Meritage Homes Corporation — Q3 2016 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2016. Meritage designs and builds single-family homes in nine states across the West, Central and East regions, and operates a title company. It was selling in 237 communities at quarter-end.
Financial performance and key metrics
- Q3 revenue and earnings: Home-closing revenue was $735.9 million, up 11.2% year over year; total closing revenue, including land sales, was $752.9 million. Net earnings were $36.9 million, up from $30.3 million; diluted EPS was $0.88 versus $0.73.
- Nine-month results: Home-closing revenue was $2.127 billion, up 20.2%; total closing revenue was $2.149 billion. Net earnings were $97.7 million versus $75.8 million; diluted EPS was $2.33 versus $1.83.
- Gross profit and margins: Home-closing gross profit was $131.0 million in Q3 and $372.1 million year to date. Home-closing gross margin declined to 17.8% from 19.0% in Q3 and to 17.5% from 18.9% year to date, primarily reflecting higher labor, construction and land costs. Margins improved sequentially by 50 basis points in Q3.
- Orders and backlog: Q3 net orders rose 10.8% to 1,737 homes, valued at $715.6 million. At quarter-end, backlog was 3,251 homes worth $1.376 billion, up 6.8% in units and 8.8% in value year over year; average backlog price increased 1.8% to $423,200. Q3 cancellation rate was 14%, versus 15% a year earlier.
- Cash flow and liquidity: Operating cash used in the first nine months was $148.3 million, versus $53.2 million used in 2015, reflecting increased real-estate investment. Cash was $107.9 million at September 30, down from $262.2 million at year-end. The $500 million revolving facility had $25.0 million drawn and $442.6 million available after letters of credit. Management reported compliance with covenants and stated it believed liquidity was strong.
- Debt and capital: Senior and convertible notes, net, were $1.095 billion; loans and other borrowings were $45.2 million. Debt-to-capital was 45.5%, down from 47.0% at year-end, while net debt-to-capital rose to 43.0% from 40.4% as cash declined. Stockholders’ equity was $1.367 billion.
- Other metrics: Financial-services profit rose to $6.0 million in Q3 and $15.8 million year to date. The nine-month effective tax rate was 31.0%, compared with 33.1% in 2015, benefiting in part from energy tax credits and the homebuilding manufacturing deduction.
Material changes versus the prior comparable period
- Higher closings and average selling prices drove revenue growth. For the first nine months, closings increased 13.8% to 5,238 homes and average selling price rose 5.6% to $406,100.
- Regional performance was uneven. West led growth, with nine-month home-closing revenue up 30.4%; Central revenue rose 11.0% and East rose 15.8%. Central and East gross margins remained under pressure, and Florida’s product mix weighed on East-region results.
- G&A expense increased in dollars but declined as a share of total closing revenue year to date, to 4.3% from 4.8%. Sales costs also fell as a share of home-closing revenue.
- Interest expense fell to $0.2 million in Q3 from $4.2 million and to $5.1 million year to date from $12.0 million, primarily because more interest qualified for capitalization. Other income also improved, including municipal interest income; the prior-year periods included an adverse legal ruling.
- Real estate inventory increased to $2.429 billion from $2.098 billion at year-end. The company said it was purchasing more undeveloped and partially finished land and spending more on development.
Outlook, commentary and risks
- Management described the housing market as improving slowly and steadily, supported by low interest rates, modest wage growth and lower unemployment. It expected near-term land, labor and construction outlays to exceed operating cash generation while it continued acquiring and developing lots; no specific earnings or revenue guidance was provided.
- Management’s priorities include growing orders and community count, returning to normalized gross margins, controlling overhead, expanding first-time-buyer offerings and maintaining liquidity. Rising land and labor costs were outpacing home-price increases in many markets, pressuring margins and cycle times.
- Principal risks cited include mortgage-rate increases and reduced buyer financing access, slower demand or higher cancellations, land availability and cost, labor and material inflation or shortages, inventory impairment, weather and natural disasters, construction-defect and warranty claims, and limited geographic diversification.
- Land purchase and option arrangements covered 16,888 lots with a stated purchase price of $1.096 billion and $91.1 million of deposits. Most options did not require the company to purchase lots; generally, exposure is limited to non-refundable deposits and related capitalized costs, subject to contract terms.
- Surety bonds outstanding were $234.0 million, with estimated remaining work of $73.2 million; letters of credit totaled $32.4 million. Management considered significant draws unlikely.
- In the South Edge joint-venture litigation, Meritage paid $16.6 million in January 2016 following judgments. Remaining attorneys’ fees were fully reserved; the company also had an arbitration claim against former co-venturers. Management said it did not believe pending legal or warranty matters would materially harm results beyond amounts reserved.
- The company had no cash dividend policy for the foreseeable future and stated it intended to retain cash for business development. Management reported disclosure controls were effective and no material change in internal control during the quarter.
Important facts for investors to verify
- Whether home-price increases and product mix can offset land, labor and construction cost inflation and stabilize gross margins.
- Whether order growth and backlog convert to closings at expected prices, particularly in weaker or changing markets such as Houston, Florida and parts of the East.
- How continued land acquisition and development spending affects operating cash flow, cash balances and reliance on revolving-credit availability.
- Debt maturities, covenant headroom, variable-rate borrowing exposure, and any plans to raise additional debt or equity capital.
- Potential cash or earnings effects from warranty claims, surety and letter-of-credit obligations, and the remaining South Edge proceedings.