bank. Please go ahead.

Thanks. So, a lot of discussion obviously about the positive investments getting the community count for the year already in the first quarter. I just wanted to dig into – obviously there has been a lot of focus on resetting, re-launching communities with new product lines, etcetera. Looking ahead, like has that – do you think that’s going to have an effect on potential growth for 2018, given that there has been so much focus on kind of resetting or obviously you laid out the land spend for 1Q, but obviously that’s just one step in the process. So, how should we think about that? Has all this internal effort perhaps deferred it some of the attention that might have gone ordinarily towards 2018 and 2019?

No, going to the contrary, 2018 is where the big reward is going to be, because everything that we are doing now that we have been doing for a couple of quarters, then we are going to be doing over the next couple of quarters, particularly in the South with the new communities opening there with our new product, the big payday for that is going to be in ‘18. And LiVE.NOW and entry-level plus is going to be at full speed. We are just accelerating right now, but it’s going to be at full speed in ‘18. So, the growth that we are experiencing this year is muted by my history and my expectations. It’s not something I am extremely proud of. We are growing, but not at the pace that I would like, but I think what we are going to see in ‘18 is going to be in line with the history of this company.

Yes, Nishu, the lots under control and the land in development spend that we are incurring every quarter for the last six quarters, it’s at a quicker pace than we have experienced since the downturn. So, we are clearly loading up for ‘18 and even into ‘19, making sure that our community count accelerate, it doesn’t decelerate and that we are reloading with the right kind of lots as Steve mentioned the entry-level focus.

Got it. Got it. Makes sense. And thinking about the longer term ‘19 to ‘20, gross margin, can you give us some good details on the individual kind of drivers or components of how you get there? How should we think about it regionally and what I mean by that is that obviously based on the disclosures the Southeast region, in particular, was where the gross margins were more depressed. So, as we think about the improvement, do you think it will be more and more regionally focused in the Southeast and the West to some extent catching up with Central or do you think the efforts that you are making will be more evenly spread across the divisions?

I think, the margin improvement is going to be clearly in the South and with 5 cities that we are operating in the South, excluding Florida, I think will have a margin improvement in Tampa. I think we are going to have margin improvement in Phoenix. We have margin improvement in Southern California. Margins may go down a little bit in Northern California. Land has gotten pretty expensive there. Our margins have been pretty good. But again, we are estimating that we have waved against with construction cost in lumber and those things. But we have a lot of markets that we can do better on the margin front and we have strategies in place to achieve better margins and expect those to start to come through later in the year and into ‘18.

Got it. Thank you.

Thanks.

The next question is from Mike Dahl of Barclays. Please go ahead.

Hi, thanks for taking my questions. Steve, just a follow-up on that regional commentary and tying it to back to your comments around pricing power earlier, are you seeing pricing power across your regions or I am thinking specifically with the South and East where you have gone through some of the – some of the – or are you in the process of going through the new product rollout, your absorptions aren’t quite up at the pace that would normally be supportive of price. So maybe you are seeing a bit slower pickup on price in that region? Can you just give us a little color there?

It’s hard for us to really get a strong indicator in the South, because when we are opening new communities, we are not – we raised prices as demand builds. There is so much transitioning communities in the South. It’s really hard for us to get a handle on that. I would say, Florida, the price increases are more muted. And Houston, it’s more muted. San Antonio is a pretty steady and stable market, but we are pushing prices certainly in Dallas. We are pushing prices in Austin. We are definitely pushing prices in Phoenix and Denver and in California, of course.

One more comment in the South. It’s difficult to compare the existing product and the existing absorption space to what will be able to achieve in the new communities. The new product has very widespread market acceptance based on our research. So our ability to gain momentum on community start will be different than what we’ve currently experienced in the south.

Okay, thanks. And as a follow-up to that one, when we are thinking about some of the potential increases in lumber costs, in a region just conceptually a region like the South or the East, we have thought of sticks and bricks representing a relatively higher percentage of your selling price than somewhere like California and so are you comfortable that you may need relatively greater price increases in those markets and you are comfortable that you have the pricing power or you can incorporate that pricing into the new product?

With sticks and bricks in those areas where you mentioned don’t cost more to the sticks and bricks in the West or in Texas, it’s just larger percentage of the total, because the land is the lower percentage and you give more house for your money in those markets. So, I don’t see those places being impacted anymore than anywhere else by lumber price increases.

We haven’t touched specifically on lumber prices and we don’t want to get too granular, but as lot of the other builders have echoed, a lot of those increases have already been built in. There have been lumber lots over the last 30, 60, 90 days that have captured a lot of this anticipated impact. So even though, it’s tough to determine where the final impact will be, we believe a majority of it or a significant portion of it has already been addressed in the existing lumber pricing.

Great, thank you.

Thank you.

The next question is from Jade Rahmani of KBW. Please go ahead.

Good morning. This is actually Ryan Tomasello on for Jade. Regarding the overall weaker East region, is there a particular cohort of the market that’s driving that, for example, how does your entry level product in those markets demand for that market compared to move-up?

We don’t have a lot of entry level product online yet in those markets. So it’s not a product mix issue or it’s a product segment issue. It’s just new product versus old product. And we have a lot of new communities opened even in those markets, in the East that we have been in a while. But I can say we have opened a couple of new entry-level communities in Atlanta and they are doing really well. So we just need to continue to get more ELP communities open in that region.

And then secondly, can you provide an update on your Artesia joint venture with iStar in Scottsdale?

We are in the design review right now, with City of Scottsdale. And we expect to break ground on that at the end of this year or in January of next year. And begin presales in the spring of 2018. But I get more bullish based upon looking at the comps in the market every day in that community and I think it’s going to be a home run for us.

Great. Thank you.

The next question is from Carl Reichardt of BTIG. Please go ahead.

Good morning everyone. Can you guys quantify the differential and absorption rate between LiVE.NOW, entry-level plus versus move-up and was the spec ramp largely confined to the low end or was there also a move-up spec ramp too?

No, we haven’t really increased our specs subsequently in the move-up space, but they are significantly higher for the entry-level communities and we differentiate the traditional entry-level communities from the LiVE.NOW communities even within those two subsets. LiVE.NOW is higher than just straight entry-level communities. Absorptions have been near four – around four for the entry-level communities and they have been closer to 2.5 for the move-up communities and that’s really what the difference is.

It’s still pretty early on in monitoring the velocity of the entry-level plus as we get a couple of more quarters [indiscernible] probably the information that we provided on the Analyst Day slides is the most current that we have, but back half of the year, we should have cleaner data to present.

Sure. It’s nice to have a baseline. And then, second, we talked about one of the reasons to move towards up combine LiVE.NOW and entry-level plus is set and I am curious as you would ramp the store base, you are seeing some improvement in either the ability to keep subs on job or even maybe on a piece rate basis starting to see a little bit of a moderation in cost, so I am curious how they have responded to the product rollout? Thanks.

Yes. Again, where we have had the most success is in Austin and Phoenix where we rolled out the most. But absolutely, we have been able to have much stronger production out of those sites than we thought. And so that trades can line build, all the way down we are starting a much higher percentages of specs. So we keep the crews on site. And as Steve mentioned earlier, the products that’s really efficient we are not sending buyers to the design studio, where it notes there is very limited structural options, there is very limited elevation, variation and so because of the simplicity the trades are giving us better numbers, that we are going to be building them faster as we roll it out and kind of let in and we are getting more stable costs as well. So it’s all been positive from that perspective.

Thanks Phillippe.

Your next question is from John Lovallo of Bank of America. Please go ahead.

Hi guys, this is actually Pete Galbo on for John. Thanks for taking my questions. Steve, you had made an interesting comment in your prepared remarks about getting communities open in the first quarter a little bit faster than you had anticipated, I am just wondering, a lot of talk on the labor side about shortages, but have you seen easing at all on the land entitlement side that made the process easier this quarter or is it just kind of a timing related incident?

No, I wouldn’t say it’s not at all. It’s we just knew that we needed a – our community count ramped up and we just [indiscernible] the comp to get some of these communities open in Q1 versus Q2 and that’s really what the bottom line is. Some of those communities, may be didn’t have quite a model completely finished and we sold out with trailer. But we have gotten to the point where customers could make a decision and we had strong interest list and so we took sales and opened them.

Entitlement process is probably occurring a couple of quarters prior to that. So it’s not necessarily that it’s mostly internal effort to the finish line.

And maybe these are communities that we thought we are going to open up in late April and as Steve said we were able to accelerate some of the things that we needed to do to get it done and got really strong interest list that we are able to open them earlier.

Got it, that’s helpful. And Hilla maybe just a point clarification on the pretax income guide that the $45 million to $50 million, is that just a home-building guide, I know there are being some confusion in the past why that not included services income and some of the other items, but just wanted to clarify that?

All-in pre-tax.

Everything.

Everything.

Got it, okay. Thanks very much guys.

Thank you.

There are two questions left in the queue. We have Will Randow of Citigroup. Please go ahead.

Hi, good morning guys and congrats on the progress.

Thank you.

Thank you.

I guess in terms of – and I apologize if I missed this, but in terms of land cost, when you are looking it from a margin perspective, with the smaller product to cause smaller front foot products, are you seeing more competition for that land and it sounds like pricing has been strong enough in that product line like the bungalows, you mentioned earlier, that you can cover that inflation?

Yes. This – land is competitive everywhere. But that being said, as we have pivoted into LiVE.NOW and ELP, we are going into some submarkets that maybe we are not looking at before from a move-up perspective, where it is still – does seem to be some availability. So I think we are getting our fair share. But it’s not to say that we are not competing head on with the horns of the world and some of the others builders that are moving to that space relatively fast as well. As you think that the entry-level segment is really strong right now across the country and specifically in Texas and the West and South, although we just don’t have a lot going on there just yet. And so there is pricing power especially as it relates to our abilities ahead of our costs. So there is strong demand and there is that we believe there is pricing power at the lower price point as that segment grows. The key to it in our opinion is staying below FHA, so that’s kind of the governor, but there is pricing power.

And I guess as a follow-up as you think about it strategically over the next 1 year or 2 years, obviously move-up was the earlier strategy, so to speak earlier in the cycle, are you worried that that call it first time buyers segment gets too crowded or it seems like there is pent up demand? I would love to hear your thoughts and thank you very much.

Yes. It’s a big part of the market, much bigger than the move-up in our opinion. The entry-level buyers is the huge segment, it fuels everything. So yes it will get more competitive for sure, all builders kind of think about being the same some times. But we think it’s plenty big enough for all of that as long as job growth continues and financing is accessible, we think there is enough share to go around and a lot of the permit volume growth is going to come from that segment.

We have been a short to mid-term, maybe the longer term, there has been such depressed demand in this segment, it’s got a longer run rate just to get back to neutral, much life get overheated.

And the last thing I would say is as interest rates rise I think more people that were thinking about being a move-up may become an entry-level or high energy level, which is sort of the ELP strategy.

It makes sense. Thanks again guys.

And the final question this morning is from Alex Barron from Housing Research Center. Please go ahead.

Yes. Thanks guys. I wanted to focus a little bit on your gross margin outlook, so you said, you want to get to 19% to 20%, I was just curious, is that more of a 2018 type timing or you think you could hit that at some point in the year or is that more further up?

It was a specific target on what we are to get there, probably not in ‘18, but maybe in ‘19. But so many factors that come into play that the [indiscernible] get there or not. Certainly, construction costs are probably the biggest one, but also look at the appreciation that we are going to see on our existing land book. But that’s the number we aspire towards and that’s the number we realistically think we can get to.

Okay. I think you can get there too, I was just trying to get a sense how so soon?

Yes. I appreciate that.

Another question on the gross margin is the component of interest that gets expensed, I think you are getting pretty close to the same rates that you are incurring right now, so I am curious whether you are expecting to see some more leverage from that next year as well?

Probably, we will continue in a similar trajectory than we have been. We actually noted on the call today, that we expect that the interest maybe a little bit higher actually in the back half of the year. It was very, very low in the first quarter, it’s only about $800,000. So as we continue to build up our land book and we continue to invest in land and development, we are going to be dipping into our revolver a little more than we have then and we expect that’s actually inch up a bit, not a lot, but inched up a bit throughout the year.

Okay, great. Well, best of luck for this year.

Thank you.

This concludes our question-and-answer session. I would like to turn the conference back over to Steve Hilton for any closing remarks.

So thank you for your support, and thank you, for participating in our Q1 2017 earnings call. I will look forward to talk with you further in July. Have a great day.

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