Things are finally lining up for the homebuilding sector, at long last. Builders entered this year with a massive supply/demand imbalance after years of underbuilding. The COVID-19 crisis has accelerated some trends that were already in place, and for some builders the last few months have been the best the industry has seen in ages. It is hard to believe that in the middle of a pandemic some companies would be recording near-record level order growth and multi-year highs in margins. Meritage Homes (MTH -0.02%) is an example of one of those builders. Its focus on entry-level home buyers is at the sweet spot of the industry right now, and emerging buyer preferences makes the stock one of the top performers in the homebuilder space.

Framework of a house under construction

Image source: Getty Images.

Meritage Homes is a builder of single-family homes in historically high-growth locations. The company focuses primarily on entry-level buyers, with a secondary focus on move-up buyers. The company operates in nine states: Arizona, California, Colorado, Texas, Florida, Georgia, North Carolina, South Carolina, and Tennessee. Meritage Homes is the seventh-largest public homebuilder in the United States, based on homes closed in 2019.

The suburbs are hot

The COVID-19 crisis accelerated the trend out of urban areas. For a long time, young adults preferred urban, walkable areas as opposed to suburbs. That began to change a few years ago as they started having kids and wanted space and access to good schools. The COVID-19 crisis has pushed that trend into overdrive, as urban renters no longer are interested in sharing elevators, laundry rooms, and communal spaces. In addition, working from home (and school closings) are making potential buyers prefer the extra space that comes from owning a single-family home in the suburbs. 

Record sales -- during a pandemic

The company recently reported second-quarter earnings, which showed that it executed well on its strategy despite the challenges of COVID. Orders increased 32% year over year while revenues increased 20%. Earnings per share were up 78%. The company reported that gross margins came in at 21.4%, which is a six-year high.

Gross margins weren't the only record set this quarter, however. Despite COVID, sales hit records as well. Steven J. Hilton, chairman and chief executive officer of Meritage Homes, had this to say about the quarter:

"The spring selling season demonstrated remarkable resilience in May and June after a slow start in April due to the global pandemic, resulting in our two highest selling months ever [emphasis mine] and an all-time company record of nearly 3,600 orders for the quarter. Our absorptions were up 42% over last year's second quarter, averaging approximately five homes per month in roughly 240 communities nationwide."

The focus on entry-level buyers pays off

Meritage entered the quarter with a lot of spec inventory, which are homes that were built without a buyer already lined up. This actually worked out to the company's advantage, as health concerns made customers reluctant to enter homes occupied by someone else. Entry-level buyers accounted for 70% of orders during the quarter, as opposed to 51% a year ago. This increase led to a 3% decline in average selling prices, from $383,000 to $372,000. Average selling prices are neither good nor bad. While they can be used as an indicator for new home sales prices, a change of product mix or geographic area can influence them as well. In Meritage's case, the drop was due to a focus on cheaper homes targeted to the first time homebuyer. 

The market seems to like the first time homebuyer exposure. Meritage stock has been on a tear this year, easily outpacing the S&P SPDR Homebuilder ETF (XHB 0.14%) as shown in the chart below.  Meritage is trading at 14 times expected 2020 earnings per share. The 2020 estimates are probably going to get taken up based on second-quarter results. On a trailing 12-month basis, Meritage is trading at 10 times earnings. The stock doesn't pay a dividend, and CEO Steve Hilton said on the earnings call that the company doesn't intend to buy back any stock this quarter or retire debt, just to buy land and expand the business. 

MTH Chart

MTH data by YCharts

Homebuilding has been a missing piece in the economic recovery since 2008. Homebuilders are early stage cyclical businesses that can help lead the economy out of a recession, and that didn't happen in 2010-2011. In the wake of the 2009 crisis, homebuilders turned extremely conservative and kept inventory low.

This conservative approach over the past decade is why we haven't see any sort of major price-cutting or inventory liquidation this time around. Any spec inventory was bought up immediately. Historically, housing starts have averaged around 1.4 million a year.  The U.S. economy hasn't seen that sort of volume for 14 years. The homebuilding sector has a lot of catching up to do to meet demand. Meritage is in the right place to do it.