A number of short-term things are still squeezing Meritage's margins. But long term, management says first-time millennial homebuyers will drive profits higher. Image source: Getty Images.
Meritage Homes Corp. (MTH 0.23%) reported financial results for the third quarter on Oct. 27, delivering 11% home closing revenue growth, a 22% jump in earnings, and strong home order growth. However, the company once again reported a lower gross margin percent on home closings, a metric that management has been dealing with for a number of quarters now, and could take some time to recover, following a reduction in guidance for gross margin percent for the remainder of 2016.
The market voted decidedly negatively on the results and outlook, sending shares down nearly 8% following the earnings release and call. But management pointed out a number of factors that are playing a role in the recent margin compression and why these things are more likely to be short term in nature, as well as why they expect to be able to continue earnings growth in the years ahead, even as the current factors continue to weigh on profitability in the short term.
A look at the financial results
| Metric | Q3 2016 | Q3 2015 | Change (YOY) |
|---|---|---|---|
| Home closing revenue | $735.9 | $661.9 | 11.2% |
| Net income | $36.9 | $30.3 | 21.8% |
| Earnings per share | $0.88 | $0.73 | 20.5% |
| Home closing gross margin percent | 17.8% | 19% | (120 BPS) |
Home closing revenue and net income in millions. Data source: Meritage Homes. YOY = year over year.
What happened in the quarter
Even as gross margin percent has continued to be a challenge, a rigorous focus on costs and leveraging energy-efficiency tax policy has helped Meritage drive profits higher:
- Commissions and other sales costs increased 9% on higher revenue to $52 million but fell 20 basis points to 7.1% of home closing revenue.
- General and administrative expenses increased 16% to $33 million, up 10 basis points to 4.4% of revenue, but this was partly due to fixed overheads tied to new community openings in the quarter. G&A percent of home closing revenue is down 50 basis points to 4.3% year to date.
- Interest expense fell 96% to $200,000, down 60 basis points to less than 0.1% of home closing revenue.
- Effective tax rate fell 370 basis points to 31.4%, from 35.1% year over year. Management says its focus on building energy-efficient homes that qualify for multiple tax incentives makes this lower tax rate sustainable going forward.
- At the same time, gross margin percent was up 50 basis points sequentially, from 17.8% in the second quarter.
Other key happenings in the third quarter:
- Closed on 5% more homes in the quarter versus last year, at a 6% higher average selling price.
- Closed 40% of home sales from spec inventory, up from 33% a year ago, and in line with 42% in the second quarter. Management says this percentage will likely grow in coming years, as the company increases the percentage of starter homes it builds and sells.
- Reported 11% increase in total orders, worth 14% more revenue than the year-ago quarter; this increased the order backlog 9% to $1.38 billion.
- Spent $232 million on land & development, slightly less than the $254 million in the second quarter, but up from $175 million a year ago.
Another thing that's worth noting is that Meritage closed 30 sold-out communities in the quarter and opened 26 new communities. That's a significant turnover for a single quarter and played at least some role in the company's continuing challenges with gross margin. CEO Steve Hilton described this on the earnings call (keep reading for more below).
What management said
Here's Hilton on the impact of a huge number of new communities opening in the quarter and how that is affecting margins:
The early homes that close in the life cycle of a community are the lowest-margin ones. In a lot of cases because you've loaded in the construction overhead for the period where you're building your models and you're getting your community started. You've got some upfront marketing expenses that you're flowing through, and as the community gets more mature you're able to push prices, generally speaking. It's hard to quantify and certainly is going to vary also by geography. Those markets where prices are stronger it's going to be better, but it certainly could be 1% to 2% difference.
And here's Hilton on how the company's expansion into the southeast has helped drive profits in the near term, but why one big long-term trend is his focus now:
Our focus has been on long-term earnings growth, which led to our geographic expansion and further diversified operations and product offerings. We're seeing benefits from that expansion on our top line and expect to see additional bottom-line benefits for both margin improvement and additional leverage in our overhead over time, as our newer divisions reach critical mass and realize expected operating efficiencies.
We're now focusing on another growth opportunity for our company: offering more homes and communities that target the growing market of first-time home buyers. That market represents potentially millions of additional household formations in the U.S. over the next decade, and I'm confident in our ability to capitalize on that opportunity and translate into solid returns for our shareholders.
Looking ahead
Management also backed off on its guidance for the remainder of 2016, revising down the top end of its home closing range to 7,600 from 7,500, reducing the home orders range by 50 to 7,300-7,500, lowering gross margin percent to the bottom of the range at 17.5%, and lowering earnings per share guidance from $3.55-$3.85 to $3.40-$3.60. The company does expect home closing revenue to come in the same $2.9 billion to $3.1 billion range that it had forecast last quarter.
There are several factors at play here, according to management. The first is the impact of so many new communities just opening for business on margins because of the front-loaded costs as described above, but there will also continue to be some impact from the following:
- Better-than-expected sales in some western communities where prices have been reduced to accommodate FHA loan limits.
- The potential impact of Hurricane Matthew. Not only could closings in Florida and North Carolina be delayed, but labor constraints could be an issue in these markets as a result of rebuilding efforts. This could also increase labor costs in the short term in these markets.
- The impact of more starter home sales driving down average sales prices and margins, particularly in new markets.
In summary, there are multiple factors that management considered when revising its guidance downwards for the full year, and some of it -- particularly concerns about labor pressure in Matthew-affected markets -- looks like management simply being conservative with its guidance.
But beyond next quarter, Meritage remains focused on investing in the next generation of first-time home buyers, with its plans to expand even further and build and sell more starter, "entry-level plus," and attached townhomes than it historically has. It's likely to take some time for this focus to yield results, but historically speaking, Meritage under Steve Hilton has delivered. In the meantime, investors will need to continue riding out the ups and downs of a volatile housing market.
