MTH - Meritage Homes Is A Buy Despite Slowing Demand

Summary

• Although the demand outlook is slowing in the near term, the housing shortage and rising community count should partially offset its impact.
• Higher sales incentives and commissions are likely to put pressure on margins.
• With a low probability of inventory writedowns, MTH is a good bargain at its book value.

Investment thesis

Meritage Homes ( MTH ) should be adversely affected by the uptick in mortgage rates. However, despite short-term uncertainty, the long-term demand outlook is still strong with the supply shortage likely to act as long-term support for housing demand. The good long-term fundamentals coupled with MTH's recent rise in community count should act as a good tailwind for the company's topline offsetting some of the macro slowdown. While I am anticipating some pressure on the top line and margins, the probability of the company experiencing an inventory write-down is very low with current all-time high margins and the structural supply shortage. MTH is trading below its tangible book value which is a good bargain even if we consider slowing macros. Hence, I have a buy rating on the stock.

Short-term demand uncertainties but positive long-term industry outlook

Since the start of this year mortgage rates have climbed from 3.11% to 5.55%. The sharp rise in mortgage rates has made homebuyers skeptical about their mortgage payments and they are now hesitant about entering into a deal to purchase homes. Moreover, some homebuyers who had entered into a contract earlier are also cancelling due to the sudden surge in rates. Due to this MTH reported a significant surge in Q2 cancellations which increased from 8% to 13% Y/Y. With rising cancellation rates absorption pace also dropped to 4.4 against 5.5 a year ago. Meanwhile, total home orders were up 8% YoY to 3761 homes last quarter due to a sharp rise in community count from 226 in Q2 last year to 303 in Q2 this year.

Looking forward, due to the rising mortgage rates, I anticipate the demand environment to remain slow in the near term. However, if one can look beyond the current tightening cycle and think a couple of years ahead when inflation will be under control, long-term fundamentals are solid. Due to the less-than-average supply of homes in the decade following the global financial crisis, the housing market is short of about five million homes according to a 2021 report by realtor.com . This has resulted in a record-low housing inventory, which stood at 747,526 single-family active listings in July compared to the ~1.2 mn to ~1.4 mn range prior to the Covid pandemic. I anticipate that housing demand will continue to be strong over the long term due to the historic undersupply of homes. Additionally, MTH's recent surge in community count, which increased by 35% year over year to 303 communities, should help the company's top line and partially help offset the near-term macro slowdown.

Margins Should Normalize

Over the past two years, the housing sector has seen unprecedented margin growth. MTH's gross margin increased from 18.8% in 2019 to an all-time high of 31.6% in the last quarter. SG&A, on the other hand, had decreased from 10.9% of revenue in 2019 to 8.3% in the last quarter. As a result, the pretax margin increased from 8.3% in 2019 to 23.5% last quarter.

Since it usually takes 6 to 8 months (8 months now due to higher cycle time) to complete a house, the current margins are showcasing the housing market situation from late 2021 to early 2022. Since the start of this year, the housing demand environment has changed a lot and, as discussed before, mortgage rates have almost doubled in a matter of two quarters which has squeezed many homebuyers out of the market thus reducing the demand. Therefore, MTH has now started offering more incentives to homebuyers and this increased spending on incentives might hit the gross margins in the coming quarters. In addition to incentives, input costs, like lumber, should also pose near term headwinds as they were locked in at higher prices from earlier this year. This should reflect in Q3 and Q4 numbers. Due to these factors management had guided for a contraction in Q3 gross margin to 27.5% - 28.5%. While they didn't guide for Q4 and beyond, I anticipate margins to continue decreasing over the coming quarters as a result of higher spending on sales incentives and commissions to attract homebuyers in a high-interest rate environment. In the long term, gross margins should return to pre-Covid levels of high teens.

Valuation

MTH is trading below $80 a share which is a significant discount to its Tangible book value ((TBV)) per share which is over $90. During the last five years, the company had traded at an average P/TBV per share multiple of ~ 1.3x . I don't think MTH should trade at a discount to its tangible book value unless there is a risk of it reporting losses because of inventory impairments, This doesn't appear to be a likely scenario in this case. Given MTH's current pre-tax margins are in the low 20% range, to bring MTH to breakeven, home prices would likely need to fall by over 20% for MTH to start making losses. There is a structural shortage of housing inventory in the U.S. and most U.S. homebuilders currently have a strong balance sheet. So, there is not much incentive for anyone to panic sell their home inventory and bring down prices. Hence, despite near-term headwinds, I believe MTH offers a good buying opportunity for long-term investors who are willing to take a contrarian bet.

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