When it comes to
, pessimism abounds, primarily due to the builder's heavy exposure to the frothy housing markets of California and Arizona.
But absent a serious meltdown in these states, the small-cap company is expected to post earnings growth of 12% to 20% this year. Growth in 2007 and 2008 will be tougher, but believers in the long-term desirability of the California, Texas and Arizona housing markets could look at Meritage as a value play.
Meritage shares have dropped 11% since the company's early January announcement that its fourth-quarter orders rose just 1%.
At $60, the stock trades at 5.3 times the consensus analyst estimate for 2006 earnings per share. That's at the low end for homebuilders, which are generally trading at a P/E of 6. Over the last 10 years, homebuilders have mostly traded at forward P/E multiples of 5 to 9.
Meritage offers homes mainly to move-up or high-end buyers, but it has been expanding its entry-level offerings and its "active adult" division for retirees.
The company has lately reported strong home sales in Texas. But in the fourth quarter, orders in California were cut in half amid a tough sales environment in the northern half of the state. Southern California sales, meanwhile, have been improving. In Arizona, sales were flat -- and thus disappointing, given how it's been such a red-hot market. (Besides these three main markets, Meritage has been ramping up developments in Nevada, Florida and Colorado.)
It's understandable why the stock has been a drag. But there might be too much negative sentiment.
"It's all perception," says JMP Securities analyst Alex Barron, who rates Meritage a strong buy. "People just conceptually think California is blowing up and Phoenix is blowing up." JMP provides investment-banking services to Meritage, and Barron personally owns the stock.
"In a nutshell, what is attractive about Meritage is
its strong levels of historical growth and
its very reasonable stock valuation," says Paul Radomski, managing partner of Renaissance Investment Management, which has owned the stock in its small-cap growth portfolios since early 2004.
"It gives us pause with the obvious deceleration of the housing market," says Radomski. "But the offset is the valuation."
Barron says that even if management's 2006 guidance is taken down -- assuming a 27% order drop in Arizona and a 21% order drop in California for the year -- Meritage should still be able to post 20% revenue growth and 12% EPS growth this year.
He expects Meritage to record earnings of $10.65 a share for 2006, up 12% from the $9.55 earned last year. Meritage has offered guidance for earnings of $11.25 to $11.50 a share, while analysts' mean estimate is $11.32. For 2007, Barron expects EPS to drop to $9.75.
Susquehanna Financial analyst Stephen East is more bullish; he projects the company's EPS will rise 23% this year and jump 11% in 2007. He projects Arizona orders will rise 5% this year, while California orders will drop 17%.
Even though orders are slowing down at the company, there are several things to like about the Meritage story right now.
The company's $2.2 billion backlog of high-margin homes represents over half of management's guidance of $3.8 billion to $3.9 billion of revenue this year.
Meritage also has healthy expansion under way. Management expects its community count to grow 20% in 2006.
The firm is opening up its first three communities in Reno, Nev., this year, which is a relatively untapped market. In Texas, Meritage's order growth has been helped by an expansion into entry-level homes. Meanwhile, more community openings are coming in San Antonio, which is probably the state's strongest housing market.
Overall, the company's results over the next two years will be heavily dependent on Texas. The state has seen strong order growth and is generally considered to be one of the best housing markets for builders this year.
Analysts say Northern California will continue to remain a tough market for now, but in the long run the greater San Francisco Bay area remains an under-housed area with rebounding job growth and strong immigration trends. Southern California remains healthy, especially the Inland Empire (the area east of Los Angeles), where Meritage focuses.
As for Phoenix and surrounding areas, the market will go through a cooling-off period over the first six months of this year, but things won't fall off a cliff, says R.L. Brown, a housing economist who focuses on the region.
"I would not look for the 2006 and 2007 marketplace to create havoc at all for any of the public builders," Brown says. Over the next five years he expects new housing permits to remain in the 58,000 to 63,000 annual range, down from 63,750 in 2005.
Another positive for Meritage is that, after
, it has the second-most-conservative land holdings. About 91% of Meritage's land is controlled under options, meaning the company isn't sitting on a
bloated land bank.
The company also has strong insider ownership, representing 16% of the stock, mostly held by the company's co-CEOs. Meritage also has posted 18 years of consecutive earnings growth.
Granted, the outlook is murkier for 2007, when results will depend on new orders this year. However, if California and Arizona return to more normal historical sales levels, Meritage should be able to post some sort of earnings growth in 2007 and 2008.