Meritage Homes Corp (NYSE:MTH) has made entry-level housing its biggest priority over the past year, and over the past couple of quarters it's really started to pay off, driving earnings steadily higher. In the fourth quarter of fiscal 2017 that acceleration continued, with the homebuilder reporting its biggest pre-tax earnings in more than 10 years. And based on a closer look at its operating results, it's clear that its strategy to build more starter homes and expand the mix even more is the biggest reason.

Let's take a closer look at Meritage Homes' financial and operating results, what management has to say about the results, and the company's future plans.

A builder working on the roof of a new home under construction

Image source: Getty Images.

Meritage is getting more profitable

Here's a breakdown of some key financial metrics for Meritage Homes:

Metric Q4 2017 Q4 2016 Year-Over-Year Change
Homes closed (units) 2,253 2,117 6.4%
Home closing revenue $923.37 million $876.094 million 5.4%
Average sales prices -- closings $410,000 $414,000 (1%)
Home orders (units) 1,795 1,493 20.2%
Home order value $760.34 million $635.995 million 19.6%
Average sales price -- orders $424,000 $426,000 (0.5%)
Ending backlog (units) 2,875 2,627 9.4%
Ending backlog value $1.246 billion $1.136 billion 9.7%
Earnings before income taxes $84.090 million $76.337 million 10.2%
Net income $35.553 million $51.807 million (31.4%)
Earnings per share (EPS) $0.87 $1.22 (28.7%)
EPS adjusted for deferred tax asset charge $1.34 $1.22 9.8%

Most dollar amounts are to the nearest thousand. Data source: Meritage Homes.

As you can see in the table above, Meritage delivered solid growth in most of the categories above, generating higher pre-tax earnings and selling more homes, while also growing its backlog of homes under order. At the same time, average selling prices declined slightly, and home unit sales are outpacing revenue growth. This is by design, as the company continues to accelerate development of lower-cost entry-level properties and communities.

Meritage actually reported a big drop in its GAAP earnings in the quarter. However, like many large companies in the fourth calendar quarter of 2018, the company took a substantial charge to deferred tax assets on its balance sheet related to the passing of the Tax Act, which lowers the value of those assets toward future tax savings. In Meritage's case, the charge was $19.7 million, the impact of which is shown in the adjusted EPS total at the end of the table above.

However, it's worth pointing out that the long-term benefit of a lower federal tax rate will contribute significantly more to Meritage's bottom line than this onetime charge will cost. Meritage reported a 57.7% effective tax rate in the fourth quarter due to the tax asset revaluation, but has reported a tax rate around 33% over the past year. Management expects to pay a new effective rate closer to 25%. That would be worth $6.7 million in additional after-tax earnings, based on the $84.1 million EBIT (earnings before interest and taxes) that the company reported last quarter.

Plans to further accelerate entry-level community growth

In its earnings presentation, Meritage explained the two big catalysts behind its "strategic focus" on the entry-level market:

  • There's an "extreme shortage" of supply to meet demand from first-time buyers.
  • Millennials are entering the homebuying market in droves.

At the end of 2016, 21% of Meritage's actively selling communities targeted this market. The mix increased sharply to 30% in 2017, while management aims to move that mix as high as 40% by the end of 2018. Similarly, starter-home orders have steadily increased, from 24% in 2016 to 33% in 2017.

In addition to skating to where the puck will be, Meritage is also taking advantage of the margin-boosting potential for starter homes, which it can build a higher percentage of on speculation. Spec homes generally sell for higher profit margins, and there's less risk with entry-level homes on spec, since there is less need or demand for customization that can add to the build cost or cause a spec property to remain unsold for a longer period. The mix of spec homes increased from 41% in 2016 to 49% in 2017.

Looking ahead

Meritage is betting big on the entry-level market driving substantial demand in the years to come. Of the lots the company acquired in 2017, 70% will be used for starter communities, and it's likely the company will continue to build its inventory of lots aimed at this market.

Company guidance for 2018:

  • Between 8,350 and 8,750 home closings, 8% to 14% higher than in 2017
  • Home-closing revenue of $3.4 billion to $3.6 billion, 7% to 13% higher than in 2017
  • Gross margin of 17.5% to 18%, slightly below to slightly above the 17.6% in 2017
  • Pre-tax earnings 6% to 13% higher than 2017's
  • A 25% effective tax rate, down from a rate of 31% to 33% in recent years

Over the past year, Meritage Homes' focus on this segment has paid off, and a lower federal tax rate is set to boost its earnings even more in 2018. There are sure to be ups and downs as the housing market goes through its normal -- and healthy -- cycles of demand. But if the pent-up demand for starter housing is as strong as it seems to be, the company's strategic shift could pay off for years to come.

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