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Meritage Homes Corp
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Greetings and welcome to the Meritage Homes First Quarter 2023 Analyst Call. At this time all participants are in a listen-only mode. [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.
Thank you, operator. Good morning, and welcome to our analyst call to discuss our first quarter 2023 results. We issued the press release yesterday after the market closed. You can find it along with our slides we’ll refer to during this call on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom of our homepage.
Please refer to Slide 2, cautioning you that our statements during this call as well as 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 2022 annual report on Form 10K, which contains a more detailed discussion of those risks. We have also 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 through May 11.
I’ll now turn it over to Mr. Hilton. Steve?
Thank you, Emily. Welcome to everyone participating on our call. I’ll start with a brief discussion about what we are seeing in the market and provide an overview of recent company milestones. Phillippe will cover our strategy and quarterly performance. Hilla will provide a financial overview of the first quarter and forward-looking guidance.
In the first quarter of 2023, we leaned into our spec strategy and achieved a net sales pace of over four per month by offering our move-in-ready inventory with the right mix of lower pricing and incentives. We also successfully managed backend production, generating our highest first quarter closings of 2,897 homes with home closing revenue of $1.3 billion, both of which slightly exceeded prior year.
Home closing gross margin for the quarter was 22.4%, which combined with SG&A of 10.3% led to diluted EPS of $3.54. The start of the spring selling season has been stronger than anticipated despite ongoing economic uncertainty, the regional banking turmoil and continuing volatility in interest rates. We saw demand begin to stabilize as buyer start to achieve – start to acclimate to a 6% to 7% mortgage interest rates as the new normal.
The true shortage of readily available new inventory coupled with extremely limited resale inventory persisted throughout the U.S. in the first order and doesn’t show any material signs of loosening in the near term. We expect this continuing housing undersupply as well as favorable demographics for the millennial and move-down buyer will provide a strong inventory runway – for strong long-term runway, I’m sorry, for future home buying demand.
Now on to Slide 4. Gives me great pride to announce that Meritage is now a top five builder in the United States based on home closings in 2022. The milestone is a result of our focus on affordable entry-level homes and our spec building strategy combined with our team’s consistent exceptional performance. This quarter we were also recognized as one of the Most Admired Home Builders by Fortune magazine, which is based on feedback from executives and the Board of Directors regarding customer satisfaction, employee engagement and development, innovation, social responsibility and financial strength. We’re honored to join other best-in-class organizations on this list.
Additionally, we became a 10-time recipient of the U.S. EPA’s ENERGY STAR
Partner of the Year, Sustained Excellence Award. Given our long-standing commitment starting in 2009 to build 100% energy efficient homes, we have completed over 112,000 Meritage ENERGY STAR certified homes and are proud to be an innovator in the sustainability space. These achievements are aligned with our corporate values and further our goal to continue to grow our responsible corporate stewardship.
And with that, I’ll now turn it over to Phillippe.
Thank you, Steve. I believe our Q1 results were a testament to our strategy, which includes our focus on the most affordable segments of the market, building specs and our streamline operations. We achieved our success this quarter by addressing the portion of the housing market buyers with the greatest need for homes as life events are necessitating a change in dwelling for them.
Further, differentiating our product by offering homes that are move-in-ready, affordable, and have surprisingly more value via upgraded finishes and energy efficient components and automation suite allows to be an attractive alternative to available resale inventory.
Slide 5. Given our team’s strong execution during the first quarter of 2023, our Q1 closing of 2,897 homes was 1% greater than prior year. Entry-level homes comprised 84% of closings compared to 86% in the prior year.
Our sales orders of 3,487 homes this quarter were up 93% sequentially from the fourth quarter of 2022 while down 10% compared to last year’s challenging cost, which resulted from a 14% decline in average absorption pace from 4.9 to 4.2 net sales per month. That was partially offset by a 4% growth in average community count. Entry-level homes comprised 87% of orders compared to 83% in the prior year. The cancellation rate for the first quarter 2023 of 15% moderated sequentially from 39% in the fourth quarter of 2022 and was in line with our historical averages.
We exceeded our target for store sales objectives of three to four per month in the first quarter of 2023 due to the available of move-in-ready homes, which is the most preferred type of inventory for first-time home buyers. And in combination of price cuts, mortgage rate locks and buy-downs and other incentives as customized to the customer expectations in each of our communities. We have seen a slight increase in our ASPs as is visible in our Q1 orders. The sequential quarterly ASP increase in orders is due to three factors.
First, we started to pull back on incentive this quarter to the tune of about $8,000 to $10,000 per home. We also started to test our markets with small price increases in geographies where supply is particularly tight and prices are more elastic. In addition to mix slightly impacting our results as well. Our Q4 order ASP was also impacted by the higher ASP on cancellations that quarter from earlier 2022 sales, which also decreased our Q4 orders ASP as the number we report is a net ASP.
Now moving to Slide 6, regional-level trends. Meritage is a builder with a balanced geographic footprint between East, Central and West regions. All of our regions achieve or exceeded our sales pace target in the first quarter of 2023. The highest regional absorption pace of 4.5 per month in the first quarter occurred in our West region. This market regained the most sales momentum as we were able to find the right market clearing price in late 2022.
Arizona’s average absorption pace of 5.2 per month was the highest, yet its year-over-year decline in ASPs on orders was also the largest, reflecting the magnitude of the pricing reset in this market. The Central region, which is comprised of our Texas markets had an absorption pace of 4.4 per month in the first quarter of 2023. Most communities and greater availability of completed specs translated into sequential improvement in sales paid for Texas.
We believe the pro business environment and in-migration trends in Texas will continue to positively impact home buyer demand in the future. The East region’s average absorption pace was 3.8 per month during the quarter. Economies remained resilient and demand was still strong in this region, but lower available supply of complete specs in Georgia and the Carolinas impacted our absorptions there as we work to ramp up production in our new communities. We’re now focused on maintaining three to four net sales per month for the remainder of the year.
Turning to Slide 7. We managed our starts on a per community basis to align with our sales pace. We have the flexibility to increase or slow down start to keep our target of four months to six months applied spec on the ground. We started nearly 2,500 homes in the first quarter, accelerating from approximately 2,100 homes in the fourth quarter of 2022, but down from 4,000 in the first quarter of 2022.
We ended the period with nearly 3,900 spec homes in inventory, which was down 21% sequentially from the artificially higher fourth quarter due to the high level of cancellations. This represented 13.9 specs per community, which was slightly lower run supply specs than our goal as we sold homes at a faster pace than anticipated during the quarter. We expect to continue to manage spec starts to align with increased demand we experienced in all of our markets.
Of the 2,897 home closing this quarter, 87% came from previously started inventory, up from 80% in the prior year. 25% of total specs were completed at March 31, 2023, increasing from 16% at year end, which is closer to our normal runway rate of one-third, and what we believe is needed to capture today’s buyer. As 45% of the homes we closed this quarter were sold during the quarter, we improved our backlog conversion rate from 50% last year to 87% this quarter. And achieved our targeted backlog conversion rate of at least 80%. While we don’t expect to hit the 80% conversion rate consistently until supply chain and labor constraint issues are resolved, we do believe our operating model supports this conversion rate on a normalized basis.
The high backlog conversion rate resulted in our ending backlog of approximately 3,900 homes. During the first quarter of 2023, our cycle times improved by approximately one week sequentially from Q4, primarily from front-end trades. But we’re still approximately six weeks longer than our pre-COVID averages. Backend trades and our suppliers generally have not caught up with the industry-level backlog. But we continue to lean on these long-term relationships and are starting to see a path to better cycle times in the back half of this year. Reducing cycle times is a company-wide initiative for us in 2023. And we’ll continue to provide quarterly updates on our progress.
Even as we increased our community count 4% year-over-year and 3% sequentially from the fourth quarter to 278 as of March 31, 2023, our ending community count was lower than we expected. We opened 27 new communities this quarter, but the continued transformer issues across the country halted some new community opens. Further, our healthy sales over-pace led to early closeouts. We now anticipate returning to 300 communities by year end.
I will now turn it over to Hilla to provide additional analysis of our financial results. Hilla?
Thank you, Phillippe. To start, I’ll provide a quick update on BFR. In the first quarter of 2023, BFR sales primarily occurred in Arizona and remained in the normalized mid-single-digit range as a percentage of total orders. We continue to gain traction with our institutional partners as we believe rentals are an important component of the housing equation. And we are committed to providing high quality newbuild inventory for this space.
Now let’s turn to Slide 8 and cover our Q1 financial results in a little bit more detail. Home closing revenue slightly increased to $1.3 billion in the first quarter of 2023, driven by higher home closing volumes as ASPs held steady with prior year. Home closing gross margin declined 790 bps to 22.4% in the first quarter of 2023 from 30.3% in the prior year due primarily to price concessions and incentives as well as continued elevated direct costs.
Our use of mortgage rate locks and buy downs did not begin to impact our gross margins until the back half of 2022. Although we expect incentives will continue to remain elevated in 2023, they are starting to moderate as today’s buyer is no longer looking for a 4% interest rate in order to qualify. And the limited available inventory is allowing us to start to increase pricing where new and existing home inventory supplies are limited. Elevated direct costs reflect the construction environment of mid- to late-2022 as our closings this quarter do not yet include recent cost saves.
We are focused on company-wide rebid efforts to return our labor and material costs back to pre-COVID levels. While the lumber savings will start to materialize at the end of 2023 and into 2024, we are also looking to recoup other cost increases we have absorbed over the last two years. Inclusive of lumber, we have captured about $20,000 per unit so far, which is approximately 8% to 10% of labor and material costs. However as demand improves, we’re seeing stickiness in costs, particularly labor. While we have seen some savings outside of lumber, progress has been slower than expected. And we don’t anticipate additional direct cost savings to impact 2023 closings as we only have a few more months to start specs that can close this year.
SG&A leverage in the first quarter of 2023 was 10.3% compared to 8.5% in the first quarter of 2022. The increase was primarily due to broker commissions and advertising costs running above the low run rates experience since 2020, although we have started to pull back on some of these initiatives as well where demand is strongest. These costs reflect the current sales environment which may remain choppy in 2023. The increase in general and administrative expenses includes severance-related costs and higher spend on technology and insurance.
The first quarter’s effective income tax rate was 20.6% in 2023, compared to 24.0% in 2022. The 2023 rate benefited from energy tax credits on qualifying homes at the higher $2,500 per home rate in effect this year. Similar credits didn’t begin until Q3 in 2022. Overall, the lower gross margin and overhead leverage in the current quarter partially offset by the favorable tax rate led to a 39% year-over-year decline in first quarter 2023 diluted EPS to $3.54.
Turning to Slide 9. The health of our balance sheet remains a top priority in today’s uncertain environment. We had nothing drawn on our credit facility. And our net debt to cap was 4.5% at March 31, 2023. We generated $96 million of free cash flow this quarter and had $957 million of cash at quarter end. The strong liquidity, our disciplined growth and max net-to-debt-cap ceiling target in the 20s, we have plenty of room to stay agile, balancing internal investments with return of capital to shareholders.
Our land acquisition and development spend totaled $310 million this quarter, in alignment with our $1.5 billion full year land spend goal. In February, we announced our inaugural quarterly cash dividend of $0.27 per share, which totaled approximately $10 million this quarter. We’re happy to announce this new channel from Meritage to return value to shareholders. It is our intent to issue quarterly cash dividends going forward with annual per share resets. Additionally, we repurchased over 93,000 shares for $10 million in the first quarter. Over $234 million remain available to repurchase under our authorization program as of March 31, 2023.
In addition to our objectives of neutralizing annual dilution from new equity issuances, we will continue to be opportunistic with our share buybacks. Looking ahead, we believe that our operating strategy and strong liquidity position us to continue driving growth by buying new land and reinvesting in our business while also having the cash flows and maximize long-term value returns for our shareholders.
On to Slide 10. When it comes to land acquisition we pulled back on spend in the second half of 2022 as we assess the changing market dynamics. Given recent momentum in the market, we put about 1,700 gross new lots under control this quarter. A total of approximately 60,900 lots were owned or controlled at quarter-end, compared to approximately 75,100 total lots at March 31, 2022. The new lot added this quarter represent an estimated 17 future communities, all of which are for entry-level product. We ended the first quarter of 2023 with 4.3 year supply of lots, which is in line with our target of four to five years. About 75% of our total lot inventory at March 31, 2023 was owned and 25% was optioned. In the prior year, we have a 65% owned inventory and a 35% optioned lot position. The rebalancing of our land portfolio in the last few quarters has elevated our split of owned versus optioned lots. Although we don’t ascribe to a target for this metric, we believe that being nimble and ready to transact quickly on land opportunities while focusing on returns has resulted in a higher percentage of lots owned currently than our historical run rate.
Finally, turning to Slide 11. Looking to Q2, we expect closings to be between 2,800 and 3,100 units with corresponding revenue of $1.22 billion to $1.36 billion. We expect margins to trend around 22%, our tax rate to also be around 22% and EPS to land between $3.15 and $3.65. We will continue to monitor the stabilization of homebuilding conditions and expect to provide full year guidance on our next quarterly call.
With that, I’ll turn it back over to Philippe.
Thank you, Hilla. To summarize, on Slide 12. We believe that our first quarter results continue to reflect our focus on pace over price and our commitment to our spec inventory, both of which position us well to capitalize on buyer demand and continue to gain market share. While we found the market in Q1, we will continue to keep a close watch on the sales pace and will adjust if necessary to maintain our three to four net sales per month goal as we start to pull back on incentives and increase prices. Having our operations dialed in, we have the available spec and near completed homes and backlog to achieve strong first quarter 2023 backlog conversion rate.
Keeping up with starts is a priority so that we can maintain our available home inventory to meet market demand. As cycle times normalize, we expect the higher inventory turns will lead to backlog conversion into 80%-plus. We also believe our disciplined growth and strong balance sheet will enable us to continue growing the business, whilst returning value to shareholders. With that, I will now turn the call over to the operator for instructions on the Q&A. Operator?
Thank you. [Operator Instructions] And our first question comes from Stephen Kim with Evercore ISI. Please state your question.
Yes, thanks very much guys. Philippe, I just want to make sure that I heard you that the backlog turnover can remain in the 80%-plus range. As I wanted to make sure that that was sort of something that you expect you could sustain quarter-after-quarter. And then also, when you talk about the start, at what point do you expect starts to match or exceed your order pace? Do you expect that in 2Q? Or do you expect maybe later this year?
Yes. So our goal as a company is to achieve an 80% plus backlog conversion rates. I think that we’ll see how the supply chain stabilizes along the way. That’s an important input for us, to maintain that. So we’re not ready to say that we’re going to hit that every single quarter just yet until we see that stability. And then, as it relates to our starts matching our sales, you’ll absolutely start to see that in Q2 going forward. Q1, it was a little slower, primarily because we had a bunch of cancellations we were clearing out. And also, we were rebidding our costs. So we were getting our cost rebid before we started these new homes at lower cost, which we thought was really important in order to achieve the margins for the year.
Yes. That’s really clear. Thanks so much. Now with respect to the cancellations impacting the order ASP because it’s kind of a net order ASP, I got that. But can you quantify that for us, Hilla? What was that impact from this cancellation dynamic? And then kind of related to that, within the incentives that you’re offering, buy-downs and what not, what’s the average mortgage rate that your buyer is receiving? Is there a way to sort of talk about the actual rate that they are actually getting when they close?
Yes. So once we kind of net all of the buy-downs, they’re right around 5.5. It may get a tick lower than that, but right around 5.5 since not everybody locked and people use the money in a different way than has capacity. So probably around 5.5 is our blended on the mortgage side. And then as far as kind of breaking down the components of the ASP. So we mentioned there was a pretty material pullback. Part of it actually is the rate buy-down of about $8,000 to $10,000 in the map that we kind of walked through. We also had some price increases, maybe that’s like another percentage point. Mix always drives a little bit of it. So if you kind of shake it all out, the piece that relates to the cancellations is maybe about third to half of the ASP increase that you’re seeing.
Okay, that’s really helpful. Thanks so much.
Thanks.
Our next question comes from Truman Patterson with Wolfe Research. Please state your question.
Hey, good morning everyone. Thanks for taking my questions. A lot of color in your commentary. Big picture, in the market we’ve seen good acceptance of your product at your price point. I’m hoping you could give just a little bit clear color on the absorptions that declined a bit sequentially through the quarter. Was it really a function of liquidating available spec for sale? Or was it kind of the intentional decision to push price a little bit since absorptions were already hitting the high end or above your kind three to four target range? And is that, we’ll call it 3.5 per month a pretty good range that you’re seeing here in 2Q?
Yes. So I think what’s happening here, your question is you’re looking for monthly sales trends, which really don’t make any sense. We gave you a January number because we were trying to give you an indication that the spring selling season was stronger. To expect to say that our sales declined throughout the quarter is actually an inaccurate statement. We just had different comps along the way. We had a weaker January last year versus a stronger February, March. So our absorption pace actually was pretty steady and consistent throughout the quarter. We have plenty of specs to sell as we roll into Q3, everywhere – or sorry, Q2 everywhere. And we’ve just been pulling back on pricing because the market is strong, not because our absorption pace is too strong. So it’s really neither of the two variables that you’re thinking of. Our pace has actually been pretty consistent throughout the entire Q1.
Okay. Got you. So perhaps it was just some community closeout or noise intra-quarter with our numbers. And then so, Hilla, I wanted to make sure that I heard you correctly. Incentives were reduced by about $9,000 per home sequentially. You pushed pricing about 1% during the quarter. And then I believe you made the comment that you were able to reduce costs in the $20,000 range. When do you think all of that will really hit your P&L? Or have you already started to realize some of that in your P&L? I think on the cost side, you made the comment that a portion of this won’t really hit until late 2023. So I’m trying to just understand some of the moving parts there.
So they don’t align exactly in the period to when they’re going to come through the financials. So Phillippe mentioned 45% of our sales in Q1 sold and closed in the same quarter. So some of the pickup that you’re seeing in the sales side, on the revenue side are going to be visible in Q2. Some of the savings that we’re having on lumber and other direct costs won’t be visible until probably Q4. So little bit of a staggered time line is kind of the difference between the spec builders and the built-to-order builders where the timing maybe doesn’t sync up quite as nicely. But by year-end, everything will be there.
Got you. Okay. So, just for clarity, that kind of $20,000 in lower cost, that’s kind of all on the come in the back part of the year?
Yes. It’s coming. I mean it’s not all on one day, right? It’s an iterative process. You go back and you get a little bit more and a little bit more and a little bit more. So it’s going to start to flow through in some amount through the financials, but the full impact won’t be until the end of the year. That’s correct.
And as we said before, we were rebidding our costs here over the last 120 days where we saw some really meaningful results. We’re now going to push out quite a bit of starts here over the next 1.5 quarters, which we hope to close this year if we can achieve the cycle time goals. You see those savings occur in the Q4 closings as long as everything remains equal, right? The incentive environment stays the same and all the other variables are the same.
Perfect. Thank you all for your time.
Thank you.
Our next question comes from Alan Ratner with Zelman & Associates. Please state your question.
Hey, guys. Good morning. Thanks for all the details. Phillippe, your first question, and I apologize for beating the dead horse here, but the monthly cadence was something I was a little confused on as well. So again, just hoping for some clarification. Understand the comps that you referenced, but I believe on last quarter’s call, you said January sales pace was 4.5 per month and you came in at 4.2 for the quarter. So it does imply a little bit of deceleration in February and March and still a very healthy level. So I think what we’re just trying to get our handle on is, was that deceleration just a function of you hitting your sales pace targets and maybe some availability of supply? Or do you think there was maybe a very subtle reaction to the price increases that you pushed through, yet still at a very strong pace?
Yes. I mean it is a dead horse. I don’t really look at our business that way. We’re trying to get four per store, four to five per store, sometimes three, depending on the community, and we’re achieving that. We really didn’t feel any slowdown in February and March. We didn’t feel anybody – we didn’t have a situation where we didn’t have specs to sell in every community. We didn’t feel like people, buyers were pulling back because we had changed our incentive structure. So it felt pretty much the same to us from our perspective. And I would tell you, April feels the same as well. We feel like we’re on track to achieve that goal of a net four plus sales per store, which I mean, whether it’s 4.2 or four or 4.3, four is our goal.
I mean, Alan, we’re, like we said, we’re questioning things at a really finite level here. I mean it was like torrential rain downpour in California, which is actually a market that’s doing fairly well for us, pretty much all of February and March. So it’s not a pullback. It’s just some weather patterns affecting comparability period-over-period for us. Sales pace feels really good and no change in April.
Yes. And we have community inflection, maybe in some communities where we had quite a bit of cancellations. We found a clearing point. We sold a bunch of houses in January more than we thought. And we have less specs in those communities. And we’re talking community by community at this point. Overall, the market feels 100% the same.
Makes sense. Appreciate the added commentary there. Second, on the SG&A, and Hilla, I apologize if I missed some detail on that, but I was just hoping to get a little bit more commentary. So your SG&A expenses were up about 180 basis points year-over-year on a pretty flattish revenue number. And I know you mentioned, I believe higher co-growth expenses but I might be wrong on that. Can you just talk through a little bit your expectations on the SG&A side going forward and if there were any kind of temporary items in there related to community growth or anything that should subside?
Sure. So we don’t give out SG&A guidance, so we can maybe just add a little bit of color here. So the commission rates that you’re seeing come through in Q1 is what we sold. Some of it is what we sold in the current quarter, but some of it is what we sold, half of it is what we sold during a pretty rough Q4 where we had to really add a lot of specs to the external commission. So you’re seeing a higher commission rate for sure than what was in the last couple of years, but even above historical levels. There’s going to be some reset there back to normal.
Now we’re not scared to push on that pedal again if the sales pace doesn’t do what we’d like for it to do. But right now, with us achieving above target, we’re definitely going to see some pullback in our level of advertising, marketing and commission. So there’s going to be some benefits that will come from that in the back half of the year. On the G&A side, we specifically called out three items. One of them is severance, which you didn’t quantify, but that’s not something that we would expect will continue in future periods. And then a little bit of noise from technology and insurance. So those are all recurring items, maybe not all to the same extent, but something that we should be able to better leverage as we go through the rest of the year.
I appreciate that. Thanks guys.
Our next question comes from Mike Rehaut with JPMorgan. Please state your question.
Thanks. Good morning everyone. First question, I just wanted to also make sure I’m understanding it right. When you talk about sales pace of 3% to 4% for the rest of the year, that would imply maybe like roughly like a 5% decline sequentially from 1Q, whereas historically 1Q and 2Q are pretty similar in terms of sales pace. So just wanted to understand if that’s how we should interpret that. And because obviously things are running pretty solid, and if you are expecting a little bit of a sequential decline in sales pace, should we also be expecting on average, continued improvement in price to drive that sales pace a little bit lower?
So the way I would answer that question is because I think we have to stop sort of looking at these year-over-year comps. You got to remember, the first quarter of last year, we were still metering sales. We had achieved almost five net sales per store. We probably could have done six or seven at that time. And then as we rolled into Q2, it felt pretty strong for us all the way through May. It wasn’t until June that things started to slow down. And then obviously Q3 and Q4 were pretty rough. So the year-over-year comps are going to be a little bit hard to explain.
At the end of the day, we’re trying to achieve three to four net sales per store, four in our entry-level communities and three in our 1MU communities. Right now, most of our communities are entry-level. So we’re trying to achieve pretty much four per month along the way. We do expect there’ll probably be some seasonality here. As we go throughout the year, we’ll see. Depends on how tight the retail market stays and what interest rates do. But we’re just trying to get a four net sales per store in our entry level and three into 1MU. That’s where that goal comes from. So I’m not sure if I’m answering your question. I’ll let one Hilla jump in here as well, but that’s kind of how we’re looking at it.
So Mike, when we said three to four, that’s our goal, right? So the point is that we’re not going to let it fall below three to four. It’s not that we’re targeting three to four if the market can give us more and if we have expected-to-sell. Obviously we sold 4.2, right, this quarter that just wrapped up. So we’re not going to arbitrarily force the market to be lower, but we’re not going to let it drop below that because that’s where we think that we operate most efficiently. So I think maybe that’s how you can interpret that comment as far as pushing on price and fully back incentives, absolutely.
Right now we’re not seeing it impact our absorptions pace. If it does impact our absorption pace, that’s a discussion that we always have internally, right, pace over price and are we sacrificing margin. And at what point do you want to push on the price at the expense of pace. It’s not linear, right? A drop doesn’t translate magically into the same reduction and you end up with the same net profitability. So we’re looking at that on a community-by-community basis. But yes, you should expect to see the impact of some of the current revenue increases flow through. But please don’t interpret that to mean that we’re trying to get back into this three to four, we just don’t want it to fall below the three to four.
Right. And based on what we’re feeling today, I think we do feel like there’s price elasticity. We can push prices and lower incentives as we move through the spring. If we see historical seasonality, which I expect us to see, we’ll have to bring back some incentives in the back half of the year, which is pretty traditional and typical in a selling year. So we’ll just have to see. And this just assumes everything stays static as it relates to interest rates and other macro context.
Right. No, no. That all makes sense. And I appreciate the color. I understand it’s been a long call on sales pace here, so I appreciate that. Also, just looking at the 2Q gross margin guide, I was hoping just to get a summary. There’s been a lot of numbers thrown around in terms of lower incentives, reduced construction costs. As it relates to 2Q specifically, I would think that some of the reduced incentive levels as they came, as they progressed throughout 1Q, if you had the fuller impact as you got towards the end of the first quarter that that might be an incremental tailwind to margins in the second quarter. What were kind of the offsets to that? And again, as you look into the back half, what would be incremental to 2Q in terms of the positives and negatives?
I mean our 2Q specs that we’re selling are still homes that we started last year. So a lot of the cost savings that we discussed are in those specs. We pulled back some incentives, but you also have some mixed stuff going on there between the regions. I think we’re going to get more out of the West than we’re getting out of the East in Q2. So there’s some of the regional influences there. So it’s kind of all of that. We probably do have homes that are closing in Q2 that have less incentives and higher prices, but they also have different cost structures and then there’s mix that’s driving that.
And we didn’t pull back materially. Our actual performance in the quarter was 22.4% gross margin. We guided to around 22%, kind of feels the same in our guidance. So we’re not anticipating a pullback. And if our trends holds true, at least short term, we sold 45% of our closings in the same quarter, we may not have as much visibility as to what the incentive market will need over the next two and a half months. Now it could be nothing. It could be improving, but it could also go on the other direction. So with limited visibility, we wanted to make sure that we weren’t guiding numbers that were not attainable. We can still sell homes for a couple of more weeks this quarter and close it in the same quarter.
All right. Thanks so much guys. Best of luck on the upcoming quarter.
Our next question comes from John Lovallo with UBS. Please state your question.
Good morning guys. Thank you for taking my questions as well. The first one is, Hilla, on the last call, I think you had talked about return of capital to shareholders and how there were a number of different initiatives that you guys were considering. And I know you guys came out with the dividend, which is encouraging, and you talked a little bit about share buybacks today. But how should we think about your just overall thoughts on capital allocation at this point? Is there an opportunity do you think to get a little bit more aggressive on the buyback front?
So thank you for recognizing the dividend. It’s the first one ever in our history. We’re listening, right? I think that’s the important takeaway. We’re hearing what the shareholders are asking for, and it’s a return of capital, and we thought that was a great way to show our commitment when our cash balances are as high as they are. Definitely makes sense for a return of capital component to be an ongoing attraction of our capital planning. So you can definitely expect dividends and share buybacks to continue to be part of our overall analysis.
As far as just general share buyback, I think we mentioned it, we’re always looking to take that dilution, right? We don’t want to dilute our shareholders. And opportunistic is exactly what it means, it’s opportunistic, right? We want to make sure that we’re putting the cash to use where it’s most accretive. So if there’s opportunities to get back into the market and buy incremental shares, then we definitely will. We’ve certainly shown that it’s something that we’re comfortable doing every year since 2018, right? So, we certainly have a track record of that. It’s just kind of managing the expectation on the capital front with our initiatives continuing to grow the company at a normalized pace.
Understood. Okay. Thank you. And then I thought it was interesting, just looking at Slide 6, is that the West division or segment had the highest absorption but has the lowest percentage of entry-level communities. Can you maybe just talk about some of the dynamics that are going on there that’s driving that?
I think a lot of it is just California. We don’t really classify California as entry-level. So most of our entry-level positions throughout the West region are in Arizona. Western Colorado and California, which makes up the rest of the West. So that’s really kind of what’s driving it as it relates to what we classify as entry-level and what we classify as first move up.
We were also really aggressive, if you recall, in Q4. We mentioned that Arizona was a tough market for us for a couple of quarters. And we really aggressively reduced pricing to try to find the market. We’re starting to find some success in Arizona and starting to increase pricing there, but there was a pretty material drop. I think it was in the scripted remarks that Arizona individually had the largest drop in ASP.
Got it. Thank you guys.
Our next question comes from Dan Oppenheim with Credit Suisse. Please state your question.
Thanks very much. I was wondering about community counts. You had talked before in terms of halting some community openings to rebid and get some savings there. And now you’re talking about the communities coming on later in the year, back to 300. I wonder if there’s anything you can do in terms of those that were halted in terms of accelerating and bringing them back and just sort of where things are in terms of that overall.
Yes. I think mostly anything that was slowed due to the rebidding effort is now sort of back on track, and we’re opening those back up. I think the bigger issue has been the transformer issue, which is national news out there. We have a lot of communities that were scheduled to open up late in Q1 and into Q2 that are now being delayed based on the lead times that were being told for our transformers. And then just a little bit of some communities that saw much stronger sales in Q1, and we expect to see them in Q2 that we were predicting as we set up our budget that are closing out earlier. But the biggest issue as it relates to not achieving 300 communities earlier is the transformer issue.
Great. And then in terms of margins, you’ve talked about for the second quarter, then those comments you made in terms of having some really push pricing here. Would you say that your expectation now is that 2Q then ends up being sort of the bottom for margins here in the year given that in the back half of the year, you then get the benefit on the cost side. Plus you’re talking about pushing price on orders, so that could then close in the back half of the year?
Yes, I was not prepared to give out margin guidance right now with so many things moving in different directions. We have a lot of communities opening up that have higher RAM [ph] basis that will impact closings in the back half of this year. We’ll have to see how stable the pricing incentive environment stay as we move into some seasonality in the summer in the back half of the year. And then although we saw some meaningful cost savings, we’re still seeing some challenges on the back-end trades with labor and the finishes. With all that moving around, it’s just really hard to say right now, which is why we’re waiting until we get Q2 in the bad before we give out full year guidance, which we’re going to do.
Great. Thanks so much.
Our next question comes from Carl Reichardt with BTIG. Please go ahead.
Thanks everybody. I wanted to ask about block count, which has dropped as you walked from a lot of options. I’m assuming those are options on lots you intended to self-develop, Hilla. I’m just curious, now that things are beginning to pick up again, how easy it is to go back to those potential sellers and start talking again about the potential for restarting a takedown? Can you just give me a little bit of color on how those deals you dropped might look now that things are improving?
Yes, I’ll take that one. It depends on where, like in the East, I don’t think prices are, land prices are changing at all. In fact, they might be getting more expensive. We didn’t really drop a lot of stuff back there because everything sort of still makes sense and the market was still strong, and we were expecting a big pricing reset. As you move from East to West, Texas, again, depending on the market, I think seeing a little bit more opportunity in Houston and Austin where maybe you can reset terms. I’m not sure about pricing, but maybe get better terms.
And then as you move to the West, we’ve definitely seen some land prices contract, some opportunities have hit the market that were under contract that we can now secure at a lower cost. Not necessarily the deals we were tracking. Most of the stuff that we walked away from the West was really long-term stuff that wasn’t going to help us out for a couple of years anyway. So those deals, those sellers are pretty patient. But we have seen some deals that were more near-term that we’ve been able to get into that another builder drops at a lower basis.
Great. Thanks you, Phillippe. And then again, you guys are self developed you on a lot relative to optioned, but once you get the house to WIP [ph] stage, it turns in a hurry. Do you have an overall sort of target internally for inventory turns over time, Phillippe? And if so, what is it?
Yes, it’s two and a half per year. We think that we should be building houses in 120 days. We were doing that before COVID hit. And when we can do that, our whole business looks completely different. That’s one of the reasons our SG&A is going a little bit sideways now because our cycle times are too long. When you’re an entry-level spec builder, you got to be able to go homes fast. So the goal is to build them in 120 days. We can turn our assets two and a half times a year. And we can basically start homes in August, even into September sometimes and close in the same year. We’re making some progress there. It’s just too early. But I’m hopeful with what we’re seeing that this year we might even be able to get to a place where we actually do start some homes in August in some of our divisions and closing this year.
Your WIP turns at two and a half, but then your land turns would be what you’d hang on to two years to three years. Is that the thinking?
Yes. I mean, it depends on what type of land you’re talking about because we entitle a lot of land and – but when we close a project that’s shovel-ready, we hope to turn it in three years to four years.
Thanks so much. Appreciated.
Our next question comes from Alex Barron with Housing Research Center. Please state your question.
Yes, thanks. Obviously your leverage has gone down significantly. I’m just kind of curious if – what the strategic thinking is going forward with regards to that? Are you guys just kind of on a hold mode until you find opportunities? Or is this more going to be the norm in terms of the way you plan to operate? Or how are you thinking about leverage going forward?
Well, we’re not really happy with where it’s at. I mean a lot of it is just coming off these really, really high margins and really high absorptions and then dealing with what happened in Q4. So our goal is to absolutely be below 10. But I think long term, as we’re building homes back to – in the 120-, 150-day cycle time, I would hope you would get closer to nine. It’s all about leverage for us. So those incremental sales and the cycle times when we can close homes faster and the more efficient operating model is when we – when we are operating at our full, kind of full efficiency. And maybe Hilla will want to comment as well.
Yes. So fully recovering leverage on SG&A, if you’re talking about debt leverage, yes, 4.5 is too low. Kind of same comment as Phillippe. It’s not the right number right now, but we ended up with a lot of cash right when the market was turning a little bit, so we pulled back on land. If you remember, in 2022, our original guidance was that we were going to have $2 billion of spend. We’re about $0.5 billion short of that. If we had spent everything that we had wanted to, our leverage would have looked different. So you can expect to see us reinvest in the business more. If the market kind of holds steady and stabilizes, it’s our expectation to reinvest back into the business, both in the form of land and new communities. And then of course those communities need WIP.
So you’ll see it in inventory in all categories. If the market doesn’t stabilize and we end up building the cash reserves even further, there’s definitely going to have to be some of that, whether it’s debtor or return of capital to shareholders. But right now, where we stand today, we’re going to give it another quarter to see how things stabilize and start to reinvest back in Meritage.
Hey, Alex, this is Steve. Good place to be, inst it?
It’s wonderful. Yes. I actually am surprised the market isn’t giving you a better multiple, given that you have such a conservative position. Anyway…
We read what you wrote and you’re spot on.
I think it will come. I have another question. So at the end of 2020, before everybody knew all these supply chain issues were coming, builders were happy to take orders and everybody’s backlog grew and all that stuff and then everybody sort of ran into the supply constraints of the industry. I’m curious, if we were to see a ramp-up in activity again, let’s say interest rates drop or whatever, are people just suddenly feel like I should buy a home now before prices go back up? How easily do you think it is for you guys to expand your capacity into 2024? Or do you feel like the industry is already somewhat – it doesn’t have that much capacity left for you guys to grow significantly?
Well, I think in this – I mean, starts are off dramatically. They could be down 25%, 30%, 35% versus last year. I think in the short term, I think we could ramp up our business pretty well. I think there’s some capacity out there. You might not see cycle times contract as fast as you like, but I do think the cost is there. There’s not the capacity to do what has been done over the last three years. It clearly broke. It feels somewhat finite. Now if some of this multifamily stuff slows down, which I think it will, there’s going to be some more capacity that flows into the residential space.
So there could be excess capacity from these other spaces, but it feels pretty finite. And it doesn’t feel like anything was solved over the last few days or few years, that would suggest we could go back in and support the type of growth that we saw during COVID. But I think, again, with our strategy, we’re in the best position to go get it. If we continue to build specs, focus on streamlined production, steady cadence, we’ll be in the front line. And now that we’re a top five builder, I think we have different trades that are willing to give us more capacity than before.
All right. Best of luck. Thanks guys.
So I think we’ll take one more question, operator.
And that last question comes from Susan Maklari with Goldman Sachs. Please state your question.
Thank you. Thanks for taking the question. Some of your peers have talked about opportunities that could present themselves if some of your smaller builders start to see stress from tighter lending standards. Given the size of the business today and the operating strategy that you have, are there things that would be of interest to you? And are those different than what they were historically?
No, I think they would be interesting to us. At the end of the day, when we think about how we can grow our business, there’s really – and we take other capital allocation opportunities off the table, whether it’s buying shares back or increasing dividends or paying off debt and whatnot. There’s really three things we look at, right? We can do big M&A. That’s the most risky. And from our perspective, really kind of the lowest ranking of the opportunities. We can do small company M&A, especially in the areas we want to be. That’s very attractive.
And I do think that we’ll see some stress here. And there’ll be some opportunities that we’re looking at. And then we can just keep investing in our team, which is what we’ve been doing over the last seven years and got us to top five builder status. So, we still have opportunities to do that. We’re not top five market share in every single market that we’re in. And that’s number one priority because we have a lot of conviction in our team and a lot of conviction in our strategy. But secondary to that would be to buy something smaller that fits within our geographical footprint that we’re trying to accomplish and complements our business.
Okay. And are there geographies that you’re targeting or that you’re thinking about getting into?
There’s geographies that we want to get bigger in, like Texas and Florida. And then there are other geographies that we’re currently not in that are on a short list as we want to leverage our business outside of the current geographies that we’re looking at constantly and just picking the right time. We went into a couple of new markets over the last three years, Coastal Carolina, Myrtle Beach. That too is fantastic. We’re jumping into Jacksonville. That’s doing great. We’re starting to enter Salt Lake City. So, we are increasing geographies that we’re in and continuing to diversify our footprint.
Okay. Thank you for the color and good luck with everything.
Thank you, operator. I’d like to thank everyone who joined the call today for their continued interest in Meritage Homes. We hope you all have a great day and a great rest of your week. Thank you. Goodbye.
Thank you. This concludes today’s call. All parties may disconnect.