Q3 2022 Meritage Homes Corp Earnings Call
[music].
Greetings and welcome to the Meritage homes third quarter 2022 analyst call at.
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'll now turn the conference over to our host Emily to Daniel Vice President of Investor Relations and ESG. Thank you you may begin.
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 close you can find it along with the slides we'll refer to during this call on our website at investors that meritage homes dot com or by selecting the inverse.
After 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.
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.
I'll report on Form 10-K, and subsequent quarterly reports on Form 10-Q, which contain a more detailed discussion of those risks.
We have also provided a 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 phillipe, Lord CEO and helix series that executive Vice President and CFO of Meritage homes, Steve Hilton, Our executive Chairman is under the weather today and unable to attend but we'll be back on for next quarter's earnings call.
We expect today's call to last about an hour and a replay will be available on our website within approximately two hours. After we conclude and we will remain active through November 10, I'll now turn it over to Mr. Lord Felipe.
Thank you Emily and welcome to everyone participating on our call.
And feedback from today I will briefly discuss current market trends as well as our quarterly operating performance. He let will provide a more detailed financial overview of the third quarter and forward looking guidance for the quarter of 2004th quarter of 2022.
Slide four after hurricane in Florida at the end of September we are grateful to share with all of our employees and homeowners are safe and our Hearts go out to the many families who were displaced duo Meritage cares Foundation has provided financial support to the hurricane relief efforts to help those in need.
The homes in our communities were damaged by the hurricane 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.
Given the current delays municipalities utilities and supply chain post Hurricane D. 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 pace from hurricane.
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 TC FTE report rejoined the approximately 3900 other institutions to become an official Tcf T support in the quarter and are excited to continue to make.
Progress in our ESG journey.
Expanding on another ESG milestone in the third quarter, we are proud to be the recipient of the 2022 environmental protection agency's indoor air plus meter for continuing to build double certified homes in certain geographies under the Epa's energy Star and indoor Air class phone 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.
Customer demand.
While favorable home buyer demographics and an under supply of overall housing are still exist we can.
Secondly, overshadowed in the short run as a lack of consumer confidence and heightened affordability are influencing buying decisions.
We anticipate weaker demand in the near term future economic conditions remain murky and consumers take time to adjust to new mortgage interest rate environment, which will include ongoing rate increases.
Given the macro backdrop, our sort of sales order volume of 2300, townhomes with 33% lower than prior year.
Our absorption pace was two seven per month compared to prior year, a FIFO out 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 historical average in the mid teens.
A majority of the cancellations during the quarter due to elongated cycle times overall passenger density driven by consumer psychology, economic concerns and changes in personal financial position of our existing buyers.
Available inventory, both Rizal and you will continue to be a priority for buyers and we saw cancellations spiked in a market where there are other moving ready alternatives.
Given that about 60% of our backlog at September 30, 'twenty to 'twenty. Two was comprised of sales prior to Q3 with a higher all in AFP.
We are proactively offer our existing buyers price concessions were needed to narrow the spread between new Empire home prices. However, we continue to expect heightened cancellations cancellation rates in the near future until our older backlog closes out.
In the third quarter of 2022, a gross sales declined 14% year over year and absorption pace on gross sales was three eight per month, which confirmed there is underlying demand today.
With only approximately 300 completed homes to sell across all of our community. This quarter. We believe our gross 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 draw in 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, a preexisting backlog allows 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 homebuilding gross margin of 27% and lowest quarterly FCA G&A leverage of eight 1% led to a record high quarterly diluted EPS of $7 in Texas.
While we are proud of the efforts of all of our team members in achieving the exceptional Q3 performance. We also note that these results mostly reflect the closing of homes sold in a different sales environment and are based on current trends, we will not be indicative of near term quarterly operations.
And now that mortgage interest rates are 7% before additional rate hike, 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 accumulated to you and have a right for five years or several years, both our strategy of free 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 tool.
Including mortgage rate loss rate buy downs, increasing status and true base price reductions based on the needs of each community and many of our markets. We have supplemented these offerings by being more aggressive with increased broker commissions were pushing to find the optimal mix of incentives for each of our communities to get back to a goal of three or four net sales for them.
Normalized pace, so that we can find the market clearing slumped.
He 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 of our land pipeline in every market to determine which deals no longer achieve our risk return profile in today's housing environment, recognizing the light we need less lots under control in a slowing market.
We have pulled back significantly on new deals over the last few quarters as we have all the way out of the need for the next several years and it really keeps getting exceptional opportunities for.
Ah recently source deals and we are engaging with our land sellers to work through closing timeline extension many are giving us additional time as market conditions continue to evolve with.
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 where covenants comfortable terminating or ran off we.
We are also re underwriting all control deal scheduled to close in the balance of this year and early 2023 and are taking a much more conservative view to assure these deals still underwrite today. If these deals are no longer feasible at the land prices in the original contract we will negotiate with managed Dallas for a price reduction or walk away from the launch in 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 turning to slide five to share our operational statistics despite of all games cycle times, our third quarter closings of 3487 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.
Third quarter 2022 sales orders of 2000, and 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 August to use it.
Cancellation rate in Q3, a 30% increase from 10% in Q2, 2021 and 13% in Q2 2022, our third quarter 2022 average absorption pace was two seven per month, which was down from five point out for months in the prior year.
Moving to regional level trends on slide six consistent with the rest of the building industry, we experienced softer conditions in a year over year decline in order volume in all of our regions. During the third quarter. However, our $2 seven net sales for my page this quarter does not tell the whole story.
Overall, our east region outperformed our other two regions with an average absorption pace of three eight per month during Q3, almost all of our markets. In this region maintained our target pace as a result of the relative affordability of those markets.
Except for Austin, and the growing pains, we are experienced their taxes also performed well relatively well in light of current market conditions excluding.
Excluding often this region achieved in this auction page of three two 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 would have weighed heavily on our company's net sales per month outages.
We believe market performance in this region weakened significantly as a result of home price appreciation over the last few years materially exceeds the growth of local household incomes and some of those for a bounce regional supply chain delays in the U S. Let's review each region in more detail.
West region experienced the highest retail percentage of cancellations. This quarter ASC that ran hot over the last few years, mainly in Arizona, and Colorado impacted affordability and bio conference. We had the largest percent of cancellations in Colorado This quarter due to the significant supply chain issues at times, pushing our closings by a full quarter to you we continue.
To work with miscibility, 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 the market, which led to elevated cancellations with an average absorption pace of one four per month in Q3 consumers. In this market were sidelined contemporary pulled out of the market are clearly pivoted to readily available inventory.
In the short term a lesser markets proved more vulnerable to biohazards each quarter different buyback driven by both real and perceived tightened affordability, but we remain committed to having readily available homes adjusting prices more aggressively and offering a full range of tenants 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 remained strong representing 44% of the region's orders this quarter. Despite the impact of Hurricane Union at the end of September relative affordability in extreme low housing inventory in Florida, resulting in strong absorption pace of five point out net sales per month, and a 12% year over year increase in ASP is on order.
South Carolina was the only market to grow order volume this quarter, it's 37% year over year increase resulted from a significant community count ramp up over the last four quarters and ongoing relative affordability in the market.
The story in Texas with different across our markets in the region demand held up in Dallas and San Antonio. Meanwhile, often 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 continuing to face fierce competition from other builders. We do believe there is 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 in the near term to changing conditions in many of our markets make it challenging to accurately predict order demand going for however, we believe that favorable fundamentals in all of our markets will enable the right combination of competitive advantage.
To drive demand and regain sales momentum.
Now turning to slide seven we moderate our starts this quarter starting approximately 2700 homes in the first third quarter compared to over 5000 homes in Q2 2022 to align with our slower absorption volume.
We've spoken about our commitment to our strategy to maintain enough move in ready inventory that aligns with our sales team not arbitrary numbers and demonstrated that execution. This quarter. We ended the period with nearly 4000 Domino's spec homes in inventory or an average of 17 per community as compared to approximately 2800 specs or an average of.
11th was evident in the third quarter 2021. This is in line with our optimal level of four to six months supply, although the elongated cycle times 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 home closings. This quarter came from previously started inventory at September 32022, we have only approximately 300 completed homes to sell a 6% complete homes is up a bit from prior quarter, but 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, Cyclothyme hasnt changed since the start of year, we recognize that things generally aren't worsening, but were still approximately six to eight weeks of additional time from our pre COVID-19 construction schedules for iron trade like Lumbra roofing are starting to find additional capacity given the industry pullback and start back and trades like appliances flooring and 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 is look for potential alternative solutions.
However, with overall capacity, losing we are working with our trades and partners to secure cost savings and cycle time reductions and all of our markets.
We ended the third quarter with a backlog of approximately 6100 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 Hela to provide additional analysis of our financial results in Q4.
Before we dig into the Q3 financial results and you wanted to get a brief VFR update in Q3 of 2022, a higher percentage of our sales came from VFR over the last 12 months, we have strengthened our relationships with both national and regional VFR operators, we were able to more heavily lean into these relationships.
This quarter as we double that and pre sold both Q3 and Q4 volume while he believe in the continued long term resiliency of our VFR business, we anticipate slower near term VFR volume as these operators are after adjusting and adapting to the changing dynamics in the rental market 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, he does 12% greater home closing volume and 12% higher ASP compared to prior year 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 that deterioration from $29 seven a year ago, mainly resulted from greater incentive $8 8 million in write offs for option deposits in diligence costs and to a lesser extent higher direct cost in the third quarter.
Last year, we had about $900000 or biopsy terminated land deals. Excluding these write off home closing gross margins were 29, 3% in Q3, 2022, and 29, 8% in Q3 2021 we anticipate ongoing elevated incentive what's the road will flow through Q4 Mark.
And into 2023, which will outweigh the savings in 2023 from lower lumber cost. Although we are not protecting any other labor or commodity cost reductions at this time, we believe direct costs will essentially align with reduced production volumes, partially offsetting the incentives and price concessions.
G&A as a percentage of home closing revenue was eight 1% for the current quarter and 120 bps improvement over prior year. 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 up this quarter and will likely continue to do so given the evolving market conditions, along with increased broker commissions.
The third quarter of 2020 twos effective income tax rate was 23% compared to 23, 3% in the prior year. The 2022 rate reflects 13.1 million energy tax credits that came from qualifying homes. We delivered in the first nine months of 2022 is the inflation rate.
<unk> Act passed in August of this year retroactively extended the energy tax credit to the beginning of the year. The 2021 rate. Similarly benefited from the 20th 19 taxpayer certainty and disaster tax relief Act overall pricing power improved overhead leverage and a catch up of tax credits.
Combined with the 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 ASP.
This pricing power translated to a 270 bps increase in home closing gross margin to 31%, while as SG&A as a percentage of home closing revenue improved 110 bps to 823% both from cost savings and increased leverage we generated a 46% increase in net.
Income, earning $19 and 65% year to date diluted EPS.
Turning to page nine.
We believe we have ample liquidity and a healthy balance sheet to manage through this changing environment at September 32020, Q nothing was drawn on our credit facility and our net debt to cap was 18, 9%, which is below our maximum internal thresholds in Hy 'twenty. Our next debt maturity is in 2025.
Our cash balance was 299 million at September 32022, compared to $618 million at December 31st 2021, primarily as a result of increased inventory spend and we work to bring our started home closer to completion.
During the quarter, we focused our focus on our liquidity and did not repurchase any shares at September 32000, $20 million to $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.
<unk> and development spend we anticipate growing our cash position to maintain maximum flexibility and the uncertain environment, while considering other opportunity, 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 are real estate asset is conducted at least annually on a community by community basis or more frequently if needed we record impairment when the cash forecasted to be generated from the sale of homes in our community is not expected to cover the costs.
Is that community even at today's moderating price it and higher direct costs, we do not have any impaired communities. We do not anticipate driving broad based impairments in the near term barring further material ASP decline.
Onto slide 10.
After landing at 300 communities during the last quarter, we dropped temporarily to $2 75 as of September 32022. 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 list that we can open with our completed <unk>.
<unk> or available inventory in the current market, we are strategically waiting to open in certain communities until they're fully ready well will also delayed and 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 it.
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 early in for our newer market. We added about 1800, new lots under control this quarter less than 20% of the gross lots, we put under control in Q3 F. 2021 as mentioned we walked away from approximately <unk>.
T 200 lots a quarter with a corresponding write off of $8 $8 million. These terminated lot related to $470 million in future land and development spend that we will not be in crane on.
On a year to date basis, the $11.6 million of walkaway 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 deposit and due diligence costs associated with our entire portfolio of controlled but not.
One month at September 32020, which includes future phases of existing communities. All in this $110 million makes up less than 2% of our total asset.
During the third quarter, we spent about $380 million on land acquisition and development down from 526 million in the third quarter of 2021, and we've been reducing our land acquisition. Our land spend is leaning more heavily towards development of our own lot since maintaining 300 communities requires much less capital than <unk>.
Going to 300, we expect to spend significantly less in the $2 billion. We initially projected for this year.
At September 32022, we had 66348 lots under control, which reflects a reduction of 3419 loss compared to 69767 lot at September 32021 based on trailing 12 months closing, we had five point year supply of lots, 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 we'll continue to evaluate our future. Many over the next several quarters and that 69% of our <unk>.
Total lot inventory at September 32022 was owned and 31% with the options at September 32021, we had a 64% owned inventory and its 36% option 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 clothing to be between 4300 4700 unit home closing revenue of 1.85 to Q1 O 1 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 bank 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 margin will be materially impacted by aggressive incentive action as well as increasing costs for rate.
And buy downs in a rising interest rate environment. However, long term, we believe our normalized margins will settle to roughly 200 bps above our historical average of 20% as a result of operating leverage and more streamlined operations with that ill turn it back over to Felipe. Thank you you are 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 right.
Repower ties we paid we are committed to finding the market clearing price in each geography to get backhaul 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 our backlog I have more move in ready inventory bill and by rationalizing our land portfolio as Lloyd pointed out how new land deals we are limiting new investments to opportunistic new land deals only lastly, as good stewards of capital, we're managing too strong.
Balance sheet liquidity, we are constantly monitoring the evolving market conditions and remain dynamic and flexible our resilient business model allow us to gain market share and maximizing profits.
Profitability in the solar market with that I'll now turn the call over to the operator for instructions on the Q&A operator.
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Our first question comes from Stephen Kim with Evercore ISI. Please state your question.
Yeah, Thanks, very much guys and good results in a tough quarter tough environment. Thanks for all the detail that you provided I guess my first question relates to the.
The interplay of incentives and the cost that you described that you touched on when you describe what you think your margins going to do.
Next year and I think that 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 stay where they are let's call. It 7% environment do you think youre going to dip below that 22% or because of your.
Our land basis and various other things do you think that you'll you'll actually be probably a little bit above that longer term and then sort of drift down to a 22% you know in the out years.
Thanks, Stephen for that question.
I mean, the first thing.
We just don't know yet.
Yes.
Market dynamics are constantly changing and we're still looking for interest rate stability, which will then lead to price discovery, which will lead to stabilize absorptions and consumer confidence. 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 move inventory that being said we.
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 this what costs are going to do.
At this point, we're not seeing a lot of cost relief Ethernet starts begin to pull back if we're able to get our cost down as we continued to start homes and trying to gain market share that could help that can be a tailwind. So it's just really difficult to tell right now.
Tenants are moving all over the place price rollback, removing all over the place and to be able to forecast. What next year is going to look like as we sit here today it is extremely difficult.
No doubt.
And 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 or are you anticipating or incorporating in that number additional lot option Walkaways and then secondarily as you're experiencing.
You know a more difficult environment and 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 temporary or is that fairly a fairly limited in the quarter.
I'd say, that's fairly limited if we have to go back.
And kind of reset our backlog its 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 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 into our guidance.
Yeah, just to clarify we were at five plant in line year supply of land and four to five is that happy place there were 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 to.
We need some additional pressure on land pipeline or if we're okay, where we are.
Okay.
Great. Thanks, very much guys.
Thank you.
Our next question comes from Truman Patterson with Wolfe Research. Please state your question.
Hey, good morning, everyone and thanks for taking my questions first.
First Gila.
In the prepared commentary I don't think that I heard this but could you give what kind of third quarter incentive levels, including you know based pricing adjustments were for orders and then also I'm, hoping you can just go across your markets and discuss.
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.
Yeah. Truman this is Felipe I'll take that and then I'll have fewer jump in.
So the first question was what have we done with incentives and pricing.
We hope we don't really look at those things differently by the way, where a spec builder. So at the end of 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 came in the form of price rollback.
I'd say anywhere from 50 high mid teens 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.
You know again community by community because we have some communities, where we really haven't had to do anything in other communities, where we had to do more meaningful we may have rolled back net pricing.
Yes.
As you work your way to test that you know with the exception of <unk>.
Houston.
And often.
Its 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 these things have been relatively normal.
Sometimes just kind of normal incentives to move things normal adjustments in pricing to move team and we really haven't seen us.
Need to do much more than that so.
So hopefully that answered your question or you would you have anything to add to that nice looking backward at all.
Okay, Okay, perfect and then.
You know I I appreciate that color, we think of kind of you know incentives or price cuts as one and the same as well, but I'm, hoping you can help us understand you know.
What sort of incentives you won't find most beneficial and stimulating buyer demand. You know are you seeing today that you know pure base price cuts or more effective rate buy downs flocks.
It's Federer just trying to understand you know what you all are seeing move moved the buyer.
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 of a combination that works for that buyer is rates have escalated. So we just had to kind of buy down rate to help those folks with their payment.
In other markets.
It's Ben.
I have a combination of all of it.
Maybe some re buy downs, maybe some closing cost support and then maybe an adjustment in that pricing and then I think as we move west it's kind of become about the price you got to solve for the payment and then God sulfur the privates and that sort of one of the same but the price matters more than the west right.
Now because theres been a lot of price cuts.
By our competitors, so buyers really want to know that they're buying a home private stats.
With the market and they're not buying at the top of the market. They are 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 ready to it's all about closing costs and maybe some marginal incentives, but recently in the west it's become about price.
Look at it is.
You need a price cut to get people in the door. He want to feel like you're reacting appropriately to what's happening in the market, but then they want the rate locked by down to get the monthly payment to be what you want it to be it's a little bit of a balancing act between Q based on.
Demographics in each market and again I'll just reinforce.
So we're just we're spec builder so the price of the one is the price of the home, we don't break out lot premiums and option.
It surprises at all is your closing costs and it's you're right. Those are the three components of getting a buyer into the home.
Perfect. Thank you all for the time.
You're welcome thank you.
Our next question comes from Alan Ratner with Zelman and Associates. Please state your question.
Hey, guys. Good morning, Thanks, as always for all the great information.
Felipe I'm just curious have you been surprised by how quickly prices have reset I mean, I think if we go back three six months ago, a common theme, we heard from most builders was inventories incredibly tight and.
The industry is quite discipline this time around and.
It just seems like when you were talking about high teens price adjustments in a matter of three or so months that seems like its much more significant in terms of the rapidity than we've seen in prior downturns before so I'm curious if if.
The magnitude and the and the quickness of it has surprised you guys at all.
Yeah, absolutely I first of all I, just want to make sure that I clarify, but the high teens as mostly a west region kind of scenario, we haven't really had to do that elsewhere. It's it may be.
A little bit in Houston, So Houston communities, but what surprised me is how fast rates have gone up.
I Couldnt really imagine a scenario where mortgage rates have done what they have done over the last four months. So that's created this scenario, where it's all it's really created the perfect storm for pricing happened to roll back as materially as it has to solve for.
The lack of consumer confidence the lack of the uncertainty in the economy.
And the you know the.
The rate and the payment that people are comfortable with so.
That's what has created this environment. So am I surprised that when rates double prices have to roll back this meaningfully now.
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 in our industry. So no I'm not that surprised given where rates are and just to clarify that that mid teens at mid teen incentives.
Our all in reduction that includes what we're offering on the rate lock. So that is included in that and I in represent in many cases in the <unk> portion of that of that reduction it reduces price COVID-19, what we're giving a buyer even if we're not actually we can see.
The base house price, so just to clarify it's not a huge reduction in baytown tight that's visible in the marketplace to other consumers.
The consumer today is pretty shaken and at this point, if theyre 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.
It's about the price.
Got it that makes sense and certainly appreciate it yeah.
And rates here was was it a lot greater as well than I anticipated.
Hilla and I'd love to circle back to the comments that you made on on impairments and kind of the stress tests there and.
Kind of tie that into a little bit the the price adjustments you've made out west. So yeah, 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 how much price depreciation there had been there, but I guess, if if we're assuming those communities might have peaked out at gross margin.
Somewhere in the thirties, and we've already seen kind of mid teens adjustments and absorptions are are still lagging kind of your three to four target rate.
Why isn't there more concerned about those projects being appeared in the near term.
Yeah. That's a fair question the math is almost right and so there is quite a bit.
A few of these communities are experiencing the most severe ah incentive need actually were north of 30, so they are coming down even.
Cloud 13, 14%, they're kind of coming back down to normal and that assumes no cost.
So there are some costs that are occurring out there today, there's going to be more.
As that lower cost number rolls through our financial statements. So it's a combination of those two that are still keeping their community.
Certainly lower than where we have been the last couple of quarters, but not not yet.
And Tammy territory danger zone.
Our likelihood that may be a couple of them may find to it maybe you always had cats and dogs in your portfolio. We haven't in the last two years back beyond that every other every other year, we certainly do back and again barring something really really material like another 15 or 20% price reduction from.
Todays price of that are already reflecting a reflecting a decrease is it's hard to.
It's hard to model, a scenario, where you're having kind of a wholesale impairment similar to what we had in the last in the last cycle.
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 at 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, and get to that three to four level or is it just simply a matter of the consumer adjusting to the new reality and it doesn't it almost it almost doesn't matter what prices offered it 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 they're certainly around rates I think we have plenty of room to find that in fact, the adjustments. We've made recently that really are in that low teens high teens in the.
Where we've seen pretty strong response on the gross 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 buy it six months ago, but yeah. We're fighting a reasonable rate with you said as we put in the market.
Or I guess you'd say the price adjustments, we put in the market. Our gross sales were pretty optimistic about what our gross sales looked like I.
And then just to clarify we're not going to be we're not going to be a ridiculous and are classifying three to four net sales came out that there is no other assisting in certain market. There's just no as I sit in either market, but right now we're not seeing indications of that but that's the fact pattern, but is that is we can certainly slow down.
Our expectation for certain markets and accelerate them for us from others, but as we've mentioned our gross sales are showing that there is demand it's the cancellation.
The cancellations that are coming in from some older inventory, where there's a little bit of fear.
In a market that that's causing that but at today's pricing. There's a healthy demand that we're still seeing in almost all of our community.
Great. Thanks for all the time and color I appreciate it.
Yeah.
Our next question comes from Mike Rehaut with Jpmorgan. Please state your question.
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 and and you know it.
When you think about the.
Adjustments that you've made throughout the quarter are you expecting to 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 demand elasticity or lack thereof.
You know or are you going to be satisfied with a lower.
Pace going into the fourth quarter as well.
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.
Felt a little bit better in August because rates kind of stabilized and rates like crazy again in September it pull back.
October was kind of felt like.
However, we're not in October so.
October 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 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.
Certainly.
The things, we're doing around pricing and other stuff is helping driving driving some more traffic more interest in our products.
The cancellations are still moving around quite a bit on us.
It's kind of unpredictable at this point.
It's just kind of hard to say in the short term.
What do you expect Q4 is traditionally a slow time.
And housing in general even when things are normal and good. So I think we're all under the impression that it'll be the spring before we really know what true demand looks like.
No. That's that's very helpful. Thanks Felipe.
I guess secondly, kind of just shifting too.
Net pricing.
And gross margins.
If you could also try and give us a sense of I mean, you guys were obviously one of the first two.
Incentivize the backlog you know give the rate locks chewed through a good portion of the backlog and Ah Yeah, maybe even ahead of your peers.
I was just trying to get a sense of you know.
We're kind of on average.
Incentives slash based 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.
Higher levels of incentives slash.
Base price reductions.
When you think about.
The impact on gross margins.
You know it would it would suggest that.
First quarter gross margins might be lower than fourth quarter, I guess, what I'm trying to get at is.
You know.
Side 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.
You know relative to you know the fourth quarter our guide.
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 first quarter, that's really meaningfully reflecting the rate lock with many other incentives that we offered so there was a decline clearly some key Q to Q3, and then we guided towards 25% all in margin for Q.
For the there's a further pull back from 29, 3% that we had this quarter without without the walkaway charges down to 25, that's fairly material youre going to continue to see.
We gave directional guidance into 2023 that we expect the higher incentives and the higher.
Weight loss cost and rate buy down cost to flow through the numbers in 2023, if you don't have a lot of visibility.
Not in totality, because we're still working through those numbers and as our competitors choose to take certain price action, sometimes that necessitate adjusted.
Adjustments on our end as well so while we know what our numbers are today, if other folks in nearby community at choose to take other actions. We may have to go back to our backbone and take incremental actions a cancellation.
It's very difficult to provide an expectation of a margin although directionally, it's likely lower although Q4 is 25%.
Desert flat at the full composition.
It started about rate locks.
Carl.
The end of Q1, we mentioned that we bought rate locks for everything including the end of 2022, you're really seeing that coming full force in that 25%.
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 sign in the guidance, we've already given for Q4.
Great. One last quick one if I could you mentioned, the VFR contribution or sales to BFR and three Q and I believe you said for Q I was hoping you could break that out and you know what we've heard from.
You know VFR the VFR community is that by and large those.
Participants are have shifted to the sidelines as well in the hopes of.
Getting homes at a lower price than today.
Perhaps similar to consumers.
Yeah. So just wanted to get a sense of what that contribution to orders were.
During the second the third quarter, what 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 a potential pullback in that demand and in 'twenty three.
Yeah.
Yeah Fair question, we don't give out specific numbers or percentages, although we did presell, our Q4 volume for VFR into Q3, so the numbers a little higher than where we typically run our long term goal is.
High single digit low double digit.
We're not we're not quite there yet.
We agree there is a pullback ally to operators have said, hey, we need to kind of assess the market.
It's really just affecting the rental operators now why it was affecting us maybe six months ago. So they're a little bit of a pipe trying to figure out how theyre new underwriting looks out of many have indicated to us that they're back in the game for 2023, they're there.
They are capital allocations are full for the current year are mostly fall for the current year, but they do expect additional volume in 2023 that one exception I'll stay there is on when you're selling entire community and you've already kind of pre contract. It and you have a consistent cadence out.
There is some of that volume that's just ongoing.
<unk> negotiated prices and makes sense in that operators seeking an entire community from you that you will still continue to see some.
Some volume, although we definitely agree with what Youre 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.
Thank you.
Our next question comes from Carl Reichardt with BTG. Please state your question.
Thanks, Thanks for all the helpful detail you.
I wanted to ask about the finished spec Felipe is is the relative shortage compared to what you like a function of customers Sopping up product as it gets close to finished age are more related to the difficulty in the supply chain and then as you get to the spring selling season ideally what percentage of your of your available product would you like to be.
Finished or or very near finished versus what it might be yes.
Thanks for the question.
So it's definitely 100%.
As a result of the supply chain issues.
When you have finished specs were able to move up and we just haven't been able to reduce our cycle times and get enough finished specs in the market and I think with the slower demand environment. It's created an opportunity for us to do that we typically like.
A third of our specs by community to be move in ready in the next 30 days for those folks that are moving out of apartments and they are moving now we like a third of them to be within a 62.
45 to 60 day window, and then a third of them to be a little further out. So as you think about 300 communities. If we're looking for three to four per month.
Somewhere between 337 hundreds back soon 4200 specs across those communities and we'd want a third to be move in ready so close to 1000.
Maybe a little bit higher than that and then a third of those to be slightly further out and then the third that we just started into our 90 to 120 days out. So that's how we think about it if demand slower obviously that would be a lower number if demand is stronger than it would be a higher number I think we're still seeing some communities out there that are doing more than four.
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.
Okay. Thank you Felipe and then.
Are you seeing consumers, even talk or think about arms today I know this spreads versus 30 years aren't necessarily terrific, but I'm curious what what their attitude is towards the potential for utilizing adjustable rate mortgages to get into the houses.
There is definitely an increased interest in.
The seven year arms at 271, now at reset or 76, I guess it resets every six months.
So there's definitely interest you can get them at really affordable prices.
Get your monthly payment down to a reasonable amount with.
With the average American being in their home six nine years seven year arm feels pretty good and most of our entry level buyers will stay in home just about that time hopefully during that time, if they choose to stay there longer and be a refinance opportunity.
The seven year arms are definitely coming back and popularity.
Okay. Thanks Hilla.
Thanks.
Thank you. Our next question comes from John Lovallo with UBS. Please state your question.
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.
Yeah, that's a great question it actually wasn't it was kind of across the board.
Where it was concentrated in stock was in stuff that.
We control recently.
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 consciously concentrate it wasn't in any specific region.
Yeah.
Probably equally distributed across all three.
Okay that makes that makes sense. Thank you and then you know.
He led one of your comments about being a little bit more conservative with cash makes sense, but you know how much cash with 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.
And a lot of number because we won a lot of cash et cetera.
We definitely are focused on making sure we have.
Kathy or a cat just in case, you don't know what the world is 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 over prepared in this situation. We do think that we're going to start to be asked fairly cash flow positive over the next couple of quarters here.
We pulled back on land acquisition and development spend are you really start to be accretive either.
Unit 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 notes.
Yeah.
Our nearest maturity the attic genotype still a really really attractive rate and the 25 at the outset and an attractive rate by them. 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 I would just amplify what she decided.
Is.
You can't have too much right now.
And we don't know if this is going to be.
One year deal or a multiyear deal still too early to tell but if it's a multiyear deal.
Deal with that 2025 maturity. So we're planning for a multiyear right now until we know what's not.
Makes sense, thanks, a lot guys.
Our next question comes from Dan Oppenheim with Credit Suisse. Please state your question.
Thanks very much.
But more in terms of just the the thoughts in terms of.
The the specs are.
The comment is about the sort of expectation of a further deterioration buyer confidence just with the the 17 specs.
They are procuring 80, now where do you see that sort of going over the course of the fourth quarter sort of where we get into sort of a little less.
It got 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 of this year and touch.
Well, we hope to move some specs this quarter for sure.
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 than.
Nine to 12 specs per subdivision feels like the right number and that kind of gets you to somewhere around somewhere between three and 3000 4000 stacks 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 or phone.
Just on moving quickly locking in the rate and closing.
Versus waiting it's also obviously in our opinion way more effective at managing margins and costs.
Securing the trade capacity out there in a tight labor market. So.
We slowed it down dramatically I think we're going to try to move some of this inventory in Q4 and Q1 to get it down to that target rate of nine to 12 per subdivision, which is somewhere between three and 4000 stacks depending on how the demand is we want more.
Three obviously a lot more as we roll into the spring and less as we roll into the winter just to manage the seasonality.
Yeah makes sense and I guess, then in terms of the the market share goals and where you'd like to be in terms of that with the the pace over price.
I think we've seen some other builders sort of pulling back and sort of start and then you certainly started if your 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 a fierce competition from in Houston and such.
And then staying in terms of this overall tight supply environment.
No that's not our strategy.
We drive pace and then the margin we pick 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.
When we slowed our 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, where an entry level builder, our asps are lower.
So the best return for our shareholders is to achieve that three or four net sales per month and figure out where the margins are afterwards.
Thank you and ladies and gentlemen, that's all the time, we have for questions I'll now hand, the floor back to Phillipe Lord for closing remarks. Thank you.
Thank you operator, I'd like to just thank everyone, who joined the call and your continued interest in Meritage homes I Hope you have a great rest of your day and great weekend. So thank you.
Thank you. This concludes today's conference all parties may disconnect have a good day.