Meritage Homes Q2 2023 Earnings Call Transcript

Quartr
Provided by Quartr
July 28, 2023

There are 10 speakers on the call.

Operator

And welcome to the Meritage Homes Second Quarter 2023 Analyst Call. At this time, all participants are in a listen only mode. A question and answer session will follow the formal presentation. Please note that this conference is being recorded. I will now turn the conference over to our host, Emily Tadano, Vice President of Investor Relations and ESG.

Operator

Thank you. You may begin.

Speaker 1

Thank you, operator. Good morning, and welcome to our analyst call to discuss our Q2 2023 results. We issued the press release yesterday after the market closed. You can find it along with the slides we'll refer to during this call on our website at investors. Meritagehomes.com or by selecting the Investor Relations link at the bottom of our homepage.

Speaker 1

Please refer to Slide 2 caution you that our statements during this call as well as in the earnings release and accompanying slides contain forward looking statements. 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 be materially different than our expectations due to a wide variety of risk factors, which we have outlined and listed on this slide as well as in our earnings release and most recent filings with the Securities and Exchange Commission, Specifically, our 2022 Annual Report on Form 10 ks and recent 10 Q, which contains a more detailed discussion of those risks. We also have provided a reconciliation of certain non GAAP financial measures referred to in our press release as compared to their closest related GAAP measures.

Speaker 1

With us today to discuss our results are Steve Hilton, Executive Chairman Philippe Lord, CEO and Hilla Sparuza, Executive Vice President and CFO of Meritage Homes. We expect today's call to last about an hour. A replay will be available on our within approximately 2 hours after we conclude the call and will remain active through August 10. I'll now turn it over to Mr. Hilton.

Speaker 1

Steve?

Speaker 2

Thank you, Emily. Welcome to everyone participating on our call. I'll start with a brief discussion about what we are seeing in the market We'll provide an overview of recent company milestones, Philippe will then cover our strategy and quarterly performance, and Hilla will provide a financial overview of the 2nd quarter and forward looking guidance. The home buying environment remained healthy in the Q2 of 2023. We made progress on our goals to improve gross margins and increase our available spec inventory sequentially.

Speaker 2

Our cycle times began to show notable improvement Back to our historical averages, driving backlog conversion to nearly 90%. We generated our highest second quarter of closings of 3,490 Homes and home closing revenue of $1,500,000,000 Home closing gross margin for the quarter was 24.4 which combined with SG and A of 9.6 percent led to diluted EPS of $5.02 per share. 2nd quarter demand held steady during the spring selling season at 3.9 sales per month, near the top of our 4.0 Goal as we continue to focus on affordable price points. Buyers are acclimating to the higher mortgage interest rates And the favorable demographics of millennials and baby boomers looking for entry level product by a large buyer pool for our homes. And lastly, the resale home market remains tight as existing buyers are hesitant to leave their low rate mortgages, which limits available inventory and helps to increase new home demand.

Speaker 2

These external factors all contribute to a strong sales pace and the return of some pricing power for builders this quarter. We believe that our strategy of having affordable entry level move in ready homes With rate lock or buy down incentives where needed, will result in a higher backlog conversion and a competitive advantage against both resale In keeping with the proud tradition of helping veterans, We teamed up with Operation Homefront for the 10th year this quarter to break ground on a new home that we donated to military families At our Crescent Lakes community in Babcock Ranch, Florida, which is the 1st fully solar powered town in the United States. This quarter, we're also truly honored to have Meritage receive a wide range of recognition related to our social and sustainable initiatives. We received the 2023 Hearthstone Builder Humanitarian Award for our long time philanthropic efforts. We earned the prestigious average production for the 2nd consecutive year, the highest accolade presented to a builder for exceptional customer satisfaction scores.

Speaker 2

And in terms of energy efficiency, we became the 10 time recipient of the U. S. EPA's 2023 market leader for certified homes. And lastly, we are one of 2 builders named to one of America's climate leaders by USA Today. We're proud to be recognized externally for our core values and corporate stewardship.

Speaker 2

I'll now turn it over to Philippe.

Speaker 3

Thank you, Steve. I want to jump right into sales on Slide 5. Our sales orders were 3,340 Homes this quarter, Where entry level homes represent 85%. Orders were down 11% compared to last year's challenging comps. We achieved 6% year over year growth versus 2021 then, and we were one of the only 2 builders with positive order growth.

Speaker 3

As a reminder, we pulled forward sales and helped minimize cancellations in the prior year, and we were one of the first builders to utilize expansive rate locks on both buyers in backlog And new sales. The average disorienting case declined year over year from 4.4 to 3.9 net sales per month. We don't typically give details beyond quarterly due to month to month anomalies. But since the community activity distorts the quarterly average, we want to provide some additional color.

Speaker 2

This quarter, average absorption rate calculations were

Speaker 3

impacted by a high volume of April community closings and a disproportionately large volume of June community openings. This quarter, we increased our community count 5% sequentially from the Q1 to 291 Apple Communities at June 30, 2023. We had 36 new community openings in Q2 of 2023. And while we are pleased with their performance, we continue to be disciplined about future openings. At ExecBuilder, we want to ensure when we open a new community, we not only have model 1 complete, but also the right amount of move in ready inventory that can close in 60 to 90 days.

Speaker 3

Moving to the regional level trends in Slide 6. We continue to achieve a balanced performance across our geographic footprint Between East, Central and West Region during the Q2, the West Region has the lowest average exposure campaign for us this quarter at 3.4 per month As some of our most challenging markets are in this region, as a result of higher ASP appreciation over the past few years, we are Still working to find the market cleaner price to hit our sales pace targets in these geographies and have seen some improvement in late June and into July. The Central region has an average absorbing pace of 4.3 sales per month, highest pace amongst all of our regions. A greater availability of move in ready sets 2nd quarter 2023 sales pace in line with its Q1 of 2023. This region also ended the quarter with the highest amount of completed steps, which we believe will support a strong future sales pace and backhaul conversion rate.

Speaker 3

Each region's average absorption pace was 4.1 per month during the quarter. The region has been tough to give us the strongest demand across all of our geographies, so we're focused on reloading our available inventory in this market As we believe this trend will continue given the strength of these local economies. Turning to Slide 7. We manage our stars per community to align with our billings. With supply chain stabilizing and labor becoming more available, we can increase our slowdown starts to keep our targeted 4 to 6 month supply cycle around.

Speaker 3

The strength of the housing market led us to increase our quarterly start to nearly 4,000 100 homes in the 2nd quarter, growing 66% from approximately 2,500 in the Q1 of 2023, but down from about 5,000 in the Q2 of 2022. We expect to make up the core of the move in ready units for the 6098 sales window in the Q3. We ended the period with nearly 4,500 spec homes in inventory, which is up 6% sequentially from the Q1. This represented 15.4 specs per community, Around the low end of our spectrum community goal due to the strongest pre selling season. Looking to Q3, we expect to maintain a high level spec to ensure sufficient move in our inventory for the remainder of the year ending 2024.

Speaker 3

During Q2 of 2023, Our closings of 3,409 Homes were 8% greater than prior year due to improved cycle time and strong execution. SG level homes as a percentage of total closings remain consistent with prior year at 83%. Of the 3,490 loan closed this quarter, 87% came from previously started inventory, up from 74% in the prior year 18% of total specs from Kmedia at June 30, 2023, which dropped from 25% in the Q1 and our complete specs were in a high demand quarter. Our typical run rate for complete specs is about onethree, Which we are still targeting. Although with the high demand for completed inventory, we are still working to meet this goal.

Speaker 3

With 31% of the loans we closed this quarter Also sold during the quarter, we improved our balance conversion rate from 48% last year to 89%. We believe we can maintain 80% -plus targeted conversion rate consistently once the supply chain and labor constraints determine normal. Our ending backlog for the quarter Total approximately $3,800 Our cycle plan improved by over 3 weeks sequentially from Q1 for new starts in June.

Speaker 4

So So we're close to returning

Speaker 5

to our pre COVID outlook. Our long term relationship

Speaker 3

with our vendors, the larger volume construction levels we can offer at the Tactile Builder Our successful negotiations have all contributed to better build time for our new stocks. To wrap up, we replenished our WIC inventory of move in ready homes to We are focused on increasing our footprint in our markets. As we prioritize pace over price, we plan to push sales pace in our active stores, So our fleet count may be choppy over the next couple of quarters. We allow our sales teams on the ground to constantly adjust and take necessary pricing action Until we

Speaker 1

find the market clear price

Speaker 3

to get to our target pace of 4.9x sales per month. But just to clarify, focusing on pace over price doesn't mean we need to be on the table. We look to get our minimum target of 4 net sales per month, yet we are cognizant of market dynamics and we increased pricing or reduced incentives in line with local trends. In Q2, we were able to increase prices moderately and reduce incentives, which led to sequentially higher margins and increased margin expectations for the balance of the year. I'll now turn it over to Eva to walk through additional analysis of our financial results.

Speaker 3

Eva?

Speaker 1

Thank you, Farid. To start, I'll provide a quick update on VFR. In the Q2 of 2023, we started to gain some traction on dedicating full communities to our BFR institutional partners. We will share additional information in the coming quarters as the data become more relevant to our results, but we're encouraged by the commitment from our multiple partners And the renewed interest from these operators in the new build space. Now let's turn to Slide 8 and cover our Q2 financial results in more detail.

Speaker 1

Home closing revenue increased 10% to $1,500,000,000 in the Q2 of 2023, driven by 8% Greater home closing volume from higher backlog conversion and a 1% increase in ASPs on closings. The ASP increase was primarily a function of geographic mix. HomeClosing gross margin decreased 720 bps to 24.4% in the Q2 of 2023 from 31.6% in 2022, although it increased 200 bps sequentially from Q1 this year. The decline from 2022 was due to the cost of financial incentives in our results this quarter and continued elevated direct costs. Our use of mortgage rate locks and buy downs did not begin to impact our gross margins until the back half of twenty twenty two.

Speaker 1

This quarter, we pulled back a bit on incentives and started to test some price increases given the strength in the market. Rate buy downs were not as pervasive in Q2, but selectively utilized in tougher markets or for specific customer qualification needs. Although we expect incentives will remain elevated For the remainder of 2023, they are moderating from the extreme levels we experienced over the last several quarters. When looking at our direct costs, they remained fairly sticky this quarter. And outside of lumber, the savings we are seeing are more muted than expected Due to higher industry production levels, savings derived from our faster cycle times though are starting to make their way through our financials.

Speaker 1

We are continuing to actively negotiate with all of our trades and expect to see cost saves by the end of 2023 and into 2024. SG and A leverage in the Q2 of 2023 was 9.6% compared to 8.3% in the Q2 of 2022. While we're glad to see a drop into the single digits, we believe there are additional opportunities to find savings here as well. The year over year increase was primarily due to broker commissions Marketing costs running above the lower 2022 levels, reflecting the current sales environment. We have started to pull back on some of these initiatives where demand is strongest As evidenced by the decline in marketing spend from Q1 to Q2 of this year, we will continue to monitor local needs and leverage less expensive technology and digital solutions where possible.

Speaker 1

Additionally, we have higher costs associated with maintaining a larger volume effect Our financial services results had a $7,900,000 in charges related to unused mortgage interest rate loss That expired in the Q2 of 2023. We didn't have any such charges in 2022. Year to date, we wrote off almost We have added a tighter process on identifying rate lock needs going forward to ensure we don't buy excess capacity and expect such charges to be limited in the future. The 2nd quarter's effective income tax rate The 22.0 percent in 2023 compared to 24.6% in 2022. The 2023 rate benefited from energy tax credits on qualifying homes at the higher $2,500 per home threshold in effect this year.

Speaker 1

Similar tax credits didn't begin until Q3 in 2022 when the new energy tax law was retroactively approved. Overall, the lower gross margin and deleveraging of overhead in the current quarter, partially offset by increased home closing revenue and the favorable tax rate, Led to a 26% year over year decline in Q2 2023 diluted EPS to $5.02 This performance drove our book value per share to $115.55 up $0.24 24% year over year. To highlight just a few results from the first half of twenty twenty three, on a year over year basis, orders were down 11%, Closings were up 5% and our home closing revenue increased 6% to $2,800,000,000 We had a 750 bps decline in home closing gross margin to 23.5%. SG and A as a percentage of home closing revenue was 9 point 9 percent and net earnings declined 32% to 318,000,000 As we turn to Slide 9, I wanted to share the exciting news that some of you may have already seen. S and P double upgraded us to investment grade yesterday.

Speaker 1

We're proud to join the elite group of companies and even smaller group of public builders that have 1 or more rating agencies issue them a BBB rating. We know that part of the reason for the upgrade was due to our steadfast focus on maintaining the health of our balance sheet and strong liquidity. We shied the balance growth in the business with returning cash to shareholders. We had nothing drawn under our credit facility, cash of 1,200,000,000 and net debt to cap of negative 0.2 percent at June 30, 2023. We generated $356,000,000 of free cash flow so far this Our land acquisition and development spend totaled $409,000,000 this quarter, in line with 2022's $422,000,000 With the demand environment stabilizing at a higher level, we expect to continue to accelerate our land acquisition and development above our prior annual target of $1,500,000,000 and look to be closer to $2,000,000,000 plus in 2024 and beyond.

Speaker 1

During the quarter, we returned $9,900,000 in cash to shareholders in the form of a quarterly cash dividend of $0.247 per share with our intent To reset the dividend in the Q1 of each year, from a share repurchase perspective, in addition to our objective of neutralizing annual dilution For new equity issuances, we will repurchase incremental shares opportunistically. We did not repurchase any shares during the quarter after buying $10,000,000 back in Q1 And over $234,000,000 remains available to repurchase under our authorization program as of June 30, 2023. As we have previously discussed, we also expect to early retire portions of our 2025 bonds with our excess cash. On to Slide 10. Given ongoing momentum in the market, we put over 2,800 net new lots under control during the quarter.

Speaker 1

A total of Approximately 60,000 lots were owned or controlled at quarter end, holding steady from Q1, but declining from approximately 71,000 total lots at June 30, 2022. The new lots added this quarter represent an estimated 26 future communities, all for entry level products. We ended the Q2 of 2023 with 4.1 year supply of lots at the low end of our target of 4 to 5 years, further validating our need to increase related spend. About 76% of our total lot inventory at June 30, 2023 was owned And 24% was optioned. In the prior year, we had 66% owned inventory and a 34% option lot position.

Speaker 1

While we're always looking for ways to carry our land off book, we believe owning a large percentage of our land, particularly in light of our negative net debt The cap ratio does not create undue balance sheet risk. When only the best slots are option, builders don't typically walk away from deals that are financed off book, eliminating the optionality of such transactions. Also, the carry cost paid to finance our balance sheet transactions are quite a bit higher Then the current in our current debt costs and don't align with our margin accretion focus. Finally, I'll direct you to Slide 11 for our guidance. We have nearly 3,800 units in backlog and another almost 4,500 specs in the ground today, which provide good visibility into our potential closing universe and go forward margin trends for the rest of the year.

Speaker 1

Given the normalization of homebuilding conditions and our higher backlog conversion rate, for full year 2023, We are projecting total closings between 13,3013,800 units, home closing revenue of 5.85000000000 to 6 dollars 7,000,000,000 home closing gross margin in the low 24% range and effective tax rate of about 22.5% And diluted EPS in the range of $19.12 to $19.80 As for Q3 2023, we are projecting Total closings to be between 333,600 units home closing revenue of 1,460,000,000 to 1,60,000,000 Home closing gross margin of around 24.5 percent and effective tax rate of about 22.5 percent and diluted EPS in the range of $4.80 to $5.29 With that, I'll turn it back over to Filip.

Speaker 3

Thank you, Diva. To summarize on Slide 12, we believe that our Q2 performance continues to reflect our focus on take and commitment to our spec inventory.

Speaker 2

We look

Speaker 3

forward to a strong back half of the year as we sell our available specs and take advantage of price increases and reduce incentives in alignment with local market conditions. As cycle times normalize, we expect the higher inventory turns will lead to consistent backlog conversion in the 80% or greater. We continue to believe in the strategy behind our business model and that our healthy balance sheet and strong cash position will allow us to deliver results and grow shareholder value, EBITDA in certain market conditions. With that, I will now turn the call over to the operator for instructions on Q and A. Operator?

Speaker 6

Thank

Speaker 5

you.

Operator

Our first question comes from Stephen Kim with Evercore ISI. Please state your question.

Speaker 5

Hey, guys. This is actually Trey on for Steve. You've talked about demand being strong and healthy. And we've heard even about demand running above typical seasonality. And with that in mind, typically you all Absorptions fall as the year progresses.

Speaker 5

Javier, we're in a it feels like we're in a unique environment right now, especially with your shift and the extreme demand for spec and entry level. We're wondering if you could see as the year Progressives, if your absorptions could be flattish or even approach flattish as you go from 2Q to 3Q to 4Q, especially as you have to. These newer communities now coming online.

Speaker 3

Thanks for the question. I think as we sit here today, the market still feels very healthy and stable. We're 4 weeks through July, and July feels good. We have there's clearly still a shortage of used homes in the market. So the new home market is really strong.

Speaker 3

Can't predict the future, but I think as you sit here today, as we look at our pipeline of buyers and the traffic in our communities, We feel like we can achieve our sales pace targets that we set forth and therefore, so expect we need to achieve our full year guidance.

Speaker 7

Yes, Philippe, it's Steve. So just to put a finer point on that

Speaker 3

I guess, we're just trying to figure out whether

Speaker 7

or not that's a statement, the target for whatever is something that would hold for the full year, even this year, which would probably require you to run close to 4 for the back half of the year, meaning 3Q and 4Q. So Trey is just trying to figure out whether that's a reasonable expectation. Also, I wanted to ask you Your backlog turnover ratio because that looks like it's also running higher than what you've you've talked about, I think about 80%. Looks like you might need to run-in like 100% or something like that in the Q4, which I can understand why, but I would love to hear you sort of talk about Is that a reasonable expectation for 100? And how long do you think you could stay elevated like that going forward?

Speaker 3

Yes. Thanks, Stephen. The first question, I think it's fair to say that we're going to achieve our sales targets that we put forth Through the rest of this year, we're not seeing anything today that would suggest we can't achieve that close to high 3s, close to 4 Sales target, that's why we put forth the guidance we put forth. We don't need to convert 100% of our backlog To achieve the full year guidance that we put forward, we have 3,800 houses in backlog to start the quarter. We have 4,500 specs That can close this year that we started over the last 3 months.

Speaker 3

We still have July August to start loans. We're halfway through July. So we can absolutely operate at above 80% backlog conversion. I do think it might be closer to 90 Given the demand for new inventory and in doing so, we have a lot of confidence in achieving our full year guidance.

Speaker 7

Thanks very much, guys.

Operator

Our next question comes from Paul Pruzylski with Wolfe Research. Please state your question.

Speaker 6

Yes. Thank you. I guess your order pricing was up 2% Sequentially, was that really a function of mix or true pricing power, reduced incentives in the market? And your price is now Over $500,000 For your new community openings, are there any plans to bring that down?

Speaker 1

I don't think our price is over $500,000 on average for our new community openings. That's not the number that we gave out. So I'm not sure on the math. I mean, we We're seeing some strength in the market for sure. We're able to pull back on some incentives and some green shoots on time to Actually, just increased prices as well.

Speaker 1

So it's pretty small, 2% on the mix, but that's definitely a function of a pullback And need to provide incentives, they're primarily financial in nature for qualification interest rate buy downs and lock, But just incentives in general have a little bit of a pullback from where we were a couple of quarters ago.

Speaker 6

Okay. I guess, how are your absorptions in your new communities performing relative to Your legacy communities, I mean, you mentioned some volatility in community count for the rest of the year. Do you still think that 300 target is achievable?

Speaker 3

Yes. Taking part 1 of that question, demand is pretty consistent Across our entire footprint, I think we highlighted in our comments that there's still a couple of places in the West region that we're Still working through, but for the most part, whether it's a new community or existing community, demand is relatively stable. I do think, as part of your question, community count can be a bit choppy, just because we're seeing stronger demand this year than we expected, and We're closing out some communities faster, but we see meaningful community count growth as we roll into next year and certainly, the back half of next year.

Speaker 6

Thank you.

Operator

Our next question comes from Mike Rehaut with JPMorgan. Please state your question.

Speaker 8

Thanks. Good morning, everyone. Thanks for taking my questions. Maybe just to circle back to the desired sales pace targets. Obviously, in the Q4, historically, there's always a bit of seasonality.

Speaker 8

And whereas maybe you're targeting For the on average, perhaps for the full year, that's often inclusive of some more moderate Pace in the back half. So just kind of wanted to get your thoughts in terms of maybe not just Q3, but also Q4, Given some of the this target, it's still inclusive of some amount of seasonality Or if you just feel like you can run the business now closer to 4 for the rest of the year With seasonality maybe being a little more muted due to a variety of factors industry and company driven.

Speaker 3

Yes. I mean, I'm not sure what exactly we're going to see as it relates to seasonality. We have July almost in the books, and it feels pretty good. Hard to say what's going to happen the rest of this year, but The used home market is very restricted, so we're seeing really strong demand in our communities. Our target is somewhere between 34.

Speaker 3

We think we're going to be closer to 4, primarily because most of our business is entry level right now. And secondly, because we have all these specs that we started and there's a lot of demand for moving ready specs. So I think We're having all these specs that can close this year and there being a high demand for those move in ready specs. We feel like we can achieve the sale targets And seasonality will be what it did, but we can achieve the sales targets that we've exhibited that we've demonstrated and that we're going to need to achieve our full year guidance.

Speaker 8

Great. I appreciate that, Philippe. I guess, secondly, Just following up on a prior comment you made about community count and that you would hope to have more meaningful growth in the back half of next I know, obviously, we're a bit away from that and not at a point to necessarily give a fine point on guidance, but for next year. But how should we think about community count over the next year or 2? I mean, 3 years ago, I believe, You put out that 300 community target that you're now kind of plus or minus at or should be at by the end of the year.

Speaker 8

How should we think about community count maybe by the end of 'twenty four and into 'twenty five, 'twenty six? Yes. And does that also assume a further increase in cycle times, which actually might Resulting sellouts occurring a little faster than expected?

Speaker 5

Yes. I mean, I think

Speaker 3

I was expecting the market to be relatively where it's at Today, I don't see anything out there changing. The buyers have been resilient in this new rate environment. So as long as rates sort of stay where they're at, I think I expect the market to be normal. Our community count is going to be a little bit choppy here just because demand has been so strong And we stopped buying land for the back half of last year. So we're now trying to navigate that.

Speaker 3

But we're going to have community count From here into next year, as we roll into the back half of next year. And then as we spoke in the script, We're ramping up land spend significantly right now. So our pipeline for new deals coming through land committee is dramatically up. We approved a bunch of deals towards the back half of last quarter, and we're out of a really busy land community calendar the rest of this quarter, Already passed in the July. So our land spend is going to go up dramatically and all those communities are going to land in 2025 to 26.

Speaker 3

And I think we're expecting significant community count growth as

Speaker 4

we roll into

Speaker 3

2025 and then beyond.

Speaker 1

Just to add a quick point, Mike. I think, Hari said it that the reason why it's going to be choppy is because of demand. We have the unit. Anything that's related to slowdown from transformers or any other delays, that was already baked into all of our I've mentioned the last couple of quarters, so the reason it's choppy is because the market is so much stronger than anyone had anticipated, causing the gap out, not because we can't get communities that don't

Operator

The next question comes from Alan Ratner with Zelman and Associates. Please state your question.

Speaker 9

Hey, guys. Good morning. Thanks for taking my questions. First, I'd love to dig in a little bit more on the pricing side. You made some comments that there were some Moderate price increases or kind of dialing back incentives.

Speaker 9

The sequential increase in margin was pretty significant and Certainly greater than you guys were expecting into the quarter. If I look at your guidance in the back half, it looks like you're expecting pretty Laddish margin, which I would have expected if incentives are on the decline, there might have been a little bit more of a tailwind there. So can you just maybe quantify exactly what's going on, on the discounting and incentive and pricing side and what your expectation is for the back half of the year as more of these specs Come to market.

Speaker 3

Yes. I'll let Hila talk a little bit more about what's going into our guidance, Alan. And by the way, congratulations on your Ken, you're over there. Thank you. Yes, you're welcome.

Speaker 3

But I'll talk a little bit about the pricing. We're a spec builder. So essentially, we just look at the net price. And over the last 6 months, We've been able to back off on incentives, and we've been able to back off on using rate buy downs in a number of places, especially since we now have more move in ready inventory, the rate locks are less expensive. So that's really driven The margin for us, we raised prices moderately in some of the hotter places.

Speaker 3

But overall, it's just been backing off on the aggressive incentives And the rate blocks we were having to use to sell homes towards the back half of last year and into this year. As we roll into The rest of this year, I'll let Eva jump in here. All the homes are started. We know what their costs are. We've already sold Quite a few of those at their price.

Speaker 3

We know what incentives we need to do. The incentives are dramatically down from what we needed in the first half of this year, Which is what's giving us confidence in our guide. But let me let Eva jump in a little bit on some other details driving the guidance for margin for the rest of the year.

Speaker 1

Thanks, Elyse. So I think, obviously, 24.4% was where we ended up for the quarter. We're guiding to around 24.5%. We feel like the next quarter is Pretty similar with those homes already in backlog. We have a decent understanding of where those margins will fall, although With about a third of our volume coming from same quarter activity, there is an opportunity for that to move a little bit, which is why we said around 24.5%.

Speaker 1

Back into Q4 from our full year guidance, it's actually quite a nice margin uptick in Q4, which is exactly what you're mentioning here, Alan. It's the Expectation that we'll be able to pull back an incentive a little bit more based on what we're seeing in the market today for closing for Q4. So there is quite a nice uptick In Q4 projected margins to get to the full year 24%, which is kind of off balance putting The balance on the 22.4 percent in Q1, we have to balance that somehow, and that's going to come from higher margins in Q4.

Speaker 9

Got it. Okay. Thank you for clarifying that, Dilo. That's exactly what I was getting at, so very helpful. Second question, a little bit more just a consumer detail question here.

Speaker 9

You guys obviously have great insight into the first time buyer and kind of their Your credit quality and aptitude to afford a house in today's market and a lot's been written about This idea of generational wealth transfer kind of offsetting some of the affordability challenges that would appear on paper, whether it's Boomers helping their kids out with down payments or perhaps even putting their names on the home and purchasing it for them. I'm curious, A, if you've seen any of that data in your mortgage statistics or any anecdotes that you could point to that would either Support or refute that thesis that trend has been increasing?

Speaker 1

I'll take that one. We're not seeing parents putting their names on their children's mortgages, but we are seeing about a quarter Our volume has DPA, the down payment assistance. So we are seeing maybe if not Clear generational wealth, but it's definitely assisting on the down payment side to make sure that they can buy that house and the maintenance of the mortgage payments on a go forward basis It's on the homeowner on the mortgage. So we are seeing that for sure.

Speaker 9

How does that compare to a few years ago, Sheila?

Speaker 1

It was about half, half

Speaker 9

that balance. Half of 20. So 10 to 15? Yes. Okay, perfect.

Speaker 9

Really appreciate it, guys. Thanks a lot.

Speaker 3

Thank you.

Operator

Our next question comes from John Lovallo with UBS. Please state your question.

Speaker 5

Hey, guys. Good morning. This is actually Spencer Coffman on for John with you for the questions and nice results. Maybe just piggybacking off of some of the prior questions On gross margins, I think the 3Q margin is well understood. But can you just talk a little bit about what gives you guys the confidence that Demand will hold and incentive activity won't need to accelerate to sort of hit your 4Q margins out of it?

Speaker 3

Yes. So, not to sound redundant, but obviously, every home that we need to close this year has already started. So we know what the costs are. So that's good. We can only base our future view of demand based on our current view of demand.

Speaker 3

And Based on what we're seeing in the market today, we're confident that we're going to

Speaker 5

achieve our absorption targets through the rest of this year.

Speaker 3

I think a lot of it is being driven by what everyone's been reading, which is the fact that there's no inventory in the market, specifically on the used home market. So the new home market is achieving a larger market share, which is giving us strong absorptions and strong buyer pools. Do I know what's going to happen in December today? No, but I know what's happening in July, and I'm basing my views on what's happening in July.

Operator

Okay. That makes sense. And can you talk a little bit about what the Benefits

Speaker 5

of gross margins were in the quarter from lower lumber rolling through. And is it fair to assume that there could be maybe a little bit more of a sequential benefit in 3Q, but the majority of that benefit was probably in the current quarter.

Speaker 1

Yes. All that benefit has been rolling through Q1 and Q2. As you guys know, lumber is actually Starting to tick up, not down. Now none of that's going to be visible yet. That's recent HomeStory, so those closings won't happen until later, and we've Comment for that.

Speaker 1

As Philippe mentioned, we know all of our cost structure for closing through the back of the year and all of that's been already addressed. But I don't think that there's going to be an incremental tick down From lumber saves flowing through the financial statements, future savings in margin are going to come from cycle time improvements And continuing a continuing push by the entire organization to get direct cost saves in other categories.

Speaker 5

Perfect. Thank you, guys.

Speaker 3

Thank you.

Operator

Our next question comes from Sparron with Housing Research Center, please state your question. Alex Badri,

Speaker 5

your line is open. Sorry, I was on mute. Thank you and great job on the quarter guys. I think you're targeted, but can you discuss what's the level of incentives in the quarter and in the closings Versus orders and what is the kind of normal historical incentives as

Operator

a percentage of sales?

Speaker 1

So we've shifted quite a bit. As you know, we're a spec builder, so incentives are just kind of part of the all in price. We don't really market as base Price and then options and then incentives like a traditional builder or based on what we used to do in the past. But all in, They used to run about 6%. They're running quite a bit north of that right now.

Speaker 1

We don't typically break out that level of detail, but I can share that between Q1 and Q2, they dropped 200 to 300 bps, which is exactly the savings you saw in the margin. So that's really the benefit that you're seeing in the margin is the pullback on incentives.

Speaker 5

Okay. But they're still running a little bit higher than Historical normals?

Speaker 9

Correct.

Speaker 5

Okay. So hopefully, that means there's still room for improvement as the market gets back to normal. I guess, similar question on the build times. What are the build times right now? Where were they at The peak of last year, let's say, when things were super slow and what's normal?

Speaker 3

So In some of our markets, when we were in the middle of the supply chain challenges, we're north of 200 days to build a house. So We didn't start a house in June. We are going to close it. Right now, we're close to 160 days. So we're down From that, that's 40 days.

Speaker 3

I would say that's the biggest decline we've seen. I think the company wide was down about 3 weeks, So, 21 days or so. Before COVID, we were building homes in 4 months, So 120 to 140 gains depending on the market. And we are looking to turn our assets anywhere between 2.5 to 3 times a year. We're definitely back above 2.

Speaker 3

In some markets, I think we can get to 3, and that would be the goal. So we still have some We need to reduce our cycle time. The trades are performing quite well right now, although there are a bunch of starts going out. So we'll see if the capacity Stay strong, but we're all spec. We line build.

Speaker 3

We have repeatable products. So I think we're going to be In the front row of getting the best cycle times in the industry, along with some other folks. So right now, about 160. Our goal is closer to 130. We still have a little ways to go.

Speaker 5

Okay. So again, it seems there's still Opportunities left. And if I could sneak one last one. I think I heard you say the start pace was 4,500. What was it last quarter?

Speaker 5

And is that 4,500 a good run rate or where you think you'll be going forward?

Speaker 3

Yes. We actually started 4,100 tons, but we have 4,500 stats coming into the quarter, just to clarify. And we think our run rate is about 4,000 starts per quarter. That's our goal as we move through the rest of this year to start about 4,000 homes. We believe that we have the lots of the communities and the trade capacity to execute on that.

Speaker 1

We did 2,500 homes in Q1.

Speaker 3

That's because we were pulling back and we were trying to monitor the market.

Speaker 5

Awesome. Thanks so much and great job guys.

Speaker 3

Thank you.

Operator

Our next question comes from Carl Reichardt with BTIG. Please state your question.

Speaker 5

Thanks, Craig. I'm going to ask about land. Obviously, you guys are moving back in fairly aggressively, some of your peers are too. What are you seeing in terms of land pricing in the market and given the business model relative to say 5 years ago? Can you talk about the changes in your underwriting in terms of Or time to market or size of watch per community that how has that underwriting idea changed with the model transition?

Speaker 3

Well, it's changed significantly since our new strategy 7 years ago to go into focus on the first time in Affordable 1 MD segments of the market and go to an all spec strategy. We're obviously looking at higher absorptions and turns. We've gone on point to tell you that we think our margins are going to be better than they were prior to that We were operating more in a 20% margin range now or closer to 22%, 21%, 22%. We're looking we obviously look to close DIRTT when it's Shell ready. So that's a big Priority as well, we spend a lot of time and money processing our projects, but don't close them until we can put a shovel in them.

Speaker 3

We buy bigger deals because we expect more volume and we are trying to spread the development cost We can achieve the price point. So really everything has changed. Things are going well. We continue to see deals that underwrite per that criteria, Allow us to stay on the bottom of the graph and be affordable, especially in the markets that we're in. Land is not on sale.

Speaker 3

I was hoping to see land prices come down more materially from last year given What happened in the back half of last year, but as we've always discussed, land prices are sticky. And as soon as the spring selling season Turned around, land was back on the market, but the prices really hadn't changed. So there was kind of an opportunity early on to get something for cheaper. But right now, it's back to being a pretty competitive market. But we see plenty of land.

Speaker 3

We have a deep pipeline. Our folks out there in the field do a great job giving us some first looks on properties. And we have plenty of Projects out there that underwrite based on the hurdles and the market position we're looking to achieve.

Speaker 5

Thanks, Tony. And then you have talked about guidance, we talked about this quarter's performance relative to guidance. What were the 1 or 2 real Critical positive surprises that you had during this quarter versus what you told us in April you do?

Speaker 1

I think the 2 most positive surprises was the conversion rate. We guided to a lower closing guidance. We weren't sure that we were going to be able to Push the trade to get all the homes closed. So that 89% conversion rate was definitely a positive surprise and one that we're now running with that ball and expect The trade should continue to deliver that, especially as we have specs available and further in the production cycle as we run into Q3. And then the other positive would be the margin growth.

Speaker 1

I don't think that we as a sector, I think everyone's giving you the same comment, but I don't think that we We believe in the ability to pull back on the financial incentives as much as we did. So with a third of our Volume coming from same quarter sales, we're starting to see that benefit early. So we're excited to be able to start to pull back on some of the incentives. Again, they're running hotter It's historical, but definitely some pullbacks from where we were at the back end of last year to where we are today.

Speaker 5

Thanks, Eli. Thanks, Ali.

Speaker 3

Thank you. Our

Operator

next question comes from Joe Ellermeyer with Deutsche Bank. Please state your

Speaker 4

question. Yes. Thanks very much. I just wanted to talk about the orders in

Speaker 3

the quarter and the communities really

Speaker 4

in the quarter as well. You may Cut the data this way, but I imagine you have a sense of how this would go. If I think about your new openings and what you closed out, It seems like really only about 250 communities started and ended the quarter actively selling. And so it's not Hard to kind of maybe those that stayed open the entire quarter were still running at that above 4 pace. Just curious if maybe you would agree with that state,

Speaker 3

I would fully agree. Yes, we as we said In the script, our comments, we had just some outside communities that closed out in April that had some remaining homes to sell From Q1 after Q1 was so strong. And then really most of the openings, we actually didn't open up our communities until Late in the quarter, again, primarily, we're just really focused on opening our communities right now. Our priority is cycle time. So we don't want to open up So you're exactly right.

Speaker 3

It's a little bit detailed, but that's exactly what And the rest of our business operated above 4 a month.

Speaker 4

Yes. Makes sense. And then congrats on the BBB. I know that's important to you guys and that's really exciting. I'm thinking about your cash balance Having grown in these recent quarters though and you talked about the pause on the land side late last year and the momentum that you're now In the current quarter in the land market, would you maybe mind sizing that even just qualitatively, can we expect Your cash balance to come down as you maybe deploy and redeploy the current excess balance and the cash you're getting from closing?

Speaker 4

And then similarly and kind of in the same vein, if you're talking about your cash and being opportunistic for share repurchases, how are you also thinking about opportunities on M and A as a way to achieve your growth aspirations.

Speaker 3

Yes. I mean, As we said, we're ramping up land spend significantly. Our target net debt to cap has always been Kind of in the low mid-20s. We're way off of that. So as we start to reinvest in land, we're going to see that Kind of revert back to that, I would hope, but not go higher than that.

Speaker 3

I think we have plenty of liquidity to drive our growth without exceeding That kind of parameter. And then we are very active in the M and A, primarily Focused on any private builders that are looking to sell their business, Focused on the ones that are inside of our markets that we are already in. We still have a number of markets where we're trying to achieve Top 3 or top 5, whether or not, so an M and A opportunity in those markets would be really compelling to us. We've looked at quite a few here over the last 90 days. We haven't gotten to the finish line at any of them, but we're Looking at all of them, and we certainly think that that's something you could see from us over the next year or so.

Speaker 4

Thanks very much. Good luck everyone.

Speaker 3

Thank you.

Operator

The next question is from Susan Maklari with Goldman Sachs, please state your question.

Speaker 7

Hi, everyone. This is Charles Ferranton in for Susan today. Thanks for taking my question and congrats on a great quarter. Maybe first, talking about SG and A, considering the trajectory that you talked about in demand And obviously, closing fee guide for the back half, how should we think about SG and A cadence for the back half of the year as part also of the broker commissions likely to come down? Yes.

Speaker 1

So I think that you're right. We're aggressively looking to squeeze SG and A a little bit lower. We always The 110 is a good place. And as we continue to be a bigger builder, that 110 is becoming something lower. So I think that it's It's an appropriate expectation to continue to see that number pull back, especially when we're getting kind of consistent or increasing closing volume.

Speaker 1

The broker commission, you should see some benefit there in the back half of the year. As far as longer term initiatives, maybe that's more into 24 or 25 on general growth and marketing trends, but the commission piece for sure should be visible in the back half of this year.

Speaker 7

That makes sense. Thanks for that, Hila. And then just maybe a broader question to follow-up. We've seen industry single family housing starts, obviously, approaching 1,000,000 unit this spring. And given the bullish outlook for new home construction, can you talk about maybe the measures you can put in place today to ensure that your supply chains are holding better this Time around and during the uptick that we've seen over the last few years, we're hearing that some materials like EWP are very hard to find these days and even in allocation for some reason.

Speaker 7

So How do you mitigate against those looking forward, if things were to go back to, let's say, 2021 start level? Yes.

Speaker 3

I mean, I think there are some lessons learned. I think communication with the trades, a high level of transparency and more frequent communication is They're already talking to us about what might happen if this were to occur and trying to get ahead of it And they're being more thoughtful about it. So I think it starts there. But I also think our strategy is key. Other builders you can see are following as it relates to more specs and less complexity and less products that go into the business of the entire industry.

Speaker 3

It does more of that. I think we allow our trade partners and the labor to perform at a higher level. So I think it's more of that. And we're continuing to migrate even further into less complexity, more repeatability and less products that go into our homes. So that's what we're focused on as the capacity increases, steady cadence, continue to start and keep those folks busy It's really the best thing we can do.

Speaker 1

And then one other benefit is as we migrate to more and more and more spec starts, our newly substitute products In the home, it's our choice someone can pick it out in the design studio. So if there are issues with 1 product type or 1 supplier, We can, at our discretion, substitute the product for something else.

Speaker 7

That's very good color. Thanks for the time, guys.

Speaker 3

Okay. Well, I think that's it. That's all the questions. We really appreciate your interest and taking the time to listen to our comments. Thank you, operator.

Speaker 3

I want to thank everyone who joined us joined the call today and your continued interest in Vericel, and I hope you have a great weekend. Thank you.

Operator

Thank you.

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Earnings Conference Call
Meritage Homes Q2 2023
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