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Meritage Homes Corp Sees Profits Rise on a Strategic Pivot

The housing market continues to remain relatively healthy according to Meritage Homes Corp (NYSE: MTH), which reported financial and operating results for the second quarter on August 1. Meritage actually sold 2% fewer homes in the quarter, but a 3% increase in the average closing sales price offset the unit decline and kept revenue relatively flat year over year. It also -- along with an increase in spec homes (homes built before a customer had agreed to buy it) -- helped drive gross margin up 40 basis points year over year, and up 150 basis points from the first quarter. This increase in margin paid off, increasing earnings before taxes 7%, and earnings per share 3%.

The company didn't deliver on big unit or revenue growth in the quarter, but Chairman and CEO Steve Hilton pointed out that Meritage's new community count was up 7% at quarter-end, ahead of the 5% growth pace management is aiming for. The company also acquired 4,000 new lots, 70% of which will be used for communities targeting the growing entry-level buyer market. 

Meritage is targeting the burgeoning first-time homebuyer population for future growth. Image source: Getty Images.

Keep reading to learn more about Meritage Homes' quarter, as well as what management has to say about the future. 

A closer look at the results 

According to the Meritage release, a number of factors came into play in the quarter to help drive the results. To start, Hilton said demand was especially high in markets where the company has opened more entry-level communities, including Arizona and Texas. The average selling price in these communities is lower than Meritage's historical averages, as was demonstrated by the 7% and 3% drop in Arizona and Texas, respectively, but the company says it will build a higher mix of spec homes in these communities, which sell with higher gross margins. 

In other words, entry-level homes may sell for less, but they can be more profitable, too. This is a big part of why the company is pivoting to a higher mix of entry-level inventory, since first-time millennial homebuyers are quickly becoming a major driving force behind home sales and will likely be for years to come. In the second quarter, 51% of home closing were spec homes, up sharply from 42% last year. 

It's worth pointing out the main reason more of the gross margin and pre-tax profit increase didn't reach the bottom line. As the first paragraph at the top mentioned, pre-tax income was up 7%, while earnings per share increased 3% and net income was up 4%. Meritage's effective tax rate so far this year was 34.8%, up 400 basis points from 30.8% last year. This increase is almost entirely tied to the expiration of a number of energy-efficiency tax credits the company had been exploiting in prior years, tied to the use of certain energy-efficient products in the construction of homes. 

This tax credit, for now, is expired, and there's very little indication of whether or not it would be reinstated under any tax reform legislation, considering the state of gridlock in Washington D.C. at the moment. 

The good news is, it wasn't only a bump in gross margin -- which is entirely the difference between direct costs tied to building a home and the selling price -- which drove higher profits. SG&A, or sales, general, and administrative expenses, were about $1 million lower in the second quarter on similar revenue. This means as a percent of revenue, SGA expenses fell about 10 basis points in the second quarter. So far this year, SG&A expenses are down 50 basis points as a percent of sales, to 11.1% of sales. The company's long-term goal is between 10.5% and 11% of sales for SG&A. 

Looking ahead

After a moderately successful quarter that showed very positive results from the company's expanded foray into entry-level communities, management made some revisions to full-year guidance. To start, the full-year home closing target was increased 1,000 units, from 7,500-7,900 to 7,600-8,000 homes closed. However, since it seems a higher mix of those homes will be entry level, management kept full-year revenue guidance between $3.1 billion and $3.3 billion, and it also held firm on its expectations for 34% to 35% effective tax rate, gross margin percent, and SG&A leverage to improve by 30-80 basis points. 

For the third quarter, the expectation is to close on 1,875 to 1,975 homes, 4% to 10% higher than last year, generating 6% to 13% higher revenue between $780 million and $830 million, and pre-tax earnings between $53 million and $58 million, which falls between a 3% decline and 7% increase year over year

All considered, the guidance above has the company on track to generate roughly the same net profits this year as last, on a nearly 500 basis point increase in its tax rate. The majority of this pre-tax income improvement will be from operating leverage as the company drives down SG&A as a percent of revenue. And while full-year guidance is for similar gross margin to last year, it's likely that if the company finishes close to the high end of its home closing guidance, margins will improve since a lot of those sales will be higher-margin spec homes. 

Bottom line: Meritage continues to perform relatively well, and the housing market is still quite healthy. If the uptick in millennials entering the home market for the first time continues -- a trend that could last for years -- the future for Meritage remains bright. 

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