Meritage Homes Corporation (MTH) Q2 2026 Earnings Report, Transcript and Summary

Thank you for your continued patience. Your meeting will begin shortly. A member of our team will be happy to help you. Please standby, your meeting is about to begin. Greetings, and welcome to the Second Quarter 20 Meritage Homes Analyst Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question and answer session. Please be advised that today's conference is being recorded. I would now like to turn the call over to Emily Tadano, Vice President of Investor Relations and External Communications. Please go ahead.

Thank you, operator. Good morning, and welcome to our analyst call to our second quarter 2020 results. We issued the press release yesterday after the market closed. You can find it along with the slides we will refer to during this call on our website at investors.meritagehomes.com or by selecting the Investor Relations link at the bottom of our homepage. Please refer to Slide 2, cautioning you that our statements during this call, as well as in the earnings release and accompanying slides contain forward-looking statements. Those and any other projections represent the current opinions of management which are subject to change at any time, and we assume no obligation to update them. Any forward-looking statements are inherently uncertain. Our actual results may be materially different than our 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 2025 annual report on Form 10-K and Form 10-Q for subsequent quarters. We have also provided a reconciliation of certain non GAAP financial measures referred to in our earnings release as compared to their closest related GAAP measures. With us today to discuss our results are Steven J. 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 later today. I will now turn it over to Mr. Hilton. Steven?

Thank you, Emily. Welcome to everyone joining today's call. Today, I will begin with a brief overview of market conditions, and our second quarter results. Philippe will then discuss our strategy and operational progress followed by Hilla's review of our financial performance and 2026 guidance. Consistent with what others have shared about the spring selling season, we also experienced slower than normal selling conditions driving quarterly sales orders of 3.58 thousand which were 9% below prior year. Demand remained relatively stable between Q1 and Q2 this year. With no meaningful sequential deterioration. Its average absorption pace of 3.5 net sales per month this quarter was in line with a 3.6 in the first quarter. Although prospective buyers continue to face affordability pressures, and economic uncertainty, we remain confident in the long term demand for housing at the entry level and first-move-up price points. And we believe that our strategy of having sufficient available home inventory combined with our growing community count, positions us to quickly convert demand into sales this quarter from the brief periods of rate relief. Operationally, we continue to focus on what is within our control delivering a 200% backlog conversion rate further improving cycle times and working down our finished inventory levels. These efforts generated 3.73 thousand home closings and $1.4 billion of home closing revenue in the quarter. Adjusted home closing gross margin was 18.6% and adjusted diluted EPS was $1.42, excluding $3.9 million of real estate inventory impairments and terminated land deal walkaway charges. As of 06/30/2026, book value per share increased 5% year over year And with that, I will now turn it over to Phillippe.

Thank you, Steven. Our strategy of pre started inventory streamline operations and go-to-market tenets enables us to be agile in our actions to the current market conditions. We leverage this strategy to generate additional direct cost savings to enhance our returns. As incentives remained elevated this quarter. Our move in ready homes and strong realtor relationships help us compete in an environment where the homebuyer values a quick close through the clarity and certainty in the home buying process. While market conditions remain softer than normal, we continue to position the business for improved financial metrics by managing our WIP inventory. We successfully reduced our finished home position by over 1.1 thousand homes year over year as we replace older inventory with an increased volume of new product with lower direct costs. At the same time, we have kept our cycle time sub-110 calendar days for the fifth consecutive quarter. And even found a few more days of improvement allowing us to start homes later while still supporting our 60-day closing guarantee. These shorter cycle times benefit our carry cost burden and improve liquidity. While allowing us to respond quickly stronger demand materializes. Our active community count of 340 as of June 30, 2026, was up 9% year over year and 1% lower than the 345 in Q1. Due to timing with a few early closeouts and some delayed openings since July. Despite the small dip, we are reiterating our expectation of a 5% to 10% full-year 2026 community count growth year over year. We also achieved another quarter of lower construction cost per foot, as our purchasing teams collaborated with our strategic trades to find incremental savings efficiencies that benefited all parties. We believe these long term partnerships based on pre started homes and limited SKU counts set us apart from our competitors by also providing certainty to our vendors. All of these actions are aligned with our disciplined capital allocation strategy. Although we moderated land spend year over year to $357 million in the second quarter from $59 million last year, we continue to invest in our future communities including the development needed to get our scheduled openings in the second half of 2026 and into 2020. We also returned $131 million this quarter to shareholders through dividends and share repurchases. By maintaining our operational and financial discipline, we believe we are well positioned to navigate uncertainty today uncertainties today while preparing for growth, and increased shareholder returns as the market conditions improve. As part of that longer term plan includes an intentional shift of a portion of our business to first-time move-up homes as we continue to serve 1 of our key buyer demographics, the millennial customer, as they begin to look for their next home purchase. While still continuing to offer our entry level product for Gen-Z and move down customers. This is a return to our long-term stated target of a diversified portfolio of offerings. Which was temporarily on pause over the last couple of years to align with prevailing demand trends. Our goal is to be around a 1-third, 2-thirds mix of first-move-up and entry-level homes consistent with the demographics of The U. S. Population. We are intentionally rebalancing our portfolio to achieve that over time starting with a heavier allocation to the acquisition of land for first-move-up customers. Second quarter 26 orders were 9% lower year over year primarily due to a 19% decline in average absorption pace which was partially offset by a 14% increase in average community count. Cancellation rate of 13% was a little higher than the 11% in Q1 but still remained below typical industry averages as we benefit from a quick sale to close process. Our average absorption pace was 3.5 homes per community per month during the second quarter. Compared to 4.3 a year ago and 3.6 in Q1. Importantly, we have a pragmatic approach to pace and price in the current environment. Focusing on both volume and margin preservation. While our long-term objective remains an average of 4 net sales per month for the year, we will not sacrifice profitability or deplete irreplaceable lot positions by forcing absorptions through higher incentive usage in a highly competitive market where demand is relatively inelastic. ASP on orders this quarter of $385 thousand was down 3% from prior year due to geographic mix shifting from higher ASP West region into the lower ASP East region. Although our incentive utilization remained elevated this quarter, we were able to keep the impact neutral with lower per home incentive costs. We grew our active communities 9% year over year from 312 in the prior year to 340 by June 30. Q2 was 1% lower than 345 active communities in Q1 as timing played a factor this quarter. Our early closeouts occurred as we took advantage of pockets of stronger demand and some anticipated June openings fell into Q3. We brought 27 new communities online across our regions during the quarter, and 67 year to date. In July, we have not seen a meaningful change in the underlying demand environment relative to what we were experiencing during Q2. Although very recent increase in interest and mortgage rates may impact demand in the coming weeks, if they do not pull back. We continue to see highly localized demand patterns with all regions encompassing markets of both strength and weakness in Q2. Although the needed volume incentives varied notably. Parts of Texas, Southern California, Atlanta, Raleigh and Coastal Carolinas were our strongest performers demonstrating more market strength in geographies with limited inventory. We also saw stronger demand across the markets when interest rates temporarily receded. Providing some visibility into a potential path for recovery longer term. In contrast, in locations where affordability pressures or competitive conditions warranted a more measured approach, we deliberately pulled back on sales pace. Demand trends were softer in Orlando, Denver, Salt Lake City and Northern California. Now turning to Slide 6. Q2 starts totaled approximately 3.9 thousand homes, down 4% year over year yet up around 1.4 thousand units sequentially from Q1, ending the quarter with sufficient supply for Q3 and replacing older inventory with newer production with improved cost structures. With nearly 60% of Q2 closings also sold during the quarter, our backlog conversion rate was 200%. Reflecting our quick close strategy and within our targeted range of 175% to 200%. Our ending backlog was approximately 3.7 thousand homes as of 06/30/2026, compared to approximately 4.75 thousand homes as of 06/30/2025. As for the combined total of specs and backlog, we had around 6.8 thousand units at 06/30/2026. 22% less than the approximate 8.7 thousand units of specs and backlog we had at 06/30/2025. Reflecting our intentional efforts to lower the inventory in light of current market conditions, we ended the quarter with approximately 5.1 thousand spec homes, down 27% from approximately 6.9 thousand specs in the prior year and up 7% sequentially from Q1. The 15 specs per store this quarter translated to about 4 months' supply intentionally near the lower end of our target 4 to 6 months' supply due to today's demand environment and our improved cycle times. Comparatively, in the second quarter of 25, we had 22 specs per store or 5 months of supply. We reduced our completed specs to 1.5 thousand units in Q2, which was 42% lower than prior year and 30% of our total specs. Our lowest percentage in 2 years and right around our target of 1-third. This compared to 38% in the prior year and 46% in the first quarter. A balanced approach of reducing aged inventory and ramping up starts allowed us to end the quarter with the appropriate supply of homes per store. Although we are starting Q3 with lower backlog, we believe the spec home inventory provides us the path to achieve our Q3 guidance. With that, I will now turn it over to Hilla to walk through our financial results. Hilla?

Thank you, Phillippe. Let's turn to Slide 7 and cover our Q2 results in more detail. Second quarter 2026 home closing revenue of $1.4 billion was 14% lower than prior year due to 11% lower home closing volume and a 4% decrease in ASPM closings to $373 thousand. While both our closing volume and ASPs reflected our intentional decision to manage margin and pace, the decline in ASP was primarily due to geographic mix. To a lesser extent, product mix within our communities also impacted ASP, with lower priced homes, outselling higher priced ones, and in certain markets where we had a greater amount of aged spec inventory, we used incremental incentive this quarter to sell those homes. With nearly 60% of our closings generated from intra quarter sales, our results reflect real time demand and incentive trends. During the temporary dips in rate this quarter, we sold and closed homes with lower cost incentives which reduced our per home incentive burden. Looking ahead, incentive costs and utilization will continue to be inversely correlated to interest and mortgage rates which remain highly volatile and move on both domestic and international political developments. Home closing gross margin of 18.3% in the second quarter of 26 was 280 bps lower than prior year's 21.1% as a result of lost leverage on lower home closing revenue and higher lot costs both of which were partially offset by improved direct costs and faster cycle times. Second quarter 2026 home closing gross margin included $3.6 million of real estate inventory impairment and about $300 thousand in terminated land deal walk away charges, compared to no impairment and $4.2 million in terminated land deal walk away charges in the prior year. Excluding these charges, adjusted home closing gross margin was 18.6% and 21.4% for the second quarters of 2026 and 2020, respectively. We are encouraged that the volume of impairments remains relatively limited and we are able to work through homes in most of our communities in slower demand markets at a lower but not impaired sales price. Our current land basis is primarily comprised of higher cost land vintages from the 2022 to 2025 time frame. Although this higher basis will continue to be a margin headwind in the near term we anticipate some margin relief will start at the tail end of 2027 or early into 2028 as lower basis land begins to roll through our P&L, assuming the current impact from oil and gas price increases is not prolonged. In Q2, direct costs per square foot were down nearly 6% year over year, reflecting the disciplined purchasing and vendor negotiations Philippe already covered with savings generated by both labor and materials. As we have noted, our newer starts should benefit from this lower cost basis and will be reflected in our margins in the second half of this year. Sequentially, adjusted gross margin improved 80 bps to 18.6% from 17.8% in Q1, driven primarily by better leverage on home closing revenue and improved direct costs from newer inventory. While we do not anticipate a significant gross margin recovery this year, our long-term target remains 22.5% to 23.5% under normalized market conditions where incentive and interest rates are more in line with historical averages. Selling, general and administrative expenses as a percentage of second quarter 2020 6 home closing revenue were 10.4% compared to 10.2% in the second quarter of 25 as decreased compensation expense and an intentional reduction in discretionary costs nearly offset the lost leverage on lower home closing revenue. Despite the tougher sales environment, we did not increase sales and marketing spend on a per sale basis. Our long standing realtor relationships continue to provide a competitive advantage, generating a consistent level of repeat business from our broker network. External commissions remain stable both year over year and sequentially, while our core book percentage continues to run-in the low-90% range. We remain committed to growing our annual closing volume which should drive operating leverage and support our longer-term SG&A target of 9.5%. The second quarter's effective income tax rate was 24.8% this year, compared to 23.9% for the second quarter of 25 due to higher state income taxes. As a reminder, we expect only a limited impact from the June 2020 expiration of the energy tax credit for the balance of this year and into the future as the higher construction requirements implemented in 2025 had already significantly reduced our eligible credit. Overall, lower home closing revenue and gross profit led to a 33% year over year decrease in second quarter 2020 diluted EPS to $1.37 from $2.04 in 2025. Adjusted diluted EPS for the current quarter was $1.42, excluding impairments and walkaway charges. To highlight the key results for the first half of 2026, on a year over year basis, orders were down 7%, closings were down 12% and our home closing revenue decreased 16% to $2.5 billion Adjusted home closing margin of 18.2% was 350 bps lower than 2025, SG&A as a percentage of home closing revenue was 11%, and net earnings decreased 46% to $146 million Adjusted diluted EPS was $2.24 for the first 6 months of 2026 excluding impairments and walk away charges. Before we turn to the balance sheet, it is worth noting that our customer credit metrics remain healthy and unchanged during the second quarter, FICO scores, DTIs and LTVs all track closely with historical averages, continuing a trend we have seen for several years. Lack of deterioration in customer credit quality validates that in ongoing market volatility, consumer psychology continues to play a strong role alongside affordability concerns and home buying decisions. On to Slide 8. As of 06/30/2026, we maintained a healthy balance sheet supported by $87 million in cash, no outstanding borrowing under our credit facility and a net debt to cap ratio of 17.1%. Additionally, in June, we refinanced our revolving credit facility to increase the facility size to $980 million, extend the maturity from 2030 to 2031 and increase the accordion feature to permit a facility size of up to $1.47 billion We are committed to supporting our long-term growth trajectory while prudently managing our capital and maintaining our investment grade credit rating. As such, our net debt to cap ceiling remains in the mid-20s range. Our capital allocation strategy looks to balance both growth and shareholder returns, As we have been more selective with land deals and timing of land development, our land spend was down 30% year-over-year this quarter, totaling $357 million in Q2. With slower demand, we are focused only on the most attractive land opportunities increasing our land spend for first time move up communities and optimizing development schedules. Our forecasted land acquisition and development spend is expected to be between $1.7 billion and $2 billion for full-year 2026. We returned $131 million to shareholders via buybacks and dividends this quarter, up 74% from $76 million in the same period last year. We bought back over 1.5 million shares, or 2.3% of shares outstanding at the beginning of the quarter for $100 million We repurchased the shares this quarter at an average 16% discount to book. To date, in 2026, we have spent $230 million on buybacks, reducing our 12/31/2025, outstanding share count by nearly 5%. As of 06/30/2026, $284 million was available under the repurchase program. Given the instability of the current environment and with the path for interest rate trends remaining uncertain, we will continue to execute on our share repurchase commitment, but pair it back slightly to a minimum of $55 million per quarter for the balance of the year while continuing to increase that opportunistically, repurchasing incremental shares on cash flows and dips in our stock price. We increased our quarterly cash dividend 12% year-over-year to $0.48 per share in 2026 from $0.43 per share in 2025. Our cash dividend this quarter totaled $31 million and $63 million year to date. For the first half of 2026, we returned $292 million of capital to shareholders or 201% of our total earnings to date this year. Slide 9. In the second quarter of 2026, we secured nearly 1.7 thousand net new lots under control which is inclusive of the impact of about 300 terminated lots. These lots primarily reflect communities for 2028 and beyond as the owner-controlled most of the lots we need to meet our community count targets through 2027. In the second quarter of 25, we put nearly 1.8 thousand net new lots under control. As of 06/30/2026, we owned or controlled a total of about 73.2 thousand lots, equating to a 5.2-year supply based on the last 12 months closings. Slightly above our target of 4- to 5-year supply but reflective of the upcoming community count growth we expect over the next 18 months. We also had approximately 15.3 thousand lots that were still undergoing diligence at the end of the quarter, which is another potential 1 year supply in the pipeline that we can choose to control. We continue to target around a 40% optioned lot ratio, About 69% of our total lot inventory at 06/30/2026, was owned and 31% was optioned. This is essentially consistent with Q1, but slightly lower than the 66% owned and 34% optioned lot position in the prior year, reflecting our terminated lots in late 2025. We review off balance sheet opportunities on a deal by deal basis on their financial merits as we do not believe every land deal can absorb the incremental cost of an off balance sheet structure. Finally, I will direct you to Slide 10. Based on current market conditions and year to date results, we are updating our guidance for full year 2026 home closings and revenues to around 5% below full-year 2025 results although home closing revenue could trend a bit lower if market conditions require higher incentives. For Q3 2026, we are projecting total home closings between 3.3 thousand and 3.6 thousand units, home closing revenue of $1.26 billion to $1.35 billion, home closing gross margin of around 18% and effective tax rate of 24.5% to 25%, and diluted EPS in the range of $1.10 to $1.30 With that, I will turn it back over to Phillippe.

Thank you, Hilla. In closing, we believe our second quarter results reflect solid execution in a softer demand environment. We also saw no meaningful deterioration in demand from the first quarter to the second quarter. Throughout this quarter, we remain focused on controlling what we can control, strategically reducing aged inventory as we target the right level of inventory per store. Balancing pace and price and allocating capital thoughtfully. To maximize returns. Looking ahead, with community count expected to grow in the second half of 2026, we believe we have the units to achieve our full year revenue guidance despite ongoing market challenges. Combined with our balanced approach to capital allocation, we believe Meritage is well positioned to navigate the current uncertain environment and deliver strong shareholder value long term. With that, I will now turn the call over to the operator for instructions on the Q&A. Operator?

Thank you. In the interest of time, we ask that you limit yourself So others can hear your questions clearly, we ask that you pick up your handset for best sound quality. And we will take our first question from Trevor Allinson with Wolfe Research. Please go ahead. Your line is open.

First 1 is on the better than expected gross margin in the quarter despite rates going higher. Keep on what drove the beat in the quarter? It sounds like maybe you are getting some better cost structure come through. Can you perhaps quantify those tailwinds in the quarter? And then should we expect incremental savings on the cost structure moving forward?

Thanks, Trevor. I will take the gross margin question. So for us, it is a combination of a couple of things. The improved volume over Q1 obviously helped us leverage the fixed component in the gross margin composition, but we also had that 6% year-over-year improvement on direct costs, which is helpful And then also, we mentioned this, but because such a high percentage of our homes sell and close in the same period, there was a nice dip in interest rates in the middle of the quarter where we were able to sell homes at a lower incentive and still close them in the same quarter. So we saw all of those benefits come together despite the higher the higher lot costs that is still rolling through the financials. We were able to harness all of those benefits together and deliver that 18.6% adjusted gross margin. On a go forward basis, I do not know that we are modeling continuing improvement on direct margin, although the or on direct costs, I should say, but the savings that we have had so far should continue to push through the financial statement. So the rest of the gross margin for the balance of the year and into next year is really a discussion of volume of incentives and overall volume of closings.

Okay. Makes sense. Thanks for that, Hilla. And the second question is on your shift back for a portion of your business toward more towards first time move up. I think from a demographic outlook by age cohort, that makes a lot of sense. what is the timeline to make that shift And is it still your expectation you are going to offer a 60 day guaranteed, fully spec model in those homes? Or any changes to your go to market strategy as you serve a little bit higher end buyer?

Yes. Great question. Will take a little bit of time because we pivoted pretty meaningfully to entry level during the last 5 years. So as we pivot back to a more balanced 30% to 70%, it is really about sourcing some new land and bringing that land on the market. So more of a 2028 and beyond type of impact. And as it relates to the operating strategy, it is going to be pretty aligned with what we do as it relates to not offering choice and options, but we are going to tweak the go to market when it comes to when we release the homes, We will probably be releasing the homes earlier because many of those folks have homes to sell. And so there will be some tweaks on sort of our focus around the closing ready guarantee. As well as pieces of the realtor strategy. Thank you.

We will take our next question from Stephen Kim with Evercore ISI. Please go ahead. Your line is open.

Yes. Thanks a lot, guys. Just a follow-up on this shift. So I know you guys, when you first rolled out this very significant shift to the move in ready homes, I mean, it was something that you had spent a lot of time thinking about and preparing for. And so, just wanted to try to understand this pivot or tweak, let's say, to move a third back to the first-time, move up, Was this something that you always envisioned you would eventually do and maybe something maybe advance that a little earlier? Or is there something that fundamentally has changed your thinking about the about maybe being 100% first-time. And so this was not initially contemplated but you are contemplating it now. And what if so, what was that change or this thing that you have seen in the market?

Yes. It really was something we have always intended to be. Even when we rolled out our strategy 7 years ago and tweaked our strategy 4 years ago, we always believe that the second consumer segment for us was the first move up Someone still looking for a move in ready home. Someone's still looking for a home that they can move in quickly. But buying their second home, potentially buying their second new home potentially. So it is always been part of our strategy. what is really changed is fundamentally, land market has changed, right? As land has gotten more expensive, prior, we could really underwrite a lot of entry level land. And now there is a more balanced opportunity out there in the market, and we see more opportunities to source 1MU land and that is really the change in the market. I think that is been something that is been happening over time. But this has always been part of our strategy, and now the land market is really lending itself to that opportunity.

I would add 1 more thing, Steven. We talked a little bit about it in the script, but the shift in the age of the population cohort in The US. Millennials are the largest population cohort that we were initially targeting our efforts towards that group. And as they were buying their first home, they were obviously an entry level buyer. Here we are 10 years later, and they are ready to buy their next home. So we are continuing to follow the same demographic groups across their homebuyer journey. So obviously, as younger cohorts enter their home buying stage, they are continuing the entry level push, but we are also following the millennial buyer and hopefully will be their first and second time home provider.

Got you. Yeah. Lots of interesting things there. So I guess just I guess following up on that, Phillippe, you said that the land market, I guess, has gotten a little bit looser perhaps at the first time move up. And so you see some opportunities there. And you also indicated that this is something that you contemplated even years in advance that you would eventually do this kind of pivot. But 1 of those sounds opportunistic and could also change back. Right? Next year, like the land markets may become there may be more less opportunity at first time move up and so forth. So I am just trying to understand, how much of this is opportunistic in terms of the land strategy and opening up? And then how much of it is something that regardless of what the land market stratification looks like, you are just going to you just think that this is the right time to move to that higher price point. And you have talked a lot about how the cycle time is reduced and it enables you to build more quickly. I just wanted to see if you could elaborate a little further on maybe some of the tweaks that you are going to make to your product if you are building a bigger product, takes a little longer. I would think the customer, maybe a little more personalization and things of that nature. Could you like, elaborate a little bit more on maybe some of the differences that you see in going after the 1mu customer again?

Yeah. I mean, probably 4 questions there, but let me try to answer them all. I think, first of all, this is not opportunistic. This is something that we intentionally had as a goal of our business. But the market's been very different for the last 5 years. And so we have played in the market the way the land market supported. First time land was much more available and priced correctly for the last 5 years. And now that bifurcation is starting to close. And 1NE land is making more sense and is more underwritable. Can that change? Certainly, it can change. We are always going to balance out the business between entry level and first move up based on the inputs in the business. But it is long term, our strategy is to be a 1-third 1MU and 2-thirds entry level. Certain markets will allow us to do more of it, and other markets will allow us to do less of it. So we are glad we have our regional and national footprint to kind of play in the market the right the right way. As it relates to, the tweaks to our operating model, I really feel like it is it is like a tweak. it is it is a modification on the margin. We are not going to start off design studios We are not going to start offering a bunch of personalization. We are just going to build a nicer home. Homes that are 50-foot-wide versus 40-foot-wide do not necessarily take longer to build. You just build in the same way but you might offer some nicer features Maybe those buyers will get nicer cabinets, countertops, flooring, and maybe some other things that we will tweak to make sure we are delivering the right value to that customer because they are looking like you said, for their second home. So I do not see a big change in our kind of core operational strategy, but maybe some things on the margin that we will tweak to make sure we deliver the right value to that customer segment.

Alright. Great. Thanks so much, guys.

Thank you.

We will take our next question from Alan Ratner with Zelman. Please go ahead. Your line is open.

Hey, guys. Good morning. Thanks for all the detail here. I will not beat the drum on the move up pivot. But I will just ask 1 quick question on that front. It seems like M&A activity has accelerated a bit across the industry. And I am curious if you would consider M&A as an avenue to maybe accelerate that process towards building up the first time move up market share?

Yes. We are very encouraged to see that well respected and smart long term investors are investing in the homebuilding industry and really reinforcing the confidence in the sector that we have and the value of scale and repeatable platforms. We look at M&A through a very strategic lens. it is not just about scale at any cost. it is about can we go out and acquire assets that will allow us to play in different markets or consumer channels. So 100%, I think if we were going to do any M&A at the local or private level, we would be looking for some type of move up penetration. Or to get into markets that we are not in that are currently performing well. there is a number of Midwest markets that seem really interesting right now. So for us, it is about a strategic add versus just incremental scale.

Got it. Makes sense. Second question, you made the comment about intra quarter where rates briefly dipped. That gave you an opportunity to maybe pull back a little bit on incentives. I just wanted to clarify, did you actually reduce the incentives you were offering? Or were you kind of maintaining the same mortgage rate buy down programs that you were offering? It was just costing less to buy down to that rate given what was going on in the market. I just wanted to clarify, is there kind of an ability if we do see further moderation of rates to actually pull back more significantly on incentives or was it just a cost dynamic?

So it is tranche. So the first step in rates pull back a bit, it is a lower cost offering. We are not if we are offering 4.99% at the right stop, we do not start offering 3.99%, it is just costing us less to offer the same incentive because the differential to the interest rate is still significant, not that it is an interesting incentive. We have seen that when rates drop a second, tick down, the utilization drops. So it kind of comes in waves. First, the cost per rate lock is lower and then the utilization shifts to a different type of discount and more traditional discount in our sector. So it was great to see that when the market started to briefly return to normal, consumer behavior followed.

Yeah. And I would just add that from a long term perspective, with inventory levels being down, and BTO builders now pivoting back strongly to BTO and out of spec. We are just seeing a general stability in the incentive environment. Now I cannot predict what is gonna happen with the economy and some consumer psychology things out there. But at least we do not see, the incentive wars happening to the level that they were happening last year and into this year.

that is great to hear. Thanks a lot.

Thank you.

We will take our next question from John Lovallo with UBS. Please go ahead. Your line is open.

The first 1 is the roughly 18% gross margin outlook for the third quarter has clearly spooked some folks out there coming off the 18.6% in the second quarter. And I do not want to get too cute here, but would you consider 18.3%, 18.4%, 18.5% to be around 18%? And if not, what, other than the lower quarter over quarter closings would drive the gross margin down from the second quarter?

Yes. I mean, it is primarily leverage. And rates did increase through June. So you saw incentive utilization, rate buy down utilization increase in June, which can hit 18.0% on the margin. We are kind of sitting here around 18.0% depending on what rates do. Is it gonna be a little bit lower or a little bit higher?? It just depends on what happens intra quarter. We guided to around 18% in Q2 and ended up at 18.6% because rates were favorable. So it is just really dependent on that factor.

Yes. I think the first part of Phillippe's response is also very important. it is the leverage. You can look at the midpoint of our closings guidance and where we ended up Q2 versus Q3 and see that there is going to be maybe 20-30-ish bps that are just a function of leverage. Obviously, looking at our full year guidance, you can extrapolate to what you think Q4 is going to be. there is going be a pickup and an improvement where the leverage will go in the other direction. So it is so tough on these intra quarter kind of discussions, especially when so much of your sales volume is unknown to us and we are closing still 200% of our backlog. So visibility into the units and to the incentive that will be part of those closing units is not as clear, which is why we have shifted our commentary from providing an exact number to kind of staying around a number because there is still a lot of movement in the closing universe for us for Q3.

Yes. And rates, again, have been increasing since mid June. They are probably the highest they have been as we roll into July, which is typically the lower seasonal kind of period.

Okay. Yes. No, I think the fourth quarter comment was going to be my next question that we should see the reversal of that gross margin. But let me just ask, the fourth quarter deliveries are implied to be up about 10% year-over-year. And so that was either seem to imply that you are expecting a decent ramp in orders in the third quarter here or that you are willing to work the back backlog down pretty meaningfully as we move through the year? I mean, how should we sort of think about this? And I just want to make sure that the idea here is that you are not going to ramp incentives to try to drive orders to meet that full year delivery.

Yes. Again, everything we say is predicated on how this plays out economically and politically over the next 6 months. But the key Q4 guide is mostly predicated on community count growth. So as we have said, we have some still some material community count growth happening into Q3 and Q4. And that is driving the incremental closings for Q4. We are not expecting the market to improve In fact, we are probably pretty conservative about what we think the back half is going to look like from an incentive and absorption standpoint. So it is 100% tied to the community count growth that we expect in the back half of this year.

And then remember, just for us, the way that we count in active community of the sale And for us, we do not sell until we are ready to close within 60 days. So for us, an active community can start producing closings same quarter. But it becomes active, not just sales in the same quarter that it becomes active. So we have quite a ramp of communities that is coming up. If you look at where we started the year in that 5% to 10% guide on ending community count where all of those will be delivering closing.

Yes. that is a great point. Our starts were up because we were starting homes for these communities that we are getting ready to open. And we do not open up communities until we can close homes.

Yes. That makes a lot of sense, guys. Thank you.

Thank you.

We will take our next question from Susan Maklari with Goldman Please go ahead. Your line is open.

Thank you. Good morning, everyone. Thanks for taking the question. Want to start on the cost side. The 6% savings that you have realized is impressive there. Can you talk a bit more about what is driving that and how you are thinking about the ability to realize further incremental benefits in the coming quarters?

Yes. So the 6% savings year over year and we are down 2% sequentially. it is both labor and materials. We saw it sort of broad based. We are seeing some savings in both categories. As you Hilla noted in her prepared remarks that our lower cost new starts are replacing aged inventory, which is being captured in the third quarter 26 gross margin guidance. I am not sure we are anticipating further cost savings on new starts that are going to go out in Q3. We are seeing a little bit of headwinds in lumber that may play out here over the next couple of quarters. So due to that factor, we are not modeling any more improvements from here for now.

Okay. Right. that is helpful. And then maybe as we think out and you reiterated the longer term target for the gross margin, And as you think about the mix shift that will come through as you start to integrate more of the move up product in there. What does that mean in terms of the path for profitability in the business? And how should we think about the shift that will come through and how you can hit that target?

Well, I think the long term target of 22.5% to 23.5% is not mix related. it is purely based on the way we underwrite land. So right now, we are not achieving our underwriting because primarily incentives are running extremely hot. We typically underwrite land at a much more normal incentive environment. So the bridge between where we are and the bridge to where we want to be is 100% interest rate and incentive related. Now 1MU land should typically be higher revenue. And you should get more leverage from the higher ASP But we do not really underwrite 1MU land at a higher margin than we underwrite entry level land. And again, this will take some time. We have about 10% of our business is 1MU right now. And there is probably some opportunity to pivot some of our existing land book to 1MU because they are in the right locations. But most of it is gonna come from new land that we are sourcing today. So the impact of the mix to 1MU will not really play out in our P&L until 2029 and beyond.

Okay. Thank you for the color. Good luck with the quarter.

Thank you.

We will take our next question from Rafe Jadrosich from Bank of America.

Hilla. Good morning. Thanks for taking my question. Just on the following up on John's question earlier, on this second half delivery guidance relative to the first half, I think it is about 1 thousand more deliveries. And if I look at the backlog and completed specs, it is it is sort of flattish. Do starts need to pick up further from here, on that to hit the back half? Delivery guidance? And can you give any color on like the Community Cat count cadence, third quarter versus fourth quarter?

Yes. I mean we do not give community count cadence. it is just too difficult. A municipality approves something, you drop below or does not approve something, you drop below a certain number of units and then you can no longer con a community's active. So it is just way too refined for us to try to figure out the specific timing on a September 30 versus December 31. So we are still really comfortable with our 5% to 10% growth year over year. And obviously, as you are running a few year model and trying to hit that full year unit number that we are fairly comfortable with at the 5% below full year 2025. Agree, there is a ramp up in volume, as Philippe already mentioned, it is a function of the community count. So you already started to see a little bit from that spec start happening now. Right? Our starts pace is or starts volume increased quite a bit between Q1 and Q2 as we are getting inventory ready for these communities. Again, that 4 to 6 months' supply of available inventory is something that we are very focused on. So I think we mentioned several times during the prepared remarks between the inventory that we are carrying to start Q3 and into Q4 and that sub-110-day cycle time, we feel really confident that we have everything that we need to hit our full year guidance.

Okay. that is helpful. And then can you just remind us the lag time between when lumber prices move and when that starts to show up in your deliveries?

it is staggered. We do not we do not hedge, but we have 30, 60, or 90 day locks. At different points in time throughout the country. So we kind of create natural hedges. So it is a little bit of noise, within 90 days, you should start to see some of it flow through into our construction. And then you should see that flow through into our numbers in about a quarter. So I think a couple of our peers said about 2 quarters and I think that is probably the right number for us as well.

And we will take our last question from Jade Rahmani with KBW. Please go ahead. Your line is open.

Thank you very much. Just on the first time move up strategy, have you considered broadening that to beyond first time move up to the broader move up market?

No. I think again, we have had this strategy in place for a long time. We feel like with our operating model and the way we want to play in the market and where the demographics are the strongest We want to stay in that 1 MU price point. We do not want to expand beyond that into a 2 MU or a luxury buyer. Those folks typically want choice and customization, which we are not going to offer based on the way we build homes. So for those reasons, it is really mostly a value focused 1MU consumer segment.

Thank you very much. And on land banking, I was wondering what you thought the value that it provides is to a company like Meritage when the cost of debt is lower than what firms such as Blackstone are offering in the land banking space?

Yeah. I mean, it is a good point. it is why we have not done a lot of land banking. Over the last 5 years. That reason we were sitting on a bunch of cash And then the price of land banking was pretty expensive. And the optionality of land banking had really changed But at some point, as a company of our size, we believe land banking allows us to control more land to allow us to grow our business at a better return. On equity. So at some point, it makes sense when your balance sheet reaches a point where that extension creates that incremental value. So that is how we think about it. it is why we have not done it. A lot. it is why we are trying to get it to 40% over time because we would like to, as we are trying to grow from 15 thousand to 20 thousand units, we want to control more land for less of our balance sheet at play.

Makes sense. Thanks.

Okay. Well, thank you, everybody. Thank you, operator. I want to thank everyone who joined this call today for your continued interest in Meritage Homes. We hope you have a wonderful rest of your day and a great weekend.

This concludes today's Meritage Homes second quarter 2020 analyst call. Please disconnect your lines at this time, and have a wonderful day.