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Meritage Homes Corp  (NYSE:MTH)
Q3 2018 Earnings Conference Call
Oct. 25, 2018, 11:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good morning and welcome to the Meritage Homes Third Quarter 2018 Analyst Conference Call. All participants will be in listen-only mode. (Operator Instructions) After today's presentation, there will be an opportunity to ask questions. (Operator Instructions) Please note this event is being recorded.

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

Brent Anderson -- Vice President, Investor Relations

Thank you, Chad. Good morning. Welcome to our analyst call to discuss our third quarter and year-to-date 2018 results. We issued the press release after the market closed yesterday and you can find it along with the slides for this call 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 two and remind you that our statements during the call, as well as the press release and slides, contain forward-looking statements, including our projections for 2018 operating metrics such as closings, revenue margins and earnings. Those and other projections represent the current opinions of management, which are subject to change at any time and we assume no obligations to update them. Any forward-looking statements are inherently uncertain and actual results may be materially different than our expectations. We've identified the risk factors that may influence our actual results and listed them on this slide, as well as in our press release and most recent filings with the SEC, specifically our 2017 Annual Report on Form 10-K and subsequent 10-Q for the second quarter of 2018.

We've also provided a reconciliation of certain non-GAAP financial measures referred to in our press release and presentation as compared to their closest GAAP measures.

With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage; Hilla Sferruzza, Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage. We expect to conclude the call within about an hour and a replay will be available on our website approximately an hour afterwards and then it will remain active for approximately two weeks.

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

Steven Hilton -- Chief Executive Officer

Thank you, Brent. I'd like to start off by thanking some of my peers who report before us for taking some of the initial slings and arrows that we were initially expecting in light of the recent shift in the market. So, we're going to try to keep this light and fun today.

So, I'm going to start off on slide four. I'll begin with a few highlights of the quarter, then review our progress on the strategic shift we entered into a couple of years ago, and finally discuss some recent market conditions.

First, we had another quarter of good earnings. We delivered double-digit closing and pre-tax earnings growth over last year in Q3. Our total home closing growth grew 10% over last year, primarily due to an improved performance in the South and higher backlog conversion associated with our entry-level strategy. Combining the increased closes with the price increases we took earlier in the year, we were able to hold our home closing gross margin and overhead leverage steady despite significant cost headwinds, which Hilla will discuss in more detail later.

Pre-tax earnings increased 13% and net earnings increased 27%, benefiting from a lower statutory income tax rate this year. As a result, diluted earnings per share were up 30% year-over-year which increased our earning book value per share to $42.51.

Second, our East region contributed significantly to those year-over-year gains with 32% more closes in the third quarter, which generated 31% greater home closing revenue over last year. The gross margin on those closes improved 160 basis points year-over-year, which greatly narrowed the gap between the East and our other two regions. Those improvements are mostly the result of some self-help measures we have implemented in the last couple of years as one of our strategic initiatives and we want to recognize those employees who have contributed to that success.

Now, I'll turn to slide five. Third and most importantly, we continued our strategic investments, focused exclusively on the entry-level market and affordable first move-up homes. We believe this positions Meritage to address the largest group of home buyers over the long-term, namely millennials and baby boomers, as we exit out of the topper second-time move-up in luxury markets.

We opened 19 new entry-level communities during the quarter, more than half of the total new communities opened in the quarter continuing our expansion into the market. Entry-level communities made up a third of our total active communities and 43% of our total orders for the third quarter, a significant increase over 2017, with entry-level represented 33% of our total orders and much higher than our starting point of 24% in 2016. Consistent with our last several quarters, approximately 80% of the lock we put under contract during the quarter were for entry-level homes. The demand in our entry-level communities continue to outperform our move-up stores. They've not only sold at a much higher absorption pace to our move-up homes, but the margins were also slightly higher for the entry-level homes compared to move-up homes.

As expected just under half of our closes in the third quarter were from spec inventory. We're building mostly on a spec basis in most of our entry-level communities. Our third quarter were 2% lower than last year's and our backlog was down 1% year-over-year, reflecting the recent softening in market demand. While this makes the short-term outlook less -- look less certain, we believe the long-term outlook the housing market continues to be positive based on demographics and economic trends. Employment is high, wages are growing, consumer confidence is high and inventories of home are still low, especially for the affordable entry-level single-family homes.

Our strategic shift anticipated slowing demand at the higher end of the market and we've been pivoting to do focus more entry-level and more affordable first time move-up markets and we've been purchasing land for these price points aggressively for the last couple of years. We believe that this is the right strategy for us and we are confident that Meritage is well-positioned for the long-term as the market continues to shift that direction. However, the next several quarters may be choppy for our industry as buyers adjust their expectations for interest rates.

I'll now turn it over to Phillippe for some additional insights into our operational performance. Phillippe?

Phillippe Lord -- Executive Vice President and Chief Operating Officer

Thank you, Steve. I'll address our third quarter order trends, as well as our outlook and plans in an operational level. Slide six. As others have reported already, market conditions have become more challenging over the last couple of months. We believe the third quarter order decline reflected a combination of normal seasonality, buyers hesitating as they have adjusted the impact of higher home prices and interest rates, and what they can afford and what they can expect in selling their existing home. We saw that reflected in our overall order trends which masked the positive impact we would otherwise be seeing from our shift to the entry-level market.

Despite the 2% decline in third quarter orders, we were encouraged that traffic and gross orders were both up year-over-year, though cancellation spiked at the end of the quarter. Our third quarter cancellation rate increased to 17% this year from 13% in 2017, indicating more buyers uncertainty as well as an inability of some buyers to qualify for lowest credit levels and delays in selling existing home for move-up and move-down buyers. We also had some weather-related disruptions from Hurricane Florence in the Carolinas and unseasonably wet weather in Texas. We expected to sell out of a number of communities during the quarter which we didn't do, so our average active communities for the quarter of 2018 was up 2% which was higher than we forecasted.

The decline in orders and increase in average community count reduced our average orders per community, which was 7.1 this year compared to 7.4 in the third quarter of last year. The slowing in move-up orders and higher volume cancellation masked the fast order pace per community from our higher absorption entry-level communities. We did see a decrease in our average sales price to approximately $391,000 compared to $480,000 a year ago as our entry-level communities became a greater portion of our volume and our California operations declined notably due to a limited community count.

Slide seven. Our East region orders were down 9% year-over-year in the third quarter after being up 12% last quarter. Slower sales were evident in the 14% decline in absorption per store. Hurricane Florence was responsible for part of the declines in North and South Carolina as we lost about two weeks of activity due to the preparations and aftermath. Additionally, we saw few orders at move-up price points across the region with a more broad-based slowing in Atlanta. With only about a quarter of our communities based in the entry-level buyer in the East, we weren't able to offset declines in our move-up communities with higher entry-level orders to the same extent as our other regions.

Slide eight. Moving to slide eight, the Central region continued to be our strongest performer. We've encountered some buyers at higher price points in Dallas and to some degree is Houston more recently, but our Austin and San Antonio communities which are predominantly entry-level continued to sell well as they are in the sweet spot of the market. Our 9% increase in order pace for the Central region more than offset a 2% decline in average community val compared to last year's third quarter.

Slide nine. Our orders in the West region were down 5% year-over-year, reflecting a 40% -- 42% decline in our average community count California and softening in the market from rising interest rates and affordability challenges. Despite a slight decline in our Arizona absorptions we produced the highest orders per average community here for the quarter and we remain very positive due to our solid entry-level presence as well as local demographics and economic trends. Colorado has been our highest absorption market in the company year-to-date. Our long-term outlook for the market remains very positive though we saw an increase in cancellations in September, mostly at higher price points. We have recently introduced more affordable cash products and expect to see solid performance from our new entry-level flags there.

I'll now hand it over to Hilla to provide some additional information. Hilla?

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

Thank you, Phillippe. I'll provide some additional details on our P&L as well as covering the land and balance sheet metric. Beginning on slide 10. Our home closing gross margin for the third quarter of 2018 was 18.1% and included a $2.6 million charge to write-off assets associated with the purchase agreement in California that we entered into several years ago, but decided to terminate since it wasn't consistent with our current strategy. The charge impacted our home closing margin by 30 basis points which otherwise would have been 18.4% in line with our second quarter guidance. This also impacted diluted EPS by approximately $0.05 per share.

We did get some relief from lumber pricing that came down in the third quarter from the highly inflated levels we've seen for most of the year. That pickup will begin to benefit our closing margin at the tail end of this year and into 2019. Total SG&A was relatively flat as a percentage of home closing revenue for the third quarter at 11% in 2018 compared to 10.9% in 2017. We incurred the charge to true-up our healthcare insurance reserves due to some rising costs and also decided to accelerate the reconfiguration of our move-up design studios and roll out of new technology for our entry-level sales centers. The total impact of these expenses on our SG&A was approximately 35 basis points for the third quarter of 2018.

Our year-to-date net earnings are up 41% over last year and diluted EPS was up 45% year-over-year for the first nine months of 2018, reflecting the higher closing volume, improved year-to-date gross margins and lower 2018 tax rate.

Turning to the balance sheet and cash flow items on slide 11. Our net debt-to-cap ratio came down to 39.2% at September 30, 2018 from 41.4% at the end of 2017. We are comfortable dropping below our low 40% target as we evaluate the current pause in the market and may choose to either reinvest excess cash in land purchases as the market conditions stabilize or redeploy it into debt and equity repurchases if the recent pullback is more than temporary.

We used $29.4 million of our $100 million share repurchase authorization to purchase and retire approximately 686,000 shares at an average price of $42.79 per share in the third quarter. And we're planning to repurchase additional shares this quarter. We expect to see the benefits to our EPS on a go-forward basis.

Total land and development spend was approximately $193 million in the third quarter of 2018 compared to $286 million in last year's third quarter. For the first nine months of 2018, our total land and development spending is approximately $154 million less than last year. We have terminated positions that are no longer aligned with our low-price point strategy and are being more conservative in our land underwriting, although we're still actively tying up lands that fits our strategy. We added approximately 3,400 new lots under control during the quarter. 82% of the lots we've added under control year-to-date in 2018 were for entry-level zones.

Our total lot supply at September 30, increased by approximately 1,100 lots year-over-year to about 34,400 lots. That translated into our 4.2 year supply based on trailing 12-months closing this year compared to 4.4 year supply at September 30, 2017. We owned about 66% of our total lot inventory with the remainder under contractor option as of September 30, 2018.

Slide 12. Based on our softer orders in the third quarter and the first few weeks of October, we're adjusting our projections for full-year 2018 home closing to approximately 8,300 homes to 8,500 homes, with total homes closing revenue of roughly $3.375 billion to $3.475 billion. That's about 6% to 9% growth over 2017. We are also slightly adjusting our expectations for home closing gross margins to be about 18% for the full year compared to last year's 17.6%, in anticipation of potential price pressures and reduced leverage. The net effect of those revisions reduces our pre-tax earnings expectations to roughly $265 million to $285 million for the full year. Our effective tax rate is expected to remain at 25% for the balance of 2018.

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

Steven Hilton -- Chief Executive Officer

Thank you, Hilla. In summary, we are pleased with the earnings growth we've delivered so far this year and believe we are well positioned in the market for the long-term with our focus on providing more affordable homes. We've been pivoting down the price band for two years and we believe this will be the best place to be as the market cycles given the shortage of affordable single-family homes. Rising interest rates only intensify this shortage. We've been expecting interest rates to rise; we've had a 5% to 6% interest rate in mind as we have evaluated new community positions. We're confident that our strategy is appropriate for these market dynamics and will serve us well over the long-term. Thank you for your support at Meritage Homes.

We'll now open it up for questions, and the operator will remind of the instructions. Operator?

Questions and Answers:

Operator

Thank you, sir. We will now begin the question-and-answer session. (Operator Instructions) The first question will be from Michael Rehaut with JP Morgan. Please go ahead.

Elliot -- JP Morgan -- Analyst

Hi. Good morning. This is Elliot (ph) on for Mike. You mentioned that 3Q cancellation rate increased, I think, to 17% versus 13% last year. Would you be able to provide that by month, and where it ended the quarter?

Steven Hilton -- Chief Executive Officer

No, we can't give that up by month, but it did end the quarter at 17%.

Elliot -- JP Morgan -- Analyst

Okay. Was that a quarter-end number or is that kind of the average over the quarter?

Steven Hilton -- Chief Executive Officer

That's the average over the quarter but it was probably a little higher than that in September.

Elliot -- JP Morgan -- Analyst

Okay. Great. Thank you. And then secondly, how did sales pace progress throughout the quarter, maybe you could provide that on a month-to-month, and then also just kind of year-on-year for those months, and what have you seen so far in October?

Steven Hilton -- Chief Executive Officer

So, without giving you specific numbers, I can tell you that July was weak, we had the 4th of July which was in the middle of the week. A lot of people took off the entire week, so the first two weekends in July were pretty soft. But then in the latter part of the July, sales popped back. But for the whole month, we were down in our year-over-year comp. August was a good month, we had a double-digit increase in August from the prior year. But then in September, things slowed down again and we had a weaker September. We had more cancellations come in later in September. And October has been soft so far. So, we still have another weekend left in October, but the first few weeks have been pretty soft.

Elliot -- JP Morgan -- Analyst

That's helpful.

Steven Hilton -- Chief Executive Officer

I can tell you that our traffic has held up really well. Our traffic is in line with last year and even slightly up in some places. So, it's not a question of whether people are interested in buying new homes that we believe that they are. We just think they are taking longer to make decisions and they're taking a bit of a pause to digest these higher prices and higher rates.

Elliot -- JP Morgan -- Analyst

Okay, thank you.

Operator

The next question comes from Stephen Kim with Evercore ISI. Please go ahead.

Stephen Kim -- Evercore ISI -- Analyst

Yes, thanks very much guys. On this cancellations issue, we typically like to look at it on a percentage of backlog, because it's your backlog that cancels, not necessarily the orders you just took. And on that basis, your cancellation rate as a percentage of your backlog went up but not very much. So I was wondering, but obviously your commentary suggested you did see something that was worth calling out. So, I guess, I was wondering if you could put some perspective on what kind of communities and what kind of buyers were doing the cancelling? Was this more higher-end folks with contingent sales? Was this more entry-level folks who had the rates move and just simply couldn't afford, or if there's any other kind of qualitative perspective you can provide on the cancellation rate?

Steven Hilton -- Chief Executive Officer

It wasn't any one particular group, but I'd say it would tilt more toward the move-up. People that were cancelling generally fell in the bucket of buyer's remorse. We didn't see a lot of people cancel because they couldn't qualify. From what we've heard from our backlog and the people we've talked to in exit survey, when they cancelled there was -- they hadn't sold their home or they're concerned about the higher interest rate, what is it going to be versus the interest rate they have on their current home and some of them just maybe felt now is not a good time to buy. So -- and we didn't throw a lot of incentives at people to try to keep them in the backlog. So, I think it's more of a psychological factor more than a qualification situation.

Stephen Kim -- Evercore ISI -- Analyst

Okay. That's actually really important about the incentive comment and that's actually where I was going to go next. So in general, we imagine builders move to pull the incentives lever first to the mortgage company and through increasing or giving away some options and so forth so as to protect the ASP.

You've been moving to a more standardized offering obviously recently with your strong pivot to the entry-level and I was curious as to whether you could comment on your decision maybe not to incentivize as much as you otherwise could have, is that in part because it is more difficult to offer incentives in entry-level communities where you have a more standardized product, or was there a different element to your strategy that would have driven you to hold off incentivizing? And is there anything that you're contemplating right now, given what you've seen so far in October, that would cause you to make any shifts that we should know about?

Steven Hilton -- Chief Executive Officer

Well I'd say -- first of all, I'd say we have increased our incentives primarily on spec homes that we will close this year as most builders have done the same and we've done that across the board, but we've had a stronger focus on increasing those incentives in 2MU communities and communities that don't fit with our strategy.

So, we would like to accelerate our shift to more entry-level and so those assets that aren't quite in that niche, in that segment, we've offered more incentives. Although our incentives have increased a bit on the entry-level, we're clearly feeling that market is better and we don't feel like we have to give as much away to sell those homes.

Stephen Kim -- Evercore ISI -- Analyst

Okay. So you don't have to incentivize much?

Steven Hilton -- Chief Executive Officer

Well, we have to give a little more incentive right now because the newspapers are reporting a lot of misinformation. But to that degree, certainly there's more demand at the entry-level price point, so we don't have to give as much incentive there.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

And, Stephen just to clarify, we're certainly offering incentives on Q4 possible closings on spec and we're looking at every one of our communities, but there's no across-the-board massive discounting that we're doing. And Steve, we were not really seeing other builders do the same. It's a targeted strategic community by community review based on what's occurring in that market and some are holding up very well and don't need additional incentives.

Steven Hilton -- Chief Executive Officer

Yes. Just underline that, I mean it is market-by-market. We have certain markets that require a lot less incentives and are much more stable than others and I think it's been widely reported what those markets are. Certainly higher priced, less affordable markets are the most challenging of all the markets.

Stephen Kim -- Evercore ISI -- Analyst

Got it. Thanks very much. Sounds very sensible.

Steven Hilton -- Chief Executive Officer

Thank you, Stephen.

Operator

The next question will be from John Lovallo with Bank of America. Please go ahead.

John Lovallo -- Bank of America Merrill Lynch -- Analyst

Hey, guys. Thanks for taking my questions as well. When you think about the first-time buyer, maybe the millennials specifically, I mean do you think of these buyers being kind of more need-based in nature, maybe having children or getting married, just kind of needing more space. And on top of that, the fact that they don't need to sell a home, would you consider them to be somewhat less influenced by interest rates?

In other words, if cost goes up a little bit, if rates go up a little bit or prices go up, maybe they buy less home, but they're going to buy a home. And if that's not how you guys feel, I mean what would give you confidence with rates continuing to go up and no real relief in supply on the near-term horizon, what would give you confidence that this buyer is going to remain strong?

Steven Hilton -- Chief Executive Officer

Well, I think that's an accurate assessment that they're not so much focused on the interest rate, they're focused on really what the payment is, and a lot of these millennials have been renting for a long time, for a longer period of time or living in their parents' home for a longer period of time than the generation before them. And once they have children and they get married, they're going to move up to the suburbs and buy a home just like generations before them, but they're just going to have to buy that plan below. We have generally six to eight plans in our line up and there's a reason we have that many because when interest rates are higher, they got to move down a plan or two. And we have four bedroom plans, that's the smallest square footage just like we do at the larger square footage. So, I think we move back and forth on that band based upon the interest rates.

John Lovallo -- Bank of America Merrill Lynch -- Analyst

Yes. That makes a tremendous amount of sense to me. Okay. And then you guys called out that the entry-level margins, I believe you called this out, the entry-level margins were slightly higher than on the move-up which was interesting to me. I mean was this just better kind of efficiencies in the build process or was this partly due to higher incentives on the move-up product?

Steven Hilton -- Chief Executive Officer

It's for a lot of reasons. I mean some of those you mentioned, but probably most importantly it is just the demand is stronger for that product, which allows us or doesn't require us to do as much incentives. But it is more efficient for us to build; we're able to build it for a lower cost on a pound per pound basis, and our trade contractors like to build that better and it's more efficient. So for all those reasons, we are able to get a little bit better margin.

John Lovallo -- Bank of America Merrill Lynch -- Analyst

Yes. That's really encouraging. Thanks guys.

Steven Hilton -- Chief Executive Officer

Thank you.

Operator

Our next question will be from Stephen East of Wells Fargo. Please go ahead.

Paul Przybylski -- Wells Fargo Securities -- Analyst

Yes. This is actually Paul Przybylski on for Stephen. I guess correct me if I'm wrong, but am I hearing it correctly that you're still focused on price versus pace given your lack of incenting I guess your backlog and focus on incentives on spec for the end of this year?

Steven Hilton -- Chief Executive Officer

Well, I'd say certainly through the third quarter, we were more focused on price than pace. As we rotate into the fourth quarter, we have to get pace. We still want to get price. We're not going to give the farm away, but we got to get some pace. And so for that reason, we're increasing our incentives on spec homes that we can deliver this year and time is running out for that. We have a few weeks left and then we're going to be selling into next year. Even if you buy back a spec, we won't be able to finish in time. So just as all builders are doing, we're trying to finish off our year strong and get these homes that are done off the books.

Paul Przybylski -- Wells Fargo Securities -- Analyst

Any color on what your gross margin is and backlog at the end versus what you reported for the company this quarter?

Steven Hilton -- Chief Executive Officer

I think it's pretty close to the same.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

We're not expecting a deterioration throughout the year. Part of that is, we have strong numbers coming into the quarter. We also have this incremental leverage in Q4 on higher volumes. If you kind of do the math and get to that 18%-ish full-year guidance, the Q4 numbers have to come in a little bit at -- or a little bit better than what we did in Q3.

Paul Przybylski -- Wells Fargo Securities -- Analyst

Okay. I guess how long do you think it will take for you to completely move your offering base to entry-level and first move-up, and be completely done with second move-up and luxury?

Steven Hilton -- Chief Executive Officer

Well, we're going to be about 35% brand target of communities that face the entry-level buyer. At the end of this year, we're going to be maybe another 10% higher or so. By the end of next year, it will be a 45%, maybe with a little tailwind we can be at 50% by the end of next year. But we're getting closer and I think we'll be pretty much out of most of the 2MU. By the end of next year, we'll have a few stragglers of course that will go into 2020, but it will become more of an irrelevant number as we get later into 2019. And then when we think about the 1MU market, we're really looking at all of our land positions and the contracts on the land that we have tied up and really trying to focus on the 1MU communities that are really more affordable, in the lower end of that bracket and that are really the more desirable 1MU projects.

Paul Przybylski -- Wells Fargo Securities -- Analyst

Thank you.

Steven Hilton -- Chief Executive Officer

Thanks.

Operator

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

Timothy Daley -- Deutsche Bank -- Analyst

Hi, this is actually Tim Daley on for Nishu. Thanks for the time. So my first question is, this quarter saw the first share buybacks done in several years and it clearly was telegraphed with the discussion on the last call following the authorization. But just thinking about it, Steve, how should we interpret this move? And then the statement in the press release from the prepared remarks regarding buybacks -- is this going to be more of a structured program or are you going to be kind of attacking buybacks as a more opportunistic, I guess, style there?

Steven Hilton -- Chief Executive Officer

Well, I think it's sort of both; it's structured for now. Certainly at these prices, it's attractive to us. We have $100 million authorization and we're going to continue to execute on that. And then as we go into next year, we'll see where we are. We have a board meeting coming up in November. Certainly we'll be talking about it there, but we actually have to stop buying back stock when we went into a blackout period which was --

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

September 15th.

Steven Hilton -- Chief Executive Officer

September 15th. So, all the shares we bought were prior to September 15th and clearly the prices are lower since then, and we'll get back into the market here since we can.

Timothy Daley -- Deutsche Bank -- Analyst

Understood. Thanks for the color. I guess and then the second question. So Hilla, you mentioned the headwinds to SG&A this quarter from the reconfiguration of the move-up design centers as well as the improvement in the -- I guess, I think it was the technology in the entry-level sales centers. So, can you just provide a bit more color on these changes? And then as well if you can some -- any kind of benefit or reversal of the headwind that I guess you guys quantified for us this quarter? Thanks for the time.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

Sure. So, I think we've talked about it previously that we're doing a change up in how we sell options at the first time (inaudible). So there's some physical and technology changes that we need to do in order to get that new process up and rolling. So that is under way. We have a couple of divisions already completed and we're rolling through the rest of the country, that cost will continue on although at a more mitigated level going into '19. We're pretty much done with the rollout of our new sales process and new technology upgrades in our entry-level communities, so that's behind us. I do think we're going to be able to see some additional leveraging of SG&A into Q4 and then rolling into 2019.

Timothy Daley -- Deutsche Bank -- Analyst

Okay, thank you.

Operator

Next question will be from Alan Ratner with Zelman & Associates.

Alan Ratner -- Zelman & Associates -- Analyst

Hey, guys. Good morning. Thanks for taking my question. So, if I look at slide 11, I'm calculating your specs are up about 3% year-over-year and completed specs are up almost 50%, which I know a lot of that has to do with the shift to entry-level. But, with your absorptions down a little bit here, it still seems like a really big increase. And Steve, I know you alluded to maybe increasing the incentives a little bit in October to get some year-end sales here, but reading between the lines, it doesn't sound like you had a big step-up in sales pace in October. So, at what point does that number become concerning to you? And are you doing anything either adjusting the construction start schedules or something else just to kind of really target that number, or is it at an optimal level in your opinion even with that increase?

Steven Hilton -- Chief Executive Officer

Well. As you know, Alan, we can do something really simple to have a big impact on that. We just don't start any new specs. So ---

Alan Ratner -- Zelman & Associates -- Analyst

Right. That's what I was getting at there. Is that something that you're really adjusting right now?

Steven Hilton -- Chief Executive Officer

Well, absolutely. I mean, we're not doing this in a vacuum and we were looking at that every week, every month. So, I can promise you, there won't be hell a lot of specs started in October in non entry-level communities. So, yes, we're very focused on managing that number. We think we have the appropriate amount, maybe have a little too much here and not enough there, but it's a strategy we feel comfortable with, and we have inventory to close, to sell that we can close this year, and we could have an impact on the bottom line, and we're comfortable with that.

Our conversion rate has steadily risen and you know those builders that have a stronger presence in the entry level like Horton and Lennar have a significantly higher conversion rate than we have, even ours has moved up quite a bit versus some of our move up peers, and that's because that's the way you have to sell those homes, to that buyer segment. And with interest rates continuing to rise, I don't think a lot of buyers are going to be excited about waiting six months for a new home and they would like to move in right away. So I think this strategy will benefit us over the long-term.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

And then Alan, just to clarify that the number of specs we have targeted for each community at the entry level space is a function of 1 to 5 sales. So, if sales are ticking down naturally our calendar for when to start new specs is going to tick down with it. So we're monitoring that every week's new start.

Alan Ratner -- Zelman & Associates -- Analyst

So Hilla, that obviously impacts the new specs that are put on the ground. But I guess just on the sales side, how -- we hear from some other builders, dynamic pricing, adjusting pricing every day, based on the sales pace and how aggressive would you say you are in actually adjusting that pricing mechanism in order to keep that spec level optimal? Because you start -- changing your starts is going to take a little bit of a while to actually flow through the system there.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

For sure, that's a fair point. I think as Steve mentioned before, the specs that can close in Q4 have the most aggressive incentive in the company currently. We're certainly looking to close out the year as strong as possible in specs that are just natural specs and we will close out in Q1. We are monitoring on a community by community basis.

Alan Ratner -- Zelman & Associates -- Analyst

Okay and I appreciate that. And second question if I could, with the shift to entry level, I am curious if you've run any analysis on your backlog and your closings, et cetera, just kind of try to get at the sensitivity of your buyers to further moves in rates, because obviously these buyers are going to be a little bit more prone to affordability issues, if there are some I would imagine. So, have you stress tested your closings or backlog to determine what the fallout might be if rates were to go up another 50, 100 basis points let's say based on the current income profiles?

Steven Hilton -- Chief Executive Officer

We're doing that right now. We're actually looking at new communities that we have in the pipeline compared to communities that we've been selling in to look at those buyers to see if they can afford higher interest rate. And we're doing that just right now as we speak, and we don't have all that data back yet. But we do believe overall that the people that are buying our homes today, both in the entry level segment and in the move up segment, are under leveraged compared to past cycles, and they could if they chose spend more money on their housing in the form of a higher payment if they wanted to. In the last cycle, which you know 10 years ago, I still remember vividly, buyers were completely stressed, and they had really DTIs and they had no room at all to afford a higher payment, but I think it's different this time and we're keeping a close eye on that.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

And Alan just one more --

Ivy Zelman -- Zelman Partners -- Analyst

Hey, Steve -- sorry, guys, it's Ivy, just wanted to jump in there. Steve, if you can tell us in your affordable product offerings what percent of those buyers are utilizing FHA lending criteria?

Steven Hilton -- Chief Executive Officer

I can tell you that. Hilla, do you have that?

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

Yes, I think it's about 17%. So, it's not as much as you think actually.

Steven Hilton -- Chief Executive Officer

Yes.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

So, they're utilizing it where they can, but they're not -- that's not the only buyer target that -- or the buyer cohort that we're testing into that pool. And just to clarify one more point, as we're looking at incentives, it's not always incentive dollars off the top. Alan, to your point, if we're finding that this drive is the ability to qualify what the interest rate by downs are certainly another lever we can hold in the type of incentives that we're offering this customer.

Alan Ratner -- Zelman & Associates -- Analyst

Got it. All right. Thanks, guys.

Operator

The next question will be from Susan Maklari with Credit Suisse. Please go ahead.

Susan Maklari -- Credit Suisse -- Analyst

Thank you. Good morning. My first question is around, you made significant progress in the East region, continuing to close the gap there from a margin perspective. I guess how much more is there that you think you can realize and does any of the current demand or the expected sort of demand trends change the trajectory of that?

Steven Hilton -- Chief Executive Officer

Well I think to quantify for you precisely how much more there is, but I can tell you there is significantly more in both margin and absorption, particularly in our five divisions in the South and certainly the demand situation there is no different than in the rest of the country although it's better than the high priced markets like California and Colorado. I'd say we're probably seeing a little bit more, little more challenges in the Atlanta than we are in some of the other markets. Florida continues to feel pretty good. We don't -- we're not in South Florida in a meaningful way and we hear the incentives are bigger down there, but they seem to be manageable in Tampa and Orlando. But we still have a lot of opportunity to improve our business in the East region and we're very focused on that.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

And let me clarify -- sorry, just a quick correction. So we're under 20% FHA buyer total. For the entry level, it takes a little bit higher than that. It's in the 20%, 30% depending on the division.

Susan Maklari -- Credit Suisse -- Analyst

Okay. And then my second question is just around, you mentioned in your remarks that you are taking a more conservative approach to your land underwriting. Can you just give us a little bit more color around that?

Steven Hilton -- Chief Executive Officer

I mean, I think we're putting a higher emphasis on auction deals, and deals that require more capital maybe that run out longer we're shying away from a little bit. We're probably ratcheting up our margin and ROA requirement on some deals in certain markets. Certainly we're thinking about some of the incentives that are out there today in the fourth quarter and how those impact the pricing of our product and how they impact the margins and velocity of the deals that we're -- have under contract and that we're looking at to purchase. So we're taking a more conservative approach. We're also -- we also want to bring our land spend down next year because we want to have liquidity available to pay down debt as we go into '20 and to buy back stock and potentially do other things. So we'll just be more conservative on what we're buying and committing to.

Susan Maklari -- Credit Suisse -- Analyst

Okay. Thank you.

Steven Hilton -- Chief Executive Officer

Thank you.

Operator

The next question comes from Jade Rahmani with KBW.

Ryan Tomasello -- KBW -- Analyst

Good morning. This is actually Ryan Tomasello on for Jade. Just piggybacking off of the land question, was wondering if you're seeing any changes in that market based on maybe competition or pricing that you're seeing, notwithstanding your underwriting?

Steven Hilton -- Chief Executive Officer

Not yet.

Ryan Tomasello -- KBW -- Analyst

And is that varying from market to market or any other color you can give there on a market basis?

Steven Hilton -- Chief Executive Officer

I'd say it's across the board, there hasn't been any really change in any markets that's notable.

Ryan Tomasello -- KBW -- Analyst

Okay. And then, just given the near-term expected pressures on pricing and margins, I was wondering if you can give your updated thoughts on off-side solutions in terms of pre-construction fabrication for various aspects of the home construction process?

Steven Hilton -- Chief Executive Officer

There's a lot of things going on out there in that area. Lot of talk, lot of great ideas, but nothing's really come to fruition yet that we think is going to give that paradigm shift. We really believe that the opportunity is really more in pre-cutting and panelizing houses in the framing area, if we get to a place where we could pre-cut -- have drywall pre-cut and other items they are doing in home pre-cuts that limit waste and labor, we still think we're a long way from a completely modulized componentized home that's built in a factory and delivered to the job site. I don't see that happening in the next few years. So, we're keeping our eyes open and we're also really focused on how we can make the sales process more efficient and how we can reduce our marketing cost and deliver a more technology based efficient process to the customers, purchase on the new home and the sale their existing home.

Ryan Tomasello -- KBW -- Analyst

Great. Thanks for the color.

Operator

The next question will be from Carl Reichardt with BTIG. Please go ahead.

Carl Reichardt -- BTIG -- Analyst

Thanks. Hi, guys. You answered my land spend question, but I wanted to ask you about the move up lots. I think we're looking at not too long ago 15% to 20% of lots under control that were really designed for second time move up. I just want to make sure I'm right in thinking that your expectation is to clear through those lots in the course of the next sort of 12 months to 18 months, maybe 12 months to 24 months. And so I'm curious, I know you're not giving guidance on 2019, but what's your expectation on how that might impact margins if business continues to be slowish in that particular price point next year?

Steven Hilton -- Chief Executive Officer

We'll tell you next quarter. It's too early to tell.

Carl Reichardt -- BTIG -- Analyst

Okay. But just to clarify, I'm right that the process here, is it 15% to 20% of controlled lots and the idea is that you want to work through them ASAP through that period?

Steven Hilton -- Chief Executive Officer

Yes.

Carl Reichardt -- BTIG -- Analyst

Okay. All right. Thanks, Steve.

Steven Hilton -- Chief Executive Officer

Yes.

Operator

The next question will be from Scott Schrier with Citi. Please go ahead.

Scott Schrier -- Citigroup -- Analyst

Hi. Good morning. Last quarter you talked about margin in the West improving due to pushing price in Arizona pretty hard, now it looks like your community count's up there. ASP is down, I'm curious what the like-for-like pricing in Arizona might be? And what you're now thinking in terms of the margin trajectory from what's in Arizona?

Steven Hilton -- Chief Executive Officer

Yes. I mean again as I said earlier, I'm not going to give any margin guidance right now. I mean we have increased our margins on our specs across the country, even in Arizona. But Arizona continues to be relatively strong and we're getting a lot of action particularly on our entry-level communities in Arizona which we have quite a few. I'd also say that one of our challenges has been as you saw our community count in California has dropped substantially over the last year. We expect that to start going in the other direction in Q4 and we're opening quite a few communities in California. And most of them were at entry level price point. So we think we're going to be able to deliver some desirable affordable homes in California to satisfy the market out there and I think hopefully over Q4 and into Q1 that will help our -- rebalance our West Coast position.

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

We don't provide guidance by state, but look early next week for the filling of the 10-Q and then you can see the margins by region.

Steven Hilton -- Chief Executive Officer

Yes.

Scott Schrier -- Citigroup -- Analyst

Great. And then if I think about Texas, obviously really strong absorptions there, community count did a little bit. But when you're looking at your land spend, I mean are you still looking to ramp up that community count in Texas.

Steven Hilton -- Chief Executive Officer

Modestly so. I mean our eyes are open to continue to grow our entry level business there. We have very strong entry level business in Austin and San Antonio. We'll let -- so in Houston, we get deeper down the price band in Houston but definitely Dallas is the place where we're too much oriented on the move up side of business. So we need to get down market and we are really focused on doing that and we have a lot of entry level communities opening there that we have been working on for the last year to 18 months.

Scott Schrier -- Citigroup -- Analyst

Great, thank you.

Operator

The next question is from Jay McCanless with Wedbush.

Jay McCanless -- Wedbush Securities -- Analyst

Good morning, everyone. First question I had, when we look at the inventories of existing homes for sale in several of the markets Meredith operates we've seen inventories moving up on both a year-over-year basis and we're seeing a sequential increase in periods where you should be seeing sequential decreases. Can you talk about what type of activity you're seeing along those lines in the field and has that had an outsized negative impact on your move-up business, is that the reason maybe that you're seeing a pickup in the cancellation rate on the move-up side?

Steven Hilton -- Chief Executive Officer

Clearly, when there's less buyers, the inventory level calculation rises, right. So there's less people buying move-up homes today, whether it's used homes or new homes because of higher interest rates. Move-up home is more of a choice, it's more of elected decision. Entry-level home is more of a need and people are looking at their existing home and they are saying, well I got 3.5% or 4% interest rate here. So I buy this new home at a 5% rate in a higher price and they are somewhat electing to stay put. And so that's not news flash. That's what we've been talking about people been talking about certainly over the summer and even in previous quarters. So, that's why we're making the shift to the entry-level market and why we think that part of market's going to do better.

Jay McCanless -- Wedbush Securities -- Analyst

Okay. And the second question to follow on that. Are you seeing any markets now where land prices are starting to come down either sequentially on a year-over-year basis, and if so, does that maybe open up an opportunity for you guys to make an acquisition and accelerate that shift into entry level?

Steven Hilton -- Chief Executive Officer

No, we hit that before, we haven't seen any change in the land sellers disposition across the country in any markets. That may change over the next couple of quarters, but at the moment, nothing has really changed.

Jay McCanless -- Wedbush Securities -- Analyst

Okay. Thank you.

Operator

At this time, we have one further question in the question queue and that question comes from Alex Barron with Housing Research Center. Please go ahead.

Alex Barron -- Housing Research Center -- Analyst

Thanks, guys. I was wondering if you could comment on what form of incentives do you feel have worked best for you so far, like raising broker commissions or rate buy downs or offering more for closing costs or even cutting prices, anything that you feel is working right now?

Steven Hilton -- Chief Executive Officer

Well, traditionally, we've been selling more build to suites. We offer incentives that people can use at design center. But now, as we shifted to selling more spec homes particularly in the fourth quarter, it's generally around closing cost and rate buy-downs and just lowering the price, and it's a combination of the three. We have not offered a lot of increased commissions. Some of our competitors use that strategy occasionally. We do it on a very limited basis, not sure how effective it is, but we're using the kind of the same toolkit of incentives that we've used before and nothing has really changed.

Alex Barron -- Housing Research Center -- Analyst

Got it. And just to confirm, so it sounds like you guys are starting to reduce specs more in the move-up, but in the entry level, you're still doing the same spec starts?

Steven Hilton -- Chief Executive Officer

That's correct. But we monitor on a weekly and monthly basis, and if we don't sell a lot of houses this month in a certain community, we're not going to start as many spec homes next month.

Alex Barron -- Housing Research Center -- Analyst

Got it.

Steven Hilton -- Chief Executive Officer

And it's really determined based upon what the sales activity is.

Alex Barron -- Housing Research Center -- Analyst

Okay. Makes sense. Thanks, Steve.

Steven Hilton -- Chief Executive Officer

Okay. Thanks, Alex. Is it the last call? I think that's our last question. So I appreciate everybody's participation in our call this quarter and we'll look forward to talking to you again in early February on our year-end results. Thank you very much.

Operator

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

Duration: 54 minutes

Call participants:

Brent Anderson -- Vice President, Investor Relations

Steven Hilton -- Chief Executive Officer

Phillippe Lord -- Executive Vice President and Chief Operating Officer

Hilla Sferruzza -- Executive Vice President and Chief Financial Officer

Elliot -- JP Morgan -- Analyst

Stephen Kim -- Evercore ISI -- Analyst

John Lovallo -- Bank of America Merrill Lynch -- Analyst

Paul Przybylski -- Wells Fargo Securities -- Analyst

Timothy Daley -- Deutsche Bank -- Analyst

Alan Ratner -- Zelman & Associates -- Analyst

Ivy Zelman -- Zelman Partners -- Analyst

Susan Maklari -- Credit Suisse -- Analyst

Ryan Tomasello -- KBW -- Analyst

Carl Reichardt -- BTIG -- Analyst

Scott Schrier -- Citigroup -- Analyst

Jay McCanless -- Wedbush Securities -- Analyst

Alex Barron -- Housing Research Center -- Analyst

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