Meritage Homes CORP Q3 FY2021 Earnings Call

Greetings, and welcome to the Meritage Homes Third Quarter 2021 Analyst Call. It is now my pleasure to introduce your host, Emily Tadano, Vice President of Investor Relations. Thank you. You may begin.

Thank you, Doug. Good morning, and welcome to our analyst call to discuss our third quarter 2021 and year-to-date 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 home page. On Page 2, please refer to our forward-looking statements. Our statements during this call, as well as the press release and accompanying slides, contain forward-looking statements, including but not limited to our views regarding the health of the housing market, economic conditions and changes in interest rates, community count and absorptions, trends in construction costs, and potential disruptions to our business from an epidemic or a pandemic such as COVID-19. 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 differ materially from our expectations due to a wide variety of risk factors, which we have identified and listed on this slide as well as in our press release and most recent filings with the Securities and Exchange Commission, specifically our 2020 annual report on Form 10-K and quarterly reports on Form 10-Q, which contain a more detailed discussion of those risks. We’ve also provided a reconciliation of certain non-GAAP financial measures referred to in our press release as compared to their closest related GAAP measures. With us today to discuss our results are Steve Hilton, Executive Chairman; Phillippe Lord, CEO; and Hilla Sferruzza, Executive Vice President and CFO of Meritage Homes. We expect this call to last about an hour. A replay will be available on our website within approximately 2 hours after we conclude the call and will remain active through November 11. I’ll now turn it over to Mr. Hilton. Steve?

Thank you, Emily. Welcome to everyone participating on our call. I’ll start with a brief discussion about current market trends and provide an overview of year-to-date 2021. Phillippe will cover our strategy and quarterly performance, and Hilla will provide a financial overview of the third quarter and forward-looking guidance. Home buying activity remained solid during the third quarter. We continued to experience elevated demand and despite the return of some seasonality in the quarter, monthly demand has improved sequentially from August to September and October. The macro drivers for market demand continued to be what we’ve experienced all of ‘21: limited housing supply, still extremely low interest rates and higher home buying activity from millennials and baby boomers who are experiencing life events associated with changes in housing needs. New and existing resale housing supply remained tight, especially for affordable entry-level homes. Mortgage interest rates are still very attractive as entry-level buyers are typically focused on monthly payment. The low interest rates continued to offset higher ASPs and we are seeing elevated demand persist. And lastly, we continued to see household formation for millennials and downsizing for baby boomers, both of which create demand for the type of housing that we build. We believe these underlying demographic factors will not fundamentally change in the near future, although they may be bumpy if interest rates move materially within a short period of time. This quarter, we leaned on our deep vendor relations to navigate ongoing industry-wide supply chain challenges. These strategic supply side partnerships and our operating model focus on spec homes and limited SKUs allowed us to deliver 3,112 homes, which set a company record for the highest third quarter of home closings. We also set 2 additional quarterly company records: we generated the highest quarterly home closing gross margin of 29.7% in company history as a result of pricing power, more than offsetting the elevated lumber and other commodity costs, and our quarterly diluted EPS of $5.25 was the highest in our company’s history. We grew community count sequentially again this quarter as well as year-over-year, overcoming municipal delays and supply shortages and land development as well. As of September 30, 2021, we had 236 ending communities and remain confident in our ability to achieve our goal of 300 communities by mid-2022. On Slide 4, I want to touch on the latest milestones we achieved this quarter. The EPA recognized Meritage as a recipient of the 2021 Indoor airPLUS Leader Award. Our advanced air filtration, ventilation and HVAC as well as spray foam insulation helped minimize the indoor exposure to airborne pollutants and contaminants, so it’s great to be recognized for these accomplishments nationally. In terms of innovation, we launched self-guided tours in select locations to address customers’ changing preferences when it comes to the home buying process. Self-guided tours allow buyers to sign up for a no contact tour of our model homes on our website and then tour the home after-hours at their convenience. We expect to have this program rolled out throughout the country in the coming months. Additionally, we expanded our offering of digital financial services, so Meritage customers can now receive guaranteed on-demand homeowners’ insurance quotes on their selected home on our website. From an ESG perspective, we memorialized our human rights policy, which can now be found on our Investor Relations website. Stay tuned as we will have more to share on ESG before year-end. Overall, it was another successful quarter, where our teams and supplier relationships helped Meritage deliver 3,112 homes. I’ll now turn it over to Phillippe.

Thank you, Steve. Affordability was one of the cornerstones of our strategic shift in 2016, and we continue to focus on today. From land acquisition to operations, we look to maintain our entry-level products as an affordable home offering in the new home marketplace. That being said, the sustained favorable pricing environment stemming from the elevated demand for our products over the past few quarters and the tight housing supply conditions led to ASP increase on orders, backlog and closings that are masking our ongoing product mix shift towards entry level. Although order ASP grew 12% year-over-year, we experienced a deceleration in ASP growth sequentially this quarter. The new product we’ll be bringing on in 2022 and 2023 will allow us to continue repositioning our future communities down the ASP band. During the third quarter, we continued metering our orders pace to align with the current production environment and supply chain challenges. Even still, our average absorption pace remained elevated at 5.0 per month. We were still typically able to sell inventory shortly after releasing it, but we are only releasing homes once we have visibility into our cost structure and confidence about closing times, which is a bit late in the process today due to supply constraints. It is unclear when the current supply challenges will work themselves out. We currently have no insight to suggest that it’s on the near term, and therefore, we are continuing to model elongated cycle times for the foreseeable future. Now turning to Slide 5. Our third quarter closings totaled 3,112 homes. They were up 4% over the prior year. Entry-level comprised 78% of closings, up from 63% in the prior year. For us, Q3 of last year was the quarterly peak of the surging housing demand since the start of COVID-19, resulting in our all-time highest third quarter absorption pace of 5.8 sales per month. In 2021, we have been metering orders due to the well-documented supply chain issues. As a result, the total orders of 3,441 for the quarter of 2021 reflected a decrease of 11% year-over-year, driven by a 15% decline in average absorption pace that was partially offset by a 5% increase in average communities. Despite metering, our third quarter 2021 absorption pace currently remained elevated at 5 sales per month. Entry-level comprised over 80% of quarterly orders, up from nearly 70% in the third quarter of last year. Entry-level also represented 77% of our average active communities compared to 60% a year ago. Moving to the regional level trends on Slide 6. Our central region, which is comprised of Texas, led in terms of average absorption pace with 5.4 sales per month this quarter, which was 14% lower than prior year. This decline was partially offset by a 5% greater average active communities, which together contributed to a 10% decline in order volume. Third quarter order ASP increased 20% year-over-year given solid market conditions in Texas. Our east region with the highest entry-level product mix, representing 80% of the average community, was the only region to generate year-over-year growth in order volume of 3% despite metering as a result of an 8% increase in average active communities in the third quarter, which offset a 4% decrease in average absorption pace. South Carolina opened several new communities later in the third quarter, which resulted in a 3.7 average absorption pace in the third quarter. This was our lowest absorption pace in the company’s quarter, despite South Carolina’s orders increasing 11% over the prior year. Given healthy demand in the state, we anticipate the order pace will increase in the near future. The west region’s third quarter 2021 order volume had our largest decline at 24% year-over-year, mainly due to 25% lower average absorption pace to 4.9 per month. Specifically, Arizona reduced its absorption pace from 6.5 per month in Q3 of 2020 to 4.8 per month this quarter as a result of supply chain challenges. Colorado remained the lowest percentage of entry-level mix at 48% of its average active communities this quarter. However, given the great representation of entry-level products in its upcoming pipeline, we expect its absorption pace will start to increase over time. During the third quarter, California had the highest average absorption pace of all our states at 5.6 per month. Given 100% of the average active communities are entry-level there, we continue to focus on affordability, particularly as it’s our most expensive geography. The third quarter order ASP increased 15% year-over-year in the west region. Arizona and Colorado had the largest increase in order ASP in all our states at 26%. So we are monitoring these markets to ensure we wire ASP to local market condition and continue to introduce products that are more affordable. Overall, demand remained healthy in all of our markets. Turning to Slide 7. Of our home closings this quarter, 74% came from previously started spec inventory, which increased from 71% a year ago. We ended the quarter with nearly 2,100 spec homes in inventory or an average of 11.7 homes per community as we push to get homes in the ground. This was an important improvement from approximately 2,300 specs or an average of 11.2 in the third quarter of 2020. At September 30, 2021, less than 5% of the total specs were completed versus our typical run rate of 1/3. Having available spec is crucial to our business model, but even as we started over 3,400 homes this quarter, maintaining our goal of a 4 to 6-month supply of entry-level spec has been challenging. As we have been ramping up our new communities, we are working very hard to get enough spec started in all of them. We didn’t accomplish all that we wanted in Q3, but we expect to accelerate our pace in Q4. We ended the quarter with a backlog of over 1,500 units as our conversion rate declined from 68% last year to 57% this year due to supply delays. Although we believe our spec strategy and entry-level focus will drive the conversion up in the long term when the supply chain normalizes, we expect current supply issues and the resulting slower backlog conversions to persist at least for the next couple of quarters. During the third quarter, bottlenecks abound in various areas along the supply chain, some on the front end and others on the back end, leading to an additional 2 weeks or so of construction cycle times sequentially from Q2 to Q3 this year. In particular, windows and truss delays impacted our operations throughout the country. As Steve mentioned, our operating structure and strong vendor partnerships have afforded us some advantage as we navigate these disruptions. We reengineered our product a few years ago which limit our SKU count and planned libraries, allowing us to order material in bulk in advance. We have also heavily invested in relationships with our vendors, which we have strengthened during the last couple of quarters. We are maintaining constant communication and remain flexible to substitute or upgrade our SKUs or find alternative supplies as necessary. We have been benefiting from our 100% spec building strategy for entry-level homes. Pre-starting homes enables us to maintain a steady cadence of homebuilding construction and makes us a preferred partner to our trades. This transparency in scheduling visibility as well as no structural changes makes our products simpler to build. At times like these, we appreciate that we can leverage our spec building strategy and our operating model to continue to deliver our backlogs and get more homes started. I will now turn it over to Hilla to provide additional analysis of our financial results.

Thank you, Phillippe. Let’s turn to Slide 8 and cover our Q3 financial results in more detail. The 10% year-over-year home closing revenue growth to $1.3 billion in the third quarter of 2021 was the result of the 4% increase in home closings and 7% higher closing ASP despite the mix shift to more entry-level products. The 820 basis point improvement in third quarter 2021 home closing gross margin to 29.7% from 21.5% a year ago was driven by the price increases over the past several quarters as well as the leveraging of our fixed costs on greater home closing revenue. The pricing power more than offset the increased cost of lumber and other commodities. Today’s more normal lumber cost will start to be reflected in our gross margin in early 2022 but will be partially offset by other increased commodity costs as well as the additional overhead burden in gross margin from our community count ramp up. Once we’re fully selling and closing from all 300 communities in 2022, we will be able to leverage the higher fixed overhead costs across the corresponding higher revenue. We are also continuing to monitor the recent increases in lumber and the impact they may have on our 2022 gross margin. Our SG&A leverage of 9.3% remained better than our 10% expectation and continued to benefit from both greater closing volumes and higher ASPs. The 80 basis point year-over-year improvement and SG&A leverage from 10.1% in the third quarter of 2020 also included lower brokerage commissions in 2021 and cost savings from technology innovations that particularly benefited our sales and marketing efforts. We will continue to find ways to incorporate technology into our operations and expect to be able to better leverage our total SG&A on higher closing volumes in 2022 as well. The third quarter 2021’s effective income tax rate was 23.3% compared to 19.5% in the prior year. Both years reflect reduced rates primarily from eligible tax credit on qualifying energy-efficient homes closed under the 2019 Taxpayer Certainty and Disaster Tax Relief Act. Increased profit in states with higher tax rates and reduced benefit of the energy tax credit due to greater overall profitability for the company both contributed to the higher tax rate in 2021. Higher closing volume, pricing power, expanded gross margin and the improved overhead leverage that we achieved this quarter all led to the 85% year-over-year increase in third quarter diluted EPS of $5.25. To highlight a few year-to-date results through September 30, 2021, on a year-over-year basis, we generated an 85% increase in net earnings, orders decreased 1%, closings were up 15%, we had a 640 basis point expansion of our home closing gross margin to 27.4%, and SG&A as a percentage of home closing revenue improved 90 basis points to 9.4%. As seen on Slide 9, our balance sheet reflects ample liquidity and flexibility for further growth. At September 30, 2021, our cash balance was $562 million compared to $746 million at December 30, 2020. It was down just $184 million despite an $815 million increase in real estate assets over the same time. Our net debt-to-cap ratio of 17.5% at September 30, 2021, remained low. We still target a maximum ceiling of net debt-to-cap in the high 20s, which is in line with the quick asset turn we expect from our entry-level and first move-up offerings. Our capital usage priority is still focused on growth. The bulk of our cash will be spent on land acquisition and development and to get specs in the ground in our new communities. We routinely repurchase shares to offset new grants and keep our dilution neutral. As demonstrated in the third quarter, we will also continue to opportunistically repurchase incremental shares. We repurchased over 95,000 shares during the quarter for $9.5 million. Since the end of the quarter, we repurchased an additional nearly 244,000 shares for another $24 million. Today, over $153 million remains in our share repurchase authorization program. We expect cash generation to accrete once our 300 communities are operating and delivering homes in the back half of 2022. On to Slide 10. Our land book increased 46% from September 30, 2020. With nearly 70,000 lots under control at the end of this quarter, we had 5.4 years supply of lots based on trailing 12-month closings, which was higher than our target range of 4 to 5-year supply of lots under control. However, looking forward to the closing volume that we would generate once our 300 communities are actively selling in the middle of next year, the ratio drops back to our 4 to 5-year objective. We secured about 9,800 net new lots this quarter compared to approximately 9,000 in the same quarter of 2020. These new lots will translate to an estimated 45 net new communities, of which 87% are entry-level with an average community size of 196 lots. Despite the additional demand for land from all builders today, we were able to meet our internal land acquisition goal while ensuring our projects meet our underwriting hurdles, modeling a normalized absorption pace and a higher incentive environment. Our understanding of who we are has sharpened as has our confidence level in the type of projects we bid on. By knowing the cost of the home and increasing our land development expertise, we feel comfortable bidding on land parcels that others might not, from acquisition of larger lot sizes to those in secondary submarkets that best align with our entry-level products and projects with complexity in land development. In fact, our year-to-date finished lot cost for newly controlled lots is right around $75,000 a lot. During the third quarter of 2021, we continued to make excellent progress in our land development despite municipal delays and supply chain constraints, and we opened 40 new communities. We grew our community count by 10 net communities from 226 at the start of the quarter to 236 actively selling communities at the end of the quarter. On a year-over-year basis, we were also up 16% or 32 net communities from 204 at September 30, 2020. We spent $526 million on land acquisition and development this quarter, which was 76% higher than last year’s Q3 spending of nearly $300 million. We continue to expect our annual land acquisition and development to be about $2 billion in 2021 and thereafter. To preserve liquidity, we use options for staggered purchasing terms wherever financially feasible. About 64% of our total lot inventory at September 30, 2021, was owned and 36% was optioned compared to 58% owned and 42% option at September 30, 2020. Finally, I’ll direct you to Slide 11. With limited visibility into when the supply chain will loosen, we continue to forecast supply chain delays and longer cycle times for the rest of 2021 and into 2022. With more than 5,800 units in backlog and another almost 2,800 specs in the ground today, we are projecting 12,600 to 12,900 home closings for the full year of 2021, which we anticipate will generate $5.05 billion to $5.15 billion in home closing revenue. We are lifting our full year 2021 guidance on home closing gross margin, which we now anticipate will be between 27.5% to 27.75%. With an increase to the projected effective tax rate to 23%, we expect diluted EPS to be in the range of $18.75 to $19.40 for 2021, a year-over-year increase of over 70%. For year-end 2021, we also anticipate around 250 active communities. We are reiterating our commitment to 300 communities by June 2022, with around $2 billion of land acquisition and development spending projected for next year as well. For 2022, we anticipate double-digit growth in unit and home closing revenue. As I previously noted, we expect gross margins in 2022 to remain elevated, although supply chain issues, commodity costs and recent lumber cost increases may all cap further upside. With the higher volume of communities operating next year, we anticipate full year 2022 SG&A rate will drop below our current SG&A rate of the low 9s. With that, I’ll turn it back over to Phillippe.

Thank you, Hilla. To summarize on Slide 12. We have capitalized on the ongoing favorable market conditions by having available supply of entry-level and first move-up homes that are attractive to both millennials and baby boomers, the largest home buying demographic today. The continued significant investment in land acquisition and development as well as the meaningful growth in community count over the past 2 quarters to 236 communities as of September 30 demonstrates our ability to attain our strategic goal of 300 communities by mid-2022. Our operating model, strong execution, growing community count and focus on the entry-level and first move-up markets have all led to the company hitting our closings, achieving an absorption pace of 5 per month while metering the order pace, growing community count again and obtaining industry-leading gross margins this quarter. Additionally, these attributes position us well to continue expanding our market share, leveraging our operating costs and driving profitability over the next several years. With that, I will now turn the call over to the operator for instructions and the Q&A.

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

Nice job in the quarter. Phillippe, I think you made a comment early on that the goal going forward is to try to bring that average price back down a little bit from, I guess, the current 430-ish range that you’re at today. On one hand, that certainly would be great news from an affordability perspective. But I’m curious if you could talk a little bit about how you’re going to make that happen. I’m sure your lot costs are going up at a pretty strong rate. Costs are going up across the board, maybe aside from lumber. So what levers are you pulling to bring that price back down a little bit? And can you put any meat behind where you actually see that ASP going over the next few years?

We are actively looking for land that enables us to price our product in the mid to low 300s in certain markets, and potentially close to 400 in others. We believe we have been successful in this effort. Over the past 18 months, the land we've acquired allows us to achieve these price points. We are open to exploring secondary markets, and while we are not venturing into tertiary markets, we are definitely targeting more affordable secondary markets where we can find low-cost land to offer our products at more accessible price points. Hilla noted that our average lot price will be $75,000 going forward, which supports our goal to keep our product priced below $400,000 in all markets. The key to this goal lies in sourcing less expensive land. We are not expecting an increase in our vertical costs and are focused on acquiring quality land in viable secondary markets to keep our pricing competitive.

Got it. That’s helpful. And I guess, drilling in a little bit deeper on that. So a, how quickly does the mix get below 400? I mean, is that just as you open up and ramp the community count to 300? So by middle of next year into ‘23 you’re kind of operating at that level? And second, on that point, with that lot cost at 75, just kind of back of the envelope, it would seem to me as that flows through, unless you do get price appreciation, maintaining a, call it, 28% gross margin into the next several years might be a little bit difficult. So any comment on that would be great.

Next year, most of the land that will not go through is land we purchased two years ago. We believe our margins will remain high throughout next year. The land acquired in the last two quarters is expected to follow more typical margins, and that won’t be incorporated until late 2023 and into 2024. We have secured enough land for the next two years, which we are purchasing with an eye on the future and accounting for standard margins. Over the next two years, we are focused on positioning our product below $400. We anticipate that, assuming no further price increases, this land will enable us to reduce our price point into the $300s during that period.

Our next question comes from the line of Stephen Kim with Evercore.

Really impressive results, so congratulations on that. My first question relates to gross margin, which was obviously up tremendously. And you had mentioned that I think 26% of your closings this quarter were what we would call dirt sales. I was curious whether those dirt sales generated a lower gross margin than the units which you had sold already in the construction process. And if there is a differential between those dirt sales and spec margins, has that differential widened versus pre-pandemic?

I’ll address that, Stephen. Our dirt sales come entirely from our entry-level homes, as we are a 100% spec builder. The dirt sales are linked to our one move-up product. There isn’t a significant difference between the two, though in the current environment, selling spec seems to offer a slight advantage. This isn't solely due to it being spec, but the entry-level process provides some extra efficiencies. We aren’t ready to quantify the exact difference, but there is a minor benefit to selling spec, particularly in today’s supply chain constrained market, which is our entry-level product.

Yes. Got it. And as a follow-up, Hilla, would you say that’s because it’s more entry-level or because it’s more spec, if you had to guess?

It’s because it’s definitely because it’s more spec. Typically, you should earn a higher margin on the more expensive options in the home. But in today’s environment, the cadence that we’re able to achieve on the spec product helps us. It helps us always kind of neutralize the benefit. But normally, we’re yielding about the same margin between the two products; the higher option cost that you’re getting on one move-up are offset by the faster cadence and the more streamlined operations of the spec product. In today’s environment, there’s a slight benefit to the spec product, even overtaking the margins of the higher options on one move-up.

And even in one move-up, we’ve completely streamlined our operations. I think you’re familiar with our new studio. Although you’re able to personalize the home, we still have a lot of visibility into those costs. They’re almost a spec, but we allow the buyer to personalize within that sort of spec process. So we’re almost all spec for the most part of the company.

Yes, great. Okay. Second question relates to gross margin outlook. I think you had talked about seeing the benefit of reduced lumber prices probably flowing through in early ‘22. But you did caution that there’s a fixed cost, I guess, in SG&A that will increase as your community count is increasing, but you’re not obviously going to be delivering a lot of homes. So there’s a little bit of a mismatch, I suppose. Could you help us quantify this, give us maybe some sort of a framework or rubric to be thinking about how this could influence your results? And I think you also indicated that fixed cost leverage helped you this quarter. So just how much of the COGS are we seeing that are kind of fixed? And maybe give us a framework for thinking about how to model that going forward?

I think in the past, we've noted that in years with typical seasonality, there tends to be almost a 100 basis point improvement between the first and fourth quarters due to volume leveraging. This improvement helps us reduce the impact of fixed costs on higher volume, and higher average selling prices have also contributed positively this quarter. Next year will bring some fluctuations since we plan to increase our community count every quarter throughout 2022. However, the closings from these communities will occur a couple of quarters later. This means we will incur costs upfront as we need personnel on-site to prepare the communities. The closings will not happen until a quarter to a quarter and a half later, leading to some unevenness until we reach our target of 300 communities in June. After that, these communities will begin delivering homes in the latter half of the year.

Congratulations on the good results.

Our next question comes from the line of Mike Rehaut with JP Morgan.

I’m Doug Wardlaw for Mike Rehaut. I just want to know if you guys can give a little bit more insight into cycle times maybe now versus a quarter ago? And then does this show any improvement or worsening in the process in that time frame?

Yes, I think in our comments we said that our cycle times have gone up around 6 to 7 weeks year-over-year, maybe another week or two from Q3 to Q2. We kind of saw those coming, frankly, when we put our guidance together for Q3. As we look into Q4 and the following year, we kind of think they’re about stable. Could they get worse is anybody’s guess. But right now, we feel like Q4 is going to be about the same.

Just to clarify. We’re not modeling any improvement at this point.

Awesome. And just for a little bit of further insight. Are there any stages or product categories that are currently the biggest challenges? Or is it just across the board right now?

I think for us nationally, we see windows being the bigger problem. Truss is a little bit of a challenge. When you go regionally, it seems like it’s a little bit of different stuff everywhere. But mostly nationally, it’s really just trusses and windows are the stages where we’re having the biggest challenge.

Our next question comes from the line of Carl Reichardt with BTIG.

Phillippe, I wanted to ask about your comment regarding third quarter orders per community per month, specifically how you described the five as elevated but down from last year. Did you mean elevated in a seasonal context or generally? Additionally, relating this to your underwriting for new communities, when you mentioned the normal absorption pace, what exactly does that refer to? Is it on a monthly basis? Given the model transformation at Meritage, is that your approach to defining a normal absorption pace with your mix of products?

Yes, I think as we think about our business long term, we look at entry-level products as something that can do 3 or 4 depending on kind of where we’re positioned in the submarket. We think about our move-up market as something that can do anywhere from 4 to 6 depending on where we’re positioned in the submarket. So when you kind of put that all together, we think we’re going to do somewhere between 4 and 5 a month long term, probably more closer to 4 than 5. We’ve stated many times that when we get to 300 communities, we think we can produce 15,000 homes. You do the math on that. It’s 48 per store and that’s kind of 4 a month. So as we look at new land, that’s how we underwrite land. And then as it relates to my comment around 5 being elevated, I would say all of the above, right? Certainly, we haven’t seen any seasonality, so we’re still seeing strong demand. And I would tell you that we could sell more than 5 a month. We’re selling 5 a month because we’re pacing in 80% of our stores. We’re doing that because that maximizes the efficiencies of our business in the current supply constrained environment. And we produced a pretty strong result at 5 a month. Doing any more than that today just seems like it creates problems for the trades. But I do believe that if we just set everything to run, we’d see something more closer to 6 or 7 or even 8 in some markets that are really strong and we’re really priced low. Demand remains very elevated out there, and we’re very happy with the 5 sales that we’re getting per store in a metered environment.

That’s great. And then looking at your own option split of lots, you’ve been reasonably consistent for a fairly long period of time now. You have some peers out there who shifted relatively aggressively to option lots. Can you talk a little bit about how you view the option market today and maybe in terms of availability of finished lots? I know you want to self-develop often. But also the emergence of the land banking industry, which was an industry you leveraged pretty heavily in the early 2000s, as I recall. So you seem to be able to find land that you can put on balance sheet and turn into communities quickly. What is the thought on utilizing options on a go forward?

Yes, I’ll take that. I’m sure Hilla will have some comments as well. I would kind of answer it in 3 different ways. First of all, we like the land we’re finding. We find that certain projects provide a better residual for us. They’re larger deals with development, big development jobs, and those don’t profile well for land bankers, but they profile well for us because we keep our land prices down. We’re constantly looking to put more land off balance sheet. That being said, we have a really strong balance sheet and we have a lot of liquidity, and we think the most effective use of that cash right now is to put it back into our business. And so, we’re doing that. We are talking to a lot of different land bankers. The pricing model out there we think is still too high for the risk that they’re taking. So we haven’t done as much as I think some other builders have, although I think you should expect us to start doing some more as we’re managing our liquidity and net debt-to-cap ratios. Hilla, do you have anything to add to that?

Yes, that's right, Phillippe. Many builders have set targets regarding their off-balance sheet percentages in relation to owned versus option land. For us, it's not really about that ratio. Our main focus is on maintaining balance sheet strength. We're aiming for our net debt-to-cap ratio to reach the high 20s; we ended the quarter at 17.5%, which gives us some flexibility. Utilizing our own balance sheet at low interest rates is a more favorable option than taking on the higher costs associated with land bank deals. While we do pursue those opportunities when it makes sense, we believe that aiming for a specific target percentage of owned versus option land is not necessary, especially since there is a significant trade-off in terms of the margin profitability of those land bank deals.

Yes. A lot of our lots that we do have on option are what we call seller options, because we buy the larger projects. And frankly, those are just way more attractive than a traditional land banking institution. So our carry cost on those types of deals is lower.

Our next question comes from the line of Deepa Raghavan with Wells Fargo.

Pretty impressive. You’re still on track to 300 with all the supply chain headwinds. So congratulations there. A couple of questions for me. Can you help us understand within your 2022 guide component, what elevated gross margins mean? Is that in line with 2021? Or is it slightly below, but still higher than 2020? Any color would be helpful.

We didn’t provide specific guidance, but we wanted to offer a general outlook for 2022. It’s intentional that we are not giving a specific percentage. Both we and our peers have indicated that the peak of lumber prices is occurring in the fourth quarter of this year, after which you will start to see some reduced lumber costs reflected in our financials. However, this will be balanced by increases in almost every other category, including labor. It’s challenging to provide specific projections because we are spec builders, and our cycle times are much shorter than others. We have visibility for maybe a quarter or two, rather than nine or ten months ahead. We can share rough expectations, but we are not ready to provide numbers for the entire year. The dynamics of the cost environment are changing daily. Currently, we do not anticipate any short-term issues that would harm our margins, although the cost environment is evolving rapidly.

Understood. That’s fair enough. My second one is on some pricing dynamics. Can you talk through what’s happening on the pricing front with your orders? I mean, some of my field checks suggest some builders actually took a pause with price increases in the last couple of months. What’s been your cadence?

Yes, I would echo what you’ve been hearing. What we’re observing is a more measured approach to pricing. It’s not that we’re not seeing price increases, but they’re occurring more on a monthly basis rather than every other week or tied to individual sales. We’re very conscious of affordability, which is central to our business plan. Therefore, we’re increasing prices where demand is strong and supply is limited. In many other areas, we’re likely keeping prices steady. We believe that based on our buyer profile in that community, this is what they can afford, and we’re not pushing beyond that. So what we’re seeing is a more normal pricing environment. There is still potential for price increases, but it is being approached in a more measured and typical way.

Our next question comes from the line of Truman Patterson with Wolfe Research.

First, just wanted to start off, supply chain challenges are clearly impacting everyone, but it seems like you all are navigating the environment a little bit better than peers. Just trying to think through if there’s anything unique to Meritage that’s driving some outperformance, your LiVE.NOW. and Studio M spec strategy. And Phillippe, you made some comments about preordering in bulk and reducing SKUs. Just hoping you could elaborate.

Yes. We think there are a lot of things unique to Meritage. This is all the work that we did 6 years ago, streamlining our product, removing complexity, reducing SKUs, and streamlining the journey for customers, the digital journey, the Studio M, all of it is paying dividends today. I do think we’re performing better. When we talk to our folks out there, they’re not telling us that there’s these weird things popping up that were completely unexpected. We’re certainly seeing the pressure from the supply chain out there, but our business is more predictable. It’s more repeatable. We’re planning it out well in advance, and our trades are communicating with us. If there’s issues, we’re seeing them earlier. So I think when you simplify what you’re doing and you streamline it, you’ve got more visibility. And with that visibility, you can manage through uncertainty better. I would say we’re doing a lot of things differently and I feel a lot better navigating the supply chain today than I would have 6 years ago.

All right. And then your 40 community openings in the third quarter, just trying to understand how did the timing of those really kind of compare to budget? I’m trying to understand, one of your competitors said that supply constraints are delaying horizontal development further. Just trying to understand what you all are seeing out there relative to earlier in the year.

Yes. I mean, we’re actually, I think, exceeding our budget when we put the path to 300 together at the beginning of this year. I think last quarter we were much higher than we thought we were going to be at that point. And now we’re trending from that point on. So we’re landing our communities as expected. We are seeing the same challenges out there, but I think we bought all this land a long time ago. As you remember, we had a goal to get to 300 last year. So it just kind of pushed out. This land was being planned, and we’ve been able to process it through, and we’re landing the communities as expected. I don’t see any issues with Q4. As we look out into Q1 and Q2 and our goal to get to 300, everything is on schedule and moving forward as planned.

Truman, just to clarify. The same logic holds true here as in our forecast on the P&L side. We’re not unique. We’re seeing the same issues that everyone else is. We were just careful in how we projected our community count and how we projected our closings and our revenue to ensure we had enough breathing room to adjust for anything that we’re seeing in the marketplace today, which, of course, occurred. But we have sufficient capacity within our guidance to still hit the numbers that we want. So in fact, we increased our ending community count expectations for 2021 a bit from where we were last quarter. As Phillippe said, we’ve not wavered from that 300 community count goal in June of ‘22. I think we’ve been saying that since pretty much June of last year. So we’re very confident in that number.

Our next question comes from the line of Ken Zener with KeyBanc.

Steve, you mentioned pace, particularly in terms of starts or orders, and I believe it leans more towards starts for your team. Long term, you aim to stay below 5. Demand has remained strong, which has made things less seasonal. I want to ask if there is any reason that might prompt you to change your current pace as you open more communities, especially if seasonality impacts demand slightly. Is there a reason you would need to shift away from that optimal pace of 5? Also, concerning the community openings, you referenced that low 9 SG&A. Hilla, does that imply that the efficiency of opening these communities will be somewhat lower in the first half of the year compared to the second half?

Yes, you're welcome. Five seems to be the right number at the moment considering the supply chain. We would prefer to do six. In the entry level, we are designed for speed, and we have a significant land position. If we can construct those homes with a cost structure that keeps them affordable and ensures a great customer experience, we could even go up to seven. If the supply chain improves next year and the market remains strong, which are two major uncertainties, then we could do more. For now, though, five is the appropriate number. We plan our specifications based on market conditions and what the supply chain allows, and we can adjust accordingly if necessary. Regarding the second question about how our fixed costs will evolve next year as we increase our community count, Hilla addressed this earlier. Initially, in the first half of the year as we ramp up, we will experience less leverage. However, once the 300 stores start to generate closings in the latter half of the year, we will see greater leverage.

I appreciate that. Regarding the efficiency of the supply chain related to closings as a percentage of backlog or inventory, what are your expectations for potentially observing improvements under these conditions that create a high pace? Is it reasonable to believe that the industry is currently operating at a lower level of efficiency from the perspective of closings?

Yes, I think you’re describing backlog conversion. Again, right now, our backlog conversion below 60% is not what we ideally model. As a spec builder with 77% of our communities being entry-level, we would like to see that closer to 80% plus. That’s where we were prior to the supply chain issues. As the supply chain works its way out, I would hope our numbers would trend back up there, especially as we get these 300 communities ramped up. If we can get back up to that 80% number, that would be the goal we have as a company. Our cycle times are 6 to 7 weeks longer than they were a year ago. We were building houses in 3 to 4 months prior to COVID. We’d like to see our cycle times get back down to that 3 or 4 a month, which means we’re turning at 2 plus, close to 3 a year.

Our next question comes from the line of Susan Maklari with Goldman Sachs.

My first question is, you mentioned in the comments when thinking about SG&A that you expect some more technology and efficiencies to come in. Can you give us a little more color there? And maybe how we should be thinking about those advantages starting to flow through your results?

Sure, Susan. They’re already in our results. It’s just going to continue to refine on that process. I think Steve mentioned that we started with self-guided tours, right, leveraging additional visibility into our models at off hours. We certainly do virtual tours online now. There’s a lot of advantages to what we’re doing online. We’re doing prequalifications online. We’re doing notary signing when we can in the states that allow it for home closing. We’re doing insurance pro forma. And there’s a tremendous volume of activity that we’re doing online, including marketing, social media, leveraging our website. There’s a lot of cost whether it’s advertising costs that we’re using digital channels, which are less expensive, or actual processes that are being automated like the remittance of our earnings deposit and the closing process itself. There are opportunities to continue to leverage. A lot of that benefit you’re seeing flow through right now; as we mentioned, our SG&A was 10.1% last year at Q3, and we’re at 9.3% this year’s Q3. You’re already seeing some of that benefit. We’re going to continue to find opportunities where technology can save us money in the long term.

That's helpful. As a follow-up, I understand that much of the cash and capital allocation is directed towards growth, but you have been repurchasing your stock for the past four quarters. Can you discuss your interest in potentially making this a more regular practice? Additionally, how should we consider your strategy regarding share count and returns to shareholders?

So far, we’ve been taking advantage of opportunities and have already bought over 600,000 shares this year, which is about 1.6% of our total outstanding shares. We are definitely exceeding our initial commitment, which was primarily to remove from the market shares issued from equity grants related to compensation. Our goal has always been to do more than just that, but we are doing it opportunistically. Currently, our main priority is to focus on increasing our community count and ensuring we have enough cash to achieve that, while also getting all the necessary specifications in place without overburdening our balance sheet. We see a potential opportunity in the future for a more structured approach. If that happens, we will reassess once we achieve our targets for 2022 and will provide further updates then. However, for the next few quarters, our emphasis will be on growth and securing the capital to support it.

Our next question comes from the line of Alex Barrón with Housing Research.

Great job. Obviously, you guys have massively improved in the last year. I wanted to focus on the interest expense. This quarter, there was a more noticeable drop in the interest that went to the cost of goods sold. And obviously, you guys have been deleveraging and refinancing your debt. So is that a pretty decent run rate? Should we expect that the interest that goes through cost of goods sold will continue to drop as a percentage of ASP?

Yes. While I won't get too technical about the economy, as our assets increase and our debt remains stable, the ratio of these two that we account for in the profit and loss statement will decrease on a per unit basis. The refinancing we completed earlier this year is important to note; last year, we had $500 million drawn from our credit facility briefly at the onset of the COVID pandemic due to uncertainty in the financial markets. This also affected the numbers compared to Q3 of 2020 and Q3 of 2021. However, you can expect that the interest component impacting gross margin will lessen over time.

Okay. I understand. Regarding capital allocation, other builders have either started or increased their dividend. Do you have any thoughts on that since you currently don't have one?

Kind of same answer as to Susan’s question about additional share repurchases. It’s something that we’re looking into along with a programmatic share repurchase program, not something that we’re committing to in the near-term because we have to make sure that our balance sheet is secure for the growth that we want for 2022 and beyond. We will definitely start looking at different cash flow projections and provide additional commentary on one or both of those channels in the next 3 or 4 quarters.

Best of luck.

That is all the time we have for questions. I’d like to hand the call back to management for closing remarks.

Thank you, operator. I’d like to thank our entire Meritage team for another solid quarter of dedication and strong execution. It’s truly these folks that work for us that are making the biggest impact on our results. I’d also like to thank everyone who joined this call today. Thank you for your continued interest in Meritage Homes. We hope you have a wonderful rest of the day. Thank you.

Ladies and gentlemen, this does conclude today’s teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.