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Meritage Homes Corporation (NYSE:MTH)

Q2 2012 Earnings Conference Call

July 26, 2012, 10:30 a.m. ET

Executives

Brent Anderson - VP, IR

Steve Hilton - Chairman and CEO

Larry Seay - EVP and CFO

Analysts

Michael Rehaut - JP Morgan

Dan Oppenheim - Credit Suisse

Nishu Sood - Deutsche Bank

David Goldberg - UBS Securities

Steven Kim - Barclays Capital

Alan Ratner - Zelman & Associates

Jade Rahmani - KBW

Joshua Pollard - Goldman Sachs

Stephen East - ISI Group

Adam Rudiger - Wells Fargo Securities

Joel Locker - FBN Securities

Alex Barron - Housing Research Center

Operator

Good morning and welcome to the Meritage Homes Second Quarter 2012 conference call. All participants will be in a listen-only mode. (Operator Instructions) After today’s presentation there will be an opportunity to ask question. (Operator Instructions)

I’d now like to turn the conference over to Brent Anderson. Please go ahead.

Brent Anderson

Thank you, Emily. Good morning everyone I’d like to welcome to our analyst conference call today. Our second quarter 2012 ended June 30 and we issued a press release with our results before the market opened today. If you need a copy of the release with the slide that accompanies our webcast, you can find them on our website at investors.MeritageHomes.com or by selecting the investors link at the top of our home page.

Turning to Slide 2. 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 opinion. Additionally, our actual results may be materially different than our expectations due to various risks factors. For information regarding these risk factors, please see our press release and our most recent filings with the Securities and Exchange Commission specifically our 2011 Annual Report on Form 10-K and our first quarter 10-Q. Today’s presentation also includes certain non-GAAP financial measures as defined by the SEC, to comply with SEC rules we have provided a reconciliation of these 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 be concluded above 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’ll now turn the call over to Mr. Hilton to review our second quarter results. Steve?

Steve Hilton

Thank you, Brent. I’d like to welcome everyone to our today. We are excited to report earnings of $0.24 per diluted share for our second quarter in addition to the 49% increase in orders that we preannounced on July 8. The earnings leverage we have been expecting to see was clearly evident this quarter as our 22% increase and closes over 2011 drove a 28% increase in home closing revenue, a 31% increase in gross profit and net income of $8 million.

We carried approximately two-thirds of the additional 12 million in gross profit to the bottom-line, increase in our net income by 7.4 million and our adjusted pre-tax income by 8.1 million year-over-year.

Net income for the second quarter of 2012 included a $5.8 million loss on the early extinguishment of debt largely offset by a $5.2 million tax benefit due to the partial reversal of our deferred tax asset reserve which Larry will explain later. Excluding those items and impairments of 863,000 this year compared to 590,000 in the second quarter of 2011, our adjusted pre-tax income was 9.5 million for the second quarter of ’12 and our resulting adjusted pre-tax margin was 3.4% compared to six-tenth of a point last year. We believe this is a better indicator of our earnings power and expect to expand it further as we leverage our increase closings and revenue to grow earnings at faster rate.

Turning to Slide 5. Home closing revenue benefited from a 5% year-over-year increase in average closing price mostly reflecting mix issues rather than price appreciation. As a greater portion of our close this year were on larger homes and homes in higher priced markets. We only began raising prices broadly in the first quarter his year, so we expect most of the impact from rising prices to appear on our second half revenue and earnings.

Some of our home price appreciation has been offset by higher cost for land and construction which are moderating our gross margin expansion. However, we improved our second quarter gross margin by 50 basis points year-over-year to 18.5 from 18% in 2011. We believe that some of these cost increase are due to temporary supply and demand imbalances caused by the rapid increase in home sales this year as suppliers and contractors ramped up to support the increase volume of activity, some of these cost pressure should diminish in the coming quarters. As we said before we expect our gross margins to gradually increase toward our 20% higher gross margin overtime. We also expect to see continued improvement in our net margins as we leverage our fixed cost while growing our closing in revenue.

Our average sales price on second quarter orders increases 10% year-over-year again mostly driven by mix. As demand for our homes increased during the second quarter, we continue to raise prices in many communities across almost all of our markets which we believe accounted for about a third of the increase ASP on our second quarter orders.

Turn to Slide 6. The spring selling season continued longer than usual this year right through the end of June. In fact June was our 8th consecutive month of year-over-year increases in orders. I command our sales teams who sold more than 400 homes per month since March of this year. We are optimistic of this strong demand we have experienced today, like somewhat mitigate the normal seasonal slowdown we would expect to see in the latter half of the year.

The second quarter of 2012 also marked our 5th quarter in a row to impart year-over-year growth in orders. Net orders increased 49% over the prior year to a total of [1,073] in the second quarter of 2012, representing our largest quarter in four year since the second quarter of 2008.

We sold an average of nine homes per community the highest we have seen since the first quarter of 2007 and amongst the best in the industry. The sales pace is 41% higher than the second quarter of 2011 and 20% above the first quarter of this year. We believe that our industry leading energy efficiency gives Meritage a competitive advantage and a highly desirable community locations to some of the best submarkets in the country also contribute to our relatively higher sales per community.

Turning to Slide 7. This slide provides details on our order growth by state. I’ll hit the highlights. California delivered the strongest performance nearly tripling orders with a 28% increase in communities and much higher orders per community than last year. Their average sales price also increased 11% resulting in a 229% increase in order value over the prior year.

Arizona delivered 61% more orders than a year ago with approximately the same number of communities since last year. Arizona’s total order value increased 69% when combined with 5% increase in average selling price.

Florida should continue strength growing orders by 47% and total order value by 54% as our ASP there also increased by 5%. We opened our first communities in Tampa in June and recorded our first sales there.

North Carolina also contributed 40 sales this quarter and just a third quarter of operation since opening their first communities for sale.

Texas has been improving in a more tampered pace, orders were up 8% despite having fewer communities opened this year and a 3% increase in average price resulted in a 12% increase in Texas’ order value.

Our cancellation rate in the second quarter fell to 13% from 15% last year. As a result of stronger sales and prices, the total value of our orders in the backlog at quarter end grew by 75% to its highest point since the third quarter of 2008. With the backlog of more than 1,600 homes under contract and almost 2,500 homes sold in the first half of this year, we believe that we will close between 4,043 homes in total during 2012, which puts us in a much better position to report strong revenue earnings growth over 2011.

I’ll now turn it over to Larry Seay, to review our financial results for the quarter and then open it up for questions. Larry.

Larry Seay

Thank you, Steve. I’ll pick it up on Slide 8. As Steve said the earnings leverage I our business was clearly shown this quarter, commissions and other sales cost improved by 40 basis points year-over-year, our absolute selling expenses increased by 23% lower than our 28% increase in home closing revenue as we better leveraged the fixed portion of our selling cost.

We achieved even greater leverage in our general and administrative expenses which improved 90 basis points year-over-year decreasing to 5.9% of revenue from 6.8% in the second quarter of 2011. While we may see some additional modest increases in the absolute level of G&A expenses as we grow, we expect these additions to be at a much slower pace than our top line growth.

Additionally, our interest expense declined to 6.3 million or 2.2% of revenue from 7.5 million or 3.4% of revenue last year as we capitalized more of our total interest incurred to homes under construction and home sites under development. Those assets have grown in support of our increased sales. As a result of higher revenues and leveraging our fixed expenses, our earnings before taxes increased by 280% in the second quarter of 2012 compared to 2011.

Slide 9. We also recorded at 5.2 million net tax benefit for the quarter as we reversed substantially all of the allowance we had previously taken against our deferred state tax asset in Florida. Florida’s piece of our DTA allowance is separately evaluated to the state tax rules there, based on our growth and profitability in Florida over the last couple of years, we were able to reverse most of the DTA related to Florida in the second quarter of this year.

At June 30, 2012 our total DTA was 95 million and the total remaining balance of the reserve against our DTA is approximately 87 million. 68 million for Federal deferred income taxes and 19 million for deferred state income taxes, including a remaining balance of approximately 1 million for Florida. We believe that we can reverse the vast majority of our remaining 87 million allowance against our DTA as we continue to report profitable results over the next few quarters.

Slide 10. We opened 19 new communities and close out at 18 communities during the quarter growing our total active community count to 151 at quarter end up from 150 at the beginning of the quarter and from 145 at the end of the second quarter of 2011. Our goal remains 165 active communities by year end 2012 and our current expectation are to add another net 20 to 35 communities in 2013.

We spend approximately 88 million to purchase approximately 1900 lots during the second quarter of 2012 and another 28 million on development of unfinished lots. We also contracted for approximately 2100 new lots in 36 communities during the quarter. About two-thirds were unfinished and one-third were finished lots; 68% were in Arizona and Texas, 21% in North Carolina and Colorado and 8% in Florida.

We ended the first quarter with the total supply of lots of approximately 17,600 which equates to approximately five year supply based on trailing 12 months closings, our 4.2 year supply based on trailing 12 months orders.

Slide 11. We further strengthened our balance sheet this quarter and are well positioned to support future growth. We completed our issuance and note due in 2022 and the retirement of our 2015 issue in part of our 2017 issue which extended our nearest maturities to 2017, and resulted in 5.8 million loss on early extinguishment of debt.

Subsequent to quarter end, we issued 2,645,000 shares of stock in a follow-on offering which raised 87 million of cash to fund our growth. By issuing equity we added capacity to grow our balance sheet to support additional revenue growth while maintaining modest leverage. Our pro forma net debt to capital ratio at June 30 would have been 34.3% with the added cash and equity rather than the 44.1% we reported.

In addition, we completed a new 125 million unsecured revolving credit facility earlier this week to provide additional liquidity that can be used for short-term working capital as our orders grow. We ended the quarter with 205 million in cash and cash equivalent, restricted cash and securities compared to 333 million at the beginning of the year. The great majority of decline can be attributed to 140 million increase in total real estate inventory since the beginning of the year.

Now I’ll turn it back over to Steve for closing comments.

Steve Hilton

Thank you, Larry. In summary we continue to demonstrate progress this quarter by reporting strong results across almost every critical operating metric punctuated by our 49% order growth and seven fold increase in adjusted pre-tax earnings. We are cautiously optimistic that housing market will continue to recover as the employment picture improves and the U.S. economy grows.

Job growth combined with low interest rates and record high affordability should drive higher demand for homes and with the low levels of listings we see in our markets today that increased demand should translate to increased home building activity and higher sales. Those factors combined with our substantial backlog and overhead leverage give us confidence that we can continue to report strong earnings growth in the second half of the year.

We are capitalizing the opportunities presented as the housing market recovers and believe that we are well positioned with a strong balance sheet, very good land positions and a differentiate in product offering and great organization for talented people.

Thank you for your attention, we will now open up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come from Michael Rehaut of JP Morgan. Please go ahead.

Michael Rehaut - JP Morgan

First question I had was on gross margins, you mentioned that third of your ASP increase was due to positive price. So, all sequel that could assume pretty meaningful improvement in margins even in the back half of this year, maybe 4Q rather than 3Q. But also offsetting that the higher, some of the creeping labor and material cost. So, how should we think about further improvement, I think your comments are largely still around modest or moderate improvement, but a 3% plus rise in price would maybe suggest even with some inflation, material inflation creep, something a little bit more meaningful. So, any thoughts around that.

Steve Hilton

(Inaudible) to exactly how much it's going to increase over the next couple of few quarters, but I do think when you get back to 20, year plus or minus. So, I think you could expect similar improvements to what you saw this quarter, next quarter and the quarter after. I think that 3% price increase points to that.

Larry Seay

I think you do have to be careful there. There are cost increases going on out there and I’d say at least half of the sales price improvement (inaudible) cost increases because subs have been out there, not making money for many years and they are seeing these headlines we see and are pushing on price. Of course, we are pushing back as hard but it's a constant back and forth battle. So, that’s why we are somewhat cautious about projecting, really strong margin increase and why we project modest or moderate increases.

Michael Rehaut - JP Morgan

Secondly, on the SG&A, as a percent of revenue little bit above what we were looking for, and if you look at 2Q versus 1Q, SG&A went up roughly 6 million while revenues went up 77 that’s a 8% incremental rate above where I’d think you would be more like 4 to 5% with commission. So, any thoughts around that and that 4 to 5% variable is that still a good way to think about future leverage.

Larry Seay

Yes, we break that out in the press release back in the summary operating results and we preferred breakout commissions on their selling cost separately. And I think you will continue to see a little bit of leverage on the selling cost as we do have a portion of those being fixed, but the great majority comes from the G&A portion. And you did see our G&A portion go up, last quarter I think we said we thought we would see the G&A kind of be in the 15 to 16 million and were up to 16.5. So, there is some variability in G&A that we are having to add to support growth, but it's not nearly one to one relationship. So, we do think most of the gross margin improvement we are picking up from increased revenue is going to fill into the bottom-line because the G&A will increase at a much more modest pace. It's difficult for us to say exactly how much the G&A is going to go up, but we think it will be relatively modest.

Steve Hilton

I’d say based upon our backlog and our conversion rate, looking forward we are certainly going to close more houses in Q3 than we closed in Q2 which will allow us to leverage that G&A even further. So, I’m expecting it to continue to come down.

Larry Seay

It's at 5.8, 5.9% now so you should continue to see that percentage drop through the year.

Michael Rehaut - JP Morgan

Just a quick modeling question, the interest expense is that something we could continue to see decline and also the other income at 3 million a bit above where it was in the past couple of quarters, any thoughts there.

Larry Seay

On interest expense, yes, you will continue to see a decline as we grow our work in process and lots under development, and trajectory of that decline if hard to project but it will go down some. And then on other income, that is mainly comprised of mortgage company income. So, as we increased volumes the other income will go up because we generate more income from the mortgage JVs we have.

Operator

The next question comes from Dan Oppenheim with Credit Suisse. Please go ahead.

Dan Oppenheim - Credit Suisse

I was wondering if you can talk little bit more in terms of the margins, as you think about the mix shift in the orders here. How much impact that’s likely to have on your margins. And I guess related, the land lock down was coming down a little bit. How are you finding the land mark in California at this point and the opportunities there in terms of the margins available?

Larry Seay

The margin improvement between mix, our margins aren’t that radically different across the board, our margins in Texas tend to be a little softer than on the coast where there is little more pricing power typically. Also our margins in Colorado tend to be a little bit softer. On the other hand we typically makeup that in lower G&A in those states, so the net operating margin in those states don’t wind up being too far different. But generally speaking in modeling, I’d be modeling a slightly higher margin in the costal type states like Florida or California generally speaking particularly as the recovery continues because that’s typically where there is less supply and there is more pricing power.

Steve Hilton

So, regarding California, the landmark there is very tight, traditionally always as tighter in California than other states, but it's very tight right now. We purposely slowed down our land acquisitions in Southern California in the last couple of quarters, because we bought quite a bit there earlier last year. And we have been ramping up our acquisitions in Northern California, our land acquisition and expect out several deals on the books this quarter and next quarter. So, California is an important state for us and we want to continue to grow our business there.

Operator

Our next question comes from Nishu Sood with Deutsche Bank. Please go ahead.

Nishu Sood - Deutsche Bank

Following up on that land topic. There is a pretty wide spread belief amongst investors that there is a severe overall shortage of quality land out there, and its severe enough that would restrict the growth. Now your capital raise, your plans for growth kind of argue otherwise, so I was just wondering if we could get your thoughts on that whether it will constrict growth.

Steve Hilton

The question just is in land, the question just is how severe is it, I don’t think it's quite as severe as people reporting that it is. I think the development curve is just going to be longer, because we are going to have to go out and buy more undeveloped lots. As you saw two-thirds of lots we bought this last quarter were undeveloped versus developed. And I think that’s going to continue and is probably going to be even a higher percentage. There is land to buy, we just going to have to pick and choose the best deals, a right deals, fortunately for us; we had bought lot of land in the Phoenix market earlier than a lot of our competition. So, we have avoided some of the high prices that people are paying today. And we are pretty stocked here for the next couple of years, but we certainly need to buy land in the Southeast, we are a new builder in Tampa, we are new builder in Rowley and Charlotte and we got to buy a lot of land there to get our businesses up and running. So, the land game is very challenging but I think we can navigate through it.

Larry Seay

Having said that we were able to improve our land purchases in the second quarter as we saw sales to be stronger. So, we have had success in ramping up the land pipeline to some extent and I’d expect us to get to see a ramped up land purchase pipeline, quite as strong as the second quarter, but it will be stronger than it was prior to that.

Nishu Sood - Deutsche Bank

So, the supply response obviously as condition gets better. So, related to that your communities account goal of 165 for year-end, 15 to 20% growth for next year. The land to feed that growth is that land you already have under control or will you need to go out and purchase to meet those goals.

Steve Hilton

We already have 2012 under control. Those are communities that we have already bought, just a function of getting them open in time to meet that 165 number for ’12. Now for ’13, we still got to buy some land to get those numbers, and that’s what we are doing this quarter, next quarter and the quarter after. (inaudible).

Nishu Sood - Deutsche Bank

Just real quick on your revolver. Where your revolver do how low would you get lay your cash balance going up.

Larry Seay

I still think we would keep a significant cash reserve, our thinking is that in past quarters we had said we were kind of comfortable operating with about 250 million on balance sheet cash position or so. And with the revolver in place we probably say well, we have $125 million of liquidity in a revolver, so we could let cash come down in another 100 million or so on balance sheet and we could still have the 250 million or so of total liquidity.

Operator

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

David Goldberg - UBS Securities

First question, Steve in the opening comments you talked about the selling season extending further into June than maybe people expected and you guys expected kind of been stronger than you expected. I’m wondering if you are seeing some seasonality, you talked about year-over-year order growth as you move through the quarter for 8 consecutive quarters, but wondering if you can talk about that on a seasonal basis, are you seeing a drop off, even though maybe it's better than last year as it dropping off at this point or is there very limited seasonality is moving to July here.

Steve Hilton

It's dropping off in July a little bit for a whole variety of reasons. Number one, it's a 100 degrees plus in a lot our markets, and people are active out in the market looking for homes in the middle of summer. It's seasonally slower. Number two, frankly, a lot of builders including ourselves are sales people who (inaudible). It's hard to really motivate them, we got to push them hard to keep building that backlog. They have a natural tendency to slow down a little bit and I think to some degree we are all kind of reloading our shelves and getting new phases opened up in lot of communities. So, July is going to be less than June, but it's going to be better than last July.

David Goldberg - UBS Securities

And then just as a follow-up question, in the opening remarks you talked about the green product and how that’s helping to differentiate Meritage product relative t some theories. And I’m just wondering when you think about the competitive advantage of that, are you seeing peers starting to mimic what you are doing. Are you finding ways to continue to innovate to keep that kind of competitive advantage and the distance from peers at the same length or do you think its kind f shortening or narrowing.

Steve Hilton

I think everybody has got a green initiative to some degree and people are constantly looking for ways to make their homes more energy efficient and market that to the customer. But I don’t think anybody has gone as far as we have on a national basis or as even close to going as far as we have. Certainly, with the (inaudible).

Operator

Our next question comes from Steven Kim of Barclays. Please go ahead.

Steven Kim - Barclays Capital

I wanted to ask you a little about your ability to maintain the very strong rate of growth that you posted in the quarter. If you look for example, at the markets you are in, do you have the ability to if you saw another leg up in the market to grow or add more than the 20 to 35 communities you talked about in 2013. Or should we think of 35 as really being the limit for you, really pretty much no matter what the environment may hold in terms of demand.

Steve Hilton

Yes, I’d say 35 is the top end. It may not be the ultimate limit, but we are going to have to really chop a lot of wood to get 35 done.

Steven Kim - Barclays Capital

That’s not a net number, right.

Steve Hilton

That’s open or we sold a house.

Larry Seay

That is a net number, so that’s an increase in community count from 165 to 200.

Steven Kim - Barclays Capital

And then second question relates to appraisals. It's one of things that we have been kind of hearing off and on from various builders, that appraisals are sort of limit to ability rate prices that obviously shutdown your ability to raise prices. Was curious if you could talk about whether you are seeing appraisals fade as an impediment for the industry particularly for you. And if so what are some of the mechanisms by which that is fading.

Steve Hilton

The only appraisal issues were really dealing with right now on a significant basis. It's VA. It's almost impossible to sell a VA home in Phoenix, because the VA appraisal just won’t consider the appreciation that we have experienced in the market. So, unfortunately we are just not able to allow customers to get VA loans in Phoenix. That said it's a very small part of our business here, and then same in other markets. I’d say in a market like San Antonio where it's a big VA market, lot of military basis there, they haven’t experienced the price appreciation. So, it's not really an issue. But that’s the one area that we are having real appraisal challenges, but fortunately overall it's a very small part of our overall business.

Operator

Our next question comes from Alan Ratner of Zelman & Associates. Please go ahead.

Alan Ratner - Zelman & Associates

First question was just on the communities count guidance, should we expect to see that growth outsized to any specific markets or do you think that’s going to be pretty evenly weighted across your footprint.

Steve Hilton

Southeast is where it's going to really happen for us, because we are brand new in three markets there. So, we are going put quite a few communities online in those markets. And then we need to build up our community count again in Texas it's been declining and we need to start to turn it around the other way. So, I think the Southeastern Texas where you are going to see most of the community count growth.

Alan Ratner - Zelman & Associates

Second question is on Vegas, I know you guys are in the process of exiting there. We are starting to see some incremental and more positive data coming out of there and looking at your quarter, you actually sold lot of homes and I’m not sure how much of that was kind of (inaudible). So, just curious if the recent trends there causing you to take another look at Vegas or if you would even consider taking look there if the positive trends continue.

Steve Hilton

I don’t think we are interest in changing our position on Vegas for a variety of reason, I don’t want to get on to this call, but we are not excited about Vegas long-term, the market pickup has allowed us to get through some of our positions there a little quicker. We sold one of our land positions there to our competitor, and that what caused a little bit most of the impairment that we took. We have a few more land positions up there we are hoping to build sell here in the next 6 to 12 months. And repatriate some of that capital back to a corporate and put it out in some other markets.

Operator

Our next question comes from (inaudible). Please go ahead.

Unidentified Analyst

Given your advantage point particularly in the Phoenix market, do you believe that market might be getting overheated, what are your views on it over the next few years in terms of pricing perspective as well as from demand perspective?

Steve Hilton

I think from house price perspective, prices go long way to go, and I think you are going to see pretty significant appreciation over the next couple of years. I think they are making real jobs in Phoenix, the economy is improving down here, and there is a lot of people that (inaudible) they want to buy house in this market and as prices go up more people build enter the market. And on the land side, I do think land prices have somewhat over shot housing prices, particularly in the last three or four months and I think we got to be real careful buying land in Phoenix right now, because the prices have got really high really quick.

Unidentified Analyst

And then I believe in the last call you guys mentioned, you saw that your conversion rate dropped down to call it high 70s. (inaudible).

Steve Hilton

Cancellation rate is surprising to us, it's hard to complain about that, I mean some people argue we are not selling hard enough, but it's hard to argue that when you had a 49% growth rate and order, it's hard to predict the cancellation rate. As far as the conversion rate I hope it would be starting 5% or better. It's probably going to drop into the 70s at some here, but hopefully not lower than 75%.

Operator

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

Jade Rahmani - KBW

Can you discuss what drove the decline in commissions as a percentage of revenues and is the current rate sustainable rate is going forward.

Steve Hilton

I think some of the decline in commissions came from the fact that we sold less specs, specs are just generally sold to realtors. And we are selling so many build to suits or third sales we will them. They were not able to get our spec houses in the ground (inaudible) which is limiting our inventory of specs which is driving the sales of specs down. That may change overtime, but I think we will probably for the short-term continue that trend.

Jade Rahmani - KBW

Secondly, on the mortgage environment you did mention the other income, it's widely known that gain on sale margins on mortgage originations are elevated right now, because of the current interest rate environment as well as capacity constraints on (inaudible). I wonder if you have enough granularity in your mortgage JVs to know whether this level of income is sustainable or could decline as gain on sale margins.

Steve Hilton

It doesn’t really apply to us because we are just pure mortgage broker. So, the transaction fee for us we are not doing any mortgage banking and it's just what the net do we make on the origination fee.

Jade Rahmani - KBW

So, it's a fixed fee per loan.

Larry Seay

The basis points that fall to our side of the JV fairly consistently been around 100 basis points.

Operator

Our next question comes from Joshua Pollard of Goldman Sachs. Please go ahead.

Joshua Pollard - Goldman Sachs

Is current underlying trend in sales were to hold, what does your net order absorption rate look like in 3Q and 4Q. In other words, if normal seasonality is it 15% decline q-on-q and 3Q and the maybe another 10 in 4Q or should I be thinking about different numbers.

Steve Hilton

Last year Q3 and Q2 were almost the same, there was no decline in Q3 from Q2. I mean on the other hand we get into Q4 there was a pretty good decline from Q2 I think it was about.

Joshua Pollard - Goldman Sachs

No I was just saying if you look back to last year, I see on 3Q as pretty flat and then you were down 22% from 3Q to 4Q, but I’m trying to understand to what degree was 2011 second half normal versus what we definitely normalized in terms of home prices going down in that expectation by consumers. I guess I want to search engines what you guys think should normally have been.

Steve Hilton

Well I think Q4 was normal, but I think Q3 last year was little bit abnormal, and we were sales, we were pushing hard, (inaudible) to hold volume. So, volume is important right now for us to build backlog in ’13 but on the other hand we are pushing on margin and we want to try up at the same time. So, it's real hard to compare year to year the environments are different.

Joshua Pollard - Goldman Sachs

As you take that look into your backlog, how much are your margin to backlog been, your margins on current deliveries. I guess I will stop there and just maybe ask one more question on DTAs. If you could elaborate on those comments, that would be great, are you guys expecting to get a bit every quarter, are you expecting about a time you hit the end of the year, you are able to just fully bring everything else back.

Larry Seay

Certainly, the backlog gross margin has improved, whether we want to throw out percentages, again it's the cost side that gives us a little bit of (inaudible) but certainly the backlog gross margins that we should be delivering in the second and third and fourth quarter are improved over the first half.

On the DTA side, the Florida we would hope that the $1 million left in Florida we get picked up over the next couple of quarters as we continue to show profitability there, and for the federal and rest of the states, it's a number of factors that come into play, whether we are out of our measurement period of cumulative loss, how strong the quarters are, how many quarters of profitability. We would hope that we might have a possibility of booking something in the fourth quarter, but on the other hand it could very well slide into the first half of next year. And because our DTA is relatively smaller compared to the profit we are making now, I’d think that when we do take it on it would come on mostly in one quarter.

Operator

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

Stephen East - ISI Group

Steve some of the comments you were talking about on volumes versus pricing. I know earlier you all really preferred volumes over pricing, now as you ramped up your backlog pretty significantly and you look at fewer up 25 or 30% in dollars next orders ideally how would you like that to be split.

Steve Hilton

It's a delicate balance between volume and price, we need to get our gross margin back up to 20 and we need to continue to push our volumes higher. It's a market by market. I’m more focused on sales per community, we got to have every community at three sales per month.

Stephen East - ISI Group

If I hear what you were saying it sounds like you still are probably more in the volume camp versus the pricing camp at least right now.

Steve Hilton

Yes, the leverage of the overhead we get we are just closing on extra 100, 200 units a quarter is phenomenal. So, we got to keep that volume going to really start to make money.

Operator

Our next question comes from Adam Rudiger of Wells Fargo. Please go ahead.

Adam Rudiger - Wells Fargo Securities

What do you think the gross margin difference is on, you mentioned earlier that what you think the bulk of your lots you purchased are undeveloped, what’s the gross margin difference on undeveloped land and pro forma versus finished lots.

Larry Seay

We factor in cost of capital that really take that up, but our finished lots doesn’t have nearly the amount of carry cost and development cost of carry loaded into it. So, if you pull that out you are probably talking 2 or 3% differential without that cost.

Adam Rudiger - Wells Fargo Securities

And then going back to the labor issues, I’m just curious how prevalent is that across your footprint. Is it handful of the Phoenix is or is it across all your states. In your opinion where you are seeing the greater shortages, how quickly does that labor come back do you think.

Steve Hilton

I’m not hearing about any real issues or shortages outside Arizona.

Adam Rudiger - Wells Fargo Securities

So, earlier when you talked about half of your price increases are been offset by materials and labor thus you are talking, on a company wide basis that’s more materials than labor.

Steve Hilton

It's more labor in contract, just contract there is ability to push prices because they can. There is no labor shortage in Arizona from our perspective.

Adam Rudiger - Wells Fargo Securities

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

Joel Locker - FBN Securities

Just wanted to talk to you about the actual community count you have in the pipeline. We touched on before in the call, but just how many do you have in the pipeline opened in the third quarter and fourth quarter and so far slated for 2013 outside of any new land purchases that you have from this point forward.

Steve Hilton

Well, we have over 100 communities that we closed on or control that we expect to open over the next couple of years. I’d say we have enough communities in the pipeline to get to the 165 number for this year by the end of the year, and we are going to buy some more to get to the 20 to 35 additional net new communities for next year. I don’t want to give a specific number on how many we got to buy. But we wouldn’t put the 165 out for this unless we had and we are really positive that we get it done.

Joel Locker - FBN Securities

And when you mentioned July orders being up year-over-year but you have taken a pause but it was reloading. I mean what kind of, are you talking of 10% or up 50% like you saw in the second quarter.

Steve Hilton

No, it's going to be something less than the 49%, but it's going to up. I can’t tell you that our orders like a lot of biller are weighted towards the end of the month, we have certain incentives, certain price increases that usually come in month end. So, the last weekend of the month is always a big selling weekend for us, and that’s coming up this weekend. So, I don’t want to put too much out there on what July is going to be, because I got to see what happens this weekend.

Operator

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

Alex Barron - Housing Research Center

To ask you about your guidance, I guess you guys are somewhat conservative, but I don’t get the 4,000 units if I just kind of look at the what you already sold in the last 12 months. I get a lot of higher than that, I’m just trying to figure out are you guys just kind of building in just extreme conservatism or is it come of these concerns about labor being able to get the houses done or what’s going on.

Steve Hilton

So, we closed about 1800 units for the year. And we have got another 1600 or so in backlog. So, that’s going to put us at about 3400. We closed all of our backlog and then we got to sell houses in July and August and pretty much after August you are not (inaudible). Most of the analyst in that same range that we put out to that, I don’t know maybe we do it little bit more but I don’t know how it could be that far off based upon what we have out there right now.

Alex Barron - Housing Research Center

In terms of going back to the Phoenix market, I was there couple of weeks ago again and lot of guys were talking about these crazy land prices up 50% and thinking that from year-to-date going to get higher by the end of the year. I guess earlier on continuously buying land as appose to kind of waiting towards the last minute to jump on and start buying it now so that’s good. But I guess my question is do you feel that right now in order to be buying land you necessarily have to be pricing in or building in strong price appreciation to justify the land prices.

Steve Hilton

I think you would have to, if you are to pay (inaudible) you are going to have to estimate that the prices are going to be higher on houses at this moment. I think we can do that to some degree for land it's two or three years out which is what we are trying to do, but I’ll be afraid to do that for land (inaudible) market within a year. So, I think that’s why the Phoenix market to me is a little bit, if you don’t have land here right now, you are at disadvantage.

Alex Barron - Housing Research Center

What is your strategy like it is to start moving out further to the so called B&C market or is it to just keep in the A markets and just keeping up in front of…

Steve Hilton

We get 11 or 12 positions we bought here last year or even earlier that are all in A and B markets. So, we can dramatically grow our business in this market, in ’13 and even into ‘14 without having to go out into C markets. But certainly, builders are going to go out into those markets because there is a big price difference between C market land and A and B market land. I’m bullish about our positions in Phoenix as I’m in any market that (inaudible) as you said we got out here early and we got land that’s really appreciated here.

Operator

At this time we are not showing any questions in the question queue.

Steve Hilton

Okay. Well, thank you for your participation and attention to our call and we look forward talking to you again next quarter. Have a good day.

Operator

This concludes the conference, thank you for attending today’s presentation you may now disconnect.

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