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Edited Transcript of MTH earnings conference call or presentation 25-Jul-19 2:30pm GMT

Q2 2019 Meritage Homes Corp Earnings Call

Scottsdale Jul 31, 2019 (Thomson StreetEvents) -- Edited Transcript of Meritage Homes Corp earnings conference call or presentation Thursday, July 25, 2019 at 2:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Brent A. Anderson

Meritage Homes Corporation - VP of IR

* Hilla Sferruzza

Meritage Homes Corporation - CFO & Executive VP

* Phillippe Lord

Meritage Homes Corporation - COO & Executive VP

* Steven J. Hilton

Meritage Homes Corporation - Chairman & CEO

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Conference Call Participants

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* Alan S. Ratner

Zelman & Associates LLC - MD

* Alex Barrón

Housing Research Center, LLC - Founder and Senior Research Analyst

* Carl Edwin Reichardt

BTIG, LLC, Research Division - MD & Homebuilding Analyst

* Elad Elie Hillman

JP Morgan Chase & Co, Research Division - Analyst

* John Lovallo

BofA Merrill Lynch, Research Division - VP

* Stephen Kim

Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Housing Research Team

* Truman Andrew Patterson

Wells Fargo Securities, LLC, Research Division - Associate Analyst

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Presentation

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Operator [1]

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Good morning, and welcome to the Meritage Homes Second Quarter 2019 Analyst Conference Call. (Operator Instructions) Please note this event is being recorded.

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

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Brent A. Anderson, Meritage Homes Corporation - VP of IR [2]

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Thank you, Jed. Good morning, and welcome to our analyst call to discuss our second quarter 2019 results.

We issued the press release yesterday after the market closed. And you can find it, along with the slides that we'll be referring to during this call, on our website at investors.meritagehomes.com, or select the Investor Relations link at the bottom of our homepage.

I'll refer you to Slide 2 and remind you that our statements during this call as well as the press release and slides contain forward-looking statements, including our projections for 2019 operating metrics such as home closings, closing revenue, margins; as well as overhead and diluted earnings per share, in addition to our expectations about market trends. Those and other projections represent the current opinions of management, which are subject to change at any time, and we assume no obligation to update them.

Any forward-looking statements are inherently uncertain. Our actual results may be materially different than our expectations due to a wide variety of risk factors, which we've identified and listed on this slide as well as in our press release and most recent filings with the Securities and Exchange Commission, specifically our 2018 annual report on Form 10-K and subsequent 10-Qs, which contain a more detailed discussion of those risks. We have also provided a reconciliation of certain non-GAAP financial measures referred to in our press release or presentation as compared to their closest related GAAP measures.

With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage Homes; Hilla Sferruzza, Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage Homes. We expect to conclude the call within an hour. And a replay will be available on our website within approximately 1 hour after we conclude the call. It will remain active through May 8.

I'll now turn it over to Mr. Hilton to review our second quarter results. Steve?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [3]

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Thank you, Brent. And welcome to everyone participating in our call today. I'll begin on Slide 4.

We had another solid quarter and are pleased with the results we've delivered through the first half of 2019. We delivered strong year-over-year order growth, driven mainly by an increase in orders per community from our strategic pivot to lower-priced homes. Our total orders for the second quarter were 22% higher than last year, and our year-to-date orders were up 14% over 2018. Our average community count was up just 2% over the second quarter of 2018. And most impressively, our absorption rate of 10.6 orders per average community was up 19%, higher than last year's 8.9% and sequentially better than our first quarter's absorption of 9.5%. It was the highest quarterly absorption rate we've achieved in 13 years, going all the way back to the second quarter of 2006.

Turning to slide 5. Clearly, those results demonstrate that Meritage is in the sweet spot of the market, with our LiVE. NOW. homes designed for entry-level buyers, as well as our first move-up homes that we've made more affordable. We have 42% year-over-year growth in our entry-level orders, 41% of our communities at quarter end. And 52% of our orders in the second quarter of 2019 were entry-level, compared to 34% of the communities and 44% of the orders a year ago. Our orders paid for entry-level is about 1.1x our average for all non-entry-level communities, mostly offsetting the corresponding declines in ASPs.

We believe our absorptions in order growth demonstrate the commitment we've made to reengineer our operations to enable us to deliver homes at lower cost with faster cycle times. More than just deciding to build smaller homes in smaller lots, the strategic changes we've made in the way we've designed to build, sell and [build our] homes are impacting our results significantly.

Turning to Slide 6. Our second quarter home closings were 5% higher than last year after we ended the quarter with 9% fewer orders and backlog than we had a year ago. And our home closing revenue for the second quarter was down only 1%, a significant accomplishment considering the total value of our beginning backlog was 13% lower than the second quarter of 2018.

The 5% increase in closing volume offset most of the 6% reduction in our average sales price resulting from our mix shift towards entry-level homes. As our mix stabilizes and the ASPs level off, we expect our sales volume growth to drive revenue growth. Until then, offsetting ASP declines with volume growth helps maintain our total revenue while we improve our margins.

We've said before we're not sacrificing margin with entry-level homes. In fact, our entry-level homes are producing higher average margins than our move-up homes. Home closing gross margin rose again this quarter to 18.4% from 16.7% in the first quarter and 18.3% a year ago. As a result, we maintained our home closing gross profit despite the small decrease in home closing revenue.

Pretax earnings for the quarter were 5% lower than the second quarter of 2018, primarily due to higher interest expense this year, which Hilla will explain later. But we expect to reduce our debt early next year, which will eliminate our non-capitalized interest expense for most of 2020.

Despite lower pretax earnings and higher tax rate in 2019, we generated the same diluted earnings per share for the second quarter this year as we did in the second quarter last year, since we have reduced our outstanding share count by repurchasing shares in the second half of last year and the first quarter of this year.

I'll now turn it over to Phillippe to discuss some highlights of our sales trends. Phillippe?

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Phillippe Lord, Meritage Homes Corporation - COO & Executive VP [4]

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Thank you, Steve.

Demand was strong across all markets outside of California, especially in the entry-level space, where we expect demand to continue to be strong. And we're well-positioned with that in mind.

Our orders for the second quarter of 2019 were up over the second quarter of 2018 for all 3 regions and 8 of the 9 states where we operate, with the sole exception of South Carolina. I'll provide additional color, beginning with the West region in Slide 7.

Our orders in the West region were up 31% over the second quarter of 2018, driven by an 18% increase in absorptions coupled with an 11% increase in average active communities. We added 9 more LiVE. NOW. communities in the West during the second quarter.

Arizona put up the strongest performance across the company. Our average absorptions there were 15.7% for the second quarter, up 45% year-over-year, which drove 40% order growth and 39% growth in total order value. Arizona is furthest along in making the strategic shift to entry-level and first move-up. So our mix in closing to our target and our ASP was down just 1% year-over-year. That is a good example of the revenue growth potential Steve described as we stabilize our mix for the company as a whole.

While California remains the highest-priced and most unaffordable and challenged market, our absorption of 10.1% this quarter were not too much lower than the company average of 10.6%. Absorptions were down 20% from last year, with our average community count in California increased by 37% year-over-year. The net 9% order growth was partially offset by a 6% decline in ASP, resulting in 3% growth in total order value for California.

We have rebuilt our community count in Colorado over the past year, after years of selling out communities faster than we could replace them. Average community count was up 22% year-over-year, and our absorption pace increased 9% on top of that, to drive a 33% increase in units and a 23% increase in total order value for the state. Overall, the West was our best-performing region this quarter, despite the decline in California demand.

Slide 8. Moving to the Central region. Texas produced 8% order growth with a 20% increase in absorption that was partially offset by a 16% decline in average communities. We closed out 14 communities in Texas during the second quarter, including several good producers in San Antonio; and opened a few LiVE. NOW. communities in Houston and Austin that are off to a very good start. We expect to grow our net community count in Texas over the next several quarters and expect that absorption should also improve as we continue to open up many more LiVE. NOW. communities to replace move-up communities that are closing out.

The 8% increase in orders offset an 8% reduction in ASP as we continued our shift towards more entry-level. Austin and San Antonio outpaced Dallas and Houston absorptions since they are further ahead in transitioning to entry-level and first move-up communities.

Slide 9, East region. We are very pleased to see the continued improvement in our East region. We opened 6 new LiVE. NOW. and 2 first move-up communities there in the second quarter this year, though we also closed out a couple of high producers. However, our average community count was up 13%, and we also increased our absorptions in East by 12% year-over-year, which drove 26% growth in total orders for the region and an 18% increase in total order value.

We more than doubled our orders in Tennessee, with a 57% increase in average communities and a 35% increase in absorptions over the last year's second quarter. Demand there was strong in our new communities and improved throughout the quarter. Orders were off [flux] 68% in North Carolina due to 20% expansion in average community count and a 39% increase in absorptions over last year, primarily associated with our entry-level communities. On the other hand, we closed out on some strong communities in South Carolina, reducing our average community count and absorptions there.

Demand also improved in Georgia during second quarter, with a 37% increase in orders mainly driven by a 42% increase in absorptions. We opened a couple new communities there last quarter that are selling very well.

Florida increased orders just 3% over last year's second quarter, which was a difficult comp. Total orders in the second quarter of 2018 was an all-time high record for Florida until we beat it this year in the second quarter. [The] timing of community openings and passive absorptions and the year-over-year comparison, since we opened a handful of LiVE. NOW. communities late in the second quarter this year, so they contributed few orders to the quarter.

Slide 10. These results validate our strategy, as the markets where we're furthest along in our shift towards entry-level and first move-up are our top performers. As we continue to roll out our strategy, we are streamlining our products and processes to enable us to start more homes, convert those sales into closings more quickly and reduce our costs in the process to drive greater profitability.

For example, we are reducing our cycle times with additional spec inventory in our LiVE. NOW. communities, as well as taking weeks out of the contract to start cycle time with our new Studio M design centers for move-up homes, which are allowing buyers to complete their option selection process much quicker, with lower stress and greater customer satisfaction.

Slide 11. We started the second quarter of 2019 with 9% fewer orders in backlog than a year earlier, yet we closed 5% more homes. We were able to do that by having more spec inventory started that consult and close quickly. Working with our trade partners, we have taken days and weeks out of our cycle times to value engineering and simplifying our construction process.

Our backlog conversion rate was 71% in the second quarter this year compared to 61% last year. And 66% of our first quarter 2019 closings were from spec inventory, up from 55% a year ago. In order to capture those sales and closings, we had to have inventories to sell. That is all part of our strategy.

I will now hand it over to Hilla to provide some more additional information. Hilla?

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [5]

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Thank you, Phillippe. I'll provide some more details on our P&L results as well as land and operating metrics, beginning with Slide 12.

Steve and Phillippe already covered how we've improved our operations to drive efficiencies and deliver more homes at lower cost. I'll highlight some of the impacts of those improvements and our financial results so far this year.

For the first half of the year, our home closing gross margin was 10 bps lower in 2019 than 2018 due to a one-time charge. We had the benefit of a $1.4 million warranty recovery that increased our gross margin in the first half of 2018. Excluding that item, our year-to-date 2019 gross margin would've been essentially flat with the prior year.

SG&A expenses were consistent for the second quarter of 2019 compared to 2018, though they increased slightly as a percentage of home closing revenue due to the reduction in ASPs year-over-year. Year-to-date, 2019 SG&A expenses were just slightly higher than 2018, mostly due to higher brokerage commission from incentives offered in late 2018 and early 2019. We also incurred severance costs of approximately $1.7 million and another $1.4 million for accelerated equity compensation this year that was pulled forward into Q1 from future periods. The combined effect of these items accounted for the entire increase year-to-date in SG&A percentage.

Interest expense increased $3.2 million for the second quarter and $7.1 million year-to-date compared to last year, primarily due to less interest capitalized to assets under development, which is a result of faster construction times and turnover of inventory as part of our entry-level strategy. We expect higher interest expense to continue throughout 2019, but it should be eliminated early next year after the anticipated retirement of our notes due in 2020.

The negative year-over-year earnings comparison was also due to first quarter 2018 net earnings benefitting from a favorable [legal sell] mix of approximately $4.8 million, which accounted for the comparative decline in net other income.

Finally, our effective tax rate was 1% higher in 2019 for the second quarter and 5% higher for the first 6 months compared to 2018. Our tax rate in 2018 benefitted from a 1-year extension of energy tax credits for all qualifying homes closed in 2017, which totaled $6.3 million. While these credits have not been renewed for 2018 or 2019, they are still in the extenders bill. So we're not ruling out the possibility that we could capture that tax benefit in the future. 75% of the new lots we put under control in the second quarter were for entry-level communities. And we're exiting non-strategic positions as expeditiously as we can.

In the second quarter, we exited one such community in the Dallas market, taking an impairment of $1.7 million on its anticipated sale, which accounted for a land closing growth loss in the second quarter of 2019.

Turning to balance sheet and cash flow items on Slide 13. We spent approximately $175 million on land and development in this year's second quarter, $46 million less than last year's second quarter but up from $141 million in the first quarter of 2019. As I explained on our last earnings call, this is primarily due to the lower lot cost for entry-level homes, as we ended the second quarter of 2019 with total lot supply of approximately 34,700 compared to 33,700 at June 30, 2018. That translates to total lot supply of about 4 years this year compared to 4.2 years last year, based on trailing 12-month closings.

About 66% of total lot inventory was owned and 34% was option at June 30, 2019. Our reduced land spend and faster asset turns contributed to the $113 million of cash flow generated from operations year-to-date in 2019. Our net debt to cap ratio was 33.4% at the end of the second quarter of 2019, down from 36.7% at December 31, 2018. That is historically in the low range for Meritage, and we expect that it will be even lower next year if we reduce our debt as anticipated by paying off our notes coming due as well as the stockholders' equity continuing to increase.

Due to reduced cycle time and higher inventory turnover, we are comfortable at a lower net debt to cap ratio and our historical guidance range in the low 40s percent, as we believe we are generating sufficient liquidity to continue to grow our operations.

Consistent with our strategy to increase our focus on the entry-level market, we are building more spec homes in those communities. We ended the second quarter of 2019 with about 2,400 spec homes or an average of 9.5 specs per community, compared to an average of 9.2 per community a year ago. Approximately 23% of total specs were completed as of June 30, 2019, compared to 31% in 2018.

Turning to Slide 14. We are encouraged by the outlook for interest rates and optimistic the demand for our homes and communities will remain strong. Based on our results in the first half of this year, we are currently projecting 2019 home closings and total home closing revenue of approximately 8,700 to 9,100 units, with $3.4 billion to $3.6 billion respectively for the full year. We are anticipating home closing gross margin to be in the mid-18% for the full year.

We expect slightly higher SG&A as a percentage of home closing revenue for full year 2019 compared to 2018 due to the increased commission expense early this year that we've discussed, and about 10 bps of cost to operate our Studio M showrooms, which are reducing our cycle times and improving our gross margins.

Interest expense is expected to trend down a bit sequentially in the last half of 2019 from the first half but will continue to be higher than 2018 due to our faster asset turns. With our tax rate holding steady at 25%, we expect to generate approximately $5.20 to $5.50 of diluted earnings per share for the full year.

For the third quarter of 2019, we're projecting 2,200 to 2,400 closings for total home closing revenue of approximately $860 million to $935 million and a home closing gross margin percentage in the high 18% for the quarter. We expect SG&A and interest expense to be higher than 2018 for the reasons I stated earlier for the full year, which translates to about $1.40 to $1.50 of diluted earnings per share for the quarter.

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

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [6]

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Thank you, Hilla.

In summary. We were pleased with our second quarter year-to-date 2019 results and believe we're further improving our business and differentiating our product in accordance with our strategy, in addition to changing our product mix for streamlining and simplifying to drive greater efficiencies and profitability, which is valued by our customers, employees and trade partners.

Demand for new homes remains healthy. And we believe the demand we've seen so far this year reflects the same positive macroeconomic factors for the housing industry. I'm proud of our entire Meritage team for putting our customers first and working hard every day to make the company successful. We're confident in our abilities to make the most of the opportunities ahead of us, and we expect to continue to grow and deliver increased shareholder value.

Thank you for your support of Meritage. And we'll now open it up for questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from Alan Ratner, with Zelman & Associates.

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Alan S. Ratner, Zelman & Associates LLC - MD [2]

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Congrats on the great quarter and all the success with the strategy shift. It's really great to see.

Steve, I guess the question I was hoping to drill in on a bit is -- just kind of thinking about the supply-demand dynamic right now, clearly the order growth, very strong -- it's apparent that the demand is there at this segment; you're pushing the entry-level. If I look at some of the supply side things, your community count has drifted a bit lower here, which is certainly expected, given how strong the sales have been. And your spec count is only up slightly year-over-year. And that had been up quite a bit more over the last couple quarters.

So where you sit today, I'm just curious, how do you see the price versus pace dynamic playing out over the next few quarters? Because I think it's clear the sales environment this spring has been very solid. Is there any risk that you and maybe some other builders might start to feel the pinch on the supply side a little bit like they experienced a couple years ago when we saw a smaller dynamic?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [3]

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Well, thanks for the compliment first. And thanks for the question.

We still have opportunities as we continue to change our mix for growth without community count growth. Because we're opening more entry-level communities than we are move-up communities. But I would say we haven't had a challenge finding entry-level land. We've bought -- I don't know if we talked about the number of lots -- 75% of lots we bought last quarter, I think we bought around 2,500 lots in the quarter or for entry-level. Or actually, more than that. I think we bought 2,500 last month.

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Phillippe Lord, Meritage Homes Corporation - COO & Executive VP [4]

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We bought 4,000 lots and 2,500 were entry-level.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [5]

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Yes, bought 4,000 lots last quarter; 2,500 were entry-level. So we're still finding them. The challenge is just bringing them to market, getting them through the entitlement and development process and getting them open. But long term, we really feel like there's a long runway for our LiVE. NOW. product. And we're going to continue to push that. And as time goes on, it will drive revenue growth and produce better margins.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [6]

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Just one quick follow-up, Alan, on the spec count. As we start to -- last prior year where we started to see the community count growth in LiVE. NOW., we're not going to continue to have the spec count growth by quite as explosive as it was in '18 and '17, as we just started to build up our LiVE. NOW. communities. We still have more specs per store than we have ever held, at 9.5 specs per community. But the shift is moving to be more LiVE. NOW. year-over-year. You're not going to see the same absolute value growth.

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Alan S. Ratner, Zelman & Associates LLC - MD [7]

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And second question, just on the entry-level, we are hearing from some others that the single-family rental operators are very interested in either purchasing bulk sale of homes in closeout communities or even entire phases of projects. I'm just curious if you've gone down that road at all in some of your LiVE. NOW. projects or entertained the prospect of building for any of the single-family rental operators.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [8]

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We've looked at it, and we've entertained it. But we feel like we can do better building them for our own account at a higher margin, which would deliver better value to our shareholders. So if we had a lot excess, entry-level positions or positions that we didn't want, maybe we would sell them to them. But that's not the case. We're really, really happy with all of our entry-level stores. And we don't see a desire, a need to discount those and sell them to those rental operators.

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Alan S. Ratner, Zelman & Associates LLC - MD [9]

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So there's no contribution or no orders this quarter were to any of those operators?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [10]

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None.

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Operator [11]

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The next question is from Stephen Kim of Evercore ISI.

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Stephen Kim, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Housing Research Team [12]

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Good job on the quarter.

Wanted to ask you a few questions regarding absorptions. You indicated they were 1.5x higher than the move-up. Did move-up absorption rates increase, too? And if so, can you give us a sense for what the drivers to that might be?

And then, with respect to the expected lifespan of LiVE. NOW. communities, given the strong absorptions, how has this changed relative to your initial expectations? How long do you think it's going to take to sell out of these communities, for example? And basically, are you seeing absorptions faster than what you had initially envisioned, and therefore the lifespan of these communities being shorter, or not?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [13]

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Well, I'll let Hilla or Phillippe come up with a number on the average size of our entry-level communities. But I can tell you they're much bigger. We're buying much bigger positions for entry-level than we were for move-up, 150-plus lots in a lot of cases. But Hilla might have the number. But I can tell you on absorptions, our entry-level was up 19% year-over-year. First, move-up was up 7%. And our second move-up and our small active adult presence was up 19% because we're really incentivizing those stores to move out of those segments. So the opportunities for the buyers were pretty compelling. But certainly, the absorption increase is better for entry-level than it was for move-up.

Do you know the average lot num count?

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [14]

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It was over 100. It was 110, 112 (inaudible) the average upside --

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [15]

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Which is for both, both segments.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [16]

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-- which is combined for both segments. Historically, they're more 70, 75-ish. So there's quite a bit of an increase.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [17]

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Yes. I'm not concerned that we're going to move through these -- we're going to run out of entry-level lots or have a supply issue. Because we anticipated that the absorption would be stronger, and that's why we bought bigger positions.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [18]

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Yes, our goal is to purchase land positions that have a 3- to 4-year life, and not based on the anticipated absorption. So obviously, we're going to tick up or down based on the product offering in that community.

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Stephen Kim, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Housing Research Team [19]

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That makes sense. So you anticipated the stronger absorptions when you originally moved in or bought these communities a couple of years ago. And that's great.

You talked about your land spend and some of the dynamics there. One of the [more] interesting [things I've heard you] say was that you're not really having trouble finding land to buy for entry-level that meets your underwriting threshold. And I'm curious about that. Because entry-level in general, and obviously LiVE. NOW. for you specifically, has been tremendously successful. And this is something which would be kind of hard to miss, I would imagine for your competitors.

So I'm curious that you're not seeing more competition, let's say, for the land parcels that would be suitable for an entry-level product. So I'm wondering why that is that you're able to find land to buy so readily. Is it that you're, let's say, moving into larger communities further out in your prospecting? Or are land sellers putting a lot more entry-level land onto the market? Or is there some other reasons that you're just simply not seeing other builders bidding on these kinds of parcels?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [20]

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Well, there's a lot of competition, number one. We're competing with a lot of builders for these parcels. That's the given. But there's a lot of reasons why we're winning out in many cases. It's our local operators' relationships with land sellers, it's our land team, it's our reputation in the market. There's a whole variety of reasons why we're getting it, particularly in a market like Phoenix, where we're a real big player, and we've been here for almost 35 years.

But in other markets, we've carved out a really strong position in the entry-level space, like in Austin and in other places. And we're just, I think, a little ahead of -- we really know our costs, we've driven our costs down. Allows us to underwrite deals quicker. And maybe we're just more comfortable in the segment than some of the other midcap builders who are just maybe dipping their toe in right now and starting to get going.

Clearly, we have competition from a couple of the bigger, larger large-cap builders on every corner. But we're still able to get the land that we need and to grow the business.

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Stephen Kim, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Housing Research Team [21]

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And then lastly for me, on community count, I just want to make sure I got this right. What are you looking for for your ending sub count at the end of the year, generally speaking? And what do you think the mix of entry-level versus move-up and second-time move-up will be at that time in terms of selling communities at the end of the year?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [22]

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So our community count will dip in Q3. It will be a little lower than where it is today. But it should rebound in Q4, and we should end the year right about where we are right now. Unfortunately, that's a little bit less than we expected starting the year. That's because of the faster sellout of communities. And it's also because when we ended last year, sales were pretty slow in the fourth quarter, and we ended with more communities than we expected.

And then, we hope as we get into next year, we can start to resume some community count growth. And we're working hard for that. So we -- end of the year, we'll probably end [with] less [2-MU] communities, as we're working feverishly to finish those up and get out of those. And we'll have more, of course, entry-level communities. But I'm afraid to give specific numbers right now for those segments. But I can tell you, as I said, it will be less in Q3, and at the end of the year will be about flat with where we are now.

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Operator [23]

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The next question will be from John Lovallo, with Bank of America.

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John Lovallo, BofA Merrill Lynch, Research Division - VP [24]

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The first one, Steve, you mentioned the entry-level having higher average margins than your move-up homes. Just curious, is that a function of just a more efficient build process, maybe less materials? Or is it more of a function of just having to put more incentives on move-up homes at this point?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [25]

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It's really both. I would say the incentives are a big part of it. I mean, just demand is stronger for entry-level than it is for move-ups, so we're not incentivizing as much. And by building 100% spec in our LiVE. NOW. entry-level communities, we're able to get better cost and build more efficiently and leverage our overhead better, of course. And all that leads to higher margins.

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John Lovallo, BofA Merrill Lynch, Research Division - VP [26]

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And then, Hilla, I think you talked about taking debt down in the early part of 2020. Should we expect non-capitalized interest expense to largely disappear by the second quarter? Is that the right way to think about that?

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [27]

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Yes. We should really not have interest breaking to the P&L after our maturity of our 2020 notes.

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Operator [28]

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The next question will be from Michael Rehaut, with JP Morgan.

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Elad Elie Hillman, JP Morgan Chase & Co, Research Division - Analyst [29]

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Congrats on the quarter. This is actually Elad on for Mike. I wanted to just ask a little bit more about the incentive levels in the overall pricing environment. You mentioned that incentive levels on entry-level are still lower than on your move-up. But just compared to last quarter, have you been able to roll back on incentives through the quarter? And maybe just some more commentary on the overall pricing environment?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [30]

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We had fewer incentives in the second quarter than we did in the first quarter, or certainly in the fourth quarter last year, especially entry-level homes. We elevated our incentives in our 2-MU to close those out. In California, the incentives have been somewhat level, but demand has been softer.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [31]

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Think there's actually some locations across the country where we've been able to start to increase pricing a little bit. Definitely not in every market, but in some geographies. And as Steve already mentioned, the incentives on entry-level are already lower than everything else. So as the mix shifts to more entry-levels, we're going to see the total incentive decrease for the company.

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Operator [32]

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The next question comes from Truman Patterson, with Wells Fargo.

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Truman Andrew Patterson, Wells Fargo Securities, LLC, Research Division - Associate Analyst [33]

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Nice quarter.

First, just wanted to dig into the rollout of Studio M, and if you guys could just give some metrics around that, the time line to completion, some of the costs on the back half of the year? And also, could you just give an update in how it's been accepted by the customer in the market?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [34]

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So for those that don't know, Studio M is our new design center strategy that we are executing for our 1-MU buyers. All of our LiVE. NOW. entry-level buyers are buying spec homes. They're already pre-plotted and pre-colorized with a variety of colorization schemes. Our 1-MU buyers come to our new design centers. They're called Studio M. And within those centers, they go through an 8-step process of picking their selections. And it's a much more streamlined version of what we were doing before. Less choices, but still a lot of choices.

If you come to our Analyst Day that we're going to have in New York in November, you can see a lot more and learn a lot more about it. But this new Studio M will allow us to offer less SKUs, which will allow us to negotiate better pricing with our vendors and, at the same time, take away a lot of the stress and anxiety that goes with going to a design center. Pricing will be more transparent. It'll be easier and quicker -- it's easier and quicker for our buyers to get through the design center process and get through 2 or 3 hours with one visit versus 2 or 3 visits before. And they'll know when they leave exactly what things cost and what they've spent.

So we're really excited about it. We've opened 8 studios up out of 16 that we planned. We'll be opening the balance of them up this quarter. A couple of them will flow into the fourth quarter.

But their acceptance has been fantastic. We're getting a lot of positive feedback on it from our customers; very little negative. And our customers are actually spending more in these design centers. And our margin from our customers for the upgrades is stronger than it was previously when we used the traditional design center method.

So we're very, very excited about Studio M, and we think it's going to be one more arrow in our quiver to improve our margins, streamline and simplify our business, and make a better experience for our customers, and make it easier to operate for our employees.

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Truman Andrew Patterson, Wells Fargo Securities, LLC, Research Division - Associate Analyst [35]

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Jumping over to your gross margin guide, you bumped it up by about 50 bps. I'm just hoping you guys can help us bridge the gap, what led to this increase. It seems like incentives are ticking down for you. But you mentioned that land competition remains pretty high, if you will. So if you can just bridge that gap for us, I'd appreciate it.

And then also, could you just give us what the gross margin delta is between your LiVE. NOW. and your first move-up and kind of legacy 2-move-up plus segments?

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [36]

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Sure. So the majority of the lift in the full year guidance on margin, it's really a function of 2 things. As we accelerate the shift into entry-level, those higher margins are improving the overall margins for the company. And the second piece is leverage. Obviously, we sold and closed more homes than we initially projected for the second quarter. And you can see those projections are flowing through for the balance of the year. It wasn't a pull-through from Q3 into Q2.

So as we've talked about on other calls, there's a fixed component of overhead in gross margin that just gets leveraged at a much faster pace on higher volume. So it's really the combination of mix continuing to find value engineering opportunities in our products, the rollout of additional Studio Ms, as Steve had mentioned, with higher margins; and the leveraging from the higher volume. So kind of a combination of all of those is driving the higher guidance for the full year on gross margin.

And then, on the entry-level, I don't know if we want to get into specifics, the kind of shift quarter-to-quarter based on the mix, even within the entry-level and the first move-ups. We'll say that the entry-level has notably higher margins than our non-first-time move-ups, the second-time move-up, the luxury stuff that we're exiting out of, and highly discounting entry-levels maybe just a hair better than our first-time move-up right now, although stay tuned. Because of the Studio M rollout, they're probably going to comp pretty close in line with one another.

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Operator [37]

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The next question will be from Jade Rahmani, with KBW.

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Unidentified Analyst, [38]

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This is actually [Ryan], on for Jade.

Just regarding M&A, do you think that the industry is really ripe for a significant consolidation at this point to drive things like scale, economics, and also the ability for the industry to more significantly invest in technology and infrastructure? And why do you think we haven't seen more consolidation at this point?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [39]

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For the same reason -- if you go back decades, there's a lot of social issues with founders that are still in control of some of the public companies and the large regional operators that are holding onto control of these companies, and family planning, estate planning. We've in a very fragmented business. And actually, it looks like on paper that we should have more consolidation. But realistically, it's probably not going to be a lot different than the past.

Our eyes are certainly operation to M&A opportunities. We're constantly looking at different things. But our first and foremost priority right now is to grow organically, particularly in those markets where we're not a top 3, 4, 5 builder. And that's the strategy that we're employing.

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Unidentified Analyst, [40]

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And just as a second question. In Arizona -- in particular, Phoenix -- are you seeing any impact in the market there from the growing share of iBuyers?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [41]

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No. I mean, the iBuyer presence has gotten larger here. We're using some of the iBuyer companies to do trade-ins for some of our move-up communities. But it's still a relatively small piece of the overall resale market here in Phoenix.

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Unidentified Analyst, [42]

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Can you put any context around any figures on the trade-ins that have occurred with you in iBuyers to date?

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [43]

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It's very, very limited. It's very limited. We're rolling it out across the country, partnering with a couple of the big names that you know. But it's not --

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [44]

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We've probably done a couple few hundred transactions with these companies over the last year plus, year to 18 months. So out of more than 10,000 orders that we've taken, we've only done a couple few hundred. Now, of course, we haven't had it nationwide, but we've had it in several markets. And it's a nice tool. I think it's a nice thing for us to have when buyers come in and they have a house to sell. But it hasn't moved the needle yet.

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Operator [45]

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The next question comes from Carl Reichardt, with BTIG.

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Carl Edwin Reichardt, BTIG, LLC, Research Division - MD & Homebuilding Analyst [46]

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Hilla, to go back to Truman's question. So the guide for this quarter was, I think, mid-17s gross margin, and you did 18.4. So is that component of differential really all related to leverage of fixed? Or are there some other things in there in terms of what you ended up with relative to where you guided 3 weeks into the quarter?

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [47]

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Yes. So same story for our actual results in Q2 versus our guidance. It's a combination of mix, obviously higher LiVE. NOW. composition of the total. We were able to lift margins.

I actually have some numbers here. I knew someone always asks on the call, how do the margins break out by region? So West and Central were relatively steady year-over-year. It's really the East where we've had problems getting our margins up in the past. The margins in the East actually grew 100 bps Q2 of last year to Q2 of this year. The value engineering, that ability to close a bigger portion of our backlog and the value engineering that we had in that product in backlog in that spec product, really helps push our margins up. Course, lumber always helps. I think all of those components, with the higher closing volume than we had anticipated, that helped us gain a leverage on the fixed component of gross margin. All of those together came to deliver a higher margin than we had anticipated.

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Carl Edwin Reichardt, BTIG, LLC, Research Division - MD & Homebuilding Analyst [48]

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And then, just on your lot options, I think it's 34% of your base now. Do you know roughly offhand what percentage of those are on paper lots or finished lots? And is that percentage within the option count changing?

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [49]

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I don't know the percentage on the actual option piece, what's paper versus not. But I believe we're right around 30%. When we purchase these, it's about a 30-70 split between finished and needing some level of development.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [50]

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Yes, but we don't option paper lots. We buy finished lots through the option. So I guess you're asking which ones haven't been developed yet, and which ones are ready to go right now?

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Carl Edwin Reichardt, BTIG, LLC, Research Division - MD & Homebuilding Analyst [51]

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Yes, that's --

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [52]

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I would say primarily [loads] need to be developed and are not ready to go right now.

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Carl Edwin Reichardt, BTIG, LLC, Research Division - MD & Homebuilding Analyst [53]

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And then, one last one to stick in that Alan asked about -- institutional purchases of single-family rentals. I'm interested in sort of the more ma-and-pa buyers. Do you know offhand what percentage of your orders have been tracking to, let's just broadly call them, non-owner occupants?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [54]

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I can tell you it's pretty small. I go out in the field quite a bit to go to our new communities, and I talk to our salespeople. And I ask them how many of these are real investors and how many are actually living here. And I can tell you the investor community, unlike what we saw in the last cycle, is really, really small. I'd say it's less than 5%.

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Operator [55]

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(Operator Instructions) The next question will be from Alex Barron, with Housing Research Center.

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Alex Barrón, Housing Research Center, LLC - Founder and Senior Research Analyst [56]

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I kind of wanted to ask 2 questions. One was on the LiVE. NOW. I guess, what percentage of your communities are LiVE. NOW.? And where do you see that trending over the next year or two?

And the second question is on the balance sheet. So you got the 2020 debt coming due. Is there any plan longer term to kind of renew -- issue some debt to replace that, or to maintain a lower level of leverage, and therefore a lower level of interest, if you're just generating enough cash to sustain the business at current growth rates?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [57]

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So 41% of our communities at quarter end were entry-level. 52% of our orders were entry-level. That 41% could go as high as 60%. We think that's our upward target, to be 60% entry-level. I don't have a time frame for that, but that's sort of where we're heading.

As far as the debt, our plan right now at the moment is to pay that debt off in March with the cash that we're building up on our balance sheet, and not [to] replace that with additional debt. Those plans certainly can change with a variety of different things, potentially opportunities potentially coming our way. But that's the point at the moment. We just feel like as we get longer into the cycle, even though we believe there's tremendous opportunity long term for entry-level housing, it's prudent to deleverage the company a bit and not refinance that issue that we're paying off and reduce our interest expense.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [58]

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And one other point on that -- I think someone asked earlier if the interest expense that you're seeing breaking in the financial payments is going to go away, and it is. But the total burden on this debt is closer to $22 million, not just the $10 million that you're seeing breakthrough. So the balance of that will, over time, help margins as well, because that interest won't get capitalized. But we'll see some margin improvement from that in upcoming years as well.

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Operator [59]

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

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [60]

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Thank you very much for your participation in our second quarter earnings call. And we look forward to talking to you again next quarter. Have a great day.

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Operator [61]

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