The southeastern U.S. is a big growth market for Meritage. Image source: Meritage Homes. 

When Meritage Homes Corp (NYSE:MTH) reported second quarter results on July 28, there was a lot to like. The homebuilder reported it closed on 1,950 new homes in the quarter -- a huge 25% jump from last year -- and that home closing revenue was up 35% to $796 million following a 7% increase in the average selling price. 

Unfortunately, a 200 basis point drop in gross margin, falling to 17.3% from 19.3% last year, combined with statements from management that it would take some time for margins to recover, left the market wanting. As of this writing, Meritage shares have fallen more than 5% since the earnings release was issued. 

So what's the takeaway? Let's dig into the earnings release and conference call with management and see what we can learn. 

The numbers

MetricQ2 2016Q2 2015Change
Home closing revenue  $795.8  $591.0 34.7%
Net income  $39.9  $29.1 37.1%
Earnings per share  $0.95  $0.70 35.7%
Home closing gross margin 17.3% 19.3% (710) basis points

Revenue and net income in millions. Data source: Meritage Homes.

How Meritage delivered in the quarter

It's not often that a company can report such a big drop in gross margin yet still deliver earnings growth that exceeds revenue growth. Here's how Meritage Homes did just that in the quarter:

  • Commissions were up 25% but fell 50 basis points as a percent of total closing revenue.
  • General & administrative expenses were up 5% but down 100 basis points as a percent of total closing revenue. 
  • Interest expense fell 64% and 60 basis points as a percent of total revenue.
  • Overall, spending on these three categories only increased 12.2%, while home closing revenue increased 35%. In short, lower expenses (as a percent of revenue) more than made up for the drop in gross margin. 

Meritage also delivered 4% growth in backlog units to 3,314. This was a nice sequential increase from 3,191 reported in the first quarter earnings. Factoring in the 4% increase in average selling price for its backlog, backlog revenue value increased 8% from last year. On a regional basis, the eastern region is driving a lot of the growth, particularly in relatively new markets in Georgia and Tennessee. The east region backlog value increased 24%, compared to a 3% increase in the central region and a 1% increase in the west region. 

The company also invested more money in real estate in the quarter, spending $254 million, up from $159 million in last year's quarter. It finished the quarter with $2.3 billion in real estate inventory, versus $2 billion one year ago. This left the company with more lots than it held a year ago, which is up from the end of 2015. 

Back to margins

Here's a look at how the company delivered by region, compared to one year ago:

Image source: Meritage Homes.

There are several factors to which management pointed that have driven gross margin down over the past year, including higher land costs for more recent land purchases, higher labor costs that have plagued the housing industry in general as new home construction has recovered, and to some extent, higher materials costs. But CEO Steve Hilton is adamant that he and his management team can drive margins back up -- even if they aren't sure how long it's going to take to do it. Here's what he said during the earnings call, in response to an analyst question:

...there's nobody more keenly aware of the margin issue than I am. Okay? I have operated for 30 years at subsequently higher margins than we're achieving today. And I wake up every single morning thinking about how can I get those margins up, because I absolutely understand it's a big issue. It's a cost issue; it's a land issue. It's some underperforming communities issue due to the FHA issue that I outlined before in the west [region], and we're working as hard as we can to fix it as fast as we can to get our margins back up to where they need to be. But I can't give you any more color than that.

I mean, at some point we'll get them back up in line with some of our competitors. But I can't tell you what quarter that's going to be.

Because of management's uncertainty when the company's gross margin percent will recover, it did reduce full-year guidance for gross margin to between 17.5% and 18%. But at the same time, the company expects its recent operating leverage improvements to continue driving strong earnings growth. 

Looking ahead

Meritage Homes is on track to having one of its most profitable years in the past decade despite continued pressure on gross margin from a number of factors. And while it may take time for management to get a handle on the key cost drivers that are impacting margins and start chipping away at them, Hilton and his team have decades of experience in the homebuilding business and a history of delivering results. In other words, there's probably a good chance that they can deliver on better margins in due time. 

For now, Meritage is doing a solid job managing its other expenses and driving profitable growth in a strong market for new homes. If management can indeed find a way to bring margins back to historical levels, the future could be very bright for Meritage Homes and its investors. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.