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Meritage Homes Corporation (NYSE:MTH)

Q4 2012 Earnings Conference Call

January 31, 2013 10:30 AM ET

Executives

Brent Anderson - Vice President of Investor Relations

Steven Hilton - Chairman and Chief Executive Officer

Larry Seay - Executive Vice President and Chief Financial Officer

Analysts

Dan Oppenheim – Credit Suisse

David Goldberg - UBS Securities

Joel Locker - FBN Securities

Stephen Kim - Barclays Capital

Jade Rahmani - Keefe Bruyette & Woods

Adam Rudiger - Wells Fargo Securities

Stephen East - ISI Group

Will Randall - Citigroup

Jeremy Pinchot - Gilford Securities

Michael Rehaut - JP Morgan

Nishu Sood - Deutsche Bank

Ivy Zelman – Zelman & Associates

Operator

Good morning and welcome to the Meritage Homes Fourth Quarter 2012 Conference Call. All participants will be in listen-only mode. (Operator Instructions) Please note this event is being recorded. I would now like to turn the conference over to Brent Anderson, Vice President of Investor Relations. Please go ahead, sir.

Brent Anderson

Thank you, Rocco. Good morning everyone. I would like to welcome you to our conference call today. Our fourth quarter of 2012 ended on December 31st and we issued a press release this morning with our results before the market opened. If you need a copy of the release or the slides that accompany our webcast today, you can find them on our website at investors.meritagehomes.com or by selecting the Investors link at the bottom-left of our home page.

Slide 2 of our presentation refers you to our Safe Harbor language. Our statements during this call and the accompanying materials contain projections and forward-looking statements, which are the current opinions of management and subject to change. We undertake no obligation to update these projections or opinions.

Additionally, our actual results may be materially different than our expectations due to various risk factors. For information regarding those risk factors, please see our press release and the most recent filings with the Securities and Exchange Commission, specifically our 2011 Annual Report on Form 10-K and our more recent 10-Qs. Our 2012 10-K will be available by the end of February.

Today’s presentation also includes non-GAAP financial measures as defined by the SEC and to comply with their rules, we have provided a reconciliation of those non-GAAP measures in our earnings press release.

With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage Homes; and Larry Seay, our Executive Vice President and CFO. We expect our call to run about an hour and a replay of the call will be available on our website within an hour or so after we conclude the call. It will remain active for 30 days.

I will now turn it over to Mr. Hilton to review our fourth quarter results. Steve?

Steven Hilton

Thank you, Brent. I would like to welcome everyone to our call today. We are starting on Slide 4. We finished 2012 with very good results overall. Our orders, home closings, revenue and margins were up, and we leveraged that growth to deliver earnings of $0.63 per fully diluted share, even before our $72 million tax benefit that increased our net earnings per share for the quarter to $2.49.

Our pre-tax income improved each quarter throughout 2012 and reached its highest level since the first quarter of 2007. We achieved another quarter of strong year-over-year growth in orders, closings, and backlog. Our sales remained brisk through the end of the year, with only a 9% sequential decline in orders, less of a seasonal slowdown that we would normally expect in the fourth quarter. Prices continue to rise in most of our markets and our average sales prices increased even more due to our mix shifting more towards move-up homes and higher priced communities in states.

Our team did a great job capitalizing on the general resurgence in home demand and increased our 2012 sales by ensuring that we had well-located land for new communities in high demand areas, design and introduce exciting new plans into most of our markets, and successfully demonstrating the benefits of our industry-leading energy-efficient homes.

I will highlight a few of our fourth quarter sales statistics. Home orders increased 46% over 2011, when combined with an 18% increase in average selling price, the total order value increased 72%. This was our seventh consecutive quarter of year-over-year growth in home orders. Our average sales price naturally climbed to $323,000 for orders in the fourth quarter. Our average orders per community increased 43% over 2011 and our cancellation rate decreased to 13% from 19% a year ago. Even with a 39% increase in closings, our order growth drove backlog up 61% in units and 93% in total value, reflecting a 20% increase in the average sales price of homes and backlog.

Turning to Slide 5, all of our markets were effective in increasing sales for both the fourth quarter and the full year of 2012 over 2011. California and Arizona showed the greatest growth year-over-year amongst our largest markets. California grew sales 154% for the fourth quarter and 146% for the year over 2011.

We had a 11% increase in average price there for the year. So, California’s total order value was up 172% year-over-year. Arizona posted a 46% sales in growth and a 7% increase in average sales price for a 57% increase in total order value for the full year. Colorado and Florida followed with full-year 2012 sales growth of 32% and 31% respectively. Colorado sales were 78% in the fourth quarter, ending the full year up 32% over 2011. ASPs grew 10% for the year on Florida and 4% in Colorado. So, Florida’s total order value increased 44% and Colorado has increased 38%.

Texas grew orders 10% for the year, despite a 11% decrease in average active communities in 2012 compared to 2011 and average prices increased 3% in Texas, where prices have been more stable than other markets over the last six years.

Our New Carolinas markets grew throughout the year and added significant number of sales to our total orders and closings, but the year-over-year of comparison isn’t meaningfully apt. Since 2012, it was the first full year of operation, we have been very pleased with our initial success Raleigh. Our full-year sales per community increased year-over-year in every major market for 2012. We finished the year with 158 actively selling communities, showing sequential growth, but not quite where we thought would be at year-end, due to some delays in obtaining permits as well as continuing the strong sales that led many communities to close out ahead of plan.

However, we have been acquiring and opening larger communities as we have been selling out of smaller ones, so we should see less turnover in 2013. We have adjusted our current plan to project approximately 190 total active communities by year-end 2013. This takes us right into the next slide regarding our lot position, and that’s Slide 6.

Based on better-than-expected growth in 2012 and our expectations for additional growth in 2013 and beyond, we invested approximately $175 million in land and development during the fourth quarter of 2012 and grew our total lots supply by 3,000 lots. That brought our total cash investment for the year to approximately $480 million in land and development spending, including the purchase of approximately 9,000 lots. Coincidentally, that’s about the same number of lots we put in our contract during the year even though we haven’t purchased all of those lots yet. We ended the year with approximately 20,800 total lots in our control, an increase of 4,100 lots over year-end 2011 for a total of 16,700 and equivalent to about five years of lots supply based upon 2012 closings.

With that, I will turn it over to Larry to review a few of our other highlights for the quarter and the full-year results. Larry.

Larry Seay

Thanks Steve. Please turn to Slide 7. Our strong sales, earlier in the year, translated to a 39% increase in fourth quarter closings and a 48% increase over 2011 in home closing revenue. In addition to the increased closing revenue, our fourth quarter gross margins increased year-over-year, resulting in a 74% increase in fourth quarter home closing gross profit or a 50% increase excluding impairments in both years.

Our adjusted gross margins excluding impairments, were 19% in 2012 and 18.8% in 2011. Additionally, excluding interest amortized in cost of sales, gross margin improved by 60 basis points to 20.5% from 19.9% last year. The sales price increases we are getting for our homes are largely being offset by industry-wide increases in various cost components.

Most of our earnings leverage came from holding SG&A expenses relative to our revenue increases. Commissions and selling expenses decreased by 120 basis points year-over-year to 7.4% of home closing revenue in the fourth quarter of 2012 compared to 8.6% of home closing revenue in the fourth quarter of 2011.

Additionally, our general and administrative expenses decreased by 230 basis points year-over-year to 4.9% of total revenue in 2012 compared to 7.2% of total revenue in 2011. Although we did have about a $2 million in insurance recoveries in the fourth quarter of ’12, so G&A would be have been closer to 5.5% before that benefit.

Interest expense decreased both in absolute dollars and a percentage of revenue in the fourth quarter of 2012 compared to 2011 as we capitalized a greater portion of interest incurred to assets under development. The net effect was that our fourth quarter 2012 adjusted pre-tax income increased by $22 million from $2 million in 2011 to $24 million in 2012. Our diluted earnings per share of $2.49 were impacted by the dilutive effect of convertible notes that we issued in 2012.

I can walk you through the details of the mechanics offline, but the net effect of our convertible notes on diluted shares was an additional 2.2 million shares for the fourth quarter and 600,000 shares for the full year of 2012, which impacted diluted earnings per share for the quarter and the year by $0.14 and $0.04 respectively.

Moving to Slide 8, our strong order growth we achieved throughout the year drove our 2012 orders at our highest point in five years and translated into much higher closing revenue and earnings during 2012. Full-year 2012 home closings increased 30% and closing revenue grew by 38% as compared to 2011.

Home closing gross profit increased 48% over 2011 and our home closing gross margin excluding impairments improved by 30 basis points to 18.5% from 18.2% in 2011. As with the fourth quarter, our full-year pre-tax earnings improvement was mainly due to a leverage in overhead. Our SG&A was 13.7% of 2012 revenue compared to 16.2% of 2011 revenue, a 250 basis point improvement. We got another 150 basis points of earnings leverage from interest expense, which dropped to 2% of revenue from 3.5% last year.

Moving to Slide 9, we indicated earlier in the year that we expected to reverse our valuation allowance against our deferred tax assets by early 2013 and we accomplished it in the fourth quarter of ’12 ahead of plan. Based on our improved results and our expectations for a continued recovery in the homebuilding market, we determined, based on our projections, that we should be able to use most of the deferred tax assets to offset future income taxes within the statutory time limits. We reversed $79.9 million of our deferred tax valuation allowance and used $8.4 million for our federal and state tax provision in the fourth quarter of 2012. The net tax result was a tax benefit of $71.5 million for the quarter. Of course, that means beginning in 2013, our net earnings will include a provision for income taxes at our normalized effective tax rate of approximately 37% with some minor adjustments that could affect it one way or the other.

We still have about a balance of $8.7 million of deferred tax valuation allowance, which relates to a couple of states. The deferred tax assets net of valuation allowance at December 31st, 2012 totaled $78 million.

Turning to Slide 10, a few highlights of our balance sheet. We ended the year with $295.5 million in cash and cash equivalents, restricted cash and securities compared to $333.2 million at December 31st, 2011. We raised $87 million of additional capital through an equity offering and another 122 million [ph] from the issuance of convertible senior notes due 2032, which increased our total outstanding debt to $722.8 million at the end of 2012.

We also secured $125 million of credit facility during 2012 for additional liquidity that had no amounts drawn on a facility through December 31st, 2012. Our net debt-to-capital ratio at December 31st, 2012 was 38.1% compared to 35.8% at December 31st, 2011, and our earliest debt maturity is in 2017.

With that, I will turn it back over to Steve before we begin Q&A.

Steven Hilton

Thank you, Larry. All in all, 2012 was a much improved year for the housing market in general and even better year for Meritage. We were pleased to finish it out with strong fourth quarter results. While 2012 was the second year of growth in the U.S. new home sales, since they bottomed in 2010 and the highest number of new homes we started since 2007, the absolute level of starts is still far below the historical average, indicating abundant opportunity for continued growth. We believe that the recent reported declines in national existing home sales statistics are due to lower inventories rather than decreasing demand.

Assuming that conditions remain favorable for the housing market, we believe that we can grow sales by 20% to 25% in 2013, with a combination of growth in active communities and somewhat higher average sales per community. We entered 2013 with significantly higher backlog, lots supply, total assets and stockholder’s equity that we had at the end of 2011 and we believe that we have sufficient liquidity to grow as the housing market continues to recover. I thank you for your attention. We’ll now open for question. The operator will remind you of the instructions, Operator?

Question-and-Answer Session

Operator

Yes sir. We will now begin the question and answer session. (Operator Instruction) Our first question comes from Michael Rehaut of JP Morgan, please go ahead.

Michael Rehaut - JP Morgan

Hi, thanks. Good morning everyone and nice quarter. First question I had was on the – your last slide, the expectations per 2013 in terms of the community count and order growth. The math on the 190 expected by year end would point to a 20%, so just don’t know if that is just being conservative with 15 to 20 in terms of may be timing of opening the communities, if you could comment on that and also the order growth basically only 5% better than the community count growth would suggest – I would assume just a fairly conservative view on what you think you can do in terms of improvement of absorption pace and given the what I think everyone expects is for the market to continue to improve in 2013 nicely if that just been conservative and an area of upside.

Steven Hilton

Yes, that is a good question Mike, but we’re still in January and naturally at this time we’re going to be somewhat conservative as to what we project for the year, but we do believe we’ll get growth from both community counts and say average sales per community, that said, we will grow our community count over the next couple of quarters, but I think a lot of our community count is going to come in the back half of the year. Therefore, we’re not going to get a tremendous benefit out of that, but we will definitely get benefit from additional communities. So, I think overall we are just getting a little bit conservative when kind of see how things develop. I would say, I am very pleased with January without giving a specific numbers because we’re just finishing off today. It was a good month and it exceeded our internal expectations.

Michael Rehaut - JP Morgan

Alright, I appreciate that. And then in terms of the growth margins, you did point to expectation of improvement in for 2013. I just wanted to know if that would also include expectations of improvement, let us say from the back half of 2012 as well which I think most people would expect given. At this point, it appears that improvement in price is still outpacing – more than offsetting an improvement – cost inflation.

Steven Hilton

We’ve said for the last couple of quarter that we expect to finish 2013 with a 20% gross margin and we still believe that is the case and we’re going to progress, our gross margins should progress throughout the year to that number. So, we are expecting incremental improvement in every quarter for the year. Larry, you want to add into that?

Larry Seay

Yes Mike, I might add on the incremental improvement. We have normal seasonality in the business. So, typically our first quarter closing, this is the lowest quarter and we do have six components in construction overhead. So, I think that first quarter sequential margin improvement, we’re rather modest with more that happening in the second, third and fourth quarter.

Michael Rehaut - JP Morgan

Okay and so by getting to 20% by the end of 2013 that is a little bit bolder than your competitors in terms of willing to put a number on that and I assume that is just based on what you have in the pipeline and the communities that are being rolled out.

Larry Seay

That is correct.

Michael Rehaut - JP Morgan

Thank you.

Operator

Our next question comes from Nishu Sood of Deutsche Bank, please go ahead.

Nishu Sood - Deutsche Bank

Thanks, wanted to ask about the land purchases you’ve been making. Obviously, you have picked up or controlled 3000 lots in 4Q, you also said something initially that you’re going to be pursuing larger communities, so it will be less close outs. So, larger community wise, is that just a reflection of the higher set absorption pace in other words obviously it’s absorption has doubled and you need a twice a long community, a lot supplied to have the same years of supply. And also on the lots that your purchasing, how far out in terms of community openings are you planning on there, these new purchases for ’14 and ’15, are they sooner than that?

Steven Hilton

Sure, a good question. You know, for the couple of years, a lot of what we bought was distress finished lots that we purchased from lenders and people like that. And we were buying 30, 40, 50 lots, the remnants of a lot of communities that we went and finished that we were gaining that we’re getting at very distressed prices. Earlier this year, we kind of didn’t see those opportunities, those opportunities have been declining. So, we’ve been more focused on buying entitled but undeveloped lots. So if we’re going to go out and develop some lots, we’re going to be looking to develop larger communities of 80, 90, 100, 150 maybe 200 lots. Doesn’t make sense to go out and develop 30 or 40 lots, it’s too much brain damage, too much work to do. A small number of lots, so as the distressed lots have burned off, the availability of stressed lots burned off, we’ve been focus more on larger development opportunities. To the second part of your question, there is not many lots we can buy today, that we’re going to develop and have them hit our 2013 income statements, so most of what we’re buying at the moment to that, right now in the first quarter is going to hit 2014 and beyond. There may be a few exceptions, but generally speaking we have everything tied up and under development or open that we’re going to be needing to meet our 2013 plan.

Nishu Sood - Deutsche Bank

Got it, great. That’s a great answer, and the second question, I wanted to ask about the cancellation rates. Statement looking great for past few quarters, below probably what you might consider normalized at 13%, so my question is what do you think is going to happen to that going forward. And maybe an odd way of asking it is, would an increase in the cancellation rate be a good thing in the recovery, because the lower cancellation rate indicates a real conservatism on the part of buyers. So, would you prefer, maybe a little less conservatism in people more fully buying into the housing recovery or your customers coming to your communities?

Steven Hilton

I don’t put a lot of stock in that number because we ask ourselves a lot, well maybe we are not selling hard enough, we should have a higher rate. I think it’s just we’re doing a better job of pre-qualifying our buyers. You burn up a lot of overhead and a lot of wasted time and energy when you sell home to somebody who is really not qualified, and maybe doesn’t really have the desire to complete the transaction. So, I think we’re just doing a better job on the front end which is drove the cancellation rate down. It might in reality be higher than that, because maybe we have people that have an interest to buyer and they don’t make it through the contract process because they don’t qualify. But again, we’ve kind of moved our business more into the move up business and lessened to the entry level, and first time move up than we were a year, or two years ago. And that means we have a more qualified buyer with the lower cancellation rate.

Nishu Sood - Deutsche Bank

Okay, thanks.

Steven Hilton

Thanks

Operator

Our next question comes from Ivy Zelman of Zelman & Associates, please go ahead.

Ivy Zelman – Zelman & Associates

Thank you, good morning. Congratulations guys on the great quarter. Steve, just to make sure I fully understand what you’re saying regarding your margins and what you can do for 2013, to clarify, is any of that contingent on home price inflation or is really a function of mix and desirable positions and maybe any changes you’ve made that are allowing you to provide some cost savings, if you can answer that first and I’ll come back with the second question.

Steven Hilton

While we’re certainly expecting some inflation but it’s not completely contingent on inflation. I think, we have a lot of internal initiatives in place to better manage our cost on the construction side, which we believe are going to come to fruition in 2013. We’ll also have a lot of new communities opening that we’re very bullish on that we expect to deliver higher margins because we bought these in 2011 and early 2012 at very good prices, and we think those land buyers are going to translate into higher margins, so there is lot of things that we’re doing internally that give us confidence that we’re going to achieve that 20% gross margin.

Ivy Zelman – Zelman & Associates

And just to follow on that, the acquisitions that you’re making now and lots that you’re going to be assumingly delivering in ’14 and beyond, are you underwriting those with inflation and assumingly non inflation, are you achieving in your underwriting at 20% gross margin or better on those acquired, yet to be put into the machine?

Steven Hilton

Oh, we underwrite everything to a minimum of 20% gross margin and we put a contingency in there through our internal interest calculation, so that it differ. We have some modest cost overruns we can absorb that, but regarding inflation, I think it depends upon what market you’re talking about. Certainly in some of the Western markets we have to include some modest amount of inflation or we wouldn’t build to buy any land. But it’s not enough to raise an eyebrow, I believe the inflation numbers are low single digits and I think it’s reasonable to expect that particularly in the West. We’re not underwriting any inflation at all and in Texas, as that market is not rising nearly to the degree of some other markets.

Larry W. Seay

Ivy, if could I add to that. Most of the time if we’re factoring a little bit of inflation and it’s in a long term contracts, in Phoenix, where we have a very good current lot supply. So, we’re looking at more 2015 and we’ve tied up a property that maybe needs a little entitlement work. So, we have a soft deposit, we’re doing entitlement work and that’s more of a case that we factor in the little inflation because we’re doing some zoning and entitlement work that adds to the value while also the closing is as out far there, and we have almost a free look to some extent for the first 6 months, 9 months or a year, while that’s going on.

Ivy Zelman – Zelman & Associates

That’s very helpful -- and I guess just lastly would ask you Steve, if you can tell us with your footprint across in a very ideal market, which market would you say you’re most excited about in terms of the near term and intermediate opportunity. Obviously Texas being your largest, but is there one that just jumps out at you right now that is the most exciting?

Steven Hilton

That’s hard to say, I’m excited about all our markets. We have a tremendous franchise here in Phoenix. We bought a lot of lots in 2011, I’m excited about what those are going to produce for us this year and beyond, we’ve done it really well in Northern California, we’ve grown our business tremendously in Colorado, we’re going to a top three or four builder in that market, if not better. Orlando continues to be strong for us, we’re top three builder in that market. I’m really excited about the Carolinas, we haven’t got much yet at our Charlotte, if that’s going to come through this year, Tampa we just got a new President there. I’ve got a lot of confidence in him and what he’s going to build deliver for us and how we’re going to build grow our land position there. And in Texas, we got some great new communities coming on in Houston, and in Austin and I’m excited what they’re going to do for us in ’13 or ’14, so I hate to just…

Ivy Zelman – Zelman & Associates

Your excited about everything, I’m excited…

Steven Hilton

Yes, I can’t put it on any one market but there is lot of good markets right now in home building that are going to have an impact, this year and beyond.

Ivy Zelman – Zelman & Associates

Thanks Steve.

Steven Hilton

Sorry if that sounded like an advertisement

Ivy Zelman – Zelman & Associates

Thank you

Steven Hilton

Okay, thank you.

Operator

Our next question comes from Dan Oppenheim of Credit Suisse, please go ahead.

Dan Oppenheim – Credit Suisse

Great, thank you. Was wondering if you can talk little bit talks about the, some of the land buys recently that will bring higher margins. Wondering else, if it’s about your sales strategy bring higher margins in California looks like your selling at above pace of four per month. And if you look forward the land supply doesn’t look that long, just wondering how you thinking about that in terms of just the taking the sales there, versus trying to push pricing a bit more in those communities.

Steven Hilton

Well, we had a breakout year in California, I mean 150% growth in orders, we’re not going to have that in 2013, but we have restocked to shelves in California and those stores will open later this year and in the next year and I think will allow us to continue our growth there. I’m not sure what you’re looking for in the first part of your question about the parcel land purchases?

Dan Oppenheim – Credit Suisse

Just wondering more that if you got affected with less than two years of land in California looking ahead and you are selling it over four month, why not split that down a bit and push the price a bit more and get the margin that way?

Steven Hilton

Yes, I think we are doing that. I mean, our margins in California, particularly in Northern California have been quite strong. We have been very cognizant of that. We know we have a shorter land position but we have a lot of land in our pipeline that hasn’t shown up yet. I am very confident that we will continue to be able to grow our business in California in ’13 and beyond.

Larry Seay

Dan, I might add to that. This last year we have talked about leveraging the SG&A more and I have said that we have really planned to get more drop into the bottom line by growing revenue and less focus on a price. But as our volumes have picked up we are pivoting a bit, particularly in places like California where we are now focused more on pushing price than pushing volumes. So, we are refocusing – we are still obviously focused on both, but the strategy is now switching more to price from volume.

Steven Hilton

Our margins in Northern California particularly are very high and they are significantly higher than the company average.

Dan Oppenheim – Credit Suisse

Okay, thanks.

Operator

Our next question comes from David Goldberg of UBS, please go ahead.

David Goldberg - UBS Securities

Good morning everybody.

Steven Hilton

Good morning, David.

David Goldberg - UBS Securities

My first questions, Steven, I know it’s very interesting comments about not seeing the seasonality as much as you might have expected in December. I am wondering, if just from your conversations that you are having, do you think there is any reason to think that there is less seasonality in the business at this point? Or do you think the trajectory has changed and we will see normal seasonality as we go into the selling season?

Steven Hilton

I think it’s more of the trajectory. There is going to be seasonality going forward but there is a real increased desire to buy home today due to the rising prices and low interest rates. I think the short inventory creates some urgency, so I think that’s why we are not seeing the typical seasonality. But at some time it’s going to come back, maybe not so much in ’13, but in the years to come, I am expecting to see seasonality again.

David Goldberg - UBS Securities

Just as a follow-up question here, on the new land that you are buying, are you finding that the larger parcel is going away from the distressed property or maybe you had to buy it straight out and not kind of go into the bigger properties that might take more development work. Do you find them easier to buy those with options vis-à-vis having to buy them out? Or is there any change in the seller going to do options versus the straight sales?

Steven Hilton

No, there is very few options available. I mean, there is literally none in the West. We are finding a few in Texas and in the South East, but these speaking, most everything we are buying today is cash and carry. We are not taking entitlement risk, but we have to pay cash.

David Goldberg - UBS Securities

Okay, thank you.

Operator

Our next question comes from Joel Locker of FBN Securities, please go ahead.

Joel Locker - FBN Securities

Hi, guys. I wanted to check on the G&A which was – it was nice, I guess lower than expectations, what do you see going forward, obviously only up $100,000 year-over-year based on the revenue growth? Larry.

Larry Seay

Yes, as we said before that number was appears lower than kind of the normal run rate because we had a pickup and an insurance recovery which affected the number of a couple of million bucks. So, I think going forward we ought to not look at $17.7 million is being the number but something a couple of million dollars higher than that. Obviously, there is some – certain things get accrued throughout the year at different points, so it’s typically a little bit lower in the first part of the year, so maybe part of that increase when it be as prevalent in the first quarter and we might feel but more increased towards the backend. But, as I said, the number was more like 5.4%, 5.5% if you adjust for that insurance reserve.

Joel Locker - FBN Securities

Right. And then the community count, I mean, how many communities do you plan to open in 2013 and if you have anything additionally for 2014?

Steven Hilton

Larry, do we have those numbers?

Larry Seay

Yes, we are going to open well over 100 communities during the year. They are pretty well spread out throughout the year, but as Steve said, there is a few more oriented towards the back half. I don’t have the specific numbers right in front of me today, but it’s well over 100.

Joel Locker - FBN Securities

Right. And just one last question on investors in your western markets, have you seen that change in the last two or three months, I mean just based on your competitors or what you are seeing in there?

Steven Hilton

We are selling very few homes to investors. Just in general, I guess from peers or on the existing side. Just a prevalence of investors in those markets versus three, six months ago. The only thing – I mean, we haven’t seen investors buying our homes at all over the last two or three years, but I am hearing that at some entry level communities in the west there are some investors buying homes, but I don’t think it’s that significant. I think they are more focused on the resale market than the new home market.

Joel Locker - FBN Securities

Alright, thanks a lot guys.

Steven Hilton

Thank you.

Operator

Our next question comes from Stephen Kim of Barclays, please go ahead.

Stephen Kim - Barclays Capital

Great guys, thanks. Good quarter and most of my questions were answered. But just two larger picture questions for you, Steve. You guys are one of the few public builders that has the opportunity to over the next several years really grow into new geographies. A lot of builders are already fairly national. I was curious as to whether or not if you look back over the last couple of decades if there is any particular lessons learned that you think will encourage you to do things a little differently in terms, specifically of expanding, maybe financing that expansion or staffing it?

Steven Hilton

Well, I think we may about nine acquisitions from 1997 to 2005. We learnt a lot from those acquisitions. Some of them worked out extremely well, some of them worked out quite averagely. I think there is a lot that we learnt from that. I think, as you know, the last three markets we entered, Raleigh, Charlotte and Tampa, we did organically. We are much more focused on our culture today than we were 10 to 15 years ago. That’s not to say that we won’t be making acquisitions going forward, I think it’s certainly a strategy that we are very much interested in but it’s got to be the right fit in the right market at the right price. We do have our eye on a handful of markets we would like to be in either through organic growth or by acquisition and we will just have to see which are opportunity present itself is better suited for the company.

Stephen Kim - Barclays Capital

Okay. Second question relates to innovation. One another things we have seen over the last few years is a significant price premium that new homes are getting over existing and I think that some of that relates to some of the pretty market improving in house construction technology. You guys have been at the vanguard of that I would say with marketing the energy efficiency of your homes. I am curious as to whether or not you feel that that has significantly more room to run in terms of distancing you versus your peers or whether you think the first mover advantage you have had on that is largely peeking. And then secondarily, if you think there is other kinds of innovations, like for example, Lennar with their next gen type product, and then there are I assume there is some other things. Just curious if you could comment on your outlook on other innovations like that?

Steven Hilton

I think there is still a lot of innovation left in housing. I think we have a lot of tricks left in our bag that we think are going to be well received and exciting but we don’t want to unveil of those all at once. Number one, we have to make sure the cost benefit, it makes sense and we can do them on a cost effective way. But I think there is a lot more to come that will increase the gap between new homes and resale homes. We think there is still a lot left in the energy efficiency area where we are prototyping and piloting several innovative ideas in that area. We expect to rollout some this year. So, I think that’s one way we can differentiate ourselves as a company, as an industry amongst – from the resale market. You got to remember, the new home market is still a very small piece of the entire housing market and in order to grow that percentage we have to show value and we can do that through innovation.

Stephen Kim - Barclays Capital

Great, thanks.

Steven Hilton

Thank you.

Larry Seay

Hey, Steve, if I could jump in here for just a second, more specific question on community openings. We expect that somewhere around 110 to 115 and then close out for around 80 or 85, netting to that 30 or 35 unit increase over year-over-year.

Steven Hilton

Community increase.

Larry Seay

Yes, community increase, right.

Steven Hilton

Next question, operator.

Operator

Yes, sir. The next question comes from Jade Rahmani of KBW, please go ahead.

Jade Rahmani - Keefe Bruyette & Woods

Thanks for taking the question. Can you comment on where you expect the average price to come in for 2013? Both your average order price and price in backlog were above 300,000 in the quarter and I wanted to see if you thought you could average above that for 2013?

Steven Hilton

Give us a second.

Larry Seay

Yes, we haven’t provided a specific number but yes, I definitely think we are going to be north of 300,000.

Jade Rahmani - Keefe Bruyette & Woods

Okay. Thanks for that. Just sort of follow-up question. The shred between your average order price or average price in backlog and the average sales on closings has been increasing last few quarters. I wondered if you can discuss the drivers, for example, is it a function of different cycle times by market or lower spec sales or moderating backlog conversion rates.

Steven Hilton

Correct me if I am wrong here, Larry, but I think the majority of the increase in ASP is mix, gaining more sales out of our higher priced markets, particularly in California and then less than a majority is coming from just pure price increase.

Larry Seay

Correct. We had about a 7% price increase this quarter and less than half of that was through price increase, maybe 3% through price increase and 4% to more mix oriented.

Jade Rahmani - Keefe Bruyette & Woods

Okay. Just lastly, is there any adjustment that’s made to the price between the time and order is counted as a sale and when the actual home is delivered?

Steven Hilton

Yes, I mean, except to buy upgrades and options after we sign the initial contract that price will rise.

Jade Rahmani - Keefe Bruyette & Woods

Thanks a lot.

Operator

Our next question comes from Adam Rudiger of Wells Fargo Securities, please go ahead.

Adam Rudiger - Wells Fargo Securities

Hi, thank you. Steve, I wanted to go back to your comments about buying some bigger land parcels because it makes a little easier from an underwriting perspective and cause less of a headache. If you were to – when we ask some of the more land heavy companies in the middle of the downturn with some of the lessons learned there might have been that they were getting, they were buying too big of a land parcels because it was easier to do. So, I was just wondering, recognizing you on a different scale you are talking about 150 to 200 lots potentially what they were doing, but if you look at your lockout mix right now versus the peak, you are an exact mirror in terms of real heavy on owned and very few auctioned. So, I was wondering what your thoughts were on – the risks associated to that in the cycle and then also do you think this is a permanent shift in your company or will you be auctioneer again?

Steven Hilton

Well, believe me, all was not lost on what happened in the last cycle. We would have rode through the downturn in a much smoother fashion if we were just stuck to our principles. But what happened was we got involved in some very large land deals. When I talk about very large, I am talking about over a 1,000 lots that we shouldn’t have and we increased our risk there. When I talk about larger land deals today I am not talking about anything like where we got involved in and past cycles. And we also got involved in these large joint ventures, particularly in Las Vegas with a lot of other builders that cause significant impairments. So, we are not going to do that again as well. So, a 100 lots, 200 lots, 300 lots is a far cry from 1,000 to 2,000 lot deal that we invested capital on the last cycle. So, we are not going to do that. When the option market comes back and there is some rumblings out there that certain people are getting back into land banking business, if the prices are reasonable we are going to take full advantage and we will try to auction more lots just as we did before but at the moment there just aren’t any really available.

Adam Rudiger - Wells Fargo Securities

Okay. I want to go back to some of the comments that were in the press release where it says, it sounded like you are taking some pricing but you mentioned that those price increases were being offset by material, labor and costs. Some of your other peers that have reported this week seem to suggest that they were getting a better spread difference there. One of my thoughts was maybe given you footprint, you are in some more highly competitive markets, maybe you are seeing some more elevated cost pressures in some of the more diversified builders. So I was wondering, A) if you thought that was a correct interpretation or B) if not. What were the differences?

Steven Hilton

No, no doubt, you are right on the money. The markets that have the highest price increases and the highest sales increases are going to have the highest cost increases. It’s not because the material cost any more in those markets or the labor cost are more, it’s just that the contractors can get it because there is few of them and they are driving these increases. So, builder like us in 14 or 15 markets is not as diversified as others that are in 35 or 45 markets and may not experience the same cost pressures across the board. So, yes, that’s the issue but that said we are going to do a better job in 2013 to mitigate those cost increases by expanding and diversifying our sub-contractor base and other measures we think that will help us keep our costs in line.

Adam Rudiger - Wells Fargo Securities

Okay, thanks for taking my questions.

Steven Hilton

Thank you, Adam.

Operator

Our next question comes from Stephen East of ISI Group, please go ahead.

Stephen East - ISI Group

Thank you. Good morning, guys. Steve, how comfortable are you all with your balance sheet leverage? You are at 38% now. I guess, I am interested in where you are comfortable taking it. And given, you are somewhat unique that you grew through in the boom through land banking and then in the bust you really taken all of the land on to your balance sheet. Sort of, how you look at it today, your preferences there, and then how close is the land banking market being able to utilize that at a reasonable cost for you all?

Steven Hilton

Well, over the long, long term I prefer to keep our leverage where it is today. But in the short term I am comfortable taking it up in to the mid-40s. If opportunities present themselves that require us to do that. I also believe that a year from now there will be some land banking going on in a meaningful way and we will be able to take advantage of that and that will help us with our growth. Like I said, there is a lot going on behind the scenes in the land banking world but nothing has really happened yet but I think it will. So, the greatest lessons learnt from the downturn is as how companies managed their debt. We don’t know how long the cycle is going to be but we certainly know now it’s a cyclical business and we have to manage our balance sheet accordingly.

Stephen East - ISI Group

Okay. I got a different question but just following up on that. You were something like 90% auction, 10% (inaudible), one, do you feel like getting back to that level makes sense or is it a more balanced approached? Then the other thing, I was just – you talked about sustainability of growth in California. If you could give a similar comments on Colorado and then just an update on the Phoenix market given all the moving pieces there?

Steven Hilton

I think the land banking met – the numbers are kind of academically, we couldn’t get back to the 80% or 90% option if we wanted to because it’s just not available. Ask me that question a year from now and maybe my answer might be different, but it’s just I can’t forecast something that’s not there or not available to us. So, if we get to a fraction of that in the next couple of years I would be happy because today’s there is just very little land banking opportunity. We have gone back into Sacramento, we have made some significant purchases there. We think that market is going to be good. We are pretty much shut down there, except in for a couple of stores.

We have a lot of new stores opening there. So, I am really bullish about what that’s going to do for our Northern California business. We have got our first communities open in Orange County in the next quarter or so Rancho Mission Viejo, I am excited about that. We have been very aggressive in Colorado, we have several multi-product line communities opening particularly in the northern part of Denver. This year, we just opened one that’s called Leyden Rock, it’s off to a really good start, in the north-western part of the Denver market.

Phoenix, which just continues to be a very strong market, and we have a very diversified geographic footprint here between the East Valley and the West Valley, very much squarely focused on the move-up market, and like I said a couple of times before, we made a lot of good land buys in the back half of 2011 and early 2012 that we think are going to pay solid dividends for us in this year and beyond.

Stephen East - ISI Group

Okay. Thank you. Are you metering sales in Phoenix right now?

Steven Hilton

Little bit, not much. In a few East Valley communities, yes, but not in all communities.

Stephen East - ISI Group

Okay. Thanks.

Steven Hilton

Thank you.

Operator

Our next question comes from Will Randall of Citigroup. Please go ahead.

Will Randall - Citigroup

Hi, good morning.

Steven Hilton

Good morning.

Will Randall - Citigroup

Thanks for taking my question, and a great quarter. Wanted a little bit more color on the lots piece, maybe I missed it in the slides, but curious where your Class D stand, I think last quarter, it was around 1,500, and in addition, it looks like you increased your lots in California by 800. Was that more a Northern? I guess that’s my first question.

Steven Hilton

Larry, you want to take the Class D, I don’t know?

Larry Seay

Sure, yes. We haven’t bought any lots in Class D market, so that number is going down, probably hasn’t gone down a whole lot, but it’s certainly dropping. And what was the second half of the question about lots in California?

Will Randall - Citigroup

Yes, looks like you guys increased your count by 800 lots in California quarter-over-quarter. I imagine that’s a lot of northern California, but I am just curious if you are burning out on southern California. You mentioned in particular Rancho Mission Viejo, which obviously is Orange County if I remember correctly. Could you kind of go through that piece on lot mix in terms of where you are growing in California?

Steven Hilton

Well, more so in northern California than southern, but with that said, we have a strong push on to acquire more lots in southern California and grow our base there. But in 2012, we certainly bought more in the north than the south.

Will Randall - Citigroup

Okay. And then, just my follow-up, I was hoping if you could talk about the merchant builder model, as I found it quite interesting, how you guys generated some of the highest returns on equity over the last cycle as well as stock returns. And really, it’s just trading off higher asset turns for a bit lower margins. Can you talk about your philosophy today on that?

Steven Hilton

Well, this is what we have been talking in the previous call before with the rolling options. A lot of those high ROA numbers were a byproduct of our ability to buy lots on rolling auction. So, going forward, we hope that will return and we will be able to do some more of that, but at the moment, there isn’t a lot of that available. That said, I think we are going to be able to grow our earnings as it get better than everybody else, because of the markets that we are in and because of the land that we have, and overall company strategy, but I think ROAs are going to become a little bit more pedestrian in this cycle than they were in the last just because the off-balance sheet opportunities just aren’t available.

Will Randall - Citigroup

Appreciate the time and great quarter, thanks again.

Steven Hilton

Thank you.

Operator

Our next question comes from Jeremy Pinchot of Gilford Securities. Please go ahead.

Jeremy Pinchot - Gilford Securities

Thanks again for taking the call and good job on the quarter, absolutely. Most of my questions have been answered for sure, but a little more detail, potentially on cost inflation versus price increase. Did you guys have the numbers on a square footage basis for that?

Steven Hilton

I don’t think so. Larry?

Larry Seay

We don’t provide, there’s a lot of issues with measuring construction costs, because people change the spec level of the house. So, you can have the same plan, but maybe you have taken some stuff out, so it looks like the cost per foot went down or you added stuff in. And so, it looks like it likely went up. So, it’s very hard for us to give out publicly those kinds of numbers and give anybody any relative sense about what’s really going on. So, we tend to speak in terms of, yes, this is how much of the price increase was mix versus real price increase and how much of that percentage was offset by cost increase. And as we have said earlier in the call, about 3% of the 7% increase was driven by true price increase, and a great majority of that 3% was offset by cost increase of one kind or another by lumber, or labor, give any sort of color on how it might look at that?

Larry Seay

Steve, you want to answer that or do you want me to do it.

Steven Hilton

No, go ahead Larry.

Larry Seay

Sure. What Steve said earlier a lot of comes through in the form of labor, but its nor necessarily the people working in the field who get a higher price sometimes of that, but a lot of times it’s just a higher markup that the owner of the business is driving, in order to increase their year profits. So, that’s kind of the labor component, I mean certainly that’s probably the most significant piece of it. The other piece is that we are seeing lumber increases, dry wall increases, and concrete increases, that’s kind of the three major building components that have had the most inflation.

Jeremy Pinchot - Gilford Securities

Okay, great, thank you, that’s helpful. And just a quick follow up to the previous question. Any sort of update on how you feel your energy efficiency marketing sales pitch is resonating with buyers, has that started to gain more attraction, had you.

Steven Hilton

I think its resonating quite well, because I think if you look at our average sales to me, per community, it’s quite strong, mugs to move up builders and I think that’s because of our energy efficiency and our ability to pull buyers from the resale market. So, we’re quite pleased with the work we’ve been able to achieve with that strategy.

Jeremy Pinchot - Gilford Securities

And you still communicating the cost savings that they get in one of your homes verse an existing home?

Steven. Hilton

Absolutely, we spend a lot of time training our sales people on how to sell that and we have a new generation of learning centre that we’re going to be rolling in our 100+ new communities. This year, we would think people are going to really be blown away by its very cool demonstration for people to see all the energy saving features that go into the home and for them to had build to quantify, what the savings mean to them. So, if you can’t sell it, it doesn’t make a lot of sense to put it in, but so we’re really focused on how we communicate that to the customer.

Jeremy Pinchot - Gilford Securities

Great, thank you very much. I appreciate it, and again good job on the quarter.

Steven Hilton

Thank you.

Operator

Our next question comes from Alex Barron of Housing Research Center, please go ahead.

Alex Barron – Housing Research Center

Hey good morning guys, great job. I wanted to ask you Steve if you could, I guess you guys are probably the closest and most knowledgeable about the Phoenix market, so just wanted to get you take on what you’re seeing there, what you expect for this year. At the end of life period seem to me like the market was taking a little bit of a breather, maybe after strong started the beginning of last year. And then I went to a forum where, lots of participants said they were expecting like a 50% type of increases here, just kind of wanted to get your take?

Steven Hilton

I don’t know if we’re going to see 50% this year, but I think we’re going to see some that’s not too far from that. Clearly, the East Valley, Southeast Valley in particularly Gilbert, (inaudible) area is very very strong and I don’t think it’s really embedded that much. We’ve got a couple of new communities opening, we’ve opened there recently and we’re metering out sales that we have waiting list of buyers. We’ve opened communities in the West side, they’ve also been successful, I’m not seeing the same swell of activity in the peripheral markets, in self good year and (inaudible), that we’re seeing in the more closer end markets, but that said those markets are improving as well, and they’re going to the extent that we have communities in those areas, they are going to contribute to our 2013 results, so its cooled off a little bit, but it’s still very strong and it’s still better than other markets.

Alex Barron – Housing Research Center

Okay, thanks and then wanted to get, I guess your if you’ve had any change of heart about exiting Vegas, and any other markets that you’re planning to enter this year?

Steven Hilton

No, no change of heart on Vegas and we are looking at some other markets, whether we’ll enter one that’s (inaudible) I can’t tell you and I really don’t want to comment on what those markets are.

Alex Barron – Housing Research Center

Okay, and last one. Are you guys seeing an increasing amount of people coming from, who’ve been renting for closures and coming back to buy houses from you guys?

Steven Hilton

Yes, that is a substance or part of the buyer pool today and we could hereby quite surprised how many people there are that know precisely when they gather the penalty box, and they want to get right back into the (inaudible) market and buy new homes, so we’re actually quite a few buyers that fit their profile.

Alex Barron – Housing Research Center

Any sense of a percentage of your buyers at present?

Steven Hilton

Maybe around 20%.

Alex Barron – Housing Research Center

Okay, thanks.

Alex Barron – Housing Research Center

Okay, thank you very much, so that will wrap up our comments for this call and I appreciate everybody’s participation and we’ll look forward to talking to you next quarter and hoping that 2013 is going to be a great year. Thank you very much.

Operator

Thank you very much Sir. And the conference is now concluded and we thank you all for attending today’s presentation. You may now disconnect and have a great day.

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