Earnings Call Transcript
Meritage Homes CORP (MTH)
Earnings Call Transcript - MTH Q1 2021
Operator, Operator
Hello, and welcome to the Meritage Homes First Quarter 2021 Analyst Call. At this time all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to turn the call over to Emily Tadano. Please go ahead.
Emily Tadano, Investor Relations Director
Thank you, Kevin. Good morning and welcome to our analyst call to discuss our first quarter 2021 results. We issued the press release yesterday after the market closed. You can find it along with the slides we'll refer to during this call on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom of our home page. Please refer to slide two, 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 and changes in interest rates, community count and absorptions, supply chain constraints and cycle times, projected second quarter and full year 2021 home closings and revenue, gross margins, tax rates and diluted earnings per share, potential disruptions to our business from COVID-19 as well as others. Those and any other projections represent the current opinions of our 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 2020 annual report on Form 10-K, which contains a more detailed discussion of those risks. We have also provided a reconciliation of certain non-GAAP financial measures referred to in our press release as compared to their closest related GAAP measures. With 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 13. I'll now turn it over to Mr. Hilton.
Steve Hilton, Executive Chairman
Thank you, Emily. I want to welcome everyone joining our call today and hope you and your families are staying safe and healthy. I will begin by discussing current market trends and provide an overview of the start of the year. Phillippe will discuss our strategy and quarterly performance. Hilla will present a financial overview of the quarter and our guidance for 2021. The housing market is very strong and continues the exceptional momentum from 2020. The spring selling season started earlier than usual and is still thriving. Meritage has achieved another record quarter, with the highest first quarter orders and closings and the highest quarterly homebuilding gross margin since Q1 of 2006. Our strategic focus on affordable entry-level homes and virtual sales channels to meet current demand led to an absorption pace of 5.8 homes per month in the first quarter of 2021, an increase from 4.3 per month last year, marking the strongest first quarter absorption pace since 2005. We accomplished this while managing our speculative starts and associated orders in most communities to align with the production constraints currently present in the market. Unless we see significant interest rate hikes, we expect current market demand to persist throughout the year, giving the housing industry ongoing pricing power to offset rising commodity and other costs and to maintain strong margins. Looking ahead, we anticipate favorable macroeconomic conditions for homebuilding will continue for several years. Mortgage interest rates are still very affordable, and despite a recent rise in average 30-year mortgage rates, they are below 3.25% in our backlog. Most entry-level buyers are focused on monthly payments, so as long as these payments remain reasonable, demand will stay strong. Moreover, strong demographic trends remain, with many millennials experiencing life events that are aligning with homeownership, while baby boomers are becoming empty nesters who seek smaller homes. Additionally, the supply of new and retail homes is still limited, and we believe Meritage is well-positioned to benefit from this environment, continuing to enhance year-over-year volume and profitability in the upcoming quarters. Now please look at Slide four. Earlier this month, the EPA recognized Meritage Homes as the 2021 ENERGY STAR Partner of the Year for Sustained Excellence, reflecting our commitment to being a leader in building energy-efficient homes. As an eight-time recipient of this honor, we aim to enhance our environmental stewardship in both our communities and the planet. Our recent launch of a multi-speed HVAC system standard in all new homes starting this April exemplifies this aim, as it operates more efficiently than traditional units, helping owners better manage comfort while reducing environmental impact and operating costs. In line with our dedication to innovation, we have also introduced an upgraded smart home automation suite for centralized management of all smart home technologies, enhancing functionality for our owners while adding door sensors and motion detectors for improved safety and security. This quarter, we made it easier for customers to transact by adding on-demand homeowners insurance to our online financial services, which already include online mortgage prequalification tools and electronic payment for earnest money deposits. Additionally, we launched our ESG page on Earth Day, detailing our commitment to the environment, employee well-being, and corporate responsibility in terms of diversity, equity, and inclusion. We are improving our recruiting processes to attract a stronger, more diverse future generation of leaders at Meritage, both in the field and at corporate. We will continue to support organizations promoting diversity, equity, and inclusion across our nation. Our progress in energy efficiency, innovation, and diversity will enhance the long-term value for our customers and shareholders. I'm also pleased to announce that we are entering our first new market since 2016, following the completion of several land acquisitions. The new Coastal division expands our operations in the East region into Charleston, Myrtle Beach, and surrounding areas in South Carolina. We plan to initiate marketing campaigns in the coming quarters in anticipation of launching these five new affordable entry-level communities in 2022. Now, I'll hand it over to Phillippe.
Phillippe Lord, CEO
Thank you, Steve. Given our strong performance in 2020, we are now a top five builder in 10 of our 17 markets, and we aim to continue gaining market share in all of our geographies. As we've covered in the past, our strategy is to offer quality affordable homes in the entry-level and first move-up markets. That being said, the ongoing surge in housing demand has enabled us to capture strong pricing power in all of our geographies with year-over-year quarterly price increases of at least 20% on average. Despite these increases, closing average selling prices are down a bit year-over-year, and orders and backlog prices are up just a small percentage year-over-year this quarter, all due to our focus on entry-level products. For the balance of 2021, we will continue to maximize pricing power wherever possible based on market conditions while managing our spec starts and the related order base to better align with current supply channel constraints. We believe this cadence will allow us to continue to generate elevated gross margins. Despite the increase in FHA city limits early this year, our pricing power has allowed us to push average selling prices of entry-level products above these new FHA limits in some locations. While this is not typical for our entry-level communities, we are closely monitoring each location to determine if the increase is impacting demand. On Slide five, we closed 2,890 homes this quarter, up 25% year-over-year. Home closing revenue of $1.1 billion in the current quarter increased 21% compared to 2020. In the first quarter of 2021, we achieved a 24.7% home closing gross margin, up 470 basis points from 20% in the prior year. We sold 3,458 homes this quarter, which was 11% higher than the same period in 2020. The per store absorptions were up 35% year-over-year from 4.3% to 5.8% per month and accelerated faster than total order growth, even as we increased prices and limited orders, demonstrating our capacity to generate significant order volume once we hit our 300 community count target in mid-2022. During the first quarter, strong demand exists in both entry-level and first move-up products. Entry-level comprised over 76% of total orders for the quarter, up from 61% in the first quarter last year. Entry-level also represented 73% of our average active communities compared to 49% a year ago. Our first move-up communities also experienced improved demand year-over-year, with absorptions 45% higher than a year ago. Now turning to Slide six. Moving to the regional level trends on Slide six, all our regions reflected solid year-over-year absorption growth in Q1. Our East region led in terms of absorption growth with a 67% improvement over the first quarter of 2020. Orders in the East region increased 39% year-over-year for the quarter, which offset a 16% decline in average community count. The East region has the largest increase in entry-level communities, resulting in 72% of its average active community selling entry-level products during the quarter compared to 36% in Q1 of last year. Tennessee's absorption pace of 6.6 per month was the highest for any of our states in the first quarter of 2021, bouncing back from storms and community count gaps in 2020. Absorptions for our central region, comprised of our Texas markets, increased by 34% over the first quarter of 2020, despite a 21% reduction in average community count. Entry-level communities represent 75% of the central region's average active communities during the quarter, up from 56% from the first quarter of the prior year. Our first quarter 2021 absorption in the West region was up 13% over the same quarter in the prior year, even with a 6% decrease in orders and 16% fewer average communities. On a year-over-year basis, Arizona increased both order volume and average community count. We've been able to open up new stores here and capture the exceptional demand in one of the strongest homebuilding markets today. The continued demand in California and Colorado led to a 31% decline in the average communities with a corresponding reduction in order volume of 17%, but 20% higher absorption pace year-over-year. Entry-level communities represented 70% of the West region's average active communities during the quarter, up from 50% in the prior year. Turning to Slide seven, of the 2,890 home closings this quarter, 71% came from previously started spec inventory, in line with 69% a year ago. We ended the quarter with over 2,200 spec homes in inventory or an average of 11.2 per community compared to approximately 2,700 in the same average of 11.2 in the first quarter of 2020. At March 31, 2021, less than 10% of total specs were completed versus our typical runway of one-third. Maintaining our goal of a four to six month supply entry-level specs on the ground has been challenging even as we manage our order pace. Selling more specs and early-stage production to meet elevated demand, as well as managing our spec starts to correspond with the supply chain constraints, drove the lower spec inventory levels as well as the percentage of completed sold specs. Similarly, this trend led to the 47% increase in our backlog to 5,240 units at the end of the first quarter. Our backlog conversion rate decreased to 62% in the first quarter this year from 83% last year and will likely remain in a lower than average range given sustained demand as a result of both selling homes earlier in the construction process and the temporarily lower volumes of specs available for sale due to longer cycle times. Although supply side headwinds minimally impacted our first quarter results, we are now expecting delays, which is leading to extended construction cycle times of two to four weeks. We are still committed to our spec strategy, which enables us to pre-plan starts and should allow us to pre-contract for building materials in advance and minimize the impact of supply chain constraints. Labor challenges are a perennial issue in our sector; although currently, we have not experienced any notable labor issues. We expect our transparency and scheduling visibility will continue to be attractive to local trades, but we continue to monitor for any indication of a tightening labor market. Even in today's environment with supply side delays, our spec strategy in the entry-level communities remains a core tenet for us. This building methodology gives us a competitive advantage, especially when commodity costs are rising. Since the homes we are selling have already started construction, we are able to better manage our profitability and avoid cost risk by locking in prices before pricing the home. Additionally, the quick close timeline of spec homes allows customers to lock in a mortgage rate. We believe that our spec strategy has enabled us to increase our market share, and we'll continue to do so as we grow to become a top five builder in all the markets in which we operate. I will now turn it over to Hilla to provide additional analysis on our financial results.
Hilla Sferruzza, CFO
Thank you, Phillippe. Let's turn to Slide eight and cover our Q1 financial results in more detail. As Phillippe noted, the 21% year-over-year closing revenue growth in the first quarter was the net impact of a 25% increase in home closings, partially offset by a 3% decline in average selling prices. While average selling prices reflect a greater mix of affordable entry-level homes, they also include year-over-year price increases of at least 20% on average due to the favorable pricing environment. The 470 basis point improvement in first quarter 2021 home closing gross margin to 24.7% from 20% a year ago mainly resulted from higher prices as well as the additional closing volume and efficiencies gained from continuing to streamline our operations. These improvements mitigated record-high lumber prices as well as other commodity price increases. It's been well documented that certain homebuilding materials are generally constrained in today's environment due to ongoing pandemic-related supply chain disruptions, some weather events, and 12-plus months of elevated demand. These shortages and rising costs are impacting all of the construction industry to some degree, and while we're certainly not immune to this phenomenon, we believe our limited SKU composition and predictable construction cadence allow us some advantages to manage these delays. SG&A as a percentage of home closing revenue was 9.8% for the current quarter, a 90 basis point improvement over the prior year. The higher revenue and savings achieved from increased technologies, particularly in the sales and marketing channel, allowed us to better leverage our SG&A. We believe we can sustain strong margins in 2021 despite higher commodity costs, and we do still anticipate some additional overhead costs related to our growth to 300 communities prior to the incremental closing and revenue from that new business. This will result in an increase in SG&A dollars over the next several quarters, but we expect the incremental revenue beyond 2021 to drive material SG&A leverage in future years. The first quarter 2021 effective income tax rate was 20.6% compared to 18.1% in the prior year; both years reflect reduced rates from the eligible energy tax credit under the 45L provision and some retroactive pickups in 2018 and 2019 energy credit. Overall, in the first quarter of 2021, we achieved price increases and higher closing volumes with more efficient streamlined operations while balancing our order pace with production. This produced expanded margins, improved SG&A leverage, and an 88% year-over-year increase in first quarter diluted earnings per share to $3.44. Moving on to Slide nine, our balance sheet remains strong even as we continue pushing forward to our 300 community count goal. We achieved several objectives this quarter. Late in the quarter, we issued $450 million of new senior notes priced at 3.875% due in 2029. We received approximately $444 million in net proceeds on April 15. On March 31, 2021, we issued a notice of redemption for all the $300 million principal outstanding on our 7% senior notes due in 2022, with the redemption date of April 30, 2021. The early redemption of the '22 notes will result in approximately $18.2 million of early extinguishment of debt charges in the second quarter of this year. We repurchased 100,000 shares for a total of $8.4 million to partially offset the issuance of the annual employee grant. We also received an S&P credit rating upgrade this past February, the third credit rating agency upgrade in the last two quarters. We are now one notch from investment-grade status from all three rating agencies. At March 31, 2021, our cash balance was $716 million compared to $746 million at December 31, 2020, primarily as a result of greater land spend and share repurchases. Our net debt-to-cap ratio remained low at 10.9%. We have previously noted that we have set our maximum net debt-to-cap target in the high 20s, low 30s range, which is in line with the quick asset turn from entry-level and first move-up offering. Our priorities for the next several years remain the same. We expect to use the bulk of our cash on land spend for our growth strategy and to get specs into the ground. We plan to continue to repurchase shares routinely to offset new grants and to keep our dilution neutral, and to opportunistically repurchase incremental shares. However, we look to put the majority of the returns back to work to achieve long-term volume growth, drive profitability, and gain market share. On to Slide 10. On March 31, 2021, with over 58,000 total lots under control, we had a 4.7-year supply of lots based on a trailing 12-month closing, in line with our target of a 4 to 5-year supply of lots under control. We increased our land book by 14% from approximately 41,500 lots at March 31, 2020. We're making good progress and remain on track to achieving our 300 community count goal by mid-2022. Despite our accelerated absorption pace, we opened more communities than we closed in Q1 this year. As we already own or control all of the land necessary for our 300 communities, we're currently working through the development of the land for the next five quarters. We spent nearly $370 million on land acquisition and development this quarter, a 50% increase from last year's Q1 spend. We expect our land spend to be more than $1.5 billion annually in 2021 and beyond to sustain and replenish our 300 communities. We recognize that land price appreciation and additional demand for land from all builders exist today. However, we've been able to refill our land pipeline without compromising our underwriting standards. In the first quarter of 2021, we secured 5,900 net new lots—more than double the volume in the same quarter of 2020. Our net new lots translated to 43 new communities, of which approximately 95% are entry-level homes to maintain our focus on affordable housing in the future. To address the higher orders pace of entry-level products, the average community size contracted for in the first quarter of 2021 is 129 lots, up 26% from the first quarter of 2020, where the average size was about 102 lots. Acquisition of larger lot sizes limits some of the competition for land and enables us to leverage a large lot count to reduce community level overhead cost per lot while minimizing the community count churn and the inefficiencies associated with opening new communities. To preserve liquidity, we're using options or staggered purchasing terms where financially feasible. About 60% of our total lot inventory at March 31, 2021, was owned, and 40% was optioned, a slight improvement compared to the prior year's 63% owned and 37% optioned. Finally, I'll direct you to Slide 11. The pricing environment has been stronger than we anticipated, which has allowed us to increase pricing by at least 20% year-over-year on average, driving up our gross margin expectations beyond where they were just three months ago. For the full year 2021, we are now projecting total closings to be between 11,700 and 12,700 units; home closing revenues of $4.55 billion to $4.85 billion; home closing gross margin of approximately 25%; an effective tax rate of about 23%; and diluted EPS in the range of $13.75 to $14.75. At March 31, 2021, we had 203 active communities, in line with our guidance and slightly up sequentially from 195 communities at December 31, 2020, but down from 241 in the prior year. Despite weather and general supply channel flow, we were able to open our expected communities on time—30 openings, up 36% from 22 in the first quarter of 2020. We continue to anticipate about 200 communities for Q2 this year, and given our strong pipeline for community openings, we expect to see an increase of approximately 20% in our community count by December 31, 2021, from the current level today. As for Q2 2021, we are projecting total closings to be between 2,800 and 3,100 units; home closing revenue of $1.1 billion to $1.2 billion; home closing gross margin of approximately 25%; and diluted EPS in the range of $3.05 to $3.35. 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 for increased demand over the next few years by continuing to execute on our entry-level and first move-up strategy. Additionally, our 100% spec building in the entry-level communities and our streamlined operations have been successful to date, and we expect our strategy will continue to serve us well in the future. We remain on track to achieving our 300 community count goal by mid-2022, given our strong balance sheet that allows us to make elevated land investments quarter after quarter to sustain a healthy land position. In the current environment, we will continue to push our pricing power where the market allows while managing our spec starts and the corresponding order pace in line with supply chain constraints to deliver greater margins and profitability. With that, I will now turn the call over to the operator for instructions on the Q&A.
Operator, Operator
Thank you. We will now be conducting a question-and-answer session. Our first question today is coming from Alan Ratner from Zelman & Associates.
Alan Ratner, Analyst
Congrats on just the amazing margin performance. It's truly remarkable. So obviously, the demand environment is incredibly strong and I think you guys are doing a great job of maximizing the pricing. I think that 20% increase definitely sounds higher than some of the numbers thrown out by some of your competitors. So it seems like the only limitation on sales, I guess, at this point is the production piece and how quickly you can get homes started. And I think it makes a lot of sense that you're not selling before starts just given the uncertainty on the cost side. So with your sales pace running close to six a month, what is your start pace running at right now? And what ability do you have to flex that higher if possible, or if not, if you could just kind of tell us where that's running at? That would be helpful.
Phillippe Lord, CEO
It's running almost the same because, as you know, in entry level, we're 100% spec, and frankly, we're in 1MU right now or more spec as well because that's what the buyers are preferring. So it's almost the same. Our ability to ramp up our spec starts is somewhat limited in today's environment just because of the production issues that we've been discussing. But we do have the ability as we open up these new communities to really come out of the ground strong and line that up. So we can leverage it up as our community count growth stabilizes. But there is some limitation out there in the market just with the current constraints that are out there in production. And frankly, we think where we're pacing our communities is really the optimal pace that allows us to be really efficient with our trade partners and then maximize the margins and control our costs. So we're really comfortable with our current pace. And we're not really looking to flex it up; we're trying to get our growth just to community count growth.
Alan Ratner, Analyst
Okay. Great. That's very helpful, Phillippe. And listen, I know this is kind of one of these unfair questions, but just given how strong margins have ramped here over such a short period of time. You guys are going to be turning your communities pretty dramatically over the next 18 months. And without asking me to predict what the prices are going to do, how realistic is it that these margins can be sustained as you open up a lot of these new communities? If pricing were to return to something a bit more normalized, obviously not up 20% year-over-year over the next 12 months?
Phillippe Lord, CEO
Yes. Well, obviously, land prices are going up. So that's going to drive some of the normalization of margins long-term. That being said, a lot of land that we're bringing to the market was bought about two to three years ago. So we feel really good about that basis. We certainly can feel comfortable sustaining these margins through 2021. We have a lot of new communities coming on in the back half of this year and into the first half of next year to get us to the 300. And again, those were bought quite a while ago, so we feel good that we're going to get above-average margins as long as pricing doesn't regress, if you will.
Steve Hilton, Executive Chairman
Alan, we're also hopeful that costs will moderate over time. Lumber will come back down somewhat once the supply chain has stabilized, and we'll be able to get some of these cost increases back.
Operator, Operator
Your next question today is coming from John Lovallo from Bank of America.
John Lovallo, Analyst
Maybe the first one on just the commentary around the FHA limits. I'm curious, how many markets are you selling above these limits? Maybe how quickly you could pivot back if needed? When is the last time you guys have been comfortable doing this? And then finally, what percentage of your customer loans are FHA?
Phillippe Lord, CEO
I don't have the exact number, but we certainly can follow-up with you on that. I would say that in the really hot markets like Phoenix, for example, and maybe a few other markets like California, we're pushing above FHA and entry-level pricing, but it's not across our entire footprint. The FHA increase that occurred this year was substantial, and for the most part, we've been able to stay below that, but we have seen opportunities to push above that and still achieve our pace that we're looking for in that entry-level space. I would tell you, as we underwrite new land, we're still looking to be below FHA and we're sourcing land below FHA for future yields. But it's not across the board. And then as it relates to the number of buyers using FHA, Hilla, do you have that?
Hilla Sferruzza, CFO
Yes. So in the entry-level space, which obviously is the bulk of what we do, it's less than a quarter of our buyers utilizing the FHA loan. So while it’s not the majority of what we do, it’s critically important for us to stay below FHA in general. In today's environment, if you are picking up slightly above that, we're certainly seeing our customers having sufficient capital to put down to get the net balance of the loan below FHA and still qualify.
John Lovallo, Analyst
Okay. That's really helpful, guys. And then historically, 2Q absorptions tend to be flat to slightly up sequentially versus 1Q. But given sort of the tight supply of homes at Meritage right now, I mean, would you guys expect to push price to the point where 2Q absorptions could be down sequentially? How should we think about that?
Hilla Sferruzza, CFO
I think we're modeling outside of normalized seasonality; we're certainly not modeling a faster pace for the rest of the year. As we noted a couple of times in the commentary in the prepared remarks, it's really the production constraints that are holding back the volume.
Phillippe Lord, CEO
Yes. Last year, Q2 was really the start of the surge we saw out of COVID. So we started seeing elevated absorption pace in May and June. We obviously have fewer communities this year than last year, so that's part of it. So it's all about getting the community count growth to really drive the order growth at the current pace per community that we are at.
John Lovallo, Analyst
Got it. And one more quick one, if I may, just given just the resin shortages that we've seen in Texas, are you seeing any pressure on the availability of spec homes?
Phillippe Lord, CEO
Yes, we saw a little bit of disruption there when the weather hit, but it was a temporary disruption and it seems to have gotten behind us. We're seeing regular production times and costs at this point.
Operator, Operator
Our next question is coming from Michael Rehaut from JPMorgan.
Michael Rehaut, Analyst
Thanks. Good morning everyone. Congrats on the results. What a difference three months makes. First question on the pricing, obviously, extremely impressive with the 20%. Just wanted to get a sense how much prices maybe have moved in the past three months because obviously, that 20% is presume on a year-over-year basis. It would seem that, obviously, from a price and backlog and such that your average selling prices appear to be a bit more stable. So you're obviously, at the same time, having the impact of, I would assume, continued significant mix shift from entry levels. So just wanted to get a little more clarity around how that 20% is working right now.
Phillippe Lord, CEO
Yes, great question. So as you think about the last four quarters, if you will, as we came out of the pandemic, the pricing power has certainly accelerated through those first quarters. We've seen the strongest pricing power in the last 90 days, as well as strong pricing in the fourth quarter of last year. What’s changed and why is that the case? I would just tell you the supply side has been the big variable that has changed as the retail market has not rebounded from the supply side. New builders are managing their production. The supply environment has created a complete dislocation between supply and demand that's generated significant pricing power as we move through those four quarters.
Michael Rehaut, Analyst
I appreciate that. Is it possible to just give us a sense of what prices have moved over the last 90 days then? Just to get a sense of the more recent level of acceleration?
Hilla Sferruzza, CFO
We can provide that. It's maybe 60% the last two quarters and 40% for the quarters before that. So it's not completely disproportionate. We've been increasing pricing pretty much steadily through July with a slight acceleration in the last quarter.
Michael Rehaut, Analyst
Okay. That's helpful, Hilla. Appreciate it. I guess, secondly, just going back to the FHA comment, which is of interest. I think it's important that you noted that your buyer pool is perhaps less dependent on the source of financing than perhaps other builders. But I thought your comments also around the fact that to the extent that the sales price is above the FHA loan limit, that if I heard you right, that buyers are able to make up for it with a bigger down payment. If they still choose, they could still get that FHA loan. I wanted to confirm that. And also, to the extent that you're making these pricing moves in these hotter markets, is it fair to say that you're not doing this in a vacuum and perhaps there's pricing in certain of these markets that's just where the price is in certain submarkets, and other builders are kind of in the same boat?
Phillippe Lord, CEO
Yes. I'll take the last piece, and then Hilla can give you some more on the FHA. We look at every community weekly. We have a robust approach to how we price our products, analyzing competitive data, including what other builders are doing, not just based on how many buyers we have lining up outside wanting to buy a home. We have a community-by-community pricing meeting that our operators execute every single week to evaluate where they can move prices on the next release of homes, and we're managing to stay competitive in the market where we believe we need to be priced based on our product and location. Then Hilla can talk a little about FHA.
Hilla Sferruzza, CFO
Yes. We don't rate prices in a vacuum. If we raise them and no one else raises, people wouldn't buy our houses. So we're seeing pricing somewhat in line with the market; although, I do agree with you that our 20% average price increase seems to be a little higher than maybe some of the peers that have disclosed so far. On the FHA, we're definitely very concerned about affordability, as we always are, being primarily focused on entry-level buyers at this time. So we're constantly looking at appraisals. We want to ensure our buyers can qualify for their mortgages and close on the homes. There are very few appraisals that don't clear, but for those that don't, typically, the buyer is just putting in the excess cash to qualify. So our buyers are well-qualified and can afford the homes in today's market.
Steve Hilton, Executive Chairman
Let me just add one sentence on that; much like one of our larger peers said on their conference call, the FHA loan limit is a really important goal post for us. And Phillippe has spoken to this, and I'll speak more to it: we need to position almost all of our communities, most of our communities, at or below the FHA loan limit, because that's what we believe is the affordable line in the sand. We've been doing that, and we are doing that, and that's what we're going to continue to do.
Operator, Operator
Next question today is coming from Stephen Kim from Evercore ISI.
Stephen Kim, Analyst
Congratulations on the great results. Just wanted to follow-up on a couple of things. First, on the FHA discussion. One of the interesting aspects of the FHA is that they raise those loan limits based on what home prices are doing. They do this once a year, so you've got a little ways to go, but as you're contemplating opening up new communities, I assume you are factoring into your thinking that the FHA loan limit is most likely to rise at a double-digit rate by the time these communities are open. Is that correct?
Phillippe Lord, CEO
That is incorrect. We always underwrite our land at current pricing. We try to consider underwriting our land at normal absorptions. So we do not underwrite land assuming that there's going to be an FHA ceiling raise, and we don't underwrite land assuming that prices appreciating from here is a given. That’s really the discipline we maintain.
Hilla Sferruzza, CFO
When we open up to increase prices, if the market gives it to you, and if the FHA limit rises, well, I don't need to remind you that generally, you track it as closely as we do. FHA limits rise until they drop. And when they drop, many of us are caught off guard, and for those targeting an entry-level community focus, this makes it critical to ensure we model today, without expectations for growth for tomorrow.
Stephen Kim, Analyst
Yes, I get it. Great. So yes, that really bolsters then the outlook for next year. With respect to the communities, I think you indicated that you are contracting for larger sizes on average, I think, for the communities that you're looking to bring on, right? My question is, are those new communities geared to run at a higher absorption rate as well? Or is your intention to live in those communities for longer?
Phillippe Lord, CEO
It's both, really. If the market remains elevated, we're hoping to avoid turning over more than a third of ourselves every single year by trying to become more efficient. But if we're out there for four years instead of three years out of four months, that works just fine as well as it relates to how we underwrite the land. So it's a little bit of both. But the primary focus is just to avoid the turn of our communities. If we want to get to 300 communities, we want to open up about 100 a year. As we go to 400 communities, we want to open up 125 to 150 a year, and that's really the math we're running on the size of deals we need.
Stephen Kim, Analyst
Yes, helpful. And then, you talked about the analysis of the loans that are in your backlog to determine what kind of mortgage rate they could sustain. Because I know that a couple of your peers have done that, and they've sort of suggested that they could see mortgage rates go above 4% and still really not have any stress in their backlog. I wanted to see if you guys have specifically looked at that.
Hilla Sferruzza, CFO
Yes. We did the same analysis. We did 50 and 100 basis points strike tests on our existing backlog, and a very low percent, around 5%, would have an issue if we had a 100 basis point increase. Now as a reminder, that's if they bought the exact same home. Certainly, they could just opt for a slightly less expensive house and buy something else. So we think that there's very little deterioration risk on qualification. Now the question is, if you had a 100 basis point increase, would there just be a pause from a psychological issue? That's a different question. But from a qualification issue, we don't see many concerns regarding the financial stability of our buyers.
Operator, Operator
Our next question is coming from Carl Reichardt from BTIG.
Carl Reichardt, Analyst
I'm reminded a few years ago, when Steve was talking, wondering about when gross margins could get above 20%. Just look at the numbers today. I wanted to ask, one, just about land and how you're looking at it, Hilla, in particular, how much utilization of land banking are you using now versus plain vanilla third-party lot developers versus self-development on the stuff that you're looking at today.
Phillippe Lord, CEO
Yes. It's still heavily weighted toward self-development. We are seeing in the entry-level space structured takedowns with the land seller. But we're doing almost zero kind of traditional off-balance sheet financing with a third-party. We have some partners that we are working on relationships with if we need to leverage that to achieve our growth goals. But for the most part, anything that's on option today is through the land seller and it's sort of a structured land seller stage takedown type of option.
Carl Reichardt, Analyst
Okay, thanks, Phillippe. And then, we talked about entry-level. Can we talk about move-ups for a second? I mean, I know it’s only a quarter of the business now, but are you seeing similar pricing power, similar margins to the entry-level now? And then, sort of over the longer run, where do you think the entry-level as a percentage of your business kind of tops out? Where are you comfortable?
Phillippe Lord, CEO
Yes. Certainly, the year-over-year absorption pace in the two segments is about the same. We've seen an increase there. But our move-up communities are absorbing at like close to five, while our entry-level is at six. So there's a discrepancy there. It is a smaller percent of our business right now, but that's mostly just due to the elevated pace that we're getting out of entry-level. As we look at new land right now, I would tell you that our LiVE.NOW land is more attractive to us. We're getting better pricing on LiVE.NOW land than on 1MU land, which appears to be more frothy and pricey for what we're looking for. So we may see a slight trend from what our long-term goals are for line over the next couple of years. But at the end of the day, we want to be somewhere between 60% and 70% LiVE.NOW and 30% to 40% 1MU, depending on the strength of the market.
Operator, Operator
Our next question is coming from Deepa Raghavan from Wells Fargo.
Deepa Raghavan, Analyst
I'll start with April commentary. Are you able to comment on the strength of April orders so far perhaps, and just how it compares versus how you exited March? I'm assuming your comps are going to be easy as well. So if you can level set some expectations for us.
Phillippe Lord, CEO
Yes. We don't give out guidance in the quarter on sales and orders, but the market hasn't shifted from what it has been doing for the last six months. The supply constraints are still there. The demand is still there. The low interest rates are there. Nothing has really changed from that perspective. April is still strong. As you pointed out, the March and April comps are a little skewed because of COVID last year. And then, we saw this big surge that occurred in May and June when everyone realized that during COVID, they actually wanted to buy a house. But right now, the market feels like it’s the same as March. I just don’t see anything out there that’s slowing it down right now.
Hilla Sferruzza, CFO
Yes. Just to reiterate, I know you guys have our numbers, but we actually had higher sales in Q2 last year than in Q1 despite COVID. April was tough but May and June recovered, so the year-over-year comps do not ease for us in Q2 over Q1.
Deepa Raghavan, Analyst
Got it. Yes. All right. That's helpful. Impressive gross margins. Obviously, our pricing power is solid. However, you're ramping up those communities at a time when supply chain has some hiccups and also, these are highly inflationary times. Can you talk to how you're trying to not be impacted more than the market on cost side because of your overwhelming demand needs, especially with that 300 community count target out there that you are pretty adamant on hitting? How do you achieve the balance, so you're not impacted more than the market on cost?
Phillippe Lord, CEO
And I assume your question is regarding vertical costs, not land costs?
Deepa Raghavan, Analyst
Yes, vertical. That's right.
Phillippe Lord, CEO
Yes. I mean, we believe there are two things about our strategy that we're leaning into that we think allow us to sort of manage costs in an environment where costs are stable and in an environment where costs are unstable. The first one is everything we've done to streamline our product. Our product is extremely repeatable. We've removed complexity. We've reduced the number of products that go in our product. So we're streamlined, and we have the ability to source products differently than if you had more products and align ourselves with our vendors and create pre-planned business. The second piece is really just the spec strategy. Every time we open up a new LiVE.NOW community, we open it up with a bunch of specs because that's what those buyers want. We're able to be really thoughtful. We’re able to plan that with our trade partners and cadence our production appropriately to come out of the ground and manage costs as best we can. So it's really about the streamlined product. And secondly, the specs is how we navigate that. We're very comfortable when we open these communities. We opened 30 this quarter, and we opened them up with good margins and good cost structures. The production was there. We managed to get homes started and framed and move them through.
Deepa Raghavan, Analyst
Okay. So what I'm hearing is you're not impacted any more than the market; your cost base is pretty similar to what the market and the rest of the industry is actually taking on, right?
Phillippe Lord, CEO
Yes. I think lumber is hurting everybody the same, honestly. I think the only differentiator is whether you're able to actually get the product to your job sites. But everyone's kind of experiencing these costs. We have fewer products that go into our homes, so we see less cost pressure from all the other products that don't go into our homes. But yes, I think we're all feeling it the same and we certainly aren't feeling it any more than anyone else.
Operator, Operator
Our next question is coming from Truman Patterson from Wolfe Research.
Truman Patterson, Analyst
Steve, I think the enthusiasm is palpable from the release in the call. So with that, I was hoping, Steve, that you could elaborate a little bit on your thoughts on lumber. You mentioned potentially or hopefully easing, I believe, what was the phrase. So any thoughts there? And then, also on just your cost inflation expectations that are embedded in your 25% gross margin guidance moving forward, just what sort of acceleration you're expecting to see?
Steve Hilton, Executive Chairman
Sure. But let's let Phillippe do that. If you've got a question about fishing, I can probably answer that for you, but I think we need Phillippe for that.
Phillippe Lord, CEO
Yes. I don't think anywhere in our remarks did we say that we thought costs were going to ease in 2021. Everything we're seeing would suggest that we're going to continue to see pressure. Lumber futures are up, and we're about to relock across most of our footprint, and we have material increases going on. That being said, we've had the pricing power to overcome that and we don't see that changing anytime soon as we look out over the remainder of 2021. So costs are up, and costs are going to keep going up until there's some catalyst on the lumber side. I don't see that changing in the near term, but we think we have the pricing power. The pricing we've already taken over the first 90 days and then continue to take as we move through Q2 will help us maintain the margins that we've guided to.
Hilla Sferruzza, CFO
Yes. As we model, Truman, when we're providing guidance, we're building in some expectation of increased commodity costs, right? So we mentioned there's a lot of rate locks coming up for lumber over the next couple of weeks, and we're modeling that into the numbers we provided in the guidance.
Truman Patterson, Analyst
Okay. Thanks for that. And then, you all reiterated your mid-2022 community count guidance multiple times. It seems like you're gaining some traction there. Community count inflected positive sequentially. So clearly, improvement there and stabilized. Could you just discuss a little bit how conditions may have changed over the past quarter or two, your ability to get communities opened? Have there been additional municipal delays, any issues in developing land, tightness in your local land and divisional teams? I'm just trying to understand what some of the potential risks are in really hitting that 2022 community count target?
Phillippe Lord, CEO
Yes. I mean, it's not getting any easier. The municipalities aren't moving any faster, and there's a lot more people trying to get communities open that are clogging up the system. Our teams are doing a great job moving through it and executing. We've said it before, but we have the land loaded, and we're processing it to get to our 300 goal in Q2. I'm extremely confident that we're going to get there. You guys are going to start seeing that number move up dramatically in the back half of this year and then continue through next year. We're one quarter further into that commitment that we made, I think, in Q3 of last year, and it's only getting clearer; things are happening on time. Weather events haven’t occurred to slow us down. We're getting the land processed and we're tightening up those timelines. So for us, we're just another quarter more confident in that commitment to that number. But at the same time, if there was a significant weather event or cities start shutting down for some reason, which I can't predict, we would be impacted. But right now, everything is go, and we're confident about hitting that number.
Hilla Sferruzza, CFO
Truman, this is a theme in the prior comment; we'd like to err on the side of conservatism. So we've built in some cushion on that 300 community count as well. Hopefully, we've appropriately modeled those time delays and potential expansion in our municipal approvals to still hit that 300 community count target on time.
Operator, Operator
Our next question is coming from Susan Maklari from Goldman Sachs.
Susan Maklari, Analyst
My first question is on the SG&A. I think when you reported back in January, you had suggested that you were targeting something just north of 10% for this year. But when we think about where you started the first quarter, actually below that 10% and kind of the normal seasonality of the cadence that we usually see, does that suggest that, that is probably coming down? And if so, what is any kind of new guide there that you can give us?
Hilla Sferruzza, CFO
That's a great question, Susan. I think it's a combination of two things. Number one is the higher average selling prices than we had anticipated that 20% lift that we mentioned. That combined with our ability to hold back on some sales and marketing expenditures, whether it's a function of using more technology, we've just not needed to meet those efforts right now due to the accelerated demand in the market allowing for benefit on both sides. I think it's fair to say that Q1 came in notably lower than what we were expecting and guiding to. So while it may be fair to see some incremental leverage for the balance of the year from what we were anticipating in Q4, as we mentioned in the prepared remarks, we want to caution there are some incremental costs that still need to be incurred that you'll see the dollar expanding; maybe the leveraging not being penalized as we might have anticipated, but there are going to be some incremental dollar spend in SG&A in the back half of the year as we ramp up the community count.
Susan Maklari, Analyst
Okay. That's helpful. And then, my next question is around the cancellation rate. Can you tell us where that stands for the quarter and any kind of changes or what is impacting that if there were any meaningful shifts?
Phillippe Lord, CEO
Yes. Hilla was looking at it. I think it was 11%. We typically think we're going to be somewhere between 15% and 20%. So especially entry-level, the rate is very low right now. As you can imagine, there's a tremendous amount of urgency from our consumers to hold onto their houses and to get into their homes. There’s not a lot of second guessing the decision and buyer remorse, so it's really low right now.
Hilla Sferruzza, CFO
Yes. As Phillippe mentioned, as the world normalizes, we’re very comfortable—and in fact, we’d like to see that number tick up a little bit more. That means we're getting more people into the funnel looking at our homes. We would much rather have a wider pool with more fallout than a smaller pool at 100% qualified at the entry-level space.
Operator, Operator
Our next question today is coming from Jade Rahmani from KBW. Your line is open.
Steve Hilton, Executive Chairman
Jade? You might be on mute.
Operator, Operator
Ladies and gentlemen, that does conclude our question-and-answer session. I'll turn the floor back over to management for any further closing comments.
Phillippe Lord, CEO
Thank you again for attending our call. We really appreciate your interest. We look forward to talking to you next quarter. Hope everyone has a great day. Thank you.
Operator, Operator
Thank you. That does conclude today's teleconference webcast. You may disconnect your lines at this time and have a wonderful day. We thank you for your participation today.