Meritage Homes Corporation — Q2 2016 Form 10-Q
Reporting period: Three and six months ended June 30, 2016; comparisons are with the corresponding 2015 periods unless otherwise noted. Amounts are in U.S. dollars; financial statement amounts are in millions unless stated otherwise.
Business context
Meritage designs and builds single-family homes across nine states in its West, Central and East regions, and provides title and related financial services. It had 241 actively selling communities at quarter-end, with base prices ranging from approximately $160,000 to $1.44 million.
Key financial metrics
| Metric | Q2 2016 | Q2 2015 | Six months 2016 | Six months 2015 |
|---|---|---|---|---|
| Home-closing revenue | $795.8 | $591.0 | $1,391.5 | $1,108.3 |
| Total closing revenue, including land | $797.9 | $597.8 | $1,395.7 | $1,116.5 |
| Home-closing gross profit | $137.7 | $114.2 | $241.1 | $209.7 |
| Home-closing gross margin | 17.3% | 19.3% | 17.3% | 18.9% |
| Net earnings | $39.9 | $29.1 | $60.8 | $45.5 |
| Diluted earnings per share | $0.95 | $0.70 | $1.45 | $1.10 |
Second-quarter home closings increased 25.3% to 1,950; the average sales price rose 7.5% to $408,100. For the first half, closings increased 18.9% to 3,438 and average sales price rose 5.6% to $404,700. Orders were up 4.4% in Q2 to 2,073 homes and 2.4% for the half to 4,060 homes. At June 30, backlog comprised 3,314 homes valued at $1.396 billion, up 4.0% in units and 7.7% in value year over year.
Margins fell despite higher gross profit, as land and labor costs rose faster than home prices. Management reported impairment charges reduced Q2 margin by 30 basis points in both years; excluding impairments, margins were 17.6% in 2016 and 19.6% in 2015. General and administrative expense was $28.9 million in Q2 and $58.5 million for the half; as a share of revenue, it declined year over year due to higher closing volume. The six-month effective tax rate was 30.8%, versus 31.7%; management cited energy tax credits as a benefit.
Net cash used in operating activities was $110.6 million in the first half, versus $76.9 million used in 2015. The main use was a $194.0 million increase in real estate inventory, reflecting land and development spending. Investing activities used $7.6 million; financing activities used $15.8 million, primarily loan repayments. Cash and equivalents were $128.2 million at June 30, down from $262.2 million at year-end 2015.
Total notes and other borrowings were $1.114 billion, including $1.094 billion of senior and convertible notes; no revolver borrowings were outstanding. Debt-to-capital was 45.6%, compared with 47.0% at year-end, while net debt-to-capital increased to 42.6% from 40.4%, reflecting lower cash. The $500 million unsecured revolving facility had $467.9 million available after letters of credit. The company reported compliance with its credit-facility covenants.
Material changes and management commentary
- Revenue and earnings grew substantially, driven primarily by more homes closed and higher average selling prices. Q2 home-closing revenue increased 34.7%; first-half revenue increased 25.5%.
- Regional performance was uneven. West and East closing revenue grew strongly; Texas orders declined 13.4% in Q2 amid oil-price concerns affecting Houston buyer confidence. East backlog value rose 23.6%, while West backlog units declined 6.4%.
- Home-closing gross margin declined 200 basis points in Q2 and 160 basis points for the half. Management cited higher land and labor costs, pricing concessions in some markets, and regional/product mix. It expected elevated land prices to continue pressuring margins.
- Management described housing conditions as generally healthy and expected a slow, steady recovery, but gave no specific full-year revenue or earnings guidance. It plans to acquire and develop strategic lots and said land, development and construction cash outlays are expected to exceed operating cash generation in the near term.
- Management noted seasonal working-capital needs: orders are typically stronger in the first half, with higher inventory requirements in the second and third quarters to support later deliveries. It may seek additional debt or equity capital, with no assurance of availability on acceptable terms.
Risks, contingencies and unusual items
- Key risks include mortgage-rate increases, weaker housing demand or order absorption, buyer cancellations, land availability and cost, labor and material inflation, inventory impairments, construction defects and warranty costs, and the company’s geographic concentration.
- The company paid $16.6 million in January 2016 following South Edge joint-venture litigation. Remaining issues include attorneys’ fees, for which Meritage says it is fully reserved, and its arbitration claims against former co-venturers to recover certain amounts.
- Other income increased partly due to favorable legal settlements and interest related to municipal development reimbursements. Warranty-reserve adjustments reduced cost of sales by $275,000 in the first half of 2016; the comparable 2015 period included a $750,000 increase in the reserve.
- Surety bonds totaled $242.2 million and letters of credit totaled $32.1 million at June 30. Management considered significant draws unlikely. The company reported no material changes to disclosure controls and procedures.
Important facts for investors to verify
- Whether order trends, backlog conversion and regional demand—particularly in Texas—support continued closing growth.
- Whether selling prices can keep pace with land, labor and material costs, and how margins develop by region and product mix.
- Cash use, inventory growth and liquidity as the company continues land purchases and development; verify revolver availability and covenant headroom.
- Potential additional capital needs, debt costs and the effect of the company’s leverage and substantial fixed-rate debt.
- Developments in South Edge litigation and arbitration, and whether warranty reserves and other contingencies prove adequate.