Earnings Call Transcript - MTH Q1 2022

Operator, Operator

Greetings. Welcome to the Meritage Homes First Quarter 2022 Analyst Call. Please note this conference is being recorded. I will now turn the conference over to your host, Vice President of Investor Relations Emily Tadano. You may begin.

Emily Tadano, Vice President of Investor Relations

Thank you, operator. Good morning and welcome to our analyst call to discuss our first quarter 2022 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. Please refer to Slide 2 cautioning you that 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, changes in interest rates, the potential benefits of rate lock, community count and absorption, trends in construction costs, supply chain and labor constraints and cycle times, projected second quarter and full-year 2022 home closings and revenue, gross margins, tax rates and diluted earnings per share, potential future disruptions to our business from an epidemic or pandemic such as COVID-19 as well as others. Those 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 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 2021 annual report on Form 10-K, 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 two hours after we conclude the call and will remain active through May 12. I'll now turn it over to Mr. Hilton.

Steve Hilton, Executive Chairman

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 our recent results. Phillippe will cover our strategy and quarterly performance. Hilla will provide a financial overview of the first quarter and forward-looking guidance for 2022. It's well documented that the ongoing labor and supply chain constraints increased cycle times and costs across all aspects of homebuilding operations in the first quarter of 2022. Yet despite these industrywide issues, the start of the spring selling season has been robust, setting new company records, including our highest quarterly sales order volume, our second highest first quarter home closings and our highest quarterly home closing gross margin which broke the 30% threshold, our highest first quarter home closing revenue, as well as our best quarterly SG&A leverage in our company's history. The first quarter of 2022 was also our fifth sequential quarter of community count growth. We believe that today's sustained demand reflects the desire for homeownership for millennials and downsizing for Baby Boomers, all driven by life event milestones that are further amplified by the low supply of new and resale housing inventory in the market. The rise in interest rates over the last couple of months and a series of additional telegraphed Fed funds rate increases anticipated for the rest of this year may likely change the dynamics of what product will be purchased. However, we believe the underlying demand for these demographic groups will remain solid. We continue to sell homes shortly after releasing them so far in April, and we are still metering sales in many communities. Now on to Slide 4 for recent events. We recognize that the recent surge in interest rates and six quarters of strong pricing power will eventually impact both buyer psychology and affordability. To alleviate some uncertainties for our customers, in March, Meritage purchased retroactive interest rate locks on all eligible floating-rate loans for homes in our backlog that are scheduled to close in the second half of 2022. We want to help our buyers remain confident and comfortable with their decision to purchase a Meritage Home and relieve concerns around the high cost of ownership since their home purchase decision. Hilla will dive deeper into the details of our bulk rate locks later. In February, we announced our expansion to the Salt Lake City market. With the first three land acquisitions approved and more identified in the pipeline, the new division expands our west region operations into an area with steady growth and solid in-migration. We will start our marketing campaign this summer ahead of the first openings of our affordable entry-level community before year-end. Last week, we reported that Malissia Clinton started as our new general counsel. With nearly three decades of legal experience, she brings extensive expertise managing risk, ethics, compliance and governance matters. Welcome to the team, Malissia. And as April is Earth month, this year we announced a national partnership with the Arbor Day Foundation and have kicked off our tree planting program with them to support urban tree populations. We will have planting events in each of our markets during the spring and fall planting season, and we've planted 1,300 trees this year. Our community tree campaign aligns our employees' contributions and our corporate social responsibility with our ESG initiatives that will help enhance the sustainability of the markets in which we operate. And with that, I'll now turn it over to Phillippe.

Phillippe Lord, CEO

Thank you, Steve. Since 2016, our strategy has been centered around the entry-level and first move-up markets and affordability of our product is paramount. We've been shifting our product mix and operations to address the underserved and under-built affordable entry-level market. Although efficient operations play a role, our land collections also significantly impact our new home average selling prices. For our new entry-level communities coming online in late 2020 to 2023, we have been buying less expensive land that comprises larger parcels and further upsell markets allowing us to lower our average selling prices, while still generating above-average margins. However, elevated demand and the corresponding favorable pricing environment over the last six quarters have masked our shift in product mix. This has resulted in increased average selling prices on orders, backlog and closings on a year-over-year basis this quarter. These higher prices, combined with our streamlined and efficient operating model, resulted in a 15% year-over-year home closing revenue growth, record home closing gross margins of 30.3%, SG&A leverage of 8.5% and a 68% increase in diluted EPS over last year. As Steve noted, demand is still healthy today. In addition to early sales from January to April, our cancellation rate of 9.6% this quarter is similar to the last eight quarters and low compared to our historical levels and what is typically expected for entry-level products. The credit profile of our homebuyers remained stable and consistent at historical averages of high 30s for debt-to-income ratios and high 730s for FICO scores. We believe that our affordable, yet quality homes are an attractive alternative for customers who are priced out of the move-up communities. That being said, we continue to monitor leading indicators for any early warning signs or changes to the market, and we remain ready to adjust our near-term operations accordingly. Although we continue selling homes fairly quickly, we recognize current dynamics are not sustainable indefinitely and eventually homebuilding demand will stabilize. We welcome the market stability, which we believe is necessary for sustainable long-term growth. We can flex with market conditions and slow down starts if there is any choppiness in the market demand and focus on smaller products or homes with fewer amenities. Compared to other entry-level offerings, our affordable homes offer surprisingly more with quick movement timelines. This quarter, we are announcing two formal relationships with large national build-to-rent operators, selling to individual homes and contracting for full communities over the next several years. While we do not have specific targets for this line of business, we expect this to be a high single-digit to low double-digit percentage of our annual closing volume long-term. In the first quarter of 2022, build-to-rent accounted for just under 5% of closings volume. Given elongated cycle times, we were pleased that our first quarter closings of 2,858 homes were just 32 homes below the challenging comps of the prior year. Entry-level comprised 86% of closings, up from 72% in the prior year. Total orders of 3,874 for the first quarter of 2022 reflected a 12% year-over-year increase, driven by a 32% increase in average community count and our seller starts despite a decline in average absorption from 5.8 per month in Q1 2021 to 4.9 per month this quarter. We intentionally restricted our pace to align our starts to production delays and to ensure an excellent customer experience that includes both the opportunity to lock in a mortgage rate and have a quick and flexible move-in process. Entry-level comprised 83% of quarterly orders, up from 76% in the first quarter last year as we continue to shift our product mix. Entry-level also represented 81% of our average community count compared to 73% a year ago.

Operator, Operator

Moving to the regional trends. All of our regions achieved growth in average community count and orders volume in the first quarter of 2022. Our central region, which is comprised of Texas, had our largest increase in regional orders volume of 16%. This resulted from a 21% increase in average community count combined with our highest regional and state added order pace this quarter of 5.8 per month. Pricing power led to a 20% increase in average selling prices on orders compared to the same quarter last year, given the state's favorable economic and business environments. Closely behind the central region, our east region's year-over-year order growth of 15% this quarter was primarily due to a 45% increase in average community count, our largest increase this quarter. This more than offset the 20% year-over-year decrease in average order pace to 4.5 per month. The east region has the largest increase in entry-level communities, resulting in 82% of its average community count selling entry-level products during the quarter compared to 72% in Q1 of last year. South Carolina had the highest increase in order volume this quarter, more than doubling its 2021 volume due to the community count ramp-up over the last four quarters. The West region's first quarter 2022 order volume increased 5% year-over-year as a result of a 28% increase in average community count that was offset by a 19% decline in average order pace. Given solid market conditions, strong pricing power and limited entry-level and first move housing inventory in the region, the West region had our highest regional increase in average selling prices on orders this quarter of 21%. Although Colorado remains the lowest percentage of entry-level mix at 15% of its average community count this quarter, we are continuing to shift towards entry-level products in the state. We expect its absorption pace will start to increase over time. In Arizona, where the housing market remains robust, our quarterly orders decreased year-over-year by 9% due to metering from numerous supply chain issues, which led to a 25% decline in our average absorption pace, despite a 28% growth in average communities.

Phillippe Lord, CEO

Turning to Slide 7. We accelerated starts to over 4,000 homes in the first quarter from approximately 3,700 homes in the fourth quarter of 2021. We expect to continue ramping up starts in the second quarter of 2022 as our community count increases as we work to return to our optimal level of specs per community of 4 to 6 months of supply. We continue to navigate production challenges to increase the amount of available specs in our entry-level communities. 80% of our home closings this quarter came from the previously started spec inventory, which increased from 71% a year ago. We ended the period with over 3,200 spec homes in inventory or an average of 12.1 per community as compared to approximately 2,300 specs on average or 11.2 in the first quarter of 2021. At March 31, 2022, less than 5% of total specs were completed versus our typical run rate of one-third due to sustained demand and supply constraints. While our cycle times did not expand in Q1 sequentially over Q4 last year, we are still about 6 to 8 weeks behind our pre-COVID construction schedules. We're pleased we were able to hold the schedules from worsening and are now pushing to gain some time back over the next few quarters. In addition to the extended cycle times, we are also selling later in the construction cycle to maximize margins and maintain a best-in-class customer experience. Our customers appreciate the ability to lock in their mortgage rates in a rising rate environment and to plan for a move-in date that fits their deadline. Given elongated cycle times and later sales, we ended the quarter with a backlog of nearly 6,700 units, as our conversion rate declined from 62% last year to 50% this year. When the supply chains stabilize, we anticipate cycle times to shorten and backlog conversion rates will pick up again. We continue to lean on our streamlined operations and pre-starting all entry-level homes before selling to help us navigate supply and labor constraints. For example, we were able to lock in supply volumes with our vendors well in advance and provide trade partners visibility into our scheduling while offering consistent and repetitive line work that doesn't require the most skilled labor. Additionally, given our reduced SKU count, we can remain nimble and substitute our selections with vendors if certain products' availability runs low. To address an anticipated incremental number of starts throughout the rest of the year from community count growth, we strengthened our long-term relationships with our critical national and local vendors. We view our trade partners not just as suppliers, and are willing to lock in guaranteed volume for their commitments to deliver additional capacity to Meritage Homes. Our whole team, from field purchasing agents up to the executive suite, continue to engage with our partners, demonstrating our focus on finding workable solutions. I will now turn it over to Hilla to provide additional analysis of our financial results.

Hilla Sferruzza, Executive Vice President and CFO

Thank you, Phillippe. First, I wanted to start by covering the retroactive rate lock Steve mentioned earlier. We believe that today's buyer is aware of the current interest rate environment and after locking in a fixed rate with our mortgage team for the duration of their construction cycle, this buyer is comfortable with their monthly payment. However, we also recognize the buyers in our backlog that were pre-qualified for floating-rate loans several months ago. We now find themselves in a different psychological and financial position regarding a home purchase after the sudden and steep surge in interest rates since the start of the year. We wanted to relieve this concern for our buyers. And in March, we purchased retroactive below-market fixed interest rate locks and applied them to all eligible floating-rate loans in our backlog that are scheduled to close in the second half of 2022. The response from our customers has been overwhelming, and we believe these actions will help limit future cancellations in Q3 and Q4 of this year and demonstrate Meritage's commitment to provide exceptional value and service to its customers. Let's turn to Slide 8 and cover our Q1 financial results in more detail. Homebuilding revenue grew 15% year-over-year to $1.2 billion in the first quarter of 2022 as a result of a 17% increase in average selling prices due to sustained homebuilding demand even as we continue to shift our product mix towards entry-level homes. Home closing volumes declined 1%, impacted by the ongoing supply chain issues, pushing some of our late-quarter closings to Q2. Our first quarter 2022 home closing gross margin was a record 30.3%. In addition to our favorable pricing power, selling homes later in the construction cycle has helped us avoid cost risk and maximize margins. The 560 basis point improvement from 24.7% margins a year ago mainly results from higher average selling prices, more than offsetting higher lumber and other commodity costs as well as the benefit of lower interest costs stemming from improved interest rates on our refinanced debt. Given lumber volatility, we anticipate the next couple of months to be choppy due to the timing of lumber locks in Q1, with potential savings impacting margin in the back half of the year. The interest cost savings and margin should be permanent. SG&A as a percentage of home closing revenue was 8.5% for the current quarter, a 130 basis point improvement over the prior year. Over internal and external commissions, higher revenue and the benefit of technology in our sales and marketing efforts allowed us to better leverage our SG&A. In addition to continuing our pursuit of overhead efficiencies, we expect the incremental revenue from closing volume growth will drive additional SG&A leverage in the future. The first quarter of 2022's effective income tax rate was 24.0% compared to 20.6% in the prior year. The higher rate in 2022 reflects the expiration of the 2019 Taxpayer Certainty and Disaster Tax Relief Act under which we earned eligible energy tax credits on qualifying homes closed in 2021. Since the energy tax credit has not yet been enacted beyond 2021, we are not assuming any such benefit in 2022 at this time. Overall, pricing power, expanded margins and improved SG&A leverage, combined with the lower outstanding share count led to a 68% year-over-year increase in first quarter 2022 diluted EPS to $5.79. Turning to Slide 9. We maintained a strong balance sheet and ample liquidity during the first quarter. At March 31, 2022, our cash balance was $520 million compared to $618 million at December 31, 2021, primarily stemming from land spend as inventories rose $294 million during the quarter as well as share repurchases, which totaled about $99 million for over 1 million shares of common stock. Our net debt to capital remained low at 16.9% as of March 31, 2022. We continue to target a maximum net debt to capital rate in the high 20s with no debt maturities until 2025. We believe we have sufficient flexibility should current economic conditions change. We continue to focus our capital spend primarily on opening our incremental communities and getting specs in the ground to help us gain market share. In addition to routinely buying back shares to offset new grants and keep our dilution neutral, we may opportunistically repurchase incremental shares, just like we did this quarter. After these purchases, we still have $54 million remaining on our share repurchase authorization. As we consider our cash spend, we look to balance our operational cash needs with maximizing long-term shareholder value. On to Slide 10. On March 31, 2022, we had over 75,100 total lots under control, flat sequentially from Q4 2021. Based on a trailing 12-month closing, we had nearly six years' supply of lots, which is slightly above our target of four to five years. Given the incremental volume that has started to flow through from the new communities that have come online over the past few quarters, we have a five-year supply of lots based on our forward closing projection of about 15,000 homes for 2022. In the first quarter of this year, we secured over 4,100 net new lots, 30% lower than the prior year. Our net new lots translated to 27 new communities, of which approximately 93% are entry level, to maintain our focus on affordable homes in the future. We prudently grew our positions at a slower pace this quarter than we did in 2021, primarily replacing our starts. Since a 300 community count is within our reach, we anticipate going beyond 2022 at a more normalized pace and we continue to gauge for changes in home buying trends in all of our markets. We opened up 32 new communities and grew our community count from 259 at the start of this quarter to 268 by March 31, 2022. We spent over $371 million in acquisition and development this quarter, which was essentially flat year-over-year. Since our community count ramp is stabilizing, our go-forward land acquisition and development spend growth will be more measured. We use options or staggered purchasing terms where financially feasible to preserve liquidity. Since we manage our capital through balance sheet metrics and margin goals, we do not target an arbitrary percentage of option land. Each deal is evaluated based on its own financial merit. About 65% of our total lot inventory at March 31 was owned and 35% via options, in line with Q4 2021. As of March 31, 2021, we had a 60% owned inventory and a 40% option position. In the first quarter of 2022, we remain selective regarding the land secured. We continue to underwrite to normalized incentive volume and absorption as well as consistent minimum gross margin thresholds. Although we haven't changed our underwriting gross margin hurdle, most deals are coming in above that, which provides us a cushion to absorb further cost increases and potentially higher future incentives. This discipline enables us to keep land costs lower and, in turn, move down the pricing band when these new communities come online. Finally, turning to Slide 11. In April, our demand remained healthy and steady even as rates continued to rise. As we manage through supply and labor issues and ramp up our starts, we anticipate incrementally higher orders and closings throughout the rest of the year. For full-year 2022, we're projecting total closings to be between 14,500 and 15,500 units, home closing revenue of $6.5 billion to $6.9 billion, home closing gross margins in the low 28% range, an effective tax rate of about 25%, and diluted EPS in the range of $26.30 to $27.90. We remain on track with our 300 community combination just around the corner in Q2 this year. We continue to expect the full-year community count this year to grow between 15% and 20%. As for Q2 2022, we are projecting total closings to be between 3,000 and 3,200 units, home closing revenue of $1.3 billion to $1.4 billion, home closing gross margins in the high 29% range, and diluted EPS in the range of $5.60 to $6.10. With that, I'll turn it back over to Phillippe.

Phillippe Lord, CEO

Thank you, Hilla. To summarize on Slide 12. We believe we are well positioned to navigate supply and labor disruptions, take advantage of our increasing community counts and ramp up our starts, and continue to capitalize on market demand by offering affordable, yet quality products. That said, we're prepared for today's rising interest rate environment, given our focus on entry level and first move-up products, and a proven strategy and operating model of driving lower cost through pre-start inventory. We have a healthy land position and a disciplined and prudent land playbook. With a focus on accelerated community counts since late 2019, we were very active in the land market post-COVID, which is now starting to become visible in our community count growth and will continue to come online over the next several quarters. The older vintage land is producing outsized profit as is visible in our strong gross margins, due to both being secured before the significant land price run-up that started in the back half of last year and benefiting from the average selling price appreciation over the last six quarters. Additionally, our strong balance sheet enables us to remain nimble and flexible for any market conditions. For the first time in our company history, we will have 300 communities. We believe that our community count growth will mitigate potential absorption declines should the market slow down and further allow us to continue to leverage our incremental revenue to achieve economies of scale. With that, I will now turn the call over to the operator for instructions on the Q&A.

Operator, Operator

Our first question is from Stephen Kim with Evercore ISI. Please proceed with your question.

Stephen Kim, Analyst

Thank you very much, everyone. The results are impressive, as has become the norm. Currently, there seems to be a lot of confusion and debate about the entry-level market segment. Is it the best position to be in, or the worst? In a rising rate environment, many people believe that entry-level buyers are facing more challenges, and some are criticizing that segment. Since you have a significant presence there, I wanted to ask if we're still seeing demand exceed supply in your communities, including those for entry-level buyers, particularly regarding order volumes. Does the current order intake reflect outdated, lower mortgage rates at all? Or can we say that today's sales are truly indicative of the current demand and supply dynamics under today's rate conditions? If that remains robust, why should we anticipate a slowdown, assuming rates hold steady and the economy stays similar to its current state?

Phillippe Lord, CEO

Thank you, Stephen. We agree with the second statement that demand is influenced by current rates. Buyers entering our communities are expecting rates around 5% to 5.5%, and they are looking for homes at those price points. Based on what we're observing, the stability of our FICO scores and backend ratios indicate that buyers are adjusting their expectations. Some buyers who were initially seeking homes in the $500,000 range are now considering options priced around $400,000. We do notice this movement within those price ranges as interest rates fluctuate.

Hilla Sferruzza, Executive Vice President and CFO

Stephen, the thesis really is, is there a population that needs housing? And we believe both millennials and baby boomers need housing. They're solving from monthly payment. As interest rates go up, the average selling price of the house needs to come down. So, as long as you're offering attractive product, which has been our thesis all along, to offer a little bit more—surprisingly more is what we'd like to call it internally—as long as you're offering a little bit more, when they're coming down with price bands and looking at our homes, they're not disappointed with what is now a substitute product for them. So, the demand is still there. As long as you can solve for a price point, a monthly payment, then we're still seeing that demand exceed supply.

Phillippe Lord, CEO

The other thing I wanted to add to this is not all entry-level buyers are created equal. So, our strategy was always to position our products for the entry-level buyer who is willing to pay more and is a little more qualified. There are entry-level buyers that are just driving for affordability. And then there's a whole bunch of buyers out there that have a more discerning preference. They're trying to get into good school districts, the millennials that are driving a lot of that. And so, we're seeing a high-quality entry-level buyer who is willing to pay more, is looking for that payment, and that market is very strong.

Stephen Kim, Analyst

Great. Yes. That's very helpful. I mean, I think at the end of the day, it's sort of sounding like rising rates are just forcing the market to focus on what they need and maybe we're in a need market rather than a want market, and that's totally fine given the scarcity out there. I wanted to ask a question about your gross margins and your outlook. Obviously, you called out lumber, which is something that does gyrate around a lot, and we're watching it, just like everybody else. But in addition to that, what we're wondering is whether or not there's any other incentives that are sort of being contemplated in your outlook. It wouldn't be terribly surprising maybe to see incentives and increase to some normalized level. Maybe you could help us understand, one, are you including any increase in incentives, maybe like, for example, offering to buy down rates at the closing table or something like that? And then two, what is the normal level of incentives that you would run through your gross - or cost of goods sold versus where it is, where it has been, let's say, in the first quarter of this year?

Phillippe Lord, CEO

Sure. As we review our gross margin guidance, we do not anticipate margins to continue to rise from the first quarter, as indicated by our full-year forecast. This expectation is largely due to the ongoing cost increases we are experiencing. We observed significant cost hikes in the first quarter, and those continue. Additionally, we expect to implement further incentives, which could include rate buydowns or other incentives and increased focus on realtors to boost our sales in the latter half of the year and facilitate the buying process. We are adopting a cautious approach given the current rising interest rate environment, which directly influences our full-year outlook. In terms of the incentives we offered in the first quarter compared to a typical scenario, they were nearly non-existent in that quarter, with the only incentive being a mortgage buydown tied to our backlog. In a typical environment, we would expect incentives to range from about 3% to 4%. When supply and demand are imbalanced in the housing market, we normally underwrite new land at this rate.

Hilla Sferruzza, Executive Vice President and CFO

And that cost rate loads even that is reflected already as we mentioned for Q3 and Q4 closing. So that's a portion of what you're seeing flowing through the margins in the back half of the year as there's obviously a decline when we're guiding to low 28 and we just closed out the quarter at 30.3%. There's obviously a sequential decline coming in the back half of the year. A portion of it is that, a portion of it is incremental conservatism that may be needed. It's difficult to gauge with what you read about the expectations from the Fed over the next one to two months; it's difficult to gauge what the market is going to be, and we don't have 100% of our expected backlog to close out the year just quite yet.

Stephen Kim, Analyst

Yes, sure. I was hoping you were going to say, Hilla, that it incorporated that conservatism. Just to clarify one thing though, when you talk about normal incentives in a normal market, is it also true that in a normal market, home prices are rising at a sort of a low to mid-single-digit rate?

Phillippe Lord, CEO

That's typically what happens. But when we look at a new piece of land and we buy a new piece of land today, we are expecting home prices to appreciate. We underwrite at current prices, we underwrite at current costs, but we are doing so at traditional incentive structures that currently don't exist in the market today.

Operator, Operator

Our next question is from Truman Patterson with Wolf Research. Please proceed with your question.

Truman Patterson, Analyst

First, just wanted to follow up on one of Steve's questions before. But your business model, you have a shorter order to close cycle time, and you reiterated your 15,000 closings, which I think indicates you're expecting demand to remain pretty healthy, strong growth for Meritage, at least for next couple of quarters despite the move in rates. I'm just trying to understand at the margin if there's been any shift in your consumer behavior outside of that mix shift, is there more handholding to get them across the line? Are you seeing more traffic that you have to get qualified before they place the order, etc.? Just trying to understand what you all are seeing on the ground floor?

Phillippe Lord, CEO

Yes, all of the above. Definitely more handholding and getting people comfortable with getting qualified, what their loan is going to be, what their payment is going to be; certainly having to go deeper in the priority list. We still have really deep strong priority lists on a subdivision-by-subdivision level but we're often having to go deeper into those as there being the pressure of the first one to buy or they won't get it. We're going in three to four deep into our priority list to find the right buyer for the right home. So we're seeing all of those leading indicators come off of what was just unprecedented highs, where it was sort of just a frenzy out there. Still very, very strong, but I wouldn't categorize it as a frenzy anymore.

Hilla Sferruzza, Executive Vice President and CFO

So I will say that once we get the buyers, the qualification process is not any more difficult than it is than it was previously, right? When we're looking at our FICO debt-to-income ratios and loan-to-value ratios, they're not any different than they were. So we're having to go down deeper into the list, for sure. But part of that is because the buyers bought from someone else on as the home becomes available. They have their needs on a whole bunch of priority lists. The first on the call gets the sale. So we're still able to qualify the buyers on our homes that had a consistent financial metric.

Phillippe Lord, CEO

All of the leading indicators around traffic, web activity, contact center activity, those are all very, very strong as well. They certainly come off of their peaks given the rise in rates, but still very, very strong flow of inbound interest in our homes.

Truman Patterson, Analyst

Okay. Okay. So the priority lists are still deep, but you're just having to go a little bit further in. I'm trying to understand the level of investor activity in your core for-sale communities, either smaller mom-and-pop investors or larger institutions. And whether or not there's been any change in investor activity given the rate backdrop? And kind of part two of this question, the BTR platform. If the for-sale market or consumer decelerates, I'm trying to understand the appetite of the BTR investor, if you will. How quickly do you think you'd be able to mature that platform?

Phillippe Lord, CEO

Yes. We have a pretty tight governor on the amount of investor activities we allow in our subdivisions and communities. We've always done that. So we try to limit it to around 5% of the overall community. We can open that up to mom-and-pop investors and whatnot. So when we look at the last four quarters, that's about where it's at is about 5%. We haven't seen – we don't particularly increase that activity. Have we seen more interest from mom-and-pop? I'd have to follow up with you on that. I do think the investor interest in the market has grown, but we govern that pretty closely. On the build for rent, that's our thesis as well, although we are also waiting to find out how they perform along the way here. Right now, they have a very, very strong interest in anything that we can provide to them. We see it as an opportunity to mature quite quickly if our core sale business were to soften or decline. That's at least the conversations and the partnership and the relationships we have in place today. As we've tried to increase that volume over the last couple of quarters, there's a very, very strong interest from those partners on buying anything that they can from us.

Hilla Sferruzza, Executive Vice President and CFO

And you're going to see a ramp-up in the individual home sale activity. As we mentioned, it's a little bit under 5% of the current quarter, but that's going to grow throughout the quarters of the year that inventories have already been identified and committed. As we roll into next year, we mentioned that there's entire communities that are structured to be sold to the build-for-rent operator. So you're going to see that volume consistency in our results again. The new emerging market for everyone here, the institutional BFR participating in new home construction. So we'll see what the appetite is. But for now, it's incremental business for us not taking away from our core business. It's additional units that we're identifying and securing for them with additional labor. So this is just a plus for us at this time.

Operator, Operator

Our next question is from Alan Ratner with Zelman & Associates. Please proceed with your question.

Alan Ratner, Analyst

Thanks for taking the questions and great performance in the quarter. First question, maybe just on that BFR topic since you were just addressing it. What are the economics? I know it's early, but what do you expect the economics to look like there? Just recognizing there's going to be some mix shift as that business grows from 5% to double digits of your volume over the next year. So I'm assuming that you're not expecting margins on that business to be kind of the 30% level you're generating today for sale. But are there any notable mix differences either on price or margin that we should think of?

Hilla Sferruzza, Executive Vice President and CFO

No. It's actually consistent. There are certain costs that we don't have to spend utilizing the BFR platform, and we pass those savings to our operator partners. So actually, it's a net neutral for us. And it's a net saving for them since they're buying the majority of what they're getting just straight off the net order stream. They're getting a savings that we're passing along for costs that we don't have to spend. It's actually net neutral right now. There may be some shifts across P&L line item, but net-net, it's the same for us at this point in time as the new communities roll on. There might be a slight de minimis 100, 150 basis point variance on the full in community versus individual homes. But again, not material at an accelerated pace. So the leveraging and the efficiency in those communities is still going to result in a net neutral impact to Meritage.

Alan Ratner, Analyst

Okay. Great. That's helpful, Hilla. Second, I would love to chat a little bit about some of your comments on the land acquisition side, kind of pulling back a little bit there this quarter. And I know you guys obviously made a concerted effort to really kind of accelerate the community count growth before a lot of your peers have, which has worked out well. I'm curious, with your new lot acquisitions down year-over-year, is that consistent with the plan you've had in place, or was that in reaction maybe to what you're seeing in the mortgage rate environment and some concerns going forward there. Just trying to figure out whether this return to more normalized growth is more of an inflection or a change in thinking or whether this was always kind of the path you envisioned.

Phillippe Lord, CEO

Both. I mean, we were very intentional about getting to 300 and stabilizing, which we're going to accomplish here this quarter. But from there, we always planned to more measured growth to allow us to get the organization positioned to be successful and, frankly, not take on unnecessary land risk. I mean, the opportunity to get to 300 we put that goal out there in 2019; COVID slowed it down a little bit. But as soon as we saw what was going to happen out of COVID, we jumped in and delivered on that. A lot of that land by the way, that we are closing that's making up the 300 today was stuff that we bought two years ago, contracted two-plus years ago. So it's really well priced, low residual land that's going to be flowing through our business plan for the next two years. We really don't need any land, frankly, for the next two years at all. But as the interest rates have risen, we've rationalized all of our land and the land in our pipeline that we're closing, the land that allows us to grow from the 300 next year and beyond and looking at every piece of land through the lens of a higher interest rate environment and does that make sense going forward. Clearly, land prices have escalated quite a bit over the last six quarters. And so the land that you're seeing out there in the market today, frankly, it's kind of uncomfortable. There are some good opportunities out there. You have to be very disciplined and look at 20 deals to find the one that you like, which we're still viewing. But I think you can expect us to have a much more measured and tempered new land pipeline from here as we look at just making sure we have the best 300 communities in our portfolio and then just grow modestly from there until we see exactly what interest rates are going to stabilize at.

Alan Ratner, Analyst

Yes. I think that strategy makes a ton of sense, given all the uncertainty, and I would imagine that given the moderation in growth, that should translate to some pretty healthy cash generation as well.

Operator, Operator

Our next question is from Carl Reichardt with BTIG. Please proceed with your question.

Carl Reichardt, Analyst

I'm sorry if I missed this. Did you talk about how many homes you had actually under construction at the end of the quarter?

Hilla Sferruzza, Executive Vice President and CFO

Or spec homes or total homes?

Carl Reichardt, Analyst

Total homes.

Hilla Sferruzza, Executive Vice President and CFO

Just spec plus the backlog. It's like 9,500.

Phillippe Lord, CEO

9,500 or so. Yes, 6,700 houses in backlog.

Hilla Sferruzza, Executive Vice President and CFO

Yes, 9,365 is the actual number, yes.

Phillippe Lord, CEO

Yes.

Carl Reichardt, Analyst

Okay. And then just trying to think about pricing strategy here. And as you're looking going forward, I mean, obviously, the average order price is up a ton year-on-year and has been for the last three or four quarters. But is this the point in time now as we look at our models where we ought to really effectively start flattening it out on a go forward as you look at the new communities coming online and the mix there. And it seems like this is kind of now where we should start to flatten it. And I'm just curious if you think that makes sense or the expectation here is that maybe it'll take the hit to margin but you'd still see average order prices up? So just like your thoughts on that.

Phillippe Lord, CEO

I can give you my thoughts. I mean, we're a ground-up company, right? We have 300 communities that make up our business plan and every community has a different story. Some have a lot of runway, some have a little bit of runway. Some have demand for years, some we're scratching for our five a month. So we price to the local market conditions. What are the competitors doing? What's the retail market doing? Who are the buyers coming through our communities? So we're pricing based on supply and demand dynamics in each market. The supply and demand market dynamics have been so upside down all the way through, frankly, even today, they're still there, that we're pricing our products based on the demand in the market. So it's hard to say what prices are going to do from here. If you look at what's going on in April, I would expect prices to continue to go up based on the dislocation of demand and the ability for us to bring supplies to the market. So it's hard to say. Maybe the interest rates will start to diminish the demand to a point where we're not going to continue to push prices. Certainly, our costs continue to go up as well. So we'll just have to see month-to-month. But we have a lot of communities where they're in coastal California, coastal Florida, urban Texas markets, etc., where there's underserved demand for decades in those markets, and we're going to price to the market.

Hilla Sferruzza, Executive Vice President and CFO

I think you've seen from our margin, we're not shy to do what the market says. We're not trying to take what's available in the market. We're going to increase our pricing in line with what everyone else was doing and maybe even push a little bit more. So the challenge with affordability, it certainly does. And I think we're trying to get there by buying cheaper land, starting at a lower average selling price, but we're not scared to take what the market is giving us.

Phillippe Lord, CEO

Yes, that's exactly right. We continue to acquire land this year, which not only reduces our average selling price despite some market appreciation, but also yields very strong margins. We are launching numerous new communities and have seen the highest growth in community count in the industry, or in fact, the only growth. We've completely revamped our community count mix, achieving industry-leading margins. This success is a testament to the excellent work of our land teams across all markets in acquiring the right land that allows us to offer affordable products with robust margins.

Operator, Operator

Our next question is from John Lovallo with UBS. Please proceed with your question.

John Lovallo, Analyst

The first one is, I guess, on the purchase of the mortgage rate locks for the customers in backlog. I mean, it seems like a very good customer service action that you guys took. But I'm curious, given how tight supply is right now, I mean, do you think that you could have actually sold those homes have folks dropped out of backlog at higher prices? And why I'm asking this is this move is not a reflection or is it a demand concern going forward?

Hilla Sferruzza, Executive Vice President and CFO

It's not a demand concern issue; it was who we are as a company and treating our customers right. So we're not buying below-market rate locks for our current customers. They know what the interest rate is when they're walking in the door today. That folks set up houses from us when the interest rate was around three, and when they're going to go to the closing table, it's going to be 5.5. They're going to probably fall out, can we resell that house? Absolutely can resell that house. Is it the right thing to do, the right thing for the company to treat your customers this way and not one or two but a large swath of your customers? We don't feel like it was the right thing to do. The market moved a little bit more quickly on all of us than what we thought. So yes, it's taking us longer to build the houses. So even from the time that they're walking to the time they're closing, just the variability is likely more than what they were expecting, frankly, more than what we were expecting; rates have probably moved up more dramatically than what everyone was looking at, everyone was expecting to see. So for us, like I said, we're not offering below market anything for new customers, and we're selling at the same pace. So we're definitely not thinking this is an indication of demand in the marketplace, although we are now locking in all customers using our mortgage company with an interest rate lock now at the current rate, so they know what it is, but we just think that it's good business and it's good for their comfort to know that the rates that they're locking in among the payments that they're solving for today. It's a multi payment that is going to be available to them really close to the house. So before we allow loans to float, there wasn't a lot of variability in the market. But today, we're asking all buyers using our mortgage company to lock in at current rates.

John Lovallo, Analyst

Okay. That makes a lot of sense. Thank you. And then I think you guys mentioned that you did not see any further extension in cycle times in the first quarter. I mean if that's correct, I mean different than some of your competitors are saying. So I'm just curious, what do you think has allowed you to sort of maintain the cycle times when others are seeing further extensions?

Phillippe Lord, CEO

Yes. That is true. We didn't see any additional incremental schedule delays or I guess our schedules didn't expand from Q4 to Q1. I think it's just the commitment to the all-spec strategy, the starts pre-planning those starts. As we've said a number of different times, we started planning out our business six months ago for this year. We knew all these communities were coming. We got in front of our trade partners. We've built out the plan. We're committed to the plan. Despite rising interest rates, we've stayed committed to that plan and because of that and our intention of scheduling out our starts and planning out our starts. The fact that our business is so streamlined and our trades can perform better when we have less complexity. I think that's what has occurred, and it's played out in our cycle times. I'm not here to tell you that it's not a mess out there; it's still very, very bad. It's still very difficult to get material and labor to our sites and things haven't gotten any better, but they definitely didn't get worse for us last quarter, and I'm not seeing them get worse this quarter either. I just think it's, again, the commitment to the stacks and planning out the business well in advance.

Operator, Operator

Our next question is from Michael Rehaut with JPMorgan. Please proceed with your question.

Michael Rehaut, Analyst

First, I wanted to clarify the impact of rate lock actions on your backlog, particularly regarding floating-rate loans. What percentage of your backlog was affected by this? I assume that most of your loans are fixed-rate, so I'm curious about the percentage of the backlog that is impacted and the estimated dollar effect this has on the company.

Hilla Sferruzza, Executive Vice President and CFO

Yes. So these are mortgages through our mortgage company partner, which is about 80% of the business that we do. And these are mortgages just for Q3 and Q4. So prior to the run-up in interest rates, only about 25% of our backlog was locked, right? It's low by historical averages, but pretty much in line with the last three years. People aren't locking rates; the likelihood is that the rate is going to go down, not going to go up. Now let me just clarify, there is a one-time slowdown on this rate loss, even though it's below market, there is a one-time rate lock down on this block as well. But the expectation of buyers has been sold maybe February of this year is that rates are only going to go lower, not to go higher. So very few lots. That's changed dramatically in the last five or six weeks. Everyone is asking to lock. So that's obviously going in our favor. But what was in the backlog before was definitely not a lot. So post this action, a great majority of the backlog that we have is now locked for the back half of the year.

Phillippe Lord, CEO

Yes. Don't get notified mixed up. We're not talking about people having interest-only loans that got floated. Everyone is on a 30-year fixed, but they let the rate float until they close the house.

Hilla Sferruzza, Executive Vice President and CFO

Correct.

Steve Hilton, Executive Chairman

We're not giving the specific costs for competitive reasons, but the cost is baked into our guidance.

Michael Rehaut, Analyst

Got it. And I guess, just more broadly then, in trying to understand the first half gross margins versus second half. I guess doing the math, I would point to second half gross margin somewhere in the 27% range, roughly speaking. If you look at that maybe 250-ish basis point differential, let's say, sorry. Yes, you still there. Sorry about that. If you look at that difference between the two first half and second half, I'm just trying to get a sense of how much is conservatism versus some of the cost increases and maybe other anticipated increases in incentives that you're anticipating?

Hilla Sferruzza, Executive Vice President and CFO

Yes. We're not going to have a breakdown of the margin analysis for the full year, but I think you hit on all the right news, Mike. A piece of it is the rate lock, a piece of it is future anticipated incentives for homes that we haven't yet sold that will be closing in the back half of the year. And some of it is timing of lumber. We had just higher direct costs flowing through everything that we're starting to build now, that's closing in the back half of the year has higher costs. So there's a whole bunch of different dynamics that are flowing through the expectations for the back half of the year, although, obviously, we still raised our full year guidance from 27.75 last quarter to low 28. So we are still forecasting an improvement from where we were just three months ago. But overall, we're also trying to be realistic and cautious as to what the next couple of months hold.

Operator, Operator

Our final question is from Deepa Raghavan with Wells Fargo. Please proceed with your question.

Deepa Raghavan, Analyst

A very high-level question for me since everyone is welcoming housing stability here. How do you define the stability in an idealistic market? Is that 1.6, 1.7 housing starts with a 7% volume growth, pricing maybe 1% to 2% annually, in line with overall inflation? I mean, like what volume do we not end up stretching the supply chain that we have right now? And also in that scenario, what is Meritage's strategy to grow and take share as you try to ramp from that 300 community count base that you've set for yourself here?

Phillippe Lord, CEO

Yes. I mean, I think when you look at annual housing starts historically, they've been 1.5 or so, and so we're not even close to that. But Meritage's strategy has always been to get to 300 communities. We think between first move-up level to first-time buyers, we can do a blended absorption rate between four and five, and that's 15,000 units over an annual period. And so that's our strategy. And then we grow based on what the market will give us from there and what the land market will give us as well. So that's really the strategy. It's not that complicated. And then when you think about home prices, when things are normal prices are moving up 3% to 4% a year, not what they've done over the last two years. So that's how we think about it. When we look at new land, we think about—we don't include appreciation; we don't include cost inflation because our assumption is that old prices will go up 3% to 4%, costs will go up 2% or 3%, and you'll end up with what you underwrote. So that's what's normal for us. We constantly said that we think the market will normalize to a 3-to 4-month absorption pace over time. We're clearly not there. We're still metering sales across the entire industry for a variety of reasons that have been articulated. And I don't think if we opened up all our communities today and just let them run, they would run at a much higher pace than three to four right now.

Hilla Sferruzza, Executive Vice President and CFO

Yes. I think that was maybe back to the first question that Stephen asked, which is what do you think of the entry space? I don't know that it's 100% tied to total housing starts; it's what homes are you building? Do we think that we're building in the area that's the most underserved? So the stabilized market for us may not be a direct extrapolation as to housing starts, but it's a normalized take, as we've said, 4-ish, a little bit maybe more than that with normalized average selling price growth when the market does that, all the dynamics make sense. Land prices are normal. Supply chains come back into alignment, labor makes sense. And that's the environment that we're looking for. That's where everything is rational and the buyer doesn't have a fear that they're buying it at a bad time in the market.

Deepa Raghavan, Analyst

That's great color. Thanks for that. My follow-up is on SG&A, and I apologize if I missed it. Are you able to provide some numbers around that for the year? I mean you talked about some additional leverage coming from this new volume reset you have.

Hilla Sferruzza, Executive Vice President and CFO

The SG&A, I wouldn't expect it to fluctuate tremendously from what we're doing right now. We've guided to higher closing volumes. So it's going to bump around. There's always some nuances as to what happens quarter-to-quarter, but the 8.5% that we had this quarter, I would expect that to remain relatively stable.

Operator, Operator

We have reached the end of the question-and-answer session, and I will now turn the call over to CEO, Phillippe Lord for closing remarks.

Phillippe Lord, CEO

Thank you so much for your time and your interest in Meritage Homes. We really appreciate you listening to our story, and we look forward to seeing you next quarter. Thank you.

Operator, Operator

This concludes today's conference, and you may disconnect your lines at this time. Thank you for your participation.