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Meritage Homes Corp. (NYSE:MTH)

Q4 2008 Earnings Call

January 29, 2009 11:00 am ET

Executives

Brent Anderson – Vice President, Investor Relations

Steven J. Hilton – Chairman and Chief Executive Officer

Larry W. Seay – Chief Financial Officer and Executive Vice President

Analysts

Nishu Sood – Deutsche Bank

David Goldberg – UBS

James Wilson – JMP Securities

Eric Landry – Morningstar

Carl Reichardt – Wachovia Capital Markets

Joel Locker – FBN Securities

Lee Bradding – Wachovia

Daniel Oppenheim – Credit Suisse

[Timothy Jones] – [Wasserman & Associates]

Operator

Good morning, my name is [Sarah] and I will be your conference operator today. At this time I would like to welcome everyone to the Meritage Homes fourth quarter and full year 2008 Conference Call. (Operator Instructions). Thank you, Mr. Anderson you may begin your conference.

Brent Anderson

Thank you [Sarah]. Good morning everyone. I would like to welcome you to the Meritage Homes Fourth Quarter and Full Year 2008 Earnings Call and webcast. Our quarter ended on December 31st and we issued our press release yesterday with our results for the quarter and fiscal the year.

If you need a copy of the release you can find it on our Web site at www.meritagehomes.com on the investor relations page, along with the slides that will accompany our webcast today. Please refer to slide two of our presentation.

Our statements during this call and the accompanying materials contain projections and forward-looking statements which are the current opinions of management and subject to change. We undertake no obligation to update these projections or opinions.

Additionally, our actual results may be materially different than our expectations due to various risk factors. For information regarding those risk factors, please see our press release and our most recent filings with the Securities and Exchange Commission, specifically our 2007 annual report on form 10-K and our latest report on form 10-Q.

Today’s presentation also includes certain non-GAAP financial measures as defined by the SEC. To comply with their rules we have provided a reconciliation of the non-GAAP measures in our earnings press release.

With me today on the call to discuss our quarter are Steve Hilton, Chairman and CEO of Meritage Homes, and Larry Seay our Executive Vice President and CFO. We’ll keep our call to about 50 minutes this morning so that we end before noon Eastern Time.

I’ll now turn it over to Mr. Hilton to review our fourth quarter results. Steve?

Steve Hilton

Thank you Brent. I would like to welcome everyone to our call today. I will begin with slide four if you’re following along on the webcast. The most significant highlights of our fourth quarter include our cash generation, year end cash balance, and expected tax refund in the first quarter of 2009.

In addition, we operated a small profit for impairments due in part to reductions in our direct cost and overhead, which we believe will continue to benefit us in the future. Let me walk you through some of the more details on those items.

As anticipated, we generated a significant amount of additional cash, increasing our cash position by $87 million, more than 70% increase in the last three months of 2008. We ended the year with $206 million in cash and no borrowings outstanding under our credit facility.

That compares to $28 million in cash and $82 million borrowed under our credit facility at the end of the $2007. In addition we expect to collect approximately $112 million of tax refunds in the first part of ’09. In addition to generating cash, the other significant accomplishments this past quarter was our small positive pre-tax income before impairments compared to the prior year’s pre-tax loss before impairments.

The recent quarter’s results were due to an increase in our gross margin before impairments, which was due to construction costs savings and the benefit of previous quarters impairments that reduced the cost basis of the homes that we closed.

Our improvement – our improved results also reflected a decrease in general administrative expenses of 47% from last year’s fourth quarter. We also reduced our community count by 14% during the quarter. I’ll address each of these in more detail. Slide five; we generated positive cash flow from our operations since the middle of 2007.

We used that cash to first pay down more than a quarter billion dollars in bank debt by the end of 2007 and have since added to that cash position every quarter. We also completed an equity offering in the second quarter of 2008 to raise $83 million and it increased our cash – year end cash balance to $206 million.

Our cash flow from operations for the fourth quarter was $94 million which brought our total cash flow from operations for 2008 to approximately $200 million. Slide six, our fourth quarter 2008 home closing revenue declined 37% from the prior year due to 30% lower closings, coupled with a 10% year-over- year decline in average sales price.

We’ve closed 1,488 homes at an average price of about $260,000 in the fourth quarter of 2008, compared with 2,139 homes closed at an average price $288,000 in the fourth quarter 2007. As we discussed last quarter, the increase in foreclosures has put pressure on both sales and margins due to their heavily discounted prices.

Slide seven, fourth quarter net orders declined six – or I’m sorry – declined 52% from 2007 to 2008 after a 56% cancellation rate in the quarter. Sequentially higher than the 40% rate in the third quarter of 2008 and above the 47% cancellation rate we experienced in the fourth quarter of 2007.

The total value of sales for the quarter was off 59% year-over-year, reflecting a further decline of 14% in average selling price. The reverberations from the financial crisis that began in September 2008 impacted all of our markets and we experienced a substantial decrease in traffic and sales during the fourth quarter, which is also historically a slow selling time due to the seasonality.

One positive sign was that the gross sales hit the quarterly low point in November and have inched up since then and into January. Shoppers seem to be taking advantage of current prices and lower mortgage rates. In fact, based on the first three weeks of January, sales appear to be on base, but is more in line with a third quarter than our fourth quarter of 2008.

We experienced a 61% decline in our Texas regions net orders, compared with the same period in 2007. This was due to a large number of late staged cancelations in December, which we believe was a result of buyer anxiety over the financial crisis. Texas remains our strongest region due to its relatively strong population in employment growth, as well as housing affordability.

Based on our experience in other markets during this down term, we were swift in taking aggressive actions in Texas as our net sales there fell during the quarter. We closed certain communities, sold some assets, terminated lot options, and consolidated operations in the region. We continue to be cautious until we are more comfortable with the activity in our Texas region.

Our sales declines were greatest in our western region where sales decreased 65% in the fourth quarter 2008 versus 2007. This reflects fewer active communities as well as weaker sales year-over-year. Our average active communities were 35% lower in the fourth quarter 2008 than the same quarter 2007.

Slide eight; we reported a fourth quarter net loss of $79 million in 2008 compared, to a 2007 net loss of $129 million. Our pre-taxed loss of $109 million for the fourth quarter of 2008 included $109 million of pre-taxed charges against our real estate and joint venture assets, plus $1 million impairment related to intangible assets.

By comparison, our pre-taxed loss of $197 million in 2007’s fourth quarter included $130 million in real estate related joint venture charges, $3 million of fixed asset impairments, and a $58 million charge to impaired goodwill and intangibles.

Excluding those primarily noncash charges in each year, our fourth quarter pre-taxed income was approximately $1 million in 2008 compared to our 2007 pre-taxed loss of $7 million. The year-over-year improvement reflects our higher adjusted gross margin and reductions in overhead and other costs.

Our GAAP gross margin for the fourth quarter was negative due to impairments, but our gross margins excluding impairments improved to 13.9% in the fourth quarter 2008 from 12.7% in the previous quarter and 11.6% in the fourth quarter 2007.

That year-over-year margin improvement of approximately 230 basis points is partially due to construction cost savings and partially from previous impairments lowered our cost basis on homes we close this quarter.

Slide nine; economic conditions in the fourth quarter of 2008 were the worst we’ve experienced to date. We reduced our number of active communities by 14% during the quarter, which we expect to result in future overhead savings in the end of the quarter with 178 actively selling communities, down from 207 at the beginning of the period, 109 of those communities are in Texas.

Approximately 43% of our active communities have fewer than 25 blocks remaining for sale. So our active community counts should continue to come down over the next several quarters.

Impairments on land sold or held for sale accounted for $23 million of the total fourth quarter 2008 real estate charges. Four properties sold generated $12 million of those impairments, but together with prior impairments accounted for $47 million in tax losses realized during the quarter. Additional impairments in the quarter included $49 million of option terminations, $32 million related to continuing projects and $5 million related to joint venture impairments.

Geographically, $44 million of the total was attributable to California, mainly from two large option terminations and one bulk land sale. In addition, option terminations and lot sales in Texas made up most of the $36 million of that region’s total real estate related charges in the fourth quarter of 2008. We have only about $52 million in option deposits remaining, $20 million of that is in Texas and the remaining balance is primarily related in one large parcel in North Scottsdale.

Due to further weakening in our markets, we made strategic decisions to cancel options and sell lots in certain marginal projects. Those actions accounted for approximately $67 million of the total impairments in the fourth quarter which allowed us to realize approximately $106 million of corresponding tax losses.

As a result, our total expected tax refunds increased to $112 million. Considering the difficult economic conditions, we believe that taking swift action today regarding lot sales and cancellations of options will limit our future losses while strengthening our balance sheet.

Slide 10; Meritage has traditionally been primarily a move up builder and most of our communities and home designs were geared to that market segment. However, in today’s market the largest demographic of home buyers are entry level and first time move up buyers.

Consequently we’ve adjusted our prior strategy to appeal to that larger demographic segment. We’ve redesigned our product offering to target homebuyers seeking lower price points. More than half our active communities outside of Texas were redesigned in the later months of 2008 and we anticipate redesigning many of our remaining communities in 2009.

We introduced 53 new plans based on extensive market research of what those buyers want in a home. All these plans are priced to fit within the FHA mortgage caps, where we believe most mortgage financing will come from in the next few years.

The average selling price of these homes is approximately $200,000, so they will compete well with existing homes and make up the largest percentage of the current sales. As our sales mix changes to more of these lower priced homes, our company wide average selling price will trend towards that $200,000 price mark.

We’ve been able to reduce the average cost per square foot of our active plans in several divisions by as much as 33% from our bench mark in 2006. Our new plans have more efficient designs and less square footage, but still offer our customers the ability to choose from a wide variety of options to suit their own style and budget.

The competitive bids we gathered to cost out these new plans have the added advantage of allowing us to benchmark materials and subcontracted labor across divisions, leveraging that knowledge to assure that we getting the best prices form our contractors.

We have also been able to reduce our average build times by about one month with these new, more efficient plans. Shorter build times should lead to higher inventory turnover, lower carrying costs and the equivalent of a month longer selling season, which will add another month of sales to our year

It also enables us to move more quickly, we’ve been able to open up communities with models and begin selling homes with our new plans within four months from the date of land contracts signed.

Let me give you one example of our new product strategy and execution, we redesigned nearly all of our communities in Orlando in mid 2008. The homes we’re selling there have an average size of approximately 2,100 square feet, where as the average size of homes we’ve previously sold was about 2,500 feet.

We brought down the average cost per square foot on our active plans in Orlando by about one-third since the second quarter of 2006, which allows us to offer Meritage quality homes at more affordable based prices and our buyers can still upgrade as they choose, whether it be a granite kitchen counter top or adding a home theater.

Our average price on homes in backlog in Florida were down 22% year-over-year in the fourth quarter and we sold 57 home there during the fourth quarter, more than we did in either of the previous two quarters, despite a much worse economy.

In today’s housing market we compete more over the existing homes and foreclosed homes than we do with other builders. We created a new department last year to research each market and submarket regarding existing home inventory, pricing, days on the market, and sales prices, as well as buyer demographics. The research assists us in making decisions regarding product, design, positioning and pricing, as well as underwriting the potential future acquisition of lots.

Slide 11; as sales and closings have declined we reduced our overhead costs in order to keep them inline with lower revenue. Our fourth quarter general administrative expenses were 47% lower than the prior year or 35% lower total revenue. As a result, these expenses declined a 3.9% of total revenue in the fourth quarter of last year, compared to 4.8% in the fourth quarter of 2007.

2008 general administrative were 36% lower in 2008 than in 2007, which includes the benefit of a $10 million legal settlement we collected during the second quarter this year. Excluding that item, our 2008 G&A expenses were approximately $28 million lower than in 2007 and were 5.1% of total revenue this year to date, compared to 4.5% last year.

Slide 12; we currently have about 800 total employees, including 131 part-time employees. That’s 42% less than our employee base one year ago, a 63% reduction from our peek in mid 2006. Because payroll related costs are the largest portion of our indirect costs, these reductions were unfortunately necessary to keep our G&A in line with the revenue.

Our fourth quarter commissions and sales costs decrease 31% year-over-year and increased just slightly as a percentage of revenue from 8.3% in 2007 to 8.9% in 2008. They have remained between 8% and 9% of total revenue for the last two fiscal years.

We’ve been able to keep these costs down by utilizing market intelligence to help us save on co-broker commissions and by taking advantage of efficiencies and the way we manage our sales people. I’ll now turn the call over to Larry Seay, our Chief Financial Officer and I’ll end our prepared remarks with a few closing thoughts before Q&A. Larry.

Larry Seay

Thanks Steve, turning to slide 13. Cancelations increased during the year as the economy continued to weaken resulting in increases in our inventory of unsold accidental SPEC homes, yet we successfully reduced our SPEC inventory to 768 or 4.3 homes per community as of December 31, 2008 from 809 SPEC home at the end of the previous quarter. That’s 31% lower than our December 31, 2007 total SPECs, 527 of the 768 homes were completed and 241 were under construction.

We are primarily a build to order builder, however, we’re adjusting our strategy with a regard to our level of SPEC inventory in order to compete more effectively with retails and foreclosures today. Many first time home buyers are renters who want to move into a home quickly and may not be willing to wait for one to be built. In addition, due to the fact that it has been taking longer for existing homeowners to sell their homes, many move up builders are also renters who sold their existing home before shopping for a new home.

We therefore feel that we need to maintain an inventory of four to five unsold homes per community that are available for quick move in. Our current strategy is to have one to two completed SPECs and two to three SPECs under construction per community. That is still well below most other home builder’s SPEC inventory levels and it does not mean that we are becoming a SPEC builder.

Slide 14; we’ve proactively reduced our total lot supply due through lot sales and option terminations, bringing it down another 24% during the fourth quarter, a decrease of almost 5,000 lots. A total of 15,802 lots controlled December 31, 2008 was 71% lower than it’s peak three years earlier and down from 20,748 at September 30, 2008.

We owned 8,750 lots representing a 1.6 years supply based on trailing 12 month closings. Consistent with our strategy to reduce risks associated with owning long land positions in depreciating markets, our own lot supplier remains one of the lowest in the industry.

Slide 15; our lots supply in many states is now quite low. We have less than two years supply of lots based on trailing 12 months closings in California, Colorado, and Florida. And in Arizona, half of our lot supply is in active adult communities, which require more lots to efficiently advertise the common amenities, and one large option contract in a good infield location in North Scottsdale. Half of our total lots at year end are in Texas, which also has the largest option position at 62% of that state's total.

Because our short position in these areas, we are actively monitoring market for finished lots but are also very cautious about entering into any new lot positions until we believe these markets are stable enough and prices are low enough for us to feel confident that we can purchase new lots that will allow us to earn an acceptable profit.

Our strategy is to contract for only small parcels of finished lots in order to sell out of the community within a year or two of opening it. We believe than many of the land investors and vulture funds who are buying lots and land today will become the land bankers of tomorrow.

Many builders have gone out of business and others have large debt maturities and reduced credit facilities, so they will need cash to meet obligations for future working capital. We therefore believe that there will be few home builders with resources or appetite to purchase large land positions when the market stabilizes.

We feel confident that we will be able to contract for new lots at lower prices in the future, without having to spend a lot of cash to purchase them outright and we have already had discussions with several land owners regarding alternative to financing structures that could provide us reasonable terms or rolling options without large deposits.

Slide 16; Lower home closing, prices, and revenue marked another year of weaker market conditions for home builders. Our full year 2008 home closing declined 36% from the prior year as a result of 27% lower closings and 12% decline in average sales price.

We reported a full year net loss of $292 million in 2008, including primarily non-cash real estate related and joint venture charges of $263 million pre-taxed and $16 million of tax expense, which is comprised of $119 million preferred tax evaluation, mostly off set by $103 million tax benefits reported in 2008. By comparison, the full year net loss of $289 million in 2007 included $398 million of pre-taxed real estate related and join venture charges and $130 million of pre-taxed charges to impair goodwill.

Slide 17; we projected last quarter that we would collect at least $80 million in tax refunds in 2009, based on our expectations at that time on the tax losses we would realize in the fourth quarter. Due to the actual losses we realized from additional lot sales and canceled option contracts, we now expect to collect a tax refund of roughly $112 million in early 2009.

Our total deferred taxes at December 31st are now approximately at $127 million, which is fully reserved. It will be carried forward for tax purposes and can be used to offset future taxable income. Current tax laws allow for losses to be carried back two years to off set prior year’s income and we’re at the end of that limit since 2006 was our last profitable year.

If a five year carry back is adopted, as has been proposed, we can reverse much of $127 million deferred tax evaluation allowance we have booked at the end of the year. The reversal would increase our book assets at the time a change is adopted by the amount of differed tax assets we could realize in 2009 and 2010.

We’ve recently taken steps to preserve the value of our deferred tax asset, primarily associated with net operating loss carry forwards and built in losses under section 382 of the Internal Revenue code. We have proposed an amendment to our articles incorporation authorizing the NLL protective amendment, and are holding a special meeting of stockholders developed on this proposal on February 16th.

Slide 18; we further strengthened our balance sheet in 2008 to better weather this recession. At December 31, 2008 we had no borrowings outstanding under our mended credit facility and our borrowing capacity was $270 million including cash and after consideration of the most restrictive covenants in place at year end. That compares to $375 million available borrowing capacity at the end of 2007. We have no bond maturities until 2014.

Our net debt to capital ratio was 45% at December 31, 2008 compared to 49% at the end of 2009. The combined effect of our increase in cash, reduction of debt, and $83 million equity offering reduced our net debt to capital ratio, more than offsetting the decrease in our stockholder’s equity from net losses during the year.

We’re in compliance with all the covenants under our mended credit facility as of December 31, 2008. Our interest coverage ratio was 1.3 times the interest incurred based on trailing four quarters adjusted EBITDA and our tangible net worth cushion was $140 million at year end. I’ll now turn it back over to Steve.

Steven Hilton

Thank you Larry, 2008 marks the end of our third year in the housing recession, which has eliminated many of our competitors and weakened all of our peers. We have built a substantial cash position that should provide greater flexibility for the future. In addition to the $206 million cash we had at the end of the year, we expect to collect $112 million in tax refunds during the first few months of this year.

Our new product strategy is designed to appeal to larger market segments of entry level and first move up buyers. We have redesigned our products, eliminating home plans in communities that didn’t meet current market requirements, and introducing more than 50 new designs to appeal to entry level homebuyers. All of these are priced within the FHA mortgage caps, and we have reduced our construction costs to allow us to sell these homes at lower prices while still earning an acceptable profit.

By executing our asset life strategy as it was designed, we have managed to lower SPEC inventory, lower lot supply, and a relatively strong balance sheet. At some point we intend to begin acquiring lots again at what will be greatly reduced prices. However, we are keenly aware of the risk in this environment and therefore plan to redeploy capital only where we believe to achieve returns to justify the risk.

We fully expect 2009 will be another challenging year, but we are not hanging our hopes on rescue packages that are out of our control. Having just entered our balance sheet well to date, we are focused on minimizing our losses and engineering our return to profitability. We have consolidated operations, reduced overhead and limited purchases in order to preserve cash.

Despite lower sales and current market conditions, we expect to generate modest positive cash flow before tax refunds for the full year 2009, before any potential limited land acquisitions. We look forward to better market conditions that will enable us to take advantage of such opportunities. We’ll now open it up for questions. The operator will remind you of the instructions fro Q&A. Thank you.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Nishu Sood – Deutsche Bank

Nishu Sood – Deutsche Bank

First question I wanted to ask was, Larry, you made a really interesting point in your commentary that with as large of the cash balances that some of the builders have built up, they're going to need that for either their debt repayment or the working capital build up.

So a lot of the builders, most of the builders are going to be migrating towards an asset light strategy similar to you folks. When you take a look at that dynamic as well as you're shifting now incredibly changed to more a first time type of project as opposed to move up.

Really the kind of differences that have marked Meritage in the past, and strategically seem to be eroding, so I just wanted to get your thoughts on that, your strategy in terms of what's going to differentiate you versus of the other builders going forward.

Brent Anderson

This is something we have been doing for a long time and other builders have not. So I think we're going to be more experienced at it, we know how to do rolling options. I think we just have more flexibility than others, Larry, you can--

Larry W. Seay

I think because we have used alternative financing structures and used them in ways that minimized our risk with keeping to our principals of low deposits and no current pay deals and things which really transfer the risks to the land owner, I think we've done a better job in the past doing that and we'll stick to our guns.

And we're just pointing out a fact that even though our cash balance may not be as large as some other big builders, w don’t have as many cash needs going forward and we don’t believe we'll be operating at a competitive disadvantage, because there will be these alternative sources of finances going forward, and as we said we are having conversations with several land owners now about innovative new option structures.

Brent Anderson

I'd also say that our product will still make the difference. We still think our product designs are going to be competitive, if not better than a lot of our competitors.

Even though we're moving down to entry level first time move up, we're still going to have that Meritage flair and excitement about our product that we think will distinguish us from our competitors.

Nishu Sood – Deutsche Bank

So just as a way for framing your capacity to pursue these sorts of opportunities, you look at your cash balances just over $200 million. You'll probably have about $325 million or so once you get that tax refund. If things were to turn around right now, how much of that – or I guess even in a broader context, how much liquidity do you think you would have to deploy right now towards new opportunities?

Larry W. Seay

Well some of the options – structures that we're talking about that land owners are sitting on land are having difficulty selling, are no down or limited down option structures where there's actually less risk than under the old structure.

So we could potentially tie up a lot of land with very little investment and the only investment then required is building a model or two and having a few spec houses, as well as--

Brent Anderson

[Interposing] They're just not going to turn around that fast, also. And if they did turn around that fast you'd have a price appreciation, which means builders would return to profitability relatively quickly and they would be able to go back into maybe their credit lines, but I don’t expect that to happen. I think it's going to be more of a gradual recovery.

Larry W. Seay

And I guess I would add we don’t anticipate utilizing much of the cash we're building up in 2009. We think we'll still have very small amounts of land acquisitions in '09 because we're still waiting to make sure it's the right time to start to tie up new potions and most of that's going to be optioned.

Operator

Your next question comes from the line of David Goldberg – UBS.

David Goldberg – UBS

The first question is on the cost. I know you mentioned bringing cost down. I'm just trying to get an idea of where you think cost per square feet may be on your new product is, maybe cost per square foot is relative to where you were before and maybe how much of that is coming from raw material savings relative to labor savings?

Brent Anderson

Well it's both. There's less materials in the house, the types of materials. The labor's less because the house is more streamlined and more efficient to build. But we're building a lot of houses in the West, in Florida, maybe excluding California for less than $40 a square foot, where previously they were in the high 50s or over $60 per square foot.

California's still is more expensive than that, maybe more in the 40s where it was in the 60s and 70s. So we're having a lot of success, either from renegotiating because the subcontractors are more eager for the business and they've become more efficient and brought their costs down and it's through the redesign.

David Goldberg – UBS

Do you have any idea what the breakout between how much you'll be able to break labor down at least?

Brent Anderson

I don’t have a break down on that but, a third I'd say; maybe more on the materials side because commodities have come down as much as 50% in the last quarter. So significant on the materials and then significant on the labor as well.

David Goldberg – UBS

Great, and then my second question was I was hoping you guys could give some more details on the Texas market and specifically, on a cash on cash basis. Are you still profitable in that market i.e., can you go out and buy if it's the right piece of dirt, can you go out and buy land take it through the process and still generate positive free cash flow on the new piece of dirt?

Brent Anderson

Can we go out and buy dirt and make money? I think you can, I mean we're not buying any dirt in Texas, so I can't give you any real life examples.

David Goldberg – UBS

Well I guess another way to put it then, would be when you're building homes in Texas you're generating free cash flow on most homes, how much of that is return on capital versus return on capital when you previously invested in land?

Brent Anderson

We made money – I think we made money in three out of four markets last year in Texas, even after impairments, so.

David Goldberg – UBS

On a cash on cash basis?

Brent Anderson

No, I'm talking on an income statement basis. We're still making – I guess its maybe on two out of the four, I may have misspoken, but we made money in markets in Texas last year at lower prices.

Now the margins are pretty skinny. They've gotten skinnier, but we have not seen the large price declines in land on the whole and on the houses in Texas that we've seen in other markets.

Operator

Your next question comes from the line of Jim Wilson – JMP Securities.

James Wilson – JMP Securities

First one as I guess you kind of noted that sales have gotten a little better in December and January. Could you give a little color on where or anything or what you would want to give credit to maybe just lower interest rates, but could you give a little color on that?

Brent Anderson

I tell you our best, actually has been in Texas the last few weeks. We've had better gross sales and less cancellations than we had in the last couple months of last year. We had a pretty good couple of weeks in Orlando and we sold some homes in Arizona.

I don’t see a big turn around. I can't tell you three weeks makes a trend, but certainly we're not seeing the December type activity in January. We're doing better in January than we were in November, December, and we're more in line with what we did in the third quarter last year.

James Wilson – JMP Securities

All right, and then with all the improvements in cost, I see a decent improvement sequentially in margins in Q4, could you give us some color on what gross margins look like in backlog.

Steven J. Hilton

Larry, you want to take that?

Larry W. Seay

Sure, we’ve some improvement in gross margins and we’d like to think that we would see that trend of being a little bit better than last year continue. In this market we really aren’t going to make any gross margin projections, it just depends on what further happens to the market too. If things stabilize and prices stabilize I think we could start to see some improvement, but it’s just very hard to make any predictions there Jim.

Operator

And your next question comes from the line of Eric Landry – Morningstar.

Eric Landry – Morningstar

Morning. Thanks.

Steven Hilton

Morning.

Eric Landry – Morningstar

Hey, Larry, I am a bit confused on the deferred tax asset valuation allowance.

Larry W. Seay

Sure.

Eric Landry – Morningstar

You talk about $127 million in the slides, yet nothing was broke out. Was there a $21 million addition in the fourth quarter?

Larry W. Seay

Well, there was – the deferred tax asset is very confusing, because you have additions from impairments recurring, you have realization occurring as assets are disposed of, and on top of that you have the reserves being booked against the asset you previously booked.

So it’s very difficult to understand but in the third quarter we – if you go to our summary and income statement we have about a $30 million benefit so in – excuse me in the fourth quarter. In the fourth quarter we had a $30 million benefit which means that we had real tax realization of write offs of that quarter that exceeded the write-offs or exceeded reserves.

So we – that, in that quarter because we sold so many, so much land and we triggered so many losses from permeating options, that actually acceded the impairments taken, so that’s why you see that trend happening, but at the end of the year, we had $127 million deferred tax assets left, of which every dollar was reserved. Does that help?

Eric Landry – Morningstar

A little bit but I still – so if the impairments are more than the actual taxes, then you can break it out, otherwise you don’t break out is what you’re saying?

Larry W. Seay

Well, we would typically not break it out. We toyed with trying to show the full detail to people and it’s just very confusing, but essentially this is just an example, if you had $20 million of impairments you took in the fourth quarter and you were able to trigger $30 million of previously recognized book losses for tax purposes, you would wind up with a $10 million net tax benefit in the quarter.

On the converse side, if it were the other way around, you reserved $30 million for book purposes, but you only triggered 10 you would wind up having the opposite occur, where you would have to reserve that tax asset and – or that net tax asset and you would have a tax expense instead of a tax benefit.

Okay? And if you would like to talk to me afterwards call me, I will be happy to walk you through more examples.

Operator

Your next question comes from the line of Carl Reichardt – Wachovia.

Carl Reichardt – Wachovia

Actually our questions have already been answered, thank you.

Operator

Your next question comes from the line of Joel Locker – FBN Securities.

Joel Locker – FBN Securities

On your sell your option deposits dropped about $17 million on your line item, but then you wrote off $49 million. I kind of just, I guess, want to know a little more color on the break down of the $49 million or how many were letters of credit or what not, where that number actually came from?

Larry W. Seay

Well, that’s a good point. I don’t have the specific detail, but there were some letters of credit outstanding relating to options that were terminated and there were also some pre-acquisition costs relating to options for the terminated, so the sum of those, the actual investment; letters of credit and pre-acquisition costs added up to the $49 million, so.

Joel Locker – FBN Securities

All right and then if you – I mean do you have a total exposure number, in addition to letters of credit, pre-acquisition costs, and plus the $52 million in option deposits, that are listed on the balance sheet, as of the end of the fourth quarter?

Larry W. Seay

Well, in our Q we do break that out.

Joel Locker – FBN Securities

Right.

Larry W. Seay

The total letters of credit we have is about $30 million, of which by memory, about $10 or $15 relates to options. So there’s not very much left in addition to what you see on the balance sheet of the $52.

Joel Locker – FBN Securities

Right and last question on the – of 8700 owned lots, how many of those are completely finished would you think?

Steven J. Hilton

Oh, I'd say almost all of them. [Inaudible] development costs.

Joel Locker – FBN Securities

Would you say that’s correct Larry?

Larry W. Seay

Well, yes, I would say maybe 75% to 90% range. There’s certainly probably 10% that aren’t but the great majority are.

Joel Locker – FBN Securities

But the 10% that aren’t or halfway, they're almost finished kind of, or?

Steven J. Hilton

Yes, I mean we don’t have any that are close to raw. I mean, I’d say there’s not much development expense left on those lots.

Joel Locker – FBN Securities

Right. All right. Thanks a lot guys.

Operator

Your next question comes from the line of Lee Bradding – Wachovia.

Lee Bradding – Wachovia

I guess my first question is in regards to community count. I guess the past year is down 20% and if I think I heard you right you said, what 43% of communities have less than 25 lots left for sale? And I guess just is there any guidance you can give us going forward? I mean there’s one way you can look at it but simple math that pays, do you look at running through 40% of your communities potentially this year on coming in on the worse side, or does it look like a similar year to last year I guess?

Larry W. Seay

Well it all depends on sales pace and I don’t know if it will be 40% but we would think that it would be a number certainly in the double digits that’s hard to give projections that we use to know what our sales pace is but I think, I think it wouldn’t be anymore than 43% on the other hand it could wind up being 20% although that’s just an estimate. It’s not a projection.

Lee Bradding – Wachovia

And that’s fair.

Steven J. Hilton

That’s assuming we’re not replacing any of those communities with new communities. Of course, today we’re not doing that but, as we get later into the year and next year if the market does recover we’ll start to replace them.

Lee Bradding – Wachovia

Okay and on the JV side, I don’t imagine there was much of a change but I just wanted to make sure it seems like you didn’t have much in impairment there, but from a Q3 kind of balance, off balance sheet was it much of a change versus Q3 from in Q4?

Larry W. Seay

I’m not certain I understand but the balance sheet exposure now for JVs is down to about $17 million, if I recall. So there’s not any one large JV in there, it's a matter of smaller JV’s and to date we’ve – the one’s we still have going seem to be performing okay.

Lee Bradding – Wachovia

Okay where I was getting at was on the balance sheet, the off balance sheet when you disclosed that, I mean last quarter you had about $560 million in real estate assets and mortgages associated with that about $400 million. I was just wondering if there was significant with that in Q4.

Larry W. Seay

Well yes there have been a lot of the joint ventures that have been – I guess we’ve had past discussions with banks where we’ve either given the property back to the bank at the joint venture level and they were non-recourse loans, or we’ve been able to sell the project to another party and pay off the debt. So I don’t have those numbers to talk about now, but we will have significant reductions that we will disclose in our summarized and capitalized balance sheet data in our K.

Lee Bradding – Wachovia

Thanks.

Operator

This is the conference operator we will only be taking two more questions. Your next question comes from the line of Dan Oppenheim.

Daniel Oppenheim – Credit Suisse

Thanks very much. I was wondering if you can talk about the gross orders bottoming November, with the cancellations, or late stage cancellations that came through in December. Can you give us a sense of how cancellations went over the course of the quarter, by month?

Steven J. Hilton

I think, I mean if I remember correctly, they spiked substantially in December.

Daniel Oppenheim – Credit Suisse

Okay that is true, that is true.

Steven J. Hilton

We had a – particularly in Texas we had a lot of closings scheduled for December and we had a lot of people that didn’t show up at the closing table for their houses and those houses turned into accidental specs. So it was the worst cancellation month we’ve ever seen in Texas.

That being said, we don’t have that many cancellations now in January and we’re making pretty gross sales numbers and sticking so and the other thing I don’t think we talked about is we’ve sold quite a few specs in the last three weeks.

Would you say, is it correct to say Larry, we sold about a third of our finished spec inventory the last few weeks?

Larry W. Seay

Yes, I think that’s right and because of ’the late stage cans, we wound up with more finished specs so our mix of finished specs was more two-thirds finished and one-third under construction. We would like for that ratio to be flipped, so we made a concerted effort to sell those completed spec homes early in January.

Daniel Oppenheim – Credit Suisse

Yes, and do you show a positive impact on cash flow for this quarter?

Larry W. Seay

For the first quarter, correct.

Daniel Oppenheim – Credit Suisse

Okay, great, and then wondering, you talked about redesigning some of the communities in the past few months of '08, how many of those, or when did those come on line and what have you seen in terms of sells performance with those redesigned communities?

Larry W. Seay

Well, we actually started early in the last few months, we started actually in the second quarter redesigning a lot of communities. We opened, as we said, several communities with new products in Orlando, in Phoenix, now every one of our communities in Phoenix now has new product in it.

Several of them are already open and some are opening in the next month or two. Everywhere we've put in this new lower priced product we've had good sales success. We're seeing the difference already in our sales number between the new product and the old product because the old product just doesn’t compete today with the foreclosures and re-sales because it's too expensive so, we need to get this new product on as quick as possible.

We built several model complexes literally in one month from the day we broke ground to the day we completed the model and opened for business, we have been able to do it in a month. We've seen build times that I haven't seen in 25 years in the business, because sub contractors aren't very busy, they're kind of standing around, they're very accommodating, they're helping us get these houses built very, very quickly.

Larry W. Seay

I'd add that other than in Florida, even though we have all these subdivisions open now, it really hasn't had time to fully impact our sales. We've seen it in Florida; we haven't seen it in the sales results so hopefully we'll see that this quarter.

Operator

Your last question comes from the line of [Timothy Jones] – [Wasserman & Associates].

[Timothy Jones] -– [Wasserman & Associates]

It's pretty impressive that you've cut your cycle time by 31 days, I love that figure. Could you tell me from what the absolute number that it went from and it is now?

Steven J. Hilton

Larry, do you have that?

Larry W. Seay

It kind of varies by product type but you know I don’t have that off the top of my head, I'm sorry.

Steven J. Hilton

We could get back to you on that, though, Tim.

[Timothy Jones] -– [Wasserman & Associates]

Okay, thank you and the other one, what's your feeling here on this [carry back] [NLL] being taken back by five years, do you know the last time it's [been up] by the Senate? Do you have any better feeling on that?

Steven J. Hilton

So far what we're hearing is, it's on track to happen, that doesn’t mean it's going to happen for sure but, so far, so good. There's still amendments to be offered and negotiations to take place between the senate and house but as of today it looks from what we know, it looks positive.

[Timothy Jones -– Wasserman & Associates]

And you said something that, under the accounting rules, you can't actually put the deferred taxes that you wrote down, back on the balance sheet, can you? You said that you could utilize them but--

Steven J. Hilton

No, I think, well Larry, can we? I think we can.

Larry W. Seay

Yes, actually we will do an estimate of what taxes – if the five year period back goes in place we'll estimate what losses will trigger for tax purposes for '09 and 2010, and we will reverse the reserve against the tax asset and a large portion of that reserve can be reversed, so it would make the deferred tax asset bounce go back up and our equity would go back up and we'd have this kind of tax gain in the quarter of implementation. Okay?

Larry W. Seay

I think he was cut off.

Steven J. Hilton

Okay, well thank you very much, we appreciate your participation and your support of Meritage, and we'll look forward to talking to you again at the end of our next quarter. Good day.

Operator

This concludes today's conference call. You may now disconnect.

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Source: Meritage Homes Corp. Q4 2008 Earnings Call Transcript
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