Meritage Homes (MTH) Steven J. Hilton on Q1 2016 Results - Earnings Call Transcript

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Meritage Homes Corp. (NYSE:MTH)

Q1 2016 Earnings Call

April 28, 2016 10:30 am ET

Executives

Brent A. Anderson - Vice President-Investor & Media Relations

Steven J. Hilton - Chairman & Chief Executive Officer

Phillippe Lord - Chief Operating Officer & Executive Vice President

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

Analysts

Alan Ratner - Zelman & Associates

Michael Jason Rehaut - JPMorgan Securities LLC

Michael G. Dahl - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Alex Barrón - Housing Research Center LLC

Nishu Sood - Deutsche Bank Securities, Inc.

Stephen S. Kim - Barclays Capital, Inc.

Jade Rahmani - Keefe, Bruyette & Woods, Inc.

John Lovallo - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Susan M. Maklari - UBS Securities LLC

Will Randow - Citigroup Global Markets, Inc. (Broker)

Jay McCanless - Sterne Agee

Operator

Good morning and welcome to the Meritage Homes First Quarter 2016 Analyst Conference Call. All participants will be in listen-only mode. After today's presentation, there will be an opportunity to ask questions. Please note, this event is being recorded.

I would now like to turn the conference over to Mr. Brent Anderson, Vice President of Investor Relations. Please go ahead.

Brent A. Anderson - Vice President-Investor & Media Relations

Thank you, Aaronson. Good morning and welcome to our analyst call to discuss our first quarter results, which we issued in a press release before the market opened today. If you need a copy of the release or the slides that will accompany our webcast, you can find them 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 of the presentation. 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. Our actual results may be materially different than our expectations due to various risk factors listed and explained in our press release and our most recent filings with the SEC, specifically our 2015 Annual Report on Form 10-K.

Today's presentation also includes certain non-GAAP financial measures as defined by the SEC. And we provided a reconciliation of these non-GAAP measures to the closest GAAP figures within our earnings press release.

With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage; Hilla Sferruzza, Executive Vice President and CFO and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage Homes. We expect the call to go about an hour today and a replay will be available on our website approximately an hour after we conclude. It will remain active for 30 days.

I'll now turn it over to Steve to review our first quarter results. Steve?

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you, Brent, and welcome to everyone who is participating in our call this morning. The housing market has remained healthy through the first quarter of 2016 and we continue to experience solid demand overall. We believe the economy can support continued growth of the housing market, additional household formations based upon pent-up demand, jobs and income growth, low mortgage rates, and the easing of mortgage credit criteria.

We were generally pleased with our results for the first quarter. We closed 1,488 homes during the quarter, 11% more than a year ago, and are on track to achieve our expected 7,000 to 7,500 closings for the full-year.

Combined with a 3% increase in our average sales price, our home closing revenue rose 15% over the first quarter of 2015. Our gross profit on homes closed increased 8% year-over-year. The increase in revenue allowed us to better leverage our selling, general and administrative expenses, which were 90 basis points lower than they were in the first quarter of 2015. That additional overhead leverage offset most of the decline in the home closing gross margin, which we had anticipated.

Our pre-tax earnings increased 14% and we captured additional energy tax credits on our energy-efficient homes, reducing our tax rate to 27% for the quarter. All that combined to drive a 28% increase in our net earnings and a 25% increase in diluted EPS.

In addition, our East region improved, growing orders and improving our absorption rates in Georgia and the Carolinas after the changes we made last year. Even our sales in Houston exceeded our expectation; first quarter 2016 orders in Houston were equal to last year's first quarter.

We ended the first quarter with a healthy backlog that was 16% higher in units and 21% higher in value than the first quarter of 2015. Based on that growth and our confidence in the market, we continue to invest in land and development. There are a couple of metrics that require some explanation as our gross margins were lower than a year ago and orders were up just slightly.

So we'll now turn to Slide five. Our home closing gross margin for the first quarter of 2016 was 17.4%, compared to 18.5% in the first quarter of 2015. While we anticipated that decline in our budget, there are two primary reasons that explain much of that. Number one, first and foremost, land and labor costs are higher than they were in the first quarter of 2015 as we're still experiencing tight supplies of labor and land in better locations.

Although these costs are no longer outpacing appreciation in the home prices, as they did last year, they did reduce our first quarter 2016 margins compared to 2015. We expect home closing gross margins to be more in line with last year in the back half of this year, as we lap the sharp cost increases caused by the tightening of the labor market in the third quarter.

Secondly, our margins in the West region were particularly impacted by a handful of communities in Southern California and Arizona that were acquired in 2013 prior to the reduction in the FHA loan limits. When these loan limits were reduced, we weren't able to get the prices we expected in those communities, resulting in substandard margins that were well below our company average. As we're selling through our remaining lots in these communities in order to redeploy the capital into better positions, those low margin closings reduced our margin for the region and the company as a whole.

Turning to Slide six. I'll now address our orders for the first quarter of 2016. Orders for 1,987 homes were in line with the first quarter of 2015 despite our average community count for the quarter being 8% higher in 2016 compared to 2015. It helps to understand a few reasons for the flat order volume.

First, we had a number of very successful communities with high absorptions in the first quarter of 2015 that closed out early, so we didn't have the benefit of those in 2016. Secondly, we made a strategic decision to meter our sales in certain communities in Northern California and Colorado, where demand has been especially strong or selling at an exceptionally high pace. And third, our sales pace in Houston was lower than a year ago due to the impact of the lower energy prices. All those combined to reduce our absorption in the first quarter of this year relative to last year.

I'll now turn it over to Phillippe to review our operating trends in a little more detail. Phillippe?

Phillippe Lord - Chief Operating Officer & Executive Vice President

Thank you, Steve. We had a good first quarter and I'm proud of our people for what they accomplished. I'll walk through our markets to provide some color on what our trends are in each of them.

Slide seven. Beginning in the West region, closings were up 20% and our backlog of orders were up 8% year-over-year in the first quarter. Orders were down 11% due to lower absorptions for the regions Steve explained earlier.

Demand remained strongest in Northern California and Colorado, which have the highest absorptions in the company. Land is expensive and difficult to find in those markets and labor is tight, so we are metering out sales in those markets. Southern California and Arizona are slower and we're working through some underperforming communities as Steve pointed out earlier.

Slide eight. In Texas, orders and closings were up 6% and backlog was up 10% in units, primarily due to additional communities opened. Our ASP increased 10% on orders year-over-year, so our order value was up 17% and backlog value increased 19%.

Dallas and San Antonio are still the best markets for us in the Texas region, but Austin and Houston are not far behind. San Antonio improved their sales pace over last year and we believe we could have another record year there. While our absorptions in Houston weren't as high as a year ago, we haven't seen a dramatic fall-off in our sales pace. With oil prices on the rise again, we're becoming more optimistic.

Slide 9. We're pleased with our progress in the East region, where closings, orders and backlog were up 8%, 10%, and 33% in units, respectively, over the first quarter of 2015. The changes we made last year have already begun to make a positive difference and we expect them to continue to improve. We grew our average community count 90%, particularly in Atlanta and Nashville, and are expecting to improve our sales pitch there over time with our newer communities and to improve our margins over time with the products replacements we've made.

Our average community count in Nashville was 80% higher than a year ago, while our absorption was 41% lower. The reason for that is that we introduced new product that should have higher margins and we basically shut down production while we re-bid the contracts for those new plans.

Orlando demand remained solid despite fewer international buyers. Our Florida orders were lower than last year's first quarter due to slightly fewer communities on average and a slower absorption pace in Tampa.

In general, land and labor cost inflation has eased somewhat, so we don't expect those cost to come down anytime soon. The land market is generally fully priced making it difficult to expect higher margins. We are continuing to pursue innovative ways to deal with that by expanding our presence in the entry-level plus market and moving towards a more even-flow production model. Neither is easy, but both of them should allow us to increase our sales while reducing our costs and therefore, improve our leverage and net margins over time.

I'll now turn it over to Hilla for some additional details on our financials. Hilla?

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

Thank you, Phillippe.

Since Steve and Phillippe covered the operating results and key variants as compared to last year's first quarter, I'll hit a few of the items on the income statement and some of the other metrics we typically provide.

Starting on slide 10. We gained 20 bps on leverage on commission and other selling costs from the increase in closing revenue in the first quarter, which was 7.8% in 2016 compared to 8.0% in 2015. Our general and administrative expenses were flat year-over-year on an absolute basis. So we picked up another 70 basis points on leverage there, with the first quarter of 2016 at 5.0% of revenue compared to 5.7% a year ago.

The additional 90 bps combined savings overhead leverage almost completely offset the decline in our home closing gross margins. We captured approximately $2.2 million in energy tax credits during the first quarter for homes we had previously closed, bringing our effective tax rate for the quarter down to 27% compared to 35% in the first quarter of 2015 and our guidance of 32% for the full year. We still expect that we will be in the 31% to 33% range for 2016.

Slide 11. Our effective tax rate is well below the statutory rate of 35%, in large part due to our energy efficiency of our homes. We spent approximately $1 to $1.50 per square foot for the spray-foam installation, upgraded HVAC systems, Loewen Windows and ENERGY STAR appliances that get to our HERS Rating and enabled us to qualify our homes for energy tax credit. No other builder has qualified nearly as high a percentage of homes closed as we have over the past several years.

If we could reflect the tax benefit with its corresponding cost in our cost of goods sold rather than below the line in taxes, it would offset much of that additional cost and raise our gross margin on home closings by approximately 40 bps to 50 bps in 2016. While accounting rules don't allow for that, we're just pointing out the fact the financial cost and benefit from our energy-efficient strategy are reflected in different sections of our income statement.

Turning to slide 12, our backlog conversion rate was 55% in the first quarter of 2016 compared to 63% in the first quarter of 2015, primarily due to the large volume of late fourth quarter sales in 2015, which we expect will close later in 2016, and relatively fewer closings from spec inventory. Just 39% of our 2016 closings were from spec inventory compared to about 43% of last year's first quarter closings.

We expect our backlog conversion rate to increase throughout the remainder of the year. We ended the quarter with approximately 1,160 specs at March 31, 2016 compared to about 1,120 a year ago, an average of less than five specs per community. Of those, approximately 35% were completed at the end of the first quarter of 2016 compared to 45% for the first quarter of 2015. As we open up more entry-level plus communities where buyers typically want to move in quicker, we expect our spec levels to increase somewhat and the percentage of closings from spec to increase as well.

Based on our focus market research and confirmed by what we're seeing on the ground, we confidently invested approximately $190 million on land and development during the first quarter of 2016 compared to approximately $154 million in the first quarter of 2015. Almost three-quarters of that was for new land.

We added approximately 2,400 lots under control and after transferring approximately 1,760 lots, to wit for start, our balance of lots increased by approximately 640 during the quarter, ending the first quarter of 2016 with 28,400 lots owned or controlled, or approximately 4.3 years lot supply based on trailing 12-month closing. We remain committed to maintaining a four to five years supply of land replenishing our pipeline with lots in our strongest market.

Our ending cash position decreased approximately $90 million during the first quarter of 2016 to $172 million as of March 31, nearly all of which was for additional homes under contract under construction.

Our total real estate inventory increased approximately $121 million to $2.2 billion as of the end of the quarter. Our net debt-to-capital ratio was 42.4% at March 31, 2016 compared to 40.4% at the end of 2015 due to our use of cash during the first quarter to grow our land supply and inventory of homes under construction.

With that, I'll turn it back over to Steve. Steve?

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you, Hilla. In summary, we were pleased with our operating results for the first quarter of 2016 and are confident in achieving our projected level of closings for the year based upon our closings and orders in the first quarter of this year.

We generated strong earnings growth during the quarter from top line growth and overhead leverage aided by a lower tax rate. Our orders closing the backlog were up – backlog were all up year-over-year in units, ASPs, and dollar value.

Our newer markets are beginning to show improved performance after the changes we made last year and demand remained solid and we believe that we're positioned in some of the best housing markets to take advantage of the return of the first-time homebuyer.

I appreciate all of our employees for their roles in putting families into new Meritage homes every day. Considering our increased home closing revenue during our first quarter and a 21% higher ending backlog value at the end of the quarter, we are confident that we'll achieve revenue and earnings growth in 2016 despite the margin compression we've experienced over the last year. We reiterate our expectation for 7,000 to 7,500 closings in 2016.

For some time now, we've been talking about our entry-level plus strategy, which targets the growing number of first-time homebuyers or entering the market and looking for something better than a shelter-oriented strip down entry-level home. They want a home with features they would normally find in a move-up home, but at affordable price. Features like granite countertops, kitchen islands, upgraded appliances, walk-in pantries, and more closet space, which you don't typically find in most entry-level homes.

We've been acquiring land positions that will allow for more affordable homes, and we've incorporated many of those features into the smaller homes that we offer today in our bungalows and townhouses. The big difference is that no other builder can offer all of that and the high energy efficient standards that Meritage Homes offers. We believe that puts us in a unique position to address the entry-level market, and we will be introducing a new product line in the next couple of months to formally plant our flag in that space.

So thank you for your interest in Meritage Homes and for supporting our growth and success. We will now open it up for questions, and the operator will remind you of the instructions. Operator?

Question-and-Answer Session

Operator

Thank you very much. The first question comes from Alan Ratner of Zelman & Associates. Please go ahead.

Alan Ratner - Zelman & Associates

Hey guys, good morning. Thanks for taking my questions. Steve, thanks for giving that info on the communities in California and Arizona with the FHA limits. I think that was interesting. Just curious, as you look at your backlog today and you look at your total community count, how much more – it sounds like you're working through that and, I guess, it sounds like you expect margins to pick back up in the back half of the year presumably as that becomes less of a headwind. But what percentage of your backlog today would you say are homes that are in those types of communities where you might have bought them in mid 2013 before the limits declined? And similarly, how many more communities do you have to work through before that's no longer an issue?

Steven J. Hilton - Chairman & Chief Executive Officer

I don't think I can give you a specific number of homes, but I could tell you it's probably a dozen or so communities, maybe a little bit less. And it's become more pronounced this quarter because we're really been focused the last couple quarters on just cutting the price and getting out of them versus trying to wait for higher prices. Hilla, do you want to add anything to that?

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

Sure. I think that that number is pretty accurate. To Steve's point, we're just trying to get through that. You are going to see a little bit of noise coming from those communities for the next couple of quarters. But after we get through that, we should be back to normalized margins.

Alan Ratner - Zelman & Associates

Got it. Thank you. And then my second question, just on the sales pace and your decision to intentionally slow in in Northern California and Colorado. It looks like you made some nice progress on the backlog conversion. Revenue is definitely better than you guys were guiding for. I think that in general we've heard the labor issue at least in the first quarter has improved a bit versus where we were in the back half of last year and maybe that proves to be a false positive, but it does seem like that problem is not getting any worse. So what went into that decision now to slow the sales pace here at the peak of the selling season? And how much of an impact do you think that actually had on your orders for the quarter? And are you still intentionally slowing sales pace or are you starting to build back that backlog now?

Steven J. Hilton - Chairman & Chief Executive Officer

I mean, the sales pace is still pretty high, but it's not crazy high like it was a year ago. I mean, we probably could have sold another 100 houses between those two markets, if we just opened up the spigot. But we had trouble getting them built because of the tight labor market and certainly we'll be challenged with our labor issues. So we figured we'd try and get a little more price. It's probably a nominal amount, but we think the demand is going to continue to be there in those markets throughout the year and it just makes more sense in our opinion to kind of do it that way.

Phillippe Lord - Chief Operating Officer & Executive Vice President

Yeah, this is Phillippe. In the first quarter of last year in Northern California, we were selling close to 17 homes per community, which was obviously unsustainable. We're focused on improving our margins there with that opportunity and, like Steve said, making sure our trades could build the houses and we could deliver the customer experience that we're trying to.

Alan Ratner - Zelman & Associates

Got it. Thanks a lot and good luck.

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you.

Operator

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

Michael Jason Rehaut - JPMorgan Securities LLC

Thanks. Good morning, everyone. First question I had was on the gross margin outlook for the year. Last quarter, you kind of talked about on a rough basis the expectation for 2016 gross margins to be similar to 2015, which was 19% – 2015 was 19%, 19.3% ex sort of the impairments. Given some of the comments around 2Q and I think basically you're saying that you don't expect to get back to year-ago margins until the back half, are we to interpret that that's not the case, that there might be a little bit of gross margin slippage in 2016 overall? But maybe you'd get back into the low 19s% in 2017 or better than that? Is that kind of the updated view on the gross margin outlook for 2016 and 2017?

Steven J. Hilton - Chairman & Chief Executive Officer

Good question, Michael. It's too early, I think, for us to commit to a very specific pinpoint number. It's certainly possible, I think, for us to match the gross margin that we had last year. And certainly, as you know, gross margins always increase throughout the year due to the extra leverage we get from the extra volume from the spring selling season and the leverage of the overhead. So I do expect gross margins on a quarter-to-quarter basis are going to – sequentially are going to increase through the year. But I don't want to commit whether it's going to be 19% or 19.2% or 18.8% or specifically what it is, but it's very, very possible that they could match up to last year, so.

Michael Jason Rehaut - JPMorgan Securities LLC

I mean, I guess the question really comes from the fact that you were talking about some of this drag from some of these Western communities continuing into 2Q and it doesn't sound like you're going to be able to match in the second quarter based on your backlog. I'm sure you have good visibility there that you're not going to be able to match 2Q 2015. So then it would require the back half to be a little better year-over-year to be able for the full year to hit the gross margin. So that's...?

Steven J. Hilton - Chairman & Chief Executive Officer

Yeah. Well, that could happen. That could happen. I don't want to commit to that, but that could happen. We made a lot of adjustments within our purchasing structure and introduced more cost-efficient plans, and we've also made improvements in our East region. So, particularly, in our East region, that could significantly outperform in the back half of this year than it did last year and it could be much better than it will be the first half of this year. So there is a lot of things going on that give us hope that those margins can get back to that or could match up to last year. But I'd rather save that conversation for next quarter when we have a little bit better visibility.

Michael Jason Rehaut - JPMorgan Securities LLC

Okay. No, I appreciate that. And looking at the SG&A, you had better than expected leverage there, in part I think because your closings were better than we had looked for. Should we expect for that type of leverage to continue? I mean, we only had a little bit of improvement on a full year basis. But certainly, when you're talking about the type of revenue growth, is 50 to 100 bps kind of a reasonable type of range for the full year?

Steven J. Hilton - Chairman & Chief Executive Officer

Yeah, I think it is because I think we've made some adjustments here. For example, we've adjusted our commission structure, which will help lower our selling expense. But we don't think we're going to get the full benefit of that until the back half of the year, because it was just implemented on homes that were sold after January 1. And there's some other subtle differences that we're implementing that over the next many quarters should lower our SG&A. And so, I feel positive that we'll continue to get SG&A leverage.

Michael Jason Rehaut - JPMorgan Securities LLC

One last quick one, if I could, just a clarification. Backlog conversion, Hilla, I think you mentioned that you expect it to improve throughout the year. Is that more of – do you expect it to improve sequentially or year-over-year – or how should we think about it versus the prior year?

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

I think you can expect to see the improvement sequentially. The 55% is a little bit lower than what we're used to in the first quarter. Definitely, happy with the conversion rates in California and Colorado and in Texas as well, where we've been able to work through some of the labor issues and we're seeing the volume pick up on the closings. But you should expect to see that. As Steve mentioned, we've introduced some new products throughout our East region, which would hopefully also help with some conversion time. So, you should model some improvement throughout the rest of the year.

Michael Jason Rehaut - JPMorgan Securities LLC

Perfect. Thanks, guys.

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you.

Operator

The next question comes from Mike Dahl of Credit Suisse. Please go ahead.

Michael G. Dahl - Credit Suisse Securities (USA) LLC (Broker)

Hi. Thanks for taking my questions. Steve, I just want to go back to the answer to Mike Rehaut's question around margins and expectations for the year, because it actually feels like it's not that dissimilar from the conversation that we were having early last year where you're starting off the year in a bit of a hole from a year-over-year basis. There's definitely some company-specific things going on with the community mix and then still some repositioning. And it seems like a really big reliance on things going very right to get back to flat for the full year. So, I guess, understand that it's a little early to know your back half margins, but just given the year-over-year declines in the first half, why not be a little more conservative with (28:33)?

Steven J. Hilton - Chairman & Chief Executive Officer

Number one, we're not starting off in a hole. I'd take offense to that. I think we had a really good quarter from EPS, we had a really good quarter back on conversion revenues. We knew our margins were going to be down in the first quarter from a year ago. Obviously, margins were declining all last year. You can expect that they were going to be equal to or better than and I'm not giving margin guidance. So it's not a repeat of last year where we gave guidance several times and we didn't hit it. I'm not giving guidance, you guys want to pin me into a corner and try to nail down a number, but we're not. Certainly, we couldn't match up the last year. We could be a little bit below, we could be a little bit above. I'm just telling you to be patient and wait another quarter.

We've got a good backlog, conversion rates increasing, there's a lot of positive things happening here. I do believe we have our labor issues under control. We've taken a lot of aggressive steps and most years are backend weighted. Spring selling -- 40% of our homes are generally sold between February and June, so it's going to always be backend weighted.

Michael G. Dahl - Credit Suisse Securities (USA) LLC (Broker)

Right. That's fair. And it didn't mean to be – sorry, I didn't mean to be offensive there, but then, I guess, that's the follow-up question is these issues with the communities and making a decision to exit, it sounds like from your commentary or accelerate the exits, that's been something that's been underway for a couple quarters, and I guess that hadn't been clear at least to us over the third quarter or fourth quarter. So just to be clear, this is something that started late last year and was anticipated in the margins for the first half.

Steven J. Hilton - Chairman & Chief Executive Officer

Yeah. No, we just haven't gotten that granular because we didn't know what the impact was going to be and where the bottom really was. But many of those communities we're selling now at a very good pace, a high pace, but the margins aren't there because we can't get the FHA buyers. We've got to go to more conventional buyers. But that's all we can really say about it.

Michael G. Dahl - Credit Suisse Securities (USA) LLC (Broker)

Okay. Then I guess second question just shifting gears on the community. Some of the successful close-outs, because clearly there's been a number of – like selling base has been very strong in some of these regions, you highlighted some of the earlier-than-anticipated sell-outs. Is there anything you can talk about as far as relative to the community count guide? How should we expect that to progress through the year and with some of the new openings coming on, how quickly?

Steven J. Hilton - Chairman & Chief Executive Officer

Well, that's a good question. I'm glad you asked that because I think we may have missed putting out the right information on that. So our community count dropped significantly this quarter. So what's the quarter end number, Hilla?

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

It's 243.

Steven J. Hilton - Chairman & Chief Executive Officer

Yeah, 243, so a drop from...

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

It dropped from 254, but were up sequentially or were up year-over-year, yes.

Steven J. Hilton - Chairman & Chief Executive Officer

Yeah. So it dropped from 254 at the end of 2015 to 243 at the end of this quarter, but we expect to get all those communities back by the end of Q2. So we have a lot of communities opening this quarter. We have more than 30 gross communities that are scheduled to open this quarter, and we expect to have good sales from those communities certainly in the back half of the year. And we still believe that we can increase our community count by year-end between 5% and 10%.

Michael G. Dahl - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thank you.

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you.

Operator

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

Alex Barrón - Housing Research Center LLC

Yeah. Thanks, Steve. Thanks, guys. Can you comment on the backlog conversion ratios that you saw this quarter? Are you starting to see some of the labor problems starting to ease or did you guys start more specs or what led to some of the improvement in the backlog conversion this quarter?

Steven J. Hilton - Chairman & Chief Executive Officer

No, I think it's just as you said and the others have said and we've been talking about, we're taking steps to get the labor issue under control. It's still a very tight labor market, but through even flow production and building better relationship with our contractors, we're getting better production efficiency and we're just doing a better job managing to it. So actually, our specs are – Hilla might have that number, but they're flat with last year. We don't have any more specs this year than we had last year. So we're certainly not achieving it through more specs.

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

Right. We closed fewer specs this quarter versus last year's first quarter, 39% versus 43%, but our total number of specs on the ground is about the same. So hopefully, we'll be able to have that help with the conversion rate.

And to Steve's point on the labor side, the cost hasn't increased, hasn't decreased. It's kind of holding steady at that higher elevated rate from the back half of the year, but the production efficiency has really started to come through, so we're seeing the closings pick up.

Alex Barrón - Housing Research Center LLC

Okay. And I guess on the margin front, I think people were kind of looking for some reassurance, but you guys don't seem to want to submit. I think the reason was probably because of last year you guys – or last quarter it seemed like you made a comment that this year you thought that margins will be flat, but I mean...

Steven J. Hilton - Chairman & Chief Executive Officer

Well, it still can be flat. I'm not saying that they won't be flat. I just learned a lesson last year, I'm not going to stick my neck out in this market and give guidance on that.

Alex Barrón - Housing Research Center LLC

Okay. All right. Well, thanks. Appreciate it. Best of luck.

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you.

Operator

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

Nishu Sood - Deutsche Bank Securities, Inc.

Thanks. Hilla, that analysis you laid out in terms of where you're getting the benefit of the energy tax credits were on your income statement was really interesting. 40 basis points to 50 basis points you mentioned in 2016 that goes below the line that would be above the line if it – in terms of offsets, extra costs like the Blown Insulation and stuff. How does that number compare for 2016, the 40 basis points to 50 basis points, versus where it would have been the last couple years? Has it been trending upwards? Is that why you're drawing it out now? Has it been steady where you're just kind of letting us know it's an accounting issue? Or how has that trended over the past couple of years?

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

Nishu, it's actually fairly consistent. Our take rate on the tax credits has been fairly consistent the last four, five years. I think we're just pointing it out, because the difference in the margin, when we're spending the money on the green efficiency items in one line item and getting the benefit in the other, I think it became more clear to us this quarter that it's something that we haven't been doing a good job communicating to the Street. So we wanted to make sure we got that point across.

The take rate is actually increasing, to be fair, but as we're adding new communities from acquisitions, we have a little bit of a lag time getting them up to our product. So even though on our existing products, our take rate is increasing with the addition of new divisions, it's kind of stabilizing hopefully over the long term as long as the energy tax credits remain in effect, we'll be able to see that even inch up a little bit.

Steven J. Hilton - Chairman & Chief Executive Officer

Yeah, let me just add on to that. Certainly, we've been doing our extreme energy efficiency now for almost five years, and we've had a lower tax rate than all of our peers for that entire period of time. I think we've done a poor job communicating that. I think one of the reasons we haven't made too big a deal about it is we're relying on the Congress and the administration to annually approve the tax credit. But what happened this last year and the end of 2015 is not only they approved it for 2015, but they went ahead and approved it for all of 2016. So we know we're guaranteed this year to get those tax credits throughout the entire calendar year. So we can speak with confidence that we're going to certainly have that lower tax rate for the rest of this year and hopefully in the years ahead as well.

Nishu Sood - Deutsche Bank Securities, Inc.

Got it. Thanks, that's helpful. And the new product higher density that you're describing, and you did relate it to your efforts on entry-level-plus, which began in late 2014, early 2015. So just wanted to get a sense of – and you described it as new product lines. So just wanted to differentiate – I wanted to see if you could differentiate for us how is the product line going to be different than the efforts under entry-level plus over the last couple of years? And I also wanted to get a sense of the percentages, maybe 2014, 2015, and 2016, if you combined the entry-level-plus, plus the other products you might have had on the ground already, how has your overall entry-level exposure in terms of closings trended 2014, 2015 and what you would expect in 2016 based upon these new efforts?

Steven J. Hilton - Chairman & Chief Executive Officer

So it's not a lot different than what we're already doing, but we're going to be announcing a new brand. I mean, I shouldn't say a brand, a segment name, a series name, and we're going to be doing more formal marketing around the entry-level-plus product, and so kind of formalizing our strategy. We're going to have about 40 communities open by the end of this year in that segment, and we expect to be, I believe, about 60 communities next year, is that opening by the end of the year? Let me make sure I got that number right. Yeah, no, I'm sorry. No, I'm sorry, we have about 60 communities open by the end of this year, and we're going to have about 90 open by the end of the next year in our entry-level-plus segment. But as I articulated in the script that we're not going to be building just the cheapest stripped-down shelter home where a doorbell and a dishwasher are optional. These are going to be homes that are appealing to that mid-30s buyer who's been renting for a while and is looking for – now has a little higher income and is looking for a home with a few more features in it than you typically find in the traditional entry-level home, kitchen islands, and walk-in pantries, and a little better appliances and granted countertops. So, we're not going to be the lowest price producer, but we think there's a niche there. Our market research tells us there is that buyer segment and that's where we're going to be going after.

Nishu Sood - Deutsche Bank Securities, Inc.

Got it. So 60 to 90, where would that have been at the beginning of these efforts? This type of product that led you to think of the niche and then, overall, how does that speak to your kind of entry-level exposure? And I'm just trying to think longer-term as well against where you folks have been historically and what is "normalized"?

Steven J. Hilton - Chairman & Chief Executive Officer

Well, we've been like around 15%, maybe a little higher entry-level communities. So, certainly that's higher. That's at least a third more than where we've historically been.

Nishu Sood - Deutsche Bank Securities, Inc.

Okay, great. Thanks.

Operator

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

Stephen S. Kim - Barclays Capital, Inc.

Yeah, thanks very much. Steve, I wanted to ask you, maybe you or Phillippe a little bit about, your commentary about metering sales in North Carolina – I'm sorry – north California and Colorado. I think you mentioned that with that metering of sales, unfortunately, there was really only nominal ability to raise price, I believe, is what you said. I was wondering if you could talk a little bit about why you think that is given that the natural tendency for investors would be to say if there's a supply constraint, well then there should be an offsetting ability to take some price. So if you could just clarify your thoughts around that?

Steven J. Hilton - Chairman & Chief Executive Officer

No, we took price. I mean, we definitely took price increases in both those markets, so I don't want to lead to anybody to believe we didn't take price increases. But as I say, we probably could have sold 100 more homes in those markets if we just wanted to just open up the spigot. But as part of the even-flow production, we have to match our pace to our ability to produce and we think that's what we did and at the same time we were able to increase our margins in those markets.

Stephen S. Kim - Barclays Capital, Inc.

Could you give us maybe a sense for how much you think you might have had some margin – or will have some margin benefit from that?

Steven J. Hilton - Chairman & Chief Executive Officer

I mean, we don't give specific margins for specific cities, so I hate to try to give you those precise numbers, but...

Stephen S. Kim - Barclays Capital, Inc.

Is it meaningful, though, or was it – would you consider it to be nominal?

Steven J. Hilton - Chairman & Chief Executive Officer

We'd raise prices in those cities between $5,000 and $15,000 over the quarter.

Stephen S. Kim - Barclays Capital, Inc.

Okay. Got it. That's helpful. Thanks. Okay. And then second question relates to this, the more formalized marketing approach to, I guess, the entry-level plus which certainly sounds very interesting and aligns with a lot of the way we see the nation's housing preferences going. So, I wanted to ask you, one of the things you mentioned was that you were looking to have these projects be – communities be more dense, I believe is the phrase you used. By more dense, do you mean that you're going to locate these communities physically closer into the metros or are you referring to just a more dense, a lot positioning so that they're maybe in the same locations, geographically, but they're just going to be built in a more dense manner.

Steven J. Hilton - Chairman & Chief Executive Officer

It's going to be a some of both. So certainly we're going to have smaller lots, 50 foot wide lots, 45 foot wide lots, 40 foot lots, 30 and 40 foot wide product that's going to be more peripheral locations, more suburban outer ring locations, but maybe not as far out as we went out in the last cycle. And we'll be competing, certainly, with the biggest players to some degree in the segment. But at the same time, particularly on the eastern seaboard in Florida, in the South, we're going to be building a lot more townhouse products that we ever built before. Those are going to be in closer in locations. We also are very successful in what we call a bungalow product on a smaller – as narrow as a 30 to 35 foot wide lot. We're going to be building more of that. We've been buying land for that product. So – and those will be in closer in locations, so it's a combination of both.

We've also been accumulating land in California now for a couple of years that we've been moving with the entitlement process that are in more Bay Area locations and more redevelopment opportunities that will come on with a three-story townhouse product we haven't built before. In both Northern and Southern California, it'll be hitting the market in late 2017 and into 2018.

Stephen S. Kim - Barclays Capital, Inc.

Yeah, all that sounds very interesting. And I think you've talked about the fact that the – it could have a beneficial impact on your margins as you get this product rolled out. But there's also this notion of perhaps as you get into slightly different products that you could pay a dumb tax and in terms of investment in this initiative.

I was wondering if you could talk about whether or not you think that they will have an immediate salutary impact on margins or if your comment was something that was referring to something more, like eventually, but not necessarily this year?

Steven J. Hilton - Chairman & Chief Executive Officer

Well, I don't think we're going to pay a dumb tax because it's not the first time we've done it. We built a lot more entry-level homes in the 2000 to 2006 period than we're building today as a percentage of our total production. So, this is not a new thing to Meritage. We've done it before and we can do it again, and I think we can do it efficiently. And it's not going to be a higher margin than the business that we have now, but the overhead leverage should be a lot better because the per community absorptions should be significantly higher than we're achieving today.

Stephen S. Kim - Barclays Capital, Inc.

Got it.

Steven J. Hilton - Chairman & Chief Executive Officer

Phillippe, you want to add anything to that?

Phillippe Lord - Chief Operating Officer & Executive Vice President

I was going to add that last part, but you got it. We don't underwrite ELP to lower margins. We don't expect higher margins. We do expect higher absorptions.

Stephen S. Kim - Barclays Capital, Inc.

Perfect. Yeah, and when you mean not higher margins, you're referring to gross margins?

Phillippe Lord - Chief Operating Officer & Executive Vice President

Correct.

Stephen S. Kim - Barclays Capital, Inc.

Right. Got it. And then the last one is elevated land spend as a result of enhancing the strategy. Do you feel like this is going to have any impact on your land spend as you maybe build out – sorry – accumulate lots for this new strategy?

Steven J. Hilton - Chairman & Chief Executive Officer

No, I don't think it's going to elevate our spend. I think – although our spend goes up a little bit every year – it's a shift in our spend.

Stephen S. Kim - Barclays Capital, Inc.

Okay.

Steven J. Hilton - Chairman & Chief Executive Officer

So, shifting our dollars from move-up communities to more entry-level plus communities.

Stephen S. Kim - Barclays Capital, Inc.

Perfect. Thanks very much, guys.

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you.

Operator

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

Jade Rahmani - Keefe, Bruyette & Woods, Inc.

Thanks for taking my questions. Can you – what do you think is reasonable in terms of either absorption pace for the balance of the year or aggregate order growth factoring in your community count expectations?

Steven J. Hilton - Chairman & Chief Executive Officer

We're not just going to give guidance on orders for the year. Certainly, we expect to sell more homes this year than we did in last year. But, I'm not going to give that specific number. We've given the number now several times of 7000 to 7500 closings, but we're not giving the order guidance.

Jade Rahmani - Keefe, Bruyette & Woods, Inc.

Okay. And just regarding the land market, could you comment on what areas geographically you think are still reasonable to invest in in terms of pricing and what kind of gross margin you are still underwriting to? Thanks a lot.

Steven J. Hilton - Chairman & Chief Executive Officer

Well, we're still underwriting to 20% gross margin and we're still buying land in most of our markets, almost all of our markets. Few markets we've slowed down our land acquisitions just because of the fact that we have a lot of land already or we don't feel like the price on most deals makes economic sense, but almost every market that we're in we're aggressively looking for land.

Jade Rahmani - Keefe, Bruyette & Woods, Inc.

Thank you.

Operator

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

John Lovallo - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Hey, guys. Thanks for taking my call as well. The first question for Hilla I guess, would be, could you help bucket maybe the year-over-year basis point impact on gross margin in the quarter with the three buckets being the land, the labor and sales at the underperforming communities?

Hilla Sferruzza - Chief Financial Officer & Executive Vice President

I don't think we want to get quite that granular. The impact of the – well, you said land, but I think you meant to say labor. The labor we're going to lapse that over in Q3. So the comps will start to be a little easier in the back half of the year. The FHA effected communities as we've spoken to. They've been there in the past. However, we are accelerating the sales pace to be able to exit those more expeditiously. So that just depends on our sales pace. So, I don't know that we can quantify the piece of each one of those impacting gross margin.

John Lovallo - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Okay. And then I guess the follow-up would be, there's been some recent flooding in Houston which seems pretty severe in some cases. Has that had any impact on the business?

Phillippe Lord - Chief Operating Officer & Executive Vice President

Would you like me to take that one, Steve?

Steven J. Hilton - Chairman & Chief Executive Officer

Yeah, please do.

Phillippe Lord - Chief Operating Officer & Executive Vice President

Yeah. We've been fortunate to – generally our communities haven't been impacted as much although our office space was impacted pretty dramatically. But we've been able to get to our community, get back on to our communities. Our communities were a little bit more well-positioned. We didn't see that much flooding down in Sugar Land area etcetera. So at least from an operation standpoint as far as building our homes, closing our homes, we're in pretty good shape and we've had a little bit of impact to sales in April, again just the bad weather. But it seems like we're getting through it and we don't see a significant impact.

John Lovallo - Merrill Lynch, Pierce, Fenner & Smith, Inc.

Okay. Thanks very much, guys.

Operator

Mr. Hilton, would you like to take any more questions?

Steven J. Hilton - Chairman & Chief Executive Officer

How many more we have in the queue?

Operator

We have five more in the queue.

Steven J. Hilton - Chairman & Chief Executive Officer

Yes, let's keep taking them.

Operator

Understood. The next question comes from Susan Maklari of UBS. Please go ahead.

Susan M. Maklari - UBS Securities LLC

Good morning. Thanks for taking the question. Just in terms of going back to your comments around moderating the sales pace, it sounds like the overall demand environment remains pretty strong. The selling season is coming together fairly well. Can you just help us understand the pursuit of this strategy and how you see this as the right way to take this on?

Steven J. Hilton - Chairman & Chief Executive Officer

Well, let's not over blow this and make it more than it is. We've only said we're doing that in two markets, companies in 17 markets across the country in nine states, so only two very hot housing markets, Northern California and Denver, Colorado, to some degree moderated our sales pace so we can matchup production to sales. So I think there's been a lot of questions about it and I think it's starting to get a little bit overplayed.

Susan M. Maklari - UBS Securities LLC

Okay. And then just in terms of the land bank as you do more of the entry-level plus, can you just help us understand what percentage of your supply today is suitable to that product and as you look to acquire more land for that are you changing the underwriting at all?

Steven J. Hilton - Chairman & Chief Executive Officer

No, we are not changing the underwriting. We still believe we can achieve a 20% gross margin. We are looking for an IRR of 25% or better. As I said last quarter, less than 20% of the homes we sell today are considered entry-level for entry-level buyers. We would like to increase that to 35 % to 40% over the next 2 to 3 years and I believe the strategy that we played out is going to allow us to do that and we will be announcing more details around that here in the next couple of few months.

Susan M. Maklari - UBS Securities LLC

Okay. Thanks.

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you.

Operator

The next question comes from Will Randow of Citigroup. Please go ahead.

Will Randow - Citigroup Global Markets, Inc. (Broker)

Hey, good morning and thanks for taking my questions. In terms of the two markets you're metering, I don't want to focus on that, but you also mentioned you're reducing commissions overall. I want to get a sense for is that market specific and kind of ultimately how do you think about that impacting sales in the short-term and the level of production? Is that purposely done or the market is just hot enough where you can trim back on third party brokers?

Steven J. Hilton - Chairman & Chief Executive Officer

No, no, we are not – we haven't changed our third-party broker commissions. We've just tweaked our internal commission strategy. Effective January 1, a lot of builders adjust their commissions year-to-year based upon a whole variety of factors. We were probably paying a little bit of a premium commission structure to our internal salespeople, so we've kind of got that back more in line with the market and we think that's going to help our SG&A leverage going forward to the rest of this year and beyond.

Will Randow - Citigroup Global Markets, Inc. (Broker)

And then on a related basis with the metering plus the adjustments like commissions, one of your competitors results yesterday is showing that their absorption has bounced back year-over-year in April. Should we suspect that the same has happened for you or not?

Steven J. Hilton - Chairman & Chief Executive Officer

They're going to bounce back -- are they going to bounce back in the second quarter is what you are saying?

Will Randow - Citigroup Global Markets, Inc. (Broker)

No, no in April based on what you've seen in terms of orders in April.

Steven J. Hilton - Chairman & Chief Executive Officer

I can tell you April sales feel really good. That's a good question. We've had so far good April. The month isn't over. We've got another weekend left and we're working hard, but I think it's going to be a good month and I think we're going to have a positive – an increase over last year.

Will Randow - Citigroup Global Markets, Inc. (Broker)

Okay. Thanks for that, guys and good luck.

Steven J. Hilton - Chairman & Chief Executive Officer

Thanks. Operator, this will be our last question.

Operator

Understood. The last question comes from Jay McCanless of Sterne Agee. Please go ahead.

Jay McCanless - Sterne Agee

Good morning, everyone. Just wanted to ask first on the new plan for the entry-level homes, or first time buyer targeted homes. What impact do you think that's going to have on your average closing prices for this year and going into next year?

Steven J. Hilton - Chairman & Chief Executive Officer

I don't think it's going to have a big impact over the next 18 months or so. I think over time what it will do is it will flatten our ASP growth. Frankly, we're approaching 400,000 and I don't think we want to be higher than that. And eventually rates will rise and income growth across the country hasn't been as strong certainly as house price appreciation. So we're very mindful of that. And that's another reason why we're getting into this segment. So, maybe we'll give you some better numbers in the quarters to come on what we think about ASP. But certainly, at some point, we don't want to keep continuing to rise.

Jay McCanless - Sterne Agee

Got it. And then, just wanted to beat the question in the list, again, and I jumped on late so I apologize on that. But it sounds like you guys could've ramped up the orders a little bit more in the last, you chose not to. Are you still seeing that kind of demand as we move into April where if you wanted to open up, you feel like you could ramp the order count again?

Steven J. Hilton - Chairman & Chief Executive Officer

We're still – we're continuing with our strategy. April's not over yet, so I don't want to – I can't really give you that granular of a response. But certainly demand in Northern California and Denver where we are, be more mindful of our absorption is – continues to be very strong.

Jay McCanless - Sterne Agee

And what about in Arizona?

Steven J. Hilton - Chairman & Chief Executive Officer

Arizona demand is good, more on the lower end than in the move out space. And I think it's going to continue to improve here.

Jay McCanless - Sterne Agee

Okay, great. Thanks for taking my questions.

Steven J. Hilton - Chairman & Chief Executive Officer

Okay. Thank you, Jay.

Steven J. Hilton - Chairman & Chief Executive Officer

Thank you for joining us this quarter and we appreciate your support and questions and we'll look forward to talking to you again next quarter. Have a good day.

Operator

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

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