Meritage Homes Corporation (MTH) Q1 2019 Earnings Report, Transcript and Summary

Good morning and welcome to the Meritage Homes' First Quarter 2019 Analyst Conference Call. All participants will be in a listen-only mode. [Operator Instructions] Please note this event is being recorded. Please note you should limit yourself to one question and a single follow-up. You may reenter the queue, if you wish. I would now like to turn the conference over to Brent Anderson, Vice President, Investor Relations. Please go ahead.

Thank you, Andrew. Good morning and welcome to our analyst call to discuss our first quarter 2019 results. We issued the press release yesterday after the market closed. You can find this along with the slides that we'll be referring to you today on our 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 our projections for 2019 operating metrics such as home closing, closing revenue and margins to all overhead and diluted earnings per share in addition to expectations about market trends. Those and any other projections represent the current opinions of management, which are subject to change at any time, and we assume no obligation to update them. Any forward-looking statements are inherently uncertain. Our actual results may be materially different than our expectations due to a wide variety of risk factors which we’ve identified and listed on Slide 2, 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, which contain a more detailed discussion of those 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 related GAAP measures. With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage; Hilla Sferruzza, Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage. We expect to conclude the call within an hour and a replay will be available on our website within approximately an hour afterward we conclude the call. It will remain active through May 8th. Now, I’d like to turn the call over to Mr. Hilton to review our first quarter results. Steve?

Thank you, Brent. And welcome to everyone participating on our call today. We appreciate your interest and I’ll begin on Slide 4. Considering the difficult market conditions we experienced in the fourth quarter of 2018, the first quarter of 2019 was a pleasant surprise. We announced on March 4th that our February year-to-date orders were flat year-over-year, which we consider a success, but March was the strongest month of the quarter of 19% over last year. We put up 7% order growth over the first quarter of 2018 with a total of 2,530 orders in the first quarter of this year. Those are highest quarterly order numbers since the first quarter of 2006 and that says a lot. Much of that was attributable to our strategic shift to more entry-level communities as our orders for entry-level homes increased 26% over last year's first quarter. Aside from California, demand was strong in all of our markets, particularly in the entry-level space. The decline in mortgage interest rates since November certainly had a positive impact, but targeted incentives buy us and other sellers also help boost the confidence of those buyers, who fear they may be buying at the top of the market. As further evidence of their confidence, our cancellation rate was only 12% for the quarter, down for 21% last quarter. Turning to Slide 5. In addition to getting the 2019 selling season after a good start with that increase in order, we also delivered a slight increase in first quarter closings, despite during the year with the backlog 15% lower than it was in the beginning of 2018. We've achieved that due to a higher backup conversion rates as a result of closing more of our available spec inventory consistent with our entry-level strategy. Our conversion rate was 73% for the first quarter versus 60% in the first quarter of last year. 67% of our closings during the first quarter were from spec inventory compared to 51% closes from specs a year ago. Our strategic shift towards more affordable entry-level and first move-up homes reduced our ASP 6% for the quarter, which resulted in a 4% decline in the first quarter home closing revenue. When combined with the targeted incentives, we offer in the fourth quarter of 2018 and the first quarter of 2019, we use these incentives to get the volume targets we're looking for a while partially offsetting the discounts with improved overhead leverage from incremental closings. The combination of sales and brokerage sales were offered over the last year or two -- sorry, the combination of sales and broker incentives were offered over the last few quarters reduced our home closing gross margin by 40 bps and increased selling expenses by 30 bps while helping to drive additional orders where we expect to improve on those through the rest of this year. Turning to Slide 6. We believe our strategic shift to focus on the entry-level and first move-up market is clearly benefiting our orders and margins relative to where they wouldn't be with a primarily move up business like we had a couple of years ago. 36% of our communities and 45% of our orders in the first quarter of 2019 were entry-level compared to 32% of our communities and 38% were orders a year ago. Our orders pace for the entry-level is approximately 1.5 times our average for all non-entry-level communities and our gross margins were also higher on average for entry-level and non-entry-level homes. For those reasons, all the new lots we've put under control in the first quarter were for entry-level communities, since we already have a good supply of lots for first move up communities. We're strategically executing our second move-up business as that market is much thinner and more challenged than the entry-level and affordable first time move-up communities, first move-up communities. We expect that to impact our margins through 2019, but throughout the minimal impact next year. In short, our strategy is proving to be the right strategy for us as it addresses the needs for millions of millennials and baby boomers who want affordable homes and highly desirable communities and a simplified and streamlined purchasing process. Along those lines, one of our latest developments is to simplify and streamline the process, the process that is our partnership with loanDepot, who's offering a fully automated, secured digital preapproval process exclusively for Meritage Homes and available on our website. Using this technology, there is no need for a loan consultant to review and approve applications, so homebuyers can be preapproved for new Meritage Homes anytime and anywhere in less than 15 minutes. It's another example of Meritages commitment to innovation. And I'll now turn it over to Phillippe to discuss some of the highlights of our sales trends. Phillippe.

Thank you, Steve. Our orders for the first quarter of 2019 were up over the first quarter of 2018 in the Central and East region, with the West region down to 3% primarily due to the continuation of software market conditions in California. I'll provide additional local color beginning with each region on Slide 8. Our primary objective in East is to grow our business in order to gain leverage, and we have been accomplishing that by opening new entry-level communities that are selling well, much better than the move-up communities they are replacing. In fact, the first quarter orders and our entry-level communities were up 59% over last year in the East region. East region orders were up 20% year-over-year in the first quarter with a 16% increase in average asset communities and slightly higher absorption. The region was led by order growth of 58% in Tennessee, where we increased community count by 75% over the last year's first quarter. Demand there was stronger in earnings communities and improved throughout the quarter. Orders were up 46% in North Carolina due to the combination of 35% expansion in average community count and an 8% increase in absorption over last year. Those gains were primarily associated with our entry-level communities. Charlotte was especially strong after a surge in March orders. Demand also improved in Florida during the first quarter with a 14% increase in orders mainly driven by more community openings and stronger demand than we experienced when interest rates rose in the third and fourth quarter of last year. As a result of our shift to entry-level, our entry, our average sales price on orders for East region was 4% lower in the first quarter of 2019 compared to 2018. The total order value was 14% higher due to community count growth and strong absorption. Slide 9, moving to the Central region, Texas produced an 8% order growth and a 10% increase in total order value as, not only grew our entry-level business, but also had solid success selling through our higher end move-up communities in Dallas, which had previously been a drag on our overall results in Texas. Those orders for higher end homes increase our AFP for the quarter, which we expect to be only temporary as we sell-through our remaining two new communities, while the longer term trends latencies should come down as the presented the order from entry-level communities increases. Absorptions in Texas were 13% higher in the first quarter 2019 verses 2018 given the strong land demand experienced across all four markets there. Slide 10, our orders in the West region were down just 3% from the first quarter of 2018 despite a 24% decline in California, where demand is softer than other parts of the country and absorptions are much lower than the market has experienced there for several years. A 12% increase in average community count nearly offset the 14% decline in order pace for the region. We've rebuilt our community count in Colorado over the past year after years of selling community stocks than we could replace them. Demand remains healthy there though as returning to historical levels at the success and tightening of affordability over the last couple of years. I will now turn it over to Hilla to provide some more additional information. Hilla?

Thank you, Phillippe. I'll provide some more details on our P&L results as well as lands and operating metrics beginning on Slide 11. As we noted when we reported last quarter, we expected our first quarter 2019 closings to be down year-over-year due to up 15% lower starting backlog. So, we are pleasantly surprised, the closings were actually up over 2018 and closing revenue was down much lower than we had anticipated. Although, we didn't provide earnings guidance for the quarter, we far exceeded our internally forecasted earnings with better-than-expected top line performance. The year-over-year decline in earnings was due to a combination of slightly lower home closing revenue and profit, as well as an increase in interest expense in several one-time items impacting the year-over-year comparisons. Our gross margin was 16.7% from 17.1% in the first quarter of last year, primarily due to the targeted incentives that Steve discussed and reduced leverage of our construction overhead expenses from lower home closing revenue despite the 2% growth in closing volume. Additionally, we had a benefit in the first quarter of 2018, a $1.4 million litigation recoveries that increased our gross margin by 20 bps. The lower revenue also had a negative impact on our SG&A leverage, which increased to 4.3% of total home closing revenue, up from 11.5 in the first quarter of 2018. Compared to the first quarter of 2018, our 2019 SG&A expenses included higher brokerage commissions, severance cost of approximately 1.1 million, and another 1.4 million for accelerated equity compensation pulled forward into Q1 from future period. The combined impact of those three items on SG&A amounted to about 50 bps. We expect to improve our SG&A leverage throughout the year assuming market conditions remain steady. Interest expense increased 3.9 million, primarily due to less interest capitalized to assets under development, which is a result of faster construction times in turnover inventory as part of our entry-level strategy. We expect that to continue to be the case throughout 2019. A negative year-over-year earnings comparisons would also due to first quarter 2018 net earnings benefiting from a favorable legal settlement of approximately 4.8 million, which accounted for most of the decline in net other income. Finally, our effective tax rate was 21% in 2019 compared to just 10% in the first quarter of '18 when we benefited from the one-year extension of our energy tax credit for all qualifying homes closed in 2017. This benefit recorded in the first quarter of 2018 totaled $6.3 million. We expect our effective tax rate for the remainder of the year to be about 25%. Slide 12. Turning to the balance sheet and cash flow items, we used $90 million to repurchase approximately 200,000 shares during the first quarter of 2019 and spent approximately 141 million on rent and development in this year's first quarter, $62 million less than last year's first quarter totaled of $203 million, partially because the last repurchase were for entry-level homes at a lower average cost. We ended the first quarter of 2019 with total loss of approximately 33,800 compared to the 34,000 at March 31, 2018. That translates to a lot supply of approximately 3.9 million this year compared to 4.3 million in the last year sequential in 12 month closing. About 71% of total lost inventory was owned and 29% auctioned at March 31, 2019. Consistent with our strategy to increase our focus on the entry-level market, we are building more spec homes in those communities. We ended first quarter of 2019 with about 2,200 spec homes for an average of 8.5 spec per community compared to an average of 7.9 per community a year ago, approximately 36% of total specs were completed as of March 31, 2019. Slide 13, we are encouraged by the outlook for interest rate stability and are optimistic that the spring season will continue as it has begun. We remain cautious in projecting quarterly results. Based on our first quarter results and our outlook, we are currently projected 2019 home closings in total home closing revenue of approximately 8,200 to 8,700 homes and $3.25 billion to $3.45 billion respectively for the full year. We are anticipating home closing gross margins to be around 18% for the year with slightly higher SG&A in 2018 due to increased commission expense and approximately $4 million of start-up cost to open our studio and showroom in the remainder of our market this year. Interest expense will trend down from Q1 but continue to be higher than 2018 due to lower land development spend and faster asset churns. Operating margin should improve throughout the year and we expect to generate $4.65 to $4.95 of diluted earnings per share for the full year. For the second quarter of 2019, we're projected 1,900 to 2,100 closing for total home closing revenue for approximately 760 million to 820 million and a home closing gross margin percentage in the mid 17% for the quarter, which reflects higher incentive offsetting cost savings over last year. We expect SG&A and interest expense to be higher than 2018 for the reasons I stated earlier for the full year translating to approximately $0.95 to $1.05 of diluted earnings per share for the quarter. Upside to those estimates could occur if stronger demand for persists throughout the selling season and beyond to the extent of at least traditional closings volumes from spec inventories as our first quarter results demonstrated. That is the benefit of our strategy but we don't have as much visibility into future closing due to our lower starting backlog and higher conversion rates and the current uncertainties in the housing market. We plan to update our outlook next quarter with a benefit of the spring selling season completed. With that, I will turn it back over to Steve.

Thank you, Hilla. In summary, we are pleased with our first quarter results and the solid spring selling we've experienced in the first three months of the year. Demand for new homes remains healthy and we believe the demand we've seen so far in the spring selling seasons reflect the same positive macroeconomic factors for the housing industry. We're confident in our strategy and pleased with the results of our LiVE.NOW communities and the early success of our streamlined Studio M offering for first move-up homes. There's still a shortage of entry-level product for buyers who are looking for more affordable homes that meet their needs and give them some extras to satisfy a few of their wants. We believe that is exactly what we provide with our new Meritage Homes. Meritage offers our industry leading energy efficiency, home automation, attractive and fresh designs in all our homes, along with stress-free experience for buyers purchasing their first home. It's clear that buyers appreciate those advantages as our customer satisfaction scores have increased to industry leading level as we've implemented those improvements. I'm proud of our entire Meritage team for putting our customers first and working hard every day to make the Company successful. We're confident in our ability to make the most of the opportunities ahead of us, and we expect to continue to grow and deliver increased shareholder value. Thank you for your support at Meritage Homes, and I'll turn over to operator open up for questions.

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Alan Ratner of Zelman & Associates. Please go ahead.

Good morning, congrats on the quarter and on the entry-level strategy. So, I was hoping just to get a little bit more info on the kind of the pricing dynamics in March, the orders were obviously very strong. And I know and I think in January, you mentioned some of the incentives and the market was very sensitive to those incentives where you kind of read a lot of contracts when you have the incentives out and then when you tried to pull them back, maybe the market softened a little bit. So, what were you doing in March on the incentive front when you experienced those strong sales? Would you say the incentives drove the sales? Or were they in spite of actually pulling back a bit on incentives?

No, we didn't do anything unusual in March. We had a national promotion in January that we called Flash Sale, which was very successful, drove a much better January than we previously announced. January was up 10%. I think that sale had a big impact on it. In February, we had Interest Rate Buy Down program as rates continued to fall. It didn't really resonate with the buyers and orders in February were a little bit less, but we didn't do anything on a national basis in March. And we left it with our local operators and the incentives were pretty consistent with what we've been doing not for many months.

Alan, this is Phillippe. I want to say that they were not higher in March than January and February. In fact, they were slightly lower. So, March was stronger without really tweaking incentives beyond what we had originally done in January and February although slightly lower.

And then second question. Obviously, the entry-level push seems to be paying some nice dividends here for you on the order side. At the same time, there has been some incremental tightening from FHA over the last month or so targeting the high DTI, low FIFO loans as well as the some down payment assistance programs. So, I was curious, if you guys have kind of looked into your business, how much of that is reliant on those types of loans and whether you've seen any impact thus far through April from the changes from FHA?

We've not seen any real impact in that. We have very a few buyers that fit into that category and we don't expect to be impacted from that at all. Our average DTI is about 38%.

The next question comes from John Lovallo of Bank of America. Please go ahead.

The first one Hilla, I believe, if I heard you correctly, you mentioned that interest expense should taper off in the second quarter and perhaps throughout the year. Can you just help us frame kind of EPS impact for the full year at the expected level of interest expense versus is at the same percentage was capitalized as we experienced in the fourth quarter?

So, the percent capitalized is going to be consistent and that's not changing, it's a piece that's breaking to the P&L that is going to be slightly elevated. It's more elevated in Q1 than any other quarter throughout the year. So, you should definitely be modeling something slightly less in Q2, Q3 and Q4 than what we saw in Q1 that is going to fix slight a bit higher than it has been last year, just because we have slightly lower land spend through the ability to capitalize interest to asset under production is lower and then just our home construction FICO is turning much faster. So, there's less month of inventory that I get the interest component. So, overall, our actual interest hasn't really changed. It's just is it coming through margin or is it economy through the P&L in the interest line.

So, was there a margin benefit in the first quarter from this?

The interest in margin is fairly consistent. It's not moving too much. We're just turning that inventory faster.

And then finally, how should we think about the year-over-year impact from commissions in equity comp in 2Q through 4Q?

So, the equity comp is one-time charge in Q1. It just pulls some cost forward with the change in the tax laws at the end of '17. We had a one year tax shelters in '18. And then that changed for us rolling into 2019. So, there were some tweaks that occurred with the equity compensation timing, but not overall dollars. So, you'll see the first quarter expense spike up, but then there's no different than modeling for the remainder of the year. The commissions are running at a slightly elevated rate right now, but lower than what we saw in Q1. And we're kind of monitoring market conditions and see, if we can pull back on those expected commissions that we have obtained in Q4 and Q1.

The next question comes from Stephen East of Wells Fargo. Please go ahead.

This is actually Paul Przybylski on for Stephen. I guess first off. Could you give us some color on how April is transpiring both from order perspective and also with respect to any incentives? And then, if you're saying any difference in incentive levels between LiVE.NOW and the first move up and move up product lines?

So, we have modestly pulled back on our incentives in April, but I'd say very modestly, but April is feeling really good. We had five weekends in March, which really helped those results whether it was phenomenal of March. Interest rates continue to decline. The weather has been great in April. I'm very confident that we will have a plus over last year for April numbers and I believe we did have -- we do have Easter Weekend and only four weekends in this month. So -- but it feels really good right now. Certainly, some markets are exceptionally strong like Phoenix is one of those right now. It's in the entry-level states it's really, really strong. Other markets are good as well, but some are certainly better than others.

And to answer the question on incentive between entry-level, first move-up and other, I mean, in terms of entry-level, they are a little higher from last year just to compete with what the other competitors are doing, but not much. First move up a little bit more than that, and then, clearly, we've articulated that work aggressively getting out of the second move-up business. So the incentives on the second move up business are meaningfully higher than they were last year as we try to strategically get ourselves out of those type of communities and reinvest that capital into entry-level versus move-up communities.

You'll see those incentives slightly elevated from the 2MU business in our margins in the first half of year and then just start to taper off as we get to the end of the year and be really negligible into next year.

And sliding into California with the order decline and the strong community count growth, did you see any improvement in that market as we move through the quarter as rates trended down? Or is that market really just set for bigger pricing reset, but -- to get it to inflect?

I think we saw certainly some seasonal improvement and we certainly saw more action in some of our lower priced communities that we newly opened. So, I'd say, it's very local in California and some of our communities performed well and some of our higher priced communities didn't performed as well. But our biggest challenge in California has really been our community count, and starting to make some inroads there, getting more communities open.

Yes, we're going to see improvement in California just because of that community count ramp up, but locally it's definitely the market where we are seeing buyers' expectations around incentives being the highest. They want to make a deal that coming in with expectations that they're going to get a deal. And then as you look at the competitive landscape other builders are aggressively delivering those deals. So, it's a very competitive environment from the incentive standpoint right now.

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

I wanted to ask about the incentive environment. I think there has been some debate about how the fluctuations in interest rates and rising home prices that kind of pressures on affordability have driven the need for incentives and obviously across the different product segment, entry-level versus move-up. The conventional wisdom says that the entry-level gets hit more by affordability concerns, but Steve your experience over the last couple of quarters say that you have had more success through this difficult period with the entry-level. So I just wanted to get your thoughts on it. What can we take from that? Is it really company by company? Is it just specific? Or what are you seeing in the market generally like what part of the market has been more affected by the volatility here in rates and affordability? And where -- how is that driven the use of incentives differently in each of those end markets?

Well, I think two things are happening. Number one, the entire entry-level market has been underserved, okay. So, there has not been enough supplier capacity or product to put market, to serve the entry-level market, as the entry-level segment is getting bigger because the millennials are becoming more into their home buying years. So, that is way offsetting the negative impacts from rising rates that we saw last year. In addition, housing prices have climbed quite a bit over the last 15 years. You go back to what the prices were in the mid 2000s versus what they are today as they rose, risen a lot for a lot of reasons. So, a lot of people skipped the entry-level market, went to the first move-up market or beyond are not coming back to the entry-level market. So then we have these baby boomers they're moving down and buying entry-level homes as well, because housing is expensive, but they still want a new home. So, I think those factors are mitigating the rising interest rates and that's why our self and others that are in the digital space are doing well.

On SG&A, so in the quarter, we had some SG&A deleveraging even if you take out those one-off factors that you mentioned, Hilla. So, the deleveraging driven by the fact that revenues were down because of ASPs even though volumes went up. Your ASPs will probably continue to fall obviously based on the success of your entry-level strategy. So, how should we think about SG&A leverage going forward? You mentioned you expected to happen throughout the rest of '19. So what will that require? And what's driving that that dynamic where even with the ASP declines or driving the deleveraging?

So, I think you've already touched on this. I'll just cover again. There's 16 bps in that 12.3% number that are either commissioned related, which we expect to kind of taper off toward the end of the year or one time item or even which you don't expect to be recurring. Because of that elevated starting price, we are going to be slightly elevated our expectation and our guidance was slightly elevated SG&A for '19 over '18. Although, there are a lot of efficiencies that are going to be coming through once we exit our second move-up communities. They're highly inefficient around absorptions pace. That doesn't sync up with the rest of our community strategy. So once those fall off and were able to redeploy those resources back into more effective and efficient communities and the move-up, first time move-up an entry-level space will be able to get back to the target number that we have for SG&A leveraging.

The next question comes from Scott Schrier of Citi. Please go ahead.

I wanted to know if you could talk a little bit about your gross margin bridge. What you might have seen from lumber deflation versus some of the other cost buckets where you're seeing in inflation as well as some of the impacts from less overhead from your faster churn asset strategy, so maybe in the quarter and how you're thinking about some of those things going forward for the year?

I'll take the cost piece of that and then maybe Hilla can piggyback on that. We were able to really get some great savings over the last three quarters, starting back in the second quarter or third quarter of last year. As you guys know, lumber was really structurally impacted in the first half of 2018. We're able to claw those costs out successfully. And our costs are -- our lumber costs are pretty much back to what they were before the ramp up. And those are all captured in our go forward business. We capture most of that in Q1. We saw that in our margin. So, it helps us offset the additional incentives and commissions that we're offering in the market. As it relates to our forward-looking kind of vision into the cost, the costs are pretty stable right now. Labor is pretty stable. Our key commodities are pretty stable. We're not tracking any spikes in lumber or concrete, et cetera, et cetera. So, we feel pretty good about a stable cost environment go forward. Lastly, and I'll let Hilla piggyback, we've just been really dialing in the cost of our products as we've rolled out our entry-level strategies. And we've been able to really refine our product offering, which has allowed us to build homes in more efficient manner in a more cost effective manner, repeating what we're doing there and drive a lot of efficiencies in our cost structure through the pivot entry-level, which is also benefited our costs as we go forward. So, we continue to capture those opportunities to help us manage the market. And I don't know, if you want to have anything to add.

Sure. So, I think we mentioned on prior calls that we expect the benefit from lumber to be about 100 bps in the margin. So most of that is now fully baked into our Q1 numbers, we've had a couple of successive quarters of home construction with those lower rates locked in. Now, the offset there, of course, are higher incentive and slightly lower revenue that's offsetting the fixed components of our overhead. So, there's some fixed components in the margins, that the lower overhead, that the lower revenue is not offsetting all the overhead. Now, just to reminder on the lumber, the improvements are there from Q3 and Q4. First quarter of last year did not have elevated lumber. So when you're comparing apples-to-apples, the limbers actually fairly consistent with what it was last year's first quarter. So there's not a benefit and the year-over-year basis. Even though there is a benefit on successive quarter basis. So that's kind of how it all shakes out with this 40 bps change, it's really does the higher incentive. We were able to recapture some of that with incremental volume and savings from our entry-level strategy. And then just a reminder, we mentioned this in the script, there's about 20 bps that use of last year's first quarter margin, gross margin that was related to a successful settlement from a legal case that was actually running through margin. So, it's some kind of apple-to-apple that was 16.9 to 16.7. So, the incremental decline on a year-over-year basis is really nominal.

I would also add that we had a reduction in headcount event in January, we've reduced our headcount 6% or 7% and that's why we took the $1.1 million charge. But we're really trying to be mindful this year of our hiring and trying to be more efficient with our overhead -- reaching our overhead levels to last year or below.

Great, thanks. I appreciate all that color. For my second question, I wanted to ask about Colorado. Your absorptions still declined there significantly, but you were -- or I should say, despite the fact that you are able to get your ASP down 7%. So I'm curious if you still have to burn through the product that you have there to get lower priced product on the ground and offer more incentives? Or is there something different there, maybe an overall slowdown in the market that you're seeing?

No, I wouldn't read too much into that. The timing, we have the new communities open, that weren't open for the full quarter. Business in Colorado is very good. Clearly, if you're at the lower end, you're going to do better. But I would not lump Colorado in with California. We're feeling pretty bullish about our business and our positioning up there and where is that -- I don't know if you want to add some more to that Phillippe?

Yes, -- no I wouldn't add too much, I mean it. It's definitely a market that has been impact by affordability. We saw that come in two years ago and started buying more entry-level stuff. So that pivot has offset some of the softening that has occurred in the higher end. But we had some really strong move-up and second move-up communities in Colorado. It's a very strong market. So although absorptions are off a little bit in that space. They're still pretty good from a company perspective. And then we continue to open up the entry-level business, which is offsetting some of that softening in the higher end.

The next question comes from Stephen Kim of Evercore ISI. Please go ahead.

Yes. Thanks a lot, guys and good job in the quarter and navigating the market. I wanted to ask about the incentives. It sounds like you're moving a little bit more away from the national type incentives to maybe more regional ones, leaving it up to the local guys. I assume that's going to continue going forward. So should we assume from that, that we are not going to see the national Flash Sale that you did in January, via repeating event? Or is that actually incorporated in another one -- incorporated in your full year guide? And then specifically to California, I know in the Inland Empire, you were bringing on a number of communities over the course of this year. I was wondering how your attitude has changed, if at all, with respect to that and if your absorption pace is okay, enough, sufficient at present or do you think you're going to need to increase your incentives there, more than you already have?

Stephen, I would disagree with the first part. I would say, a good fisherman is always changing his bait, and we're not going to tell the fish when we're going to change the bait and what bait we're going to use. But we are going to be really nimble and creative, and one month there may be a national promotional and the next month there may be a local. But we have some definite plans and ideas for what we're going to do the rest of the year. And we are learning what's working and what's not. Yes, you can't -- the Flash Sales were great in January, but you can't do that every month because then it's not going to have its effect of course. What was the second part of the question?

Inland Empire.

Inland Empire.

Inland Empire, we are not a good barometer for the Inland Empire. I think we have two stores open out there. So I would encourage you to seek out others to really get a beat on that market.

Okay. My sense was that you were going to be bringing on a number of them over the course of the next 12 to 18 months. I guess that's not really the case then going forward?

No, we are bringing on some more stores out there. But again until we are open. You're not really going to get a beat on what's happening there.

As we sit here today, we have two communities opening in the Inland Empire. One has been open for a bit here. And another one that just opened and they're doing okay, right. Like Steve said, there's lot of diversity to the Inland Empire, and we're only in two sub-markets. And so we're just not a good, a data point on how that market is doing.

I'm hearing from other builders that we are talking to, that it's kind of a mixed bag. Some people doing well in certain locations and some are not.

Yes, that's fine. Okay. And then regarding margins, just as a -- from a longer-term perspective I look back, Meritage generated double-digit operating margins in the previous cycle, and that was even when you were not really doing much in the way of land development. Today you're willing to do a little more land development. And so I was curious, just longer term, is a double-digit operating margin simply not in the cards over the next couple of years, or do you think it is, and if it isn't, what would be the reason for that?

Well, it's not in the cards this year. But certainly we hope it to be in the future. But we're really targeting more of a 10% or a mid 20% gross margin and getting our SG&A close to 10% to get to that double-digit operating margin. And we got to clear out the 2MU. We got to get our entry-level position higher and we got to get more efficient. In the last cycle we had 40% entry-level. So we're just getting back to that point, to where we were in the last cycle. And there's a whole variety of other factors why we are not double-digit today. But clearly, that's our aspirational goal of where we want to be.

And then Stephen just one more comment on that. We have been telegraphing our intent to pivot on entry-level and first time move-ups. So there's a little bit of inefficiency, as you make a pivot, since you are carrying some of the old product and the old processes as you're converting to the new product and the new process, as we read through the higher level, higher price points, community that require different operating structure and we are fully implemented in just entry-level and first-time move-ups. You will see the full benefit of the efficiency that we're putting in place right now.

But we 100% believe that the clearest path for our business to get to a 10% double-digit operating, is all about volume, and our entire strategy is built around driving higher volume per store, being able to build those houses faster, and more efficiently, and our goal is to get there through that strategy.

Yes. You guys have been really clear about that and definitely making progress. So that's been good to see. My last question is related to volume; in the past, Meritage has been among the builders that has been the most -- has grown -- had the most success with integrating acquisitions. You stubbed your toe on a recent slate several years back, but that's been kind of a while ago. I am curious with your pivot here that you've made, more toward the entry-level, whether you feel confident enough in the degree to which you have worked through that transition, to now once again be open to doing M&A, and we have observed that the M&A in the industry seems like it has been pretty strong as -- over the past year or so, and curious if you could speak to the pipeline you're seeing out there, your general interest level, and your preparedness to do something in that regard.

We are ready to do M&A. Our eyes are open to M&A opportunities. We're regularly looking at them. But we're going to be very disciplined about doing one that fits with our strategy. So buying a move up builder is really not going to -- good for us and we -- our preference is to find somebody who is in a market that we're already in, so we can leverage our overhead. And we just have not seen those opportunities that fit with our strategy at prices that make sense. That's not to say, there is not going to be anything in the future. But many of the deals that we've seen over the last couple of years, just really haven't fit for us.

The next question comes from Alex Barron of Housing Research Center. Please go ahead.

So my questions were precisely around the -- I guess the benefits of being more in this new kind of spec entry-level driven model. I'm just curious if you can speak to, what do you think or in your experience so far has been the more interesting changes in either been in the year -- In the sales space you're able to see or in the cycle time to build these homes, or in the ability to change or improve your margins based on how much you're able to, I guess, buy things in bulk, can you just kind of talk about your experience on benefits you've seen so far?

I mean it's both. I mean, we carry volume down just a touch. Alex, we're getting more feedback from it, but it's both. We're seeing from our surveys and talking to our customers that more than half of our entry-level customers are renters, and they don't want to wait six months for a home, they want to move in sooner than later. They don't want to go to the design center, get overwhelmed by all the different choices and selections. But they do want a premium finish. They want a nicer carpet, nicer flooring, nicer cabinet. So, we're able to meet those needs and demands of those customers with the way we're selling our LiVE.NOW product. They come into our office, they come to our sales kiosks. They can see all the products that's available, when it will be ready. We can immediately text it to them on their phone or email to them. They love that and that's really really helping. And on the other side, the production side, our contractors that work for us really love having a consistent pace. They really prefer building spec houses over build-to-order, it's easier for them. They keep their got -- their people on our job site. We are giving better pricing. We have value engineered a lot of our product now across the country. We've been able to reduce our construction costs significantly, as we pivoted to entry-level and so it's working for both sides of the equation. When we get our costs down, we're able to deliver better value to the customer, which allows us to sell more homes and be more competitive with those other high-volume entry-level builders. So we learn a lot every day. Not only in the entry-level space, but also in the move up space, I would encourage you to come out and see one of our new Studio M's. I think there -- it's revolutionary, the way that we're approaching colorization and design for the move-up buyer by moving away from the a-la-carte model to a model that offers seven or eight or nine professionally curated choices for those customers, that include the cabinets, the countertops, the paint colors, the flooring, all in one module. one designated package and all the packages are the same price, and the feedback we're getting from our customers is they really love it and it really makes the whole design center experience better, allows us to sell more options at a higher margin, and move the people through the process in a quicker and more efficient timeframe. So we're excited about what we do on an entry-level side and what we're doing on the move up space, it's both of those things combined and are going to make us much more efficient over the long term.

Yes. Alan this is Phillippe. I just can't emphasize enough what building homes faster does for our business, and in the entry-level space, we been able to shave off anywhere from two to three weeks in our bill time on average companywide, as we rolled into these entry-level communities. And that has just allowed us to drive a much more efficient cost structure. As Steve articulated, the trade point to work for builders have builds homes faster in a more predictable manner. So the speed in which we are building our homes is having a significant impact on our business.

Okay, great. And can you just talk a little bit, how low of a price point have you guys been able to achieve that this point? Like are there are some markets where you're in the mid 100's, like how low have you been able to get and which market, would you say right now, you're kind of the furthest along into this kind of transformation revolution?

Yes. So we're not going to be the lowest per cost producer of entry-level homes. I mean there are guys, I have mentioned their names that are hitting a lower price point than we are. But we're -- in Phoenix we have one or two communities slightly below $200,000. In Texas we have a few communities that are slightly below $200,000. But we're definitely not going to be in the mid 100s. The sweet spot for us, for the entry-level, is the $200,000 to $250,000 price range in those lower price regions and in Arizona and Texas and in the south. We are building quite a few more townhouse communities, particularly in the South and Florida, they are allowing us to drive down our ASPs and be more affordable. But again, we're not going to be the $150,000 or $175,000 builder anywhere.

The next question comes from Michael Rehaut of JP Morgan. Please go ahead.

Hi this is Elad on for Mike. Congrats on the quarter and on the guidance. I was just wondering how we should be thinking about community count growth for 2Q and the full year given the strong sales pace for the quarter and the close out of some of the floor communities and the openings of the new community?

The community count growth is going to be flattish to slightly down for the quarter and for the year. We'll probably be able to get a better read on that next quarter. But we're moving through a lot of our -- second move-up communities faster than we originally anticipated which is muting our community count growth.

Although you'll see the entry-level become a more meaningful percentage of our total competition of community.

Right. Right.

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

Thanks. Hi guys and just following up on that. Steve, last -- at the end of last quarter, you talked about 15% of your store base being the second move up, and Hilla I think today, you said by the third and fourth quarter, you're expecting effectively minimal margin drag. So what's your composition of 2MU at the end of the first quarter? What will it be at the end of the year and what is the margin differential as you see it, of 2MU backlog versus a LiVE.NOW. or entry-level backlog?

We have done some stats today and we put 2MU into the bucket. We call 2MU and other, so we have luxury in there and we have some active adult in there. And that -- we have 109 communities that were in that bucket a year ago. And now, we are down -- I'm sorry, I gave you the wrong number. We had -- what am I looking at here? It's down 23%. I don't know, what was the ending community count? Oh, we had 63 communities and now we've got 40.

It's going to continue to decline, but the sales pace in those communities is much slower. So you can hang on to what we consider an active community when you're selling one or two a month for quite a while, right. There is going to be a noticeable decline in our community count for sure. But more importantly, the volume of the homes coming from those communities, that's going to become less and less meaningful to our total. And then as far as the margins, it could be a couple of hundred basis point difference in the margins between our first time move-up and entry-level communities versus the stuff that we're exiting.

Carl, we get a believer out of you today?

Not a matter of belief, it's a function of just what that drag is and how fast you have to get out of it, that impacts how we think about things. You know what we think about the entry-level. I wanted to go back though, and Stephen, ask you a little more about about Studio M too. And I'm just curious in terms of the rollout, how far along are you with it, and what's your anticipation of what it can do in terms of improving the speed at which you build, or is it a function of being able to better and more efficiently price options that would help your margins?

It's all of the above. We are -- by the end of this quarter, we will be halfway there, and the end of the year, we will be 100% of the way there. So every divisional has its Studio M by the end of the year, and we'll really have it dialed in really tight. What it allows us to do is, single source a lot of the products. You know, for example, all the flooring -- all the carpet materials and some of the EVP we're buying exclusively from Shaw. Shaw gives us better pricing. We've reduced the number of SKUs, and makes it more efficient for them. We're buying carpet by the roll, as opposed to by the house. And then the same thing with the cabinets and ceramic tile and wood flooring and the other components that go into -- that you sell to a design studio. We are able to get much better pricing. We were able to pass some of that pricings on to the customer, which gives them better value, but also allows us to increase our margin at the point of sale on those goods. So sometimes you're waiting for our product, but slowing down the construction cycle. We're not going to be having to wait for certain products, because we are buying less products, more products that are in stock, that we can get quicker, that we have in our vendor's warehouse locally. So this is just a whole plethora of advantages and we're not -- all these studios, for the most part, are being run my Meritage people, their in-house studios. We do have some contractual relationships with outside vendors to run a few of them. But we're also able to reduce the costs by running them ourselves versus contracting them out. So I think long term, it's going to be a great, great strategy for 1MU.

I think the last thing I would add to that is, if you go onto to other builders offer traditional design studio experience, you will find that it typically takes two to three appointments for a customer to make all of their selections. We're able to navigate our customers through our Studio M in one appointment, usually not taking more than two hours. So you can imagine that allows us to permit the house and start billing the house much faster than a traditional design experience.

And then just one last point, I don't know if you were alluding to this in your question or not, the reason why there is a drag on the financials and the SG&A, is as you're building these, you're incurring the costs. But the benefits are coming from the margin, those homes aren't closing yet. So since we are doing the rollouts throughout the country, this is going to be the year of transition and then starting in 2020, all the divisions will be closing homes, under the new Studio M option structure, in which you'll see the benefit of the revenue, versus just the expense running through this year.

We are open today in Florida. We are open in Houston. We are open in Denver. We are open in Tucson. We're going to be open in Phoenix really soon. And then we have many other markets, particularly in the south, coming right on the heels of that of course, by the end of the year, we'll have them all open.

I see that we're at the end of the hour. So, there is time for hopefully one or two more questioners. The next question comes from Jade Rahmani of KBW. Please go ahead.

This is Ryan on for Jade. In terms of gross margins, can you quantify the approximate differential between the entry-level and first time move-up product versus your other products, and similarly, the difference between your spec build and non-spec homes?

So I think we just mentioned that there's a couple of 100 basis point benefit to our strategic projects product, which is entry-level and first time move-up versus what we are currently exiting out of, which is anything higher level luxury second time move-up. A slight benefit on the entry-level versus first time move-up, but they are fairly similar. It depends on the community and its geographies. So those are fairly consistent and then -- I am sorry, what was your second question?

Just the difference between spec builds versus non-spec?

Oh, so entry-level is 100% spec build. So there is no comparison to be built, that's all we offer, and that's almost half of our business. So it is not really a differential for us between spec and non-spec. I will caveat that by saying there is a differential on the second time move-up between spec and non-spec, because we're trying blow through that inventory a little bit quicker and exit that segment of the market. But for the most part, it's fairly limited between spec and non-spec for us.

And then just in terms of the land market, any noticeable change in competition or prices there or underwriting in response to the choppiness that the market has seen overall?

No, I mean we have seen people -- builders pull away from some things over the last few quarters just to fill out the market. But that hasn't resulted in land prices coming down. They're pretty sticky, and they are the last things to move. And now that sales are picking up, we don't really expect them to move that much. So I'd say generally, we haven't seen really any impact the land market.

The next question comes from Susan Maklari of Credit Suisse. Please go ahead.

My first question is just around, you talked to the improvement that you've been able to see in build times, as you've made this transition with your strategy. Can you talk to how much more you think you can realize there, and maybe what are -- how do we think about the constraints that are in place today, and what they will mean for build times, even as you fully transitioned to a more entry-level model?

I mean, we're building entry-level homes today in less than 100 days. So we think that's pretty good. We might be able to get that down a little bit more, as we continue to drive some efficiency here. There's -- the constraints of labor and what -- I mean, all the other builders are building homes too, and so we don't think there's a big opportunity to drive that down. That's our target. We build a house in three months, that, that's a pretty good number. So I don't see a lot of opportunity to drive that down any further. But as we continue to make our product more efficient, focus on how we build those houses, again Steve mentioned a number of times, how do we really drive a repeatable cost structure. There continue to be some benefits there, but I mean bringing out 2 to 3 weeks in the last year is really -- we thought would be pretty good and that's priority we're going to be sitting. The big impact is going to be, as we move $400 million to $500 million of our balance sheet out of these segments, which is entry-level -- which is the second move up on luxury and some active adult, that we're not going to continue to pursue and move that money, which is not making much profit for us right now back into the entry-level on the first move up, it should have a meaningful impact on our ROA, ROE and then our margins over the long term. So that's really what we're focused on. And then I also think that the new studio and it's going to allow us to build our first move-up homes faster and we will have some better cycle times there as well. So everything that we're doing today is in the pursuit of our long-term strategy to improve all of our financial metrics.

Okay. Thanks. And then just as a follow-up, you mentioned in your opening remarks, some relative strength that you saw in Dallas. Can you just talk to generally what you've been seeing in the Texas markets, and maybe how it compares to your expectations?

Yes, I'll go around the horn. You know, San Antonio feels really good to us. I know other builders have suggested a more difficult market. We're doing really well there. We have great operations there. We know our markets. We know our products. So we are doing really well there. We feel like that market is strong. We have strong entry-level business there. Austin continues to be extremely strong, specially below $300,000, all of our new communities that we have and the new communities that are coming on, are generally positioned there. We see tremendous strength below $300,000. Houston is kind of cats and dogs, the entry-level s strong, certain move-up places are strong, second move-up slow, but overall, pretty healthy market. And then Dallas is just -- it's highly competitive. It's gotten very unaffordable. It's very sensitive to interest rates. The move-up is much slower than the entry-level. We need a lot more entry-level, we haven't pivoted as hard there it's coming . But Dallas is probably the choppiest market of the four, and we see sort of buyer resistance, buyers wanting big incentives, especially the move-up. Overall, it's a strong market. Especially if you're an entry-level business like some of our competitors, but it's a very choppy market.

I'd say also on Dallas, we had the best month in March in Dallas, since the last cycle. Since 2006, by a long distance, I mean, we really killed it in March and we're not really exactly sure why the star, the sun, and the moon all lined up in March in Dallas. It's not as good this month. But I'd also say we have 14 entry-level communities in the pipeline that are all going to be opening in the next 12 months or so in the Dallas metro area, that are going to dramatically reposition our products to much more entry-level focus in that market.

And the last questioner today will be of Jay McCanless of Wedbush. Please go ahead.

So I guess on the 2MU and other, what is your internal timeline for getting those sold through and out of the way; because I think at this point, it seems like there's still potentially some earnings and revenue volatility as you guys try to move through in fits and starts.

Yes, it's like still like 15% of our business. I don't think it's going to be all gone this year. But within the next four to six quarters, it will drop down below 10% and then closer to 5% and will become less relevant. But as we continue to make that pivot, it will continue to be a drag. But we won't be down to zero for quite a while.

We're not wholesale discounting this to get it off the books at large charges. We're selling it at low margin and we're getting it off the books as quickly as possible. But this is still a viable product, we're not wholesale discounting.

And then just a request, if you guys could start breaking that out, the 2MU versus the entry-level, breaking that out in the orders and closings, because I think that would give us a better sense of where organic growth is in your core strategy?

Yes. It's too small of a number of us to start breaking it at that level of detail. Yes, that's going to create some of the headaches, right. So, I mean, it's going to be -- I think we have been pretty clear, it's going to taper off. There is going to be some continuing volatility from those incentives through the rest of '19 and by 2020, it stops being a meaningful impact on the financials.

We will try to continue to give you color on our every call, but I don't know that we can give that detail.

And just one other quick question, what are you hearing from investors, from the single-family rental guys? Is there an opportunity maybe for you guys to move some of this 2MU and even the land associated with it, move it off to some of those folks and help you get through that quicker?

They don't want 2MU. What they want is entry-level, and we will talk to them and the prices that they are offering, really we can't make money. So we didn't have really any success selling to them, our products. I mean, we are more of a premium entry-level product, generally buying more of a strip-down entry-level product. And, we have been asked about why don't we just build communities for the single family rental market, and the answer to that is, why will we build for them and sell at a wholesale, when we can build it for ourselves and sell them at retail and make money on it. So again, we are not tone deaf to the old segment. We have certainly examined it and explored it. But can't seem to figure out a way where it really makes sense for us.

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

Thank you very much for your participation in our first quarter earnings call and we look forward to speaking with you again here over the summer, when we conclude our second quarter. Thank you very much. Have a great day.

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