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How Meritage Homes Corp. Is Improving 1 Metric, and It's Driving Profits Up

An important number for homebuilders is average home sales price, or ASP. One might think this number should go up over time. But when Meritage Homes Corp. (NYSE: MTH) reported third-quarter earnings on Oct. 27, and disclosed that the average sales price of homes that its customers ordered in the quarter had declined, that was actually a good thing. This was especially true since it corresponded with higher profit margins, more homes sold and ordered, and a double-digit increase in profits.

Let's take a closer look at Meritage's results, and at why its strategic plan to build more entry-level homes is starting to pay off.

Image source: Getty Images.

A look at Meritage's results

Here are some of the homebuilder's key metrics in the third quarter:

Metric Q3 2017 Q3 2016 Year-Over-Year Change

Homes closed (units)

1.969 million 1.800 million 9.4%
Home closing revenue $805,008 $735,870 9.4%
Average sales price -- closings $409,000 $409,000 N/A
Home orders (units) 1.874 million 1.737 million 7.9%
Home order value $765,027 $715,562 6.9%
Average sales price -- orders $408,000 $412,000 (1%)
Ending backlog (units) 3.333 million 3.251 million 2.5%
Ending backlog value $1,408,801 $1,375,857 2.4%
Earnings before income taxes $63.455 million $53.802 million 17.9%
Net income $42.550 million $36.887 million 15.4%
Earnings per share $1.02 $0.88 15.9%

Data source: Meritage Homes Corp.

It's worth noting that Meritage's home ASP is starting to trend lower, even as home closing and order unit counts trend higher. This is by intent, as the company builds a larger and larger mix of starter homes, and develops more entry-level buyer-focused communities. As a matter of fact, higher real estate prices over the past year helped offset the lower revenue from a higher mix of starter homes.

This is likely to accelerate. This quarter, the company secured another 2,400 new lots, and intends to develop entry-level homes on 70% of them. This follows last quarter's acquisition of 4,000 new lots, where it will develop a similar 70% portion into entry-level houses.

Why Meritage is focused on starter homes (and why it's increasing profits)

The key reason that, a couple of years ago, the company laid the groundwork for this shift: Younger people -- especially millennials -- are gradually entering the homebuying market. Meritage sees the entry-level market as being underserved, and open to a builder offering homes that are both environmentally sound and technologically advanced. Factor in that millennials are the biggest segment of the U.S. population, and there are really two reasons for the company to target younger first-time buyers.

So why is this strategy more profitable? In short: Starter homes may sell for lower prices, but they can also sell for higher margins. In the quarter, the company's gross margin percentage on home closings was 18.1%, up from 17.8% last year, and 17.7% in the second quarter of 2017. The higher profitability is driven by a higher mix of speculative homes -- houses built without any buyers lined up under contract. In the quarter, 48% of homes closed were spec homes, up from 40% last year.

With the increased focus on this segment, the mix of spec homes -- and hopefully the higher margins they bring -- will increase as the company develops more and more entry-level communities.

The other thing Meritage is doing to improve profits

Meritage also reported improvements in its sales, general, and administrative (SG&A) expenses. General and administrative expenses were $31.6 million, down from $33.3 million last year. Commissions and other sales costs were $55.8 million, up from $52.5 million, but as a percentage of sales, they declined from 8.68% to 8.47%.

To some extent, SG&A is a combination of both fixed expenses (such as corporate overhead) and variable ones (such as commissions and community staffing). If the company can contain and even shrink its fixed expenses, while driving down variable expenses as a percentage of revenue, it's a winning combination that will improve profits through increased operating leverage. That's what Meritage did in the third quarter, so it's paying off.

Looking ahead

The effects of the two major hurricanes in Texas and Florida are affecting the company's efforts. CEO Steve Hilton said the company probably would have delivered sales growth of over 10% in the third quarter, without two weeks or so of lost sales and closing activity in multiple Texas and Florida communities; he also said it would have a hard time "making up" those delayed sales in the fourth quarter, which is already the company's busiest period.

The combined effects of the storms did lead to a narrowing of the range of its full-year guidance. Management was projecting a range of 7,600 to 8,000 homes closed this year, but backed the high end down to 7,800. Revenue is expected to be between $3.15 billion and $3.25 billion, a narrowing from a range of $3.1 billion to $3.3 billion at the end of last quarter. The midpoint of the units guidance reflects a loss of around 100 home closings due to the hurricanes. Many of those will just be delayed to next year, but some will be lost sales.

The company is also seeing signs of higher costs in storm-affected areas, and this could affect gross margin in the fourth quarter, which is expected to be between 17.5% and 18%. At the same time, management is trying to accelerate the company's exit from several higher-priced, lower-margin communities in the West. This could put further pressure on gross margin percentage, but it will free up resources to develop more entry-level communities heading into 2018.

As the past two quarters have shown, Meritage's focus on developing more starter homes looks like it could be the key to unlocking years of future growth.

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Jason Hall owns shares of Meritage Homes. The Motley Fool recommends Meritage Homes. The Motley Fool has a disclosure policy.