M.D.C. Holdings, Inc. (MDC) Q4 2022 Earnings Call Transcript

M.D.C. Holdings, Inc. (NYSE:MDC) Q4 2022 Earnings Conference Call January 31, 2023 12:30 PM ET

Company Participants

Derek Kimmerle – VP & Chief Accounting Officer

Larry Mizel – Executive Chairman

David Mandarich – CEO

Bob Martin – CFO

Conference Call Participants

Stephen Kim – Evercore ISI

Truman Patterson – Wolfe Research

Jesse Lederman – Zelman and Associates

Operator

Good day, and welcome to M.D.C. Holdings 2022 Fourth Quarter Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Derek Kimmerle, Vice President and Chief Accounting Officer. Please go ahead.

Derek Kimmerle

Thank you. Good morning, ladies and gentlemen, and welcome to M.D.C. Holdings 2022 fourth quarter earnings conference call. On the call with me today, I have Larry Mizel, our Executive Chairman; David Mandarich, Chief Executive Officer; and Bob Martin, Chief Financial Officer. At this time, all participants are in a listen-only mode.

After finishing our prepared remarks, we will conduct a question-and-answer session, at which time we request that participants limit themselves to one question and one follow-up question. Please note that this conference is being recorded and will be available for replay. For information on how to access the replay, please visit our website at mdcholdings.com.

Before turning the call over to Larry and David, it should be noted that certain statements made during this conference call, including those related to MDC’s business, financial condition, results of operations, cash flows, strategies and prospects and responses to questions may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements involve known and unknown risks, uncertainties and other factors that may cause the company’s actual results, performance or achievements to be materially different from the results, performance or achievements expressed or implied by the forward-looking statements.

These and other factors that could impact the company’s actual performance are set forth in the company’s 2022 Form 10-K, which is expected to be filed with the SEC today. It should also be noted that SEC Regulation G requires that certain information accompany the use of non-GAAP financial measures. Any information required by Regulation G is posted on our website with our webcast slides.

And now, I will turn the call over to Mr. Mizel for his opening remarks.

Larry Mizel

Thank you for joining us today for a review of our operating results for the fourth quarter and full year 2022, and an update of our strategies for navigating today’s new home landscape. MDC reported net income of $562.1 million for the 2022 full year, or $7.67 per diluted share, representing one of the most profitable years in our company’s history.

We generated $5.6 billion in homebuilding revenues and produced a gross margin from home sales of 22.4%, which is a testament to the strong demand environment we experienced earlier in the year and solid execution by our homebuilding teams despite persistent operational headwinds. We are proud of these accomplishments, and I want to thank all of our team members for their contributions in making 2022 such a profitable year.

As we turn our attention to 2023, we face a much different housing environment than the one that was in place at the beginning of 2022. The demand tailwinds we enjoyed in 2021 in the first half of 2022 namely low mortgage rates and high consumer confidence turned against us in the second half of the year creating a much more difficult selling environment.

Buyers became more cautious and the value proposition that homeownership presented became much less compelling through the combination of rapid home price appreciation and higher financing costs. These headwinds led to a sharp drop in new order activity and a big increase in cancellations in the third and fourth quarter, resulting in a much smaller backlog to start 2023 as compared to the beginning of 2022.

In response to these new market realities, we have taken decisive steps to adjust our business practices and stay competitive in our markets. We delivered a significant portion of our high margin backlog in the third and fourth quarters of 2022, allowing us to be more aggressive in our approach to pricing and incentives as we enter the spring selling season.

We realize that most homebuyers or trying to solve for a monthly payment that meets their budget, and we have multiple levers that we can at use to address their affordability needs. In addition, we have an increased and expect to continue to increase our spec home construction starts to appeal to buyers who are willing to forgo some personalization with their homes in exchange for a faster close. This should keep our inventory turns moving in the right direction, help reduce our cycle times, and reduce the number of cancellations as compared to the previous two quarters.

Another way of bringing our cancellation rate down is through higher deposit requirements in our build to order homes, buyers in general must now put down 5% in order for us to move forward and a new build versus the 2% we required in more favorable times. In addition, we have modified our deposit requirements on options and upgrades purchased at our home gallery studios. These changes should result in a more stable backlog and give us better visibility into our delivery schedules for build to order homes.

Despite the near term challenges facing our industry, we remain confident in the long term outlook for new home construction. Existing home inventory remains at a historically low level on a national basis, and there continues to be a strong desire for home ownership by a large segment of the population. We believe that comparisons made between this housing correction and the one we experienced during the 2007 and ‘08, financial crisis or unwarranted.

U.S. households are in a much better shape today than they were 15 years ago. And today’s unemployment levels remain incredibly low despite the best efforts of the Federal Reserve to slow the economy. In addition, we have a much more stable and closely regulated mortgage finance system in place today, which has curtailed much of the speculative activity that led to the last downturn.

We also have the benefit of hindsight and wisdom that comes from weathering a difficult downturn, which has led to a more resilient and return focused industry. All of these factors give us confidence in the future of our industry and the outlook for our company.

Now I’d like to turn the call over to David, who will provide more detail on our operating results this quarter.

David Mandarich

Thank you, Larry. The soft demand trends we experienced in the third quarter carried into the fourth quarter as buyers remain cautious about moving forward with their purchase. However, we did see a pickup in demand starting in December, once we reduced pricing and increased incentives. We believe this is a good sign that the price of elasticity exists in our markets and that the buyers remain active and engaged, despite the higher interest rate environment.

Cycle times remained stubbornly long in the fourth quarter despite some improvements we’ve made in our internal processes, which reduced the time between sale to start and finish to close on a year-over-year basis. Ongoing challenges relating to municipal delays labor and product availability to finished arms continue to be a headwinds for our industry. We expect to see some relief on these fronts once the current slowdown in demand works its way through the system.

Another area in which we expect to see some relief is on the cost side. Lumber prices have been moving down for some time and we expect to see the benefit of this downward movement in our results as we move through 2023. We have been working closely with our trades, suppliers and vendors to make sure the prices we pay stay a more competitive and reflect today’s slowing market conditions. We are also being very vigilant about our overhead costs and we’ll continue to look for ways to do more with less.

With respect to land, we have taken decisive action to adjust our lot (ph) position and renegotiate the terms of many option agreements. We expect to see real opportunities for land investment as better terms and pricing has been recently available. Overall, we expect 2023 to be a year of continued adjustment for our industry, but I share Larry’s enthusiasm for the future of our industry. We remain committed to the markets we’re in and see a long runway for growth once industry fundamentals stabilize.

MDC has been building homes for over 45 years and has been through numerous downturns. We know how to navigate through difficult times and how to capitalize on opportunities that arise from market dislocations such as this. We are well positioned both in a financial way and operational perspective to address the challenges of today and look forward to building on the legacy of MDC and Richmond American Homes.

With that, I’d like to turn it over to Bob, who will provide more color on our financial performance.

Bob Martin

Thanks, David, and good morning, everyone. During the fourth quarter, we generated net income of $79.8 million, or $1.08 per diluted share, representing a 51% decrease from the fourth quarter of 2021. Pretax income from our homebuilding operations for the quarter were $94.5 million, which represented a 51% decrease from the fourth quarter of 2021. This decrease was primarily due to inventory impairments of $92.8 million recorded during the quarter, impacting 10 communities within our West segment and six communities within our Mountain segment.

The impairments mostly related to communities already open for sale, as well as a few communities scheduled for opening during the first quarter of 2023. This decrease was partially offset by home sale revenues, which rose 4% year-over-year to $1.49 billion. Our financial services pretax income increased during the fourth quarter of 2022 to $18.7 million. This increase was primarily due to increased insurance premium revenue recognized by our captive insurance companies.

Our tax rate increased from 22.2% to 29.5% for the 2022 fourth quarter. The increase in our current quarter rate was driven by an increase in our estimated state tax rate whereas the prior year benefited from the reversal of an uncertain tax position. For 2023, I would roughly estimate an effective tax rate of 25.5%, which includes our current estimate of the anticipated benefit under the new 45L energy efficient home tax credit. This estimate does not include any discrete items or any potential changes in tax rates or policies.

We delivered 2,554 homes during the quarter, which represented a 4% decrease year-over-year, but exceeded the previously estimated range for the quarter of 2,200 to 2,500 closings. Our backlog conversion rate in the fourth quarter was 48%, which represented a 1,300 basis point improvement from the fourth quarter of 2021. This was due to an increase in the number of quick move-in homes we sold and closed during the fourth quarter, which accounted for nearly 500 closings or 19% of our total deliveries for the quarter.

These quick move-in or spec homes were the result of cancellation activity during the second half of 2022 and to a lesser extent, strategic spec construction starts from earlier in the year. Our ability to convert these homes into closings played a big role in exceeding our closing guidance for the quarter. The average selling price of homes delivered during the quarter increased 8% to $582,000. This was primarily the result of price increases implemented during 2021 and the first quarter of 2022, which were partially offset by an increase in incentives.

We currently anticipate home deliveries for the 2023 first quarter of between 1,500 and 1,600 units and we expect the average selling price of these units to be between the $550,000 and $560,000. There continues to be a heightened risk of underperformance relative to our forecast, as we look forward to the first half of 2023, due to the increased volatility of economic and industry conditions.

Gross margin from home sales decreased by 850 basis points year-over-year to 15%. Excluding inventory impairments, gross margin from home sales decreased only 230 basis points to 21.3%. The decrease was primarily due to increased incentives as well as increases in land and construction costs year-over-year. These items were partially offset by higher base house pricing due to price increases implemented in the 2021 and the first quarter of 2022.

We are currently expecting gross margin from home sales for the 2023 first quarter of between 18% and 19%, assuming no impairments or warranty adjustments. Our total dollar SG&A expense for the 2022 fourth quarter increased $1.8 million from the 2021 fourth quarter, driven by increased commission expenses as a result of the increase in home sale revenues.

As noted last quarter, we continue to take steps to reduce our general and administrative expenses and saw these expenses decrease during the fourth quarter of 2022, both sequentially from the third quarter, as well as on a year-over-year basis when compared to the fourth quarter of 2021. We currently estimate that our general and administrative expenses for the first quarter of 2023 will be between $50 million and $55 million, which represents a $19.5 million or 27% decrease from the first quarter of 2022 at the midpoint.

The dollar value of our net orders decreased 95% year-over-year to $74.4 million, due to a 93% decrease in net unit orders. Net unit orders were negatively impacted by the number of cancellations during the quarter, which nearly doubled from the prior year to 1,312 cancellations. While our cancellation rate as a percentage of homes in backlog has been above our historical average during the second half of the year, these cancellations have provided us with a source of quick move-in homes at a time when more buyers are looking for homes that can close quickly in order to provide certainty as to their ultimate mortgage rate at closing.

As Larry mentioned at the outset, due to this change in consumer preference, and the ongoing uncertainty around mortgage rates that has negatively impacted the build to order market, we have pivoted our strategy to focus on more speculative construction starts to supplement build to order construction activity. Before cancellations, our gross order activity for the fourth quarter was down 55% year-over-year and 4% from the third quarter of 2022. 74% of our fourth quarter gross order activity was for spec inventory with a sizable portion of those orders contributing to fourth quarter closings.

Looking at our average selling price of new orders, we analyzed this metric on a gross basis given the magnitude and mix of cancellation activity during the quarter. On a gross order basis, our average selling price of new orders decreased approximately 1% as compared to the prior year and approximately 6% as compared to the third quarter of this year. The decrease in our average selling price from the third quarter of 2022 was due to an increase in incentives as well as a decrease in base pricing across many of our communities.

Our Active subdivision count was at 225 to end the quarter, up 20% from 17% a year ago. Looking at the graph on the right, the number of soon to be active communities significantly exceeded the number of soon to be inactive communities at December 31, 2022. This indicates a strong possibility that our active subdivision count will continue to increase as we enter the 2023 spring selling season.

During the fourth quarter, we acquired 258 lots, resulting in total land acquisition spend of $38 million and incurred $119 million of land development costs. For the full year, we invested $1 billion in land acquisition and development, which represented a 46% decrease from the prior year. As of year-end, we had $19 million in cash deposits, $3.7 million in letters of credit and $3.4 million of capital costs at risk associated with the 3,703 lots remaining under option.

Our financial position remains among the best in the industry as of year-end. With our slowdown in land acquisition and development activity during the year, operating cash flows increased to $905.6 million for the full year 2022 compared with $208 million of cash used to fund operating activities during fiscal 2021. We ended the year with $1.28 billion of cash and short-term investments. Thanks to our opportunistic senior note issuances during 2021, we entered 2023 with a very attractive capital structure, highlighted by the fact that we have no senior note maturities until January 2030.

Our year end debt-to-capital ratio was 32.6%, and our net debt-to-capital ratio was just 6.6% to end the year. Our book value per share at December 31, 2022 was $42.60, which represented an increase of 23% year-over-year after adjusting for our industry-leading cash dividend. We ended the year with 4,770 homes under construction, which is a 34% decrease from the prior year end.

Spec homes comprised 31% of our homes under construction at year end, and we expect this percentage to increase in the near term as we continue to supplement our build-to-order construction activity with the construction of spec homes.

In summary, we remain confident in the long-term growth prospects for the industry given the underproduction of new homes over the past decade and the strong desire for homeownership in this country. Our strategic decision to build more spec inventory should provide us the inventory we need to satisfy current consumer preferences and give us the opportunity for another very profitable year in 2023.

Similar to past home building cycles, we believe we are well positioned to navigate today’s evolving market conditions given our seasoned leadership team and strong financial position.

That concludes our prepared remarks. We will now open up the line for questions.

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Stephen Kim with Evercore ISI. Please go ahead.

Stephen Kim

Yeah. Thanks very much, guys. Appreciate the color. I think you had even last quarter, talked about maybe changing the — some of your policies regarding the deposit earnest money that you’re taking. And it’s interesting to hear you’re talking about making this change to your spec strategy. So obviously, we’ve seen your spec count per community increasing in the back.

You made it sound in your prepared remarks this time and also last quarter, that, that was kind of unintentional that, that was really just due to cancellations. So is it correct to think that this change to your spec strategy is something that you are really just starting to implement to be deliberately doing some more specs in January or was there some point in the fourth quarter where you made that change? And how many specs per community should we be anticipating that you’ll run with for as long as the customer is behaving the way they are?

David Mandarich

Steve, it’s Dave. Good morning. Good afternoon, in your case. You know what, I think that we made some changes in the fourth quarter and we did a little bit more changes yet this quarter, and maybe Bob can kind of go through some of the numbers. But we do think, based on the consumer today is they want a house, they want to close in three or four months.

So we feel pretty good about the strategy of building some inventory houses. Plus, as you well know, today, people want to know what their house payment is going to be, and they’re going to feel a lot better about buying a house that they can get closed into 60 to 120 days, and they’ll know what the mortgage payment is. Bob, what can you add to that?

Bob Martin

Yeah. I think really in terms of the starts, intentionally starting the specs, you’ll see that more in earnest here in the first quarter. The idea is to keep our production levels up. And as David mentioned, really make sure that we are meeting the needs of our customers. At the same time, we are still offering build to order as well. So I don’t think there’s a long-term target on the number of specs. I think we’re going to play that by year and look at what the market is telling us. But we are committed to adding that spec strategy and maintaining it here in the near future.

Stephen Kim

So you ran at 6.6 specs per community, I think, this quarter, you were five last quarter. Historically, you’ve generally run around two and change. Some of your peers that are kind of hybrid, I would say, are kind of running close to 10. So I’m inclined to model, but you’re going to run at about 10 specs per community in the near term. So correct me, if I’m a little wrong on that, maybe too high or too low.

And then in terms of your gross margin, I believe you had indicated previously the gross margin on specs as a little higher than on dirt closings. I was curious if that’s still the case or if I remember that incorrectly, if you could just give us a sense for your gross margins on specs this quarter or quick move-in homes were they higher or lower than the BTOs?

Bob Martin

This quarter, they were about 100 basis points lower for closings due to some of the incentives that we offered during the fourth quarter.

Stephen Kim

All right. And then the 10 specs per community, is that a reasonable level to be thinking?

Bob Martin

Yeah. I don’t think it’s unreasonable that that’s the way the math would work out. I think you calculated roughly six per community at this point as you look at what is currently on balance sheet. So to see it migrate up or to a greater percentage of the homes we have under construction at any given point in time, I think it’s a reasonable assumption.

Stephen Kim

Great. Well, I appreciate the color. Thanks very much.

Operator

The next question comes from Truman Patterson with Wolfe Research. Please go ahead.

Truman Patterson

Hey. Good morning, everyone. Thanks for taking my questions. And Larry, please don’t tap the Fed over the low unemployment rate. So Bob, just hoping you can give us a little color on January trends. When I’m looking at your fourth quarter orders, clearly, you had elevated cancellation rates, but now you’re making changes to your spec strategy. You’re pushing incremental incentives. Clearly, it’s kind of muddied right now. So I’m hoping you could just let us understand how January is trending regarding orders maybe on a year-over-year basis? And how you all are kind of thinking about 1Q?

Bob Martin

Yeah. So year-over-year, I think it’s a little confusing, Truman, because we were still in a period of time where rates were really low. So I’m not sure that’s a really fair comparison. But versus December, and keep in mind, December was our best orders month, both gross and net for the fourth quarter. So relative to December, for January, I expect both gross and net orders to exceed our December activity. And that’s with a lower number of cancellations in January relative to December. So that’s something that we’d really like to see.

Truman Patterson

Okay. Thank you. And again, I realize seasonality is a little strange right now, but would you characterize January as above normal seasonality as we sit today?

Bob Martin

It’s tough to really peg seasonality at January versus December when you’re coming off of a very simultuous time, but I would say it certainly gives us a good bit of optimism going into spring.

Truman Patterson

Okay. Perfect. And then any chance you could help us quantify the magnitude of any potential cost tailwinds you’re experiencing as of like today’s starts, I realize lumber is down meaningfully year-over-year. It might have popped back up some recently, but hoping you can help us think through some of the potential cost savings outside of lumber.

Bob Martin

I think those are still materializing. We might, I think, relative to the peak be in the 4% to 5% range outside of lumber. But as you indicated, really lumber is the biggest potential tailwind at this point.

Truman Patterson

All right. Thank you, all. Good luck in the upcoming quarter.

Operator

The next question comes from Michael Rehaut with JPMorgan. Please go ahead.

Unidentified Participant

Hi. This is Andrew (ph) on behalf for Mike. Thank you for taking my question. I wanted to ask if you would be able to give any color on the potential for any future land impairments or how we should be thinking about that?

Bob Martin

Land impairments is an analysis we do on a quarterly basis. And really, one of the biggest contributing factor is pricing and whether that’s base pricing or incentives. So to the extent that we have a decrease in base pricing or an increase in incentives that is significant, we could realize additional impairments just as we did in Q4. So not really much more to say about it than that. We try to be very thorough every quarter going through our assets and making sure we do a very thorough analysis and take the impairments as appropriate.

Unidentified Participant

Okay. Appreciate it that. And I apologize if I missed this. Did you ever break out the incentives in the quarter as compared to last quarter?

Bob Martin

Versus Q3. So Q3, we talked about 800 basis points of incentives, and that’s on sales. In Q4, that was closer to 1,200 basis points on sales. On closings for Q4, it was about 800 basis points.

Unidentified Participant

Okay. I really appreciate that. That’s all for me. Good luck for the next quarter.

Bob Martin

Thank you.

Operator

The next question comes from Jesse Lederman with Zalman & Associates. Please go ahead.

Jesse Lederman

Hi. Thanks for taking my question. So in the past, you guys have really largely resisted doing more spec building for a number of reasons. And we agree with the interest rate dynamics, it makes it more attractive to home buyers having this quick moving product, but your business seems really built upon built-to-order from your sales strategy and revenue generation with your options and upgrades to your overhead structure. So how confident are you in being able to execute this pivot compared to other homebuilders who specialize in the sales model? And how can you compete from a cost perspective?

David Mandarich

This is David speaking. I’ll tell you, we’re very encouraged over the last couple of months because we are getting a percentage of what I call build-to-order houses. And I think this month, Bob will go through the numbers, but we’re seeing a lot of customers that are coming in I want my lot in my house I’m going to give you a deposit, I want to pay whatever it is for upgrades at our home gallery. So we’ve got a number of customers that are looking at that kind of product. In the past, we’ve done mainly that kind of product. And so we’re excited that there’s customers out there that really are willing to wait for that kind of house, but they want their house on their lot with their options. So Bob, you might kind of go through the numbers.

Bob Martin

Yes, I think that was about.

Jesse Lederman

Just to step in here and clarify. I’m just curious about your ability to execute the spec strategy given that’s kind of veering away from the build-to-order model that your business kind of built around. So in terms of like selling specs, particularly, how confident are you in being able to compete against some of your competitors who specialize in this strategy, the spec strategy?

David Mandarich

I’d say we’re very confident. I mean, we executed it really well at fourth quarter. And Larry, I’ve been doing this for 46 years. So over time, we’ve had times where we did inventory houses. I think the last couple of years, we’ve just been built to order, but we’re very confident on the execution and the product that we’re putting out. Bob?

Bob Martin

No, I think that’s absolutely right. There’s a lot of experience during the period of time where it’s much higher spec concentration, what we saw as a percentage for now. We were about 25% dirt for orders and about 75% spec. So we have pivoted. We think that makes sense. We think we can execute, and it’s in line with consumer preferences. So we definitely have the team to execute on that strategy.

Jesse Lederman

Absolutely. Thanks for that. And then just a quick follow-up. Are you altering the product given presumably you generate a fair amount of revenue through your design studio. So how are you thinking about creating these spec homes? Are you just trying to drive the price lower versus your build-to-order product?

David Mandarich

Well, I’ll just start off, and Bob can probably enhance it a little bit. But essentially, what we’ve done is we looked at customer preferences on dirt starts, we put those kind of preferences in our inventory houses, including what I call some sunrooms or patios or cabinet types. But we think we’ve looked at the metrics, and we feel really good about what our inventory houses would look like when they’re finished.

Bob Martin

Yes, I think that’s absolutely right. We basically looked at the take rate for both structural upgrades and design center upgrades, and we’re trying to emulate that see what’s the most popular. So as a result, it really should put us in the same range of options and upgrades that we had before. It just so happens that a lot of them are now going to be preselected for many of our consumers versus them selecting them.

Jesse Lederman

Got it. So is the ASP roughly on par with your build-to-order product when all said and done or what — just lastly, what’s kind of the variance there as it can today?

Bob Martin

Yes. I wouldn’t see necessarily a huge variance in ASP just because of that. I mean right now, the metrics on spec versus dirt ASP could be a little bit skewed just depending upon where the cancellations have come to and therefore, where the spec inventory is the highest. But for now, I think the intent is not to reduce the average selling price because of the spec strategy.

Jesse Lederman

Understood. Thanks for all the color. I really appreciate it.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Bob Martin for any closing remarks.

Bob Martin

Thank you all for joining the call today. We look forward to hosting you again when we announce our Q1 2023 results.

Operator

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.