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Standard & Poor's


02/23/15 10:00:07 AM



This week's Focus Stock of the Week is Meritage Homes Inc. (MTH: $42.45), which carries S&P Capital IQ's highest investment recommendation of 5-STARS, or Strong Buy. Arizona-based Meritage Homes is a relatively small builder of single-family homes, with a 10-state Sunbelt footprint that stretches from North Carolina to California. Meritage delivered 5,862 homes last year, with 2,224 in Texas, 924 in Arizona, 785 in California, 699 in Florida, and the other 1,230 total in North and South Carolina, Georgia, Tennessee, Colorado, and Nevada.

In our view, the number one issue for 2015, and one of the main drivers of earnings for homebuilders, is the gross margin, which is highly sensitive to revenue growth, and is the key driver of earnings growth for the homebuilding industry. We calculate that industry gross margins have increased significantly to nearly 23% in 2014, from about 12.5% in 2008, driven by revenue growth that has averaged 28% per year the last three years. Now, with industry revenue growth expected to moderate in 2015 (we expect 12% growth and consensus expects high teens growth), due to an easing of pricing growth, industry gross margins may be under pressure.

Earlier this year, two large US homebuilders indicated anticipated downward pressure on their 2015 gross margins, which pressured shares across the industry. This was due to anticipated higher labor costs, a mix shift away from more expensive homes, and some price reductions to clear out speculative inventory. We had believed the recent oil price decreases would help reduce the cost of asphalt, shingles, and transportation, but these homebuilders noted it takes a long time for downward trends in materials prices to help the gross margin. However, more recently, other homebuilders provided more stable guidance for their 2015 gross margins, partly alleviating the industry-wide concern on margins.

We think Meritage, a smaller builder, has done a very good job of keeping its gross margin relatively high vs. larger peers, at 21.2% in 2014, and 20.3% in the fourth quarter of 2014. MTH's outlook for 2015 is gross margin near 20.5%, and this reassurance drove the stock up 9% when the company reported earnings on January 29. The company's fourth quarter and full year 2014 gross margin was hurt by 0.48% from the effect of purchase accounting adjustments on the closing of the homes acquired in late 2014 from Legendary Communities, but it was helped by what they termed "inflated" prices in Arizona and California. Meritage's 2015 outlook is based on its large land holdings, much of which was purchased for lower prices years ago; holding the line on price discounts; lack of speculative inventory (homes constructed in advance of purchase); and expected cost controls on labor and materials.

Meritage's homebuilding revenues rose 21% in 2014, on 11.5% unit growth, and an 8.7% average price increase. For 2015, Meritage has stated it is focused on unit growth in attractive regions, and not on price growth. Thus, we expect Meritage's homebuilding revenues to rise 10.6% in 2015, based on our assumption of relatively strong 7.5% unit growth, with a modest 3.0% average price increase. Consensus expects 18% growth, which we think would require higher average price increases than we predict. We expect 2016 homebuilding revenues to rise 7%, based on our assumption of 6% unit growth, and a 1% average price increase, while consensus expects 14% growth.

Mortgage availability is also an important driver of homebuilding revenues. Post-crisis, banks have been exceedingly cautious in writing mortgages that they sell to Fannie Mae or Freddie Mac, since the banks can be held responsible for any future deterioration of credit quality. The U.S. government has tried, thus far unsuccessfully, to pressure banks to make more mortgages. One step was the Qualified Mortgage Program, which shields banks from liability if they follow certain strict underwriting guidelines. Another significant step was the Federal Housing Finance Agency's December announcement of a new "low down-payment" program for first-time and lower-income home buyers. Meritage and peers expect this program to help bring the first-time buyer back into the market, in 2015.

Mix shift also plays an important role in margins. Some homebuilders have finished work on high-end California communities, and are focusing on lower-cost, and lower-margin communities elsewhere. This has a meaningful downward effect on margins, and was noted by at least two other homebuilders. Based on management's outlook, we think Meritage is still building and selling in higher-value communities.

However, we note the recent fall of energy prices raises concerns about the health of the Texas economy. In 2014, 32% of Meritage's homebuilding revenues were in the Texas market. Meritage has not seen a drop in demand in Texas, and has not had to reduce prices. It expects to sustain its sales pace in Texas in 2015. However, Meritage is being cautious by not acquiring any more land in Texas. Other homebuilders and banks we cover have also noted that the Texas economy is much more diversified than it was in 1986-1989, the last period of falling oil prices, which especially hurt the Houston economy back then.

We also note Meritage's relatively strong balance sheet. Cash and equivalents were $103 million at year-end 2014, plus a $400 million available credit. Meritage controls 30,300 building lots, which it estimates are sufficient for 5.2 years of home building, higher than peers. Their net debt-to-capital ratio was 42.9%, below the peer median of 54%, and, in our view, strong for a small-cap homebuilder.

Meritage's tax rate of just 25.9% in the fourth quarter of 2014 was due to energy tax credits, and we expect some contribution from these credits, going forward. Partly offsetting this, we expect the share count to increase 2.5% per year, following a 7.2% increase in 2014. We see EPS of $3.77 in 2015, up 9%, and we see 2016 EPS of $4.00, up 6%. Capital IQ consensus views are $3.63, up 5%, and $4.10, up 13%, respectively.

Our 12-month target price of $49 is 13X our 2015 EPS estimate of $3.77. Publicly-traded U.S. homebuilders currently trade at about 15X forward 12-months earnings, and our target multiple reflects Meritage's relatively smaller market capitalization of just under $1.7 billion, versus the $2.3 billion median of peers, some of which approach $10 billion. Shares of Meritage currently trade at 11.7X the Capital IQ consensus 2015 EPS estimate of $3.63, a level we consider attractive relative to peers and to its own history, even after recent strong share price appreciation.

Risks to our recommendation, EPS estimates, and target price include a fall-off in demand for new homes, potentially caused by higher unemployment, competition from existing homes, higher mortgage rates and lending standards, and slower permitting and land improvements.

S&P Capital IQ's views on stocks are constantly re-evaluated. Please refer to our most recent publication on this stock to see our current view.


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