- Meritage Homes recently reported strong results with all-time high gross margins and EPS.
- The company is poised to increase its active community count substantially over the next nine months.
- While I expect absorption and gross margins to normalize, even after building it in my forecasts, I am seeing a significant upside.
Meritage Homes (NYSE:MTH) recently reported strong Q3 2021 results with both earnings and revenues beating consensus estimates. The company’s revenues increased ~11% YoY to $1.26 bn (vs. $1.19 bn consensus estimates) as it navigated supply chain issues to deliver 3,112 homes in the quarter, which is the highest third-quarter home closings in the company’s history. The company’s home closing gross margins were also at an all-time high of ~29.7%. Better than expected revenues as well as strong gross margin performance helped the company post ~85% YoY increase in its EPS which came at $5.25 vs. $4.45 consensus estimates. On the flip side, new orders declined ~11% YoY despite a 5% increase in average community count as absorption moderated to 5.0 new orders per community per month (vs. 5.8 in Q3 2020). This is not a surprise as the absorption pace post-Covid benefited from exceptionally high demand conditions as well as constrained supply of communities resulting in very high absorption levels which were unlikely to sustain as things return to normal.
Over the past few years, the company has increased its mix towards entry-level homes. This strategy paid a huge dividend in the aftermath of the pandemic. While the whole housing market saw robust demand post-pandemic thanks to lower interest rates, stimulus checks adding to income (especially for white-collar workers), and higher savings among consumers (due to fewer avenues to spend outside), the demand for entry-level homes have outperformed the other categories. In addition to focusing more on entry-level homes, the company is also building more speculative ready-to-move-in homes which are helping it gain market share in the current market with tight supply-demand conditions.
Looking forward, I believe the stock is a good buy as the company is poised to increase its community count which will help its revenues, and while absorption (net new orders per community per month) are expected to moderate, I expect them to still be much better than pre-pandemic levels.
After declining from 241 at the end of Q1 2020 to 195 at the end of Q1 2021, the company’s active community count has increased in the last two quarters. Meritage Homes opened 40 new communities last quarter and its net active community count (quarter ending) increased to 236 for Q3 versus 226 at the end of Q2 end. Management is planning to ramp up their community count significantly over the next three quarters and plan to reach 300 active communities goal by mid-2022. The company has already acquired land for reaching this level and continues to acquire more to make sure it is able to maintain its community count near that level. The company has a strong balance sheet with net debt to capital of just 17.5% and I believe it has ample resources to reach and maintain its 300 communities target. This bodes well for the company’s revenues and order growth in the near term.
On the absorption front, there are some concerns around the sustainability of the current elevated levels as things return to normal. While I agree that the current absorption levels (especially the mid to high five range we saw in the first half of this year) are unlikely to sustain as some of the industry-wide supply of new communities (which was delayed by pandemic-related constraint) comes to market, I expect absorption levels to still remain healthy. Management has guided for an absorption level between 4.0 and 5.0 in the long term which doesn’t look difficult given its absorption was 4.3 in Q1 2020 even before the pandemic-related surge began.
While management believes absorption can be closer to 4.0 than 5.0 in the long term, I believe we can see absorption closer to 5.0 at least for the next couple of years. There are a couple of reasons behind it. The company reported absorption of 5.0 last quarter despite metering its sales in 80% of the communities. If it wouldn’t have metered down its sales, the numbers could have been possibly higher. So, even as normalization occurs and industrywide absorption sees some downward pressure, the company can exit its metered sales approach to offset a part of its impact. Also, if we look at management commentary, monthly demand has improved sequentially from August to September and October. So, I believe we are already at a monthly absorption level of slightly more than 5.0 in October, i.e., better than Q3 levels.
The industry fundamentals also look supportive. If we look at industry data, there has been a significant underbuild in the housing industry in the decade following the great housing recession. I have discussed it in a previous article here, but I am briefly summarising it here. From 1959 to 2007, annual total housing starts in the U.S. have averaged at ~1,546,900 houses while single-family housing starts have averaged at ~1,101,800 houses. However, from 2008 to 2019, there has been a significant underbuild with annual total housing starts averaging at ~949,400 and single-family housing starts averaging at ~656,500.
So, from 2008 to 2019 there has been an average annual deficit of ~597,500 [ =1,546,900 - 949,400 ] total houses and ~445,300 [ =1,101,800 - 656,500] single family houses versus the long-term averages. In other words, in order to return to long-term averages over the next decade, total housing starts will have to average at ~2,144,400 [ =1,546,900 + 597,500] and single family housing starts will need to average at ~1,547,100 [ =1,101,800 + 445,300] from 2020 to 2031.
There is a significant amount of pent-up demand in the market which got unleashed post-pandemic. Even if we assume supply conditions to improve and demand to normalize, we will still likely see absorption settle at a level higher than where it was before the pandemic-related acceleration began. I believe the company can see absorption in the high 4s after the conditions normalize. While this is a decline versus the current levels, I still see a good upside for the stock price using these levels of absorption (high 4s) in my forecast.
In addition to strong business trends, the company’s solid balance sheet with net debt to capital of ~17.5% gives it ample leeway to purchase shares. While I have not built it in my estimates, I believe share repurchases can be a big part of the thesis once the company reaches its 300 community target by the middle of the next year. This can result in further upside for the stock.
I have assumed that the company will be able to reach its 300 active communities goal by June 2022 in line with management targets and its active community count will stabilize at that level. For absorption, I have assumed a slight increase in Q4 as management has talked about sequential improvement in demand from August to September and October. However, for FY2022 and FY2023, I have assumed monthly absorption at 5 and 4.7 respectively which is a slight decrease versus FY2021 as supply-demand conditions normalize but still remain stronger than pre-pandemic levels. The company reported ASP of ~$402k on homes closed last quarter while ASP in order backlogs was around $438k. So, I expect the ASP closing to continue increasing for the next couple of quarters as the backlog gets executed. However, in the long term ASPs are expected to drift lower as the company is opening more entry-level communities. I have assumed closing ASPs slightly above 400 for FY22 and then drifting below 400 in FY23. Right now homes closed to new order ratio is less than one as the company struggles to complete homes in backlog due to raw material and labor constraints. However, as these constraints ease over the next couple of years, we will see this ratio move closer to one. We get the following revenue forecast using these assumptions.
Source: Company Data, GS Analytics estimates
On the margins front, the company’s gross margins are benefiting as it is selling communities for which it acquired land a couple of years back before pandemic-related real estate appreciation happened. Management believes that gross margins will continue to be high for the next year before declining in the back half of FY2023 when some of the impact from land acquired post-pandemic begin showing in the results. I believe eventually the gross margin will settle somewhere in the low 20s as the conditions normalize, but still be higher than the ~19% gross margins we were seeing pre-pandemic due to increased scale as the fixed cost will now be spread over a larger base of 300 communities. For the current year, management has guided for gross margins between 27.50% and 27.75%, I believe they can post gross margins at the upper end of this guidance range. For next year I am assuming gross margins of 27%, and for FY2023 I am seeing it at ~25% as it begins to take a leg down.
Similarly, for SG&A, management’s target range is between 9% and 10%. While it might be on the higher side of the range for the next couple of quarters as the company opens an extraordinarily high number of communities (and there are associated costs with it), once it reaches 300 active communities target the benefits from the larger scale will become apparent and it will move towards the lower end of this range. For my forecast, I have assumed SG&A to be 9.5% for FY2022 and 9% for FY2023. For interest expense, tax rate, and other income, my estimates are more or less in line with consensus estimates. I am also assuming the share count will remain constant. I am being conservative here and as acknowledged before there is a good chance that there may be a further upside as the company buys back shares. Using these assumptions, we get the following forecast for Meritage’s P&L.
Source: Company Data, GS Analytics estimates
Valuation and Conclusion
Homebuilders are usually valued at a multiple of their tangible book value (Price/Tangible Book Value or P/TBV). It makes sense as their growth depends on how effectively they use their balance sheet in buying land, developing it and building a home on it, and selling it at a profit.
Meritage Homes has traded at P/TBV between 0.5x and 2x over the last five years with an average multiple of 1.3x. If we exclude Covid related correction and a sharp recovery thereafter, its P/TBV has been in the 0.8x and 1.6x range. As of the last quarter-end, the company has a tangible book value of ~$73 per share. So, the stock is trading at 1.48x TBV which is towards the higher end of its valuation range. It makes sense as we are in an extraordinarily strong housing market currently. However, as the conditions normalize by the end of FY23, I believe the stock will revert back to its historical average valuation multiple of 1.3x.
Source: SeekingAlpha Charts
Since the company gives no dividend and we haven’t assumed buyback in our estimates, the company’s tangible book value at the end of FY2023 can be calculated by adding the company’s Q4 2021, FY 2022, and FY 2023 EPS to the company’s Q3 2021 end tangible book value. This gives us $125 (=$73+ $5.56 + $24.19 + $22.22) in Meritage’s tangible book value at the end of FY2023. Applying 1.3x P/TBV multiple we get a target price of $162.5 which implies ~49% upside over slightly more than two years. Thus, I believe the stock offers a good upside in the medium term and hence believe it is a good buy.
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