January 27, 2019 - 9:28pm EST by
2019 2020
Price: 39.70 EPS 5.00 5.40
Shares Out. (in M): 40 P/E 8.0 7.3
Market Cap (in $M): 1,585 P/FCF 0 0
Net Debt (in $M): 1,105 EBIT 0 0
TEV (in $M): 2,690 TEV/EBIT 0 0

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Meritage Homes Corporation is a mid-size US single-family homebuilder that builds homes primarily in Arizona, Colorado, California, Georgia, Florida, Carolinas, Texas and Tennessee. The company has a $1.6B market capitalization.


The company was founded in 1985 and had its IPO in 1997. Originally, it went public with a merger of Monterey Homes and Homeplex Mortgage Corporation, a REIT. Monterey owners received 29-33% of the entity. As of 2000, they had 56 communities and sold 2,227 homes in Texas, Arizona, and California. In 2006, they were in 14 markets and were selling in 213 communities selling 10,487 homes. In 2012, sales were 4,238 homes from 158 communities for $1.18B in revenue. The business grew through acquisition into new markets. For most of its history, the acquisitions worked out, save the 2005-2006 acquisitions due to poor timing. But the company did two acquisitions in the south over the last few years and those have not been good, one of which was a disaster. This appears to be finally worked through, which should improve results going forward.


Current CEO Steven J. Hilton co-founded Monterey Homes in 1985. Steven owns 1.6 million shares. Shareholder dilution has been unfortunately steady with time as the company was financially stretched following the financial crisis, and available cash has been used to purchase land. In addition to issuance of stock for employees, the company raised further equity capital following the downturn.


In 2017, they had 7,709 sales at an average selling price of $413,000 generating $3,187 million in revenue out of 244 communities (a 2.63 monthly absorption level). Average selling communities have remained roughly flat over the last 3 years. Their strategy is to grow scale in existing markets (they are top 5 in five of their markets) and expand geographically through acquisition. They also have shifted their focus down market to first-time and lower-end move-up communities.


The common stock at $40 is interesting because: 1) on the numbers, it sells at an attractive price, and 2) the industry is below normal and will benefit from increased volume and/or margins.


Stated book value is $42.51 a share as of September 30th, 2018. So my guess is that we are buying into the business at maybe 90% of replacement value. Management agrees that the net assets are worth more than equity trading price, and has undertaken a $100 million repurchase program.


As you would expect, the stated assets are primarily land and homes under construction. The total breaks down as follows: homes completed and under construction $1,444, and raw and developed land $1,443. This is financed with $1,295 in senior debt, of which $300 million paying 7.15% is due in 2020 (it is amazing that their buyers will finance their new home well below the selling company!). The 40% debt-to-capital is conservative enough, and the assets are likely to be money good, if not understated.


Meritage will generate an 11-12% ROE in 2018, and I believe they have a good shot at growing the ROE closer to 15% on a larger book value in the next several years, generating EPS near $7.


Important to this assessment is the second “pillar” of the thesis – that the industry is below normal and this is likely to improve over the next several years, perhaps strongly. As I’m sure you are aware, demand for homes softened in the US beginning in the last spring of 2018. This softness started in the white hot markets of San Francisco and Seattle, but is now occurring throughout much of the “smile” states, including California, Arizona, Texas, and the Carolinas (Florida reflects multiple markets, some of which remain strong). The combination of rising prices for new and used homes over the last several years and rising borrowing rates for home buyers in 2018 of course played a role in this softness in demand. The typical monthly cost of owning the median new home has risen to $1,600, up from $1,300 in 2014 (there are some mix effects in these numbers which may overstate the increased costs).


But I believe also very important are psychological effects. Purchasers require confidence to borrow money and buy a home: confidence in their employment and financial situation, confidence in the economy and policies from the government, and confidence that owning a home versus their alternatives is attractive. No buyer needs reminding of the severity of the housing crisis which began fifteen years ago – and I believe that has made them temporarily nervous and fickle. What they may need reminding of is how unusual that event was in the longer historical context of the post-WWII era, and how so much in the housing industry has not changed.


I like to say that housing is driven by biology; housing is in most circumstances a requirement to get married and/or have a kid. So housing demand is primarily driven by population growth over the long-term (with around 350,000 units replaced each year due to obsolescence or damage). At reasonable prices, owning your home will usually make more financial sense than renting. As Bethany McLean has emphasized, owning one’s home is an (uniquely) important source of savings for the average American compared to other countries, aided by the government subsidization of the 30-year fixed rate mortgage.


And the price of a house (as they are somewhat fungible) is primarily driven by supply and demand. And supply and demand dynamics today are very different than fifteen years ago.


When the government returns to work, they will tell us that we completed around 1,200,000 dwellings in the United States in 2018 (inclusive of rentals and attached, multi-unit dwellings), the largest number of starts since the Financial Crisis. But if you look at the proceeding 25 years prior to the peak in housing in 2006, there was only one year (1983) when dwellings produced were less than 1,200,000. And this was for a smaller US population. It is obvious on its face that the housing production of the last decade was unsustainably low.


But the underproduction is partially absorbed by two important factors: 1) overproduction prior to the Financial Crisis, and 2) demographic changes leading to increased doubling-up. The former is easier to estimate. If we assume that normal demand for dwellings is 1,450,000 beginning in 1998, then completions above this figure led to 2,300,000 more dwellings than expected by 2007 (normal demand of around 1,500,000 is widely agreed upon, such as by the Harvard Joint Housing Studies). At that point, the following twelve years of significant underproduction shifted the cumulative surplus to a deficit in 2018 of 3,800,000, and is still growing.


The second factor of demographic change is more difficult to gauge. Included are: 1) lower marriage rates and household formation, 2) increasing multi-generation households (adult children living with their parents), 3) lower Millennial earnings power and worse balance sheets, inclusive of student debt, 4) higher home prices and more savings required for down payments, differing first-time home purchases, 5) tighter lending standards, and 6) cultural changes leading to less ownership and more doubling-up. Many of these changes compound upon each other.


There are several important considerations. First, the list above appears to be a mix of secular and cyclic dynamics following a severe recession, and we may not know which is which for a while. Second, after a period of normalization, none of these impact the underlying demand for dwellings – which again is about population growth. A period of changing demographics can reduce underlying demand during the period of change, but eventually a new “normal” is reached and demand returns to that determined by population growth (and obsolescence).


The government has provided us with a lot of useful figures to get a handle on this “lost” demand due to demographic change. I find the change in the living arrangements of 18-34 year old cohort particularly interesting. In 2005, there were 65,000,000 in this cohort, and a little more than a quarter lived with their parents, the remainder living independently (51%) or with roommates (23%). Ten years later, the cohort had grown to 71,000,000, and over one-third now lived with their parents, taking share primarily from those who lived independently. If we apply the 2005 figures to the 2015 cohort size, one can estimate that 5,740,000 more people are doubled-up than would have been expected. Assuming 2.5 people per household, this explains 2,300,000 fewer households formed than we might have guessed before the demographic changes. So even if we assume the demographic change from 2005-2015 is secular and will not be reversed, there has been 1,500,000 fewer homes built than that needed to satisfy underlying demand (3.8MM less 2.3MM). Said another way, the changes in housing demand brought by the unusual stress of the financial crisis would have to worsen going forward in order to sustain the unusually low volumes of dwellings produced currently.


This is all to say that Meritage is serving a market which has been undersupplied for an extended period of time – and we can expect the demand to increase 25% to 1,500,000 units with time, and possibly exceed this due to pent-up demand. Some homebuilders have described the softening of demand in 2018 as a “pause.” Given the large base and inherent flexibility of occupied homes of around 130,000,000 (there are a lot of basements and guest rooms), a “pause” can continue for a little while, particularly if there is a downturn in employment. But given the apparently clear tightness in the market, it is not likely to continue for very long.    


There is one further supply-demand consideration that is important for investors, and that is the current difficulty in increasing the supply of homes. Buildable and developed land in some geographies appears in short supply, labor to perform the construction may not be available to produce at higher rates, and there has been some hot spots with supply of materials (particularly the spike in lumber prices in the spring and summer of 2018, which has now abated). Further, builder managements have been chastened by the poor returns they have produced for their owners over the last fifteen years and are attempting to improve their financial results, particularly their cash flows and returns on capital. This is being pursued in a number of ways: increased use of options, less inventory relative to production rates, creative structures with land developers, etc. Like other commodity-like industries driven by supply-demand dynamics (i.e. think oil rigs or airlines), an industry that is cautious increasing supply in spite of favorable supply-demand dynamics can lead to surprises in earnings buoyancy. And I will not be surprised if the slow down in housing demand in 2018 along with all the recent negative sentiment will prove to be a long-term source of improved earnings power to Meritage and their competitors with time.


In my experience, conservatively financed businesses in industries with unusually favorable supply-demand dynamics with equity securities selling at prices below replacement value makes for a very favorable opportunity. Meritage is one such security.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Spring selling season, I'm just not sure which one yet. 

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