Meritage Homes Corp. (MTH -1.98%) reported first-quarter results on April 23, with a small increase in the number of homes it sold indicating that its transition to more entry-level homes is paying off. However, its top- and bottom-line financial results, and several key profitability measures, went backwards in the quarter.

So what gives? In short, the mixed-bag result wasn't really that unexpected. Management didn't offer financial guidance on the fiscal 2018 earnings call, citing uncertainty in market conditions heading into the spring 2019 selling season; it only gave a range of 1,500 to 1,625 home closings in the quarter. The company blew past that, closing 1,765 new homes. But the transition to entry-level houses pushed the average sales price (ASP) down 6%, while a combination of incentives for buyers and brokers took a bite out of margin and pushed up expenses.

Wood frame of a house under construction

Image source: Getty Images.

Moreover, last year's first quarter saw $11.1 million in combined benefits that didn't recur this year. Let's peel back the layers a little more to uncover what happened in Q1, and particularly how it applies to Meritage.

Strong demand, but higher costs and nonrecurring gains took a bite out of profits

Here are some key metrics for Meritage Homes' first quarter:

Metric Q1 2019 Q4 2018 Change
Home closing revenue $698.7 million $728.5 million (4.1%)
Net income $25.4 million $43.9 million (42.1%)
Earnings per share $0.65 $1.07 (39.3%)
Homes closed 1,765 1,725 2.3%
Average sales price $396,000 $422,000 (6.2%)
Home-closing gross margin 16.7% 17.1% (40 basis points)
SG&A percentage of home-closing revenue 12.3% 11.5% 80 basis points

Data source: Meritage Homes Corp. SG&A = sales, general, and administrative expenses.

As the table above shows, besides selling more homes, Meritage's results went backwards pretty much across the board. Management did offer some context on the results; this included the impact of exiting the higher-end custom-home -- called "second move-up" or 2MU -- business, as well as some items which boosted last year's quarterly profits.

To start, the entry-level shift was the key reason why the ASP fell 6% in the quarter. Consequently, revenue fell 4.1%, as the modest 2% increase in homes sold couldn't make up the difference. Moreover, while the transition to entry-level is ongoing, Meritage still has an inventory of 2MU properties it is working to sell through.

On the earnings call, management indicated that this played some role in the incentives, which took a bite out of gross margin, and also pushed up sales-related expenses (reflected in SG&A). CFO Hilla Sferruzza said: "There is going to be some continuing volatility from those incentives through the rest of [20]19, and by 2020 it stops being a meaningful impact on the financials."

Lastly, let's take a look at the two items that boosted Meritage's profits last year but didn't recur. It got $4.8 million in pre-tax gains from a legal settlement, and $6.3 million from energy-efficiency tax credits that expired and have not been renewed. While all $11 million of that doesn't flow straight to the bottom line, it makes up a substantial amount of the difference between last year's Q1 net income and the 2019 result.

Margin and profit are set to improve

While the company will continue to offer some incentives and discounting to move through its legacy inventory and drive higher volume (which can boost profits via higher operating leverage), that's expected to take some time to play out. Management set guidance for both the second quarter and full year in the earnings release, as follows.

In the second quarter, Meritage expects to close 1,900 to 2,100 homes, for $760 million to $825 million in revenue; this compares to 2,139 homes closed for $872.4 million in last year's Q2. The company expects gross margin in the "mid-17%" range, which would be a deterioration from last year's 18.3% -- but a sequential improvement from the first quarter, as incentives take a smaller bite out of the pie while the inventory of 2MU properties shrinks.

For the full year, Meritage is aiming to close 8,200 to 8,700 homes, for $3.25 billion to $3.45 billion in home-closing revenue. It expects gross margin of "approximately 18%" to result in earnings between $4.65 and $4.95 per share. This would put it slightly off last year's $3.47 million in home-closing revenue and $5.58 in earnings per share. However, it would be relatively similar to last year's 18.2% gross margin, as higher-profit entry-level homes make up a bigger part of the sales mix, and the shrinking mix of upmarket homes reduces the drag from incentives and discounting.

CEO Steve Hilton ended his prepared remarks on the earnings call this way: "There's still a shortage of entry-level product for buyers who are looking for more affordable homes that meet their needs, and give them some extras to satisfy a few of their wants. We believe that is exactly what we provide with our new Meritage homes."

Moreover, this trend is expected to last potentially for a decade or longer, and to meet the combination of pent-up demand and a significantly undersupplied market. There will be a little pain as the company completes its transition to the starter-home and first-move-up market, but management continues to say that the long-term tailwinds should give the homebuilder a lot of gain.