I had high hopes for Meritage Homes (MTH) before and after the company reported earnings last month. Home builders were leading the market into a big sell-off, and I expected MTH to set the record straight on the health of the housing market. The headline earnings were solid but not quite inspiring enough. The stock gapped down at the post-earnings open, but buyers took the stock up to a healthy 5.8% gain on the close. MTH has not closed higher since then as its 50-day moving average (DMA) held firm as resistance and soon after the 200DMA gave way as support.

In a sign of lost momentum, Meritage Homes (MTH) has gone nowhere after two earnings reports.

Source: FreeStockCharts.com

For its last fiscal year, MTH reported the following changes over the previous year:

• Homes closed (units) +5%
• Home closing revenue +6%
• Ending backlog (units) +9%
• Ending backlog value +10%
• Earnings before income taxes +14%
• Net earnings -4%
• Diluted EPS -4%
• cash and cash equivalents +29.6%

MTH highlighted that its results delivered a “…seventh consecutive year of annual order growth and [its] highest pretax earnings in over a decade.”

Net earnings in the 4th quarter were impacted by a $19.7M charge representing a devaluation of MTH’s deferred tax asset as a result of the cut in the corporate tax rate. Without this charge, full year net earnings would have increased 9.0% over the previous year – similarly for diluted EPS. MTH plans to take its $20 to $25M in savings on the reduction in the corporate tax rate to build 4 to 6 more communities. I consider those plans a key confirmation on the company’s confidence in the health of its housing markets.

Home closing gross margin remained flat year-over-year at 17.6% “…as anticipated, with cost inflation offsetting the appreciation in average sales prices of homes closed in 2017.” MTH’s biggest cost headaches are coming from concrete and lumber.

On a regional basis, MTH shifted revenue share as follows from fiscal 2016 to fiscal 2017:

• West: 43% to 45%
• Central (Texas): 26% to 28%
• East: 31% to 27%

The lag in the East occurred despite the company focusing investments on improving results in the region.

MTH provided guidance as follows:

“For 2018, we expect a normal seasonal decline in our revenue, margins and overhead leverage for the first quarter, followed by positive trends throughout the remainder of the year. We expect to deliver approximately 8,350-8,750 home closings in 2018 for total home closing revenue of approximately $3.4-3.6 billion, which should drive an 6-13% increase in pre-tax earnings. At this time, we are also projecting a home closing gross margin for the year of approximately 17.5-18%, with an opportunity for additional overhead leverage and the added benefit of a lower effective tax rate of approximately 25%, which should drive strong earnings growth in 2018.”

The guidance for revenue is a 6 to 13% bump up from fiscal 2017. So, MTH is expecting flat to incremental improvements from the 2017 annual growth rate. The news was good but not great.

On an earnings basis, MTH will likely need to report upside surprises to regain upward momentum in the stock. On a valuation basis, MTH has a lot of upside if and when sentiment in the sector improves. MTH’s stock is very cheap according to Yahoo Financeat 13.2 trailing P/E, 7.9 forward P/E, 0.6 price/sales, and 1.2 price/book. Recall that home builders typically trade around 1.0 price/book during economic downturns.

MTH’s emphasis on entry-level buyers was the biggest headline. The company attributed a lot of its 20% year-over-year order growth in the 4th quarter to “robust demand for homes designed to meet the needs of entry-level buyers.” These buyers accounted for almost 33% of MTH’s total orders in 2017, a big surge relative to the 24% share in the prior year.

In the conference call (according to the transcript from Seeking Alpha), MTH made clear its change in business focus:

“A key strategic driver of our growth has been our successful pivot to the entry-level market.

Our stated target was to have 35% to 40% of our communities to entry-level market by the end of 2018. We’re already at about 30% and our absorption rate in those communities are higher, resulting in about one-third of our 2017 orders coming from entry-level homes geared to the first-time homebuyers, up from less than one quarter in 2016.”

The change in strategy generated more spec homes. MTH ended 2017 with a 24% year-over-year increase in spec homes completed or under construction. The company is going to a “near 100% spec strategy” where buyers get preplanned options (over the long-term the actual number could be in the high 60% range). Since the recession, most builders have tried to limit spec homes and emphasize build-after-order strategies as a way to reduce operational risks. Yet, MTH believes it has pricing power in the entry-level market. The pivot toward entry-level has not negatively impacted margins.

MTH will spend 70% of its dollars on the entry-level until this segment reaches 40% to 50% company total sales.

MTH’s main regret is not moving earlier and bigger into the entry-level market:

“But looking back, we were a little tentative in our early execution of the entry-level strategy. And I wish we would have been more aggressive sooner and bought more land earlier for entry-level and made that pivot stronger.

Clearly, a couple of our larger competitors have been exploiting that segment now for a couple a few years, if not even more, for some of them. And it’s really working out to their favor.

So, I just think being — traditionally being a move-up builder, we had more entry-level in the last cycle, but we don’t have much entry-level in this cycle, made us a little more cautious about moving into that space but it’s full swing right now, and we have a lot of success, and we expect that to continue to have success going forward.”

As long as the U.S. economy continues to perform at least well as current levels then I expect MTH to perform well enough to deliver a respectable return on its shares. Investors may even find themselves underweighted in MTH after the next few earnings as this pivot to entry-level buyers further unfolds. Of course, MTH may also suffer first and hardest if a slowdown occurs in the middle of its ramp. I am keeping a wary eye on the housing market data to keep ahead of any such slowdown.