Meritage Homes Corp
NYSE:MTH

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NYSE:MTH
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Market Cap: 5.6B USD
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Earnings Call Transcript

Earnings Call Transcript
2022-Q4

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Operator

Greetings and welcome to the Meritage Homes Fourth Quarter 2022 Analyst Call. [Operator Instructions] As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Emily Tadano, Vice President of Investor Relations and ESG. Thank you. Please go ahead.

E
Emily Tadano
Vice President of Investor Relations & ESG

Thank you, operator. Good morning and welcome to our analyst call to discuss our fourth quarter and full year 2022 results. We issued the press release yesterday after the market closed. You can find it along with the slides we'll refer to during this call on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom of our home page.

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 2021 annual report on Form 10-K and subsequent quarterly reports on Form 10-Q which contain a more detailed discussion of those risks. We've 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 2 hours after we conclude the call and will remain active until February 16. I'll now turn it over to Mr. Hilton. Steve?

S
Steve Hilton
Executive Chairman

Thank you, Emily. Good morning and welcome to everyone participating in our call this morning. I'll start with a brief discussion about what we are seeing in the market and provide an overview of our recent company milestones. Philippe will cover our strategy and quarterly performance. Hilla will provide a financial overview of the fourth quarter and forward-looking guidance.

Q4 marked a strong finish to a year of exceptional execution and dedication from the Meritage team. We delivered 29% more homes this quarter and generated $2 billion in home closing revenue in the fourth quarter which was 32% higher than the fourth quarter of '21. Our home closing gross margin of 25.2% and quarterly SG&A leverage of 8.4% led to our quarterly diluted EPS of $7.09. Although favorable demographics and the low supply of housing inventory should drive long-term demand, we believe they were overshadowed in the back half of the year by ongoing economic uncertainty and buyer psychology, increasing mortgage interest rates and inflation. With homebuyers on a [indiscernible] about when to get back into the market, our fourth quarter sales orders declined 46% year-over-year driven by a cancellation rate of 39%.

Today's higher mortgage interest rates continue to pressure housing prices as monthly payments still remain above 2020 and 2021 levels despite price cuts and rate locks. We believe that until rates stabilize, home sales activity will remain choppy. We see some potential buyers who could qualify but are waiting for further price declines as they anticipate additional builder incentives are coming. Other current buyers with rate locks in place or below current market mortgage rates were cancelling due to the buyer hesitancy as they may have been nervous of the general economy or their own financial positions. However, given our available inventory, we are seeing some buyers -- the market and respond favorably to our quick movement selection as well as our incentives and company-wide sales initiatives.

Now, on to Slide 4. As the team that embodies our start with heart core value, Meritage employees donated countless hours to deliver 3 mortgage-free homes to deserving military veterans and their families on Veterans Day in Houston, Nashville and Tucson. This is one of the most impactful annual initiatives that the entire organization looks forward to and we were excited and humbled to continue that tradition in 2022. We also expanded our long-term history of contributing to local non-profit organizations to further our diversity, equity and inclusion mission as well as voluntary time and donated financial support to organizations, combating food and security across the country and providing shelter to those in need.

This quarter, Meritage was recognized by the Phoenix business shareholder, both as one of the best places to work and one of the healthiest employers. And as a result of our overall commitment to ESG, Meritage was named one of the 2023 America's Most Responsible Companies by News League Magazine. Overall, we are proud of what our team members accomplished this quarter on top of the quarter of solid operational execution.

I'll now turn it over to Philippe.

P
Phillippe Lord
Chief Executive Officer

Thank you, Steve. During the quarter and looking into 2023, we are analyzing the business through the lens of market events and actions that are within our control. We could not influence the macroeconomic factors impacting Q4 sales that Steve described. However, we can control how we react to them and how agile our business can be are focused around our core strategies that we have honed for many years now.

To reiterate our strategies and the actions we have taken, we remain committed to prestarting 100% of our entry-level homes. This readily available home inventory puts us in a favorable position since buyers in the current market want homes are ready to close within 45 to 60 days. Eliminating uncertainty and reducing stress are a premium in today's murky economic environment. Further, line building allows us to complete homes on a shorter cycle time than a build-to-order model despite supply chain issues. Prestarting homes with a limited SKU library means we can also offer more affordable products as we pass on our savings to our customers. As an added benefit, when we have cancelled inventory, the lack of customization of our homes, stemming from our streamlined and -- specifications, results in limited discounting for the future resell of that home. Since we mainly build entry-level products, we expect a higher average absorption pace and prioritize pace over price.

Like all homebuilders, we benefited from the runup in home prices for the first 2 years at COVID. And despite higher costs, we experienced industry-leading gross margin levels. More importantly, we increased our market share. Consistent with our strategy, we continue to target 3 to 4 net sales per month. As we had a net order absorption pace of 2.2 per month in Q4, we have taken additional actions to get back on our target, including lowering prices and utilizing a full range of incentives such as mortgage rate locks, rate buydowns until we find the market clearing point to move our inventory and get back to our target sales pace. The timing of these actions align with the production time line of our spec inventory which is now completed or near completed and ready for quick moving sale ahead spring selling season.

Further, during Q4, our operations team worked hard to close a large portion of our backlog despite supply chain issues impacting cycle times. We also aggressively validated every home that remain in our backlog as of year-end. Most confirmed their commitment to their homes. Some use incremental pricing or rate adjustments that we were able to offer. In other cases, though, we had to cancel the sales, it was clear the buyer is not going to purchase home with a reasonable incentive structure. By proactively showing our backlog, we likely identified some cancellations earlier in the cycle than normal but this gave us more confidence in our backlog at the end of 2022 and added available inventory for sales into January.

While we certainly don't have a crystal ball regarding what cancellations rates will do in 2023, we are comfortable that the buyers who purchased homes in earlier March 2022 under a different market and economic environment represent a smaller portion of today's backlog compared to a greater portion coming from buyers that have a more fulsome understanding of the current market conditions, their monthly payment expectations and the relative advantage of their rates and pricing incentives.

In addition to our sales initiatives, our purchasing team is actively rebidding our vertical costs to capture cost savings as incremental capacity is growing within our supply chain. Hilla will touch on more details but suffice to say, we are pursuing cost savings across all cost categories in all of our markets this year. These intentional actions enable us to adjust pricing and can structure community by community so that we can take advantage of our supply of available inventory as we kick off 2023. We believe we have the right level of completed and near-completed hotel which combined with a different mix of pricing actions, financing solutions and incentives allows us to offer a total package that is aligned with each local market environment.

Now, turning to Slide 5 to share our operational statistics. The 29% year-over-year increase in our Q4 closings to 4,540 homes was attributed to our team successfully managing the persistent labor and supply chain challenges. Entry-level loans made up 85% of closings, up from 81% in the prior year. Our fourth quarter 2022 sales orders of 1,808 homes were comprised of 89% entry-level homes, up from 82% in the fourth quarter last year.

The 46% decline in sales orders year-over-year was primarily due to elevated cancellations and weaker overall demand despite a 10% year-over-year increase in average communities. Our cancellation rate in Q4 of 39% increased from 12% in Q4 2021 and 30% in Q3 2022. Quarterly gross sales orders declined a more modest 22% year-over-year. Our fourth 2022 average absorption pace was 2.2 per month which was down from 4.5 per month in the fourth quarter of 2021 but gross sales pace was 3.6 per month at our 3 to 4 monthly target, affirming the underlying consumer demand is indeed present. In finding the right pace to price relationship, we expect our average absorption pace will get fast towards a target of 3 to 4 net sales per month during 2023.

Moving to the regional level trends on Slide 6. The highest regional absorption pace of 2.6 per month in the fourth quarter occurred in our Central region which is comprised of our Texas markets. Orders were down 46% year-over-year in Texas overall. With all 4 Texas markets holding a growth sales pace greater than 3.0 per month, we believe we are starting to find stability in Houston, Austin and San Antonio, while in Dallas, we are experiencing a steadier environment and are gaining market share.

The fourth quarter regional absorption pace for the East region was 2.5 per month. We still have work to do here but all of our Eastern markets actually had a gross sales pace in line with our 3 to 4 per month per target. And we are confident that we are well positioned in this part of the country. The East had the lowest region of decline in orders up 41% year-over-year and the lowest cancellation rate in the fourth quarter.

In Florida, ASPs on orders were up 11% due to product mix shift even after our price adjustments, while orders were down to 25% reduction in average communities. Consumer pullback was most evident in the West region, where the absorption pace was 1.6 per month for the fourth quarter. California was the only place to have an increase in orders year-over-year which is primarily the result of more convenience. California also had a gross sales pace over 3 per month, given the quality of our locations and our entry-level positioning in the market. Colorado and Arizona continue to experience be hesitate to transact as they adjust to the higher lovely payments in these markets that experienced a higher runoff in ASPs over the past 2 years. Further, cycle times in these 2 markets are still so are the longest and least predictable. Although the new incremental capacity showing up in the supply chain now is providing a run rate for improvement here.

We wanted to provide some color into January sales. As we know, that's top of mind for everybody on today's call. Compared to the average absorption pace of 2.2 per month in Q4, we saw a notable improvement in January, achieving a net absorption pace greater than 4.0 per month per community as well as a more normalized cancellation rate in the mid-teens. We sold over 1,200 houses in January, up approximately 4% over last January. We have some initial confidence that we found the right combination of pricing incentives to sell at our targeted 3 to 4 net sales per month.

Now, turning to Slide 7. To align starts with lower demand we further moderated construction this quarter, starting approximately 2,100 homes in the fourth quarter compared to approximately 2,700 in Q3 2022 and more than 3,700 in the fourth quarter of 2021. We ended the period with nearly 4,900 spec homes in inventory or an average of 18 per community as compared to approximately 3,200 specs or an average of 12.3% in the fourth quarter of 2021.

Market demand dictates our target amount of available inventory in each of our communities. Our goal is to keep 4 to 6 months' supply of specs on the ground by managing our starts to match our sales pace and production capabilities, although excess cancellations increased our specs slightly above our target rate in the quarter. To align with the additional supply of inventory on hand, we will flex and slow down our starts until we reach our optimal equal liver. But as noted, we have already worked through about 25% of these stacks in January. Similar to last year, 79% of our home holding this quarter came from previously started inventory.

At December 31, 2022, we added over 750 complete homes to sell. Our 15% completed homes is higher than the last couple of quarters and, coupled with our homes that can close by the end of Q1, represent about 1/3 of our spec inventory. We ended the fourth quarter with a backlog of 3,300 units as we closed out a significant portion of our backlog and improved our conversion rate from 60% last year to 75% this year.

Q4 cycle times continue to be similar to the earliest 3 quarters of 2022 which were still approximately 6 to 8 weeks longer than our pre-COVID [indiscernible]. However, we are targeting aggressive reductions in construction time for 2023 and are already starting to see some improvements from our front-end trades. We are hopeful that with the industry backlog clearing over the next few quarters and the capacity of back-end trades like appliances, flooring, countertops in cabinets loosening, our cycle plan and backlog conversion rates will improve in the back half of this year.

I'm now going to turn it over to Hilla to provide additional analysis on our financial results. Hilla?

H
Hilla Sferruzza

Thank you, Philippe. Like last quarter, we'll start by providing a bit of color on our BFR business before reviewing the financials in detail. Sales through our built-for-rent partners in the fourth quarter only represented a low single-digit percentage of our net orders volume as the rental operators, much like the rest of the sector, are pausing to analyze their financial hurdles and adjust underwriting targets. We're encouraged to see some incremental interest in January and continue to believe in the viability of this channel due to the historical countercyclical strength of rental market and higher interest rate environment. Now let's turn to Slide 8 and cover our Q4 financial results in more detail.

Home closing revenue grew 32% year-over-year to $2.0 billion in the fourth quarter of 2022 combining 29% greater home closing volume and 3% higher ASPs when compared to prior year as we overcame supply chain challenges to close a substantial portion of our backlog. Our fourth quarter 2022 home closing gross margin was 25.2%. The 380 bps deterioration grew 29.8% a year ago was the result of greater incentives and higher direct costs as well as several nonrecurring items, including $10.9 million and warranty adjustment related to 2 specific cases and $4.2 million in write-offs for option deposits and due diligence costs for terminated land yields which were partially offset by $5.4 million in retroactive vendor rebates. In the fourth quarter of 2021, we had $2.5 million in write-offs for terminated land deals and no warranty or rebate adjustments.

Excluding these nonrecurring items, adjusted fourth quarter 2022 home closing margin was 25.7% compared to 29.2% in Q4 of 2021. We expect that price concessions elevated discounts and a continuation of financing incentives for rate locks and buydown will negatively impact gross margins in 2023. We However, with our sales ASP down 10% to $389,000 this quarter when compared to last year, we've already taken material pricing action, demonstrating our commitment to elevating our sales pace. And although we're not projecting broad-based cost savings to offset the challenging market conditions today, we are starting to make some headway to reduce direct costs and improve cycle time.

There are full company initiatives to drive substantial cost reductions with success stories of $15,000 per home in savings just since already emerging in some divisions, particularly in our slower markets where trades have excess capacity. However, we likely won't benefit from the full impact of these savings until the tail end of 2023 and into 2024 as they will be captured in our home starts until mid to late this year. We still believe that long term, our normalized gross margin will benefit from better operating leverage from our increased volume and our streamlined operations and will end up at or above 200 bps from our historical average of 20%, although the next several quarters are likely to be bumpy.

SG&A as a percentage of home closing revenue was 8.4% for the current quarter which was a slight improvement over 8.5% in the prior year. Our higher revenue allowed us to better leverage our SG&A. This was partially offset by higher commissions and advertising costs that reflects our response to the current sales environment. We believe marketing costs and broker commissions will remain above historical averages in the near future which, combined with lower expected closing volume in 2023, will drive lower SG&A leverage.

The fourth quarter 2022 effective income tax rate was 23.3% compared to 23.8% in the prior year. Tax credits were earned on qualifying energy-efficient homes under both the 2022 Inflation Reduction Act for the current quarter and the 2019 Taxpayer Certainty and Disaster Tax Relief Act for the prior year. Overall, higher claim closing volume, combined with the lower outstanding share count in the current quarter, led to a 13% year-over-year increase in fourth quarter 2022 diluted EPS to $7.09.

To highlight a few full year 2020 results on a year-over-year basis, order units declined 15%. Closings were up 10%. We had an 80 bps expansion of our home closing gross margin to 28.6% in fiscal 2022 and SG&A as a percentage of home closing revenue improved 90 bps to 8.3%. We generated a 35% increase in net earnings and diluted EPS was a record $26.74 for the year, a 39% increase from 2021.

Turning to Page 9. Given slower market conditions, we are also focused on exercising balance sheet discipline. We reduced spend on land, development and phone inventory, ending the year with over $860 million in cash and generating $562 million of free cash flow just this quarter. At December 31, 2022, nothing was drawn on our credit facility and our net debt to cap was just 6.8% which is well below our maximum internal threshold of high 20s. With no shares repurchased during the quarter, we ended 2022 with $244 million available under our authorized share repurchase program.

Ahead of the spring selling season, we felt it was prudent to grow our cash position to maintain maximum flexibility in an uncertain environment. In the coming months, we will look to strike a balance between cash preservation for operations and returning dollars to shareholders and we expect to provide additional updates on our next quarterly call.

Shifting gears, I want to remind everyone about how impairments are calculated. When we estimate that the cash to be generated from the sale of homes in a community is not expected to cover the cost we will incur in that community and impairment is present. We review all of our assets every quarter and determined that there were no impaired communities in Q4 despite the reduced ASPs and higher direct costs. Looking at our expected home prices in 2023, we do not expect broad-based impairments across our assets.

On to Slide 10. Even with the increased liquidity this year, we grew our community count 5% in 2022 to 271 communities at year end. In Q4, we opened 21 new communities compared to 11 in Q3 this year. The ongoing supply chain issues [indiscernible] transformers continue to extend the time line for our new community openings. Additionally, we have strategically slowed and at times halted some of our openings to take advantage of the opportunity to rebid and lower our vertical costs so that these communities can open in a more competitive position when they come online. We expect to continue to open new stores throughout the year and return to our 300-community targets over the next several quarters.

This quarter, we continue to rightsize our land portfolio, walking away from underperforming land deals or recently sourced deals where we could not secure closing extensions. Even with slightly more than 10,000 terminated loss this year, we still ended 2022 with 4.5-year supply of lots within our target of 4 to 5 years. So we're comfortable that we have all the land we need right now. In Q4, we did not add any new lots under control while we terminated roughly 3,700 lots with a corresponding write-off of $4.2 million. These terminated loss relate to approximately $280 million of future land and development spend that we will not be incurring.

For full year 2022, after considering $15.8 million of walkaway charges from terminated land yields, we only have $92.5 million of incremental exposure related to deposits, due diligence for future lots under control which includes next phases of our existing communities. All in, this makes up less than 2% of our total assets. During the fourth quarter, we spent only $351 million on land acquisition and development, bringing our full year total spend to $1.5 billion. With reduced land acquisitions, about 2/3 of the spend was on land development costs. We expect our 2023 land acquisition and development spend to be at or below the $1.5 billion extended in 2022 despite the anticipated community count growth.

At December 31, 2022, we had approximately 63,000 total lots under control compared to approximately 75,000 total lots at December 31, 2021. About 73% of our total lot inventory at December 31, 2022 was owned and 27% was auctioned as the terminations of auctioned lots understandably drove the mix of controlled but not one lot lower. In the prior year, we had a 65% owned inventory and a 35% auctioned lot position. With just under 50% of our current portfolio sourced from land secured in 2022 or earlier, we are comfortable with the basis of the land control as well as the balance of owned and auctioned lots.

Finally, turning to Slide 11. Looking to Q1, we expect closings to be between 22 and 2,600 units with corresponding revenue of $940 million to $1.1 billion. We expect margins to trend down to 21% to 22% and our tax rate to be around 22% to 23%. With limited visibility and market conditions, we're holding off on providing full year guidance at this time.

With that, I'll turn it back over to Philippe.

P
Phillippe Lord
Chief Executive Officer

Thank you, Hilla. To summarize on Slide 12. January is off to a great start but too early to quantify the strength in spring selling season. We are prepared to find the right combination of product pricing incentives for all of our communities to achieve a pace of 3 to 4 net sales per month. Our commitment to prestarting 100% of -- homes, streamline operations and prioritizing takeover price positions us to capture market share, gain leverage and maximize profitability as market conditions evolve.

In conclusion, I would like to thank all Meritage employees for their hard work and the job well done in 2022. Their dedication drove our success.

And with that, I will now turn the call over to the operator for instructions on the Q&A. Operator?

Operator

[Operator Instructions] The first question today is coming from Truman Patterson of Wolfe Research.

T
Truman Patterson
Wolfe Research

First, just making sure I heard this correctly. Did you all say previously that January net orders were about 1,200 and up 4% year-over-year?

P
Phillippe Lord
Chief Executive Officer

Yes. We have sold about -- approximately 1,200 houses in January, a little bit over 1,200 which over last January was up about 4%. And then our absorption pace per store was right around 4.5 per -- sales per community.

T
Truman Patterson
Wolfe Research

Okay. Perfect. And I realize not reading too much into January trends. But we have lower lumber costs beginning to flow through the P&L. You all mentioned perhaps some other stick and brick costs maybe hitting later in the year. We also have some higher land costs in maybe an uncertain pricing or incentive environment that maybe you all found the floor. But I'm hoping -- can you help us think through 1Q gross margins if you all think that might be kind of the floor for the year? Or should we still expect it to be pretty choppy?

P
Phillippe Lord
Chief Executive Officer

I'll let Hilla dive into a more detailed description of what's going on in Q1. But I mean, it's just really too murky right now to know what pricing is going to do. Obviously, we've been aggressive. We're an affordable spec builder. So we're going to price ourselves in the bottom 2 piles of our competitor set community by community which is what we've done which is why our prices. Our ASPs are down now into the 300s from $4.80 at the peak. So, we feel like we've made some really significant adjustments to be affordable and to find the pace that we need to and feel like we're well positioned for the long term. But it's hard to tell what our competitors are going to do. Some builders still have quite a bit of backlog that they're going to close out and I don't think they've adjusted pricing yet. So we'll have to wait and see how that plays out and we certainly don't know what interest rates are going to do. We're happy to see them stabilize where they are and feel optimistic about that but those 2 factors are really driving our inability to predict pricing at this point.

And then, I'll let Hilla share kind of how we got to our Q1 margin guidance.

H
Hilla Sferruzza

Yes. So thank you, Philippe. Our Q1 is primarily what we saw in activity over the last 4, 5 months as the ASPs that you're seeing in our sales. As we mentioned, we had fairly decent gross sales. It's really the scrubbing of the backlog and the cancellations that brought the net sales down in Q4. So we think we found a market for 3 to 4 net sales per month. January definitely proved it. So right now, we're not comfortable giving guidance beyond Q1 but what we're seeing in Q1 reflects the current sales environment does not reflect anything yet in the direct cost initiative. However, as we said, we don't think that those margins are really going to materialize until the latter part of the year. And that's assuming that there's no other increases that are coming our way.

So kind of looking at where we are, we're comfortable at our current pricing structure. We're down almost 20% from the peak and we're able to sell at an acceptable pace. So we don't feel like we need to move it any further at this time, although we're constantly adjusting with market conditions.

T
Truman Patterson
Wolfe Research

Perfect. And you all clearly have streamlined business model generally with fewer vendor SKUs and floor plans than competitors. I'm hoping -- we'll leave lumber alone. It's clearly down a lot year-over-year. It's jumped up here pretty quickly so far in January. But I'm hoping you can help us maybe quantify the magnitude of potential cost tailwinds that you're experiencing as of today's starts outside of lumber. Any chance you can help us think through those?

P
Phillippe Lord
Chief Executive Officer

Well, we're going through an entire rebidding effort right now. As Hilla mentioned, we're aggressively rebidding all of our communities for spring starts. We also have been holding off on opening some new communities to really rebid those to get our vertical costs as far as we can. So it's way too early to let you know exactly what that's going to look like. But as we said in our script, we're having success on the front end and less success on the back end as it relates to the build. So we've seen in some of the hardest hit markets that we've recovered over $15,000 per house which, on a $200,000 construction budget, you can do the math. In other markets like Florida, we haven't seen -- you've seen that because the market is still pretty stable, starts are still going out pretty fast and we haven't seen that opportunity. But that's all we're prepared to say right now because we literally are going through this effort right now. But the early feedback from our vendors is that there's opportunity here and we're going to capture everything we can and we'll report back to you next quarter on how we did.

Operator

The next question is coming from Stephen Kim of Evercore ISI.

S
Stephen Kim
Evercore ISI

Yes, exciting times. I appreciate all the color. And particularly, the commentary on January really dovetails with what I've been hearing. A lot of excitement out there but everyone seems extremely cautious about predicting the sustainability of the rebound. So with regard to that, obviously, the sales that were extremely good. You were over your 3 to 4 order per month pace in January. And so the market clearly has done a kind of an about face. And I'm wondering if you're beginning to ratchet down incentives at the community level or taking other actions which would effectively mean that you're raising your net price.

P
Phillippe Lord
Chief Executive Officer

Yes. So at the end of the day, we're going to try to get 4 net sales per store. And that's how we built our business and we're going to try to get a 21% to 22% margin at that pace. And we -- everything from that point of view. So we went out there, we had some additional inventory. And I'm optimistic that having that inventory really is why our sales rebounded in January. We're not sure the market, frankly, is any better other than the fact that it's the spring and not the winter and interest rates have somewhat stabilized. From our perspective, it's about having move-in ready inventory which we have. That's what consumers want. And that's why we feel like we saw the January result.

In a number of communities where we made adjustments, we did see very strong elasticity in demand when we lowered prices and we were able to achieve even above our 4 net sales. So in those communities, we're pulling back on incentives where we think that's sustainable. And we'll back off on rate buydowns. We don't have to use rate buydowns nearly as much as we did now that we're selling all specs. People can move in relatively quickly and we can drive those costs down. So it's community by community. But it's one month and we're going to go take market here right now. We're going to be aggressive. If we can do more than 4 months at today's margins, we'll probably take more than 4 months at today's margin. It's spring selling season and we want to go get this market share while other builders don't have the spec homes to go get it.

So, we'll pull back a little bit where it makes sense. But for the most part, we're comfortable where our absorptions are, our entire margins are. And we're going to go try to sell more houses.

S
Stephen Kim
Evercore ISI

Yes, that makes a lot of sense. Your commentary, though, about community count and your rollout of those communities would seem to be a bit at odds, though, with running hotter than 4 a month. So correct me if I'm wrong. If this demand actually proves to be deeper and broader than anyone is really willing to bet on yet, do you have the ability to do an about face on your community count openings or community openings so that you can maintain a positive year-over-year community count over the course of the year?

P
Phillippe Lord
Chief Executive Officer

We can always accelerate opening our community. The demand is really strong. I think we don't feel that that's prudent today. So it would have to be really strong for us to make the decision to do that. Right now, we're seeing some meaningful opportunity to lower our vertical costs on those new openings and I think that's probably more critical for the long-term success of the community than opening it up early and getting community count comps because we have these big investments we made. And we don't want to compromise the integrity of those communities by opening them up at high vertical costs that don't underwrite. So that's number one.

Number two is it's still not getting any easier to open these communities, get the municipality, municipal approval, get transformers to the job site and, frankly, get finished inventory so that when we open up a community, we have ready to -- move in ready inventory in every single one of community. So that's driving the decision is the operational discipline there. And I don't think we're going to compromise that just to hit -- to accelerate community count this year. It's more about opening up those communities with strong momentum, opening them up clean, well executed, opening up with Sandy inventory ready to move in and opening up with the best vertical cost structure we can.

H
Hilla Sferruzza

Just to clarify, Stephen, the 300 community count target that we say we're going to hit in a couple of quarters, that already peaks in the rebidding process. So as we said, it's going to take us a couple of quarters to get through the full rebid. We said we're not going to have those home starts until the latter part of this year which is exactly aligned with our community count opening target that we just provided. Opening a community without inventory doesn't really work. As we said, the volume that we're seeing is because we have available specs. And putting a whole bunch of specs in the ground at an inflated cost and you know it's coming down in just a couple of quarters doesn't seem to be the right decision. So we're willing to be patient to make sure we drive that accelerated pace while not sacrificing what sales price, we can set the targets at and just have those sales in the back half of the year instead of more anaemic at a lower margin pace in the front end of the year.

P
Phillippe Lord
Chief Executive Officer

And just one last comment, the cancellations in Q4 were all part of the issue was people opening up communities without production. And then you're hoping to hold on your buyer for 9 months and that just doesn't make any sense when we don't know what interest rates are going to do. So we want to open up with move-in ready inventory. Customers are willing to engage with something that moves in 30, 60, 90 days. They can lock their rate. And I think it minimizes your cancellation exposure. So we've got our cancellations down to where we want it now. And we're going to run our business to make sure we keep those cancellation rates low, assuming that interest rates will continue to remain volatile.

S
Stephen Kim
Evercore ISI

Yes. So that's interesting, Philippe, because I think that you mentioned that you'd like to see rates stabilize. And what you just said is that we've seen a lot of volatility in the mortgage rate which we certainly have. And so I'm curious -- you sort of suggested that buyers need to see some rate stability. But I'm curious if that's really true. For instance, if we were to see the mortgage rate drop into the which it certainly seems as possible here in the relatively short term, do you not think that, that might represent an additional boost to a home buyer sentiment as that starts to make the headlines?

P
Phillippe Lord
Chief Executive Officer

I mean, clearly, you're asking me a trick question. If rates are lower, there's more demand. It's absolutely one-to-one relationship. So yes, if rates go to 5, we're going to see stronger demand. But we're going to stay with our operational discipline of selling move-in ready specs. It's about our supply chain. It's not our cost structure and it's about not knowing what the future holds. We could see a great -- a strong spring selling season. But rates could go up in the back half of the year. The Fed made their speech yesterday. They certainly didn't say they were going to lower them. So we don't know yet and we're going to focus on operating the way we think is in the best interest of our company.

Operator

[Operator Instructions] The next question is coming from Alan Ratner of Zelman & Associates.

A
Alan Ratner
Zelman & Associates

Thanks, as always, for all the great info. First on the pricing side, Hilla, you brought up average order price down 20% over the last couple of quarters which is obviously way more than the market is down and certainly way more than your peers are. And it sounds like maybe some of that is you guys being more aggressive. But I would imagine there's a decent amount of mix in there as well. So, I'm just curious if you're able to kind of parse that out for us because I do recall a couple of quarters ago when you were kind of giving the impairment sensitivity. I think you said like home prices would need to drop 20% for there to be any meaningful impairment risk. And now you're saying there's obviously not a ton of risk out there which makes a lot of sense given the current market. I'm just curious if you could kind of drill into that a little bit.

P
Phillippe Lord
Chief Executive Officer

I'll let you unpack the impairment question but I would just tell you, it's not a lot of mix. It's mostly just price. We absolutely -- our ASP was close to [indiscernible] middle of last year and we're now close to 390 and it's mostly store-to-store. Primarily, the biggest adjustments have been in the West and certain parts of Texas, although a little bit to the east. And our position is that we're an affordable builder. We have to get to a payment that makes sense for our customers. And we believe that payment exists when we're under 400 ASP. So we underwrote most of our land that's come into our income statement 2 years ago, assuming our ASP was going to be in the 3s to low 4s and that's where we position our product. And so we're about competitively positioning ourselves at the bottom of the graph or slightly above the bottom of the graph and being the affordable new homebuilder in our competitive set; so all that is mostly price.

It's -- yes, we've opened up a few new communities and they're maybe at lower ASPs. But it's pretty much all priced. And then Hilla can speak to the impairments.

S
Steve Hilton
Executive Chairman

Well, we do have geography with the East.

H
Hilla Sferruzza

When we're looking at it, Alan, we mentioned, just on a mix perspective, 89% of our sales in the quarter were entry-level. It's not that different from 82% last year's fourth quarter. So the mix is in somewhere in the 80s category. So that's not probably a material shift that with this material, a price reduction that we're still north of 20% margin. That gives us the confidence to say that, as we sit here today, we don't see broad-based impairment with north of 20 margins not just in the current quarter but in the quarter that we gave guidance for. So, how does that math work? How can you drop 20% from 31.6% and still be above 20%?

There are some other pieces that go into the mix, certainly some increased efficiencies and simplification of the product. But then also the high volume is helping us leverage some costs, particularly as we saw in the fourth quarter. So there's a lot of other pieces that roll into those calculations. But overall, you're seeing the impact of lower prices already in our numbers which is why we feel comfortable, especially looking at our January numbers that without any large material shifts in the market that we have a good ASP to hit our 3 to 4 net sales.

P
Phillippe Lord
Chief Executive Officer

And where we've made the most meaningful adjustments in Phoenix, Denver, we've also saw the most meaningful direct cost savings which have softened what our margins have done. When we quoted earlier in our script that we got 15,000 per house, that's in Colorado and Phoenix. That's where we got those numbers where the market has adjusted the most and also where prices ran up the most over the last 3 years.

A
Alan Ratner
Zelman & Associates

That's all really helpful. And I think it's really impressive that you've been able to reduce prices as much as you have and bring the affordability equation at a more reasonable level for your consumers and still generate the margins you are. I think it obviously speaks to the execution of the operation there. So well positioned to kind of take -- continue taking share from that regard. The second question, we heard from another builder last night that kind of gave similar commentary on January activity but they did kind of add in a comment that they might have seen a bit of a leveling off of the improvement over the last week or 2 kind of implying that things really accelerated kind of back half of December into early January. Not to get too fine here on weekly activity here but is that a statement you would agree with? Or do you feel like the market is continuing to gain momentum at this point?

P
Phillippe Lord
Chief Executive Officer

I mean we just gave out monthly. Now you want weekly sales trends. I can just tell you, we would not agree with that statement.

Operator

The next question is coming from Mike Rehaut of JPMorgan.

M
Mike Rehaut
JPMorgan

I appreciate you taking my questions. I just wanted to circle back and make sure I'm understanding some of the puts and takes on the gross margin side and obviously appreciating you're only giving first quarter guidance at this point. But if I heard right, you said that you're thinking about your long-term gross margins being in a 21% to 22% range, I believe you said which is where you are in the first quarter. How should we think about the puts and takes beyond first quarter just directionally at least? Because obviously, we're talking a lot about reduced construction costs, either materials or labor or both which, everything else equal, could be a tailwind, as you had said, might impact late 2023, early 2024.

I'm wondering if there's anything that would kind of perhaps even offset that, if you're thinking about trying to hit a 21%, 22%, it could even still be above that, given some of the lower construction costs. Or is there any lag in the impact of the incentive and pricing environment that you've seen over the last few months that might create a little bit of a -- even a further dip in the second quarter relative to where you are in the first quarter?

H
Hilla Sferruzza

So thanks for the question, Mike. The 2020 -- the 21%, 22% that we guided to for the first quarter that's -- but there are any homes that are under production. So we know what those costs are, right? They're closing in the quarter. We either came in to them with backlog or there's specs that can close in the quarter. So we have a good visibility into Q1.

Now not to be too cute here but when we spoke about our long-term trend, obviously, we're not talking about 2023 as a whole. We're talking about long-term trends. We said at or above from the normal margin of 20%. So I think that what we're trying to communicate there is that the long-term margins are 22% or north of that. So to be honest, we kind of just really got our whole operational structure in place right when COVID hit, right? 2019 is the first year that we really kind of had all engines coming in a new strategy. And then we had COVID and it was impossible to look at what an environment would be in a normalized pace.

So at the beginning, we thought it would be 21. Since then, we raised it to 22. And on today's call, we said normalized would be at or north of 22 as we continue to harvest the efficiencies that we're seeing in the business. So when we look at Q1, I don't -- I can't predict sitting here today if it's the trough. I know the builder took that position, so that's going to be the low point for the year. By not providing guidance for the whole year, we're not confident that we understand all the dynamics yet for the rest of 2023. We do feel confident in the long term operational structure that we have, the long term will be 22% or higher. As that clarifies over the coming quarters, we'll give additional insight there.

M
Mike Rehaut
JPMorgan

That's great. That's helpful. I appreciate that, Hilla. And just to make sure also one element of my question around the current pricing environment. Would you say that in terms of where you are in the last couple of months, in terms of incentives on orders that, that is more or less fully reflected in your first quarter gross margin guidance? Or because I would assume that incentive levels in December were higher than October, let's say but maybe I'm wrong on that? So just trying to get a sense of where the first -- what the first quarter gross margins reflect and if current incentive levels are higher than that or in line with that.

H
Hilla Sferruzza

So I'll just clarify. I know you said incentives but just to clarify, we don't look at incentives because we expect builder primarily with 89% of our volume coming from entry level. So we use base price incentives and financial discounts interchangeably because we're solving for a payment for the buyer. So all in, what you're seeing in our Q1 guidance includes the January sales. This is our current volume and what we expected. Those specs that we mentioned that we have 1/3 of them entering the year, ready to close in the quarter, we sold some of those. We sold 1,200 of those in Q1 already. So what we're seeing in the margin guidance of 21 to 22 reflects the current environment.

Operator

The next question is coming from John Lovallo of UBS.

J
John Lovallo
UBS

I know you mentioned about potentially being more open to returning capital to shareholders. But just thinking about your liquidity position, the stock's valuation, there's no debt coming due to 2025, I mean, is there an opportunity here to get aggressive on share buybacks?

H
Hilla Sferruzza

Sure. There's an opportunity to get aggressive on share buybacks to consider other methods of getting cash to shareholders to look at the debt paydown. We're looking at everything and trying to make sure that what we do optimizes the return to the shareholders while keeping us in the strongest balance sheet position possible. So there's definitely some action that we'll be taking in 2023 but the magnitude and which action it is, we're still betting through our Board. So stay tuned for next quarter's call for some more visibility into that.

J
John Lovallo
UBS

Okay, that's good to hear. And then the 89% of orders for entry level, how high can this go? And how high would you like it to go? And is there -- just remind us, is there any margin differential on the entry level versus other parts of your portfolio?

P
Phillippe Lord
Chief Executive Officer

Yes and there's really no differential. We have 3 consumer segments that we focus on entry-level buyer, what we call the move-down value-conscious buyer and then we move up the value-conscious higher. And it's kind of blurry. The lines get blurry. Some of them are the same people, same type of families, aspirational entry-level buyers are kind of moved up value-conscious. So I think you go -- it can get all the way up to 90%, 95% based on your definition of our customers and our communities. But our target is 70%, 75% entry level and 25% to 30% value conscious move down and move up buyers. And so I think it can move around depending on what interest rates are doing and what the market is doing but that's kind of the sweet spot.

Operator

The next question is coming from Carl Reichardt of BTIG.

C
Carl Reichardt
BTIG

Philippe, you mentioned that cycle times in Arizona and Colorado were the longest in the company. I'm just curious why is that.

P
Phillippe Lord
Chief Executive Officer

It's a good question. I think it's a couple of different things. I think and they're both different actually, not the same reason. But in Arizona, there was just so much demand during COVID. And I just don't think the trade capacity could keep up with the amount of starts that were being pushed out both in multifamily and single-family. So tremendous ramp-up in 2020, '21, just put a lot of constraints on them and they just weren't able to keep up and we saw some pretty meaningful expansion in cycle times across a lot of categories not just front end versus back end but across the board. So just big market, lots of demand. Colorado has always had a labor issue. It's always been difficult to attract skilled labor there. It's -- a lot of folks don't get into that business there. It's always been somewhat constrained. And then when you add a surge in demand that we saw again out of COVID, you just saw our cycle times get really, really long.

So 2 different reasons; I think Phoenix recovers relatively quickly as demand has slowed significantly here. And so we're already seeing that. I think we'll be able to get our cycle times down here relatively quickly as demand slows. Denver is always going to be a challenge. We always have the longest cycle times there. We build basements. We do a lot of high density there because affordability. So we'll continue to have challenges there but hopefully, we'll do better as the market slowed there as well.

C
Carl Reichardt
BTIG

And then second, in the past, you've talked a lot about the importance of keeping your pricing near to below FHA conforming loan limits. Obviously, you've had a big jackup in those limits. Has that helped at all in January? Are you hearing that from consumers or seeing that in terms of apps?

P
Phillippe Lord
Chief Executive Officer

No. It's really not even a factor for us anymore because FHA and conforming loan limits have gotten so high. So now it's just all about where we're positioned against our competitive set. We want to be, as I said earlier, on the bottom to the middle of the bottom of the graph, depending on who we're competing with and really be the affordable offering in the market. So it's just driven by our pricing and our research department that looks at every community every week and tells us where we need to price our inventory to find the ideal pace. But it's no longer really connected to that unless it is, right? It clearly matters. We want to be below that but we probably want to be well below that these days given how high we are.

H
Hilla Sferruzza

Just visibility, Carl, FHA for the year for us was 15% of our total mortgage pool certainly, some people are using FHA but it's so high that a lot of people are just getting conventional loans. They don't need the assistance that comes from FHA, the dollars kind of got a little bit disconnected. It was a 2-year lag to where they needed to be and they came up right when ASP started to come down.

Operator

Our final question today is coming from Alex Barron of Housing Research Center.

A
Alex Barron
Housing Research Center

Yes. I wanted to ask regarding your land position, how you guys are thinking about what's transpired, I guess, in the last few weeks and your approach to land going forward, if there's going to be opportunities to replace the stuff you guys cancelled at better deals? Or are you just going to hold off? Or how are you guys thinking about the current land environment?

P
Phillippe Lord
Chief Executive Officer

We're definitely going to be cautious and patient here. We're going to get through certainly the spring and sort of re-evaluate what the market looks like, what the long-term prospects look like. We're seeing some opportunity out there. I saw a survey recently that land prices have started to decline modestly, I think, around 5%. I don't think that's enough. We've got to get our land development costs down as well, if things are hard to underwrite. Today's interest rate environment is the new reality; so we have plenty of land. As you've articulated, we have the ability to maintain our 300 community count trajectory for the next couple of years without really buying anything. So it will be about when it's time to grow from there. We're in some new markets. We clearly want to be active there but we want to be patient as well.

So, I think you're just going to see us be really, really patient. We're definitely going to get through the next couple of quarters to read the tea leaves, kind of evaluate what 2024 and 2025 are going to feel like before we start ramping it up. That being said, we have $850 million sitting in the bank. And if opportunities present themselves, we'll certainly go get.

H
Hilla Sferruzza

Yes. Alex, just to clarify, you're hearing from all of our peer builders. A lot of folks are dropping options that don't make sense. We're walking away from land deals. Those land deals still exist. They're just going to be repackaged and sold to the builders at a cheaper price. So at some point, there is going to be a jumping point that we're going to enter the market opportunistically more than having land committee every week and buying land aggressively but there will be opportunities to buy land at more attract prices.

A
Alex Barron
Housing Research Center

Got it. And if you reflect back to the last 2 years, I mean, we had supply chain issues, then we had rising interest rates. What do you think are the, I guess, lessons for you guys? Or how are you thinking about maybe if either of those 2 things -- let's say, the market reaccelerates and we start to see supply chain issues again, what do you think you'd be doing differently this time to capitalize on these opportunities? Or how would you approach things differently this time around, given your experience in the last 2 years?

P
Phillippe Lord
Chief Executive Officer

Well, we're always learning. I think that we've demonstrated over the last 5 years that we're probably one of the -- we're an extremely agile and proactive organization. We've been ahead of a lot of the trends. We came out of COVID more aggressively than anybody, grabbed market share. We pivoted our strategy. I think we're playing in the -- with the right side in the right part of the market. We have specs. So we're going to continue to be agile. We do this job 24/7. We're paying attention to everything. We have a very aligned, engaged team out there. We talk all the time. We listen to one another and we're going to continue to collaborate as a team and move quicker and faster than we have before so that we can take advantage of whatever opportunities represented in this market but also properly manage the risks that are still evident as well.

So it's about being agile. It's about being willing to change and innovate constantly and we have a real strong capability here and we'll continue to invest in that. And that's what we've learned, right? Don't continue to think that everything that was is going to be and just be willing to evolve and adapt.

Thanks. Thank you, operator. I'd like to thank everyone who joined this call today for your continued interest in Meritage Homes. We hope you have a great rest of the day and a great weekend. Thank you.

Operator

Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect your lines at this time or log off the webcast and enjoy the rest of your day.