Meritage Homes Is A Good Long-Term Buy Trading Below Its Book Value – Meritage Homes Corporation (NYSE:MTH)

Stock markets have corrected meaningfully in the short span of time, and Federal Reserve is responding with interest rate cuts and massive liquidity injection. While fear due to coronavirus and people going into self-quarantine might cause some more pain in the short term for businesses, it also is sowing seeds for the next bull run. After dot com crash and September 9/11 attacks, Federal Reserve responded by reducing interest rate considerably. This led to a massive bull run in housing and commodities over the next several years.

I expect something similar to happen this time. After coronavirus impact recedes over the next quarter (if it goes away in the summer or results of Gilead’s (GILD) remdesivir phase 3 trials are positive) or year (vaccines are developed), life will likely return to normal. People need to buy houses, and housing starts have remained below their long-term annual average of 1.43 mn for a good part of the last decade. So, the supply remains relatively tight.

One thing which has impacted the housing demand from millennials is affordability. While there is a lot of demand for housing, it is on entry level or first move up side. Meritage Homes (NYSE:MTH) is one company which realized this shift early and took strategic actions to capture this demand.

The company decided to focus on entry level and first move up segment in 2016. Meritage’s entry-level communities amounted for just 23% of total community count back then. Now, they have increased to 47% of the total community count. Since entry-level housing is seeing a good demand due to affordability, entry-level mix in terms of new orders is even higher at 55%.

Meritage’s revenues have grown from $2.57 bn in 2015 to $3.65 bn in 2019, while its EPS has more than doubled during the same period. While the whole housing sector has seen a good recovery over the last five years, I believe Meritage’s strategy to focus on entry level and first move up market has placed it very well for future growth as well.

The company’s LiVE.NOW offering, which provided advantages like energy-efficient design, faster move in time, and transparent pricing, resonated with the customers and helped Meritage grow its presence in first time home buyer market. If we look at management commentary, the company’s absorption rates for LiVE.NOW communities have significantly outpaced traditional move-up communities, with equal or better margins.

After LiVE.NOW’s success with entry-level buyers, the company has turned its focus on first move up market with its Studio M design offering, which is seeing a good initial response from the customers. Meritage has done away with the wide selection it had for build-to-order design approach. Instead, it is focusing on SKUs which accounted for majority of the installations. Limiting choices to a few good ones (with high take rates) and focusing on transparent pricing has made the experience stress free and faster for the customers. The customers can now complete the process in a couple of hours versus three to four visits at a traditional design center. So, the cycle time to turn over a house to customer is also decreasing.

I expect Studio M to receive a similar response from first time move up customers as LiVE.NOW received from entry-level customer, and the company can continue to post above-market growth in the near future.

In addition to making the process of buying a home more transparent and stress free, the company’s LiVE.NOW and Studio M offering have also helped the company improve its margins. Transparent pricing has decreased the incentive and commission costs, while doing away with a wide choice of selection has made the process faster and efficient.

These factors in addition to leverage from volume growth have helped the company improve its gross margin to 18.61% in FY2019 vs 17.56% in FY2017. The company’s goal is to reach ~20% gross margin, which it should be able to achieve in the medium term as its LiVE.NOW and Studio M continue to gain traction and impact of coronavirus fades.

The company has a strong balance sheet with real estate assets worth $2.74bn and net debt of ~$700 mn. The company’s tangible net worth is $1.93 bn, and net debt to capital ratio is 26.2%. So, I believe the company will be able to weather any short to medium-term slowdown caused by coronavirus.

The company’s book value is $51.77, and tangible book value per share is $50.60 per share. While the company might face some temporary slowdown in demand if coronavirus continues to disrupt economic activity, low interest rate environment will prove to be a boon to the company in the medium to long run. The company’s focus towards affordable entry level and first move up homes will likely help it outperform the broader housing sector, and I believe it is a good long-term buy trading below its book value.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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