SPY - Meritage Homes: Not Enough Upside Post The Recent Rally

Summary

• Meritage stock is up 42% since I recommended buying it in August last year.
• The company reported strong earnings, but orders were weak.
• I see a downside to sell-side estimates.

Meritage Homes ( MTH ) has seen a significant 42.67% increase since my recommendation to buy the stock in August of last year. This is a notable outperformance compared to the S&P 500's ( SPY ) gain of just 3.20% during the same period. While I acknowledged slowing demand at the time, the company had a strong backlog of homes with higher average selling prices ((ASP)) and margins, which was expected to drive solid earnings growth over the next few quarters. Additionally, the stock was trading at a discount to its tangible book value, making it an attractive investment opportunity.

The story played out as expected, Meritage Homes delivered strong results over the last two quarters. In Q4 2022, the company reported revenue of $1.99 billion, a YoY increase of 32.7%, exceeding consensus estimates by $10 million. Additionally, EPS came in at $7.09, up 13% YoY, beating consensus by $0.06. However, the key metric to watch for homebuilders is the order rate, as it serves as an indicator of future revenues and earnings. In Q4 2022, Meritage Homes reported net new orders of 1,808 homes, a decrease from the 3,367 orders in the same quarter the previous year. The net absorption rate, or the average number of net new orders per community per month, was only 2.2 in Q4 2022, compared to 4.5 in Q4 2021. This was largely due to a high cancellation rate of 39% in the quarter.

One factor contributing to the high cancellation rate was the company's proactive approach in validating every home in their backlog to gauge homebuyers intent to close the sales on completion. This led to the cancellation of some home orders in the backlog earlier in the cycle than is typical.

Despite the underwhelming absorption rate in Q4, investors were invigorated during the company's Q4 earnings call due to management's positive commentary on January sales trends. Management reported that net absorption in January was greater than four orders per community, and the cancellation rate had returned to a more typical level in the mid-teens. This optimistic update was well received by investors, resulting in a positive reaction in the stock price.

Moving forward, management has set a target for net absorption of between 3-4 orders per community per month. Given the January sales trend, some investors are expecting absorption to be around the mid to high end of management's target range. However, I disagree.

The proactive validation of the backlog by the company likely caused some of the cancellations to shift from January to December, making January numbers look better. Also, with the absolute panic around mortgage rates in the last quarter, it is likely that some of the buyers held back on their orders last quarter. With the 30-year mortgage rate showing some signs of stabilization, that demand might have come in January. If we average Q4 2022 and January absorption, it comes to around 3.1, or the lower end of management's target.

I have estimated the normalized earnings per share ((EPS)) for Meritage Homes in the current environment and for it, I have assumed an absorption rate of around 3.0, as I believe the new housing demand will remain challenging in the near term. The company ended the last quarter with 271 active communities and management aims to reach 300 communities over the next few quarters, but I'm skeptical and believe an average active community count of 280 is more realistic. This gives a run rate of 10,080 home orders per year (absorption * average number of communities * 12), with an average value per new order of $389,000 (same as ASP of new orders last quarter), resulting in normalized annual homebuilding orders of $3.92 billion. Since supply chain constraints are receding, net new homebuilding orders and homebuilding revenues should be around similar levels.

For margins, I have assumed a return to pre-Covid levels due to price cuts, higher land costs in newly opened communities, and increased selling, general, and administrative expenses as a percentage of revenues due to volume deleverage. I estimate normalized gross margins at around 18% and SG&A as a percentage of sales at 11%. This results in an operating profit of $274 million based on the $3.92 bn revenue we estimated above. With an estimated $25 million annual contribution from financial services and other income (in line with historical), and no contribution from land closing (it is a relatively small volatile number, sometimes positive other times negative), the normalized operating profit for the company is around $299 million. Most of the company's interest expense is capitalized in individual projects and accounted for in inventory, cost of goods sold, and gross margin, so there's not much interest at the corporate level. I've assumed a tax rate of 23%, resulting in a net income of ~$260 million and an EPS of around $7 (assuming the share count remains similar to 37 mn in the previous quarter).

The last quarter ended with a tangible book value of approximately $105 per share and a book value of around $108 per share. The stock closed at $111.78 yesterday. The consensus earnings per share estimates from sell-side analysts are $12.48 for FY 2023 and $13.43 for FY 2024, which are higher than my own normalized EPS estimates. While I recognize that the current year's EPS may be slightly higher than my normalized estimate due to benefits from backlog carried over from the previous year, I still believe the estimates are too high. For FY 2024, analysts are forecasting Y/Y growth in EPS, which I find optimistic, and believe the number should be closer to my normalized estimate.

Even if we were to accept the sell-side estimates and assume the company generates $12.48 in EPS this year, we would get a year-end tangible book value of approximately $117-$118 (current tangible book value of approximately $105 + $12.48 in EPS). This implies a mid-single-digit upside if the stock trades at a price-to-tangible book value ratio of 1.0. Historically, the stock has traded at a premium to its tangible book value during good times, but reverts closer to it or even trades at a discount during challenging times.

Given the potential for downward revisions in estimates and the challenging housing market that may put pressure on the price-to-tangible book value multiple, I don't think a mid-single-digit upside is compelling enough to take the risk and buy the stock. I won't recommend selling either as the tangible book value of $105 should provide some downside support. So, I believe it's best to sit on the sidelines. I will reconsider my position if the stock corrects below $100, but as of now, I have a neutral rating on the stock.

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