Over the past few years, Meritage Homes (NYSE:MTH) has gradually shifted its focus away from "move-up" homes, and made entry-level housing its biggest business. This was a bold step by the company, already a top-10 homebuilder at the time, to shift away from a business model that had proven successful and profitable.
However, CEO Steve Hilton saw a huge opportunity on the horizon, and realized that it would take many years to fully realize the opportunity. The past decade saw homebuilders almost completely give up on building small, affordable homes for young people looking to make their first home purchase, leaving a massive underserved market with too little inventory to meet the needs of a growing population of first-time buyers.
So far it's paid off for the company and for investors, but the starter-home market remains undersupplied, and millions of young adults are looking to buy a home. That makes Meritage Homes, which is still relatively small considering the size of the U.S. housing market, an excellent growth stock to own in your retirement account.
Making the starter-home pivot has paid off
It's paid off in spades for Meritage and its investors. Since the beginning of 2017 -- early in the company's transition to build primarily entry-level homes -- its shares have more than doubled. That's crushed a strong market, and also most other large homebuilders, measured by the SPDR S&P Homebuilder ETF (NYSEMKT:XHB), over the same period.
The interesting thing about Meritage's growth so far is, its profits have skyrocketed over the past few years, even though revenue is only about 21% higher. That's because, despite selling for lower prices, entry-level housing has proven to be more profitable:
Gross margin has increased more than 6%, largely because starter homes can be build in a more efficient manner, with less customization. Its ability to increase gross margin in recent years is particularly impressive considering skilled labor shortages and volatile lumber prices.
A trend Meritage can keep building on
Despite a great run that's seen its stock price double in three years, Meritage Homes still has plenty of room to grow. Housing starts have only recently returned to levels that are generally considered sustainable.
Moreover, the data above includes multi-family housing such as apartment buildings, not just single family properties. If we look at single-family home sales and inventory, you'll see that even with steady growth in recent years, we've only just now seen the market return to historical levels during healthy economic periods. The catch is, the country's population is significantly higher now:
Moreover, the biggest generation in the U.S. is now millennials, many of whom delayed home purchases for a litany of reasons, including lack of economic opportunity or access to affordable housing. This is set to be a generational challenge, and Meritage is one of the few homebuilders that's made starter housing its primary focus.
A great growth stock for your retirement account
Meritage Homes' growth is accelerating. The company saw home closing revenue 11% in the fourth quarter of 2019, but orders were up a strong 27% and order value was up 25%. Earnings per share increased 15% for the full year but leapt ahead 39% in the fourth quarter. At the same time, its operating expenses are also improving, with SG&A -- sales, general, & administrative -- expense falling as a percentage of sales in the year and quarter. This is another benefit of the shift to entry-level homes, helping drive down marketing and sales costs.
Looking at valuation, Meritage shares trade for 11.4 times trailing earnings, a solid price for a homebuilder, particularly one with solid margins and lower-than-average debt leverage. Its PEG ratio -- a version of the P/E ratio that factors in growth expectations -- looks even better at 0.82. A PEG ratio below 1 is generally considered "cheap."
Put it all together, and you have a well-run company that's made the pivot to exactly where new housing demand will be strongest over the next decade, trading for what appears to be a reasonable valuation. There will likely be plenty of ups-and-downs in the years to come (homebuilding is a cyclical business, after all -- but investors looking for growth in their retirement accounts should give Meritage Homes a close look.