Meritage Homes CORP Q1 FY2020 Earnings Call

Greetings and welcome to the Meritage Homes First Quarter 2020 Analyst Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Brent Anderson, Vice President of Investor Relations. Thank you, sir, you may begin.

Thank you, Donna. Good morning, and welcome to our analyst call to discuss our first quarter 2020 results. We issued the press release yesterday after the market closed, and you can find that along with the slides we will be referring to during our 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 2 and remind you that our statements during this call, as well as our press release and accompanying slides, contain forward-looking statements, including but not limited to our views regarding current business conditions and the potential adverse impacts related to the COVID-19 pandemic. Our expectations are projections regarding the demand for our homes, home prices, costs, mortgage financing, margins, overhead expenses, cash flow, and liquidity. Those and other projections represent the current opinions of management, which are subject to change at any time, and we assume no obligation to update them. Any forward-looking statements are inherently uncertain. Our actual results may materially differ from our expectations due to a wide variety of risk factors, which we've identified and listed on this slide as well as in our press release and our most recent filings with the SEC, specifically our 2019 Annual Report on Form 10-K, which contains a more detailed discussion of these risks. We'll also be filing our 10-Q shortly. We have also provided a reconciliation of certain non-GAAP financial measures referred to in our press release as compared to their closest related GAAP measures. With me today, or at least distant, are Steve Hilton, Chairman and CEO; Hilla Sferruzza, our Executive Vice President and CFO; and Phillippe Lord, Executive Vice President and Chief Operating Officer of Meritage Homes. We expect the call to conclude in about an hour, and a replay will be available on our website approximately an hour after we conclude the call. It will remain active through May 13. I'll now turn the call over to Mr. Hilton to review the first quarter. Steve?

Thank you, Brent. I'd like to welcome everyone participating on our call today and sincerely hope that all of you and your families have been able to stay safe and healthy through this global health crisis. Our hearts go out to those who are sick or caring for loved ones stricken by the virus, and our heartfelt thanks to all the healthcare workers, first responders, and those who rely on vital necessities like groceries and gas during this time when most of us are safe in our homes. We are grateful for your service. Our number one concern since the coronavirus began to spread has been the health, safety, and well-being of our people, including each of our Meritage team members and their families as well as our customers and business partners, and I commend our entire Meritage team for their commitment to overcoming challenges we've never experienced before over the last six weeks. We'll cover what we're seeing on the ground in April shortly, as well as the changes we've made, but we think it is important to also review a few of the financial highlights of our first-quarter performance that we realize is not a firm indicator of the remainder of the year. We believe the financial strength of our balance sheet and our strategic market position in Q1 will allow us to successfully weather the uncertainty of the upcoming quarters and be prepared for the near to mid-term volatility while keeping our long-term focus aligned with our strategy. Turning to Slide 4. Through most of the first quarter, we enjoyed strong demand for new residential construction, among the highest demand I've seen in my 35-year career. As you are well aware, active buyer conditions have deteriorated across the U.S. since mid-March, which, coupled with declining consumer confidence and a tightening of the mortgage markets, have negatively impacted our traffic and our sales. Demand was especially strong in the entry-level and first move-up, our strategic markets that make up 90% of our communities, while we were able to capture that strong demand and generate 23% order growth, with almost 70% of that coming from spec inventory that we were able to close quickly. That, in turn, drove significant revenue growth and a 180% earnings growth over last year's first quarter. In addition, the streamlined operations we've completed as part of our strategy have driven our costs down and resulted in the first-quarter home closing gross margins expanding 330 basis points with a 160 basis points improvement in our SG&A leverage. In other words, while strong demand for most of the quarter provided us with the opportunities, the execution of our strategy allowed us to capitalize on those opportunities and deliver 180% earnings growth. It also provided cash flow for our early retirement of debt in December of last year while maintaining the liquidity we need for the flexibility through this period. I'll now turn it over to Phillippe to discuss more specifics regarding recent trends and changes we've made in how we operate.

Thank you, Steve. Slide 5. As we reported earlier this month, the spread of the coronavirus began to have a notable impact on our operations in the latter half of March. We saw an 8% drop in orders compared to March 2019, following year-over-year increases of 38% and 51% in January and February. Based on our sales through the past weekend, we expect major orders to be down approximately 25% to 30% from April 2019, with about 650 sales compared to 916 last year. Our order cancellation rates increased from 13% in the first quarter to the high teens in late March and are currently around 20% month-to-date in April. Shelter-in-place orders are still in effect across most of our markets. Our residential construction is currently deemed an essential service in almost all of our locations, with the exception of a handful of communities in California. We are continuing to build and deliver homes following the protocols recommended by the CDC and other government and health agencies to stay safe and minimize our risk. Slide 6. While the world we are living in today is very different than what it was just a couple of months ago, I am proud of the way in which our teams have quickly adapted to the new temporary model, and we are leveraging our technology for solutions to continue to operate remotely. For example, we are seeing customers via virtual appointments only in our sales offices and studio and design centers, allowing customers to practice social distancing during their home buying process. Our online traffic has helped surge, increasing almost 50% since last year's April. Additionally, approximately 15% of our net orders came from virtual tours, a validation of the creativity and determination of our sales team during these new times and the acceptance from buyers of this home purchasing format. Our sales counselors are also taking photos or videos of those homes under construction to update home buyers on the progress of their home when they cannot physically visit the construction site. We are getting accustomed to working remotely and are accelerating the adoption of new technologies throughout the organization. We will continue to abide by that even after the market is fully functioning again. With mobility restrictions in place, the customers we are seeing today tend to be highly motivated buyers who are ready and able to purchase a home. We assist them in their research with a robust website, a customer contact center, and agents available to answer their questions by phone, text, or email without the need to visit the community until they are comfortable. Consequently, our conversion rates of traffic to sales have increased monthly from earlier this year. Customers are using our 24/7 online mortgage pre-approval tool to help them move through the process of qualifying to purchase a home more quickly. MTH Mortgage Consultants work with them to complete the process without ever needing to come to the office in most cases. We are also conducting drive-through closings and are now equipped to process earnest money deposits on customers' debit or credit cards remotely through a secure email link. These tools and procedures make it more convenient and safer for our home buyers to work with us. Since many of the changes we made are also more efficient and in sync with today's more digital lifestyle, we intend to keep and expand upon them to help reduce the cost of selling homes even after the current pandemic recedes. We're working effectively remotely with municipalities and utilities we do business with to enable us to get permits and complete inspections, as well as billing and payment for services. Our crews are typically able to maintain our construction schedules, and we have not experienced any significant supply chain disruption so far. For the safety of our employees and customers, we have temporarily suspended all non-emergency warranty work involving the interior of occupied homes. We will begin warranty work as soon as we are allowed in our markets. Moving on, rather than covering our operating results in as much detail as I typically do, I'll point out just a highlight from the first quarter before turning it over to Hilla to review our financial results. Slide 7. The first 10 weeks of the quarter were exceptional by any measure. Absorptions were up 35% year-over-year. So despite having 9% fewer communities open on average than a year ago, we still achieved 23% order growth. Our ongoing pivot to entry-level housing continues to benefit our results. Entry-level orders were up 69% year-over-year and represented 51% of our total ending community count at March 31, 2020, and 61% of our total orders for the first quarter. Those are up significantly from Q1 2019 when 36% of our community and 45% of our orders were entry-level. Orders from our non-core assets, which is anything outside of entry-level or first move-up, dropped to under 6% of our order volume for the quarter. Slide 8. Our spec inventory at quarter end was up 23% year-over-year to a total of just over 2,700 homes started, of which only 48% were completed. The number of completed stocks at quarter end was down 7% from a year ago. We're selling more spec homes before completion and have been able to resell homes that were canceled typically without any additional concessions. We ended the quarter with an average of a little over 11 specs per community, compared to 8.5 a year ago, mainly due to having more entry-level communities, which are 100% spec. Although we certainly reduced the volume of specs we are starting over the last month, we do not plan to change our strategy of selling spec-built homes in the entry-level space. We are managing spec inventory to keep a 40-month supply to meet the demand for quick movements. That 4 to 5-month supply is based on order volume, so it will be a smaller number as demand softens and larger when demand increases. Slide 9. Our orders in the West region were up 35% over the first quarter of 2019, driven by a 41% increase in absorption with 5% fewer communities on average. Entry-level now makes up almost 70% of our total California communities, with very limited exposure to the jumbo market. Total orders and order value in California more than doubled over last year's first quarter. Despite a 40% drop in average community count, Arizona again produced the strongest absorption across the company at an average of 17.8 per average community for the quarter, up 44% year-over-year, resulting in 25% order growth for the quarter. Our Texas region had a 41% increase in absorptions and, despite a 13% decline in community count, orders were up 22%. Austin had exceptional growth of 85% year-over-year for the first quarter due to our strong entry-level presence with our LiVE.NOW communities. Overall, we believe Texas will be resilient as we continue to come out of this downturn, as we experienced in the last cycle. We continued to see improvement in our East region during the first quarter. Year-over-year order growth was 11% due to a 20% increase in absorption, which offset an 8% decline in average community count. Closings and orders were reduced due to the devastating tornado in Nashville during March. Within the region, North Carolina produced the largest year-over-year with a 25% increase in orders, primarily driven by product mix, which contributed significantly to a 39% increase in absorptions there. Our backlog is solid. We don't count contingent contract buyers at the homes to sell, and that's the sale just waiting to close. We are seeing limited cancellations on our near-term backlog, and we expect most of it to close quickly, which is an advantage in today's market due to the employment uncertainties and higher standards to qualify for mortgage financing. Our JV partner is honoring all pre-qualified mortgage approvals for customers in our backlog without requalifying them using the tighter qualification standards that exist with many lenders today. I will now hand it over to Hilla to provide some additional analysis of our financial results.

Thank you, Phillippe. Considering the fluid conditions and lack of clarity regarding the timing and return to a more stable economy, before I begin, I'd like to note that we're withdrawing our previous guidance until an appropriate time in the future. Starting on Slide 10. We produced strong earnings growth of 180% in the first quarter of 2020 over 2019 and achieved that result with margin expansion and SG&A leverage in addition to 27% home closing revenue growth. Closings were up 31% over the first quarter of 2019, with 69% coming from spec inventory and a backlog conversion rate of 83%, compared to 73% last year. Our home closing gross margins increased 330 basis points over last year's Q1 to 20% for the first quarter of 2020, traditionally our lowest margin quarter. Our margins benefited from pricing power over the last couple of quarters as well as construction efficiencies due to simplification of our products and processes, cost efficiencies from better negotiating power on a lower number of SKUs and incremental efficiencies in construction overhead from the additional closing revenue. Although we've not yet seen notable discounting for new or resale homes in our markets, our high gross margins would be able to absorb material price concessions before we would have any concerns about taking meaningful impairment, which has been a topic of discussion among investors lately. At this time, we anticipate volume will be lower in the current environment, but we are still continuing to sell and close homes every day. While profit is always front of mind, in the current environment, we believe it is important to continue to maintain cash flow from home closings to cover our fixed costs. It's also important to maintain a production cadence to deliver cost savings with our streamlined construction processes. As we continue to operate over the next couple of quarters, we will monitor our markets and adjust conditions with pricing decisions locally as necessary in order to maintain our minimum volume threshold. The additional closing revenue in Q1 also resulted in increased leveraging of our SG&A, which declined to 10.7% from 12.3% a year ago. We were on pace to hit our 10% long-term target for the full-year. Although we aren't expecting that trajectory to continue in the current economic environment. Earnings from our Financial Services segment were $2 million lower in the first quarter of 2020 compared to 2019. We changed our mortgage joint venture structure relating to customer incentives offered for using our mortgage JV last year, such that the profit from those incentives is now included as part of home closing revenue rather than being reported as part of our Financial Services results. Our early repayment of debt in December of 2019 resulted in a $4 million net decrease in interest expense that aided our first quarter 2020. We also benefited from a lower tax rate with the extension of the energy tax credits into 2020. Our tax rate was approximately 18% for Q1 this year versus 22% last year. Our full-year tax rate this year is expected to be between 20% and 21%. Our Board had previously authorized $100 million for share repurchases, and we repurchased 1 million shares at an average price of around $61 per share this quarter. We have $23 million remaining authorized, but we have suspended repurchases indefinitely in light of the current economic conditions. The benefit of the share repurchases was fairly limited in the first quarter of 2020, as the majority of activity occurred in March, but it will more meaningfully benefit diluted EPS on a go-forward basis. Slide 11. Our balance sheet is in the best condition it's ever been, with net leverage at one of the lowest points in our company's history. We have ample liquidity, and our banking partners are willing to extend additional credit if needed. We borrowed $500 million against our credit facility in March to provide additional flexibility during this period of extreme economic uncertainty, and we expect to hold that cash reserve at least for the short-term. The net cost of that debt is very low at under 2%. We ended the quarter with almost $800 million of cash, additional liquidity of almost $220 million under the credit facility, and net debt to cap of about 26.6%. We have no debt maturities until 2022 and have been deferring most of our land acquisition and development over the last six weeks, while eliminating non-essential discretionary expenses and metering the production of spec homes to preserve ample liquidity for future uncertainties. We don’t feel any pressure to liquidate assets to generate cash, and our recent operating results are trending better than our internal downside projections, with lower cancellations and higher sales than we anticipated short-term. Slide 12, we spent approximately $246 million on land and development in this year's first quarter. That was about $110 million less than what we expected to spend when we entered 2020 due to deliberately curtailed spending in March. We added about 2,900 net new lots during the first quarter of 2020 to end March with approximately 41,500 lots, just about where we ended in 2019. That represents a 4.2-year lot supply based on trailing 12 months closings. We were on target for our goal of 300 communities by the end of 2021 prior to our decision in mid-March to pull back incurred cash spending to preserve liquidity. Since mid-March, we deferred approval of approximately 1,800 additional lots in the quarter. We terminated several deals prior to the end of the quarter and a couple more since in April prior to the expiration of their feasibility period, resulting in very limited charges of just under $1 million. We continue to work with our land sellers to extend purchase and feasibility deadlines, although more sellers have been willing to work with us and are offering acceptable terms. We're closely monitoring additional deals for termination if the economic recovery is more protracted than currently anticipated. We expect such actions to only result in a limited number of walk-away charges for the rest of the year. In addition, we have daily reviews of our upcoming land acquisition and development spending, with all land cash expenditures requiring corporate-level approvals for the current time. Unlike the last significant downturn in the market, we have far less risk in our land book now, no speculative luxury projects, no deals with significant development or entitlement risk, and a well-defined land playbook with consistent expected margins that provides us with much more confidence in our land position. We also want to provide some additional information regarding our buyer profile in relation to mortgage financing on Slide 13. Our buyers have solid FICO scores, typically around 730, with more than 70% of them above the 700 mark. Even for our entry-level buyers, the average FICO is 720, and well over 60% of those buyers are over the 700 mark. Our back-end DTI for the average buyer is below 40%. That's true across all of our buyer groups, including entry-level, and has been for many years. Nearly two-thirds of our buyers finance with conventional mortgages, with down payments averaging in the mid-teens. All of those are indicators of a more stable credit profile than the credit profile for traditional entry-level buyers. Our longtime JV partner has been able to continue to deliver mortgages for our buyers where other banks and non-bank lenders can't or won't in this environment. While there is a risk that the market could tighten further and impact buyers' ability to qualify for a mortgage, there is no cash or put-back risk to Meritage for mortgage servicing as our JV is a broker only, not a mortgage banker, and doesn't own any loans or servicing assets. We have been successful thus far in working through mortgage solutions with our lenders and navigating the financing environment, which seems to be shifting daily. To date, we have had limited impact from the inability to qualify buyers that would have qualified pre-COVID-19. With that, I'll turn it back over to Steve.

Thank you, Hilla. As our first quarter results demonstrated, our strategy was hitting on all cylinders until late March when closures of large sectors of the U.S. economy began to severely impact the market. Since then, our focus has changed as we are leading and managing the company through a much different landscape now. However, we reminded our employees, partners, homeowners, and investors that this is not 2008. Home inventories are still in short supply, and the industry has been under producing relative to demand for many years. Demand for homes is from buyers who are taking possession and moving into them. The attraction of single-family homes is even more compelling in today's shelter-in-place world. Prices have not been arbitrarily inflated by investors looking to flip homes for a quick profit. Mortgage standards are tighter, yet interest rates are still very low, and builders are focused on bringing costs down to make homes more affordable rather than offering aggressive discounts to harvest cash. We believe Meritage is well positioned in that regard with our strategy in simplifying and streamlining our operations, which has been very successful to date and we believe will continue to serve us well through this crisis and in the future. Our entry-level LiVE.NOW home offers surprisingly more value than some of our competitors at the bottom of the entry-level market, allowing us to attract a higher credit buyer. Our first move-up homes have the features and finishes that also attract second move-up buyers, which expands our potential buyer pool. We are also in much better condition now than before the last recession. Our balance sheet is the strongest it's ever been, with ample liquidity and very manageable debt levels and maturities. We have curtailed discretionary spending and delayed development projects where possible, reduced our cash outlays in 2020 and beyond as necessary. We are carefully managing our spec starts and inventory. We will maintain the cost base of that model to keep a competitive edge for our entry-level communities and help protect our margins. We are well positioned in the market with our entry-level and first move-up communities, which we believe will continue to serve us well. We have an experienced management team that is in sync with our current strategy. Employee morale is good, and we are supporting each other, our families, our business partners, and the communities that we serve. This is not the end of the world. It's the most remarkable act of global solidarity the world has ever seen. To that end, we rolled out a new charitable program last week where the Meritage Cares Foundation and our employees are contributing $250,000 to Feed America. I'm proud of our entire Meritage team for putting our customers first and working hard every day to make a positive contribution. That concludes our prepared remarks. I'd like to thank you for your support at Meritage Homes, and we'll now take questions.

Thank you. Our first question is coming from John Lovallo of Bank of America. Please go ahead.

Hey, guys. Thank you for taking my questions, and I hope you all are well. First question, Hilla, I think you mentioned more recently that some of the activity has improved a bit. In the context of that 25% to 30% decline you're expecting in April, can you maybe frame the past two weeks versus the first two weeks in April in terms of year-over-year declines, just so we can gauge how things are progressing?

Let Phillippe take that one.

Yes, I'll take that, John, it's Phillippe. So, certainly when the shelter-in-place started to occur and state home orders were instituted, we saw a dramatic slowdown that occurred in the back half of really the last week of March. The first two weeks of April were pretty slow; they were off 50%, 60% from last year's April. But then as we moved through the month of April, things have gotten much better. So that’s where you start to see us being off 20%; that really gets you to that 25% to 30% that we're talking about. So what I would tell you is that April is not over yet, and we still have a few more days here, but we have seen a meaningful difference in the back half of April compared to the first half of April and sort of that last week of March.

Just one other point I'll add to that, John, I know some other folks have mentioned detailing and describing a backlog and a higher cancellation rates during the last week, and that's not typical for us. We scrub backlog every day. So we're not expecting an unusually high spike in cancellations to occur in the last days or through the month.

Yes, we don't report any contingent sales in our sales numbers or in our backlog numbers.

Got it, that's all really helpful, guys. And then I think there was mention that I think 15% of orders came from virtual tours or something in that neighborhood. I'm just curious about the percentage of those folks that will typically need to come in physically to see the house before purchasing?

I think they will all come to the house at some point in the process. The point of that stat is they are buying the house basically sight unseen virtually, and then before they close, they’ll come see it. It's a pretty remarkable stat that I really want to believe. I couldn't believe—I struggled to believe that people would actually buy a home without physically going out and walking and touching it, but in this new reality, we are happy that 50% of our buyers are doing that, and we think that number could potentially increase. That said, in many of our markets, the shelter-in-place orders are expiring and being replaced with Phase 1 of America reopening. So many of our communities this weekend, and then into the following weekend, will be back open for business under more normal situations. We will begin to bring some of our offices back online next week in those states where shelter-in-place orders have been relaxed.

I would just add that obviously, having finished specs is really how you’re able to sell a home virtually. It's much more difficult to do that in a built-to-order environment. Our LiVE.NOW models are our LiVE.NOW specs; we have to carry more specs and carry a variety of specs. So we have to demonstrate that home in virtual tours. What you see is what you get when you get out there. And I will tell you that all of those sales, for the most part, are on finished specs.

It's a good proxy for folks that are nervous about existing inventory, as the inventory that's being lifted declined, and people are nervous about doing tours in someone else's home – it’s a very good proxy for that.

Makes sense, thanks, guys.

Thank you.

Thank you. Our next question is coming from Alan Ratner of Zelman & Associates. Please proceed with your question.

Hey, guys, good morning. Glad to hear everyone's doing well, and congrats on the strong performance both in the quarter and since then as well. So, my first question, I guess, just touching a little bit on that last comment about the advantage of having finished specs. One of the things that we've been seeing on the resale side in this current environment is there's been a huge decline in inventories as people are sheltered in their homes and presumably can't sell if they're looking to move? And I would imagine you guys have benefitted to some extent from that there. I guess the question is, as you look forward and eventually, perhaps listings do start to increase. And you have to think about that four to five-month ideal supply of specs that you have on the ground. How quickly are you kind of adjusting that that start case? Because obviously, the trends are changing so dramatically by the week? So should we think about your current start activity being down in that 25% to 30% range that you're forecasting for April, or are you taking some different view based on what's going to happen with resale inventory once it eventually comes back online?

First of all, Alan, thank you for the question and I hope you guys are doing well also. I'll tell you that I think our spec strategy is going to be the defining element of our overall strategy. It's going to be what allows us to gain market share in this downturn because many builders don't do it. We believe very strongly that buyers in this environment and the environment going forward don't want to wait for a home, and they want to move quickly, and we have that inventory for them. That said, obviously, our April starts are going to be down significantly. We don't report starts, but I can tell you our April starts will be down significantly from previous months and from what is normal for us, because we're fine-tuning where we want specs and where we don't, we have made adjustments where we'd have too many and where we don't have enough. We’re selling houses at a fast rate, and there are many places where we're building specs. We manage that by adjusting every day; every day we figure out what we've sold and where we need to replace it. Phillippe leads the effort on that, and I support him. I can tell you this is hand-to-hand combat. We are managing that part of the business very aggressively, as we're managing our land acquisitions and land development. It's not just about conserving cash, but about putting the right product on the ground in the right place at the right price.

That's very helpful. I appreciate the insights there. Your second question, just as you think about your footprint, I know it seems like there are some markets that at least from a job perspective are being hit harder by this current pandemic. When you're thinking about, say, Houston with what's going on with oil or maybe Orlando, obviously with the Disney resorts there being shut down indefinitely. So when you look across your footprint, are you seeing any discernible differences in trends of late, maybe ones where the demand hasn't seemed to bounce back as sharply, perhaps due to that job uncertainty? Or is this strength over the last week or two, is that pretty widespread across your footprint?

I would say that I think about the kind of just the way you just laid it out going into this pandemic and through it. I was most concerned about Orlando and Houston, right? There are 75,000 people in Orlando that work for Disney. They furloughed 43,000 people a couple of weeks ago—it’s a resort market, a travel leisure market—very worried about Orlando. I was also very worried about Houston with oil prices near zero. But surprisingly, our sales in Houston have been very robust for April. I’m awed by how well we're selling homes in Houston this month. Orlando, sales have been off, but not as much as I would have expected. Really, where we're having the most challenges at this moment would be California. California is the one state that I think could be the most challenged. Fortunately, our footprint in California is not that large. We only have 29 communities in California, but that's what I'm concerned about. I'm also a bit concerned about Colorado. Our community count has fallen dramatically in Colorado from 23 a year ago to 13 because we've been selling out of communities and replacing them with new lower-priced local communities. But the price of housing is pretty high in Colorado, and I think buyers there are being a little more cautious. But demand in Arizona is stellar even through the last six weeks, and demand in most of our Texas market continues to be very good as well.

Yes, that's great. Thank you for the color and good luck and stay healthy.

Thank you.

Thank you. Our next question is coming from Truman Patterson of Wells Fargo. Please go ahead.

Thanks, actually it's Paul Przybylski. I guess, Steve, as we look for an inflection in demand, what would you need to see to give you comfort to reengage the land market and develop it? How long would you remain conservative?

We're not unengaged, okay? We're going through our land pipeline. Maybe we had a couple hundred deals in escrow; maybe a hundred of them we've gone hard on. We're reviewing those. We may have some of those—a modest amount of those—that we decide to part ways with. We're not just going to completely blow up the land pipeline. We're going to reanalyze every one of them. Every market is different. I think some land prices are going to be somewhat sticky in certain places, but I think in other places, they may go down, and we don't want to be in a position where we overpaid for land. We also think other builders, private builders, are going to be stressed in this environment and they're going to have to let go of some land that we maybe wanted to buy that we couldn't buy, that maybe now we'll be able to buy. We're going to be very strategic, and we're going to use this opportunity; this is an opportunity to increase our market share. So, I don't know that we're going to be running out and buying land tomorrow, but we're going to be ready this summer, for sure. Particularly if our sales rates hold up, especially in some markets, we will be ready to buy land where it makes sense. As I said earlier, it’s not 2008, where we're just throwing pots and pans off the ship to stay afloat. This is a different situation.

Just to clarify, Paul, we've only walked away from a handful of deals so far. For the most part, all we've done is just pushed out the timeline for the deals that we have.

We'll have some more deals that we’ll walk away from this quarter, and there’ll be some expense too for that, but I don't think it's going to be that material.

Okay, and Hilla, earlier on the call, you mentioned you had significant headroom on the incentive front before triggering impairments. Do you have any color on the magnitude? Is it probably in the 10% range?

Yes, I mean, you guys saw the margin this quarter was 20%. So, there is quite a long runway between that and breakeven. There are some additional costs for not to get too geeky on the accounting part, but the auditors are making still on a little bit more money, but you probably have between 10% and 15% decline before we would need to start having conversations about impairments. And that's assuming that there are no price concessions at all to be gotten in the market today, which obviously there are. So, I think that kind of combination of all of those items gives us a lot of breathing room.

We had 30% to 40% price declines in the last great recession, which certainly caused all those impairments. Our margins were really strong then, even stronger than they are now. But we're not seeing any real price declines yet. Incentives have picked up a little bit, but not meaningfully.

Okay, thank you.

Thank you. Our next question is coming from Stephen Kim of Evercore ISI. Please go ahead.

Yes, thanks a lot, guys. Encouraging stuff. Good to hear. Yes, it certainly does seem like things are holding up a lot better than they were looking like they were going to be a few weeks ago. I guess I'm curious as to whether you could comment on what you're expecting or what you're anticipating will be different as you in the markets where you reopen versus the markets, I mean, where the states are reopening versus the states where it will be more delayed. And what specifically are you looking for in these markets that are opening up earlier to gauge how you're going to perhaps pivot your strategy in the other markets that may follow?

It's traffic, it's sales activity, it is buyer engagement, and it's pricing. What incentives are necessary or not necessary to get people to transact. It is no different than in a good time than in a bad time. The activity that we're seeing in the field and in the communities is really going to drive our decisions around building specs and buying land. It's a pretty simple formula. In markets like Georgia, South Carolina, we're now seeing Texas opening up here. In the markets that are paving the way for opening, we're seeing incremental traffic right away. We're seeing buyer engagement as we articulated. So we're seeing all that. It will just be key to watch the economic landscape for each of these markets. Someone mentioned where the job loss is going to occur, and we need to keep an eye on that. But we've already seen buyer engagement improve just with the idea of opening back up. So we’re certainly expecting incremental activity in traffic when we can actually open up in a non-virtual appointment-only environment.

Yes, absolutely. Particularly, seeing things improve over the last couple of weeks is important. Do you attribute or how are you anticipating that you're going to utilize incentives during this, what you might call a diagnostic phase? You've indicated you've seen some nice pickup and traffic and buyer engagement. I'm assuming that is in the absence of a material increase in incentives on your part or any special programs. Can you talk about the degree to which you are planning to maybe pull back on incentives in the near-term or conversely, increase incentives as these markets open up?

Well, the question really should be more about what were our incentives in April? I would say we used a variety of tools in April, but they all add up to about 150 basis points. Some of it was commissions, some of it was more closing costs, a variety of different things that we did. That being said, we were raising prices in March. I don't believe that our April incentives, that 150 basis points that we spent, is going to have a meaningful impact on our margin because I think our prices were on the upswing of our inventory going into April. It's going to be interesting to watch. But I’m going to refrain from telling you what we're going to do in May; I know a lot of our competitors are listening to these calls as well, reading the transcripts, so I don't want to telegraph to the market what we're going to do. But I can tell you this: We're not going to sit on our hands and watch the movie go by. We're going to be aggressive and active in making sure that we maintain our volume to a reasonable level and move our product and compete. That is what the really good entry-level builders do, the good builders did it in the last downturn, and they're going to do it now. We're going to be right up there with them.

I would just add, this is not a peanut butter approach. Every community has a different story. We believe we're going to sell over 650 houses in April in a largely sheltering-in-place environment. We have a lot of communities, especially in the entry-level space that performed at or above our original underwriting expectations. We're not looking to over-incentivize those, especially as we think they'll do better coming out of this. So every community we look at, we evaluate what our competition is doing, and what the story on that community is, what's our spec story? So, it's a community-by-community thing, a market-by-market thing. I would also tell you that I believe this is the advantage of having specs. When you look at incentivizing specs, it's very different than incentivizing dirt. You can control the margin erosion much better.

Yes, I know it's all very encouraging. I appreciate it. And you also didn't mention the fact that lending standards tightened a little bit too in the recent weeks. So the strength is really encouraging. Thanks a lot, guys. I appreciate it.

Thank you.

Thank you. Our next question is coming from Carl Reichardt of BTIG. Please go ahead.

Thanks, good morning, folks. Glad to hear you're well. I was curious, Phillippe, if you could talk about April in terms of entry-level LiVE.NOW spec versus the move-up side of the business, and maybe how absorptions on a net or gross basis had turned out between those two segments?

No, I don't have those stats right in front of me for April yet on how much of that was entry-level versus first move-up versus sort of our non-strategic assets. But I can look at the data in front of me and tell you that LiVE.NOW is continuing to perform very strongly. There has been modest pullback in the first move-up. It's definitely stronger there than it was now. The two move-ups are definitely slower than in the first quarter. I would just tell you in general that entry-level, entry-level plots, lower-end first move-up is performing much better than the higher-end stuff. I think you'll see that trend in April and as we come into May.

Higher-end stuff costs made only 6% of total volume for Q1. It's not really even a footnote for us anymore, and the pace is holding relatively consistent at about 150% of first-time movers, and entry-level is about 150% absorption space, and first-time movers and those ratios are holding relatively consistent.

We've been watching some of our competitors, and we do have a few communities that are closer to what I would deem as ultra-entry level, and I see that some of those are more challenged because their buyers are less creditworthy and tend to have a lower credit score. We cater to a little bit more of a premium entry-level buyer who has a better credit score. Our entry-level buyers' credit is generally over 700. We do have some in the 600s, but we don't have any of those low 600 or even high 500 entry-level buyers that some other people might have. So our entry-level communities have not really seen a drop-off in activity.

Okay, I appreciate that answer. Thanks, guys. And then, Hilla, you talked before at the Analyst Day and previously about community count – what 20 would have been, which was a transition year before 21 community count grew. If - let's operate under the assumption that you're sort of down 25%, 30%, and that's sort of where we are for a few months before there is some type of a rebound. Is your sense then that effectively you'll just run your community count down, or replace communities that do sell out at a slow rate? I guess the question to me is, what does the market need to look like before you start to think about a more aggressive expansion of your community count?

That's just too hard to answer at this moment because we have so many moving parts. We have some communities that we've frozen development for a short period of time to see what's going on, so those will be, but some of those will be delayed that had planned opening later this year. We have some communities that are selling out a little bit slower than others and maybe continue to be open through the year. We have some that are going faster. We're just in the eye of the storm right now, and I don’t want to give any guidance on community counts until we get a little farther down the road with this. I think next quarter it's a more reasonable question to ask. We definitely still have our mindset and our target on getting to that 300 communities, wanting to be there by the end of 2021. We're still going to get there; it’s just going to take us a little bit longer. We were dealt a curveball here. With these low interest rates and the tight supply of housing, we are going to get through this in a pretty good way. But I don't want to give any guidance.

Steve had mentioned in his prepared remarks that we're just trying to navigate the short and midterm, but nothing has changed for us long-term. That’s still the strategy to hit the 300 community mark. Not sure it's going to happen on the quarter that we thought it was going to happen in, but that’s still the eye on the prize.

Okay, I appreciate it. Thanks.

Thank you. Our next question is coming from Michael Rehaut of JPMorgan. Please proceed with your questions.

Thanks and good morning everyone. I hope everyone is healthy and safe. First question, I was just hoping to get maybe in some ways a clarification on some of the numbers provided earlier, specifically, just around down 25% to 30% in April that appears to be more of a gross decline. If you could kind of extrapolate the…?

Mike, we had—I think there's a slide in our presentation—916 sales last year's April net, and we're projecting north of 650 net. So that's how we're getting to the 25% to 30%. So that already has all of the cancellations in there.

Okay, that's helpful. I guess, maybe we could follow up offline with some of those numbers. But also around the down 50% to 60% early in April and then down 20% in the last couple of weeks. Is that also net or gross?

This is all net. The first two weeks of April we were—and I'm trying to think about week-to-week trends year-over-year is what the question was. I'm not sure if I'm spot on. I think the point is that the last two weeks and as we move through this week are meaningfully stronger than the first two weeks of April.

And maybe wouldn't get caught up on the weekly percentages. I think the takeaway is that it was rougher in March. It's been improving steadily ever since, and we expect April to close out 25% to 30%. As Phillippe mentioned, likely April will be the toughest month considering almost the entire country is shelter-in-place right now and we're exiting out of that going into next year.

Yes, and Mike I know you've noticed a long time that sales numbers always build as you get later in the month because incentives expire, and salespeople get more motivated and work harder at the end of the month than they do at the beginning of the month. People clean up their backlog and sales. So as you move through a month, numbers are always building. So that said, the last two weeks in March as Hilla said, numbers were declining, and the first two weeks of April numbers were lower than what you’d expect for the prime selling season. But the last couple of weeks, particularly last week, it’s been pretty strong. We endeavor to deal with our sales on a daily basis, and we're always reporting net numbers.

Okay, okay, I think maybe I was also just confused with the bar chart there was a 600 number in there. Basically, that's again where we can follow up on. But I appreciate the clarity. I guess secondly, just on the gross margins in the first quarter, understanding a lot will change off of the current market conditions going forward. But, there was a very impressive number around 20% gross margin for the first quarter, which compares to the mid-18s that you were expecting. So I was just hoping to get a little bit in terms of what the drivers were of that upside on a relative basis and if that's kind of the new starting point, all else equal. If you were to kind of take out maybe one incentive and market demand is going to do, but if there was any type of mix shift or timing that benefited that quarter, or if structurally perhaps you're at a higher level than you realize?

Well, here's the thing with our strategy and our model. We're able to sell homes in the quarter and close them because we had an 83% conversion ratio in Q1. We had a robust January and a robust first half of February, and we were able to sell inventory and close it within the quarter, which allowed us to outperform the guidance that we gave you for closings, which drove higher margin because we didn't have to create any additional overhead to produce outside revenue. So, that's why it's important to keep building and selling, because the overhead leverage is significant and has a tremendous impact on the bottom line. Because in January and February we saw strong sales, and we sold quite a few more homes than we expected to. We were able to close those and produce a better gross margin.

So, Mike, if you're looking at year-over-year—Q1-to-Q1 of that 330 basis point improvement, about 80 basis points of that is increased leverage from the higher volume. The rest of that is a combination of what we talked about, which is our ability to increase pricing. The strength that we talked about coming into the quarter, but also those cost efficiencies we've been improving in our processes and products over the last couple of years. The combination of all that really became evident in our closings in Q1. So again, that 330 is mostly comprised of improved processes and cost reductions, although there is 80 basis points in there from that overhead, leveraging from the additional volume.

Okay, thank you.

Excuse me, thank you. Our next question is coming from Jade Rahmani of KBW. Please go ahead.

Good morning. This is actually Ryan Tomasello on for Jade. Thanks for taking the questions. I was wondering if you're seeing any early indications for a potential increase in acquisition opportunities across the landscape, including large-scale M&A in the market?

No, no one's looking at acquisitions in the middle of a pandemic. Even I don't think any builders are inclined to be selling right now unless they're looking for a lifeline. So, the short answer is no.

Okay, and then are you seeing any preliminary signs in your market today of increasing demand as a result of specifically the pandemic from multifamily renters?

I think it's too early to tell. I mean, we believe long-term that people are going to want to own a home. They're going to want to be in the suburbs. They're going to want to socially distance, you know, not live in tight quarters. We think we're getting an influx of people from high-density cities to move out to the Sunbelt where we build. But it’s just too early to really draw any trends based on anecdotal evidence.

Got it. Thank you.

Certainly. Our next question is coming from Alex Barrón of Housing Research Center. Please go ahead.

Yes, thanks. Hope you guys are well. I wanted to ask about how much is your build time being affected by social distancing and all that stuff?

Yes. Thanks, Alex. This is Phillippe. The first thing I would say is it's not getting any worse. In fact, I will tell you that we're seeing more effective construction activity. We think that's largely attributed to us being an essential service being carved out. The trade crews are performing at a very high level right now. They are getting to the job site faster. They have less other work to do that distracts them. Supply chains are moving effectively at this point. So we're building houses probably faster than we have ever right now because of all those reasons, and our cycle times are still extremely tight. I think we are seeing a little bit of a lag with permits and things like that, but it's nothing too big, and we're certainly making that up on the build times, the actual vertical build time. So again, I think this will start to unwind over time, but I will tell you, the trade crews are executing at an extremely high level.

I would say, Alex, one or two of our big builders opened early in the pandemic and shut down construction, and those crews came over to our job site and said, 'Can we double up?' and we said, 'Sure, come on over; let's just get some more stuff built.' So both guys are reading the paper too—they're nervous—and they're working hard to maintain their share as well.

That's good to hear. The other question is, Steve, you said you're not going to let anybody else, I guess, are you going to be aggressive and not let others take your market share? So, my question is, how much flexibility does each individual salesperson have on getting a sale done? In other words, do they have some pool of money that they can work on incentives, or do they need to check more all the way up to you guys? I guess I'm trying to understand how centrally controlled the sales and incentives are versus does each salesperson have their own flexibility? Just trying to get the sale done regardless of what it takes?

Obviously, they have a little bit of pocket discretion. But we control things locally at the division office to the regional leadership, and centrally corporate. So, this is our job; that’s Phillippe's job. He monitors that every day. He has his hands on the wheel. He is pulling the levers as needed. We don't have any delay in reacting to what's happening on the ground.

Yes, and I mean, we rarely go into an environment where salespeople are empowered to just get buyers on paper at whatever cost.

Yes.

Okay, my last question is if you guys have any communities that maybe haven't had a sale for a few weeks, or what is the trigger to kind of reevaluate your incentive or your pricing? How many weeks would need to go by without seeing any activity before you need to kind of re-look that?

That's a little too granular. I don’t think we're going to talk about that. But yes, clearly we haven't—we're not showing houses somewhere or whatever the reason is, there could be multiple reasons. It could be something with a salesperson, it could be something wrong with the product, or it can be rational what the competition is doing, etc. We're going to send the SWAT team in there to figure out what the problem is and make the adjustments accordingly. But I can't tell you a formula: after three weeks, we're going to have to slash the price. We don't function that way.

Okay, thanks and best of luck for this.

Thanks, Alex. Stay well. Operator, I think we're getting close to the end. Do we have any more questions? We may take one more.

We are showing time for one last question, which will be from Charles Perron from Goldman Sachs. Please go ahead.

Hey, good morning, gentlemen. My first question is can we discuss the different trends that you're seeing in the labor and material costs through April. And if you believe these provide a tailwind to the margins in 2020, assuming a weaker demand environment?

I would say that—we haven't had any price increases in April. Our cost increase is mainly from our trade base. Certainly, we did experience some in March, but it's been more muted. I do think with the low price of oil, we will be able to get some price concessions going forward, cost concessions, I should say, from our trade base. I also believe that lumber is—we have a lot of lumber contracts expiring, and we're going to be renewing those contracts. We believe at lower costs, maybe 10% to 20% lower in certain geographies—some more than others. I think the cost environment has become more favorable for us and for builders moving forward.

Okay, thank you. That's very helpful. And second, I would like to go back a little bit more on the SG&A. And obviously, even if you don't hit your 10% target for the year, can you give us a sense of where things could go on the agenda for this year? And what do you expect that to trend overall for the year?

That would be guidance. We're not giving guidance, so I don't know how to respond to that.

We can't. That percentage is a function of revenue, and we're not giving out revenue numbers. The only thing we will say, and we said it a couple of times during the prepared remarks, is we're pulling back dramatically on non-essential discretionary spending. So we're going to be controlling costs very tightly, but the revenue piece is so murky that I don't think we're prepared to provide any guidance on SG&A right now.

Okay, that's very helpful. Have a good day.

Okay, thank you. That concludes our question-and-answer and prepared remarks here today. We appreciate everybody coming in and joining our call. We hope you stay well and navigate through this crisis and come out on the other side. We'll look forward to talking to you again next quarter. Thank you very much. Have a great day.

Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect your lines at this time and have a wonderful day.