Meritage Homes Corporation (NYSE:MTH) Q3 2023 Earnings Call Transcript

Meritage Homes Corporation (NYSE:MTH) Q3 2023 Earnings Call Transcript November 1, 2023

Operator: Greetings, and welcome to the Meritage Homes' Third Quarter 2023 Analyst Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Emily Tadano, Vice President of Investor Relations and ESG. Thank you. You may begin.

Emily Tadano: Thank you, operator. Good morning and welcome to our analyst call to discuss our third quarter 2023 results. We issued the press release yesterday after the market closed. You can find it along with the slides we will refer to during this call on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom of our homepage. Please refer to Slide 2, cautioning you that our statements during this call as well as 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.

A real estate investor inspecting a property, illustrating the bank's portfolio of mortgages and real estate investments.

Our actual results may be materially different than our expectations due to a wide variety of risk factors, which we have outlined and listed on this slide, as well as in our earnings release and most recent filings with the Securities and Exchange Commission, specifically our 2022 Annual Report on Form 10-K and our most recent 10-Q, which contains a more detailed discussion of those risks. We also have provided a reconciliation of certain non-GAAP financial measures referred to in our press release as compared to their closest related GAAP measures. With us today to discuss our results are Steve Hilton, Executive Chairman; Phillippe Lord, CEO; and Hilla Sferruzza, Executive Vice President and CFO of Meritage Homes. We expect today’s call to last about an hour.

A replay will be available on our website within approximately two hours after we conclude the call and will remain active till November 14th. I will now turn it over to Mr. Hilton. Steve?

Steve Hilton: Thank you, Emily. Welcome to everyone listening on our call. I'll start by touching on what we're experiencing in the Markets Day and recent company achievements. Phillippe will cover our operational performance, Hilla will provide a financial overview of the third quarter and forward-looking guidance. The home buyer environment this quarter was impacted by the same overarching macroeconomic factors that we've been experiencing since mid-2022. Mortgage rates remain elevated and have now increased to nearly 8%. Meanwhile, millennials and baby-boomers are still collectively having life events that create need-based housing demand, but they are finding limited inventory due to the chronic shortage of existing home listings in the market as current homeowners are wearing and believing they're below market mortgages.

With this backdrop, home buying demand held steady in the third quarter of 2023 as we use financing incentives to help customers solve for a monthly payment for our selection of available stack homes. Our third quarter 2023 sales orders increased 50% over last year's third quarter and we achieved an average absorption pace of 4.1 per month. Further, we achieved a record backlog conversion of 96% to generate our highest third quarter of closings of 3,638 homes and home closing revenue of $1.6 billion. Home closing gross margin for the quarter was 26.7%, which combined with SG&A of 10.1%, led to diluted EPS of $5.98. Now on to Slide 4 for our recent milestones. During the quarter, we announced our entry into Jacksonville, Florida is how long a successful history throughout our Florida divisions and with several recent land acquisitions, we are excited to start to generate closings in Jacksonville later in 2024.

As a result of our strong workplace culture and employee engagement, Meritage became certified as a great place to work this quarter. We were humbled to be added to the prestigious group of companies with this designation. We were also proud of the continuing acknowledgment of our corporate citizenship -- as it relates to sustainability, we received the EPA's 2023 Indoor airPLUS award for the third consecutive year for building healthy homes and joined Green Builder Media's 2023 ECO Leaders List. We also earned two honors in our headquarters' hometown for our social initiatives by making Arizona most admired companies of 2023 list and we named one of the 2023 Arizona Business Angels Honoree. In August, we published our 2022 ESG report with the enhanced TCFD task force on climate-related financial disclosure data, we have progressed along our ESG journey and encourage the investor community to learn more about our stakeholder engagement, national vendor survey and expanded UN sustainable development goals detailed in that report.

And with that, I'll now turn it over to Philippe.

Phillippe Lord: Thank you, Steve. When looking at the current market dynamics, we believe Meritage has two distinct competitive advantages. First, we built stack and provide affordable move-in ready inventory, so we are offering the most desired criteria in homebuilding today. Second, as a large public builder with long-term mortgage financing relationships, we were able to access interest rate locks and rate buydowns that today's customers in searching for to ease the impact of higher monthly payments. We are providing our local teams with a toolkit of available financing solutions that can be customized to each potential homebuyers needs, allowing us to merge the benefit of being a top five builder with the personal service and agility that are required to sell homes in today's markets.

Existing home sellers cannot replicate the financing incentive and even smaller private builders may struggle to do so. Consumers reacted positively to our incentives this quarter, resulting in an average absorption pace of 4.1 in Q3, slightly above our target range even in a tough rising rate environment. We also benefited from the further loosening of the supply chain and stabilization of labor this quarter, which helped shorten our construction schedule another 15 days from Q2 to Q3 or a cumulative reduction of over 50 days so far this year. This improvement brings us closer to our internal target of turning our inventory three times a year and to driving increased cash flow. Our structural time for 140 days in Q3. Our operational improvements and careful attention to local market needs resulted in this quarter's stronger sales pace, incremental closings and backlog conversion nearing 100%, significantly exceeding our goal of the high 80s.

Now turning to Slide 5. Our sales orders for the third quarter were 3,474 homes with 88% of the volume coming from entry-level homes. Orders were up 50% year-over-year due to a stable housing environment and a cancellation rate of 11% this quarter, which was below our historical average in the mid-teens. As a reminder, last year, our cancellation rates spike to 30% in Q3 when the rapid rise in mortgage rates impacted by technology. Going forward, we expect Q4 to have a similar year-over-year dynamic as Q3. ASP on orders this quarter of $430,000 was up 2% from prior year due to geographic mix. The third quarter of 2023 average sorption pace of 4.1 per month improved from 2.7% in the prior year. We believe Q4 demand will remain steady, although we do see traditional seasonal patterns returning and ongoing concerns regarding interest rate volatility.

So we plan to carefully monitor our available finance fee incentives and adjust as needed in order to maintain our sales pace on our targets. In the third quarter of 2023, our average community count of 282 was 3% below prior year, and down 1% sequentially compared to the second quarter of 2023. As a result of early community closeouts due to the strength of demand in the market. We opened 20 new communities this quarter and remain focused on our commitment to get back to growing our community count in 2024 as we acquire additional land and work to develop our existing land inventory. We still anticipate further choppiness over the next few quarters, but expect the general community count trend to increase two and beyond our 300-community target over the next year or so.

Slide 6, moving to regional level trends. Our strategy at pace over price led to improvement in our sales pace in the third quarter across all geographies, both year-over-year and sequentially from Q2 to Q3. The Central region had the highest regional abridge absorption pace of 4.5 per month compared to 2.7 last year. The job growth and in-migration environment in Texas, coupled with our steady spec production enabled our Central region to convert over 100% of its backlog this quarter. With the highest regional completed spec inventory at the end of the quarter, we believe this region is well positioned to maintain a strong sales pace. The East region had an average absorption pace of 4.3 per month this quarter compared to 3.8 in prior year, capitalizing on stable market conditions as average community count held study.

With some of the tightest home inventory in certain markets, the cancellation rate in this region was in the single-digit this quarter, well below our historical averages. Looking at October results, demand is still solid in these markets. The West region had an average absorption pace of 3.6 per month compared to 1.5 per month for the same period in 2022, benefiting from improved bio psychology and a cancellation rate in line with company average this quarter. The 116% improvement in order volume in the region, coupled with their highest fees drove the consolidated level mix shift and resulted in an increase in order ASPs this quarter. Market conditions in selected markets like Denver and Houston continue to be some of the most challenging in the country, resulting in a lower monthly pace as we continue to work through the right combination of financing incentives in these markets.

Now turning to slide 7. During the third quarter of 2023, our closings of 3,630 homes were 4% greater than prior year, due to a shortened cycle time and the commitment to our spec building strategy. With over a-third of the homes we closed this quarter also sold intra-quarter, we achieved a record backlog coverage rate of 96%, which compared to 48% last year. We believe we can maintain the 80% plus targeted conversion rate consistently with the normalization of construction time lines. Given the steady strength of the housing market, our quarterly starts of approximately 4,000 homes in the third quarter, was up 47% from about 2,700 in the prior year and remained in line with the stars cadence in Q2 this year. We ramp-up or down our stars per community as necessary to align with our sales pace.

Looking to Q4, we expect to replenish our spec inventory by starting around 4,000 homes to ensure sufficient move-in ready inventory for the 2024 spring selling season. We ended the third quarter with approximately 4,900 spec homes in inventory, which was up 10% sequentially from nearly 4,500 specs in the second quarter. This represented 18 specs per community this quarter, which equates to 4.4 months supply of specs on the ground. This is in line with our optimal level of four to six months of supply. Of our home closings this quarter, 89% came from previously started inventory, up from 75% in the prior year. 16% of total specs were completed at September 30. While we target our run rate for completed specs of about one-third and given sustained high demand for completed inventory, we are still working to meet this goal.

Our ending backlog at September 30, 2023 totaled approximately 3,600 homes down from about 6,100 in the prior year, and slightly down from nearly 3,800 at June 30, 2023. I will now turn it over to Hilla to walk through additional analysis of our financial results. Hilla

Hilla Sferruzza: Thank you, Phillippe. Let's turn to Slide 8 and cover our Q3 financial results in more detail. Home closing revenue increased 3% to $1.6 billion in the third quarter of 2023 driven by 4% greater home closing volume, which was partially offset by a 2% decrease in ASPs due to more costly financing incentives. Home closing gross margin decreased 200 bps to 26.7% in the third quarter of 2023 from 28.7% in the prior year from the same financing incentives with rates hovering around 8%, our continuing commitment to purchasing rate buydowns and other financing incentives is more costly than what we were paying for similar financial solutions in 2022. This quarter's 26.7% gross margin increased 230 bps sequentially from Q2, benefiting from cycle time reductions and greater leverage of fixed costs.

Although our teams are continuing to pursue rebuild and are in constant negotiations with our national trades, our total direct costs held steady this quarter as the acceleration in industry starts since January has left little excess capacity in the homebuilding supply chain. Outside of lumber, costs related to all other building materials and supplies are still higher than historical norms, and our direct cost savings are primarily derived from improvements in production times. We believe our target of gross margins of 22% plus remains achievable, although we do expect today's still elevated margins to be potentially impacted in future periods by continuing financing incentives and some stock costs starting to come through our financials from record high land development costs incurred over the last couple of years.

Since we know it's front of everyone's mind, I wanted to quickly touch on our customers' credit metrics and what we're seeing in our mortgage operations over the last several quarters. Even with 80% to 85% of our buyers receiving some sort of financing incentives, our qualified buyer profile remained consistent with our historical averages, with FICOs near 740, DTIs around 41 to 42 and LTVs in the mid-80s. Since March of 2022, we have been offering some combination of rate lock and rate buydown assistance like our current 5.875% 30-year fixed rate lock. However, these rate locks were utilized by less than 20% of our closings in Q3, although usage has ticked up a bit in our Q4 backlog. The rest of our customers are using other forms of less expensive financing incentives from 321 or 21 buy-downs, arms and just traditional rate locks or rate buydowns that are not part of our larger forward commitment.

We expect utilization of financing incentives to remain elevated and likely more costly at least for the short term as uncertainty around future interest rates is still driving a desire for rate locks. SG&A leverage in the third quarter of 2023 was 10.1% compared to 8.1% in the third quarter of 2022. Higher commissions comprised about 130 bps of the change with the balance primarily relating to higher employee count, mostly within our start-up markets as well as the wage growth pressures. With our increased specs, we also had higher expense this quarter associated with maintaining this larger volume of inventory. We are actively working to reduce our SG&A leverage and expect long-term averages to be in the high single digits. In the third quarter of 2023, we recognized a loss on the early extinguishment of debt of $900,000 in connection with the $150 million partial redemption of our 6% senior notes due 2025 there were no debt redemptions in 2022.

The third quarter's effective income tax rate was 22.4% compared to 20.3% in 2022. Although the 2023 rate benefited from the energy tax credit at the higher $2,500 per home level in effect this year, nine months of energy tax credits were recognized last year in Q3, when the new energy tax lot was retroactively approved. Overall, the lower gross margin, greater overhead costs and a higher tax rate partially offset by increased home closing revenue led to a 16% year-over-year decline in the third quarter 2023 diluted EPS to $5.98. This performance resulted in a book value per share of $121.29, up 20% year-over-year and a return on equity of 18.1%. To highlight a few items from the September 30, 2023 year-to-date results compared to 2022, orders were up 4%, closings were up 5%, our home closing revenue increased 5% to $4.4 billion.

We had a 540 bps decline in home closing gross margin to 24.7%, primarily due to more costly financing incentives, SG&A, as a percentage of home closing revenue was 10.0% from higher commissions, compensation and technology spend and net earnings declined 26% to $539.9 million. As we turn to Slide 9, we wanted to share a follow-up to last quarter's upgrade by S&P, Fitch has also just elevated us to investment grade with a BBB- rating. We appreciate that two reading agencies have recognized our disciplined approach to balance sheet management even as we pursue a comprehensive plan that encompasses both growth in the business and returning capital to shareholders. We were very active this quarter in our capital spend activities through a three-pronged approach.

First, we accelerated our investment in internal growth this quarter with $537 million spent on land acquisition and development, which was up 41% from prior year and up 31% sequentially. On a year-to-date basis, we spent $1.3 billion, and we expect full year 2023 land spend to total north of our prior expectation of $1.5 billion, as we replenish our land portfolio after a short hiatus from land acquisitions that started in the latter half of 2022. As for the next year and onwards, we plan to spend $2 billion plus on land acquisition and development, as we look to grow our community count 10% to 15% on an annual basis. Second, we also prioritize returning cash to shareholders by repurchasing over 3,019 shares of common stock for $45 million this quarter.

This brings our year-to-date 2023 spend to $55 million buying back about 413,000 shares of stock or 1.1% of shares outstanding at the beginning of the year. Over $189 million remained available under our authorization program as of September 30, 2023, and we'll continue to be opportunistic with our share repurchases. This quarter, we also spent $9.8 million on our quarterly cash dividend payment of $0.27 per share, and it is our intent to reset the dividend amount in the first quarter of each year. And lastly, we redeemed $150 million of our 6% senior notes due 2025, using our excess cash this quarter, $250 million remained outstanding under the notes as of September 30, 2023. Even given all of our internal and external capital uses, we continue to generate positive cash flows, maintained ample liquidity and a flexible balance sheet and remain below our net debt-to-cap ceiling of the high 20s percent.

We had nothing drawn on our credit facility, cash of $1 billion and negative net debt-to-cap of 1% at September 30, 2023, as well as generated $460 million in operating cash flows and $187 million of total cash flows so far this year. In the last five years to seven years, we have been disciplined in reinvesting back in the company and repurchasing equity. This year, we also implemented paying quarterly cash dividends. It is our intent to continue prioritizing both growth in the business and returning cash to shareholders, and we have structured our capital plan to do so. On to slide 10. We picked up momentum on land deals in Q3 by putting approximately 5,000 net new lots under control compared to about 2,800 in Q2. We owned or control a total of about 6,700 lots at quarter end, slightly higher than when we started the quarter.

This equated to 4.2 year supply of lots at September 30, 2023, which compared to about 66,300 lots or 5.1 year supply of lots at September 30, 2022. The new lots added this quarter represent 37 future communities, all for entry-level product. We also have almost 30,000 of additional lots where we're still undergoing due diligence that we're actively pursuing. Our ability to source land that meets our return hurdles has not been impeded by the flurry of land acquisition activity. Land is always competitive where we have been successful in finding dirt that underwrites to for 4 net sales per month pace and our IRR and gross margin hurdles assuming today's current ASPs and direct costs. About 74% of our total lot inventory at September 30, 2023, was owned and 26% was optioned.

In the prior year, we had a 69% owned inventory and a 31% option lock position. While we're always looking for ways to carry our land off book, we don't artificially create a financing vehicle to target a specific percentage of option land. We have land bank when it makes sense for a specific deal. Otherwise, we've been able to fund our growth through retained earnings. Our balance sheet is in good shape, especially in light of the recent upgrades to investment grade, and we look to leverage this cheaper capital. While we haven't been an active player in the land banking markets recently, as we look to grow our land position and we see market conditions stabilizing, we do intend to utilize land banking more frequently in the near future. Finally, I'll direct you to slide 11 for our guidance.

Our spec strategy, combined with cycle times that have started to normalize, give us visibility into the next quarter's potential closing universe based on our over 3,600 units in backlog and another approximate 4,900 specs in the ground today. For Q4 2023, we are projecting total closings to be between 3,500 and 3,700 units, home closing revenue of $1.45 billion to $1.53 billion, home closing gross margin of 25% to 26%, an effective tax rate of about 23% and diluted EPS in the range of $4.84 to $5.43. While we expect to provide 2024 guidance next quarter, we do anticipate an acceleration in our closing units in the mid to high single digits next year. With that, I'll turn it back over to Philippe.

Phillippe Lord: Thank you, Hilla. To summarize on slide 12, in the third quarter of 2023, we focused on pace by offering financing incentives and achieved an average absorption pace just above our internal goal. We believe housing market demand will remain steady in the near future. Although with the turn of normal seasonality and some near-term volatility from interest rate concerns, we will continue adjusting our suite of financing incentives in order to maintain our sales pace target. With higher order volumes, we gained the operational efficiencies and improved leverage of fixed costs to drive better financial results. We believe in our proven business model of prestarting 100% of our entry-level homes. We are replenishing our move and ready inventory with approximately 4,000 starts a quarter to align with our sales pace and to meet the anticipated Q4 and 2024 spring selling season demand.

With normalizing cycle times, we can deliver homes faster and turn our inventory three times a year. Even with the choppiness in our community count over the next several quarters, we believe we can deliver 13,525 to 13,725 homes this year and drive sustainable long-term growth. With that, I will now turn the call over to the operator for instructions on the Q&A. Operator?

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