Meritage Homes CORP Q2 FY2023 Earnings Call

Greetings, and welcome to the Meritage Homes Second Quarter 2023 Analyst Call. Please note that this conference is being recorded. I will now turn the conference over to our host, Emily Tadano, Vice President of Investor Relations and ESG. Thank you. You may begin.

Thank you, operator. Good morning, and welcome to our analyst call to discuss our second quarter 2023 results. We issued the press release yesterday after the market closed. You can find it along with the slides we will refer to during this call on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom of our homepage. Please refer to Slide 2, cautioning you that our statements during this call as well as in the earnings release and accompanying slides contain forward-looking statements. Those and any other projections represent the current opinions of management, which are subject to change at any time, and we assume no obligation to update them. Any forward-looking statements are inherently uncertain. Our actual results may be materially different than our expectations due to a wide variety of risk factors, which we have outlined and listed on this slide, as well as in our earnings release and most recent filings with the Securities and Exchange Commission, specifically our 2022 Annual Report on Form 10-K and recent 10-Q, which contains a more detailed discussion of those risks. We also have provided a reconciliation of certain non-GAAP financial measures referred to in our press release as compared to their closest related GAAP measures. 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 today’s call to last about an hour. A replay will be available on our website within approximately two hours after we conclude the call and will remain active until August 10. I will now turn it over to Mr. Hilton. Steve?

Thank you, Emily. Welcome to everyone participating on our call. I will start with a brief discussion about what we are seeing in the market and provide an overview of recent company milestones. Phillippe will then cover our strategy and quarterly performance, and Hilla will provide a financial overview of the second quarter and forward-looking guidance. The homebuying environment remained healthy in the second quarter of 2023. We made progress on our goals to improve gross margins and increase our available spec inventory sequentially. Our cycle times began to show notable improvement back toward our historical averages, driving backlog conversion to nearly 90%. We generated our highest second quarter of closings of 3,490 homes and home closing revenue of $1.5 billion. Home closing gross margin for the quarter was 24.4%, which combined with SG&A of 9.6%, led to diluted EPS of $5.02 per share. Second quarter demand held steady during the spring selling season at 3.9 sales per month, near the top of our 4.0 goal as we continue to focus on affordable price points. Factors are coming from the higher mortgage interest rates and the favorable demographics of millennials and baby boomers looking for entry-level products provide a large buyer pool for our homes. And lastly, the resale home market remains tight as existing buyers are hesitant to leave their low-rate mortgages, which limits available inventory and helps to increase new home demand. These external factors all contributed to a strong sales pace and the return of some pricing power for builders this quarter. We believe that our strategy of having affordable, entry-level, move-in ready homes with rate lock or buydown incentives where needed will result in a higher backlog conversion and a competitive advantage against both resale and other new home inventory in the quarters to come. In keeping with the proud tradition of helping veterans, we teamed up with Operation Homefront for the 10th year this quarter to break ground on a new home that will be donated to military families at our Crescent Lakes community in Babcock Ranch, Florida, which is the first fully solar-powered town in the United States. This quarter, we are also truly honored to have Meritage receive a wide range of recognition related to our social and sustainable initiatives. We received the 2023 Hearthstone BUILDER Humanitarian Award for our long-time philanthropic efforts. We earned the prestigious AVID Cup - Production for the second consecutive year, the highest accolade presented to a builder for exceptional customer satisfaction scores. And in terms of energy efficiency, we became the 10-time recipient of the U.S. EPA’s 2023 Market Leader for Certified Homes. Lastly, we were one of the two builders named as one of America’s Climate Leaders by USA Today. We are proud to be recognized externally for our core values and corporate stewardship. I will now turn it over to Phillippe.

Thank you, Steve. I want to jump right into sales on Slide 5. Our sales orders were 3,340 homes this quarter, with entry-level homes representing 85%. Orders were down 11% compared to last year’s challenging costs, but we achieved 6% year-over-year growth versus 2021, making us one of only two builders with positive order growth. As a reminder, we pulled forward sales and helped minimize cancellations in the prior year as we were one of the first builders to utilize expensive rate locks on both fires and backlog and new sales. The average absorption gains declined year-over-year from 4.4 to 3.9 net sales per month. We don’t typically give details beyond quarterly due to month-to-month anomalies, but since the community activity distorts accordingly, we want to provide some additional color. This quarter, average absorption rate calculations were impacted by a high volume of April community closings and an disproportionately large volume of June community openings. This quarter, we increased our community count by 5% sequentially during the first quarter to 291 active communities at June 30, 2023. We had 36 new community openings in Q2 of 2023. While we are pleased with our performance, we continue to be disciplined about future openings. As a spec builder, we want to ensure when we open a new community, we not only have model homes complete, but also the right amount of move-in ready inventory that we can close in 60 to 90 days. Moving to the regional level trends in Slide 6. We continue to achieve a balanced performance across our geographic footprint between East, Central and West regions during the second quarter. The West region had the lowest average absorption pace for this quarter at 3.4 per month; some of our most challenging markets are in this region as a result of higher ASP appreciation over the past few years. We are still working to find the market clearing price to hit sales pace targets in these geographies and have seen some improvement in late June and into July. The Central region had an average absorption pace of 4.3 sales per month, the highest pace among all of our regions. A greater availability of move-in ready inventory kept its second quarter 2023 sales pace in line with its first quarter of 2023. This region also ended the quarter with the highest amount of completed inventory, which we believe will support a strong future sales pace and backlog conversion rate. The East region’s average absorption pace was 4.1 per month during the quarter. The region did exhibit some of the strongest demand across all of our geographies, so we’re focused on reloading our available inventory in the market as we believe this trend will continue given the strength of these local economies. Turning to Slide 7. We managed our starts per community in line with our sales pace. With supply chain stabilizing and labor becoming more available, we can increase our slowing starts to keep our targeted 4 to 6 months supply of specs on the ground. The strength of the housing market managed to increase our quarterly starts to nearly 4,000 Meritage Homes in the second quarter, growing 66% from approximately 2,500 homes in the first quarter of 2023, but down from about 5,000 in the second quarter of 2022. We expect these homes to make up the core of the move-in ready units for our sales window in the third quarter. We ended the period with nearly 4,500 spec homes in inventory, which is up 6% sequentially from the first quarter. This represented 15.4 specs per community, around the low end of our spec per community goal due to the stronger spring selling season. Looking to Q3, we expect to maintain high-level spec starts to ensure sufficient move-in ready inventory for the remainder of the year ending in 2024. During the second quarter of 2023, our closings of 3,490 homes were 8% greater than the prior year due to improved cycle time and strong execution. Entry-level homes, as represented to total closings, remain consistent with the prior year at 83%. Of the 3,490 homes closing this quarter, 87% came from previously started inventory, up from 74% in the prior year. 18% of total specs completed at June 30, 2023, dropped from 25% in the first quarter as our complete specs were in high demand this quarter. Our typical run-rate for completed specs is about one-third, which we are still targeting, although with the high demand for complete inventory, we are still working to meet this goal. With 31% of our homes closed this quarter also sold during the quarter, we improved our backlog conversion rate from 48% last year to 89%. We believe we can maintain the 80% plus targeted conversion rate consistently once the supply chain and labor constraints return to normal. Our ending backlog for the quarter totaled approximately 3,800 homes. Our cycle time improved by over 3 weeks sequentially from Q1 for new starts in June, so we are close to returning to our pre-COVID averages. Our long-term relationship with our vendors, the larger volume of construction levels we can offer as one of the top five builders, and our successful negotiations have all contributed to better build time for our new stocks. To wrap up, we replenished our WIP inventory of move-in ready homes to sell for the remainder of 2023, and we are focused on increasing our footprint in our markets. As we prioritize pace over price, we plan to push sales pace in our active inventory, so our community could be choppy over the next several quarters. We empower our sales teams on the ground to cause and adjust and take necessary pricing actions until we find a clearer price to hit our target pace of 4 net sales per month. But just to clarify, focusing on pace over price doesn’t mean we overlook profitability. We aim to achieve a minimum target of 4 net sales per month, yet we are cognizant of market dynamics, and we increased pricing or reduced incentives in line with local trends. In Q2, we successfully increased prices moderately and reduced incentives, which led to sequentially higher margins and increased margin expectations for the balance of the year. I’ll now turn it over to Hilla to walk through additional analysis of our financial results. Hilla?

Thank you, Phillippe. To start, I will provide a quick update on BFR. In the second quarter of 2023, we started to gain some traction on dedicating full communities to our BFR institutional partners. We will share additional information in the coming quarters as the data become more relevant to our results, but we’re encouraged by the commitment from our multiple partners and the renewed interest from these operators in the new build space. Now let’s turn to Slide 8 and cover our Q2 financial results in more detail. Home closing revenue increased 10% to $1.5 billion in the second quarter of 2023, driven by 8% greater home closing volume from higher backlog conversion and a 1% increase in ASPs on closings. The ASP increase was primarily a function of geographic mix. Home closing gross margin decreased 720 bps to 24.4% in the second quarter of 2023 from 31.6% in 2022, although it increased 200 bps sequentially from Q1 this year. The decline from 2022 was due to the cost of financial incentives in our results this quarter and continued elevated direct costs. Our use of mortgage rate locks in buy-downs did not begin to impact our gross margins until the back half of 2022. This quarter, we pulled back a bit on incentives and started to test some price increases given the strength in the market. Rate buy-downs were not as pervasive in Q2 but were selectively utilized in tougher markets or for specific customer qualification needs. Although we expect incentives will remain elevated for the remainder of 2023, they are moderating from the extreme levels we experienced over the last several quarters. When looking at our direct costs, they remained fairly sticky this quarter. Outside of lumber, the savings we are seeing are more muted than expected due to higher industry production levels. Savings derived from our faster cycle times, though, are starting to make their way through our financials. We are continuing to actively negotiate with all of our trades and expect to see cost savings by the end of 2023 and into 2024. SG&A leverage in the second quarter of 2023 was 9.6% compared to 8.3% in the second quarter of 2022. While we are glad to see a drop into the single digits, we believe there are additional opportunities to find savings here as well. The year-over-year increase was primarily due to broker commissions and marketing costs running above the lower 2022 levels reflecting the current sales environment. We have started to pull back on some of these initiatives where demand is strongest, as evidenced by the decline in marketing spend from Q1 to Q2 of this year, and we will continue to monitor local needs and leverage less expensive technology and digital solutions where possible. Additionally, we had higher costs associated with maintaining a larger volume of specs year-over-year and some incremental technology spend as we start to set up our digital foundation for AI opportunities. Our financial services results included $7.9 million in charges related to unused mortgage interest rate locks that expired in the second quarter of 2023. We didn’t have any such charges in 2022. Year-to-date, we wrote off almost $10 million relating to expired locks. We have added a tighter process on identifying rate lock needs going forward to ensure we don’t buy excess capacity and expect such charges to be limited in the future. The second quarter’s effective income tax rate was 22.0% in 2023 compared to 24.6% in 2022. The 2023 rate benefited from energy tax credits on qualifying homes at the higher $2,500 per home threshold in effect this year. Similar tax credits didn’t begin until Q3 in 2022 when the new energy tax law was retroactively approved. Overall, the lower gross margin and deleveraging of overhead in the current quarter were partially offset by increased home closing revenue and the favorable tax rate led to a 26% year-over-year decline in second quarter 2023 diluted EPS to $5.02. This performance drove our book value per share to $115.55, up 24% year-over-year. To highlight just a few results from the first half of 2023. On a year-over-year basis, orders were down 11%, closings were up 5%, and our home closing revenue increased 6% to $2.8 billion. We had a 750 bps decline in home closing gross margin to 23.5%. SG&A as a percentage of home closing revenue was 9.9%, and net earnings declined 32% to $318 million. As we turn to Slide 9, I wanted to share the exciting news that some of you may have already seen: S&P double upgraded us to investment grade yesterday. We are proud to join a select group of companies and an even smaller group of public builders that have one or more rating agencies issue them a BBB rating. We know that part of the reason for the upgrade was due to our steadfast focus on maintaining the health of our balance sheet and strong liquidity. We strive to balance growth in the business with returning cash to shareholders. We had nothing drawn under our credit facility, cash of $1.2 billion and net debt to cap of negative 0.2% at June 30, 2023. We generated $356 million of free cash flow so far this year. Our land acquisition and development spend totaled $409 million this quarter, in line with 2022’s $422 million. With the demand environment stabilizing at a higher level, we expect to continue to accelerate our land acquisition and development spend above our prior annual target of $1.5 billion and look to be closer to $2 billion plus in 2024 and beyond. During the quarter, we returned $9.9 million in cash to shareholders in the form of a quarterly cash dividend of $0.247 per share. It is our intent to reset the dividend in the first quarter of each year. From a share repurchase perspective, in addition to our objective of neutralizing annual dilution from new equity issuances, we will repurchase incremental shares opportunistically. We did not repurchase any shares during the quarter after buying $10 million back in Q1, and over $234 million remains available to repurchase under our authorization program as of June 30, 2023. As we have previously discussed, we also expect to early retire portions of our 2025 bonds with our excess cash. On to Slide 10. Given ongoing momentum in the market, we put over 2,800 net new lots under control during the quarter. A total of approximately 60,000 lots were owned or controlled at quarter end, holding steady from Q1 but declining from approximately 71,000 total lots at June 30, 2022. The new lots added this quarter represented an estimated 26 future communities for entry-level products. We ended the second quarter of 2023 with a 4.1-year supply of lots at the low end of our target of 4 to 5 years, further validating our need to increase related spend. About 76% of our total lot inventory at June 30, 2023, was owned and 24% was optioned. In the prior year, we had a 66% owned inventory and a 34% option lot position. While we’re always looking for ways to carry our land off-book, we believe owning a large percentage of our land, particularly in light of our negative net debt-to-cap ratio, does not create undue balance sheet risk. The best lots are optioned; builders don’t typically walk away from deals that are financed off-book, eliminating the optionality of such transactions. Also, the carry costs paid to finance off-balance-sheet transactions are quite a bit higher than our current debt costs and don’t align with our margin accretion focus. Finally, I’ll direct you to Slide 11 for our guidance. We have nearly 3,800 units in backlog and another almost 4,500 specs in the ground today, which provide good visibility into our potential closing universe and go-forward margin trends for the rest of the year. Given the normalization of homebuilding conditions and our higher backlog conversion rate, for the full year 2023, we are projecting total closings between 13,300 and 13,800 units, home closing revenue of $5.85 billion to $6.07 billion, home closing gross margin in the low 24% range, an effective tax rate of about 22.5%, and diluted EPS in the range of $19.12 to $19.80. As for Q3 2023, we are projecting total closings to be between 3,300 and 3,600 units, home closing revenue of $1.46 billion to $1.60 billion, home closing gross margin of around 24.5%, and an effective tax rate of about 22.5%, and diluted EPS in the range of $4.80 to $5.29. With that, I’ll turn it back over to Phillippe.

Thank you, Hilla. To summarize on Slide 12. We believe that our second quarter performance continues to reflect our focus on change and commitment to our spec inventory. We look forward to a strong back half of the year as we sell our available stocks and take advantage of price increases and reduced incentives in alignment with local market conditions. As cycle times normalize, we expect the higher inventory turns will lead to consistent backlog conversion in the 80% range or greater. We continue to believe in the strategy behind our business model, and our healthy balance sheet and strong cash position will allow us to deliver results and grow shareholder value even in uncertain market conditions. With that, I will now turn the call over to the operator for instructions on Q&A. Operator?

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

Hey, guys. This is actually Trey on for Steve. You’ve talked about demand being strong and healthy. And we’ve heard even about demand running above typical seasonality. And with that in mind, it feels like we’re in a unique environment right now, especially with your shift and the extreme demand for spec and entry level. I’m wondering if you could see, as the year progresses, if your absorptions could be flattish or even increasing as you go from 2Q to 3Q to 4Q, especially as you have these newer communities now coming online?

Thanks for the question. I think as we sit here today, the market still feels very healthy and stable. We’re four weeks through July and it feels good. There’s clearly still a shortage of used homes in the market, so the new home market is really strong. I can’t predict the future. But I think as we sit here today and we look at our pipeline of buyers and the traffic in our communities, we feel like we can achieve our sales pace targets that we set forth and therefore, expect to achieve our full year guidance.

Yes, Phillippe, it’s Steve. So just to put a finer point on that though. We’re just trying to figure out whether or not that’s a statement, the target for achieving close to 4 for the back half of the year, particularly in 3Q and 4Q, is something that you feel confident about. Also, I wanted to ask you about your backlog turnover ratio because that looks like it’s also running higher than what you’ve talked about, I think about 80%. It looks like you might need to run like 100% or something like that in the fourth quarter, which I can understand why, but I would love to hear you sort of talk about, is that a reasonable expectation for 100%? And how long do you think you could stay elevated like that going forward?

Yes. Thanks, Stephen. The first question, I think it’s fair to say that we’re going to achieve our sales targets that we put forth through the rest of this year. We’re not seeing anything today that would suggest we can’t achieve that close to high 3s, close to 4 sales target. That’s why we put forth the guidance we’ve established. We don’t need to convert 100% of our backlog to achieve the full year guidance that we put forward. We have 3,800 houses in backlog to start the quarter. We have 4,500 specs that can close this year that we started over the last three months. We still have July and August to start homes, we’re halfway through July. So we can operate at above 80% backlog conversion consistently. I do think it might be closer to 90% given the demand for move-in ready inventory. In doing so, we have a lot of confidence in achieving our full year guidance.

Thanks very much, guys.

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

Yes. Thank you. I guess your order pricing was up 2% sequentially. Was that really a function of mix or true pricing power? Are your prices now over $500,000 for your new community openings? So are there any plans to bring that down?

I don’t think our price is over $500,000 on average for our new community openings. That’s not a number that we provided. So I’m not sure on the math; we can chat on that one offline. But we’re seeing some strength in the market for sure. We’re able to pull back on some incentives and some initiatives to actually just increase prices as well. So it’s pretty small at 2% on the mix, but that’s definitely a function of a pullback in need to provide incentives, primarily financial in nature for qualification, interest rate buydowns and locks, but just incentives in general have had a pullback from where we were a couple of quarters ago.

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

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

Thank you.

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

Thanks. Good morning, everyone. Thanks for taking my questions. Maybe just to circle back to the desired sales pace targets. In the fourth quarter, historically, there’s always a bit of seasonality, and whereas you’re targeting on average perhaps for the full year, which is inclusive of some more moderate pace in the back half. Just kind of wanted to get your thoughts in terms of maybe not just third quarter, but also the fourth quarter, if this target is still inclusive of some amount of seasonality or if you feel confident that you can run the business now closer to 4 for the rest of the year with seasonality possibly being a little more muted due to a variety of factors, both industry and company-driven?

Yes. I mean, I’m not sure what exactly we’re going to see as it relates to seasonality. We have July almost in the books; it feels pretty good. Hard to say what’s going to happen for the rest of this year. But the used home market is very restricted, so we’re seeing really strong demand in our communities. Our target is somewhere between 3 and 4. We think we’re maybe closer to 4, primarily because most of our business is entry level right now. Secondly, because we have all the specs that we started and there’s high demand for move-in ready specs. So I think we can achieve the sales targets we’ve established, and seasonality will be what it is, but we can achieve the sales targets demonstrated to achieve our full year guidance.

Great. No, I appreciate that belief. I guess, secondly, just following up on a prior comment you made about community count and that you would hope for more meaningful growth in the back half of next year. I know, obviously, we’re a bit away from that and not at a point to necessarily give a fine point on guidance for next year. But how should we think about community count over the next year or two? I mean, three years ago, I believe you put out that 300 community target that you’re now kind of plus or minus at by the end of the year. How should we think about community count maybe by the end of 2024 and into 2025/2026? Does that also assume a further increase in cycle times, which might result in sell-outs occurring a little faster than expected?

Yes. I think I’m expecting the market to remain relatively stable today, but I don’t see anything out there changing. The buyers have been resilient in this new rate environment. As long as rates stay where they are, I think I expect the market to be normal. Our community count is going to be a little bit choppy here because demand has been so strong, and we didn’t find land for the back half of last year. So we’re going to try to navigate that. But we should see community count growth from here into next year as we roll into the back half of next year. As we spoke in the script, we’re ramping up land spend significantly right now. Our pipeline for new deals coming through land committee is dramatically up. We approved a bunch of deals towards the back half of last quarter and we have a really busy land community calendar for the rest of this quarter; we’ve already had a busy July. So our land spend is going to go up dramatically, and all those communities are going to land in 2025 and 2026. I expect significant community count growth as we roll into 2025 and beyond.

Just to add a quick point, Mike. I think, as Phillippe said, the reason why it’s going to be choppy is because of demand. We have the units; anything that’s related to slowdown from transformers or any other delays that was already baked into all of our estimates for the last couple of quarters. So, the reason it’s choppy is because the market is so much stronger than anyone had anticipated, causing the gap out not because we can’t get communities that don’t have the lots in place.

Great, thanks. Appreciate it.

Thank you.

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

Hey, guys. Good morning. Thanks for taking my questions. First, I’d love to dig in a little bit more on the pricing side. You made some comments that there were some moderate price increases or kind of dialing back incentives. The sequential increase in margin was pretty significant and certainly greater than you guys were expecting entering the quarter. If I look at your guidance for the back half, it looks like you’re expecting pretty flat margins, which I would have expected if incentives are on the decline. There might have been a little bit more of a tailwind there. Could you just maybe quantify exactly what’s going on with the discounting and incentive and pricing side and what your expectations are for the back half of the year as more of these specs come to market?

Yes. I’ll let Hilla talk a little bit more about what’s driving our guidance, Alan. And by the way, congratulations on your tenure over there.

Thank you.

But yes, you’re welcome. Regarding pricing, we’re a spec builder. So essentially, we just look at the net price. Over the last six months, we’ve been able to back off on incentives and we’ve been able to back off on using rate buydowns in a number of places, especially since we now have more move-in ready inventory; the rate locks are less expensive. So that’s really driven the margin for us. We’ve raised prices moderately in some of the hotter spaces. But overall, it’s just been the backing off on the aggressive incentives and the rate locks we were having to use to sell homes towards the back half of last year and into this year. As we roll into the rest of this year, I’ll let Hilla jump in on some details driving the guidance for margin for the rest of the year.

Thanks, Phillippe. So I think, obviously, with 24.4% was where we ended up for the quarter, we’re guiding to around 24.5%. We feel like the next quarter is looking pretty similar with those homes already in backlog. We have a decent understanding of where those margins will fall; there’s an opportunity for that to move a little bit, which is why we said around 24.5%. Back into Q4 from our full year guidance is actually quite a nice margin uptick in Q4, which is what you mentioned here, Alan. It’s the expectation that we will be able to pull back on incentives a little bit more based on what we are seeing in the market today for closing in Q4. So, there is quite a nice uptick in Q4 projected margins to get to the full year of 24%, which is going to balance out the lower margins we expect in Q1.

Got it. Okay. Thank you for clarifying that, Hilla. That’s exactly what I was getting at, so very helpful. Second question, a little bit more of just a consumer detail question here. You guys have great insight into the first-time buyer and their credit quality and attitude to afford a house in today’s market. A lot has been written about this idea of generational wealth transfer kind of offsetting some of the affordability challenges that would appear on paper, whether it’s boomers helping their kids with down payments or perhaps even putting their names on the home and purchasing it for them. I am curious, a, if you have seen any of that data in your mortgage statistics or any anecdotes that you could point to that would either support or refute that thesis; has that trend been increasing?

I will take that one. We are not seeing parents putting their names on their children’s mortgages, but we are seeing about a quarter of our volume having DPA, the down payment assistance. So, we are seeing what could be considered generational wealth assisting on the down payment side to make sure that they can buy that house, and the maintenance of the mortgage payments on a go-forward basis is on the homeowner on the mortgage. So, we are seeing that for sure.

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

It was about half that for down payment assistance, so quite a significant increase.

Got it. Okay. Perfect. Really appreciate it, guys. Thanks a lot.

Thank you.

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

Hey guys. Good morning. This is actually Spencer Kaufman on for John looking for questions and nice results. Maybe just piggybacking off of some of the prior questions on gross margins. I think the Q3 margin is well understood. But can you just talk a little bit about what gives you the confidence that demand will hold and incentive activity won’t need to accelerate to hit your Q4 margin target?

Yes. So, not to sound redundant, but obviously, every home that we need to close this year are already started. So, we know what the costs are. We can only base our future view of demand on our current view of demand. Based on what we are seeing in the market today, we are confident that we are going to achieve our absorption targets through the rest of this year. A lot of this is being driven by what everyone has been discussing, which is the lack of inventory in the market, specifically in the used home market, and so the new home market is achieving a larger market share, which is giving us strong absorptions and strong buyer pools. So, do I know what’s going to happen in December today? No, but I know what’s happening in July, and I am basing my views on that.

Okay. That makes sense. And can you talk a little bit about what the benefits of gross margins were in the quarter from lower lumber rolling through? Is it fair to assume that there could be maybe a little bit more of a sequential benefit in Q3, but the majority of that benefit was probably in the current quarter?

Yes. All that benefit has been rolling through Q1 and Q2. As you guys know, lumber is actually starting to pick up, not down. The impacts of that won’t be visible until later, and we have accounted for that. As Phillippe mentioned, we know all of our cost structure for the next half of the year, and that has all been addressed. I don’t think there will be an incremental tick-down from lumber savings flowing through the financial statements; future savings in margin are going to come from cycle time improvements and ongoing efforts by our entire organization to achieve direct cost savings in other categories.

Perfect. Thank you, guys.

Thank you.

Our next question comes from Alex Barron with Housing Research Center. Please state your question. Alex, your line is open.

Sorry. I was on mute. Thank you and great job on the quarter, guys.

Thank you.

I am not sure if I missed it, but can you discuss what’s the level of incentives in the quarter in the closings versus orders? What is the kind of normal historical incentive as a percentage of sales?

So, we have shifted quite a bit. As you know, we expect, though there are some incentives that are just part of the all-in price. We don’t really market a base price and then options and then incentives like a traditional builder or based on what we used to do in the past. But all-in, they used to run about 6%. They are running quite a bit north of that right now. We don’t typically break out that level of detail, but I can’t share that between Q1 and Q2; they dropped 200 bps to 300 bps, which is exactly the savings you saw in the margin. So, that’s really the benefit that you are seeing in the margin is that pullback on incentives.

Okay. But they are still running a little bit higher than historical norms?

Correct.

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

So, in some of our markets, when we were dealing with the middle of the supply chain challenges, we were over 200 days to build a house. So, we didn’t start a house in June; we weren’t going to close it. Right now, we are close to 160 days, which is down from that, a big improvement of about 40 days. I would say that’s the biggest decline we’ve seen. I think company-wide, we are down about three weeks, so 21 days or so. Before COVID, we were building homes in four months, typically 120 to 140 days depending on the market. We are looking to turn our assets anywhere between 2.5x to 3x a year. We are certainly back above 2x; in some markets, I think we can get to 3x, and that would be the goal. So right now, it’s about 160 days, with a goal of closer to 130 days; we still have some ways to go.

Okay. So again, it seems there are still opportunities left. And if I could sneak one last one. I think I heard you say the start pace was 4,500. What was it last quarter? And is that 4,500 a good run rate or where you think you will be going forward?

Yes. We actually started 4,100 homes, but we have 4,500 specs coming into the quarter, just to clarify. We think our run rate is about 4,000 starts per quarter. That’s our goal as we move through the rest of this year to start about 4,000 homes. We believe that we have the locks in the communities and the trades to execute on that.

We did 2,500 homes in Q1.

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

Awesome. Thanks so much and great job, guys.

Thank you.

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

Thanks. I am going to ask about land. You guys are moving back in fairly aggressively, and some of your peers are too. What are you seeing in terms of land pricing in the market? Given the business model relative to, say, five years ago, can you talk about the changes in your underwriting in terms of absorption or time to market or size of lots per community? How has that underwriting idea changed with the model transition?

Well, it’s changed significantly since our new strategy seven years ago, focusing on the first-time affordable market and transitioning to an all-spec strategy. We are looking at higher absorptions and turns. We’ve pivoted to indicate that we think our margins are going to be better. Previously, we operated more in a 20% margin range; now we are closer to 21%, 22%. We look to close dirt when it’s shovel-ready, so that’s a big priority. We spent a lot of time and money processing our projects and we don’t close them until we can put a shovel in them. We buy bigger deals because we expect more volume, and we are aiming to spread the development costs so we can achieve the price point. Everything has changed; things are going well. We continue to see deals that underwrite to those criteria allow us to maintain affordability, especially in the markets we are in. Land has not been on sale. I was hoping to see land prices come down more materially from last year, given what happened in the back half of last year. Unfortunately, as spring selling season turned around, land was back on the market, but prices really haven’t changed. It’s a competitive market currently, but we have plenty of land. Our field team does a great job getting us first looks on properties. We have plenty of projects that meet our underwriting criteria.

Thanks, Phillippe. And then I’m going to talk about guidance and this quarter’s performance relative to guidance. What were one or two real critical positive surprises that you had during this quarter versus what you told us in April you would do?

I think the two most positive surprises were the conversion rate. The guidance for a lower closing rate was initially uncertain; we weren’t sure that we would be able to push the trades to get all the homes closed, so the 89% conversion rate was a pleasant surprise. It’s one we are now running with that ball, and we expect the trades to continue to deliver that, especially as we have specs available and continue production into Q3. The other positive would be the margin growth. As a sector, I think everyone is giving the same comments, but I don’t think we believed in the ability to pull back on the financial incentives as much as we did. With a third of our volume coming from same-quarter sales, we are starting to see that benefit early. We are excited to be able to start to pull back on some of the incentives. Again, while they are running higher than historical, we’ve seen definite pullbacks from the levels we experienced at the end of last year.

Thanks, Hilla. Thanks, Phillippe.

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

Thanks very much. I just wanted to talk about orders in the quarter and the communities really in the quarter. You may not cut the data this way, but I imagine you have a sense of how this would go. If I think about your new openings and what you closed out, it seems like really only about 250 communities started and ended the quarter actively selling. And so it’s not hard to imagine that those that stayed open the entire quarter were still running at that above four pace. Just curious if you would agree with that statement.

I would fully agree. Yes, as we said in the script, our comments, we had some communities closing in April and we had some remaining homes to sell from Q1 after Q1 was so strong. The openings didn’t come until late in the quarter. Again, we are really focused on opening communities right now. Our priority is cycle time and we don’t want to open communities that don’t have move-in ready inventory that can close within 60 to 90 days. So, you are exactly right; it’s a bit detailed, but that’s exactly what happened. The rest of our business operated about four.

Yes, makes sense. And then congrats on the BBB; I know that’s important to you guys, and that’s exciting. I am thinking about your cash balance having grown in these recent quarters. You talked about the pause on the land side late last year and the momentum you are now seeing in the current quarter in the land market. Would you mind sizing that even just qualitatively? Can we expect your cash balance to come down as you maybe deploy and redeploy the current excess balance and the cash you are getting from closings? Similarly, if you are talking about your cash and being opportunistic for share repurchases, how are you also thinking about opportunities on M&A as a way to achieve your growth aspirations?

Yes. I mean, as we’ve said, we are ramping up land spend significantly. Our target net debt to cap has always been in the low to mid-20s; we are way off of that. So, as we start to reinvest in land, we expect to revert back to that. I would hope but not to go higher than that. I think we have plenty of liquidity to drive our growth without exceeding that kind of parameter. We’re actively pursuing M&A, primarily focused on private builders looking to sell their business, especially in markets we are already in. We still have several markets where we want to achieve top three or top five status. So, an M&A opportunity in those markets would be compelling for us. We have looked at quite a few here over the last 90 days; we haven’t closed any yet, but we are exploring options and we certainly think you could see something from us over the next year or so.

Thanks very much. Good luck to everyone.

Thank you.

Our next question is from Susan Maklari with Goldman Sachs. Please state your question.

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

Yes. So, I think you’re right. We are aggressively looking to squeeze SG&A a little lower. We always used to say that under 10% is a good place. As we continue to grow as a builder, that target is becoming lower. It’s appropriate to expect to continue seeing that number pull back, especially as we begin to have consistent or increasing closing volume. The broker commission should reflect some benefits in the back half of the year in terms of longer-term initiatives, more related to 2024 eventually. But the commission piece should certainly be evident in the back half of this year.

That makes sense. Thanks for that, Hilla. And then just maybe a broader question to follow up. We have seen industry single-family housing starts approaching 1 million units this spring. Given the bullish outlook for new home construction, can you talk about the measures you can implement today to ensure that your supply chains hold up better this time around than during the uptick we’ve seen over the last few years? We are hearing that some materials like EWP are very challenging to find these days, experiencing allocation struggles in various regions. So how do you mitigate those concerns moving forward if things were to revert to, say, 2021's starts level?

Yes. I think there are lessons learned. I believe that communication with the trades, a higher level of transparency, and frequent communication are key. They are already discussing what might happen if this were to occur, and we’re trying to get ahead of it, making them more thoughtful. Our strategy is also crucial. Other builders have been following us with more specs, less complexity, and repetitive products. By allowing our trade partners and labor to perform at a higher level, I think it’s possible to mitigate potential supply chain issues. We continue to migrate to less complexity, focusing on repeatability in products. As capacity increases, maintaining a steady cadence to start homes and keep the trades busy is vital for us.

Additionally, as we move closer to more spec starts, our ability to substitute products in the home becomes more manageable. This is because it’s our choice; making changes when one product or one supplier is having issues is more feasible since no one has selected elements in the design studio.

That’s very good information. Thanks for your time, guys.

Okay. Well, I think that’s it; that’s all the questions. We really appreciate your interest and the time you took to listen to our comments. Thank you, operator. I want to thank everyone who joined the call today and for your continued interest in Meritage Homes. I hope you have a great weekend. Thank you.