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spk02: Greetings and welcome to the Meritage Homes third quarter 2022 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. Please note this conference is being recorded. I will now turn the conference over to our host, Emily Tadano, Vice President of Investor Relations and ESG. Thank you. You may begin.
spk00: Thank you so much. Good morning and welcome to our analyst call to discuss our third quarter 2022 results. We issued the earnings 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 in the earnings release and accompanying slides contain forward-looking statements. 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 earnings release and most recent filings with the Securities and Exchange Commission, specifically our 2021 Annual Report on Form 10-K and subsequent quarterly reports on Forms 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 earnings release as compared to their closest related GAAP measures. With us today to discuss our results are Philippe Lord, CEO, and Gilles Ferruza, Executive Vice President and CFO of Meritage Homes. Steve Hilton, our Executive Chairman, is under the weather today and unable to attend, but will be back on for next quarter's earnings call. We expect today's call to last about an hour. A replay will be available on our website within approximately two hours after we conclude and will remain active through November 10th. I'll now turn it over to Mr. Lord. Felice?
spk07: Thank you, Emily. Welcome to everyone participating on our call. In Steve's absence today, I will briefly discuss current market trends as well as our quarterly operating performance. Hilo will provide a more detailed financial overview of the third quarter and forward-looking guidance for the fourth quarter of 2022. Slide 4. After Hurricane Ian hit Florida at the end of September, we are grateful to share that all of our employees and homeowners are safe. Our hearts go out to the many families who were displaced. Through Emeritus Cares Foundation, we provided financial support to the hurricane relief efforts to help those in need. None of the homes in our communities were damaged by the hurricanes or floodwaters. However, about 150 closings in Florida that were slated for late September did not close in Q3 and will push out to Q4. Given the current delays with municipalities, utilities, and supply chain post-Hurricane Eden, some late Q4 scheduled closings may also get pushed into Q1 of 2023. Our sales teams are back in their communities as soon as local municipalities allow them to return, and we do not anticipate a material impact to our Q4 quarterly sales page from Hurricane Ian. I also wanted to share that in September, we released our 2021 ESG report, which included our inaugural Task Force on Climate-Related Financial Disclosures, or TCFD report. we joined the approximately 3,900 other institutions to become an official TCST supporter this quarter and are excited to continue to make progress in our ESG journey. Expanding on another ESG milestone, in the third quarter, we were proud to be the recipient of the 2022 Environmental Protection Agency's Indoor airPLUS Leader Award for continuing to build double-certified homes in third geographies under the EPA's ENERGY STAR and Indoor airPLUS home certification programs. Now turning to our perspective on the current market environment. The weaker conditions that started last quarter continued into Q3. The rapid and steep increases in mortgage rates and the expectations of further significant rate hikes to come, coupled with inflation and uncertainty in the economy, as well as elevated cycle times, all drove the meaningful deterioration in customer demand. While favorable home buyer demographics and an undersupplied overall housing inventory still exist, We expect them to be overshadowed in the short run as a lack of consumer confidence and tightened affordability are influencing buying decisions. We anticipate weaker demand in the near term as future economic conditions remain murky and consumers take time to adjust to the new mortgage industry environment, which will include ongoing rate increases. Given the macro backdrop, our sales order volume of 2,310 homes was 33% lower than prior year. Our absorption pace was 2.7 per month compared to prior year of 5.0 per month and our target of three to four net sales per month. This quarter, our cancellation rate was 30%, which was above our historical average in the mid-teens. A majority of the cancellations during the quarter were due to elongated cycle times, overall asset density driven by consumer psychology, economic concerns, and changes in personal financial conditions of our existing buyers. Available inventory, both resale and new, continue to be a priority for buyers, and we saw cancellation spikes in our markets where there are other move-in ready alternatives. Given that about 60% of our backlog at September 30, 2022, was comprised of sales prior to Q3, with a higher all-in ASP, we have proactively offered our existing buyers price concessions where needed to narrow the spread between new and prior home prices. However, we continue to expect heightened cancellation rates in the near future until our older backlog closes out. In the third quarter of 2022, our growth sales declined 14% year-over-year, and our absorption pace on growth sales was 3.8 per month, which confirms there is underlying demand today. With only approximately 300 completed homes to sell across all of our communities this quarter, we believe our growth sales were impacted by the lack of available homes that are ready to close within the next 45 to 60 days. With move-in ready inventory drawing the highest demand, we look to capture incremental volume with more completed or near completed inventory available over the next few quarters. Even with this difficult housing market, our pre-existing backlog allowed us to achieve our highest quarterly home closing revenue of $1.6 billion this quarter, despite the persistent labor and supply chain challenges. Our elevated home closing gross margin of 28.7% and lowest quarterly SEA G&A leverage of 8.1% led to our record high quarterly dilute EPS of $7.10. While we are proud of the efforts of all of our team members in achieving the exceptional Q3 performance, We also know that these results mostly reflect closings of homes sold in a different sales environment, and that based on current trends will not be indicative of near-term quarterly operations. And now that mortgage interest rates are 7% before additional rate hikes, we anticipate further deterioration of buyer confidence, which will impact both new customers and those already in our backlog, further challenging demand in the market. Even so, we continue to execute on what we have been committed to and have refined for several years. Both our strategy of pre-starting 100% of our entry-level homes and our streamlined operations. To gain leverage and drive profitability, we plan to continue to prioritize pace over price. In the current environment, we are utilizing everything in our incentive toolkit, including mortgage rate locks, rate buy-downs, increased incentives, and true base price reductions based on the needs of each community. In many of our markets, we have supplemented these offerings by being more aggressive with increased broker commissions. We are pushing to find the optimal mix of incentives for each of our communities to get back to a goal of three to four net sales per month, normalized pace so that we can find the market clearing point. Hila will cover the details to our land portfolio later, but I wanted to speak to our land strategy. This quarter we conducted a deep dive in our land pipeline in every market to determine which deals no longer achieve our risk return profile in today's housing environment, recognizing we'll likely need less loss under control in a slowing market. We've pulled back significantly on new deals over the last two quarters as we have all the land we need for the next several years and are only considering exceptional opportunities. For recently sourced deals, we've been engaging with our land sellers to work through closing timeline extensions. Many are giving us additional times as market conditions continue to evolve. With a strong land pipeline, we can take our time to gauge demand over the next several quarters before we commit to any additional land acquisitions. In cases where we cannot work through an extension, we are comfortable terminating our land option. We are also re-underwriting all control deals scheduled to close in the balance of this year and early 2023, and are taking a much more conservative view to ensure these deals still underwrite today. If these deals are no longer feasible at the land prices in the original contracts, we will negotiate with LandCellus for a price reduction or walk away from the lot option deposits and due diligence costs. In Q3, we terminated our lowest performing land deals, which resulted in an $8.8 million in write-offs of such walk-away costs. Now turn to slide 5 to share our operational statistics. Despite elongated cycle times, our third quarter closings of 3,487 homes were 12% greater than prior year, reflecting our efforts to successfully navigate the supply chain disruptions. Entry level was 84% of closings, up from 78% in the prior year. The third quarter 2022 sales orders of 2,310 homes was comprised of 88% entry-level homes, up from 84% in the third quarter last year. As I mentioned earlier, our Q3 sales orders were down 33% due to an acceleration of cancellations, despite a 25% year-over-year increase in outage communities. A cancellation rate in Q3 of 30% increased from 10% in Q3 2021 and 13% in Q2 2022, Our third quarter 2022 average absorption pace was 2.7 per month, which was down from 5.0 per month in the prior year. Moving to regional level trends on slide 6. Consistent with the rest of the building industry, we experienced softer conditions and a year-over-year decline in order volume in all of our regions during the third quarter. However, a 2.7 net sales per month pace this quarter does not tell the whole story. Overall, our east region outperformed our other two regions with an average absorption pace of 3.8 per month during Q3. Almost all of our markets in this region maintain our target pace as a result of the relative affordability of those markets. Except for Austin and the growing pains we have experienced there, Texas also performed relatively well in light of the current market conditions. Excluding Austin, this region achieved an absorption pace of 3.2 per month during Q3. The story really changes in our West region, which represents more than a third of our total average community count. The region struggled in the third quarter, as demonstrated by the 1.5 net sales per month pace, which weighed heavily on our company's net sales per month averages. We believe market performance in this region weakened significantly as a result of home price appreciation over the last two years materially exceeding the growth of local household income and some of the most pronounced regional supply chain delays in the U.S. Let's review each region in a bit more detail. Our West region experienced the highest regional percentage of cancellations this quarter. ASPs that ran hot over the last two years, mainly in Arizona and Colorado, impacted affordability and buyer confidence. We had the largest percent of cancellations in Colorado's quarter due to the significant supply chain issues at times pushing our closings by a full quarter or two. We continue to work with municipalities and our subcontractors to manage through these issues. Arizona also experienced more acute supply chain challenge and one of the longest cycle times in all of our markets, which led to elevated cancellations. With an average absorption pace of 1.4 per month in Q3, consumers in this market were sidelined and temporarily pulled out of the market or pivoted to readily available inventory. In the short term, our Western markets proved more vulnerable to buyer hesitancy this quarter, driven by both real and perceived Titan affordability. But we remain committed to having readily available homes, adjusting prices more aggressively, and offering a full range of incentives to overcome these concerns and get us back on target pace. With sales holding up best in the eastern part of the country, our East region grew order ASP year-over-year and also had the smallest year-over-year decline in order volume. Our Florida market remains strong, representing 44% of the region's orders this quarter, despite the impact of Hurricane Ian at the end of September. Relative affordability and extreme low housing inventory in Florida resulted in strong absorption pace of 5.0 net sales per month and a 12% year-over-year increase in ASPs on orders. South Carolina was the only market to grow order volume this quarter. Its 37% year-over-year increase resulted from the significant community count ramp-up over the last four quarters and ongoing relative affordability in the market. The story in Texas was different across our markets in the region. Demand held up in Dallas and San Antonio. Meanwhile, offices struggled with persistent material delays and labor shortages, resulting in one of the longest cycle times in all of our markets, which led to greater cancellations. Houston continued to face fierce competition from other builders. We do believe there's still high demand in these markets, but we need to sharpen our pencil to find the right incentives to better manage our cancellations. In the near term, the changing conditions in many of our markets make it challenging to accurately predict order demand going forward. However, we believe that favorable fundamentals in all of our markets will enable the right combination of competitive incentives to drive demand and regain sales momentum. Now turning to slide seven. We moderate our starts this quarter, starting approximately 2700 homes in the 1st, 3rd quarter compared to over 5000 homes in 2022 to align with our slower absorption volume. We've spoken about our commitment to our strategy to maintain enough movement ready inventory that aligns with our sales, not arbitrary numbers and demonstrated that execution this quarter. We ended the period with nearly 4,700 spec homes in inventory or an average of 17 per community as compared to approximately 2,800 specs or an average of 11.7 in the third quarter of 2021. This is in line with our optimal level of four to six months supply. Although the elongated cycle time stemming from supply chain issues leaves us at a disadvantage as we have very limited available finished inventory in that count. Similar to last year, 75% of our homes closing this quarter came from previously started inventory. At September 30, 2022, we have only approximately 300 completed homes to sell. Our 6% completed homes is up a bit from prior quarter, but is still not where we want to be due to elongated production timelines and supply chain disruptions. Our goal is to get back to a typical run rate of one-third completed available inventory. Our Q3 cycle time hasn't changed since the start of the year. We recognize that things generally aren't worsening, but we are still approximately six to eight weeks of additional time from our pre-COVID construction schedules. Front-end trades like lumber and roofing are starting to find additional capacity given the industry pullback and start. Back-end trades like appliances, flooring, countertops, and cabinets are still challenged. The entire market is also struggling with the lack of transformers needed to electrify homes, and we continue to monitor this nationwide issue as we look for potential alternative solutions. However, with overall capacity loosening, we are working with our trades and partners to secure cost savings and cycle time reductions in all of our markets. We ended the third quarter with a backlog of approximately 6,100 units as our conversion rate declined from 57% last year to 48% this year. When the supply chain stabilizes, we anticipate cycle times will shorten and backlog conversion rates will improve. I will now turn it over to Hila to provide additional analysis of our financial results. You up?
spk05: Thank you, Philippe. Before we dig into the Q3 financial results, we wanted to give a brief BFR update. In Q3 of 2022, a higher percentage of our sales came from BFR. Over the last 12 months, we have strengthened our relationships with both national and regional BFR operators. We were able to more heavily lean into these relationships this quarter as we doubled up and pre-sold both Q3 and Q4 volume. While we believe in the continued long-term resiliency of our BFR business, we anticipate slower near-term BFR volume as these operators are also adjusting and adapting to the changing dynamics in their rental markets. Now let's turn to slide eight and cover our Q3 financial results in more detail. Home closing revenue grew 25% year-over-year to $1.6 billion in the third quarter of 2022 due to 12% greater home closing volume and 12% higher ASPs compared to prior years, as stronger pricing over the past several quarters worked its way through the P&L. Our third quarter 2022 home closing gross margin was 28.7%. The 100 debt deterioration from 29.7 a year ago mainly resulted from greater incentives, 8.8 million in write-offs for option deposit and diligence costs, and to a lesser extent, higher direct costs. In the third quarter of last year, we had about $900,000 of write-offs for terminated land yields. Excluding these write-offs, home closing gross margins were 29.3% in Q3 2022 and 29.8% in Q3 2021. We anticipate ongoing elevated incentives will flow through Q4 margins and into 2023, which will outweigh the savings in 2023 from lower lumber costs. Although we are not projecting any other labor or commodity cost reductions at this time, we believe direct costs will eventually align with reduced production volumes, partially offsetting the incentives and price concessions. SG&A as a percentage of home closing revenue was 8.1% for the current quarter, a 120 BIP improvement over prior years. In addition to lower commission expense as a percentage of home closing revenue from sales in prior quarters, our higher revenue allowed us to better leverage our SG&A. We have seen marketing costs start to tick off this quarter and will likely continue to do so given the evolving market conditions along with increased broker commissions. The third quarter of 2022's effective income tax rate was 20.3% compared to 23.3% in the prior year. The 2022 rate reflects $13.1 million in energy tax credits that came from qualifying homes we delivered in the first nine months of 2022 as the Inflation Reduction Act passed in August of this year retroactively extended the energy tax credits to the beginning of the year. The 2021 rate similarly benefited from the 2019 Taxpayer Certainty and Disaster Tax Relief Act. Overall, pricing power, improved overhead leverage, and a catch-up of tax credits combined with a lower outstanding share count led to a 35% year-over-year increase in third quarter 2022 diluted EPS to $7.10. To highlight just a few of the September 2022 year-to-date results, compared to 2021, orders were down 5%, closings were up 3%, and our home closing revenue increased 17% to $4.2 billion, primarily driven by higher AFPs. This pricing power translated to a 270-bit increase in home closing gross margin to 30.1%, while SG&A, as a percentage of home closing revenue, improved 110-bits to 8.3%, both from cost savings and increased leverage. We generated a 46% increase in net income, earning $19.65 year-to-date diluted EPS. Turning to page 9. We believe we have ample liquidity and a healthy balance sheet to manage through this changing environment. At September 30, 2022, nothing was drawn on our credit facility and our net debt to cap was 18.9%, which is below our maximum internal threshold of high 20s. Our next debt maturity is in 2025. Our cash balance was $299 million at September 30, 2022, compared to $618 million at December 31, 2021, primarily as a result of increased inventory spend as we work to bring our started homes closer to completion. During the quarter, we focused on our liquidity and did not repurchase any shares. At September 30, 2022, $244.1 million remains available to repurchase under our authorized share repurchase program. As we move into the next few quarters and generate higher positive cash flow from slower land acquisition and development spend, we anticipate growing our cash position to maintain maximum flexibility in the uncertain environment while considering other opportunities, including incremental share repurchases and a potential early repayment of debt. Since we frequently get questions about how impairments are calculated, as a reminder, our impairment assessment of real estate assets is conducted at least annually on a community-by-community basis or more frequently if needed. We record impairments when the cash forecasted to be generated from the sale of homes in a community is not expected to cover the costs of that community. Even at today's moderating prices and higher direct costs, we do not have any impaired communities. We do not anticipate broad-based impairments in the near term, barring further material ASP declines. On to slide 10. After landing at 300 communities during the last quarter, we dropped temporarily to 275 as of September 30, 2022. During the third quarter, we grew community count 17% year-over-year. For the last two years, we had new communities come online with such strong interest lists that we can open without completed models or available inventory. In the current market, we are strategically waiting to open certain communities until they're fully ready, while we're also delayed in others due to factors outside of our control, like the national transformer shortage. In Q3, we opened only 11 new communities compared to 49 in Q2. While we had a dip in Q3 community count, we expect to increase again over the next two quarters. We are forecasting to end the year just below 300 communities and then be back to our 300 community count target during the spring selling season. With the current uncertainty around the pace of demand, we are only putting under control exceptional land deals or land for our newer markets. We added about 1,800 new lots under control this quarter, less than 20% of the gross loss we put under control in Q3 of 2021. As mentioned, we walked away from approximately 5,200 lots this quarter with a corresponding write-off of $8.8 million. These terminated lots related to $470 million in future land and development spend that we will not be incurring. On a year-to-date basis, the $11.6 million of walk-away charges from terminated land deals represented about 10% of the total exposure related to our capitalized costs, as we only have about $110 million remaining of deposits and due diligence costs associated with our entire portfolio of controlled but not owned lots at September 30, 2020, which includes future phases of existing communities. All in, this $110 million makes up less than 2% of our total assets. During the third quarter, we spent about $380 million on land acquisition and development, down from $526 million in the third quarter of 2021. As we've been reducing our land acquisitions, our land spend is leaning more heavily towards development of our own lots. Since maintaining 300 communities requires much less capital than growing to 300, we expect to spend significantly less than the $2 billion we initially projected for this year. At September 30, 2022, we had 66,348 lots under control, which reflects a reduction of 3,419 lots compared to 69,767 lots at September 30, 2021. Based on trailing 12-month closings, we had five-point year supplies loss, which is just slightly above our target of four to five years. However, with approximately 60% of our portfolio sourced from land secured in 2020 and the first half of 2021, when land prices were cheaper, we're comfortable with this balance and will continue to evaluate our future land needs over the next several quarters. About 69% of our total lot inventory at September 30, 2022 was owned and 31% was optioned. At September 30, 2021, we had a 64% owned inventory and a 36% optioned lot position. Finally, turning to slide 11, we continue to monitor and evaluate shifting market conditions. For the fourth quarter of 2022, we're projecting total closings to be between 4,300 and 4,700 units, home closing revenue of 1.85 to 2.10 billion, home closing gross margin around 25%, an effective tax rate of approximately 23.5%, and diluted EPS in the range of $6.50 to $7.40. We are forecasting full-year 2022 land acquisition and development spend to be around $1.5 billion, notably lower than the $2 billion we initially anticipated. We are working through our next budget cycle at this time and expect to be able to provide additional guidance on our next quarter's call. Directionally, our future gross margins will be materially impacted by aggressive incentive actions as well as increasing costs for rate locks and buy-downs in a rising interest rate environment. However, long-term, we believe our normalized margins will settle to roughly 200 bits above our historical average of 20% as a result of operating leverage in more streamlined operations. With that, I'll turn it back over to Philippe. Thank you, Hila.
spk07: To summarize on slide 12, at Meritage, we are executing our strategy of pre-starting 100% of our entry-level homes and focus on what we can control to navigate the changing environment. By prioritizing pace, we are committed to finding the market clearing price in each geography to get us back to our target of three to four net sales per month, even as aggressive incentives and price reductions will impact our future home closing gross margin. By continuing to find ways to manage the ongoing supply chain issues, our team is working hard to close out our backlog and have more move-in ready inventory available. And by rationalizing our land portfolio, as well as pulling back our new land deals, we are limiting new investments to opportunistic new land deals only. Lastly, as good stewards of capital, we are managing to strong balance sheet liquidity. We are constantly monitoring the evolving market conditions and remain dynamic and flexible. Our resilient business model allows to gain market share and maximize our profitability in a slower market. With that, I will now turn the call over to the operator for instructions on the Q&A. Operator?
spk02: Thank you. At this time, we'll be conducting our 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 that your line is in a 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. Once again, to ask a question press star 1 on your telephone keypad. Our first question comes from Stephen Kim with Evercore ISI. Please state your question.
spk11: Yeah, thanks very much guys. Good results in a tough quarter, tough environment. Thanks for all the detail that you provided. I guess my first question relates to the interplay of incentives and the cost that you touched on when you described what you think your margin is going to do next year. And I think that it was really helpful to hear you say that you think your long-term gross margin is going to settle out, call it, let's say, around 22%, if I heard you correctly. Next year, given the moving pieces, with lumber coming down significantly, your cost negotiations, et cetera, but also the incentives you see today, if rates sort of stay where they are, let's call it a 7% environment, Do you think you're going to dip below that 22%? Or because of your land basis and various other things, do you think that you'll actually be probably a little bit above that longer term and then sort of drift down to a 22% in the out years?
spk07: Thanks, Steven, for that question. I mean, the first thing, we just don't know yet. I mean, the market dynamics are constantly changing. We're still looking for interest rate stability, which will then lead to price discovery, which will lead to stabilized absorptions and consumer coffins. So we're still way early in this and it's hard to know where pricing is going to go, what incentives are going to be needed. To to move in towards that being said, we do feel very strongly about our land position and feel like they give us the ability to outperform as incentives continue to become a material part of the equation. The piece that we also don't understand is just what costs are going to do. At this point, we're not seeing a lot of cost relief, even as starts begin to pull back. If we're able to get our costs down as we continue to start homes and try to gain market share, that can be a tailwind. So it's just really difficult to tell right now. Incentives are moving all over the place. Price rollbacks are moving all over the place. And to be able to forecast what next year is going to look like as we sit here today is extremely difficult.
spk11: No doubt. And, you know, I appreciate the difficulty there. Yeah, thanks for that. As we think about your commentary about gross margins, the first thing I wanted to clarify is are you anticipating or incorporating in that number additional lot option walkways? And then secondarily, as you're experiencing, you know, a more difficult environment, rapidly changing environment, did you have significant amounts of incentives at the closing table? Or are, you know, incentives, discounts and other accommodations in the closing table? Or is that fairly, fairly limited in the quarter?
spk07: I'd say that's fairly limited. If we have to go back and kind of reset our backlog, it's been mostly around getting them into a rate that makes sense for them versus renegotiating the price, although there was a little bit of that going on. And then as we look out into our future margins, we're not modeling any walkaways. But, you know, each quarter we're looking at everything that's getting ready to close, everything that we're getting ready to spend more money on and sort of rationalizing that. So I think there will be more, but we're not putting that in our guide.
spk05: Yeah, just to clarify, we were at 5.1 years supply of land, and 4 to 5 is our happy place. So we're a little bit above that. So we're really just monitoring what sales are going to do over the next couple of quarters to know if we need some additional pressure on the land pipeline or if we're okay where we are.
spk03: Great. Thanks very much, guys. Thank you.
spk02: Our next question comes from Truman Patterson with Wolf Research. Please state your question.
spk09: Hey, good morning, everyone, and thanks for taking my questions. First, Hila, in the prepared commentary, I don't think that I heard this, but could you give what kind of third quarter incentive levels, including base pricing adjustments were for orders. And then also, I'm hoping you could just go across your markets and discuss, you know, which regions or states you're seeing the highest level of incentives and potentially quantify those. I'm really thinking about the Western markets in particular.
spk07: Yeah, this is Philippe. I'll take that and then I'll have Hila jump in. So the first question was, you know, what have we done with incentives and pricing? We don't really look at those things differently, by the way. We're a spec builder. So at the end of the day, we're just looking at the net price and what we've rolled the net price back, whether it came in the form of incentive or it came in the form of a price rollback. But I'd say... anywhere from high bid teams in some of the more challenged communities to something really, really quite normal as you move east, just sort of on the margin. So if you look at the Western markets, again, community by community, because we have some communities where we really haven't had to do anything and other communities where we had to do more meaningful, we may have rolled back net pricing high teams. As you work your way to Texas, With the exception of Houston and Austin, it's been more high single digits, 10%. And then Austin and Houston maybe back into those high teens, especially Houston where we've had the rollback pricing to really compete with the competition. And then as you roll east, things have been relatively normal. You know, sometimes just kind of normal incentives to move things, normal adjustments in pricing to move things, and we really haven't seen a need to do much more than that. So hopefully that answers your question. Hila, do you have anything to add to that?
spk05: No, I think that covers it all.
spk09: Okay, okay, perfect. And then... I appreciate that color. We think of incentives or price cuts as one and the same as well. But I'm hoping you can help us understand what sort of incentives you all find most beneficial in stimulating buyer demand. Are you seeing today that pure base price cuts are more effective, rate buy-downs, locks? et cetera, just trying to understand what you all are seeing move the buyer.
spk07: Yeah, I mean, I'm not trying to phone in your question, but it's market by market, right? I mean, in certain markets, it's really just about getting a rate combination that works for that buyer as rates have escalated. So we've just had to kind of buy down rates to help those folks with their payment. In other markets, you know, it's been... you know, kind of a combination of all of it. You know, maybe some rate buy downs, maybe some closing cost support, and then maybe an adjustment in net pricing. And then I think as we move west, it's kind of become about the price. You've got to solve for the payment and then you've got to solve for the price. And they're sort of one and the same, but the price matters more in the west right now because there's been a lot of price cuts by our competitors. So buyers really want to know that they're buying a home price that's competitive with the market and they're not buying at the top of the market. You know, they're buying where the market is today. So certainly in the West, price rollbacks have been the most effective in the last like 60 days. Prior to that, it was all about rates. It was all about closing costs and maybe some marginal incentives. But recently in the West, it's become about price.
spk05: we really look at it as you need a price cut to get people in the door they want to feel like you're reacting appropriately to what's happening in the market but then they want the rate lock buy down to get the monthly payment to be what you want it to be so it's a little bit of a balancing act between the two based on um you know the demographics in each market yeah and again i'll just reinforce
spk07: We're a spec builder, so the price of the home is the price of the home. We don't break out lot premiums and options. It's the price of the home, it's your closing costs, and it's your rate. Those are the three components of getting a buyer into the home.
spk03: Perfect. Thank you all for the time. You're welcome. Thank you.
spk02: Our next question comes from Alan Ratner with Zellman & Associates. Please state your question.
spk10: Hey guys, good morning. Thanks as always for all the great information. You know, Philippe, I'm just curious, have you been surprised by how quickly prices have reset? I mean, I think, you know, if we go back three, six months ago, a common theme we heard from most builders was, you know, inventory is incredibly tight and the industry is quite disciplined this time around. And It just seems like when you're talking about high teens price adjustments in a matter of three or so months, that seems like it's much more significant in terms of the rapidity than we've seen in prior downturns before. So I'm curious if the magnitude and the quickness of it has surprised you guys at all.
spk07: Yeah, absolutely. First of all, I just want to make sure that I clarify, but the high teens is mostly a West region kind of scenario. We haven't really had to do that elsewhere, except maybe, you know, a little bit in Houston, some Houston communities. But what surprised me is how fast rates have gone up. I couldn't really imagine a scenario where mortgage rates have done what they have done over the last four months. So, yeah, That's created the scenario where it's really created the perfect storm for pricing having to roll back as materially as it has to solve for the lack of consumer confidence, the lack of uncertainty in the economy, and the rate and the payment that people are comfortable with. That's what's created this environment. So am I surprised that when rates double, prices have to roll back this meaningfully? No. What surprised me is how fast rates have gone up. And I think pricing is going to have to reset in that environment. It's what the Fed has created for us in our industry. So, no, I'm not that surprised, given what rates are.
spk05: And just to clarify, the mid-teens, the low mid-teens incentives are all in reduction. That includes what we're offering on the rate locks. So that is included in that amount and represents, in many cases, the material portion of that reduction. It reduces price because it's what we're giving the buyer, even though we're not actually reducing the base house price. So just to clarify, it's not a true reduction in base house price that's visible in the marketplace to other consumers.
spk07: Yeah, but the consumer today is pretty shaken. And at this point, if they're going to buy a home, they got to be confident that they're getting in at a price that they don't feel like they're going to lose equity on over the next year or two. And it's about the price.
spk10: Got it. That makes sense. And certainly appreciate the moving rates here was a lot greater as well than anticipated. Hila, I'd love to circle back to the comments that you made on impairments and kind of the stress test there and kind of tie that into a little bit the price adjustments you've made out west. So, you know, I'm presuming a lot of these markets that have seen the greatest price adjustments also are coming off of the highest starting point from a gross margin perspective, just given how much price appreciation there had been there. But, you know, I guess if we're assuming those communities might have peaked out at gross margins somewhere in the 30s, And we've already seen kind of mid-teens adjustments and absorptions are still lagging kind of your three to four target rate. Why isn't there more concern about those projects being impaired in the near term?
spk05: Yeah, that's a fair question. The math is almost right. So there's quite a bit... Quite a few of these communities that are experiencing the most severe incentive need actually were north of 30. So they're coming down, even at 12, 13, 14%, they're kind of coming back down to normal. And that assumes no cost saves. So there are some cost saves that are occurring out there today. There's going to be more as the lower-cost lumber rolls through our financial statement. So it's a combination of those two that are still keeping those communities certainly lower than where we have been the last couple of quarters, but not yet in the impairment territory danger zone. You know, is there a likelihood that maybe a couple of them may fall into it? maybe you always have cats and dogs in your portfolio. We haven't in the last two years, but beyond that every other year, we certainly do. But again, barring something really material like another 15 or 20% price reduction from today's prices that are already reflecting those decreases, it's hard to model a scenario where you're having kind of wholesale impairment similar to what we had in the last cycle.
spk10: Got it. That's helpful. And if I could just squeeze in one other related question on that point, though, because you mentioned it would need another 15% or so. I guess the question now becomes, though, what is the elasticity there? Because if you've kind of put out a three to four target where you want to be, and these regions were in the one to two, this range, this quarter, is there a number in your mind that you could discount today in a market like Arizona or California?
spk07: get to that three to four level or is it just simply you know a matter of the consumer adjusting to the new reality and it doesn't almost it almost doesn't matter what price is offered you're not going to get that level yeah again it's just it's all predicated on what rates do if rates stabilize and there's certainly around rates I think we have plenty of room to find that and in fact I The adjustments we've made recently that really are in that low teens, high teens in the West, we've seen pretty strong response on the growth sales side. Now, we're still working through cancellations in our backlog due to the cycle time issues. And as prices are moving, buyers are less confident in the home they bought six months ago. But yeah, we're finding a reasonable rate with the incentives we put in the market, or I should say the price adjustments we put in the market. Our growth sales, we're pretty optimistic about what our growth sales look like.
spk05: Yeah, I mean, just to clarify, we're not going to be ridiculous in our quest to find three to four net sales per month if there's no elasticity in certain markets. There's just no elasticity in the market. But right now, we're not seeing indications that that's the fact pattern. But if that is, we can certainly slow down our expectations for certain markets and accelerate them from others. But as Philippe mentioned, our growth sales are showing that there is demand for cancellation the cancellations that are coming in from some older inventory where there's a little bit of fear in the market that's causing that. But at today's pricing, there's a healthy demand that we're still seeing in almost all of our communities.
spk10: Great. Thanks for all the time and color. Appreciate it.
spk02: Our next question comes from Mike Rehout with JP Morgan. Please state your question.
spk06: Thanks. Good morning, everyone. Thanks for taking my questions. Wanted to just get a better sense of some of the trends around sales pace during the quarter. And, you know, obviously you talked about the 2.7 for the quarter overall. Where did that end? And, you know, when you think about the, you know, adjustments that you've made throughout the quarter, Are you expecting for that to improve a little bit in the fourth quarter? In other words, are those adjustments giving you some additional traction? Or, you know, to the earlier question around, you know, demand elasticity or lack thereof, you know, are you going to be satisfied with a lower pace going into the fourth quarter as well?
spk07: Yeah, we're not going to tell you anything different than what you've already heard from our competitors and us. We saw a similar trend throughout the quarter. It felt a little bit better in August because rates kind of stabilized. Then rates went crazy again in September. It pulled back. October kind of felt like... We're not in October, so October is kind of feeling about the same. We're not expecting a much better Q4 based on what we're seeing today. Again, I think we think that rates really have to stabilize before we start to say that we're going to see meaningful improvement in the demand environment. The things we're doing around pricing and other stuff is helping driving some more traffic, some more interest in our product, but the cancellations are still moving around quite a bit on us. It's kind of unpredictable at this point, so it's just kind of hard to say in the short term what to expect. Q4 is traditionally a slow time in housing in general, even when things are normal and good. So, you know, I think we're all under the impression that it'll be the spring before we really know what true demand looks like.
spk06: Now, that's very helpful. Thanks, Philippe. I guess, secondly, you know, kind of just shifting to, you know, net pricing and gross margins, if you could also try and give us a sense of, you know, I mean, you guys were obviously one of the first to you know, incentivize the backlog, you know, give the rate locks to a good portion of the backlog. And, you know, maybe even ahead of your peers. We're just trying to get a sense of, you know, where kind of on average incentives slash base price reductions stood at quarter end versus the beginning of the quarter. And, you know, when you think about the impact of where you stand today on those, you know, higher levels of incentives slash base price reductions. When you think about the impact on gross margins, you know, it would suggest that, you know, first quarter gross margins might be lower than fourth quarter. I guess what I'm trying to get at is, you know, aside from the beginning and end point of, you know, whatever percent price adjustment you have had to make, what are the gross margins on the orders that you're taking in today relative to the fourth quarter guide?
spk05: Yeah, so we're not, we're not giving guidance into 2023 just quite yet, but obviously you can see that this quarter is the 1st quarter. That's really meaningfully reflecting the rate locks and some of the other incentives that we offer. So there was a decline clearly from Q2 to Q3. And then we guided to a 25% online margin for Q4. So there's a further pullback from the 29.3% that we had this quarter without the walkaway charges down to 25. That's fairly material. You're going to continue to see, you know, we gave directional guidance to 2023 that we expect the higher incentives and the higher rate lock costs and rate buy down costs to flow through the numbers in 2023. We don't have a lot of visibility On that in fatality, because we're still working through those numbers and as our competitors choose to take certain price action, sometimes it necessitates adjustments on our end as well. So, while we know what our numbers are today, if other folks in nearby communities choose to take other actions, we may have to go back to our backlog and take incremental action to save cancellation. So it's very difficult for us to. provide an expectation of a margin, although directionally it's likely lower, although Q4's 25% does reflect the full composition of the start of our rate locks. If you guys recall, at the end of Q1, we mentioned that we bought rate locks for everything closing through the end of 2022. We're really seeing that come in full force in that 25%. in that 25% margin. So we'll have more to share on our next call. Directionally lower, although you are starting to see the incentives and the rate lock flowing through the guidance we've already given for Q4. Great.
spk06: One last quick one, if I could. You mentioned the BFR contribution or sales to BFR in 3Q, and I believe you said 4Q. I was hoping you could break that out. And what we've heard from you know, BFR from the BFR community is that, you know, by and large, those participants are, have shifted to the sidelines as well in the hopes of you're getting homes at a lower price than today, perhaps similar to consumers. You know, so just wanted to get a sense of what that contribution to orders were during the second, the third quarter, what you expect it to be in the fourth quarter and if, you're seeing any type of similar, you know, actions, maybe not for the back half of this year, but, you know, potential pullback in that demand in 23.
spk05: Yeah, that's a fair question. We don't give out specific numbers or percentages, although we did pre-sell Q4 volume for BFR into Q3, so the number's a little higher than where we typically run. Our long-term goal is high single-digit, low double-digit. We're not quite there yet. we agree there is a pullback a lot of the operators have said hey we need to kind of assess the market it's really just affecting the rental operators now what it was affecting us maybe six months ago so they're there a little bit of a pause trying to figure out how their new underwriting looks although many have indicated to us that they're back in the game for 2023. Their capital allocations are full for the current year or mostly full for the current year but they do expect additional volume in 2023. The one exception I'll say there is when you're selling entire communities and you've already kind of pre-contracted and you have a consistent cadence. So there's some of that volume that's just ongoing because negotiated prices make sense and the operators taking an entire community from you so you will still continue to see some volume although we definitely agree with what you're hearing out there that it's going to be slower in q4 and then a little bit of uncertain into 2023 although it's not going to dry up completely great thanks so much you
spk02: Our next question comes from Carl Reichert with BTIG. Please state your question.
spk08: Thanks. Thanks for all the helpful detail, y'all. I wanted to ask about the finished spec, Philippe. Is the relative shortage compared to what you like a function of customers sopping up product as it gets close to finish stage or more related to the difficulty in the supply chain? And then as you get to the spring selling season, ideally, what percentage of your available product would you like to be finished or very near finished versus what it might be?
spk07: Yeah. Thanks for the question. So it's definitely 100% a result of the supply chain issues. When we do have finished specs, we're able to move them. And we just haven't been able to reduce our cycle times and get enough finished specs to In the market now, I think with the slower demand environment, it's created an opportunity for us to do that. We typically like a. 3rd of our specs by community to be moving ready in the next 30 days for those folks that are moving out of apartments and ready to move in. Now. We like a 3rd of them to be within a 60 to 45 to 60 day window and then a 3rd of them to be a little further out. So, as you think about 300 communities, if we're looking for 3 to 4. Per month, you know, we want somewhere between 3,700 specs and 4,200 specs across those. Communities and we'd want a 3rd to be moving ready. So close to a 1000. maybe a little bit higher than that. And then a third of those to be slightly further out. And then the third, you know, that we just started in our 90 to 120 days out. So that's how we think about it. If demand's slower, obviously that would be a lower number. If demand's stronger, it would be a higher number. I think we're still seeing some communities out there that are doing more than four months. So we have more specs there. We're seeing some communities that are doing a little bit less than three months. So we have less specs there, but that's really how we think about it.
spk08: Okay, thank you, Philippe. And then are you seeing consumers even talk or think about arms today? I know the spreads versus 30 years aren't necessarily terrific, but I'm curious what their attitude is towards the potential for utilizing adjustable rate mortgages to get into the houses. Thanks.
spk05: There's definitely an increased interest in the seven year arms. It's a seven one now. It resets or seven six. I guess it resets every six months. So there's definitely an interest. You can get those at really affordable prices. You can get your monthly payment down to a reasonable amount. With the average American staying in their home 6.9 years, seven-year arm feels pretty good. Most of our entry-level buyers will stay in the home just about that time. Hopefully during that time, if they choose to stay there longer, there'll be a refinance opportunity. So the seven-year arms are definitely coming back in popularity. Thanks, Hila.
spk02: Thanks. Thank you. Our next question comes from John Lovallo with UBS. Please state your question.
spk12: Good morning. Actually, good afternoon, guys. I appreciate you taking my questions. The first one is, where was the land concentrated that you guys walked away from? I imagine it was out west, but were there particular markets where it was really focused?
spk07: Yeah, that's a great question. It actually wasn't. It was kind of across the board. Where it was concentrated was in stuff that we controlled recently, right? Stuff that we may have tied up in the back half of last year. or early this year when things were still looking pretty good. I think anything that we tied up in that time period, it's tough to rationalize today. So that's where it was concentrated. It wasn't in any specific region, probably equally distributed across, you know, all three.
spk12: Okay. That makes sense. Thank you. And then, you know, Hila, one of your comments about being a little bit more conservative with cash, Makes sense. But, you know, how much cash or total liquidity do you think you would need before exploring some of those other options like repurchasing and repurchasing shares? And what would sort of be the pecking order for allocating that capital?
spk05: Yeah. Is a lot a number? Because we want a lot of cash. So we definitely are focused on making sure we have a hefty war chest just in case. Right. You don't know what the world's going to look like in the next couple of quarters. We think it's going to stabilize, but we don't know. So it's better to be overprepared in this situation. We do think that we're going to start to be fairly cash flow positive over the next couple of quarters here as we pull back on land acquisition and development spend. You really start to be accretive as those units that were nearing completion on the spec inventory start to convert to cash. So we expect that to happen in the near term. Priority is likely first. jumping back into the market with share repurchases, and then looking at our 2025 note. Our nearest maturity, the other two notes are still at really, really attractive rates. The 25 is also an attractive rate, but if we can reduce our interest expense and help our net debt to cap, that's also very attractive to us. So that's kind of the order of priority.
spk07: Yeah, I would just amplify what she just said. I mean, you can't have too much right now. And we don't know if this is going to be, you know, a one-year deal or a multi-year deal. Still too early to tell. But if it's a multi-year deal, we have to, you know, deal with that 2025 maturity. So we're planning for a multi-year right now until we know it's not.
spk03: Makes sense. Thanks a lot, guys.
spk02: Our next question comes from Dan Oppenheim with Credit Suisse. Please state your question.
spk01: Thanks very much. I'm wondering a little bit more in terms of just the thoughts in terms of the specs, given the comments about the sort of expectation of a further deterioration in buyer confidence, just with the 17 specs that you have per community now. Where do you see that sort of going over the course of the fourth quarter, sort of where get into sort of a little better in terms of demand on a seasonal basis, sort of this current environment, but just wondering how you're thinking about that in terms of where the spec level will likely end this year and such.
spk07: Well, we hope to move some specs this quarter for sure. And I think we slowed down our starts dramatically in Q3. So we feel like this is the right number. I think I just went through the math. We're going to have 300 communities. If we're expecting three to four a month and we can get our cycle times back to something more manageable, then, you know, nine to 12 specs per subdivision feels like the right number. And that kind of gets you to somewhere around, you know, somewhere between 3,000 and 4,000 specs, depending on how the market is. So that's going to be kind of our target as we roll into spring. We want to make sure we have a lot of finished inventory because we really think buyers are focused on moving in quickly, locking in their rate and closing versus waiting. It's also, obviously, in our opinion, way more effective at managing margins and costs. and securing the trade capacity out there in a tight labor market. So we slowed it down dramatically. I think we're gonna try to move some of this inventory in Q4 and Q1 to get it down to that target rate of, you know, nine to 12 per subdivision, which is somewhere between, you know, three and 4,000 specs, depending on how the demand is. We want more as we roll into spring. Obviously we want more as we roll into the spring and less as we roll into the winter, just to manage the seasonality.
spk01: Yep, makes sense. And I guess then in terms of the market share goals and where you'd like to be in terms of that with the pace over price, I guess we've seen some other builders sort of pulling back and sort of start, and you certainly started fewer homes here. In an environment like this where it's more uncertain, what about sort of just tolerating a lower pace of absorption for some time, not having what you described as sort of the fierce competition in Houston and such, and sort of then staying in terms of this overall tight supply environment?
spk07: No, that's not our strategy. We drive pace and then the margin, we figure out the margin and the cost that we need to be profitable. Our entire business strategy is built around achieving that three to four per community. We have to find the price to do that and then work our cost structure, et cetera. We don't, When we slow down pace, we can't get the cost structure that we need to be profitable. We can't get our cycle times where they need to be. So we have to drive that pace. We're an entry-level builder. Our ASPs are lower. So the best return for our shareholders is to achieve that three to four net sales per month and figure out where the margins are afterwards.
spk02: Thank you. And ladies and gentlemen, that's all the time we have for questions. I'll now hand the floor back to Philippe Lord for closing remarks. Thank you.
spk07: Thank you, operator. I'd like to just thank everyone who joined the call and your continued interest in Meredith's Homes. I hope you have a great rest of your day and a great weekend. So thank you. Bye.
spk02: Thank you. This concludes today's conference. All parties may disconnect. Have a good day.
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