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Edited Transcript of MTH earnings conference call or presentation 30-Jan-20 2:30pm GMT

Q4 2019 Meritage Homes Corp Earnings Call

Scottsdale Feb 6, 2020 (Thomson StreetEvents) -- Edited Transcript of Meritage Homes Corp earnings conference call or presentation Thursday, January 30, 2020 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

* Jade Joseph Rahmani

Keefe, Bruyette, & Woods, Inc., Research Division - Director

* John Lovallo

BofA Merrill Lynch, Research Division - VP

* Stephen Kim

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

* Susan Marie Maklari

Goldman Sachs Group Inc., Research Division - Analyst

* 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 Fourth Quarter 2019 Analyst Call. (Operator Instructions)

Please note, this event is being recorded. I would now like to turn the conference over to Brent Anderson, VP 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, Brandon. Good morning, everyone. Welcome to our analyst call to discuss our fourth quarter and 2019 full year results. We issued our press release yesterday after the market closed, and you can find it on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom of our homepage.

I'll refer you to Slide 2 in the deck and remind you that our statements during this call as well as our press release and slides contain forward-looking statements, including projections for the full year and first quarter 2020 operating metrics such as home closings, closing revenue and margins as well as overhead and earnings per share and earning -- in addition to expectations about market trends. Those and any other projections represent the current opinions of management, which are subject to change at any time, and we assume no obligation to update them. Any forward-looking statements are inherently uncertain. Our actual results may materially differ from 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 annual report on Form 10-K and subsequent 10-Qs, which contain a more detailed discussion of those risks. We've also provided a reconciliation of certain non-GAAP financial measures referred to in our press release as compared to their closest related GAAP measures.

With me today to discuss the results of our quarter and year are: Steve Hilton, Chairman and CEO of Meritage Homes; Hilla Sferruzza, Executive VP and CFO; and Phillippe Lord, Executive VP and Chief Operating Officer of Meritage. We expect to conclude this call within about an hour, and a replay will be available on our website approximately an hour after we conclude the call, and it will remain active through February 13.

I'll now turn the call over to Mr. Hilton to review the results. Steve?

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

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Thank you, Brent. I'd like to welcome everyone participating on our call today, and I'll begin on Slide 4.

In 2016, we introduced our strategic plan centered around shifting our product focus to meet the growing demand for more affordable homes, which was and remains the largest part of the housing market. We ushered in our LiVE. NOW. homes for the value-conscious entry-level buyer and decided to concentrate the rest of our business around first move-up buyers, transitioning out to higher end and move up in luxury and home markets. We undertook a complete -- a company-wide effort to streamline our business to support that strategy with the ultimate goals of improving our operating efficiency and driving growth and profitability. We have been effectively executing that strategy over the last 3 years as demonstrated by the results we deliver. We've improved significantly each year. The impact was fully visible on our 2019 results.

Building on our success, we believe we can continue to grow and improve, and we've set a path to achieve that growth and enhance our profitability. 2019 was a good year for homeowners in general and for Meritage in particular. After an initial slow start, demand picked up quickly and was strong through the end of the year as housing fundamentals continue to improve. We gained momentum across many operating measures as the year progressed. Our year-over-year comps improved each quarter of 2019 over 2018 for orders, closings and backlog growth, both in units and total dollar value. That growth was driven by higher absorptions, which were up 19%, 27% and 37% year-over-year from the second through the fourth quarter, respectively. We attribute that mainly to our expanding position in the entry-level and first move-up markets. We have the right product at the right price in the right locations, which is the basic recipe for success as a homebuilder.

In addition to volume and revenue growth, our home closing gross margins improved in 2019, both sequentially by quarter, and year-over-year compared to 2018 due to efficiencies and purposing of production as well as lower price incentives. For the last 2 quarters, our home closing gross margin has been 19.8%, very close to our 20% target level. We're earning better margins on both our entry-level LiVE. NOW. homes and our first move-up homes with the success of Studio M.

Our SG&A leverage also improved through the year as a result of both volume growth and the efficiency we've gained by simplifying and streamlining our processes. Those improvements drove significant growth year-over-year in our pretax margins, net earnings and diluted EPS for the fourth quarter and full year 2019, even before the tax savings we recognized in the fourth quarter from energy tax credits after they were officially renewed last year and retroactive to 2018.

Our book value increased to nearly $52 per share as of the year-end 2019, and we retired $300 million of debt in the fourth quarter using positive cash flow from operations, ending the year with over $300 million in cash and a net debt-to-capital ratio of just over 26%, the lowest it's ever been for the company.

Turning to Slide 6. When we reported our results last quarter, we said that our biggest challenge was keeping up with the accelerated pace of sales, which would result in the early closeout of many communities and that we were saying a goal to get to 300 communities by the end of 2021. I'm happy to report, we've made significant progress towards that goal. We've reaccelerated our acquisitions of new lots and communities to rebuild our pipeline after pulling back on the reins in 2018 and early 2019 after the market slowed. And in just the last 3 quarters, we put approximately 16,400 lots under control, bringing our total for the year to more than 18,000 new lots added for approximately 140 new communities and 85% of those were for LiVE. NOW. products. That compares to about 10,000 lots put under control in 2018. It fulfilled our 2020 plans and put us well on our way to meeting our 2021 goal. I commend our entire Meritage team for making that happen, and we're excited about the opportunity it presents for us and for our shareholders.

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. Slide 7. Our orders for the fourth quarter were up 27% year-over-year, which pushed our full year order growth to 19% over 2018, despite a small decrease in community count. We delivered a 72% year-over-year order growth in the entry-level market with our LiVE. NOW. homes. They made up 55% of our orders for the fourth quarter of 2019, up from 40% in last year's fourth quarter and 54% in this year's third quarter and ahead of where we thought we'd be a year ago. 47% of our communities at quarter end were entry-level compared to 33% of total communities a year ago. While year-over-year comparisons to the fourth quarter of 2018 were easier than the first 3 quarters, the success of our entry-level LiVE. NOW. homes clearly exceeds the broader market in terms of year-over-year absorption growth.

In addition to the success of our entry-level product, the design collections we're offering and the simplified process of personalizing your home in our new Studio Ms has been very well received. If you attended our Analyst Day in November, you heard that directly from homebuyers, realtors and our own sales associates.

Looking at our fourth quarter orders, demand was strong across all 3 regions. I'll provide additional local color, beginning with the West region on Slide 8. Our orders in the West region were up 38% over the fourth quarter of 2018, driven by a 38% increase in absorptions and relatively flat community count in total, with a 43% increase in total order value. While Arizona has been one of our strongest markets since we made the hard pivot to the entry-level, our California business is also starting to gain strength, and it feels like we may be turning the corner after a very difficult 2019. We've made this shift to entry-level in California over the last year, and our results in the fourth quarter demonstrates the success we have had with it. Our average community count grew 55% year-over-year in California, and we ended the year with 58% of California communities being entry-level compared to just 35% a year ago.

Reflecting that shift, along with some improvement in the California housing market, our absorptions were up 37% for the state. The combination of higher absorptions and more communities resulted in a little over a doubling of orders in California with just a 6% decline in ASP. Even though we experienced the close-out of several strong performing communities, Arizona, again, produced the strongest absorptions across the company at an average of 10.4 orders per average community for the quarter, up 46% year-over-year. We grew orders 18% in units and 17% in total value.

With the continued strength in the market, our ASP was flat compared to a year ago, even as our community mix in Arizona ended the year close to our target with 55% entry-level. In Colorado, our absorptions were up 29% year-over-year to 7.5 for the fourth quarter, despite 5% fewer communities opened on average than a year ago.

With affordability as the primary challenge in Denver, we have been acquiring more affordable duplex and townhome communities to replace higher-priced move-up communities. We ended the year with half our communities that are facing the entry-level market. Overall, the West was our best-performing region again this quarter in terms of orders and closing growth over the fourth quarter of 2018.

Slide 9. Turning to the central region. Texas had a 46% increase in absorptions that was partially offset by a 19% decline in average communities. We've sold out a number of communities and are in the process of bringing more communities online over the next few quarters. At year-end, 56% of our communities in Texas were entry-level. So despite a decline in community count, our orders were up 18% and order value was up 11% year-over-year for the fourth quarter. All 4 of our markets in Texas are doing well and have plenty of opportunities for future growth and market share expansion.

Slide 10. We are very pleased to see the continued improvement in our East region again during the fourth quarter. Year-over-year order growth in each region has been at about 20% for the last 4 quarters. Even with slightly fewer average active communities in the fourth quarter, the East region produced 25% order growth. Due to a 29% increase in absorptions, our total order value was up 19% year-over-year. Approximately 1/3 of our East region communities are positioned for entry-level as of the year-end 2019, and we are intently focused on getting our product mix to be more entry-level as we are in the other regions. That target mix shift represents a huge opportunity for the East region and Meritage over the next couple of years.

Within the region, North Carolina produced the largest year-over-year growth with a 39% increase in orders. This was a combination of a 33% increase in absorptions and 4% growth in average community count. Their absorptions of 8.8% for the quarter were the highest in the region. Florida generated 34% order growth with a 13% increase in average community count and 19% higher absorptions over last year's fourth quarter. Florida has the greatest entry-level footprint in the East region at 40% as of December 31, 2019. Demand also improved in Georgia, where a 37% increase in absorptions for the quarter was more than offset an 18% decline in average communities for 13% order growth.

We've closed out some strong communities in South Carolina this year, which reduced our average community count by 21% compared to last year and our orders by 26%. We will be opening new LiVE. NOW. communities over the next several quarters that should increase our absorption pace as well as rebuild our community count to drive future growth in South Carolina. And lastly, Tennessee produced 37% order growth, with a 53% increase in absorptions, partially offset by a decline in community count. We are set up to quickly rebuild community count there with a number of new LiVE. NOW. communities.

Slide 11. We closed 13% more homes in the fourth quarter of 2019 than last year, with just 7% more orders in backlog as we entered the fourth quarter. As we've explained before, this is due to having more spec homes available for quick move-in, which is a core tenet of our entry-level strategy. 61% of fourth quarter 2019 closings were from spec inventory compared to 56% a year ago. As a result, our backlog conversion rate increased to 80% in the fourth quarter this year compared to 76% last year.

Before we began our hard pivot to the entry-level market, our conversion rates were in the low to mid-60% range. We ended the fourth quarter of 2019 with a little over 3,000 spec homes in inventory or an average of 12.4 per community, which compared to an average of 9.2 a year ago. Only 28% of those specs were completed as of December 31, 2019, compared to 32% in 2018. We continue to sell homes early in the construction process and monitor demand constantly so that we can pull back on starts and reduce our inventory relatively quickly should we see a sharp downturn in the market, which we aren't currently anticipating.

I will now hand it over to Hilla to provide some additional analysis of our financial results. 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 detail on our P&L results as well as land and operating metrics beginning on Slide 12. Our home closing gross margin for the fourth quarter of 2019 increased 80 bps over the fourth quarter of 2018 to 19.8%, including $3.1 million in inventory write-downs relating to assets that don't fit our current product strategy. Excluding similar charges in both years, our home closing gross margin was 20.1% for the fourth quarter of 2019, a 100 bps higher than the fourth quarter of 2018's gross margin, net of impairment, and right in line with our underwriting criteria.

For the full year 2019, home closing gross margin improved 70 bps to 18.9% compared to 18.2% in 2018. Our earnings from financial services unconsolidated were $3.7 million lower in the fourth quarter of 2019 compared to 2018. We changed our mortgage joint venture structure relating to customer incentive. The profit from those transactions are now included as part of our home closing revenue rather than being part of financial services profit, which resulted in about 30 bps of margin improvement in the fourth quarter of 2019 over 2018. This new structure will continue into 2020 and beyond. SG&A expense of 10.1% were down 50 bps as a percentage of home closing revenue for the fourth quarter of 2019 compared to 2018, bringing our full year SG&A expense ratio in line with 2018, 10.9%.

Higher broker commissions from incentive in late 2018 and early 2019 as well as severance payments and accelerated equity compensation cost of about $3.7 million earlier this year negatively impacted our full year SG&A leverage for 2019. Our total interest expense decreased in the fourth quarter of 2019 due to the early retirement of our 2020 notes in December. Prior to that early retirement, we capitalized nearly all interest incurred and had minimal interest expense for the fourth quarter of 2019. Interest expense was $7.6 million higher in fiscal 2019 compared to 2018 as quicker inventory turns resulted in less interest capitalized to inventory this year. We announced last quarter that we expect to redeem our $300 million notes due in 2020 before the end of 2019, and we completed that repurchase in December, which included a $5.6 million loss on early extinguishment of debt, but will reduce our total interest incurred going forward. We do not expect to have any noncapitalized interest in 2020.

Our pretax earnings for the fourth quarter of 2019 were 20% higher in the fourth quarter of 2018, while our net income increased 37% as we recognized a tax benefit of approximately $20 million in the fourth quarter of 2019 for energy tax credits and qualified homes that we closed over both 2018 and 2019. Congress retroactively renewed and extended energy credits in December of 2019 through 2020 that reduced our tax rate to approximately 6% for the fourth quarter and 18% for the full year 2019 compared to 20% for full year 2018.

We will continue to recognize these tax credits on a quarterly basis in 2020 and expect them to reduce our effective tax rate to about 22% for the year. As a reminder, in order to achieve such a high acceptance rate on our energy efficiency qualification, we incur additional costs in every house we build to provide a high-quality, energy-efficient home to all of our buyers. These costs allow us to earn the tax credit.

Internally, we really view the credit as a direct offset to our cost of sales rather than a reduction in taxes.

Turning to a few highlights of our balance sheet and cash flow items on Slide 13. We spent approximately $245 million on land and development in this year's fourth quarter, putting over 6,800 lots under control for 46 new communities. That was about $50 million more than what we spent on land and development in last year's fourth quarter. As we've said, we've been purposefully reloading our pipeline for new communities to materially grow our orders and market share over the next several years. We ended the fourth quarter of 2019 with a total lot supply of approximately 41,400 lots compared to approximately 34,600 lots at December 31, 2018, increasing our year supply of lots to approximately 4.5 years based on trailing 12 months closings. About 63% of total lot inventory was owned and 37% optioned at year-end.

We ended the year with $319 million in cash even after redeeming $300 million of debt, reducing our net debt to just $700 million from under -- from just under $1 billion at the end of 2018 and reducing our net debt-to-cap ratio to 26.2% at the end of 2019 from 36.7% at the end of last year. We're planning for approximately $1 billion to $1.2 billion in land and development spending annually for the next couple of years as we continue to purchase and develop land for community count growth. We're targeting community count of approximately 300 million (sic) [300] by year-end 2021, and we should see meaningful growth in sales and closings from that increase. Even with this higher expected spending, we'll continue to manage our net debt-to-cap to -- in the 20% to 30% range, and expect our cash flow to be neutral to slightly positive this year, which we believe is appropriate for our current operating structure as opposed to the mid-40% that we targeted under our previous operations.

Slide 14. As we look forward, we're encouraged by the strength of the housing market and the results we've achieved with our shift towards more affordable homes and the operating efficiencies we're realizing. We expect our earnings growth to exceed our top line growth with the added benefit of improved gross margins and leverage from the operational efficiencies we've made, and we will continue to refine.

For the full year 2020, we are projecting 9,700 to 10,200 total home closings and ASPs in the $360,000 to $370,000 range, with home closing gross margin in the mid-19s and the tax rate of approximately 22%. For the first quarter of 2020, we're projecting 1,800 to 2,000 total home closings, ASPs of approximately $380,000 to $390,000 and home closing gross margin in the mid-18s. With that, I'll turn it back over to Steve. Steve?

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

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Thank you, Hilla. Our performance is the direct result of our strategy to focus entirely on the entry-level and first move-up markets, which are the strongest areas of demand across our footprint. We are not only providing buyers what they want in terms of affordable, high-quality homes or building, selling and delivering those homes efficiently and cost effectively by simplifying and streamlining our operations.

Our strategy has allowed us to grow at a faster pace than the market and take market share while improving our margins and operating leverage to deliver better earnings growth and grow our shareholder equity.

We've been generating positive cash flow and have strengthened our balance sheet while providing sufficient capital to reinvest in future growth. I'm proud of our entire Meritage team for putting our customers first and working hard every day to make the company successful.

The outlook is positive for housing demand based on employment and income levels, low inflation and interest rates and solid consumer confidence. Demand is especially good for homes that deliver great value at lower price points, which Meritage Homes do. With the investments we've made over the last several quarters and have committed to continue to -- and have committed to continue in order to expand our pipeline for community count growth over the next couple of years. We are positioned to deliver strong volume growth as those communities open, anticipating that recent demand trends continue.

That concludes our prepared remarks for today. I'd like to thank you for your support of Meritage Homes, and we'll now take some questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Michael Rehaut with JPMorgan.

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Elad Elie Hillman, JP Morgan Chase & Co, Research Division - Analyst [2]

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This is Elad on for Mike. Congrats on another impressive quarter. First, would you be able to share any monthly sales pace trends in the quarter and so far in January? And any early indications for the spring selling season?

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

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I can tell you that order growth in the fourth quarter was strong and steady throughout the quarter. December was stronger than traditionally, as December is a seasonally slow month for sales. It was less seasonal this year. It was a very strong month. And I will tell you that January has been exceptionally strong, exceeding our internal expectations. But I'd also say we shouldn't get carried away because we have some challenging comps in February and March, particularly in March. But we're very encouraged by what we've seen so far in January. It's been a real strong month.

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Elad Elie Hillman, JP Morgan Chase & Co, Research Division - Analyst [4]

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Great. That's helpful. And then also are you still expecting 2020 community count to be roughly like flattish? And what's the potential for the community openings to be pulled forward before 2021? And then specifically, like how should we think about community count growth in 1Q?

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

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Community count growth would be flattish to slightly up this year. I know community count growth is important. It's something that everybody is focused on. But we don't see it as the end-all be-all. What really matters is absorptions. Our absorption increases have been very strong throughout 2019, and we expect them to continue to improve. Higher absorptions allows us to leverage our overhead, allows us to improve our return on invested capital. It has many advantages to the company of more than just growing community count. That said, as we commented in our remarks earlier, we bought more than 18,000 lots last year. That's going to result in strong community count growth next year. Precisely what quarter that comes in, it's really too early to tell. We think it will be relatively even throughout the year. But I'm not ready. So a lot of things have to fall into place from a development entitlement perspective for us to give specific guidance on each quarter in 2021. But we think 2021 is going to be a really, really big year for the company for community count growth.

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

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And we think 2020 will be relatively flat.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [7]

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Yes. I said flat to modestly higher.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [8]

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Yes.

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Operator [9]

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Our next question comes from Alan Ratner with Zelman & Associates.

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Alan S. Ratner, Zelman & Associates LLC - MD [10]

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Congrats on another great quarter and a strong end to the year. Steve or Hilla, I'm not sure which one of you want to take this, but my first question is just kind of on the drivers of the guidance for the year. And I think closing growth somewhere in that kind of mid- high single-digit range definitely makes sense, given the comps are coming up against and what your comments are on community count. But given the fact that your business right now is predominantly a spec business. The way I generally am thinking about this is, to some extent, you're going to control the volume that comes through and perhaps price and margin becomes more of [the solve point] based on where demand is. And I'm just curious, if you -- when I look at your spec count, it's up about 20% right now year-over-year. If the market continues on this solid footing and certainly, your January comments are really encouraging, is there potential to take that volume growth higher? Or in that scenario, would you kind of keep that steady mid-high single-digit growth rate and push more on the price and margin front? Just curious how you're thinking about that.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [11]

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No. I think in the entry-level space, there are some price ceilings. Obviously, we can push price to some degree. But no, there's significant competitors out there that are really focused on driving volume. And if we're going to be competitive with them, then we're going to have to do the same. I think we have the spec inventory to produce higher volumes, but we're just going to have to balance price and pace. And I think we can do that. I think we can do that. But I think, for us, it's about leveraging our overhead and being more efficient. And we get there more from volume than we do through price.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [12]

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Yes. I think, Alan, to your point, the guidance -- the midpoint of the guidance is high single digit. But the top end of the guidance is low double digit. So depends on what the market is going to give us, but we're not willing to sacrifice volume for margin at this point.

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Alan S. Ratner, Zelman & Associates LLC - MD [13]

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Got it. That's very helpful. Just to hear your thinking on that. And Steve, you touched on the overhead. So I know you haven't given formal SG&A guidance. But with the kind of the midpoint of revenue being roughly flattish, maybe up a tad, how should we think about SG&A leverage in 2020?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [14]

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I think we'll be able to continue to reduce SG&A as a percentage of the revenue, but I don't want to give any specific numbers at this point. But directionally down.

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Operator [15]

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Got it. Our next question comes from Stephen Kim with Evercore ISI.

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Stephen Kim, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Housing Research Team [16]

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Great quarter. Steve, just to touch on that -- follow on, on that answer regarding SG&A. Is it right to think -- well, first of all, directionally down, I assume you mean year-over-year. And then is it right to think that SG&A dollars increase a quarter or 2 ahead of when the communities -- the community ramp actually comes online? Or should we think about the dollars you spend on SG&A sort of increasing as the communities come online?

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

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Well, I'm going to answer the first part, in that yes, year-over-year. I'm going to let Hilla take the rest of it.

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

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So a big piece of the increase that we have before a community goes live, as you guys know, we have a really big ramp-up to 300 communities, I apologize, I said 300 million communities in my prepared remarks, so obviously 300. The ramp-up is actually happening at the margin line. So it's in the overhead component, where we have folks on the ground prepping for a community. It's not so much in the G&A line, maybe just a hair in the G&A line. So even with that increased burden in our margin, we're still holding to that mid-19s for full year.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [19]

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For gross margin.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [20]

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For gross margin, and as Steve said, directionally lower for full year SG&A margin. There's a couple of noise issues that we called out in 2019 that won't be recurring in 2020, although the cost of operating our Studio Ms obviously will continue.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [21]

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Yes. But obviously, if you go back to the first question we had today, volumes are better and that will allow us to do even a better job with our SG&A because we'll be able to leverage it even more. But directionally down SG&A for the year, driving that mid-19s gross margin based upon the guidance that we've put out for closings.

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Stephen Kim, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Housing Research Team [22]

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Got it. And then regarding the gross margin, just wanted to clarify a couple of things. First of all, there was the commentary about moving about, I think you said, 40 bps of margin benefit into the GM out of the financial services. I got the impression that was a fourth quarter event. I assume it did not affect any of the other quarters of last year. I wanted to know whether or not -- what we can expect, basically, in terms of that kind of a transition from one line to the next or from the -- out of the financial services into the gross margin in 2020. If you could dimensionalize that for us?

And then regarding the gross margin, broader gross margin comment and pricing comment, Steve, that you made earlier to Alan. I think you were talking about balancing price versus pace. You talked about the fact that there is kind of a ceiling at the entry-level. But isn't it right to think that with mortgage rates, probably, if anything, coming down with a little bit of loosening perhaps coming in the form of maybe less onerous DTI calculations, that the entry-level prospects look really good here from an affordability perspective, near term, as sequentially from the last, let's say, 6 months to the next 6 months. And in that context, you do have the ability to move price up because of these other factors in terms of lower borrowing costs and so forth, and you would be positioned to take advantage of that. Is that -- I mean that's a correct way of thinking about it, right?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [23]

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Yes, of course. Yes, of course. [Amazing]. And certainly, what we've seen in January so far, it's been really encouraging. But you also got to keep in mind that more volume just means probably a higher cost. And we're already starting to see a little bit of pressure on lumber prices. So it won't all come to the bottom line. But clearly, I'm not saying that we're not -- you can't raise prices at all at the entry-level. Certainly, you can. But you got to keep the homes affordable to drive the value equation to be competitive. I'll let Hilla talk about the mortgage joint venture and what we're doing there.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [24]

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Sure. So Stephen, you're right. It was a Q4 event. It will continue on a go-forward basis. So it's not impacting the first 3 quarters of the year. And just to clarify, it was 30, not 40 bps. We still have financial services operations with our title and insurance companies that will continue to flow through our financial services, with our insurance companies just starting to ramp up, you'll see that become more meaningful into 2020 and beyond. But it's just the mortgage component that's changed, and it will continue to be in revenue and margin versus financial services on a go-forward basis.

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Stephen Kim, Evercore ISI Institutional Equities, Research Division - Senior MD & Head of Housing Research Team [25]

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And so just to clarify, you're basically, in zooming in your gross margin commentary of mid-19s, roughly 30 basis points of betterment year-over-year largely because of this factor, correct?

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [26]

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Correct.

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Operator [27]

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Our next question comes from Susan Maklari with Goldman Sachs.

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Susan Marie Maklari, Goldman Sachs Group Inc., Research Division - Analyst [28]

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I guess to begin with, can you talk a little bit to some of the regional trends that you've been seeing? You highlighted the fact that California seems to be stabilizing. Can you just give us a bit more color on that?

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Phillippe Lord, Meritage Homes Corporation - COO & Executive VP [29]

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Yes. This is Phillippe. Last year, California was a difficult market. There's a lot of incentives, demand wasn't there, buyer confidence was pretty low coming out of '18. We've seen it firm up quite a bit here in the last 2 quarters. Prices are definitely starting to firm up. More importantly, demand is there, the quality of traffic, the buyer interest, the consumer confidence is much better. So early on, again, at the back half of last quarter, and early in January, we're seeing much different kind of conditions. I think we've got a long ways to get back to where we were before this all happened. I would tell you, Northern California feels a little bit stronger than Southern California. And I would also tell you that obviously entry-level feels a little stronger than anything else. But overall, we're feeling optimistic that California is kind of turning the corner. I think incentives will still be part of the game out there, but a much firmer pricing structure than we're seeing last year.

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Susan Marie Maklari, Goldman Sachs Group Inc., Research Division - Analyst [30]

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Okay. Great. That's very helpful. And then turning to the land side. You noted that you put, I don't know, more than 16,000 lots under control in the last few quarters. Can you talk to how you're thinking about the optioned piece of that? How we should be thinking about that going forward?

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

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Sure. So you can see that our optioned percentage of land increased to 37% from low 30s where we've been the last couple of years. So that was encouraging. We're definitely looking to get to that large community count growth leveraging our own balance sheet, of course, but also off-balance sheet opportunities. So we're actively seeking incremental off-balance sheet financings for our lot acquisitions. And hopefully, you'll see that number continue to increase.

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Operator [32]

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Our next question comes from John Lovallo with Bank of America.

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John Lovallo, BofA Merrill Lynch, Research Division - VP [33]

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The first one, I guess, for Phillippe. You mentioned Northern California feeling a little bit better in particular. What are the price points that you're seeing the most interest at there?

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Phillippe Lord, Meritage Homes Corporation - COO & Executive VP [34]

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I think if you're below $450,000, it definitely feels much stronger. That's -- essentially, most of our communities that we're opening up are LiVE. NOW. communities, and we're focused on that sub-$500,000 price point, but even closer to $400,000 where it feels really good.

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John Lovallo, BofA Merrill Lynch, Research Division - VP [35]

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Okay. That's helpful. And then in terms of the gross margin outlook, Hilla, can you just kind of help us with some of the underlying thoughts on cost inflation and maybe the change in product mix that you guys are contemplating in that outlook?

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

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The product mix is not going to look too different than where we are right now. We've pretty much hit our target with the only exception being the contribution from our noncore products that nonentry-level and first time move up is going to be pretty de minimis in 2020. So that incremental 10%-ish that's still coming from not first-time or entry-level, first-time move-up or entry-level is going to shift to those 2 categories. You can see that with the ASP reductions that we've guided to, $360,000 to $370,000 for the full year is notably what we're -- than where we were in 2019. And then in the gross margin, I think Steve mentioned it, we're starting to see a little bit of noise around lumber. Everything else is feeling pretty normal. We still have some pricing power. I think Steve covered it fairly well as to what we can and can't and won't push above a certain point. But we don't feel like what we're seeing on the cost side is going to give us concern beyond what we can offset on the revenue side even with all of that and the incremental labor burden that we've talked about with getting these new communities online for 2020. We're still very comfortable guiding to a higher overall gross margin.

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Operator [37]

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Our next question comes from Truman Patterson with Wells Fargo.

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Truman Andrew Patterson, Wells Fargo Securities, LLC, Research Division - Associate Analyst [38]

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Let me throw out there another congrats on a good quarter. First, just wanted clarity on the prior question regarding community count. That's flat to up, that's by year-end, correct?

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

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That's correct. It may dip a little bit through the year, but we should finish the year flat to up.

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Truman Andrew Patterson, Wells Fargo Securities, LLC, Research Division - Associate Analyst [40]

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Okay. Okay. You've gone out and aggressively purchased lots in 2019. Are you still finding attractively, and that's hitting or exceeding your underwriting hurdles? Have you had to adjust some of those hurdles in certain regions? And then just wanted to get an update on that 300 community count target by the end of 2020. One, how much more do you have to go on the land side? Or do you pretty much have all of your land bank in hand?

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

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I would say we're absolutely continuing to find land that we like that fits our strategy for both entry-level and first move-up. Number two, we have not changed our underwriting criteria at all. If anything, we've continued to refine it and tighten it. And number three, we have identified much of the land, most of the land, almost all of the land that we need to get to that 300 community count, but we still need to get the land fully contracted, documented through the entitlement process, developed, open, et cetera. So still much work to do, but we see a pathway to getting there. And we're going to work real hard to make that happen.

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Truman Andrew Patterson, Wells Fargo Securities, LLC, Research Division - Associate Analyst [42]

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Okay. Great. Jumping over to your backyard in Phoenix, it's been pretty red hot over the past year or so. Historically, it's gone through these many boom and bust cycles, at least this cycle. It seems like the Phoenix orders decelerated a bit. They were still up about 18%. But do you think Phoenix is at risk of softening at all? Or how should we think about that market in 2020?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [43]

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No. Absolutely not. The ebbs and flows of the orders in Phoenix are really more related to community openings and closings, and it's not a straight line on store count and lot availability. So we closed some communities. We waited on some lots to be available in some communities. We're opening some new communities. We're getting rid of some older 2MU communities. But we've made some significant acquisitions of lots in 2019 that we're bringing on in 2021 to really fuel that entry-level market. The Phoenix market has made tremendous strides in job growth over the last several years. I think that the Phoenix market's been averaging almost 100,000 jobs a year. And good news and bad news is a lot of those jobs are more lower wage jobs that really feed into the entry-level market. And that's why that market is so strong here versus the move up in luxury market being a little bit more challenged. And I don't see that continuing. I think there's a pent-up demand for quality, affordable entry-level homes and, the Phoenix market is going to be taking advantage of that.

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Operator [44]

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Our next question comes from Carl Reichardt with BTIG.

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Carl Edwin Reichardt, BTIG, LLC, Research Division - MD & Homebuilding Analyst [45]

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Hilla, can you talk about -- or Steve, Phillippe, the sort of the net opens and closeouts? You're flat to slightly up communities in '20, but what percentage of the total you've got now when you close out versus open?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [46]

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I think -- I don't have the exact number, but I think most of [the big homes] that we're going to be opening are going to be entry-level. I know in the first quarter, we're closing out 6 or 7 2MU communities. So we're just continuing to move towards better absorbing communities. We have some really exciting, large, well-positioned communities we're going to be opening in Texas in the next quarter or 2 that should drive some meaningful absorptions. So I'm not trying to try to undersell the community count issue that we have. But I think it's quality over quantity. And we're continuing to move our business to the right place in the market where there's the most demand. And that could propel off the top line for us if the market continues to remain strong.

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

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So Carl, I look at it -- we've been very vocal about our intent to have a 4- to 5-year supply of lots. It takes about a year to 1.5 years to get lots going. That means you're selling through a community 3-ish years. of course, there are some that are 4, some that are 2, some that are 5. So for us, if you think about roughly a 3-year community life, about 1/3 of your communities are turning annually, a little less, a little more, but that's just like a rough figure in any given year.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [48]

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With that said, with our shift to entry-level, we've been focused on buying larger lot positions to reduce the turnover.

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

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Yes.

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

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Because the turnover -- smaller lot positions with higher turnover doesn't help us leverage our overhead. There's a cost of getting in and getting out. And we'd rather find bigger positions that are more in the sweet spot of the entry-level market that we could stay in longer. So our average number of lots that we're buying per transaction just continues to increase. And as we move into later years, we think the churn is going to decline and that will help a lot of the other metrics as well.

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

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Yes. Okay. That makes sense. That was going to be my next question. So you just answered it. I did want to ask Phillippe, though, just in terms of the mix shift in the East, if -- I just want to make sure I understand this. If you think your core mix right now of LiVE. NOW. versus other for the company is going to be roughly similar through this year, but the East still needs to make more of a move towards LiVE. NOW., is that the right way to think about the most move toward -- mix move in '20 towards LiVE. NOW. will be in the East?

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Phillippe Lord, Meritage Homes Corporation - COO & Executive VP [52]

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Yes. That's the right way to think about it. As I think I said in our prepared comments, we're around mid-30s in the East for entry-level and our target, our goal, if you will, for each region is to get to near 50%. So there's a lot of opportunity. Most of the communities that we're opening up this year and next year in the East are LiVE. NOW. entry-level communities, which is really going to propel our absorptions. In the other regions, we've kind of achieved the goal, although there's still some opportunity there as well in Texas, Florida, et cetera.

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Operator [53]

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Our next question comes from Alex Barrón with Housing Research Center.

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Alex Barrón, Housing Research Center, LLC - Founder and Senior Research Analyst [54]

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Great job. Steve, I wanted to ask you about the point you just made about the larger communities. Can you give us a sense of roughly how much larger are they versus, say, a year or 2 ago before you guys kind of shifted strategies? In other words, what does the new community look like? Is it like 200 lots versus 100 lots? Can you just kind of give us a sense of what the change is versus 2 years ago when -- before you kind of shifted strategy?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [55]

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Yes. I think the average today is about 140. And a couple of years ago, a couple of few years ago, it was probably about 80. But I'd say the median is probably even higher than 140 because we've bought a lot of 200, 300 or 400 lot positions last year. We've bought many positions where we're going to have multiple product offerings. We may have 40-foot value homes and townhouses together in a community. We may have an entry-level 1MU positioned together. So that also allows us to leverage our overhead better and be more efficient from a marketing perspective, from a construction supervision perspective. So that is -- that's where we're heading.

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

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Okay. That's helpful. So basically, even if you have a flattish, call it, community count, it doesn't necessarily mean there's an equivalent order pace?

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Phillippe Lord, Meritage Homes Corporation - COO & Executive VP [57]

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No. That's why we're buying bigger deals is because they absorb much faster with kind of the 80 lot deals we were buying 2 years ago when we were primarily focused on move up. We're now buying entry-level deals where the absorptions are 1.5x what we were thinking a couple of years ago when we were focused on a higher price point.

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [58]

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Yes. I mean that's reflective in the guidance we gave. We guided to 10,000 or so closings versus around little less than 9,300 this year on a flat community count. So that means we're going to have higher absorptions.

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Phillippe Lord, Meritage Homes Corporation - COO & Executive VP [59]

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Yes. I mean that's the whole deal. You take X percent of our land book that's absorbing at 3 a month and you replace it with another group of communities that are absorbing at 6, lower ASP, but still, the volume is huge, volume difference.

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Alex Barrón, Housing Research Center, LLC - Founder and Senior Research Analyst [60]

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Got it. Yes, that makes sense. Now a couple of your larger peers commented that they are starting to kind of feel labor shortage issues again. I'm just wondering whether you guys are seeing that or whether you have any concerns that labor availability will affect your ability to deliver homes?

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Phillippe Lord, Meritage Homes Corporation - COO & Executive VP [61]

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Right now it feels pretty stable to us. We're not seeing very much on the labor side. I mean it's still tight out there. We still have all -- some of the macro issues that we're all trying to deal with. But it seems like it's pretty stable right now. Like Steve said earlier, right now, what's -- what we're sort of seeing out there is lumber, some increase in lumber, but not necessarily the labor piece of that. But spring selling season is really strong. We'll have to see what that looks like. I believe our strategy, focusing on just dedicating to specs, we've really simplified what we're doing. I think our homes are easier to build than some of our competitors. So we have a pretty good access to labor right now. We feel like we're a builder of choice out there. So we hope that helps us solve that a little bit better than everyone else. But right now labor feels pretty stable and feels like it has capacity.

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Operator [62]

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Our next question comes from Jade Rahmani with KBW.

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Jade Joseph Rahmani, Keefe, Bruyette, & Woods, Inc., Research Division - Director [63]

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In terms of the guidance, the biggest differential was ASPs. And was wondering if you could give any color on that, particularly given the 1Q guidance that you provided on ASPs of $380,000 to $390,000, which is higher what you -- than what you expect for the full year.

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Hilla Sferruzza, Meritage Homes Corporation - CFO & Executive VP [64]

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Right. As we continue to close out of those move-up communities throughout the year, you're going to see our ASP continue to decline. So it's the combination of the closeout of the higher end communities and the accelerated openings of the first time move-up and entry-level communities. You're going to see a pretty notable mix shift throughout the year. It's pretty successive, so you'll see that decline throughout 2020. But yes, this will be our highest ASP quarter -- the quarter that we're in right now. Q1 will be our highest ASP quarter, and then we'll continue to ratchet back down to get to that $360,000, $370,000 full year number.

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Jade Joseph Rahmani, Keefe, Bruyette, & Woods, Inc., Research Division - Director [65]

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On homebuilder M&A, with respect to local private builder M&A, are you seeing anything notable in terms of trends, in terms of deal flow? And what are your overall thoughts about whether that makes sense to add to Meritage's platform?

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Steven J. Hilton, Meritage Homes Corporation - Chairman & CEO [66]

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There's nothing going on right now that's unusual. It's pretty much steady with what it's been the last few years. We continue to keep an open mind to many different opportunities. And to the extent that it fits with our strategy and our culture and the prices reached is fair, we will be pursuing private builder acquisitions. But I can't say that it's a stronger or weaker market at this moment than it has been the last couple of years, pretty much the same.

I think that was our last question, operator. And I will thank everybody for participating in our 2019 year-end call, and we look forward to talking to you in April with our first quarter results. Thank you.

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Operator [67]

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