Meritage Homes has been treading water for the past six months, recording a small loss of 1.6% while holding steady at $71.70. The stock also fell short of the S&P 500’s 15.7% gain during that period.

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Why Do We Think Meritage Homes Will Underperform?

We're cautious about Meritage Homes. Here are three reasons why MTH doesn't excite us and a stock we'd rather own.

1. Backlog Declines as Orders Drop

Investors interested in Home Builders companies should track backlog in addition to reported revenue. This metric shows the value of outstanding orders that have not yet been executed or delivered, giving visibility into Meritage Homes’s future revenue streams.

Meritage Homes’s backlog came in at $695.5 million in the latest quarter, and it averaged 36.5% year-on-year declines over the last two years. This performance was underwhelming and shows the company is not winning new orders. It also suggests there may be increasing competition or market saturation.

2. Free Cash Flow Margin Dropping

Free cash flow isn't a prominently featured metric in company financials and earnings releases, but we think it's telling because it accounts for all operating and capital expenses, making it tough to manipulate. Cash is king.

As you can see below, Meritage Homes’s margin dropped by 6.6 percentage points over the last five years. Almost any movement in the wrong direction is undesirable because of its already low cash conversion. If the trend continues, it could signal it’s becoming a more capital-intensive business. Meritage Homes’s free cash flow margin for the trailing 12 months was negative 4%.

3. New Investments Fail to Bear Fruit as ROIC Declines

ROIC, or return on invested capital, is a metric showing how much operating profit a company generates relative to the money it has raised (debt and equity).

We like to invest in businesses with high returns, but the trend in a company’s ROIC is what often surprises the market and moves the stock price. Over the last few years, Meritage Homes’s ROIC has unfortunately decreased. We like what management has done in the past, but its declining returns are perhaps a symptom of fewer profitable growth opportunities.

Final Judgment

Meritage Homes falls short of our quality standards. With its shares underperforming the market lately, the stock trades at 8.2× forward P/E (or $71.70 per share). While this valuation is optically cheap, the potential downside is huge given its shaky fundamentals. There are better stocks to buy right now. We’d recommend looking at the most dominant software business in the world.

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