Meritage Homes: Fairly Valued After The Strong Rally

Overview

Meritage Homes Corporation (NYSE:MTH) designs, builds, and sells single-family homes in the United States. In my opinion, the 1Q23 earnings have provided underlying insights to the coming quarters and years performance, and they have undoubtedly contributed to the recent surge in share price that has taken it to a new 12-month high. One of the primary reasons for the strong share price performance is likely from the resulting expectations given that demand improved throughout the quarter, with incentives reduced and prices increased, all on the back of limited supply. However, MTH stock has soared by nearly 100% in the past 7 months, and its valuation has returned to its normal levels as a result. There is a good chance that investors will sell the stock to lock in some of the gains they have made since the beginning of the year because the risk/reward ratio is less attractive now than it was then. Therefore, I am suggesting a hold rating for the time being.

1Q23 earnings

While revenue and ASP were flat year over year, closings increased by 1% to 2,897, and EPS surpassed expectations. Lower EBIT margins were the result of lower gross margins (22.4%) and higher SG&A (10.3%). Absorption metrics were very encouraging, averaging 4.2 per month in 1Q23, which was above the 3-4 goal. This is largely due to the MTH plan to raise specs. Additionally, the cancellation rate for 1Q23 has slowed to 15%, which is in line with historical norms. However, despite the larger community count, orders fell by 10%.

Guidance

The headline guided 2Q23 figures are for closings to be between 2,800 and 3,100, with home closing revenue of $1.22-1.36 billion, implying an ASP of $436 thousand to $439 thousand. The key information, however, is found in the qualitative remarks. The situation appears to be as bad as ever at first glance, but in my opinion, things are actually improving. Cycle times, for example, have begun to improve (by 1 week compared to the previous quarter), despite still being 6 weeks longer than they were before the pandemic. The main bottleneck here is that suppliers and relevant personals in the supply chain are still not able to keep up with the pace of demand and accumulated industry backlogs. In my opinion, fixing the supply chain problems is just a matter of time, which will lead to even faster production cycles in the second half of this year. Following this is gross margin, which is anticipated to fall in 2Q23 due to increased incentives. The good news is that the size of these incentives is beginning to shrink, which bodes well for the eventual recovery of the gross margin. Additionally, management highlighted the impact on margins from MTH's capture of roughly $20k in cost savings per home, which will be felt more strongly in the P&L in 4Q23 and FY24.

Margins

Demand was higher than expected, allowing MTH to cut incentives by $8,000 to 10,000 per home while still having room to raise prices. That said, I think the stickiness in labor cost inflation will continue to be a headwind for the near term, despite the fact that the guidance for cost savings (thereby improving margins) was encouraging. Furthermore, management claims that eastern land prices are still rising, which will inevitably put a damper on profits. Overall, I have a mixed opinion on margin because there are so many factors at play, but I do anticipate a short-term dip (or flattish) followed by a recovery as the aforementioned positive developments begin to favor MTH.

Valuation

I've shown below why I believe MTH's valuation and share price have already accounted for market expectations. Assuming consensus is correct, which I believe it is (earnings and margins to improve over the next two years), MTH should earn $645 million in FY25. When the current 8x forward PE is applied to that figure in FY24, it equates to around $140 per share at the end of 2024. Using a 10% discount rate to return $140 to today's terms suggests a 4% downside (or fairly valued).

Conclusion

MTH 1Q23 earnings have provided insights into underlying improvement in certain metrics, and the recent surge in share price reflects the resulting expectations from improved demand, reduced incentives, and higher prices. Also, the company's guidance shows improvements in cycle times and cost savings, but I expect margin may continue to face short-term headwinds due to labor cost inflation and rising land prices. Overall, MTH's valuation and share price have already accounted for market expectations, and the stock appears to be fairly valued with a potential downside of 4% based on current estimates. Therefore, I suggest a hold rating for the time being.