Meritage Homes Corporation

Greetings and welcome to Meritage Homes second 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. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Emily Tadano. Vice President, Investor Relations for Meritage Homes. Please go ahead.

Thank you, Brock. Good morning and welcome to this call to discuss our second 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 two, cautioning you that our statements during this call, as well as the press release and accompanying slides, contain forward-looking statements, including but not limited to our views regarding the health of the housing market, economic conditions and changes in interest rates, Community Count and Absorption, Trends in Construction Costs, Supply Chain Constraints and Cycle Time, Projected Third Quarter and Full Year 2021 Home Closings and Revenue, Gross Margin, 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 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 and Quarterly Reports on Form 10-Q, which contain 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 August 12th. I'll now turn it over to Mr. Hilton. Steve?

Thank you, Emily. Welcome to everyone participating on our call. I'll start out by discussing the market trends we're experiencing today, provide an overview of the first half of the year. Phillippe will cover our strategy and quarterly performance, and Hila will provide a financial overview of the quarter and 2021 guidance. The housing market continues to be very healthy. Home buying activity in the second quarter of 2021 remains strong and steady in all our geographies. Even as we manage our order space to align with production constraints, our second quarter of 2021 average absorption base was 5.5 per month, up from 5.0 per month from the prior year. This quarter, we also successfully navigated supply chain challenges as our long-term partnerships with our trades allowed us to minimize the impact to our job sites where possible. We delivered 3,273 homes, which was both above what we forecast considering our anticipated cycle time expansion and also greater than the prior year. We achieved our best second quarter of closings We generated the highest quarterly home closing gross margin in company history of 27.3%, with pricing power more than offsetting commodity cost increases. We grew our community count from 203 at March 31st to 226 at June 30th, as our focus remains on our 300 community goal. We believe this 11% sequential quarterly increase is the start of meaningful growth. To address the macro backdrop and what we are seeing and hearing in our communities, housing supply remains constrained. Lower interest rates continue to influence purchase decision and demographic trends in home buying for millennials and baby boomers are driving consistent demand in the housing industry today. Mortgage interest rates remain at or near historical low levels. Buyers in the entry-level space are mostly buying at payment, so as long as rates remain low and the average monthly payment make sense that demand continues to be strong. Secondly, the tight supply of new and resale homes remains an issue in the market. While we anticipate builder pipelines and new resale home listings will eventually adjust, we believe the current supply and demand constraints will persist for the foreseeable future. Lastly, demand based on demographics should continue to drive home building for the next several years. Millennials and baby boomers are still in the early stages of life events that align with home ownership. With our growing community count and focus on entry level and first move up markets, we believe marriage is well positioned to deliver a greater volume and drive profitability over the next several years. At 300 communities, we can generate 15,000 orders and normalize run rate of 50 orders per store, which is just a bit over four net orders per month. I'll now turn it over to Phillippe. Phillippe?

Thank you, Steve. While we continue to meet and exceed our absorption pace objectives in 2021, we are also able to prioritize price in today's favorable market environment. We increased prices on the same sort of basis by about 9% to 10% year-over-year this quarter. This led to order ASP increasing 18% year-over-year, even as product shifts towards entry level. Despite managing our orders to align with production, we still achieved 5.5 net orders per month this quarter. The elevated absorption pace is partially a function of the current market conditions, although as we continue to focus on energy-level homes, our long-term absorption pace should increase from its historical levels. While we are certainly being optimistic in today's environment, our business model was designed to operate at normalized pricing and pace. We recognize the current demand and pricing dynamics are not sustainable indefinitely, and we anticipate the market will revert to historical sales pace over the next double quarters as supply becomes more available. We believe stable markets are necessary for sustainable growth long term. However, today, we are still able to sell our homes soon after they are released. We acknowledge that there are early indicators that affordability is being stretched in some markets. Our energy level and first move up strategy is based on affordability, which influences all areas of decision making. Pricing, plan library, land strategy, and target customers. Our strategy has been and will continue to be to offer quality yet affordable homes. As we continue to shift to more energy level in our portfolio, we are moving down the price band. That being said, the ongoing surge in housing demand has enabled us to raise prices again this quarter, leading to year-over-year increases in order, backlog, and closing ASPs, and masking some of the shifts to more affordable products and communities. Despite higher ASPs, continuing low interest rates have kept average monthly payments affordable. We have experienced minimal pushback on our pricing from the market, and we continue to sell our inventory with limited or no incentives. We are constantly monitoring all our geographies and will adjust incentives accordingly to align with local conditions as necessary. Even as market demand remains strong, we evaluate the overall affordability of our homes and credit metrics of our buyers to ensure customer KPIs remain stable and consistent. We also conduct interest rate sensitivity stress tests on our backlog to determine buyers' ability to qualify if rates go up. To date, we have not seen any pervasive indicators that concern us. We have also continued our commitment to a 100% spec building strategy in entry-level product and our focus on streamlined operations in order to keep costs as low as possible and to pass along those savings to our customers. When it comes to our land acquisitions, which Hilla will talk about in greater detail, our strategy of buying in bulk and in further out sub-markets allows us to find less expensive lots for entry-level communities. Every aspect of our business is focused on affordability to ensure we are keeping our customers' needs in mind. Before we get into the detailed numbers, I would like to share some of the exciting milestones we achieved this quarter on slide four. In our series of ongoing education at Meritage, we held diversity equity inclusion, or DEI training, and a company-wide conversation hosted by a third-party DEI expert to discuss inclusive leadership. In addition to conducting a company culture survey, we also formed our DEI Council comprised of married employees from various backgrounds to help management communicate and execute our DEI initiatives. This quarter, we renewed our relationship with Operation Homefront for an eighth year to build and deliver a brand new, mortgage-free, and energy-efficient marriage home near Tampa, Florida for a deserving military family. We thank veterans for their service and want to show our support as they transition back to civilian life. From a technology perspective, we rolled out an interactive chatbot feature to our consumer webpage and we'll be talking about some further enhancements to the customer experience in the coming months. I am proud of all we have achieved in the first half of 2021. Our continued focus on new energy efficient features, digital offerings, technological innovations, as well as additional DEI efforts all positively impact our financial performance and help to create long-term value. Turning to slide five. Our second quarter closings totaling 3,270 homes were up 18% over the prior year. Additionally, closing ASP increased 4% year-over-year due to sustained and elevated housing demand, which has allowed us to push through 2% in the prior year. Together, these increases drove home closing revenue 23% higher year over year to $1.3 billion in the current quarter. We sold 3,542 homes this quarter. Orders were slightly down, 2% lower than last year's challenging comps driven entirely by a lower community count. 2020 had an average community count of 239 compared to this quarter's average count of 215. As Steve mentioned, average absorption pace was up 9% year over year, from 5.0 sales per month to 5.5 per month, despite a tightly metered order pace. Both orders and average absorption pace actually improved between April and June when we released more homes to the market towards the end of the quarter. The low housing supply conditions combined with strong home buying demand created considerable pricing power in the market. Despite mix, ASP on orders in the second quarter of 2021 exceeded $420,000 and was up 18% year-over-year. During the second quarter, strong demand existed in both entry-level and first move-up products. Entry-level comprised over 80% of total orders for the quarter, up from 70% in the second quarter last year. Entry-level also represented 75% of our average active communities, compared to 54% a year ago. Our absorption pace for first new homes increased 21% year-over-year. Moving to the regional level trends on fly sticks. Our East Regions order volume increased 17% over prior year as a result of 25% growth in average absorption pace, partially offset by a 6% decline in average community count. Performance in this region can be largely attributed to our strong entry-level pivot. The region continues to demonstrate the largest shift to entry level, with 77% of its average active community selling entry level homes during the quarter, compared to 45% in the same quarter last year. Georgia had the highest average fridge absorption pace in the East, at 5.8 per month, which, partially offset by a 31% decrease in average community count, led to a 2% growth in orders. Our average absorption pace in the central region, comprised of all our Texas markets, grew 8% over prior years to 6.0 per month, which was the highest absorption pace in the company, while average community counts increased 16%. This led to a 95% decline in order volume. Entry-level communities represent 78% of Central's average active communities during the quarter, the highest among all three regions. Our second quarter 2021 average absorption pace in the West region was relatively flat year-over-year at 5.5 per month. Order volume decreased 10% over prior year due to the 10% decline in average active communities. The West's strong demand and pricing power resulted in a 22% increase in order ASP. California experienced an increase from 4.5 to 5.9 net orders per month, largely due to the shift in average entry-level community makeup, increasing from 68% to 97%. Arizona demonstrated the strongest pricing power with order ASP increasing 31% year over year. Arizona's average community count remained flat. If the supply chain was working more efficiently, the demand we are seeing in the marketplace today would allow us to sell homes even faster. Turning to slide seven, of the 3,273 homes closing this quarter, 74% came from previously started spec inventory. The same percentage as a year ago. We ended the quarter with nearly 2,600 spec homes in inventory or an average of 11.3 per community as we pushed to get homes in the ground despite production delays. This is an improvement from about 2,200 specs on average or an average of 9.3 in the second quarter of 2020. At June 30, 2021, less than 5% 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 has been challenging, even as we started over 3,800 homes this quarter. At an annualized rate, 15,200 home starts validates our ability to maintain a necessary level of inventory to support our community count objectives. We ended the quarter with backlog of over 5,500 units, as our backlog conversion rate declined from 78% last year to 63% this year, although in line with the first quarter 62%. We expect slower conversions to persist in the coming months as we sell homes early in the production cycle, but believe our spec and edge level focus will drive the backlog conversion back up in 2022 and beyond. Having available specs is crucial to our business model. Although supply-side headwinds have resulted in construction cycle times extending approximately four weeks, we were able to navigate through the challenges this quarter and we have not yet seen any further expansion. We believe our spec building strategy gives us a competitive advantage by enabling us to pre-plan our starts and contract for building materials in advance. By locking costs before pricing the home, we avoid cost risk and can better manage our margins, especially in a rising cost environment. Additionally, since our spec strategy is built on months of supply of sales and not an absolute number of specs, we were able to adjust spec construction volumes according to market demand. We believe that our spec strategy has enabled us to increase our market share and will continue to do so as we grow to 300 communities. I will now turn it over to Hilla to provide additional analysis of our financial results. Hilla.

Thank you, Phillippe. Let's turn to slide 8 and cover our Q2 financial results in more detail. As Philippe noted, the 23% year-over-year home closing revenue growth in the second quarter was a result of the 18% increase in home closings and 4% increase in closing ASP despite being comprised of a greater mix of entry-level homes. The 590-bit improvement in second quarter 2021 home closing gross margin to 27.3% from 21.4% a year ago reflects higher ASPs and leveraging of our fixed costs on greater home closing volume. The ASPs more than offset higher lumber prices and increases in other commodity costs. Lumber futures peaked in May and have begun a notable decline in June and July. The anticipated positive margin impact will start to work its way through our financials in the coming quarters that may be partially offset by other costs that continue to rise. As we scale our community count towards 300, our gross margin will eventually benefit from even greater leveraging of fixed overhead in the future. It's well documented that many home building materials, both raw and finished, are constrained in today's environment due to ongoing supply destruction and five consecutive quarters of elevated demand. The entire industry is impacted to some degree, and while we're certainly not immune to this phenomenon, we believe our reduced plan library, limited SKU counts, strong vendor partnerships, and constant, predictable construction cadence allow us some advantages to navigating these delays. While labor shortages are commonly associated with the home building industry during periods of high growth, fortunately, labor is still relatively stable. We believe our strategy makes us a preferred builder of choice since our transparency and scheduling visibility are attractive to local trade. However, we have had to absorb higher transportation costs affiliated with some of our inputs due to indirect labor challenges. We continue to monitor for indications of a tightening labor market. Our SG&A leverage benefited from both greater closing volume and higher ASPs in the quarter, bringing our SG&A down to below our 10% goal to 9.2%. One of our more permanent changes is the increased technology use in sales and marketing where possible, which is an effective yet lower-cost solution we rolled out in 2020 that we continue to employ and refine. The second quarter 2021's effective income tax rate was 22.4% compared to 21.7% in the prior year. Both years reflect reduced rates that primarily stem from eligible tax credits on qualifying energy-efficient homes closed under the 2019 Taxpayer Certainty and Disaster Tax Relief Act. The price increases and higher closing volume, expanded gross margin, and improved overhead leverage that we achieved this quarter led to an 83% year-over-year increase in second quarter diluted EPS of $4.36. To highlight just a few items from the first half of 2021 results, on a year-over-year basis, we generated an 85% increase in net earnings, orders were up 4%, closings were up 21%, we had a 530-bit increase in home closing gross margin to 26.1%, and SG&A, as a percentage of home closing revenue, improved 100 bps to 9.5%. Moving on to slide nine. Our balance sheet remains strong, even as we invested a record amount in land acquisition and development. We achieved several objectives this quarter. On April 15, we closed our offering of $450 million 3-7-8 senior notes due 2029 and received approximately $444 million in net proceeds. On March 31st, we issued a notice of redemption for all of our 300 million 7% senior notes due 2022. This redemption that occurred in April resulted in 18.2 million of early debt extinguishment charges this quarter or approximately 37 cent impact to our EPS. In the first half of 2021, we repurchased 300,000 shares of stock for a total of $27.5 million, of which 200,000 shares, totaling $19.1 million, were repurchased during the second quarter. At June 30, 2021, our cash balance was $684 million compared to $746 million at December 31, 2020. Our net debt-to-capital ratio was still low at 15.4% compared to 10.5% at December 31, 2020. Our current maximum net debt-to-cap target remains in the high 20s, which is in line with both the quick asset turns from entry-level and first move-up offerings and our solid commitment to maintaining sufficient liquidity to weather any unforeseen events. We have not wavered from our capital usage priorities. We will continue using the bulk of our cash on land spent for organic growth and to get specs in the ground. Routine share repurchases are intended to offset new grants and keep our dilution neutral. While we will opportunistically repurchase incremental shares, our main focus remains on land acquisition and development to achieve long-term growth, drive profitability, and gain market share. On to slide 10. On June 30, 2021, with over 63,000 total lots under control, we had a 4.9 year supply of lots based on trailing 12 months closings in line with our target of four to five year supply of lots under control, but closer to the middle of that range when we look at our expected closing volume at 300 communities. We increased our land book by 47% from approximately 43,000 lots at June 30, 2020. As we get closer to attaining our mid-2022 goal of 300 communities, we exceeded our own expectations on community count growth this quarter. We made tremendous progress in land development and overcame supply chain issues to aggressively grow our community count by 11% sequentially from 203 at the start of the quarter to 226 active communities at the end of the quarter. On a year-over-year basis, we were down 5% from 237 communities due to an accelerated orders pace in both 2020 and 2021. Like Steve said, we believe this quarter was the start of significant growth. We opened 45 new communities. Our strong pipeline of upcoming community openings over the next four quarters should position us well both to address market demand with greater volume and to drive continued profitability. As we already own or control all of the land necessary for our 300 goals, we are focused on working through development of land over the next 12 months. We remain confident that we will have 300 active communities by mid-2022. We spent $551 million on land acquisition and development this quarter, which was about 157% higher than last year's Q2 muted spend of $214 million and 49% higher sequentially from Q1 spend of $370 million. To demonstrate our commitment to sustain and replenish our 300 communities, we expect to spend about $1.75 to $2 billion on land acquisition and development in 2021 and maintain an annual pace of about $2 billion in the future. Despite the additional demand for land from all builders today, we are able to find enough land to meet our internal goals while remaining disciplined in our underwriting standards. In the second quarter of 2021, we secured approximately 9,000 net new lots, about 114% more volume than about 4,200 net new lots in the same quarter of 2020. These new lots will translate to 64 new communities, of which approximately 80% are entry level. Our comfort with acquisitions of larger lot sizes and in secondary and further out submarkets that best align with the entry-level products have limited some of the competition for the land we are interested in and also allowed us to contract for less expensive lots. These positions allow us to leverage community-level overhead costs, reduce the per-lot impact of development and infrastructure allocations, as well as mitigate community count terms. In the second quarter of 2021, the average community size we contracted for was 153 lots. To preserve liquidity, we used auctions or staggered purchasing terms where financially feasible. About 63% of our total lot inventory at June 30, 2021 was owned and 37% was auctions, similar to last year. Finally, I'll direct you to slide 11. We have more than 5,500 units in backlog and another almost 2,600 specs in the ground today, which provides good visibility into our go-forward margin trends for the rest of the year. Additionally, with today's strong pricing environment and anticipated lower lumber costs, we are lifting our guidance with allowances for other commodity cost increases and cycle time delays. For full year 2021, we are now projecting total closings to be between 12,500 and 13,000 units, Home closing revenue of $5 billion to $5.25 billion, home closing gross margin of approximately 27.5%, an effective tax rate of about 22.5% to 23%, and diluted EPS in the range of $18.55 to $19.45. given our strong pipeline of community openings. We anticipate communities at December 31st, 2021 will be about 10% greater than today's level. As for Q3, 2021, we are projecting total closings to be between 2,800 and 3,100 units, home closing revenue of 1.15 to 1.25 billion, home closing gross margin of approximately 27.5 to 28%, and diluted EPS in the range of 435 to $4.70. With that, I'll turn it back over to Phillippe.

Thank you, Hilla. To summarize on SliceWell, our healthy land spend has led to our significant community town growth. demonstrating our commitment to sustain a strong land position. We are confident that we will achieve our 300 community goal by mid-2022. Our robust backlog and increased spec counts combined with the ASP on backlog exceeding 420,000 will allow us to drive greater volume and home closing revenue in the second half of 2021. In the current environment, we will continue to push pricing based on what the market will bear while managing our orders pace to account for supply chain challenges in order to deliver greater margins of profitability. We believe we can capture increased demand and greater market share over the next three years by continuing to execute on our entry level and first move strategy under elevated demand or at normalized levels. Additionally, we believe our successful spec building strategy in the entry level communities and our streamlined operations will continue to serve as well as the future. With that, I will now turn the call over to the operator for instructions on the Q&A.

Operator? Thank you. At this time, we'll be conducting a question and answer session. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. One moment, please, while we pull for questions. Our first question today is from Alan Ratner of Zellman and Associates. Please proceed with your question.

Hey guys, good morning. Congrats on the really fantastic quarter and results. So, you know, Phillippe, I think you opened off the call with some pretty realistic comments just about eventually you would expect to see some normalization on absorptions and you actually kind of put a time frame around that over the next couple of quarters or a few quarters. I'm guessing at this point that's being driven by you guys in terms of kind of limiting the sales since it seems like demand is clearly outpacing supply. But I'm curious what impact, if any, you would expect over the long run that normalization to have on the very strong gross margin trends you're seeing today. Hilla, you know, you mentioned the benefit of leveraging the fixed expenses as you ramp community count, but the flip side to that, I would imagine, is you're probably benefiting today from the very, very strong absorption pace that you're at and kind of leveraging some fixed expenses. So can you kind of just talk through the moving pieces there on the margin side as that absorption normalization occurs?

Yeah, thanks, Alan. You know, obviously in the near term, we've kind of guided to what we think our margins are going to be in the back half of the year. And so we feel like the margin profile in the near term is still really strong with lumber sort of moving down, even if the pricing power in the market isn't as strong as it used to be. We feel like there's offsets there. And, you know, today we're still able to push prices in some of our communities, even though we're being more mindful of it than we were, you know, in prior two quarters. As we sort of look out into the future and revert back to a more normal absorption pace, there's a couple things that we see. First of all, All the communities we're opening to get to our 300 is land that we bought prior to the pandemic, late 2019, 2020. So we think the margin profile in that land looks really good. We do think costs will stabilize. We're seeing what's going on with lumber, so we think that's going to go in the right direction. You know, the big question is out there is just kind of what are incentives going to do? You know, we're not thinking that, you know, we push prices beyond a place that are sustainable long term without some without some sort of incentives to kind of still achieve the pace sort of a normalized pace out there in the market. As of right now, we're not incentivizing anything, really anywhere, to sell the houses that we're releasing today. But we fully expect over the next several quarters that incentives will come back into the market as supply does. To what extent that is, it's hard to say at this point. I don't know if Hilla has anything else to add to that.

Yeah, I think just to answer your question, on the margin side of the discretion, Hilla Agree with Philippe, I don't think that we're going to be able to continue to increase pricing at the current pace indefinitely, but even just for argument's sake, if we hold it steady, with lumber coming down and just for Meritage specific, having additional volume from those communities is going to more than offset any normalization. Thank you. Thank you.

Second question, Phillippe, you also made a comment that you're seeing some early indicators that affordability is being stretched in some markets. I'd love any additional color you might have there that kind of supports that statement, whether it's data you're seeing from your mortgage company or perhaps just general less enthusiasm from the consumer given the price increases. Any commentary you can give there would be great.

Yeah, it's more of the later. We do obviously look at our backlog, look at our pipeline of prospects, find out where they're at from FICA stores, DTI ratios. All that looks pretty stable at this point, even at the current prices. Given the way interest rates have trended, the payments are still very much affordable and achievable. It's more about the consumer feedback. When we go out and release homes to our priority list, there's a larger percent of that priority list that just prefer not to buy today just because of where the pricing is and how it's stretching their total, what they were thinking was going to be their payment for a new house. So it's much more qualitative at this point than it is quantitative. We seem to still have plenty of buyers who are willing to pay the price and are comfortable with the payment, but we definitely have seen more pushback from our priority list over the last, say, 30, 45 days.

Yeah, just one more data point in addition to FICO and DTIs. I think we mentioned on our call last quarter that there's a couple additional data points that we're continuing to monitor, which is broken appraisals and the ability to make up that money from the buyer's perspective, as well as a stress test on our backlog if interest rates were to increase. And whether it's interest rates or increases in prices, it's really kind of the net payment calculation that we're doing there. So even if interest rates hold steady, how comfortable is the buyer population with price increases and both have had also de minimis effects. The appraisal is almost a non-event. If there are broken appraisals, buyers are coming up with the extra funds and on the stress test continues to be very low percentage of our backlog. That would have an issue qualifying for the exact same house. that they were looking for, although they could certainly still qualify for a slightly less expensive house in the same community.

Gotcha. Thanks a lot, guys. Appreciate it.

The next question is from Steven Kim of Evercore ISI. Please proceed with your question.

Yeah, thanks a lot, guys. Lots of good things to talk about, but I want to address this question of peak lumber. I think you mentioned that you thought that you'd have a positive margin impact from falling lumber in the coming quarters. Just want to get a little bit more granularity in 3Q and 4Q. Can you give us a sense of what you foresee with the shape of lumber costs running through your P&L relative to what you saw in 2Q?

For the back half of this year, we're not going to see a significant impact from the lumber relock that we're about to go into starting with all starts August and on. So most of the homes that are going to close this year have been started already at prior lumber rates. So we don't see a very positive impact in the back half of the year. This will start to be felt more in 2022. The way builders experience lumber savings is very inefficient, as many have written about. We'll relock here. There's still quite a bit of supply in the lumber yards that they bought at the prior rate, and they're trying to still push those prices through to us. So to achieve all those savings will take some time. but it is dropped significantly. It's staying there, which is exactly what we needed for there to be some real significant savings here. So I think we'll get some meaningful re-locks here in August, but the big savings will come at the next lock after that and really start to impact Q1, Q2 of next year if everything else stays equal.

I guess just to clarify my question a little bit, I would think that actually the shape of lumber means that 3Q might actually have higher lumber costs than 2Q. I just wanted to clarify that. Obviously, on the back end of that, there would be a benefit, which is what you addressed. But I was talking specifically about 3Q maybe absorbing even higher lumber and that being incorporated in your margin guidance. And then also, with respect to the amount of the lumber hit, if you will, year-over-year, the headwind hit, One of your peers mentioned that they thought that it could be about 300 basis points year over year in terms of the kind of hit that you absorbed in 2Q and maybe will absorb in 3Q. I wanted to see if you could comment on that range.

I don't think I have that exact math, but certainly we are not unique in what we've experienced in lumber costs versus our peers. So if they had an accurate number there, I would probably agree with it. But To your earlier question, yeah, I mean, lumber peaked, it appears, in Q2. All the starts that went out in Q2, which will close in Q4, is probably going to be the peak of the lumber impact to our P&L. Now, as I said and Hilla has said, the pricing power in the market more than offset that. which is why we're comfortable with our margin guidance. But yes, you're 100% right. The biggest impact of the increase in lumber costs when we close houses is going to be felt here in Q3 and Q4.

Yeah, that's encouraging. And then with respect to the comment about incentives, you mentioned you're not really doing any incentives at all. I mean, obviously incentives are a normal part of the business in most times. And so I wanted to talk about that a little bit. First of all, what is the normal rate of incentives? When you just think about what a normal market is, is it like low single digits kind of a thing? And do you typically have prices increase even as you have incentives, normal level of incentives? So in other words, I'm asking if you have an increase in your incentives over the course of the next year, Would it also be consistent that you would also be having some asking price increases at the same time?

I'll take that one. So you're right. Typically, let me just clarify, incentives come in two forms here at Meritage. I know every builder does it a little bit differently. We have just traditional incentives, and then we have incentives affiliated with using our mortgage company. So the mortgage company incentives are still there. Those are an incentive to use our affiliate and for us to have additional visibility into the backlog. The incentives affiliated just for coming into our community and buying a home, those are the ones that are right around zero. Low single digits is the right number in a regular environment. And you're right, typically they go lockstep with ASP increases. So if you think in a normal environment, ASP increases are maybe 2%, 3%, 4% a year. That should still continue despite the fact that you're having an incentive in future years as we normalize. Now again, it's difficult to predict What normal will look like or how normal will come to be? Is it going to be abrupt? Is it going to be steady and slow? It's difficult to know, you know, chicken or the egg, which is going to come first, continuing increases in ASPs or a halt in ASPs, the proliferation of incentives, and then kind of a normalization. So it's hard to try to pinpoint any specific quarter, what the action is going to be. But we do think that over the next, you know, two, three, four quarters, will see with every builder that's reported so far. I've mentioned that they're increasing starts and specs and looking to get more inventory in the ground. There feels to be a little bit of a loosening of inventory in the existing home market as well. So we think that there will be some stabilization there and whether that manifests itself in slower increases on ASP or the return of the incentive, that's really sometimes a market-by-market decision.

Sure. Makes sense. Appreciate it. One last one, if I could just sneak it in here, is the loan limits. One of the things that you raised, I think, earlier this year was the fact that loan limits, you're bumping up against loan limits, I think, in some communities. And yet, we know that the loan limits, formulaically, will increase perhaps as much as 20%, something, a jump to a degree we've never seen before, on January 1. And given the abruptness of that, I was curious as to how you are strategizing with your sales force in terms of how you will manage customers who come in who may be a little challenged because of the loan limit in 4Q but can look forward to the significant breathing room being provided on January 1.

So the loan limit I think is a Really important data point, but one data point maybe more important is affordability because loan limit is really just driving the availability to get an FHA loan, right? So we're looking at that in tandem with overall affordability for our buyers. We do have quite a few of our upcoming communities that are going to be opening at lower rates. ASP, so we think that will alleviate some of the issues, but the way that we're looking at it is really the broken appraisal. So do the customers have the ability, if the mortgage is coming in slightly above FHA and they really want or need the FHA loan, do they have the ability to put a little bit more cash down to get the loan total below FHA, even if the house price Thank you for joining us. So we're certainly monitoring the FHA limit and our company objective for our entry level product is to be below the FHA limit. But we're in today's kind of unique environment. We're monitoring FHA limit in tandem with just general affordability since the FHA take rate is a little bit lower today than we've typically seen.

I just want to drive that last point home. You know, we're out there sourcing land. That allows us to position our product below FHA, today's FHA, at today's lumber costs, at today's pricing. So we continue to look for land to move down, move our ASP down in our future business. and I think that's really important for folks to understand because I know we're going to get a lot of questions about what land prices are doing and they're certainly going up but our focus is to buy land that positions all of our products below FHA and again current FHA thresholds not what they might be in the future.

Yeah, great. Appreciate it guys. Thanks.

Thank you. The next question is from Michael Reha of JP Morgan. Please proceed with your question.

Hi, thanks. Good morning, everyone. I'll try and limit myself to two questions here. First, I'd love to get your thoughts. You talked about sales pace going forward, and obviously there's different pushes and pulls. Hilla, I think you kind of talked about at some point sales pace normalizing. At the same time, You're having more communities come online as we progress through the year. And supply, despite supply constraints, you're still putting out starts at a decent pace relative to a quarter or two ago. So just wanted to clarify, as we think about sales pace in 3Q and 4Q relative to 2Q, Is 2Q's pace sustainable for the rest of the year and how should we think about 2022 at this point even?

Yeah, I mean, so we don't really guide to sales, so I'm going to stay true to that. The sales pace in the market today is being 100% tied to production. So we're just managing orders based on our ability to get spec started, get into the stage that's interesting to consumers to transact, and what we can sustain and deliver a great customer experience around. Making sure we can deliver the health on time and fully complete to those consumers. So, you know, the supply chain, I don't know if I can say it's getting worse. It's not getting any better. And it continues to be, you know, the biggest challenge to the market. So, you know, the 5.5 sales pace in Q2 was a strong sales pace. It's unclear if we'll maintain that through the back after this year. It'll just all be tied back to our ability to kind of get those starts in the ground, get them through the production cycle, and sort of manage our backlog conversion and keep our costs in line with what we're trying to achieve on our margins. I know that's not the answer you're looking for and you're looking for something different, but it really is just connected to that 100%. And then the last thing I'll say is We think a normalized sales pace and we underwrite new land at three to four per month for one MU and four to five per month on live now. and our three-year business plan, that's what the absorptions are being underwritten at. So as the new land opens up, if we get more than that, we get more than that. But that's the assumptions that go into how we underwrite land. And when we achieve 300 communities, we think that generates a 15,000-unit business at four months. We'll be there middle of next year.

Okay, I appreciate that, Philippe. Maybe just to clarify then, maybe you could just maybe talk to the fact, just to finish off this thought here, to the extent that you're saying production isn't getting worse, would you expect your starts rate to be sustained in the back half? And then my second question is just on owns and options. You know, kind of staying in that 60-40 range, a little bit above 60% this quarter. You obviously have other builders that are trying to push or have pushed the option portion of their lot position higher. Is that a goal of yours over the next one or two years and how do you see that playing out? Thanks very much.

Yeah, well... We're absolutely trying to do as much as we can on option. You have to be optimistic in the landmarks of the day. It's very, very competitive. Paying both for deals sometimes gets you a better deal. It depends on what markets and what other builders are willing to do. We're so focused on our affordability metrics and again getting our ASP down that if we can do the bulk transaction and successfully position our future product at a much more attractive price point, we're going to do that over the option. That being said, we continue to do well on the options. We'll continue to push harder and try to do more. But I think the market's just really hot right now on the land side and a lot of other builders are out there, you know, willing to do bulk and we just have to compete with them. So I think we're kind of where we are, but we're continuing to push. As far as the start cadence, I say you should fully expect it to continue as we ramp into the 300 communities. You know, we're going to be getting to a pace where we can do 15,000 units. And we've said this other times on the calls, but starts and sales are almost the same for us these days, right? We've changed the way our business model works. We're selling almost 100% specs. So as we try to ramp up to these 300 communities, we believe that we need to be at 15,000 starts for the year, and it starts now, right, as our community count growth continues. So that's the trajectory on. That's why we started a bunch of homes last quarter. We're trying to replenish the specs, but we're also getting community count growth, and I fully expect our start cadence to continue to escalate as the community count growth comes behind it.

Great. Thanks very much.

The next question is from Carl Rickardt of BTIG. Please proceed with your question.

Thanks. Morning, everybody. Philippe, I wanted to ask about the cycle time extension. I think I got it right that you said a four-week extension. Can you talk a little bit about sort of where in the build process that that's occurring? And is it more product or labor pool related? And then just sort of on that point, the thesis here being low-end spec built in a hurry is great for subs and they love it. Now we've got a lot of other builders looking to jack starts. So how are you feeling about retaining that labor pool as you move forward maybe the next sort of couple three quarters?

Yeah, I'm feeling really good about it right now considering we started 3,800 houses last quarter. It was a big focus and effort of ours. You know, the team did a great job driving that, so I'm feeling pretty good about it, but Things are shifting around all over the place. You asked us where it's happening. It's kind of happening everywhere and it's happening in different places depending on geographies, depending on trade relationships, etc., So I'm not sure I could tell you that it's back-end trades versus front-end trades, you know, which stage of the house we're slowing down. It's just kind of like a death by a million cuts. They're all over the place, and that's what's generated the four-week elongated cycle time, which will obviously impact, you know, inventory returns and et cetera. But I'm feeling that our operating model allows us to plan stuff in a different way. We already know what we need to start in Q3. We've been planning for it for 60 days. So we told the trades what we're doing, where we're doing it, how we're doing it, and we got them lined up. And I think that's what the spec strategy gives you. As far as the other builders getting into this, I think they're seeing the same thing we're seeing, and then in turn, consumers want to move quickly today. So the ability to move them in quicker is something that's really important. So they're diving in. The key though is the repeatability of your business to really drive that spec cadence. If you're still building a lot of different plans out there, you have a lot of different SKUs you're managing, you're relying on your sales folks to pick out design packages and things like that, it just slows down the process. So with these other builders jumping into it, you know, I'm confident that they're figuring that out, but we've been working five years on that. And that's why I feel like, you know, we can ramp up our starts to 3,800 like we did in Q2. So, again, I'm optimistic that based on our performance and what I'm seeing in Q3, you know, we're going to be able to ramp this thing up pretty fast so that we have the specs in these 300 communities that we're getting to by next year and putting ourselves in a position to deliver on, you know, our long-term goals.

Thank you very much, Philippe. And then, Hilla, just looking at this particular quarter's gross margin guide, 25% is a guide at the end of Thank you very much.

It's in every category, honestly. So because our backlog conversion was a little bit off from what we expected, we had a higher volume of spec cells in the period than what we entered into, and those were at higher ASPs. So that obviously helped every category. depending on the timing of the specs there were some savings on the expected lumber impact so there were some savings on the cost side and then again the volume of closings as well as the ASP increase helped us leverage the fixed component that's a fairly material component for us that leverages up pretty well with when the volume increases so it was kind of across the board obviously the land's fairly fixed that's sometimes impacted Thanks so much for that detail. I appreciate it.

The next question is from Deepa Raghavan of Wells Fargo. Please proceed with your question.

Hi, good morning, everyone. Great quarter, great guide. My first question is more generic. As we reopen and resume towards some normalcy post-COVID and seasonality coming back, are there any trends that positively surprised you or underpaced your expectations so far?

No, because so we're really metering and governing sales in every community. And it's really hard for us to tell everyone exactly, you know, if we took the governor off of every single community, what we would see in the market and did anything change from last year when we weren't governing sales. So as of right now, everything feels like we can sell what we have and we don't have to incentivize it. And it's still a very strong, healthy demand market. People are still seeking out housing. There's a lot of supply constraints. And we really haven't seen much change in buyer behavior for the most part. But it's hard to exactly say just because of the governors we have out there in our communities. Thank you for joining us. and so it's just hard to say at this point if anything's really changed as it relates to seasonality.

All right, that's fair. You're tracking better than your expectation for this 300 community count through mid-2022. Does it mean you can achieve this target a little earlier than you'd have thought? Or are there other constraints like, you know, you talked about supply chain, etc. That's still the big hurdle. And, you know, right now, just getting to 300 by mid 2022 would be a victory by itself.

Yeah, I mean, now we are going to grow our community count by 80 communities essentially over the next four quarters. That's net, right? Because we close out of communities as well. So opening up 100 plus communities over the next four quarters will take everything the organization has to execute on it. You know, as we sit here in July, we're in great, great shape, but we still have a lot, you know, we have 12 more months of work to do here to execute on this. And so I don't think that there's going to be a meaningful pull forward of that community council.

All right, great. Thanks. I'll pass it on.

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

Hi, good morning everyone and thanks for taking my questions. First question is on the discussion on kind of 22 gross margins and the outlook. If I heard you correctly, it seems like there's lower lumber flowing through that's largely going to be offsetting some of the inflationary pressures. Going forward, at least through early 2022, it seems like you have some fairly low-cost land coming online through 2022. And your commentary regarding consumers is that you might be seeing a little bit of anecdotal pushback on pricing, but when you look at their financials, it doesn't seem like affordability is that stretch. So I guess when I'm thinking through this, really, the The only item or the main item of concern for you all is most likely what happens when additional capacity comes online and whether or not incentives outstrip kind of home price appreciation in 2022. Is that correct?

Hi Chairman. Yeah, that's certainly one of the data points. There are, while we're all excited as an industry to see the lumber costs come down, Thank you for joining us. Thank you for joining us. that the expectation, you know, unless something unusual happens with lumber again over the next couple of months, the expectation is that the industry will harvest significant savings from the lumber cost. But there's certainly some concerns about items going in the other direction and whether they're going to perfectly offset or not offset or be more than the lumber savings. It's kind of unclear right now, but I don't think we're prepared to provide guidance into 2022. But the thesis that the lumber, if it holds steady, should be decreasing into 2022 is the correct one.

Yeah, and even though we're excited that the land that we're opening up here to get to the 300 is all land we bought prior to the pandemic, but the land that's going through our income statement right now is land that we bought before that. So, you know, that land is not getting any cheaper, but we're excited about the land that we have flowing through.

Okay. Okay. Thanks for that. And then on the community count, I did not hear any guidance on 2021. Thank you for joining us.

As we said in the opening comments, we believe we'll be up another 10% from here by the end of this year, approximately 10%.

Okay. Okay. Thanks for that. And one final one on SG&A. Nice leverage. Going forward, how should we think about the amount of new communities that you're opening just balanced against leverage for solid growth while at the same time we've We've encountered builders just kind of lowering outside third-party realtor fees pretty aggressively as well as some take down internal commissions. Just hoping you can help walk us through those moving parts.

Yeah, there's some benefits that you'll see from commission changes. Again, those are recently implemented here, so it's going to take a couple quarters for those sales to come through, and hopefully the offset of the timing will be as we ramp up on costs for the community count growth. So we're not providing any SG&A guidance specifically, although we do expect to see some of those commission cost savings coming through in the next couple quarters.

Okay, thank you, and good luck in the upcoming quarter.

So, operator, I think we'll take two more questions and then we'll close it up.

Yes, sir. We'll take the following question from Susan McEllary of Goldman Sachs. Please proceed with your question.

Hi, this is Jake Titelman on for Susan. Congrats on a great quarter. Just a question. As you expand your footprint both geographically as well as just grow community count in your existing markets, how do you think about securing the necessary labor given the challenges there as you continue to scale the business?

Well, I think as you scale the business is how you secure the labor. You know, I mean, the largest builders have access to the best labor pools in those markets. So, you know, we always talk about being a top five market builder in each market, and that gives you access to better land. Better Trades, Capacity, etc. So that's our focus, right? And as we've grown to a top five builder in many of our markets, I think we're seeing that, which is why we feel really comfortable about our ability to grow our capacity. In our newer markets that we're in, like we entered Charleston, it's going to be a little more challenging. And we're on the bottom of the pecking order. We've got to earn our way up. That's why we try to go as fast as we can. But it's all about market share. You know, there's a reason the big guys got the access to the best labor pools.

That makes sense. Thanks. And just for my follow-up, I'm curious if you guys are exploring the possibility of becoming more active in the single-family rental market as others in the industry get involved here. And given your focus on the entry level, I'm just curious to gauge your appetite.

It's an exciting energy-filled space right now. There's Just so much stuff being written about it. It's highly successful. Right now we're really focused on organic growth. We have a great growth strategy focusing and investing in our existing markets with our existing people, with our existing products and our existing strategies. So that's the focus right now. But we're always entertaining everything that might give us some other scalable opportunity.

Thank you and good luck. Thank you.

The next question is from Alex Baron of Housing Research Center. Please proceed with your question.

Thanks for squeezing me in. You know, we've seen home prices go up quite a bit this year. In some places, you know, up $80,000, $100,000. And I think you guys said you're planning on introducing new communities at lower price points. So I'm curious, you know, what's different about these new communities? Are they... Smaller in size, you know, how do you prevent from some type of cannibalization?

Yeah, so the newer communities, first of all, it's just a pivot, right? We've been really focused on this for a while, so we've been buying cheaper lots in secondary, tertiary markets that we feel good about in the path of growth that allows us to position our products, you know, in the 300s. versus, you know, 400, 500, which is where we typically play. The second thing, and I think we've said this quite a bit, but we've just been very successful. Our teams have been very successful sourcing larger deals. and in buying the larger deals we're getting better basis land residuals and also able to spread out the horizontal cost over more land which is helping us bring lots to the market at lower prices which allows us to price our homes at lower prices so a lot of that land we started buying two years ago and it's going to start flowing through and it's really the larger deals that are allowing us to position our product in a more affordable price band.

Okay, thanks. And then my second question is, obviously you guys shifted the business model to building mostly specs. I'm just curious if you guys have also shifted the timing of when you release that home for sale or has it not changed meaningfully in the last three to six months?

Well, when we release... Well, it has changed because of the elevated demand and the production constraints. So in the normal market before the pandemic, you know, we were always sort of had a third of our specs were complete, a third of our specs were, you know, middle stage, and then our third of our specs were early stage. Now, you know, we have less than 5% of specs that are finished just because there's so much demand out there and we're able to sell it earlier in the release. We'd like to get back to where we were, where we have a third, a third, a third, and we have sort of something for everybody and can meet their timing of when they want to move and need to move. So things have changed. We're releasing houses earlier on and people are buying them earlier on in today's environment.

Okay, thanks so much.

Thank you. Well, thank you, operator. Thank you, everybody. I'd like to thank our entire marriage team for their great effort and continued high-level execution. And everyone who joined this call today, thank you for your continued interest in marriage homes. We hope you have a great rest of your day. And again, thank you very much.

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