Meritage Homes Corp. (NYSE:MTH) reported second-quarter results on July 26, and once again saw profits spike as revenue and gross margin increased on strong home sales growth. Even better for investors, the trend is very positive, as margins and sales of starter homes continue to improve with each passing quarter, playing a big role in margin expansion and growing the company's backlog of home orders.

Let's take a closer look at how Meritage delivered another solid quarter, and at what management says to expect.

A young couple carrying boxes into a new home

Entry-level homebuyers are helping Meritage grow its profits. Image source: Getty Images.

Starter-home sales continue to accelerate (and that's a good thing)

Meritage Homes sold 2,139 homes in the second quarter, 12% more year over year; this generated home-closing revenue of $872.4 million, a 9% increase. Average sales price fell 3% in the quarter, a trend that's developed over the past year as the mix of entry-level homes has increased. But as discussed in prior earnings releases, this is a byproduct of the intentional strategy of developing a higher mix of starter communities.

And this shift continues to pay off. Starter homes made up 44% of total orders, up sharply from 35% in last year's second quarter. This helped drive the order backlog 6% higher at quarter-end, to $1.53 billion. At the same time, the entry-level strategy continues to drive sales of so-called spec homes, which are built without a firm order in place. Of the quarter's home closings, 55% were from specs -- up from 49% last year, and 41% in 2016.

The benefit of starter homes -- particularly specs -- is that they generally drive higher margins. They are built with less customization and generally with fewer floor plans than more upscale neighborhoods, which can lower the builder's construction expenses and lead to higher profitability. That's certainly been the case for Meritage, which once again saw its gross margins expand to 18.3%, up from 17.7% last year and 17.1% in the first quarter.

A look at expenses and the balance sheet

Selling, general, and administrative expenses were 10.9% of home-closing sales in the quarter, up slightly from 10.6% last year. The company said that 15 basis points of the increase -- or roughly half -- were due to the timing of some equity compensation expense recognized in the quarter, which had no comparable expense last year.

Interest expense fell $1.6 million in the quarter, but this was essentially an accounting quirk, since homebuilders capitalize a portion of their interest expense to assets under development. Total interest incurred in the quarter was actually up $2.1 million, due to the aforementioned capitalization, and the issuance of new senior notes used to pay off maturing prior debt that actually had lower interest rates. Rates are increasing, so higher interest rates are likely to become reality for Meritage and other homebuilders.

Meritage finished the quarter with $1.31 billion in debt and $169 million in cash, giving it a net debt of $1.14 billion, slightly up from last year's $1.11 billion.

At the same time, its real estate holdings have increased. The company finished the quarter with 33,719 lots under control, 260 more lots year over year (though at a lower rate of years' supply as development speeds up). The number of unsold homes has increased substantially, to 2,323 spec homes, up 30% from 1,790 last year. Management continues to direct the majority of its investments toward starter communities, with 85% of its land contracts in the quarter for entry-level development.

Looking ahead

While management held firm on its full-year expectations for a range of 8,450 to 8,850 home closings and $3.5 billion to $3.65 billion in revenue, its recent results did lead to a bump in home-closing margin to between 18% and 18.5%, and a higher pre-tax earnings range of $295 million to $315 million, up from $285 million to $3015 million after first-quarter earnings. Management also continues to see healthy demand, particularly for entry-level homes, and "positive housing market drivers."

As things stand today, Meritage's strategy to grow its entry-level mix continues to pay off with bigger profits and strong demand. So long as the economy and housing market remain healthy, it should continue delivering positive results for the foreseeable future.

Jason Hall owns shares of Meritage Homes. The Motley Fool recommends Meritage Homes. The Motley Fool has a disclosure policy.