Greetings, and welcome to Meritage Homes' third quarter 2021 analyst call. At this time, all participants are on a listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Emily Tadano, Vice President of Investor Relations. Thank you. You may begin.
Thank you, Doug. Good morning, and welcome to our analyst call to discuss our third quarter 2021 and year-to-date 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 homepage.
On page two, please refer to cautioning you that our statements during this call, as well as the press release and accompanying slides, contain forward-looking statements, including but not limited to our views regarding the health of the housing market, economic conditions and changes in interest rates, community count and absorptions, trends in construction costs, supply chain constraints and cycle times, projected full year 2021 home closings and revenue, gross margins, tax rates, and diluted earnings per share, potential disruptions to our business from an epidemic or pandemic such as COVID-19, as well as others. 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 press release and most recent filings with the Securities and Exchange Commission, specifically our 2020 annual report on Form 10-K and quarterly reports on Forms 10-Q, which contain a more detailed discussion of those risks. We have also provided a reconciliation of certain non-GAAP financial measures referred to in our press release as compared to their closest related GAAP measures. With us today to discuss our results are Steve Hilton, Executive Chairman, Philippe Lord, CEO, and Hilla Sferruzza, Executive Vice President and CFO of Meritage Homes. We expect this 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 November 11th. 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 current market trends and provide an overview of year-to-date 2021. Philippe will cover our strategy and quarterly performance, and Hilla will provide a financial overview of the third quarter and forward-looking guidance. Home buying activity remained solid during the third quarter. We continue to experience elevated demand, and despite the return of some seasonality in the quarter, monthly demand has improved sequentially from August to September and October. The macro drivers for market demand continue to be what we've experienced all of 2021. Limited housing supply, still extremely low interest rates, and higher home buying activity from millennials and baby boomers who are experiencing life events associated with changes in housing needs. New and existing resale housing supply remain tight, especially for affordable entry-level homes.
Mortgage interest rates are still very attractive. As entry-level buyers are typically focused on a monthly payment, the low interest rates continue to offset higher ASPs, and we are seeing elevated demand persist. Lastly, we continue to see household formation for millennials and downsizing for baby boomers, both of which create demand for the type of housing that we build. We believe these underlying demographic factors will not fundamentally change in the near future and although they may, they may be bumpy if interest rates move materially within a short period of time. This quarter, we leaned on our deep vendor relations to navigate ongoing industry-wide supply chain challenges. These strategic supply-side partnerships and our operating model focused on spec homes and limited SKUs allowed us to deliver 3,112 homes, which set the company record for the highest third quarter of home closings.
We also set two additional quarterly company records. We generated the highest quarterly home closing gross margin of 29.7% in company history as a result of pricing power more than offsetting the elevated lumber and other commodity costs. Our quarterly diluted EPS of 5.25 was the highest in our company's history. We grew community count sequentially again this quarter as well as year over year, overcoming municipal delays and supply shortages and land development as well. As of September 30, 2021, we had 236 ending communities and remain confident in our ability to achieve our goal of 300 communities by mid to 2022. On slide four, I wanna touch on the latest milestones we achieved this quarter. The EPA recognized Meritage as a recipient of the 2021 Indoor Air Plus Leader Award.
Our advanced air filtration, ventilation, and HVAC, as well as spray foam insulation, help minimize indoor exposure to airborne pollutants and contaminants, so it's great to be recognized for these accomplishments nationally. In terms of innovation, we launched self-guided tours in select locations to address customers' changing preferences when it comes to home buying, the home buying process. Self-guided tours allow buyers to sign up for a no-contact tour of our model homes on our website, and then tour the home after hours at their convenience. We expect to have this program rolled out throughout the country in the coming months. Additionally, we expanded our offering of digital financial services so Meritage customers can now receive guaranteed on-demand homeowners insurance quotes on their selected home on our website. From an ESG perspective, we memorialized our human rights policy, which can now be found on our investor relations website.
Stay tuned as we will have more to share on the ESG front before year-end. Overall, it was another successful quarter where our teams and supplier relationships helped Meritage deliver 3,112 homes. I'll now turn it over to Philippe.
Thank you, Steve. Affordability was one of the cornerstones of our strategic shift in 2016, and we continue to be focused on it today. From land acquisition to operations, we look to maintain our entry-level products as an affordable home offering in the new home marketplace. That being said, the sustained favorable pricing environment stemming from the elevated demand for our product over the past few quarters and the tight housing supply conditions led to ASP increase on orders, backlog and closings that are masking our ongoing product mix shift towards entry level. Although ordered ASP grew 12% year-over-year, we experienced a deceleration in ASP growth sequentially this quarter, and the new product we'll be bringing on in 2022 and 2023 will allow us to continue repositioning our future communities down the ASP band.
During the third quarter, we continued metering our orders pace to align with the current production environment and supply chain challenges. Even still, our average absorption pace remained elevated at 5.0 per month. We were still typically able to sell inventory shortly after releasing it, but we are only releasing homes once we have visibility into our cost structure and confidence about closing timings, which is a bit later in the process today due to supply constraints. It is unclear when the current supply challenges will work themselves out. We currently have no insight to suggest that it's in the near term, and therefore we are continuing to model elongated cycle times for the foreseeable future. Now turning to slide five. Our third quarter closings totaled 3,112 homes. They were up 4% over the prior year.
Entry level comprised 78% of closings, up from 63% in the prior year. For us, Q3 of last year was the quarterly peak of the surging housing demand since the start of COVID-19, resulting in our all-time highest third quarter absorption pace of 5.8 sales per month. In 2021, we have been meeting orders due to the well-documented supply chain issues. As a result, the total orders of 3,441 for the quarter of 2021 reflected a decrease of 11% year-over-year, driven by a 15% decline in average absorption pace that was partially offset by a 5% increase in average communities. Despite moderating, our third quarter 2021 absorption pace currently remained elevated at five sales per month.
Entry level comprised over 80% of quarterly orders, up from nearly 70% in the third quarter of last year. Entry level also represented 77% of our average active communities, compared to 60% a year ago. Moving to the regional level trends on slide six. Our central region, which is comprised of Texas, led in terms of average absorption pace with 5.4 sales per month this quarter, which was 14% lower than prior year. This decline was partially offset by a 5% greater average active communities, which together contributes to a 10% decline in order volume. Third quarter orders ASP increased 20% year-over-year, given solid market conditions in Texas.
Our East Region, with the highest entry-level product mix representing 80% of the average communities, was the only region to generate year-over-year growth in order volume of 3% despite metering as a result of an 88% increase in average active communities in the third quarter, which offset a 4% decrease in average absorption pace. South Carolina opened several new communities later in the third quarter, which resulted in a 3.7 average absorption pace in the third quarter. This was our lowest absorption pace in the company's quarter, despite South Carolina's orders increasing 11% over prior year. Given healthy demand in the state, we anticipate the order pace will increase in the near future.
The West Region's Q3 2021 order volume had our largest decline at 24% year-over-year, mainly due to 25% lower average absorption pace to 4.9 per month. Specifically, Arizona reduced its absorption pace from 6.5 per month in Q3 of 2020 to 4.8 per month this quarter as a result of supply chain challenges. Colorado remained the lowest percentage of entry-level mix at 48% of its average active communities this quarter. However, given the greater representation of entry-level products in its upcoming pipeline, we expect its absorption pace will start to increase over time. During the third quarter, California had the highest average absorption pace of all our states at 5.6 per month.
Given 100% of the average active communities are entry level there, we continue to focus on affordability, particularly as it's our most expensive geography. The third quarter order ASP increased 15% year-over-year in the West region. Arizona and Colorado had the largest increase in order ASP in all our states at 26%. We are monitoring these markets to ensure we align ASP to local market conditions and continue to introduce product that is more affordable. Overall, demand remains healthy in all of our markets. Turning to slide seven. Of our home closings this quarter, 74% came from previously started spec inventory, which increased from 71% a year ago. We ended the quarter with nearly 2,000 spec homes in inventory or an average of 11.7 homes per community as we push to get homes in the ground.
This was an important improvement from approximately 2,300 specs or an average of 11.2 in the third quarter of 2020. As of September 30, 2021, less than 5% of the total specs were completed versus our typical runway of one-third. Having available specs is crucial to our business model. Even as we started over 3,400 homes this quarter, maintaining our goal of a 4- to 6-month supply of entry-level specs has been challenging. As we have been ramping up our new communities, we are working very hard to get enough specs started in all of them. We didn't accomplish all that we wanted in Q3, but we expect to accelerate start space in Q4.
We ended the quarter with a backlog of over 5,800 units as our conversion rate declined from 68% last year to 57% this year due to supply delays. Although we believe our spec strategy and entry-level focus will drive the conversion up in the long term when the supply chain normalizes, we expect current supply issues and the resulting slower backlog conversions to persist at least for the next couple of quarters. During the third quarter, bottlenecks abound in various areas along the supply chain, some on the front end and others on the back end, leading to an additional two weeks or so of construction cycle time sequentially from Q2 to Q3 this year. In particular, windows and trusses delays impacted our operations throughout the country.
As Steve mentioned, our operating structure and strong vendor partnerships have afforded us some advantage as we navigate these disruptions. We re-engineered our product a few years ago, which limit our SKU count and plan library, allowing us to order material in bulk in advance. We have also heavily invested in relationships with our vendors, which we have strengthened during the last couple quarters. We are maintaining constant communication and remain flexible to substitute or upgrade our SKUs or find alternative supplies as necessary. We have been benefiting from our 100% spec building strategy for our entry-level homes. Pre-starting homes enable us to maintain a steady cadence of homebuilding construction and makes us a preferred partner to our trades. The transparency and scheduling visibility as well as no structural changes makes our products simpler to build.
At times like these, we appreciate that we can leverage our spec building strategy and our operating model to continue to deliver our backlog and get more homes started. I will now turn it over to Hilla to provide additional analysis of our financial results. Hilla.
Thank you, Philippe. Let's turn to slide eight and cover our Q3 financial results in more detail. The 10% year-over-year home closing revenue growth to $1.3 billion in the third quarter of 2021 was the result of the 4% increase in home closings and 7% higher closing ASP despite the mix shift to more entry-level product. The 820 bps improvement in third quarter 2021 home closing gross margin to 29.7% from 21.5% a year ago was driven by the price increases over the past several quarters, as well as the leveraging of our fixed costs on greater home closing revenue. The pricing power more than offset the increased cost of lumber and other commodities.
Today's more normal lumber costs will start to be reflected in our gross margin in early 2022, but will be partially offset by other increased commodity costs as well as the additional overhead burdens in gross margin from our community count ramp up. Once we're fully selling and closing from all 300 communities in 2022, we will be able to leverage the higher fixed overhead costs across a corresponding higher revenue. We are also continuing to monitor the recent increases in lumber and the impact they may have on our 2022 gross margin. Our SG&A leverage of 9.3% remains better than our 10% expectation and continue to benefit from both greater closing volume and higher ASPs.
The 80 basis points year-over-year improvement in SG&A leverage from 10.1% in the third quarter of 2020 also included lower brokerage commissions in 2021 and cost savings from technology innovations that particularly benefited our sales and marketing efforts. We will continue to find ways to incorporate technology into our operations and expect to be able to better leverage our total SG&A on higher closing volume in 2022 as well. The third quarter 2021 effective income tax rate was 23.3% compared to 19.5% in the prior year. Both years reflect reduced rates, primarily from eligible tax credits on qualifying energy efficient homes closed under the 2019 Taxpayer Certainty and Disaster Tax Relief Act.
Increased profit in states with higher tax rates and reduced benefit of the energy tax credit due to greater overall profitability for the company both contributed to the higher tax rate in 2021. Higher closing volume, pricing power, expanded gross margin, and the improved overhead leverage that we achieved this quarter all led to the 85% year-over-year increase in third quarter diluted EPS of $5.25. To highlight a few year-to-date results through September 30, 2021. On a year-over-year basis, we generated an 85% increase in net earnings. Orders decreased 1%. Closings were up 15%.
We had a 640 bps expansion of our home closing gross margin to 27.4%, and SG&A as a percentage of home closing revenue improved 90 bps to 9.4%. As seen on slide nine, our balance sheet reflects ample liquidity and flexibility for further growth. At September 30, 2021, our cash balance was $562 million compared to $746 million at December 30, 2020. It was down just a $184 million despite an $815 million increase in real estate assets over the same time. Our net debt to cap ratio of 17.5% at September 30, 2021 remain low.
We still target a maximum ceiling of net debt to cap in the high twenties, which is in line with the quick asset turn we expect from our entry-level and first move-up offerings. Our capital usage priority is still focused on growth. The bulk of our cash will be spent on land acquisition and development and to get specs in the ground in our new communities. We routinely repurchase shares to offset new grants and keep our dilution neutral. As demonstrated in the third quarter, we will also continue to opportunistically repurchase incremental shares. We repurchased over 95,000 shares during the quarter for $9.5 million. Since the end of the quarter, we repurchased an additional nearly 244,000 shares for another $24 million. Today, over $153 million remains in our share repurchase authorization program.
We expect cash generation to accrete once our 300 communities are operating and delivering homes in the back half of 2022. On to slide 10. Our land book increased 46% from September 30, 2020. With nearly 70,000 lots under control at the end of this quarter, we had 5.4 years supply of lots based on trailing twelve months closings, which is higher than our target range of four years-five years supply of lots under control. However, looking forward to the closing volume that we would generate once our 300 communities are actively selling in the middle of next year, the ratio drops back to our four years-five year objective. We secured about 9,800 net new lots this quarter, compared to approximately 9,000 in the same quarter of 2020.
These new lots will translate to an estimated 45 net new communities, of which 87% are entry-level with an average community size of 196 lots. Despite the additional demand for land from all builders today, we were able to meet our internal land acquisition goals while making sure our projects meet our underwriting hurdles, modeling a normalized absorption pace and a higher incentive environment. Our understanding of who we are has sharpened, as has our confidence level in the type of projects we bid on. By knowing the cost of the home and increasing our land development expertise, we feel comfortable bidding on land parcels that others might not. From acquisition of larger lot sizes to those in secondary submarkets that best align with our entry-level products and projects with complexity in land development.
In fact, our year-to-date finished lot cost for newly controlled lots is right around $75,000 a lot. During the third quarter of 2021, we continued to make excellent progress in our land development despite municipal delays and supply chain constraints, and we opened 40 new communities. We grew our community count by 10 net communities from 226 at the start of the quarter to 236 actively selling communities at the end of the quarter. On a year-over-year basis, we were also up 16% or 32 net communities from 204 at September 30, 2020. We spent $526 million on land acquisition and development this quarter, which was 76% higher than last year's Q3 spending of nearly $300 million.
We continue to expect our annual land acquisition and development to be about $2 billion in 2021 and thereafter. To preserve liquidity, we use options or staggered purchasing terms where financially feasible. About 64% of our total lot inventory at September 30, 2021 was owned and 36% was optioned, compared to 58% owned and 42% optioned at September 30, 2020. Finally, I'll direct you to slide 11. With limited visibility into when the supply chain will loosen, we continue to forecast supply chain delays and longer cycle times for the rest of 2021 and into 2022.
With more than 5,800 units in backlog and another almost 2,800 specs in the ground today, we are projecting 12,600-12,900 home closings for the full year 2021, which we anticipate will generate $5.05 billion-$5.15 billion in home closing revenue. We are lifting our full year 2021 guidance on home closing gross margin, which we now anticipate will be between 27.5%-27.75%. With an increase to the projected effective tax rate to 23%, we expect diluted EPS to be in the range of $18.75-$19.40 for 2021, a year-over-year increase of over 70%. For year-end 2021, we also anticipate around 250 active communities.
We are reiterating our commitment to 300 communities by June 2022, with around $2 billion of land acquisition and development spend projected for next year as well. For 2022, we anticipate double-digit growth in units and home closing revenue. As I previously noted, we expect gross margins in 2022 to remain elevated, although supply chain issues, commodity costs, and recent lumber cost increases may all cap further upside. With a higher volume of communities operating next year, we anticipate full year 2022 SG&A rates will drop below our current SG&A rates of the low nines. With that, I'll turn it back over to Philippe.
Thank you, Hilla.
To summarize on slide 12, we have capitalized on the ongoing favorable market conditions by having available supply of entry-level and first move-up homes that are attractive to both millennials and baby boomers, the largest home buying demographic today. The continued significant investment in land acquisition and development, as well as the meaningful growth in community count over the past two quarters to 236 communities as of September 30, demonstrates our ability to attain our strategic goal of 300 communities by mid-2022. Our operating model, strong execution, growing community count, and focus on the entry-level and first move-up markets have all led to the company hitting our closings, achieving an absorption pace of five per month while meeting the order pace, growing community count again, and obtaining industry-leading gross margins this quarter.
Additionally, these attributes position us well to continue expanding our market share, leveraging our operating costs, and driving profitability over the next several years. With that, I will now turn the call over to the operator for instructions and the Q&A. Operator?
Thank you. Ladies and gentlemen, at this time, we will be conducting a question-and-answer session. If you'd like to ask your question, you may press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. Our first question comes from the line of Alan Ratner with Zelman & Associates. Please proceed with your question.
Hey, guys. Nice job in the quarter, and thanks for taking my questions. Philippe, I think you made a comment early on that you know, the goal going forward is to try to bring that average price, you know, back down a little bit from, I guess, the current $430,000-ish range that you're at today. You know, on one hand that certainly would be, you know, great news, you know, from an affordability perspective. But I'm curious if you could talk a little bit about how you're gonna make that happen. You know, I'm sure your lot costs are going up at a pretty strong rate. You know, costs are going up across the board, maybe aside from lumber. What levers are you pulling to bring that price back down a little bit?
Can you put any meat behind where you actually see that ASP going over the next few years?
Yeah. Thanks, Alan. You know, we continue to try to source land that allows us to position our product in the 300s, you know, mid-300s, low 300s in certain markets, maybe higher, close to 400 in other markets, and I think we're being successful doing that. The land that we have sourced over the last 18 months allows us to do that. We've said multiple times that we're willing to go out to sort of secondary market. I wouldn't say we're going out to tertiary markets, but definitely further out secondary markets where we're able to source, you know, low cost land where we can position our product into much more affordable segments. You know, Hilla, in her comments, mentioned that our average lot price is $75,000 on a go-forward basis.
You know, you can do some math on that, but for the most part, that should allow us to position our product below $400,000 across all of our markets. That's really the goal, and that's really the target. It just comes down to the land. We don't expect our vertical costs, or are certainly not modeling our vertical costs, to do anything from where they are today. It's just about sourcing less expensive land. We still think we're finding quality land in good secondary markets where we can do that.
Got it. That's helpful. You know, I guess drilling in a little bit deeper on that. You know, how quickly does the mix get below 400? I mean, is that just as you open up and ramp the community count to the 300, you know, by middle of next year into 2023 you're kind of operating at that level? Second on that point, you know, with that lot cost at $75, you know, just kind of back of the envelope, you know, it would seem to me, you know, as that flows through, unless you do get price appreciation, maintaining a, you know, call it 20%-28% gross margin, you know, into the next several years might be a little bit difficult. Any comment on that would be great.
Yeah. I mean, next year, most of the land that's flowing through is land we bought two years ago. We still feel that our margins will stay elevated through next year. Obviously, land we bought over the last two quarters, we underwrite to more normal margins. That land doesn't come on until late 2023 and 2024. We have all the land we need for the next two years, so this is land we're buying for future years. That land is underwritten at a more normal margin. As it relates to the next two years, you know, like I said, it's really about positioning our product below $400.
We think that, you know, barring further price appreciation and anything else out there, the land is positioned to allow us to move our price point down into the 300s over the next two years.
Great. Thanks a lot for that, guys. Good luck.
Our next question comes from the line of Stephen Kim with Evercore. Please proceed with your question.
Yeah. Thanks a lot, guys. Really impressive results, so congratulations on that. My first questions relate to gross margin, which was, you know, obviously up tremendously. You had mentioned that, I think, 26% of your closings this quarter were what we would call dirt, you know, dirt sales. I was curious whether those dirt sales generated a lower gross margin than the units which you had sold, you know, already in the construction process. If there is a differential between, you know, those dirt sales and spec margins, has that differential widened, versus pre-pandemic?
I'll take that one, Steve. Primarily our dirt sales, as you know, we're 100% spec builder and entry-level. The dirt sales are coming from our first move-up product. There's not a tremendous variance between the two, although in today's environment, there's a slight benefit, not necessarily for the fact that it's spec, but the entry-level process allows some additional efficiencies. I don't think that we're prepared to quantify the difference between the two, but there is a slight benefit, particularly in today's supply chain constrained environment to selling spec, which for us is our entry-level product.
Yeah. Got it. As a follow-up, Hilla, would you say that that's because it's more entry level or because it's more spec, if you had to guess?
It's definitely because it's more spec. Typically, you should earn a higher margin on the more expensive options in a home. In today's environment, the spec cadence that we're able to achieve on the spec product helps us. It helps us always kind of neutralize the benefit that normally we're yielding about the same margin between the two products. The higher option costs that you're getting on first move-up are offset by the faster cadence and the more streamlined operations of the spec product. In today's environment, there's a slight benefit to the spec product, even overtaking the margins from the higher options on first move-up.
Yeah.
Even in first move-up, we've completely streamlined our operations. I think you're familiar with our new studio.
Yeah.
Although you're able to personalize the home, we still have a lot of visibility into those costs. You know, they're almost a spec, but they're just, you know, we allow the buyer to personalize within that sort of spec process. We're almost all spec, for the most part of the company.
Yeah. Great. Okay. Second question relates to gross margin outlook. I think you had talked about seeing, you know, the benefit of reduced lumber prices probably flowing through in early 2022. You did caution that there's a fixed cost, I guess, in SG&A that will increase as your community count is increasing, but you're not obviously gonna be delivering a lot of homes. There's a little bit of a mismatch, I suppose. Can you help us quantify this, give us maybe some sort of a framework or rubric to be thinking about how this could influence your results? I think you also indicated fixed cost leverage helped you this quarter. Just how much of the COGS are we, you know, are we seeing that are kind of fixed?
Maybe give us a framework for thinking about how to model that going forward.
I think historically we've said that between, you know, in years where you have normal seasonality, I know the last couple of years haven't really held to that standard, but in years of normal seasonality, there's almost a 100 bps improvement between Q1 and Q4 on the leveraging just based on volume. There's a fairly material portion that we can, you know, minimize the impact of those fixed costs on higher volume and also higher ASPs obviously have also helped us this quarter. Next year is going to be a little bit of ups and downs because we're going to be growing our community count every quarter of 2022. However, the closings from those will come a couple quarters later, right? We're incurring the cost up front.
Obviously, we have to have people on the ground getting the community ready, but the closings won't come until a quarter or a quarter and a half later. You're gonna see a little bit of unevenness until we kinda hit that 300 community count target in June. Then all of those communities will start delivering homes in the back half of the year.
Okay, great. Well, appreciate it. Thanks very much, guys, and congratulations on the good results.
Thank you.
Thank you.
Our next question comes from the line of Michael Rehaut with JPMorgan. Please proceed with your question.
Hi, I'm Doug Wardlaw from Michael Rehaut. Good morning, guys. I just want to know if you guys can give a little bit more insight into cycle times maybe now versus a quarter ago, and then if there's just been any improvement or worsening in the process in that timeframe.
Yeah, I think in our, you know, comments, we said that our cycle times have gone up around six weeks-seven weeks year-over-year, maybe another week or two from, you know, Q3 to Q2. We kind of saw those coming, frankly, when we put our guidance together for Q3. I would say as we look into Q4 and the following year, we kind of think they're about stable. Could they get worse? It's anybody's guess. But right now, we feel like, you know, Q4 is gonna be about the same.
Just to clarify, we're not modeling any improvement at this point.
Awesome. Just for a little bit of further insight, are there any, you know, stages or product categories that are currently the biggest challenges, or is it just across the board right now?
You know, I think for us nationally, we see windows being the bigger problem, trusses a little bit. When you go regionally, it seems like it's a little bit of different stuff everywhere. Mostly nationally, it's really just trusses and windows are the stages where we're having the biggest challenge.
Awesome. Thank you, guys.
You're welcome.
Our next question comes from the line of Carl Reichardt with BTIG. Please proceed with your question.
Thanks. Hey, everybody. Philippe, I wanted to ask, you made a comment about third quarter orders per community per month, five, I mean, you called them elevated, you know, down from last year. I didn't know if you meant elevated just seasonally or you meant elevated generally. Sort of tying that to your underwriting for new communities. You said normal absorption pace or Hilla did. So what is that? Is that four a month? Is that how you look given the model transformation at Meritage? Is that how you look at what a normal absorption pace should be with your product mix?
Yeah, I think as we think about our business long term, you know, we look at first move-up as something that can do three or four , depending on kind of where we're positioned in the, you know, the sub-market. We think about LiVE.NOW. as something that can do anywhere from four-six, depending on kind of where we're positioned in the sub-market. When you kind of put that all together, we think we're gonna do somewhere between four and five, you know, a month long term, probably more closer to four than five. We've stated many, many times that when we get to 300 communities, we think we can produce, you know, 15,000 homes. When you do the math on that, it's 48 per store, and that's kind of four a month.
As we look at new land, that's how we kind of underwrite land. As it relates to my comment around five being elevated, I would say all of the above, right? Certainly haven't seen any seasonality, so we're still seeing really strong demand. I would tell you that we could sell more than five a month. We're selling five a month because we're pacing in 80% of our stores. We're doing that because that maximizes the efficiencies of our business in the current supply constrained environment. You know, we produce really strong results at five a month. Doing any more than that today just seems like it creates problems for the trades.
I do believe that if we just let a lot of these run, we'd see something more closer to six or seven or even eight in some markets that are really, really strong and we're really priced low. In my mind, demand remains very elevated out there, and we're very happy with the five sales that we're getting per store in a metered environment.
That's great. Thank you for that comprehensive answer. Then looking at your own option split of lots, you've been reasonably consistent for a fairly long period of time now. You have some peers out there who've shifted relatively aggressively to option lots. Can you talk a little bit about how you view the option market today, maybe in terms of the development of the availability of finished lots? I know you want to self-develop often. Also the emergence of the land banking industry, which was an industry you levered pretty heavily in the early 2000s, as I recall. So you seem to be able to find land that you can put on balance sheet and turn into communities quickly. What is the thought on utilizing options going forward? Thanks.
Yeah, I'll take that, and I'm sure Hilla will have some comments as well. I would kind of answer it three different ways. I think first of all, we like the land we're finding. We find that certain projects provide a better residual for us. They're larger deals with development, big development jobs, and those don't profile well for land bankers, but they profile well for us because we keep our land prices down. We're constantly looking to put more land off balance sheet. That being said, we have a really strong balance sheet, and we have a lot of liquidity, and we think the most effective use of that cash right now is to put it back into our business. You know, we're doing that. We are talking to a lot of different land bankers.
You know, the pricing model out there we think is still too high for the risk that they're taking. We haven't done as much as I think some other builders have. Although I think you should expect us to do, start doing some more as we're sort of trying to manage our liquidity and manage our net debt to cap ratios. Hilla, do you have anything to add to that?
Yeah, I think that's exactly it, Philippe. I know a lot of other builders have put out targets that they're looking for off balance sheet percentages on a relative ratio of owned versus option. For us, it's not so much a ratio. We're really just focused on the balance sheet strength. If we're seeing our net debt to cap get closer to our target, which we said is high twenties. You know, we closed out the quarter at 17.5. There's quite a bit of breathing room. Using our own balance sheet at very, very cheap interest rates seems like a better solution than taking the much higher carry that you would on land bank deals. Not that there's not opportunities to do so.
We are doing so where it makes sense, but we don't feel like an arbitrary target percentage of owned versus option is something we should be striving for, understanding that there's a fairly large trade-off on the margin profitability of those deals that you land bank.
Yeah, a lot of our lots that we do have on option are, you know, what we call seller options because we buy the larger projects. Frankly, those are just way more attractive than a traditional land banking institution. Our carry cost on those type of deals is lower.
Great. I appreciate that. Thanks very much all.
Thank you.
Our next question comes from the line of Deepa Raghavan with Wells Fargo. Please proceed with your question.
Hi. Good morning, everyone. Thanks for taking my question. Pretty impressive you're still on track to 300 with all the supply chain headwinds, so congratulations there. Couple questions from me. Can you help us understand within your 2022 guidance components what elevated gross margins mean? Is that in line with 2021 or is it slightly below but still higher than 2020? You know, any color would be helpful.
We didn't provide specific guidance. We wanted just to give directional guidance on 2022, so it's intentionally not providing a specific percentage. I think that there's been enough commentary both from ourselves and from our peers noting that the peak of the lumber is really happening in Q4 of this year, and then you're gonna start to see some of those lower lumber costs starting to flow through the financials. Of course, they're offset with increases in literally every other category, including labor. It's difficult to sit here today. As you guys know, we are a spec builder, so our cycle times are much quicker than some others. We will be through our inventory. The visibility that we have is maybe a quarter or two rather than nine months, 10 months into the future.
We can give you guys rough expectations, but we're not comfortable putting numbers out there for the entire year yet. The dynamics of what's happening on the cost side are literally shifting every day. We see nothing short term that's going to result in a deterioration on the margin, although the cost environment is still rapidly shifting.
Understood. That's fair enough. My second one is on some pricing dynamics. Can you talk through what's happening on the pricing front with your orders? I mean, some of my field checks suggest some builders actually took a pause with price increases in the last couple of months. What's been your cadence?
Yeah, I would, I guess, sort of echo what you've been hearing. I mean, I think what we're seeing out there is a much more measured approach to pricing. It's not to say that prices, we don't see price increases happening, but they're, you know, they're more on a monthly basis versus every other week or on a per sale basis. You know, we're very, very mindful of affordability. Our whole business plan is built around that. So, you know, we're doing the same. We're raising prices where demand is really strong and we have limited supply. In a lot of other places, you know, we're probably staying put. We feel like as we look at our buyer profile in that community, this is what they can afford and we're not pushing any further. I think that's what we're seeing.
It's a much more sort of normal pricing environment. Again, I think there's still pricing upside, but it's something, you know, much more measured and much more normal.
Thanks so much for the color. I'll pass it on.
Our next question comes from the line of Truman Patterson with Wolfe Research. Please proceed with your question.
Hey, good morning, everyone. Thanks for taking my questions. First, just wanted to start off, you know, supply chain challenges are clearly impacting everyone, but it seems like you all are navigating the environment a little bit better than peers. Just trying to think through if there's anything unique to Meritage that's driving some outperformance. You know, your LiVE.NOW. and Studio M spec strategy. Philippe, you made some comments about, you know, pre-ordering in bulk and reducing SKUs. Just hoping you could elaborate.
Yeah. Thanks, Truman, and good morning. We think there's a lot of things unique to Meritage. You know, this is all the work that we did six years ago, streamlining our product, removing complexity, reducing SKUs, streamlining the journey for the customers, you know, the digital journey, the Studio M, you know, all of it's paying dividends today. I do think we're performing better. When we talk to our folks out there, you know, they're not telling us that there's these weird things popping up that were completely unexpected. We're certainly seeing the pressures from the supply chain out there, but our business is more predictable, it's more repeatable, and so we're planning it out well in advance, and our trades are communicating with us, and if there's issues, we're seeing them earlier.
I think when you simplify what you're doing and you streamline it, you got more visibility, and with that visibility, you know, you can manage through uncertainty better. I would say we're doing a lot of things differently, and I feel a lot better navigating the supply chain today than I would have six years ago.
All right. Thank you for that. Your 40 community openings in the third quarter, just trying to understand how the timing of those really kind of compare to budget? What I'm trying to understand, you know, one of your competitors said that, you know, supply constraints are delaying horizontal development further. Just trying to understand what you all are seeing out there relative to earlier in the year.
Yeah, I mean, we're actually, I think, exceeding our budget. When we put this, the path to 300 together, at the beginning of this year, I think last quarter we were much higher than we thought we were gonna be at that point, and now we're trending from that point on. We're landing our communities as expected. We are seeing the same challenges out there, but I think, you know, we bought all this land a long time ago. As you remember, we had a goal to get to 300 last year, so you know, it just kind of pushed out. This land was being planned, and we've been able to process it through. We're landing the communities as expected. I don't see any issues with Q4.
As we look out into Q1 and Q2 and our goal to get to 300, you know, everything's on schedule and moving forward as planned.
Truman, just to clarify, same logic holds true here as in our forecast on the P&L side, right? We're not unique. We're seeing the same issues that everyone else is. We were just careful in how we projected our community count, same as how we projected our closings and our revenue to make sure that we had enough breathing room to adjust for anything that we're seeing in the marketplace today, which of course occurred, but we had sufficient capacity within our guidance to still hit the numbers that we want. In fact, we increased our ending community count expectation for 2021 a bit from where we were last quarter. As Philippe said, we've not wavered from that 300 community count goal in June of 2022. I think we've been saying that since pretty much June of last year.
We're very confident in that number.
Perfect. Thank you all for your time.
Thank you.
Our next question comes from the line of Ken Zenner with KeyBanc. Please proceed with your question.
Morning, everybody.
Morning.
Steve, you talked about pace, whether it starts or orders, obviously, I think more to starts for you guys. Long term being near four, you don't want to get above five. Things haven't been seasonal because demand has remained strong. I reiterate that to ask you, is there any reason or what would change your pace from, you know, the kind of current rate you are as you open up more communities? Meaning if seasonality occurs, i.e., demand shifts a little bit. I mean, is there any reason for you to be moving right now from that five pace that's optimal? Second, related to the community count openings, you talked about that low 9% SG&A. Hilla, does that suggest as you open up these communities, it'll be a little less efficient in the front half of the year versus the back half of the year? Thank you.
Yeah, you're welcome. The five feels like the right number today, given the supply chain. I think we'd love to do six, you know, and in entry-level, you know, we're built for speed. We have big land positions. So even doing seven, as long as we can build those homes with the right cost structure, keep affordable and deliver a great customer experience, we'll do that much. So if the supply chain gets better going into next year and the market stays as strong as it is, those are two big ifs, you know, we'll do more. But right now, that's really the right number.
We basically, you know, we plan our specs according to what the market's going to give us and what the supply chain will give us, and we can pull that lever appropriately if we need to. I think the second question was about how our fixed costs will roll through next year as we ramp up the community count. Hilla answered this question earlier, but certainly in the beginning, first half of that year, as we ramp up, you're going to see less leverage. Then as those 300 communities start producing closings in the back half of the year, you're going to see more leverage.
I do appreciate that. The efficiency, the supply chain related to closings as a percent of, you know, backlog or inventory, what are you kind of looking for to perhaps see that? Or under these conditions that generate high pace, is it reasonable to think that, you know, the industry is just at a lower level of efficiency from that closing perspective? Thank you.
Yeah, I think you're describing backlog conversion. Again, right now, you know, our backlog conversion below 60% is not what we ideally model. As a spec builder with, you know, 77% of our communities being entry-level, we would like to see that closer to 80% plus. That's where we were prior to the supply chain issues. As the supply chain works its way out, I would hope our numbers would trend back up there, especially as we get these 300 communities ramped up. If we can get back up to that 80% number, that would be the goal we have as a company. You know, our cycle times are, you know, six weeks-seven weeks longer than they were a year ago. We were building houses in three months-four months prior to COVID.
We'd like to see our cycle times get back down to that three or four a month, which means we're turning, you know, at two plus, close to three a year.
Thank you.
Our next question comes from the line of Susan Maklari with Goldman Sachs. Please proceed with your question.
Thank you. Good morning, everyone. My first question is, you know, you mentioned in the comments, when thinking about SG&A that you expect some more technology and some of those efficiencies to come in. Can you give us a little more color there and maybe how we should be thinking about those advantages starting to flow through your results?
Sure, Susan. They're already in our results. It's just going to continue to refine on that process. I think Steve mentioned that we started with self-guided tours, right, leveraging additional visibility into our models at off hours. We certainly do virtual tours online now. There's a lot of advantages to what we're doing online. We're doing pre-qualifications online. We're doing online notary signing when we can in the states that allow it for home closings. We're doing insurance quotes online. There's a tremendous volume of activity that we're doing online, including marketing, social media, leveraging our website. There's a lot of costs, whether it's advertising costs that we're using digital channels, which are less expensive, or actual processes that are being automated, like the remittance of our earnest deposits and the closing process itself.
There is opportunity to continue to leverage, but a lot of that benefit you're seeing flow through right now. As we mentioned, our SG&A was 10.1% last year Q3, and we're at 9.3% this year's Q3. You're already seeing some of that benefit, but we're going to continue to hone in on opportunities where technology can save us money in the long term.
Okay, that's helpful. As a follow-up, you know, appreciating that a lot of the cash and the capital allocation is focused on growth, but you have purchased back your stock for the last, I think it's four quarters now or so. Can you talk about, you know, your interest in kind of doing that on a more consistent basis and how we should be thinking about your approach to the share count and shareholder returns?
To date, we've just been opportunistic. We've purchased over 600,000 shares this year already, so it's about 1.6% of our total outstanding. We're definitely doing more than what we initially committed to, which is just to make sure that we're taking out of the marketplace all the shares that are issued from equity grants associated with compensation. We're definitely doing more than what we committed to, which has always been the goal, but only opportunistically. Right now, as we mentioned in our prepared remarks, we're hyper-focused on getting that community count growth, making sure we have sufficient cash to get there, get all the specs in the ground, and not overtax our balance sheet as we do that.
We do believe that there's an opportunity in the future to maybe do something more programmatic. If that's the case, we're gonna take a look at it once we hit the targets that we wanna hit in 2022, and we'll come back and provide more visibility. At least in the next couple of quarters, our focus is on growth and making sure that we have the capital to do that.
Gotcha. Okay. Thank you.
Our next question comes from the line of Alex Barron with Housing Research. Please proceed with your question.
Yeah, thank you and great job. Obviously, you guys have massively improved in the last year. I wanted to focus on the interest expense. This quarter, there was a more noticeable drop in the interest that went through the cost of goods sold. Obviously, you guys have been delevering and refinancing your debt. Is that a pretty decent run rate? Should we expect that the interest that goes through cost of goods sold will continue to drop as a percentage of ASP or revenues?
Yes. Not to get very technical on the accounting side, but as our assets grow and our debt doesn't grow, the relative ratio of the two that we take through the P&L is going to be lower on a per-unit closing. The benefit of the refinancing that we did earlier in the year, and just as a reminder, last year also, we had $500 million drawn in our credit facility for a short duration right at the onset of the COVID pandemic because we were unsure what was gonna happen in the financial market. That also kind of skewed the numbers a little bit. Obviously, you see that coming through the financials a couple of quarters later. Q3 of 2020 is a little off from Q3 of 2021.
You should continue to expect to see that component of interest running through gross margin be smaller over time.
Okay, got it. Along the lines of capital allocation, other builders have been either initiating or increasing their dividend. Any thoughts along those, either of those lines since you guys don't have one yet?
Kind of same answer as to Susan's question about additional share repurchases. It's something that we're looking into, along with a programmatic share repurchase program, not something that we're committing to, in the near term because we have to make sure that our balance sheet is secure for the growth that we want, for 2022 and beyond. But we will definitely start looking at different cash flow projections and provide additional commentary on one or both of those channels in the next, you know, three or four quarters.
Got it. Thanks, and best of luck.
Thank you.
Thank you.
That is all the time we have for questions. I'd like to hand the call back to management for closing remarks.
Thank you, operator. I'd like to thank our entire Meritage team for another solid quarter of dedication and strong execution. It's truly these folks that work for us that are making the biggest impact to our results. I'd also like to thank everyone who joined this call today. Thank you for your continuing interest in Meritage Homes. We hope you have a wonderful rest of the day. Thank you.
Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.