Meritage Homes Corporation

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's now my pleasure to turn the call over to Emily Tadano. Please go ahead.

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 homepage. Please refer to slide 2, cautioning you that our statements during this call, as well as the press release and accompanying slides, contain forward-looking statements including, but not limited to, our views regarding the health of the housing market, economic conditions and changes in interest rates, community count and absorption, 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 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 13th. I'll now turn it over to Mr. Hilton. Steve?

Thank you, Emily. I'd like to welcome everyone participating in our call today and hope that you and your families are continuing to stay safe and healthy. I'll start by discussing current market trends and give an overview of the start to the year. Phillippe will cover our strategy and quarterly performance. Hilla will provide a financial overview of the quarter and 2021 guidance. The housing market remains very robust, a continuation of the exceptional momentum of 2020. The spring selling season began earlier than normal and is still going strong today. Meritage delivered another record performance including the company's highest first quarter orders and closings and the highest quarterly home closing gross margin since Q1 of 2006. The successful execution of our strategy focused on affordable entry level and first move out homes to meet the current demand culminated in our absorption pace of 5.8 per month for the first quarter of 2021, up from 4.3 per month in the prior year, which was the strongest first quarter absorption pace since 2005. We achieved this pace even as we managed our spec starts and the corresponding orders in most communities to align with the production constraints in the market today. Absent significant interest rate increases, we believe the current market demand will continue the rest of this year and provide the housing industry ongoing pricing power to offset commodity and other cost increases and deliver strong margins. Looking forward, we believe the favorable home-building macroeconomic conditions will continue for the next several years. Mortgage interest rates remain very affordable, and despite the recent uptick on an average 30-year mortgage rate, 30-year mortgage rates are below 3.25% in our backlog. Buyers in the entry-level space are mostly buying a payment, so as long as the payment still makes sense, the demand continues to be very strong. Secondly, strong demographic trends persist. Most millennials are having life events that align with home ownership, and most baby boomers are becoming empty nesters, wanting a smaller home. Lastly, the supply of new and resale homes continues to be constrained, and we believe that Merida is well positioned to capitalize on this current environment and will continue to deliver greater year-over-year volume and drive profitability over the next several quarters. Now please turn to slide four. Earlier this month, Valadie and Merida's deep commitment to be an early adopter and industry leader in building energy efficient homes The EPA awarded Meritage Homes the 2021 Energy Star Partner of the Year for Sustained Excellence. As an ACON recipient of this recognition, we challenge ourselves every day to improve upon our environmental stewardship in our communities and the planet as a whole, as evidenced by our recent launch of a new multi-speed HVAC system standard in all new homes as of this April. This system operates more efficiently than traditional air conditioning units, allowing owners to better manage the comfort of their home while reducing their environmental impact and operating costs. In keeping with our commitment to innovation, we also rolled out an enhanced M-connected smart home automation suite to complement existing home technologies to complement existing features we've introduced as a centralized management hub of our entire smart home technologies to enhance functionality for our owners while also adding door sensors and motion detectors to increase safety and security. This quarter, we allowed customers to transact quicker and more easily by adding an on-demand homeowner's insurance quotes to our online financial services offering, which already included online mortgage pre-qualification tools and electronic payment of earnest money deposit. In addition to launching our ESG page on Earth Day last week, detailing our commitments to the environment, our employees, well-being, and corporate responsibility from a diversity, equity, and inclusion perspective, we enhanced our recruitment process targeting an even stronger, more diverse next generation of Meredith's leaders, both in the field and at corporate. We will continue to financially support organizations that drive more diversity, equity, and inclusion across our nation. Our achievements in energy efficiency, innovation, and DE&I will continue to add long-term value to the customer experience and shareholder return. I'm also proud to announce that we're entering our first new market since 2016. With the completion of several land acquisitions, the new Coastal Carolinas Division expands our East Region operations into Charleston, Myrtle Beach, and surrounding areas in South Carolina. will start marketing campaigns in the next few quarters ahead of opening these five new affordable entry-level communities in 2022. I'll now turn it over to Phillippe.

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 yet 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 ASPs are down a bit year-over-year, and orders and backlog ASPs 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 pace to better align with current supply channel constraints. We believe this cadence will allow us to continue to generate elevated gross margins. Despite an increase in FHAD limits early this year, our pricing power has allowed us to push ASPs of entry-level products above these new FHAD 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. 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 475 from 20% in the prior year. We sold 3,458 homes this quarter, which was 11% higher than the same period of 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-2020-2022. 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 represents 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 absorption 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 communities 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 gap outs in 2020. Absorption 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. Energy 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 were 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 home building 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 in Georgian 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 and 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 of entry-level specs on the ground has been challenging, even as we manage our order pace. Selling more specs in early stages of 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 total specs. And 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 the longer cycle times. Although supply-side hen wins 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 our starts and should allow us to pre-contract for building materials in advance and minimize the impact of supply chains and strengths. 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 costs before pricing the home. Additionally, the quick, closed timeline of a spec home allows customers to lock in a mortgage rate. We believe that our spec strategy has enabled us to increase our market share and will continue to do so as we grow to become a top buy 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?

Thank you, Phillippe. Let's turn to slide 8 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 25% increase in home closings partially offset by a 3% decline in ASPs. While ASPs 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 BIP improvement in first quarter 2021 home closing gross margin to 24.7% from 20.0% a year ago mainly resulted from higher ASPs 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 home building 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 skew count and predictable construction cadence allows us some advantages to manage these delays. SG&A as a percentage of home closing revenue was 9.8% for the current quarter, a 95th improvement over prior year. The higher revenue and savings achieved from increased technology use, particularly in the sales and marketing channels, 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 in 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 of 2021's 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 credits under the 45L provision and some retroactive pickups in 2018 and 2019 energy credits. Overall, in the first quarter of 2021, we achieved price increases and higher closing volume with our more efficient, streamlined operations while balancing our orders pace with production. This produced expanded margins, improved SG&A leverage, and an 88% year-over-year increase in first quarter diluted EPS 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 in three and seven eighths due in 2029. We received approximately $444 million in net proceeds on April 15th. On March 31st, 2021, we issued a notice of redemption for all of the 300 million principal outstanding under 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 annual employee grants. 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 below investment grade from all three rating agencies. At March 31st, 2021, our cash balance was $716 million compared to $746 million at December 31st, 2020, primarily as a result of greater land spent and share repurchases. Our net debt to cap remained low at 10.9%. We've 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 turns from entry level and first move up offerings. Our priorities for the next several years remains 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 may 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 4.7-year supply of lots based on a trailing 12-month closing, in line with our target of 4-5-year supply of lots under control. We increased our land book by 40% 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 space, we opened up 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 depreciation and additional demand for land from all builders exists today, but 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 to maintain our focus on affordable homes in the future. To address the higher orders pace of entry-level product, 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 larger lot count to reduce community level overhead costs per lot while minimizing the community count churn and the inefficiencies associated with the opening and closing out of communities. To preserve liquidity, we're using options or staggered purchasing terms where financially feasible. About 60% of our total lot inventory at March 31st, 2021 was owned and 40% was optioned, a slight improvement compared to prior years 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, with these higher ASPs offsetting increased commodity costs. For the full year 2021, we are now projecting total closings to be between 11,700 and 12,700 units, home closing revenue of 4.55 to 4.85 billion, home closing gross margin of approximately 25% and effective tax rate of about 23% and diluted EPS in the range of $13.75 to $14.75. At March 31st, 2021, we had 203 active communities in line with our guidance and slightly up sequentially from 195 communities at December 31st, 2020, but down from 241 in the prior year. Despite weather and general supply channel flowing, we were able to open up 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 31st, 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 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 Philippe.

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 energy 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?

Thank you. We'll now be conducting a question and answer session. If you'd like to be placed in the question queue, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star Q if you'd like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing star 1. One moment, please, while we poll for questions. Our first question today is coming from Alan Ratner from Zellman & Associates. Your line is now live.

Hey, guys. Good morning. 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 pace 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. 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.

It's running almost the same because, as you know, in entry level, we're 100% stack. And frankly, in 1MU right now, we're more stack 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 lever 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. It 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 through community count growth. Okay, great.

That's very helpful, Philippe. 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. Without asking you to predict what 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?

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 two, 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 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. But over the long term, as we buy new land today, we're buying more at our underwriting hurdles, not above our underwriting hurdles.

Alan, we're also hopeful that costs will moderate over time. Lumber will come back down somewhat once the supply chain is been more stabilized and we'll be able to get some of these cost increases back.

Sounds good. I appreciate that caller and insight, guys. Good luck.

Operator, next caller.

Thank you. Our next question today is coming from John Lovallo from Bank of America. Your line is now live.

Hey, guys. Thank you for taking my questions as well. 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's the last time you guys have been comfortable doing this? And then finally, what percentage of your customer loans are FHA? Okay.

Yeah, 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, California, we're pushing above FHA and entry-level, 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 the opportunity 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 deals. But it's not across the board. And then as it relates to the number of buyers using FHA, Hila, do you have that?

Yeah, so at the entry-level space, which obviously is the bulk of what we do, it's less than a quarter of our buyers are utilizing the FHA space. So it's not nothing, but it's not the majority of what we do. So while it's critically important for us to stay below FHA in general in today's environment, if we're 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 to qualify.

Okay, that's really helpful, guys. And then, you know, historically, 2Q absorptions tend to be flat to slightly up sequentially versus one cue. But given sort of the tight supply of homes at marriage right now, I mean, would you guys expect to push price to the point where two cue absorptions could be down sequentially? How should we think about that?

I think we're modeling, you know, outside of normalized seasonality, we're certainly not modeling faster pace for the rest of the year. As we noted a couple times in the commentary and the prepared remarks, it's really the production constraints that are holding back the volume. I think women's builders have made similar commentary that volumes could have been higher on the sales side, but it's really production constraints that are holding us back. So I think that's going to be the same governor in Q2 in the balance of the year.

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 less 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 sort of current pace per community that we're at.

One more quick one, if I may. Just given just the resident shortages that we've seen in Texas, are you seeing any pressure on the availability of spray foams?

I'm sorry, are you talking about spray foam? Yeah. Yeah, we saw a little bit of disruption there when the weather hit, but it was a temporary disruption and it seemed to, we're getting it behind us and we're seeing regular production times and costs at this point. Thanks very much, guys.

Thank you. Our next question is coming from Michael Rio from J.P. Morgan. Your line is now live.

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, you know, how much prices maybe have moved in the past three months, because obviously that 20% is presumed on a year-over-year basis. and it would seem that obviously from a price and backlog and such that your ASPs appear to be a bit more stable. So you're obviously at the same time having the impact of, I would assume, a continued significant mix shift from entry level. So just wanted to get a little more clarity around you know, how that 20% is working right now.

Yeah, great question. So if you think about, you know, the last four quarters, if you will, as we came out of the pandemic, you know, the pricing power has certainly accelerated through those first quarters and we've seen the strongest pricing power in the last Thank you for joining us. The supply environment has really just created a complete dislocation between supply and demand that's generated, in my mind, outside pricing power as we move through those four quarters.

So 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?

We can provide that. It's maybe 60% the last two quarters and 40% the quarters before that. So it's not completely disproportionate. We've been increasing pricing pretty much solidly through July with a slight acceleration in the last quarter.

Okay. That's helpful, Hilla. I appreciate it. I guess, secondly, just going back to the FHA comment, which is of interest, and I think it's important that you kind of noted that your and so on. So, you know, I think the buyer pool is perhaps less dependent on this source of financing than perhaps other builders. But, you know, I thought your comments also around the fact that to the extent that, you know, the sales prices above the FHA loan limit, that if I heard you right, that, you know, the buyers are able to make up for it with a bigger down payment and if they so choose or still want, can still get that FHA loan. So I wanted to make sure I heard that correctly if that's indeed how you what you said before and also to the extent that you know you're making these pricing moves in these hotter markets is it fair to say that you know I presume that you're not you know this is something that you're not doing in a vacuum that you know perhaps there's pricing in certain these markets that you know, that's just where the price is in certain sub markets and, you know, other builders are kind of in the same boat.

Yeah, I'll take the last piece and then Hilo can give you some more on the FHA. We look at every community weekly. I mean, we have a robust approach to how we price our products. Lots of competitive data, what are other builders doing? Not just based on, you know, how many buyers we've got lining up outside the door that want to buy a home. So we have a robust community by community pricing meeting that our operators execute every single week to evaluate, you know, where they can move prices on the next release of homes and etc. And we're managing to stay, you know, competitive in the market where we think we need to be priced based on our product, our location, and etc. And then Hilla can talk to you a little bit about FHA.

Yeah, so Philippe's finding we can't Thank you for joining us. And then on the FHA, I'll give you an anecdotal answer. You know, we're definitely very concerned about affordability as we always are being a primarily entry-level focused buyer at this time. So for us, we're looking at busted appraisals all the time. We want to make sure that our buyers can qualify for their mortgages and clothes on the home. There's very few appraisals that don't clear, but 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 the market today.

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 goalpost for us. And Phillippe spoke into this, and I'll speak more to it, that 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. And we've been doing that, and we are doing that, and that's what we're going to continue to do.

Great. Thanks very much. Congrats on the results. Thanks.

Thank you. Next question today is coming from Steven Kim from Evercore ISI.

Your line is now live.

Steven?

Hello, Steven.

I was muted. Yes, I apologize for that. Congratulations on the great results. Just wanted to follow up on a couple of things. First on the FHA thing that people have been talking about, one of the things that's interesting about the FHA, as you know, is that they raise those loan limits based around what home prices are doing. They do it once a year, so you've got a little bit of a ways to go, but as you are contemplating opening up new communities and want to stay below that quote-unquote FHA loan limit, I assume that you are factoring in, you're 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?

That is incorrect. We always underwrite our land at current pricing. and we try to think about underwriting our land at normal absorptions. So we do not underwrite land assuming that there's going to be an FHA ceiling raised and we don't underwrite land assuming that prices are going to be appreciating from here. That's really the discipline. Now, I can't speak for everyone, but that's our focus right now. We're moving further out. We're buying bigger deals where we can leverage costs, but our focus is to stay below current FHA limits on buying new land. It's just an additional layer of conservancy.

We have.

Oh, yeah, totally. When we open up to increase prices, if the market gives it to you and the FHA limit rises, and then I don't need to remind you, I know you track it as closely as we do, FHA limits rose until they dropped, right? And when they dropped, a lot of us were caught off guard if your target is an entry-level community focus. So for us, it's safest to model today, not expectations for growth for tomorrow.

Yeah, I get it. Great. So that's really bullish then for the outlook for next year. With respect to the communities, I think you indicated that you are 26% larger on average, I think, for the communities that you're looking to bring on. 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?

Either or. If the market remains elevated, we're hoping to avoid turning over more than a third of our sales every single year, trying to become more efficient. but if we're out there for four years instead of three years at a four-month pace or a five-month pace 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 the deals we need.

Yeah, helpful. And then you talked about the, I think, earlier in your remark, I may have missed it, but did you talk about Analyzing the loans that are in your backlog and your buyers 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.

Yeah, I'll take that one, Steven. So we did the same analysis. We did a 50 and a 100-bip stress test on our existing backlog and a very, very low percent, like five-ish would have an issue if we had a 100-bip increased. Now, just a reminder, that's if they bought the exact same home. Certainly, they could just tick down to 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-bit increase, would there just be a pause from a psychological issue? That's a different question, but from a qualification issue, we don't seem to have too many concerns on the financial stability of our buyers.

Awesome. Thanks very much, guys. Great results.

Thank you. Thank you. Next question today is coming from Carl Ricart from BTIG. Your line is now live.

Thanks very much, everybody. I'm reminded of a few years ago when Steve was talking, wondering about when gross margins could get above 20%. I was just looking at the numbers today. I wanted to ask one just about land and how you're looking at it. You 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?

Yeah, it's still heavily weighted towards self-development. We are seeing in the entry-level space, we are seeing sort of 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.

Okay, thanks, Philippe. And then we talked about entry level. Can we talk about move up for a second? I'm knowing it's only a quarter of the business now, but are you seeing similar pricing powers, 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? Thanks.

Yeah, certainly the... 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 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 Live Now is more attractive to us. We're getting better pricing on Live Now land than 1MU land. 1MU land 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 Live Now over the next couple of years. But at the end of the day, we want to be somewhere between 60-70% live now and 30-40% want to view depending on what the strength of the market is.

I appreciate it. Thanks, Phillippe. Thanks, everyone.

You're welcome. Thank you. Our next question is coming from Deepa Raghava from Wells Fargo. Your line is now live.

Hey, hi. Good morning, everyone. Thanks for taking my question. 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 expectation for us.

Yeah, we don't give out guidance in the quarter on sales and orders, but the market hasn't Thank you for joining us. April Feilstrong. As you pointed out, the March and April comps are a little weird 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 doesn't feel like it's any different than March and it feels like it's just continuing on and I really just don't see anything out there that's slowing it down right now.

Yeah, just to reiterate, I know you guys have our numbers but we actually had higher sales in Q2 last year than 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.

Got it. Yeah. All right. That's helpful. My reference was more April comps, but yeah, that's helpful too. So impressive gross margins, obviously your 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 not to be impacted More than the market on the 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 impacting more than the market on cost?

And I assume the question is around vertical costs, not land costs?

Yeah, vertical, that's right.

Yeah, I mean... We just believe there's two things about our strategy that we're leaning into that we think allow us to sort of manage our costs in an environment where costs are stable and an environment where costs are unstable. The first one is, you know, 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 very streamlined and we have the ability to source products probably differently than if you had more products and align ourselves with our vendors and create relationships and plan out our business. The second piece is really just the spec strategy. and you know 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 and we're able to be really thoughtful we're able to plan that with our trade partners cadence out our production appropriately and come out of the ground and manage our costs as best we can so it's really about the streamlined product and secondly the specs is how we sort of navigate that. And we're very comfortable as we open up these communities. We opened up 30 this quarter and we opened them up with good margins and good cost structure. The production was there. We were able to get the homes started and get them framed and move them through. So that's really where our strategy is.

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 has actually taken on, right?

Yeah, I mean, I think lumber is hurting everybody the same, honestly. I think the only differentiator is whether you're able to actually get to the product to your job sites, but everyone's kind of experiencing the cost. We have less 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 yeah, I think we're all feeling it the same and we certainly aren't feeling it anymore than anybody else.

That's pretty helpful. Thanks very much.

Thank you. Our next question is coming from Truman Patterson from Wolf Research. Your line is now live.

Hi. Good morning, everyone. Thanks for taking my questions. Steve, I think the enthusiasm is palpable from the release and the call. 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, 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?

Let's let Philippe do that. If you've got a question about fishing, I could probably answer that for you, but I think Philippe is better set for that.

Fair enough.

Yeah, 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. We're about to relock across most of our footprint and we have material increases that are going on. That being said, you know, we've had the pricing power to more than overcome that and we don't see that changing anytime soon as we look out over the remainder of 2021. So, you know, costs are up, costs are going to continue to go up until there's some catalysts 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 to maintain our margins that we've gotten to.

As we model Truman, when we're giving our guidance, We're building in some expectation of increased commodity costs, right? As Philippe mentioned, there's a lot of rate locks coming up for lumber over the next couple of weeks. So we're modeling that in the numbers that we provide in the guidance.

Okay. Okay. Thanks for that. And then, you know, you all reiterated your mid-2022 community account guidance, you know, multiple times. It seems like you're gaining some traction there, you know, 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, you know, your ability to get communities open? Have there been, you know, additional municipal delays, any issues in developing land? I'm just trying to understand what some of the potential risks are in really hitting that 2022 community count target.

Yeah, 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 ahead We're further into that commitment that we made, I think, in Q3 of last year, and it's only getting more clear, right? Things are happening on time. Weather events haven't occurred and slowed 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 committing to that number. But at the same time, if there was a significant weather event or cities start to shut down for some reason, which I can't predict, we would obviously be impacted. Right now everything's a go and we're very confident about hitting that number.

Truman, this is the same as 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. So hopefully we've appropriately modeled those time delays and potential expansions in municipal approvals to still hit that 300 community count target on time.

Okay. Thank you all.

Thanks, Truman. Thank you. Our next question is coming from Susan McCleary from Goldman Sachs. Her line is now live.

Thank you. Hello, everyone. My first question is on the SG&A. You know, 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 or the cadence that we usually see, does that suggest that That is probably coming down and if so, what is, you know, any kind of new guide there that you can give us?

That's a great question, Susan. I think it's a combination of two things. Number one, it's the higher ASPs 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 or just not meeting those efforts right now due to the accelerated demand in the market, allowed us to benefit on both sides. I think it's fair to say that Q1 came in notably Thank you very much. that still need to be incurred, that you'll see the dollars expanding, maybe the leveraging not being penalized as much as we had anticipated, but there are going to be some incremental dollars spent in SG&A in the back half of the year as we ramp up the community count.

Okay, that's helpful. And then my next question is around the cancellation rate. Can you tell us where that fell in the quarter and any kind of changes or what's impacting that, if there were any meaningful shifts?

Yeah, he was looking at it. I think it was 11%. We typically think we're going to do somewhere between 15 and 20, especially entry level. So it's very low right now. As you can imagine, there's a tremendous amount of urgency with our consumers to hold on to their house and get into their house. There's not a lot of... Second guessing their decision and buyer remorse. So it's really low right now.

Yeah, as we've mentioned, 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'd much rather have a wider pool with more fallouts than a smaller pool that 100% qualifies at the entry-level stage.

Gotcha. Okay, thank you.

Thank you.

Thank you. Our next question today is coming from Jade Romani from KBW. Your line is now live.

Jade? Might be on mute.

I believe he did. Jade, are you there? Could you press star one again? 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.

Well, 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.

Thank you. That does conclude today's teleconference webcast. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.