We believe Meritage Homes (MTH) is a stock with significant upside potential that is driven by several strong growth signals and catalysts. The company has large upside from their current land holdings and backlog as well as has an enticing green initiative that could help drive strong future demand in the company. Foremost, Meritage has strategically increased its lot supply by more than 46% in the past 2 years, which serves as the main catalyst for the company's growth. We expect a best-case scenario of 100% stock appreciation in the next 12 months with a price target of $80.
As of June 30, 2013, the company had developed 165 communities and that number is projected to increase to 185 by the end of the year. According to the latest earnings report, 3500 new land lots were added in the second quarter and more than $156 million was invested in land and development. There is a ton of value in the company's current lots. After the 3500 add in Q2, total lots have risen to 22,600. The company believes this lot supply is good for five years. The company, further, can make top operating margins on these lots because they paid limited priced in 2008-2011 while they were at rock-bottom prices. Talking about these lots, the company's CEO Steven Hilton wrote:
These lots are in very desirable locations in our key markets, especially in some of those areas where demand has been the highest as in California, Colorado and Florida, while further solidifying our position in Raleigh and in several communities in some of the most promising areas of Texas, particularly in Houston.
How much value is in these lots? Why is it a major catalyst?
The market seems to be not correctly pricing these lots. Currently, MTH is closing units at a rate of $330K per. These prices are expected to rise given the still deflated levels of homes, which we talk about more in our Bear Case section. Even if these levels stay the same, 330K x 22.6K equals $7.5B in revenue for the next five years or $1.5B in revenue. To us, that means that the company should be priced at a fair value currently given that its TTM revenue is at $1.5B. Currently, though, PE is 10.8 and future PE is 10.0. Both levels are very cheap.
The current state of the real estate industry without doubt functions as a catalyst for MTH and housing prices should continue up. Building permits in July 2013 were up 2.7 percent from June and up 12.4 YOY. Housing starts in July 2013 were up 5.9 from June and up 20.9 YOY. These stats are significant not necessarily for the value of the company, but to see the industry is in a general upward trend. Some of the main markets for MTH are Texas, Arizona and the Carolinas, all states that have seen recent population inflows and are poised to outperform national averages in terms of economic growth.
Why do we believe MTH has a potential 100% upside? Because the company is developing communities in strategic regions. Out of the top 20 leading markets for homebuilding, the company is present in 11 of them. MTH reported a 9%-10% increase in orders per community for each of its last 3 quarters. The company also reported a 76% YOY increase in value of backlog orders which is due to in part to rising home prices as well as a 21% increase in total orders. At the end of 2012 the backlog value was $479 million, whereas in the first half of 2013 alone, the value grew to $806 million. Net earnings grew by 252% in the latest quarter YOY. We see further growth opportunity through the company's expansion into new markets. New communities are being developed in Tampa, Charlotte, Orlando and Raleigh. These cities experienced between 28% and 59% YOY increase in residential construction permits, a good indicator of local homebuilding activity.
All systems point to high demand, which creates higher prices. There is only so many units that MTH is comfortable closing a month and creating a backlog creates demand and increases prices. With permits rising and high demand in MTH's communities, we believe prices are due to continue to rise. The company believes that it will see some slowdown in these increases, but they can see 200 basis points of gross margin increase over the next twelve months. As we have shown earlier, even if prices stay the same, the company has nice upside with a 10 PE. Given a stronger increase in prices, these valuations show even more value.
There is a shift in many sectors and industries towards finding more eco-friendly and energy efficient alternatives of producing goods. The same trend plays out in the residential construction market. Some of the more popular energy efficiency programs are Energy Star and Leadership in Energy and Environmental Design (LEED). Both are certification programs, one government backed, the latter private, that rate the energy efficiency of a building. Their rating scales are nationally recognized and act as benchmarks in comparing one structure to another. All of the homes offered by MTH are 100% Energy Star Certified, offering energy efficient alternatives such as solar energy systems that considerably reduce related monthly expenses. All homes developed by MTH are new constructions, which makes it cost efficient to implement energy saving related products as opposed to going through the process of replacing conventional ones. Why is this important? Between 2005 and 2011, green building grew from 2 percent to 17 percent of the green residential building market. The value of this growth is around $17 billion and the number is expected to grow to $87-$114 billion by 2016. We believe MTH is strategically positioned to take advantage of this growing market and maintain an edge over the competition.
The valuations scores tell us that MTH is a growth stock with good value. Revenue growth projections stand out in particular, with a YOY projected revenue of 53% for this year and 33% for next year. The spike in revenue is fueled by the addition of new land. Nevertheless, the stock price of MTH has been somewhat stagnant year to date, rising from $37.35 to close to $40. This tells us the future growth from this added land has not been factored into the stock price yet, which is great for long investors looking for upside in residential construction. Key valuations support this claim as MTH has low p/e and forward p/e values of 10.88 and 9.95 respectively. A very low PEG ratio of 0.19 further suggests the company is undervalued to its expected earnings growth.
We see that most of the operating income is spent on supplies, which leaves the purchase of new lots done through the leveraging of debt. Meritage Homes has a low debt to equity ratio of 1.06. Long term debt accounts for 78% of total liabilities, which shows an aggressive approach at business expansion. The company does not run the risk of default with an interest coverage ratio of 5.14. Moreover, based on the latest earnings report, the debt to capital ratio decreased from 44.1% to 37.2% YOY. Its current and quick ratios are at healthy levels of 1.99 and 1.76 respectively, which means the company maintains adequate levels of current assets to current liabilities.
For the DCF analysis, we made certain assumptions based on the catalysts we see in the company.
Operating income: Currently, we expect the company to come in with operating income around $126M for 2013 and continuing a strong cycle of gains in 2015 and 2015. We expect a 2016-2017 slowdown due to a cyclical top in demand, pricing, etc. A double dip seems unlikely as well as employment has stayed strong.
Taxes: We are assuming a 28-30% tax rate.
Depreciation: We expect depreciation to steadily increase as the company continues to increase lots, sees depreciation of units and lots, and grows in overall asset size.
Capex: We expect this to continue to rise as cash flow is strong and can be returned to shareholders as well as the company will continue to look to build its assets. We would expect a slowdown towards the top of the cycle and it to start to build again in 2016.
Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.
Available Cash Flow
Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for MTH: 7.7%
PV Factor of WACC
PV of Available Cash Flow
For the fifth year, we calculate a residual calculation. Taking the fifth year available cash flow and dividing by the cap rate, which is calculated by WACC subtracting out residual growth rate, calculate this number. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. Cap Rate for MTH: 2.7%
Available Cash Flow
Divided by Cap Rate
Multiply by 20167PV Factor
PV of Residual Value
Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:
Sum of Available Cash Flows
PV of Residual Value
Interest Bearing Debt
Divide equity value by shares outstanding:
An issue that may be holding the stock back is the fear of rising interest rates. The potential shift in the current monetary policy, where the Fed would end its bond-buying program could signal a drawback for the real estate market and curb the short boom the market has seen lately. Tight lending standards are also an impediment as it prevents potential homeowners from qualifying for mortgages. Because of these issues, we might see the recovery of the real estate market slow down which in turn could hinder some of the growth expected by Meritage Homes.
David Guarino did a great job of talking about these interest rates in a recent article:
While the focus of this article is not on monetary policy, one has to assume that given the accommodative language of the Federal Reserve, we are not likely to see interest rates spike 100bps higher next month, maybe not even next year. If in fact rates were to rise, we would very likely see action taken from our central bankers to keep them depressed. Additionally, the Fed has indicated that if rates were to rise, it would be due to a growing economy, which is capable of stabilizing itself (one which would be conducive to homebuilders). Regardless of the direction of interest rates, home price affordability still remains at all time highs.
An interesting, often overlooked index is the National Association of Home Builders-Wells Fargo Housing Opportunity Index. The index may sound confusing but it really focuses on two major components, income and housing costs. The index looks at 225 metro areas throughout the US and finds the annual median family income (with help from HUD). The index assumes 28% of this income can be spent on housing (conventional estimate in the lending industry). Next Corelogic provides data on sales prices for homes sold. Assuming a 30-year mortgage with 90% down, the index then takes a weighted average of fixed and adjustable rate mortgages to figure out what the monthly payment would be.
Nevertheless, we believe there is strong upside potential to the stock as we believe the housing market will continue its upward trend in the near future. As we will show in our price target analysis below, we expect operating income to double in the next 5 years. Meritage Homes shows significant growth potential in a rebounding real estate market. Its continuous land expansions through leveraging of debt along with its green building initiatives, makes MTH a good growth prospect with solid value.