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spk07: Nian Enterprises Festival 2022 Second Quarter Earnings Conference Call. An archive of the webcast will be available after the completion of the call and run for 12 months. This conference is being recorded for rebroadcast and all participants are currently in a listen-only mode. Management will make some opening remarks about the second quarter results and then open the lines for questions. The company will also be webcasting a slide presentation along with the opening comments from management. The slides are available on the investor page of the company's website at www.khof.com. Those listeners who would like to follow along should now log onto the website I will now turn the call over to Jeff O'Keefe, Vice President, Investor Relations. Jeff, please go ahead.
spk05: Thank you, Carmen, and thank you all for participating in this morning's call to review the results for our second quarter, which ended April 30th, 2022. All statements in this conference call that are not historical facts should be considered as forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such statements involve known and unknown risks, uncertainties, and other factors may cause actual results, performance, or achievements of the company to be materially different from any future results, performance, or achievements expressed or implied by the forward-looking statements. Such forward-looking statements include but are not limited to statements related to the company's goals and expectations with respect to its financial results for future financial periods. Although we believe that our plans, intentions, and expectations reflected in or suggested by such forward-looking statements are reasonable, we can give no assurance that such plans, intentions, or expectations will be achieved. By their nature, forward-looking statements speak only as of the date they are made, are not guarantees of future performance or results, and are subject to risks, uncertainties, and assumptions that are difficult to predict or quantify. Therefore, actual results could differ materially and adversely from those forward-looking statements as a result of a variety of factors. Such risks and uncertainties and other factors are described in detail in the sections entitled risk factors, and management's discussion and analysis, particularly the portion of MDMA entitled Safe Harbor Statement and our end report on Form 10-K for the fiscal year ended October 31, 2021, and subsequent filings with the Securities and Exchange Commission. As otherwise required by applicable securities laws, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, changed circumstances, or any other reason. Joining me today are Ara Hobnamian, Chairman, President, and CEO, Larry Sorsby, Executive Vice President and CFO, and Brad O'Connor, Senior Vice President, Chief Accounting Officer, and Treasurer. I'll now turn the call over to our CEO. Ara, go ahead.
spk03: Thanks, Jeff. I'm going to review our second quarter results, and I'll also comment on the current housing environment. Larry Sorsby, our CFO, will follow me with more details, and then we'll open it up to Q&A. Despite the steady presence of supply chain issues, lumber volatility, rising mortgage rates, labor shortages, and uncertainty in the economy, we are very pleased with our second quarter results. On slide five, we compare our results to our guidance. Additionally, we added a third column to compare our results without the benefit of $6 million of phantom stock benefit this quarter. If you focus on that third column, you can see that our revenue was within our guidance range and our SG&A was 0.1 percent over our guidance range. The standouts were gross margin and adjusted pre-tax income, which were both well above the upper end of our guidance range. Moving on to slide six, we show year-over-year comparisons for our second quarter. Starting in the left-hand portion of the slide, you can see that our total revenues for the second quarter were $703 million, about flat with last year. Moving to the right-hand portion of the slide, you can see that our adjusted gross margin increased 530 basis points to 26.6% this year compared to 21.3% in last year's second quarter. The magnitude of this increase is due to strong home demand that allowed us to raise home prices more than labor and material cost increases and brought our average sales price to approximately $507,000 per home delivered. Turning to slide seven, here you can see that lumber prices have been very volatile over the past two years. Lumber prices have dropped significantly in recent weeks. The homes that we are about to start will benefit from this price decline. The lower lumber costs from these homes will show up in our results in the first half of fiscal 23 as these homes begin to deliver. At the same time, lumber prices have been trending down our average sales price for new contracts is trending up. In the second quarter, our new contracts averaged a sales price of $564,000. That is about 10% higher than the homes we just delivered. These two facts will be helpful as the cooling of the housing market will likely cause pressure on gross margins. As of the last few weeks, gross margins on new contracts have stayed exceptionally strong. On slide eight, we show lumber prices over the long term. While lumber prices have declined recently, we're still a long way from normal lumber pricing. We use current lumber pricing in our internal budgets However, it's reasonable to assume that as the housing market slows from the white hot pace we recently experienced, and as supply chain disruptions are resolved, lumber pricing will return to normal levels. Lumber, as you know, is a major cost component of housing, and that will be very helpful. Turning now to slide nine, in the left-hand portion of this slide, you can see that our SG&A was 9.7% for the second quarter compared to 11.7% in last year's second quarter. If the COVID-related delays did not adversely affect our delivery count, our SG&A ratio would have been lower yet. In the right-hand portion of the slide, we show that adjusted EBITDA increased 63% year-over-year to $124 million. Turning to slide 10, you can see the benefit of the $181 million reduction of senior notes that we completed last year. Our percentage of interest expense to total revenues decreased 130 basis points from 6.2% in last year's second quarter to 4.9% this year. The absolute dollar amount of interest was down 22%, from $44 million in last year's second quarter to $34 million this year. Given the fact that we reduced our senior notes by an additional $100 million at the very end of the second quarter, and that we expect to pay off at least an additional $100 million of senior notes later this year, we anticipate even lower interest costs in the future. On slide 11, you can see that our adjusted pre-tax income improved 184% to $88 million compared to $31 million last year. Our net income for the second quarter of 2022 was $62 million. Net income in last year's second quarter would have been $20 million if you reduced our actual net income by the $469 million from the valuation allowance reduction. Regardless of the gap federal tax expense this year compared to the huge benefit last year, We do not have to use cash to actually pay federal income taxes for the next $1.5 billion of pre-tax income as a result of our deferred tax asset. This allows us to generate substantially more cash than our net income implies. We're using a significant portion of the cash we generate to reduce debt and strengthen our balance sheet. Now let me talk about our second quarter sales environment when we saw 30-year mortgage rates increase from about 3.6 percent to 5.1 percent. On the right-hand portion of slide 12, we show contracts per community for the second quarter going all the way back to 2017. You can see that our contract pace jumped from an average of 10.7 in the second quarters of fiscal 17, 18, and 19 to a white-hot pace of 18.3 in fiscal 21. That was a 71% increase. While not as strong as last year, our sales pace of 15 contracts per community in the second quarter was still much stronger than the pre-COVID years of 17, 18, and 19. Further to the left, we show that the average second quarter contract pace from 97 to 02 was 13.5. This was a time that was neither a boom nor a bust for the housing industry. The current pace of 15 contracts per community in this year's second quarter is higher than our historical average. Given all the uncertainties regarding inflation, the Ukrainian war, rising mortgage rates, and a fear of recession, it's reasonable to assume home demand may slow down further this summer. In a related topic, Larry will discuss our conservatism in underwriting land purchases a little later in our presentation. Due to our ability to raise home prices more than construction costs, our recent home contracts continue to be written with very high gross margins. If home demand softens further, similar to sales pace returning to normal levels, it's also reasonable to expect that gross margins will return to more normal levels. While we're not going to review our multi-year key metric targets that we discussed last quarter, I will note that when we prepared those key metric targets, we assumed and showed that our pace and gross margins would eventually decline to lower, more normal levels. For greater transparency, on slide 13, we show contracts per community monthly from May through April, the last month of our quarter. The most recent month is in dark green, The same month a year ago is in light blue. The same month two years ago is in gray. For all 12 months shown on this slide, our contracts have been lower than last year's blazing pace. However, we compare favorably every month with the same month's pre-COVID sales pace. The sales pace shown on this slide reflects a decreasing sales pace from last year, but also shows that demand for homes remained strong every month in our second quarter. Although we continue to raise home prices in many communities during the month of May, if mortgage rates rise further going forward, it's reasonable to expect moderation in both current sales pace and in home prices. Turning to slide 14, we show contracts per community for the month of May beginning in 19 all the way through 22, which just ended yesterday. We had 3.2 contracts per community for May of 22. Unlike every month of the second quarter where our sales pace was greater than the pre-COVID pace, in May of 22, the pace was slightly lower than the pre-COVID pace of 19. There is little doubt that the rise in interest rate, as well as fears of inflation, the war in Ukraine, et cetera, have dampened home demand in May. As of today, we still have very modest use of incentives and concessions. We believe this to be true for the industry as well. If sales paces reduce further, it's likely that both we and the industry will return to normal use of incentives and concessions. For us, that would increase concessions and incentives from about 3% recently to our more historical levels of about 6.5%. The additional incentives could be used to qualify customers by buying down mortgage rates. Fortunately, today's gross margins are quite high, and can sustain increases to more normalized concessions while still generating strong returns. On slide 15, we show how quickly mortgage rates have risen since the beginning of the calendar year. This slide shows that since January 1st of this year, mortgage rates have increased about 190 basis points. It's interesting to note that mortgage rates have declined slightly over the past few weeks. Perhaps it's a sign that rates are stabilizing for now. Any increase in mortgage rates is not helpful as a portion of homebuyers will not be able to qualify for the same mortgage that they were able to before. When the rate increase happens this quickly, it usually takes time for some consumers to adjust to the reality of higher mortgage rates and reset their expectations for of how large and expensive of a home they can afford. On slide 16, we show a long-term perspective of where the 30-year fixed rate mortgages have been since the early 70s. Although it has increased to 5.1 percent, today's 30-year fixed rate mortgage remains among the lowest levels that we have seen for the past five decades. While I recognize home prices have increased significantly, they've increased in double-digit percentages many times in the past. As you can see on slide 17, the increase in mortgage rates has had very little impact on our cancellation rates. For the second quarter of 22, our cancellation rate was 17 percent compared to 16 percent in last year's second quarter. If you look back on this slide, you can see that a normal cancellation rate is in the range of the high teens to the low 20s. The 17% cancellation rate in the second quarter is consistent with what we have seen in the second quarter since 2015. On slide 18, we show existing single family inventory for sale over the last 40 years. As you can see on this slide, the number of existing homes currently for sale is near an all-time low at 910,000 homes. Even if you doubled this supply, we would still be below the historical average of 2.1 million homes. This lack of supply of existing homes for sale is one of the reasons that demand for new homes remains as strong as it is. With respect to new homes, there are virtually no finished specs on the ground today for both us and the industry in general. On slide 19, we show that we had 2.0 spec homes per community, which is significantly below our long-term average of 4.4 spec homes per community. Like existing homes, if we doubled our specs per community, we would still be below our long-term average. We also show on this slide that we had 205 homes started that were unsold at the end of the second quarter. We consider a home a spec the day we start construction. Only two of our 205 started unsold homes in the entire country were finished. There is very little supply. On slide 20, we show that our community count increased slightly year over year. Our consolidated community count increased by five communities or 5% year over year at the end of the second quarter. We expect our community count to increase in the second half of this year. Given no material changes in market conditions, we expect to end the year with a community count at or slightly higher than 135 communities, including unconsolidated joint ventures. This is slightly lower than our previous guidance due to land development delays and permitting delays, which have set our scheduled openings slightly behind the pace we initially anticipated. We are incredibly pleased with our performance through the first half of 22. We couldn't have achieved these higher levels of profitability without the combined efforts of our dedicated company associates throughout the country. As we look at the back half of this year, we still have a lot of homes we need to deliver, but I'm confident that our teams can get this job done. We already have all of this year's expected deliveries in backlog, and we've begun to build our backlog for fiscal 23. We firmly believe we're going to be able to achieve the significant profit growth of our fiscal 22 guidance. I'll now turn it over to Larry Sorsby, our Chief Financial Officer.
spk06: Thanks, Eric. I'm going to start with the progress we've made in growing our lot position, which is the key raw material we need to build our homes. Turning to slide 21. We show that year over year, our lot count increased by more than 5,400 lots or by 19%. We now control about 33,500 lots. Based on trailing 12-month deliveries, this equates to a 5.8-year supply. Primarily through the use of finished lot options, we have been steadily increasing our lot position over the past couple of years. As you can see, our owned lot position remained flat year over year while our lot opposition position increased. On slide 22, we show the percent of lots controlled by option increased from 45 percent in the second quarter of 2015 to 69 percent by the second quarter of 22. A low percentage of owned lots gives us tremendous flexibility in a shifting market. The market for land acquisitions remains rational and we continue to feel very comfortable with the acquisitions we've made over the past year. We now have a 5.8 year supply of lots. Until the housing market stabilizes, we will remain cautious when making new land acquisitions. By using current home prices, current construction costs, and current sales pace to underwrite to a 20 plus percent internal rate of return hurdle rate, and a minimum 6% pre-tax profit, our underwriting standards automatically self-adjust to changes in market conditions. However, since the onset of the COVID-fueled increase in sales pace in the late summer of 2020, we have taken a more conservative approach to underwriting our new land parcels by consistently using lower, more normal pre-COVID sales paces rather than the unsustainable higher COVID sales paces we experienced over the past 20 months. Even when using these slower sales paces, we've been able to win our fair share of land deals and grow our land position. Given the recent slowdown in sales pace per community and concerns regarding inflation and rising mortgage rates, We recently further tightened our underwriting standards to assume that we will increase our use of incentives and concessions when underwriting new land deals today. Keep in mind that there's a lag between when we place lots under control and when those same lots will be fully developed and we can open a community for sale. Most of the land we put under control during our second quarter of fiscal 22 will not be open for sale until the fourth quarter of fiscal 23 and beyond. We currently control 100 percent of the land and communities necessary to achieve our significant growth in revenues and profits during fiscal 22 and control virtually all of the lots we need to achieve our current fiscal 23 revenue and profit targets. On slide 23, we show the vintage of our land position. Eighty-two percent of our total 33,000 lots controlled were put under contract before October 31st of 2021, and 46% were controlled prior to October 31st of 2020. Those lots were underwritten at substantially lower home prices than today's housing market, which if needed, provides us the room to adjust concessions and incentives while still delivering very strong margins. Turning to slide 24, even after $155 million of land spend and paying off $100 million of senior notes during the second quarter, we ended the second quarter with $282 million of liquidity. That means that we continue to have excess liquidity. Today, Our land acquisition teams are primarily focused on obtaining control of some additional land for home deliveries in fiscal 24, but primarily they're focused on fiscal 25 and beyond. Given rising mortgage rates, the uncertain economic environment, and a cooling housing market outlook, we are now taking an even more conservative underwriting approach on new land purchases. Turning now to slide 25, compared to our peers, you see that we have the third highest percentage of land controlled via options. We continue to use land options whenever possible to achieve high inventory turns, enhance our returns on capital, and to reduce risk. Our use of land options increased from 63 percent at the end of the second quarter of fiscal 21 to 69 percent at the end of the second quarter of 22. Turning now to slide 26. Compared to our peers, we continue to have the second highest inventory turnover rate. High inventory turns are a key component of our overall strategy. We believe we have opportunities to continue to increase our use of land options and to further improve inventory turns and our returns on inventory in future years. Turning now to slide 27. On this slide, we show our debt maturity ladder at the end of the second quarter. Last year, we paid off $181 million of senior notes, and at the end of the second quarter of 22, we paid off an additional $100 million of our 7.75% senior notes due in 26. Furthermore, we're committed to paying off at least another $100 million of senior notes during the remainder of fiscal 22. We believe that we should be able to refinance our currently undrawn revolving credit facility ahead of its maturity in the first quarter of fiscal 23. After that, we do not have any note maturities until fiscal 26. Given our $401 million deferred tax asset, we will not have to pay federal income taxes on approximately $1.5 billion of future pre-tax earnings. This tax benefit will significantly enhance our cash flows in years to come and will accelerate our progress of rapidly improving our balance sheet. Our focus in the coming years is to further reduce our debt. On slide 28, we show the dollar value of our consolidated backlog increased 16% year over year to $2.1 billion at the end of the second quarter. Sequentially, backlog dollars were up 9% from the end of the first quarter of 22 to the end of the second quarter of 22. Given the recent sharp rise in mortgage rates, our mortgage and home building teams have been diligently analyzing our contract backlog to make sure our customers can still qualify for a mortgage. If customers are not able to qualify at current mortgage rates, we attempt to provide them with alternative mortgage programs where they can be approved. We have performed stress tests on our backlog. If mortgage rates increase to 6% or 6.5%, We estimate that roughly 10 and 12% respectively of our customers currently in backlog would not be able to obtain a mortgage. The strength of our backlog, including a strong expected gross margin, sets us up nicely to achieve our expected improvements in our fiscal 22 financial performance. We are already developing our backlog for fiscal 23 as well. Our financial guidance for the third quarter And the full year of fiscal 22 assumes no adverse changes in current market conditions, including no further deterioration in our supply chain or material increases in mortgage rates. Our guidance assumes continued extended construction cycle times of six to seven months compared to our pre-COVID cycle times for construction of approximately four months. Further, it excludes any impact to our SG&A expense from phantom stock expenses related solely to the stock price movement from $46.02 stock price of HOV at the end of the second quarter of 22. Due to uncertainty surrounding ongoing supply chain issues, persistent labor market tightness, lumber price fluctuations, and potential mortgage rate increases, we are reiterating rather than increasing our guidance for the full year of fiscal 22. Moving now to slide 29, we provide guidance for the third quarter of fiscal 22. We expect total revenues for the third quarter to be between $780 and $830 million. We also expect gross margins to be in the range of 24 to 26 percent. SG&A is expected to be between 9.5 and 10.5 percent. Finally, we expect our adjusted pretax profit for the third quarter of fiscal 22 to grow to between $70 and $85 million. On slide 30, we reiterate guidance for our full fiscal 22 year. We expect total revenues for the year to be between $2.8 and $3 billion. We also expect gross margins to be in the range of 23.5 to 25.5 percent. SG&A as a percent of total revenues is expected to be between 9.3 and 10.3%. Adjusted EBITDA is expected to be between $410 and $460 million. We expect our adjusted pre-tax profit for fiscal 22 to be between $260 and $310 million. Finally, we expect our earnings per share, assuming a 30% tax rate, to be between $26.50 and $32 per share. Given where our stock closed yesterday and the midpoint of our EPS guidance, we're only trading at a 1.75 multiple of earnings. On slide 31, you can see how our credit metrics have significantly improved over the past few years, as well as the further improvement we expect to achieve at the midpoint of our guidance for fiscal 22. Total debt to adjusted EBITDA has declined from 9.7 times in fiscal 19 to 3.8 times in 21 and to 3.2 times projected for fiscal 22. Net debt to adjusted EBITDA declined from 8.9 times in fiscal 19 to 3.1 times in fiscal 21 and to 2.6 times projected for fiscal 22. Adjusted EBITDA to interest incurred coverage has more than doubled from one times in fiscal 19 to 2.3 times for fiscal 21 and up to 2.8 times projected for fiscal 22. Turning to slide 32, assuming we hit the midpoint of our fiscal 22 guidance for pre-tax profit, our shareholders' equity is expected to more than double from fiscal 21's fiscal year-end levels. This improvement in our equity position will result in our net debt to capital ratio continuing to decline from 146% at year-end fiscal 19 to 87% at the end of fiscal 21. And at the midpoint of our guidance, it's projected to reduce further to 76% by the end of fiscal 22. We expect to continue improving our balance sheet by reducing debt and growing equity. our goal is to achieve a mid 30% net debt to capital ratio. We expect to continue our trend of improving our credit metrics in future periods. On slide 33, we show that at 33.9%, we have the fourth highest consolidated EBIT return on inventory compared to our peers. On slide 34, We show that we have the highest return on equity when compared to our peers at above 100 percent for the last 12 months. And on slide 35, we show the trailing 12-month price-earning ratio for us and our peer group. The entire homebuilding industry is being valued as if we're going to have a repeat of the great housing recession, which we believe is very unlikely to occur. We recognize that our stock should trade at a discount to the group because of our higher leverage. However, given how our returns on equity and our EBIT return on inventory stack up compared to our peers, and given how rapidly we've been improving our balance sheet, we believe our stock is the most undervalued of the entire universe of public homebuilders. Based on our price earnings multiple of 1.99 times at yesterday's closing stock price of $51.20, we are trading at a 34% discount to the next lowest peer and a 61% discount to the industry average. We remain focused on increasing our levels of profitability and further strengthening our balance sheet. The market will eventually give us credit for our superior performance. Now I'll turn it back to Eric for some brief closing comments.
spk03: Thanks, Larry. Let me start by making one correction. I mentioned May sales, which ended last night, were 3.2 contracts per community. They were actually slightly higher at 3.3. Let's wrap up the call by saying that while many of our peers have already reduced their debt levels and have had the luxury of buying back stock with their excess cash over the last two years, we've been focused on using our cash to aggressively reduce our debt and strengthen our balance sheet. On slide 36, we show the outstanding principal value of our public debt from the end of fiscal 19 through the guidance we gave for the end of this year. Over this period of time, we will have reduced our debt by almost $500 million. If you turn to slide 37, you can see that we've made some significant progress in strengthening our balance sheet from 2019 to the end of this fiscal year. Our equity is expected to increase by $854 million And simultaneously, we've reduced our public debt by almost $500 million. We believe that the steps we're currently taking to strengthen our balance sheet will have a positive impact on our future cost of debt and the valuations of our stock price. On slide 38, we show single-family housing starts for the past 50 years. We think it gives a good perspective of the current state of the housing market. In the previous boom, we clearly, as an industry, produced homes well over the long-term averages for several years, thanks to subprime mortgages. This time, the industry has just recently reached the long-term average production levels. 21 was the first time we had more than a million single-family starts since 2006, and this year we're just slightly over that at the current pace. More importantly, the previous 14 years saw housing production at dramatically lower than average levels. I know there are varying views on demographics and average levels of production aren't necessarily indicative of the future, but it's a good benchmark, and the housing supply in the industry is definitely better positioned. We recognize the housing market will likely be cooling off regarding the sales pace and price. Having said that, we feel like it will be nothing like the great recession of the late 2000s, and we feel like Hovnanian Enterprises is better prepared and in a better position than we have been at any time in the last decade and a half. We have a strong land position, much of which we controlled at fixed prices prior to the recent significant home price increases. We have a very large backlog of $2.1 billion with really solid margins. We're seeing lumber prices trending down. We have solid gross margins in our current home sales, which give us room to absorb net price declines. And we have the flexibility of a large land option position. We know that there's a lot of uncertainty out there. We feel very prepared. All in all, we're excited about our future, and we look forward to reporting continued solid performance in the quarters ahead. Thank you. That concludes our formal comments, and we'll be happy to turn it over for Q&A.
spk07: Thank you. And the company will now answer questions so that everyone has an opportunity to ask questions. Participants will be limited to one question and a follow-up, after which they will have to get back into the queue to ask another question. So we will open the call for your questions. If you press star 1, you will be in the queue. And to remove yourself, press the pound or hash key. Your first question comes from Alan Ratner with Zellman and Associates. Your line is open. Please go ahead.
spk01: Hey, guys. Good morning. Thanks for taking my questions, and I appreciate all of the color and comments so far. First, just on the May activity, and thank you for that disclosure, when you look at the sales pace and kind of the cooling you saw in May versus the second quarter, can you talk a little bit about whether there were any notable differences either across price points or across your various markets where you saw a greater pullback in demand? And adding to that, can you just talk about cancellation trends in the month as well and whether that contributed to the sequential pullback?
spk03: Sure. I'd say from a big picture perspective, the active adult segment has been stronger, and the Uber entry level has been slightly weaker, and everything in between has been around the same. And regarding cancellation rates, no, May has been very solid. I mean, our mortgage team and our divisions have been working diligently to make sure that the backlog we have is qualified or can qualify for alternative mortgage programs. So at this stage, as Larry commented, we've been pretty good as far as cancellations.
spk06: Just to make it crystal clear, we saw no change to speak of at all in our cancellation rates in the month of May.
spk01: Perfect. Thanks for that, guys. Second, I guess this is kind of a multi-part question, but if I look at gross margin, obviously well in excess of what you guided to for the quarter. Looks like the guidance in the back half of the year implies some pullback from these levels. Yet, on the other hand, you're saying you haven't really increased incentives yet. It sounds like maybe you're getting some benefit on lumber, although that might be coming more next year. What's contributing to the expected pullback in margins over the next quarter or two? Because presumably those were homes that were predominantly sold before this run-up in mortgage rates. And when do you hit that point where you would likely start to think about increasing incentives if the sales pace stays at these levels or even moves lower?
spk03: Alan, first, regarding gross margins, it's in this supply chain disrupted environment, in this labor shortage environment, it's a very tricky number to predict super accurately. because we're allowing for a little extra cost for these last-minute solutions where all of a sudden we've got a handful of windows missing or garage doors are gone or we've got to replace an appliance with a higher-end appliance because it's backordered. So we're trying to be a little more cautious in our costs And, you know, as it turns out, we've been able to do a little bit better than we were cautious about, and hence that was part of the reason why our gross margins were better than the upper end of our guidance range. So you can take that same comment interview regarding the balance of the year. I mean, generally speaking... Our gross margins in our new contracts, our brand new, as of like this weekend, have been really, really solid. I don't know what more to tell you about that. They're just really solid. We've seen pace fall off a little more, as you saw in May. And then finally, regarding the last part of your multi-part question, and then I'll turn it to Larry to answer some more, We are looking community by community. It's not an average movement in terms of slowness. We have communities that we're still metering sales and increasing sales prices. On the other hand, we have some communities that have definitely slowed, and those are the communities that would be the first ones that we start going back to normal concessions. So we're looking carefully at this stage. We haven't really implemented going back to normal concessions across the board at all, and we'll continue to be tactical and look community by community. Larry, you want to elaborate?
spk06: Yeah, a couple more points on the gross margin just to emphasize the difficulty in making the projections. The first point I make is I believe that We projected the second quarter back in December and reiterated it when we announced our first quarter results. Any cancellations that occurred from December forward, ironically, Alan, we were able to resell at a higher price and got higher margins than we anticipated because home prices continued to go up. So that's one of the things that led to it. The other thing is lumber prices, which are the biggest single component that goes into home construction, have been very volatile. And that, too, certainly in the second half of this year, in terms of the deliveries that we're going to have, lumber prices went up a few months ago. And that is coming through in a higher cost than we had anticipated previously as well. So that could lead to some dampening of the margin out in the second half of the year. So I'll leave it at that. I think Eero's explanation was pretty comprehensive.
spk01: Great. Thanks. Thanks, both of you guys, for the detailed answers.
spk07: And your next question comes from Alex Barron with Housing Research Center. Your line is open. Please go ahead.
spk04: Thank you, gentlemen. Congratulations on the strong results and, you know, good job on paying down the debt so far and strengthening the balance sheet. On that note, I wanted to ask, I know you guys had previously expressed some potential, you know, kind of global refi. At this point, you know, is it more likely that you guys are just going to go down the path of paying down debt as you did now and as you've said for the rest of the year?
spk06: Yeah, I think that for right now, obviously, the high-yield market has also been disrupted by inflation and higher rates, et cetera. So we didn't have any pressure to refinance earlier. We would opportunistically do it if we saw a great opportunity. But I think given changes in the market, it's safe to say that we're just going to continue to pay down debt. We were also concerned about refinancing, and then given our expectations, especially the key metric targets we gave last quarter, have to pay call premiums on debt that we would have refinanced. So right now I think you'll just see us continue to chip away at the debt, and at some point in the future as we've got our balance sheet in better condition, condition and strengthen, we will look at refinancing. Nothing near term is on the horizon there.
spk04: Okay, good. Well, the good thing is we didn't need to do it, so that's good. On the other hand, I wanted to ask about your backlog and the discussion on incentives. To what extent have you guys secured of the people through the end of the fiscal year through some extended rate locks or something that minimizes potential cancellations. Along those lines, you know, what, if any, incentives are you guys offering? Are you guys just like buy down the rate locks? And if so, who's paying for that, the customer or you guys?
spk03: Well, first, I'll just mention, I mean, we've been closing homes in April and May, and those have been largely with market rate mortgage rates in the 5% levels. We haven't seen huge cancellations. And as I mentioned, the team has been working diligently to check on the qualifications of our buyers. Larry, you want to comment on rate locks?
spk06: Yeah. We obviously have been offering both short-term and long-term rate locks to our contract backlog, and it's been taken by some and refused by others. We're encouraged by kind of the recent last few weeks that rates have dropped a little bit. At least they haven't been going back up. Maybe that's given comfort to some consumers as well. Having said that, I'd say more than 50% of our third quarter backlog has already been locked. That's a little higher than it would normally be. If, in fact, when we scrub the backlog... Sorry.
spk07: No problem.
spk06: and we have a customer here and there that does need some assistance in order to still qualify, we'll make those decisions case by case. And because our margins are so strong, we've seen instances that our divisions will decide to help buy down a rate or help with a rate lock to provide comfort to a consumer. But I would say those have been isolated at this point in time, but they have occurred.
spk03: Just a clarification. As Larry mentioned, we've offered rate locks to all of our backlog that hasn't been offered at our cost. Generally, the consumer can look at it and consider the cost themselves.
spk04: Correct. Got it. And if I could ask one more, you know, on new communities that haven't opened yet, I mean, it's no secret that home prices are, you know, gone up very significantly, and that combined with the interest rates have perhaps made it difficult for some people to afford a home. So on the new communities, is there any plan to somehow make them more affordable, either introduce smaller sizes or fewer upgrades included in the houses, or... just start them off at lower ASPs or something? Can you comment anything along those lines? Sure.
spk03: It's a good question. At all of our communities, we typically offer a range of home sizes and home prices, and we also offer a range of upgrades. When the rates were lower, we were selling a lot of our largest, most expensive homes that were offered. They could select small homes, but they tended to gravitate toward the larger end of the home size spectrum. Similarly, they were adding a fair amount of upgrades. I want to mention our gross margin, we typically priced, At a very, very similar gross margin percentage, whether it's a small home or a large home, we price margins almost the same. I'd say more recently we've definitely seen more interest at the same community without changing our product offerings. There's just been a little greater selection from our smaller homes or midsize homes at least. and a little dampening of the options or upgrades they've been collecting. So there is an ability without us really doing anything that the customers can make their own decisions and make the homes more affordable. Having said that, a lot of times in the past when rates rise rapidly, we definitely see a little hesitation. And I think you saw that in May. people are disappointed that all of a sudden they have to reduce the upgrades they were hoping for or choose the next house smaller, it takes a little time for them to adjust their expectations. But they have the ability to do that and obviously we still sold a lot of homes in May and many buyers did make those adjustments.
spk04: Okay, well, thank you very much for all the explanation. Good luck, and I'll get back in the queue. Thank you.
spk07: Thank you. Thank you. Your next question comes from Kwaku Abrokwa with Goldman Sachs. Please go ahead. Your line is open.
spk00: Hi, guys. Congrats on the quarter. Just wanted to follow up on the month of May, if you'll permit me, to kind of get a sense of what you're seeing in terms of buyer attitude at the current mortgage rates. Specifically, I'm trying to compare between what we're seeing today versus what we saw in late 2018 when we saw a comparable surge in mortgage rates. And, you know, additionally on that, I'm trying to get a sense of you mentioned 3.3 absorption pace. Is there a level that if you go below, you start to introduce more incentives into the marketplace? I'll stop there.
spk03: I'll start with that. by just responding again that it's highly neighborhood and community specific. We still have a metering situation and price increases at many communities. That's certainly the case. We see it in many in Dallas, in many communities in Phoenix, in many communities in Delaware, in the southeast Florida, in the Carolinas. we have many examples where the pace hasn't been slowing. So it's community by community. It has a lot to do with our internal budgets and getting a regular pace. If we have communities that fall off on pace, and if some of our very entry communities have fallen off on pace, If that can be, again, for some of that phenomenon I mentioned before, the expectations have been not met, then they're disappointed. But if they don't ultimately adjust at those communities and buy a smaller home, then we'd look at concessions there to be able to get that community back on pace. Fortunately, gross margins are very high, as we've mentioned numerous times and there's plenty of room to return to some normal concessions.
spk00: Just a quick clarification on that. Is the pace level that you're targeting, I'm not sure if you revealed it, is it around three per community per month or is it somewhere else?
spk03: It varies dramatically from community to community. Higher end communities would be lower than that or three or lower. our very entry-level communities might be higher than that. So, it's very much a community-by-community basis.
spk00: Roger. I appreciate the color on that. And just to follow up on a different sort of question here, in terms of your contract cancellation, would you guys be willing to talk about what you've been seeing in terms of cancellation out of backlog over the past two quarters? And, you know, if you look at what the buyers in the backlog are doing, you know, what's the spread or combination or I guess if you have to, you know, split the pie, how many are moving to adjustable rate mortgages versus, you know, buy downs versus, you know, greater down payments, et cetera?
spk06: Yes. Again, our... Contract cancellation rate has been very modest by historical standards, still well below normalized cancellation rates. We do provide, I think in the K and Q, Brad, what our backlog cancellation rate is. Those two have not materially been different than what our historical trends have been. They've been lower on the contract cancellation rate or backlog cancellation. I don't have it at my fingertips. Maybe Brad can look that up. I wouldn't say that we've seen a significant shift at this point to adjustable rate mortgages. To answer the second part of your question, we've seen a little bit of a use of adjustable rate, but because there's not a huge spread and rate between, let's call it a 5-1 arm versus a 30-year fixed, not a lot of people are going that direction. Certainly there's some people that just can't qualify the 30-year fixed rate that can qualify and an adjustable, and they're going that direction. But it hasn't been a material number at this point in time.
spk03: I will add one other bit of color. We probably have a little bit of a greater percentage of age restricted communities than many of our peers, those consumers are typically not very affected at all by mortgage rates. Many of them are cash buyers. Many of them get small mortgages. So that's part of the reason I made the comment earlier. We just see more strength in that segment, and I suspect they're more indifferent about mortgage rates.
spk02: Adding to Larry's comment, the cancellation rate on beginning backlog for the quarter was 9%, which is exactly the same as it was last year's second quarter. Historically, that's relatively low.
spk00: I appreciate the callers, guys, and best of luck for the rest of the year. Thank you.
spk07: Thank you. And as a reminder, to ask a question, simply press star 1 on your telephone. Next question is from Alex Baron with Housing Research Center. Please go ahead.
spk04: Yeah, thanks for taking my follow-up. Regarding specs, it doesn't sound like you guys have any or very little completed specs. I'm just wondering, you know, do you guys see a need at this point to slow down any spec starts? Or do you see a risk that you could end up with some finished specs by the end of the year if things don't improve in terms of sales pace? That's my first question.
spk03: Well, there are many things to worry about in this time of uncertainty. Right now, we're just scrambling to start the homes we have in backlog. We have a huge backlog, over $2 billion. So We're just not focused on specs, nor are we very worried about our specs. We are less than half the number of specs per community than we are historically, less than half. So it's far from a concern, and we have virtually zero. I think we have two in the entire country, two finished specs. So it's just not on our radar of one of the many concerns.
spk04: Got it. I also wanted to ask in terms of, you know, in any communities where you are starting to do incentives, rate buy downs, rate locks, whatever, you know, how much would that impact margins generally? Is it like one or two percent?
spk06: Again, I think as mentioned, it's going to be community specific. It's not going to be a broad brush across the whole company. So I think in terms of impacting margins near term, it'll be extremely modest or not even noticeable. If, in fact, the market slows further and use of incentives by the industry and then by us starts to increase, there's room to increase the use of incentives. I just think it'll be gradual over time. But, you know, if we decided at a slow-scaling community to increase incentives by a couple of hundred basis points, I just don't think, you know, one or two or three, half a dozen communities would be noticeable anytime soon. But as you do more and more communities, if that becomes an industry trend, it would come through, you know, in maybe the second half of next year or something.
spk03: Alan, I do want to add that we are not delusional about the uncertainty in the marketplace, and we certainly don't think that the gross margins we've just reported and the gross margins that we're currently selling at, we don't think that can happen indefinitely. I mean, the market will eventually normalize, And as I mentioned earlier, last quarter we talked about our multi-year key metrics. And in those metrics, we forecasted that we'd ultimately get back to a 20% gross margin. Right now... we're not seeing anything like that. It's far better. But we think eventually the market's going to gravitate to normalcy and that will eventually make its way into our results as well.
spk04: Yeah, no, it's good you've implemented that conservatism in your outlook because even though you guys might not have a ton of specs or almost any, obviously a lot of your peers did start a ton of homes on spec, and we're hoping to sell them at the last minute. We'll see what happens. But thanks very much, and good luck. Thank you.
spk07: Thank you. And this concludes our Q&A session. I will turn the call back to Ara Hofnanian for his final remarks.
spk03: Great. Well, thank you very much. We've tried to be as transparent as possible, and I don't think anybody else has reported May contracts yet. So hopefully you've got fresh information, and we look forward to giving you continued good results in our upcoming quarters. Thank you.
spk07: And this concludes our conference call for today. Thank you all for participating, and have a nice day. You may now disconnect.
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