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MTH - Meritage Homes Corp


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Has Meritage Homes (Ticker: MTH) been on anyone's radar? I can't help but think this is a great opportunity. But maybe too good to be true? I realize a bear would argue that an increase in interest rates would penalize a company like this. However, based on my valuation, I believe the margin of safety more than makes up for this.

 

Current Value Multiples:

P/E: 8

Market Cap / Free Cash Flow: 9

P/B: 1.4

Total Enterprise Value/EBIT: 6.88

 

 

KEY RATIOS & METRICS:

Debt to Equity: .43

Current Ratio: 1.79

ROE: 19.6%

ROIC: 13%

DEBT PAYOFF TIME (Phil Town debt Metric): 2.43 years

Industry Rank: 6th

 

Who is Meritage?

Meritage Homes Corp. engages in the designing and building of single-family detached homes primarily in the western and southern United States. Operations break down into three regions and nine states: West (California, Arizona, and Colorado; 40% of 2020 sales), Central (Texas; 29%), and East (Florida, Georgia, Tennessee, and the Carolinas; 31%). It should be noted that Meritage has shifted its efforts to focus on first-time home buyers and first-time mover uppers (millennials). As of 12/31/20, Meritage sold homes in 195 communities with base prices ranging from $191,000 to $921,000.

 

VIC Write Up: https://www.valueinvestorsclub.com/idea/MERITAGE_HOMES_CORP/1173921363

 

My Personal Bullish Thesis (Brief Summary):

 

Not only is this company a cash flow generating machine with great management, but it also sports a great balance sheet that has proven to generate attractive returns over the past few years.

 

Meritage generated an astonishing 20% ROE in 2020. Of course, this isn't sustainable; however, I do think with a sales to capital ratio of about 1.6 (industry average 1.3) they could be able to maintain a return on capital of around 15% for the next few years (well above their current cost of capital).

 

Management is making strong moves to position the company for the long haul. The land acquisition should be a primary focus this year, as leadership races keep pace with burgeoning entry-level first-time move-up demand by replacing recently closed-out communities (Meritage spent more than $500 million on lot acquisition and development in the December period alone).

 

Going forward, the majority of the company's community development (their goal is 300 communities by 2021), in my view, will likely be skewed toward affordable units (targeting Millenials). All told, near-term land purchases ought to support community expansion three to five years out. Over that time frame, I envision a healthier economic landscape, an improved job market, and attractive, albeit slightly higher, mortgage rates.

 

My Valuation:

 

Assumptions:

 

I am growing FCF at 15% for years 1 through 5. Then, 8% through years 6-10.  The US industry average growth rate in the most recent year was 33%. So, all though this seems high, I think 15% is actually pretty conservative. After years 6-10, I expect the company to grow at a rate that is just above its cost of capital which I determined to be about 6%.

I am using a terminal value of 10 for the FCF (keeping it simple with a standard Pabrai/Dhando terminal).

After adding back the debt and cash, I am getting an intrinsic value of about 7B (about $185/share). The current enterprise value is 3.5B.

 

Of course, this is just my opinion, and I would love to hear others' thoughts.

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I am growing FCF at 15% for years 1 through 5. Then, 8% through years 6-10.  The US industry average growth rate in the most recent year was 33%. So, all though this seems high, I think 15% is actually pretty conservative. After years 6-10, I expect the company to grow at a rate that is just above its cost of capital which I determined to be about 6%.

I am using a terminal value of 10 for the FCF (keeping it simple with a standard Pabrai/Dhando terminal).

After adding back the debt and cash, I am getting an intrinsic value of about 7B (about $185/share). The current enterprise value is 3.5B.

 

Of course, this is just my opinion, and I would love to hear others' thoughts.

 

What is the nationwide amount of annual home sales in years 1-10 implied by your FCF compound annual growth rate?

 

If I've done the math right, you have FCF tripling in 10 years.  If I assume that 50% of that growth comes from nominal inflation, then that implies Meritage's units sold will grow by 2.5x or so.  Assuming Meritage has a constant industry share, I think that would imply something like 2 - 2.5 million single family homes sold in the US in 2030, based on roughly 1 million single family homes being sold last year.

 

There is a chart of single-family home sales since 1963 reproduced in this post:  https://www.calculatedriskblog.com/2021/03/new-home-sales-decrease-to-775000.html

2 - 2.5 million annual single-family home sales would be (literally) off the chart and represent a very long expansion since new home sales turned upward around 2011, which would mean a boom even larger and longer than  the great housing boom of 1991 - 2006 that preceded the GFC.  So, what you describe as a conservative case seems rather blue sky to me.

 

That being said, you don't need anything like 15% annual FCF growth to do well in a company that's trading for 8 or 9 times earnings. 

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I am growing FCF at 15% for years 1 through 5. Then, 8% through years 6-10.  The US industry average growth rate in the most recent year was 33%. So, all though this seems high, I think 15% is actually pretty conservative. After years 6-10, I expect the company to grow at a rate that is just above its cost of capital which I determined to be about 6%.
I am using a terminal value of 10 for the FCF (keeping it simple with a standard Pabrai/Dhando terminal).
After adding back the debt and cash, I am getting an intrinsic value of about 7B (about $185/share). The current enterprise value is 3.5B.

Of course, this is just my opinion, and I would love to hear others' thoughts.


What is the nationwide amount of annual home sales in years 1-10 implied by your FCF compound annual growth rate?

If I've done the math right, you have FCF tripling in 10 years.  If I assume that 50% of that growth comes from nominal inflation, then that implies Meritage's units sold will grow by 2.5x or so.  Assuming Meritage has a constant industry share, I think that would imply something like 2 - 2.5 million single family homes sold in the US in 2030, based on roughly 1 million single family homes being sold last year.

There is a chart of single-family home sales since 1963 reproduced in this post:  https://www.calculatedriskblog.com/2021/03/new-home-sales-decrease-to-775000.html
2 - 2.5 million annual single-family home sales would be (literally) off the chart and represent a very long expansion since new home sales turned upward around 2011, which would mean a boom even larger and longer than  the great housing boom of 1991 - 2006 that preceded the GFC.  So, what you describe as a conservative case seems rather blue sky to me.

That being said, you don't need anything like 15% annual FCF growth to do well in a company that's trading for 8 or 9 times earnings.



Thanks for taking the time to respond! I love the critiques as well as it forces me to re-think my evaluation. Maybe you could take a look at this update on my numbers? And, I do apologize, though, as I meant to say, growing total revenue at 15% in the first five years and then converging with the industry average over the next five years.

I agree FCF tripling in 10 years is aggressive. Take a look at my notes below and compare to Lennar (the current industry leader, I believe).

In 2020 the company ended with 11,834 closings (with an average sales price of $377,300), a 27.7% increase over 9,267 closings in 2019. Orders improved by 42.7% in 2020, with 13,724 orders for the year compared to 9,616 in 2019.

Of course, the strong results for 2020 reflect strong growth in both closings and orders as it seems young (millennial) buyers took advantage of the historically low-interest-rate environment and capitalized on their desire to purchase their first home. However, if we grow home closings by 7% (years 1-5) and by 3% (years 6-10) with the current avg sales price, I get the following:

Ratios used:
Gross Margin: 22%
Pre-tax operating margin: 13%
Sales to Capital Ratio (years 1-5): 1.6
Sales to Capital Ratio (years 6-10) 1.3 (industry average)

Years 1-5:
Homes Closed in Year 5: 16598
Revenue in year 5: $ 5,593,457.65  
Total Gross Profit in Year 5:  $1,230,560.68
Free cash flow to the firm in year 5: 354M

Years 6-10:
Homes Closed in Year 10: 19241
Revenue in Year 10:  $6,484,350.44
Total Gross Profit in Year 10:  $1,426,557.10
Free cash flow to the firm in year 10: $590M

Lennar Comparison:
Total homes closed in 2020: 18,821
Average Sales Price: $415,000

With this in mind, as Meritage continues to target millennials who are eager to purchase their first home, is it unreasonable to believe that in 10 years, MTH could be one of the industry leaders (producing around a comparable number of homes as the current leader)?

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