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Meritage Homes Corporation (NYSE:MTH)

Q1 2009 Earnings Call

April 28, 2009 11:00 am ET

Executives

Brent Anderson - VP, IR

Steve Hilton - Chairman and CEO

Larry Seay - EVP and CFO

Analysts

David Goldberg - UBS

Nishu Sood - Deutsche Bank

Russell Lane - Credit Suisse

Carl Reichardt - Wachovia Capital Markets

Joshua Pollard - Goldman Sachs

Timothy Jones - Wasserman & Associates

Jim Wilson - JMP Securities

Joel Locker - FBN Securities

Bose George - KBW

Operator

At this time, I would like to welcome everyone to the Meritage Homes first quarter 2009 analyst conference call. (Operator Instructions).

I would now like to turn the call over to Mr. Brent Anderson, Vice President, Investor Relations. Mr. Anderson, you may begin your conference.

Brent Anderson

Thank you, Sarah. Good morning. I would like to welcome you to the Meritage Homes, first quarter 2009 earnings call and webcast. Our quarter ended on March 31, and we issued a press release with our results for the quarter after the market closed yesterday.

If you need a copy of the release or the slides that accompany our webcast today, you can find them on our website at www.investors.meritagehomes.com, or by selecting the Investor's link at the top of our homepage.

Refer to slide two in the 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 our risk factors, please see our press release and most recent filings with the Securities and Exchange Commission, specifically our 2008 Annual Report on Form 10-K and our first quarter 2009 report of Form 10-Q after it's filed.

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

With me today to discuss the quarter are Steve Hilton, Chairman and CEO of Meritage Homes, and Larry Seay, our Executive Vice President and CFO. We expect our call to run about an hour this morning so that we end before noon Eastern Time.

I'll now turn the call over to Mr. Hilton to review our first 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 are following one on the webcast. The continued weakening of the housing market over last year was reflected in our revenue decline and net loss in the first quarter 2009.

However, despite harsh conditions, many of our results were positive this quarter. We ended the quarter with $344 million in cash, an increase of $138 million from our year-end 2008.We reduced our net debt to capital ratio to 35% at quarter end.

We lowered our general and administrative expenses by 35% year-over-year, and we generated $10 million of first quarter adjusted EBITDA. We nearly doubled our net orders over the fourth quarter of 2008, and we are positioned to take advantage of opportunities to acquire lots at lower prices will help us return to profitability more quickly.

Slide five. We generated positive cash flow of $139 million from operations during the first quarter. This is our sixth consecutive quarter of positive cash flow. We ended the quarter with $344 million of cash, the largest cash balance we have ever carried with no bank debt outstanding since we paid it off early last year.

Our cash balance includes the collection of $108 million of tax refunds in March, which we obtained by carrying back tax losses from 2008 to reclaim taxes paid in 2006. The increase in cash generated on our balance sheet proved our liquidity and reduced our leverage.

Our net debt to capital ratio decreased to 35% at March 31, 2009 from 45% at the end of 2008, and 47% at March 31, 2008. Considering that we are in compliance with all of our covenants and have no bond maturities until 2014, that includes liquidity represents additional capital available for selective future acquisitions of new lots at lower prices.

Slide seven. Our first quarter home closing revenue declined 38% year-over-year to the 30% fewer homes closed and 11% reduction in average closing price. We also had 21% fewer actively selling communities at the end of the first quarter than we had a year ago which contribute to our decreases in both closings and sales.

Our closing per communities were down just 12% year-over-year. We closed 932 homes at an average price of about $248,000 in the first quarter compared with 1,328 homes closed at an average price of about $280,000 in the first quarter of last year.

Slide eight. Our impairments this quarter were lower than they have been since the downturn began. Our charges for real estate related valuation adjustments were $10 million in the first quarter of 2009, 83% lower than the $60 million charges we incurred in the first quarter of 2008.

The lower impairments were the result of our greatly reduced lots in our option contracts and our minimal remain investment and joint ventures. Together, these accounted for approximately $30 million of impairments incurred in the first quarter 2008 and then our much lower inventories of lots and homes compared to last year. Nearly, all of our impairments in the first quarter this year related to specific homes or lots rather than impairing entire communities as we did in 2008.

With the possible exception of one large option contract in Arizona, we have little remaining option deposits that could be written-off. Our option deposit balance at March 31, 2009, was approximately $50 million with $19 million of that related to options in Texas. Because Texas has been less impacted during the downturn, we believe these have less risk for future impairment.

In addition, approximately, $28 million of the $50 million in option deposits relates to one 1,200 lot project in North Phoenix coupled with approximately $20 million of pre-acquisition cost is the largest investment we have in a single project, about two times the size of the next largest. We are continuing to evaluate possible development scenarios for this project to determine the best course of action that will maximize our long-term returns.

Slide nine. Our first quarter 2009 adjusted gross margins were level with the first quarter of 2008 at about 12% in both years excluding charges for impairments. Considering that price declines, prices declined 11% over the same year, same one year period, you might expect margins to have been compressed for the current quarter.

While they are still far below our historical average gross margins of approximately 19% to 20%, we have been able to resist further deterioration in our gross margins by further reducing our building costs as our home prices have come down.

Slide 10. We have brought our average selling down more than 30% from the peak in 2006 by as much as 50% in some markets, and part of this was due to our redesign of new series of homes that are smaller and more efficient to build. We have designed these homes at prices that compete more effectively with resales and foreclosed homes and nearly all are within FHA limits.

In order to protect our margins, we have also reduced our construction cost by 30% or more in many divisions by renegotiating vendor contracts and by utilizing many construction efficiencies in our redesigned product.

We further reduced our overhead cost structure by reducing overhead cost. Our strategy has been to recalibrate the size of our organization as our revenues declined through the consolidation of several divisions and the elimination of a couple combined with related personal reductions and aggressive control of other overhead expenses.

As a result, we have taken general and administrative expenses down by 35% over last year to just one-third of the total G&A expenses incurred in the first quarter of 2006. That one year reduction is in line with our 38% decline of revenue over that same period.

Our total SG&A expenses of $33 million for the first quarter 2009 were 40% lower than the $55 million totaled in the first quarter of 2008 with a 43% reduction in commissions and other sales cost in addition to the savings in G&A. We believe all these factors positioned Meritage to well the current recession and to return to profitability as conditions improve.

I will now turn it over to Larry. Larry?

Larry Seay

Thanks, Steve. Moving to slide 12, we reported a smaller loss before taxes of $18 million in the first quarter of 2009 compared to a loss of $71 million in the first quarter of 2008. After backing out the charges for impairments in both years, our pretax loss in the first quarter of 2009 was $8 million compared to $11 million loss in 2008.

One consequence of our reduced inventories is at less of the fixed interest charges we incur in our debt is eligible for capitalization and must be instead expensed through our income statement in the current period.

The interest income earned on our cash is very nominal. For this reason, there was a significantly greater drag on income in the first quarter due to interest charge directly to operations approximately $8 million of the total $12 million interest incurred. Without this expense, and excluding our non-cash impairments taken during the quarter, we would have operated at about break-even for the first quarter.

We generated approximately $10 million in adjusted EBITDA excluding impairments. That is a 28% improvement year-over-year in adjusted EBITDA evidencing our progress toward returning to profitability.

Slide 13. Our net sales were down. Our net sales were 40% lower this quarter than in the first quarter of 2008, reflecting the continued difficult housing market conditions. Our year-over-year comps are more difficult than other builders due to the fact that our sales held up better last year. We have a smallest decline in sales from 2007 to 2008 among all the major public builders. So, our year-over-year comps will continue to be challenging for the next couple of quarters.

However, our sales rebounded from a decimal fourth quarter last year increasing by 97% sequentially and they have continued at our first quarter pace into April. This increase was due to an overall improvement demand, some seasonality, repositioning of our product in a much lower cancellation rate of 26% in 2009 less than half of the 56% cancellation rate we experienced in our fourth quarter of 2008 and more consistent with the 27% rate one year ago. Our normal historical cancellation rate is in the low to mid-20s.

Our central region which includes Texas, Arizona and Colorado experienced the smallest declines in orders during the first quarter of 2009. The relative strength of Texas market has greatly benefited as during this downturn and accounted for approximately 60% to 65% active communities and orders this quarter.

Some key advantages of the Texas homebuilding markets through this cycle have included lower levels of foreclosures, less price volatility, lower unemployment rates in the national average. We believe these conditions will likely continue benefiting Texas as a whole and in turn Meritage.

We are leading builder in Texas and have been growing our market share there over the last couple of years. Many of our competitors are having difficulty obtaining construction and development financing which we will believe will allow us to continue to gain market share.

Slide 14. As anticipated with our asset light strategy, we have reduced our real estate inventory during this slowdown and harvested millions of dollars in cash are regionally invested in that inventory. Our total real estate inventory came down by 391 million since the end of the first quarter of 2008 or up to less than half what it was in March of 2007.

This decrease resulted from a combination of factors, including the reduction of unsold, pre-sold and model homes in inventory. Strictly limiting lot purchases or building through lot inventory and impairments due to valuation adjustments.

Slide 15. We reduced our spec inventory to 550 homes or 3.2 homes per community as of March 31, 2009 from 768 spec homes at the end of 2008. That's lower than we believe is necessary today in order to maximize our sales opportunities to renters or existing home owners who have sold their homes. They often want completed or nearly completed homes ready for them to move into and may not be willing to order and then wait for a home to be built unlike in past years.

Therefore, we remain a build-to-order builder, but we are making an allowance to adjust our strategy to current market conditions. We may increase our level of spec inventory to get closer to a target of four to five homes per community.

Slide 16. Our owned lot supply remains one of the lowest in the industry in terms of trailing 12 months closings. We had a total of 15,069 lots owned or controlled at March 31, 2009, representing a 2.9 year supply of lots based on trailing 12 months closings. That includes 8,340 owned lots. By comparison, our total lot supply was 24,591 lots or 3.4 years supply at March 31, 2008 with 9,920 of those owned.

Traditionally, we have targeted a much higher option to own ratio. However, in the current economy, we own a higher percentage of lots due to our termination of the vast majority of our options over the last couple of years.

As we previously noted, our lot supply in many states is now quiet low. We have about 1 to 1.5 years supply of lots in California, Colorado and Florida. In addition, while lot supplies look healthy or even heavy, almost half of those lots are in active adult communities, which can actually require more lots over which to spread a larger upfront infrastructure cost and one large option of undeveloped lots in a prime location in north Phoenix, which Steve discussed earlier.

Slide 17, our strategy while sinking new acquisitions is to contract for small parcels of well located finished lots and we believe we can sell and build out within a year or two of opening.

With our financial strength, liquidity, and relatively light lot supply, we are in a position to replace some older lower margin communities with the deeply discounted lots in certain markets where we see immediate opportunities and we began to make some selective lot acquisitions to take advantage of these.

For example, we recently purchased a note from the bank that covered about 80 lots in Arizona. The original cost was approximately 190,000 per lot and we purchased a note from the bank for what amounts to approximately 35,000 per lot.

These lots are completely finished in a gated community. We anticipate completing the foreclosure process within the next week and expect to sell homes priced in low 200,000 on these lots.

We'll just below the prices of foreclosures in that market. That is a typical deal we are looking for in today's market and where we have relatively short supply of buildable lots.

Slide 18, during the quarter we retired 6.6 million principal amount of our senior subordinated notes by issuing approximately 250,000 shares of common stock in exchange for those notes with an implied discount of 45% to the face value of the notes retired.

The 2.0 million gain on the early extinguishment of debt is reflected as a component of other income in the first quarter. We may transact additional exchanges in the future depending upon terms and market conditions.

But our bank debt covenants prohibit us from repurchasing bonds for cash. We also adopted an amendment to Articles of Incorporation that is designed to preserve the tax treatment of our net operating loss. These tax assets totaled approximately 134 million at March 31, 2009 and were fully reserved for accounting purposes, but are available to offset approximately 380 million of future taxable income at current tax rates.

There has been a fair amount of press regarding some problems with Chinese drywall used in homes. It appears that such issues for Meritage are only in the Fort Myers area of Florida for homes that were closed in the late 2006 through 2008.

We believe our exposure is limited as we closed only approximately 150 homes in Fort Myers during that time period, and we're currently aware of only a small number of those homes that have any issues alleged due to the drywall. We are working with affected home owners, contractors, and insurance companies to inspect and remedy any issues, but we do not expect to have any significant adverse impact on our financial position.

I'll now turn it back over to Steve.

Steve Hilton

Thank you, Larry. Housing affordability today is the best it's been in almost four decades, with the biggest improvements in those markets that experienced the greatest depreciation in home prices during the first half of this decade.

According to a recent study by John Burns, a national real estate consultant, the monthly cost of home ownership has fallen 43% from its peak in this cycle due to declines in pricing and mortgage rates as well as an increase in income over the past few years. Since entry-level buyers compare the cost of ownership to the cost of renting, Mr. Burns projects that buying activity will increase substantially as more renters recognize the attractiveness of home ownership.

We agree and emphasize that buyers have a unique opportunity today to acquire new home at historically low prices and low mortgage rates, further enhanced by Federal and some state tax incentives.

Slide 20, our primary objectives in managing through this downturn have been to strengthen our balance sheet and return new profitability by reducing our inventories and debt, generating cash, building liquidity, and reducing our cost structure in line with lower revenue.

I'm pleased with the progress we've made towards these objectives today and as demonstrated in our results. There is less competition today, as many other builders who are overloaded with land, inventory and debt, or do not have adequate access to capital are disappeared during this recession.

Meanwhile, we have increased Meritage's market share and are now 10th largest builder in the US according to the most recent Big Builder rankings. We believe Meritage is uniquely positioned with the right products in the right markets. Our strong balance sheet and relatively low lot supply given us the ability to take advantage of opportunities as it become available.

As we continue to roll out our lower priced more affordable homes, our new lower cost well located finished lots, we expect our margins to gradually improve returning us to more normal levels of profitability.

Thank you for your attention, and we'll now open up for questions. The operator will remind you of the instructions for Q&A. Operator?

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of David Goldberg from UBS. Your line is now open.

David Goldberg - UBS

The first question was about your geographic footprint, and if you think it makes sense to being in all the markets that you're in, given that the order numbers have come down so dramatically in some of our markets?

Steve Hilton

We're very bullish about the market we're in. We think we're in the best markets in the country, markets that are going to rebound. Someone could argue why are we in Las Vegas? I mean, we are in Las Vegas today because we have assets up there that we need to work through and when I could build do that over night.

So, we continue to evaluate every market, every quarter, but I do believe over the long-term, we like very much all the markets that we are in and we are going to continue that to have a substantive presence in those markets.

David Goldberg - UBS

Great. A follow-up question was really about the land and a liquidational land from banks and I know you kind of gave, Larry gave an example earlier about an example where you found a bank liquidate in a portfolio of land and you guys were able to acquire it.

I guess what I am trying to understand is, first, I guess the first part is, what gives you guys the confidence there is going to be enough of that land coming from distressed sellers that you can acquire at the right price to reload the balance sheet as you look forward kind of, especially if there are markets that you are going to see look forward to grow the business again?

Then I guess the second part of the question is when you look at that deal and you guys now have bought some land, what kind of gross margins and operating profits were implied by the prices that you paid for the lots?

Steve Hilton

Well, first of all, we wouldn't buy any new lots unless we could earn a normal gross margin and that's 20% or more. So, we are underwriting purchase of assets, new assets, new lots, to today's housing prices and to what we deem as normal and acceptable gross margins and IRRs.

I think there is going to be a lot more opportunities. I think the opportunities are accelerating. I think there is a lot of private builder assets there getting disposed through banks, and we think they are going to accelerate through the later part of this year and we are going to have some good choices out there to make.

David Goldberg - UBS

If I could sneak one more and Steve…

Steve Hilton

Sure.

David Goldberg - UBS

You mention that cycle times have come down 31 days, which I think is great. Can you kind of put some color on where that leaves you and where you can think can get to in terms of cycle times and turnover?

Steve Hilton

Well, we would like to do turn our assets upwards of three times a year which we were able to do not quite do that well at the peak of the market, but as we get some of these legacy assets of the books and work through them and work away towards lower price housing that we can build quicker, we think our inventory turns are going to increase substantially and that allows us to build more with less capital and requires us to carry less debt. So, that is the objective.

David Goldberg - UBS

For the frame of reference, 31 days lower, where does that leave you now?

Steve Hilton

I don't know the exact number, but Larry I think we are about 120 days, 125 days.

Larry Seay

It varies from market-to-market and product type, but when we talk about cycle times, we are talking about from point of sale to closing not just construction time. So, we have squeezed not only construction times, but also time from sale to start and time from finished to close and that total time kind of runs from 120 to 150 and in some cases it is lower than that, because we made strives, but bear in mind that is the full time and not just the construction time.

Steve Hilton

I would say this is a major company initiative for us and we see an opportunity to drive it even lower than we are at right now and that is something that I think we are going to see considerable progress on over the next several quarters.

Operator

Your next question comes from the line of Nishu Sood from Deutsche Bank. Your line is now open.

Nishu Sood - Deutsche Bank

Thanks for the detailed disclosures as always. I wanted to ask about this shift to the lower price point product that you're offering. I wanted to just get a sense of how that is going, because just as I was rescanning across some of the products you are offering in a place like Houston, I didn't see anything you are offering that is below let's say 130,000, 140,000 base price for the lowest level of floor plans and that is kind of a median in that market.

So, is this something that you expect to take, I mean, how long is it going to take to kind of the transition…?

Steve Hilton

Well, I would say the shift to the lower price point products has been done primarily outside of Texas. We haven't changed our product that much in our Texas markets, but I can tell you for example, in the Phoenix area where we have approximately 14 communities, we have changed the product in every one of our communities and brought the price down substantially.

In Orlando, Florida, we have changed our product in almost all of our communities and brought the price down significantly by building smaller and less amenities homes.

In Texas, it is not our goal to get down to low 100s and compete with the extremely volume oriented builders, but we are a dominant builder in the Houston market, for example, you mentioned where we have 40 plus communities, but whole, particularly, outside Texas, we are changing our product and bringing the prices down substantially and it is working well. We got several communities in the Phoenix market where we had very strong sales over the last couple of months because their prices are down low to mid-100s.

Nishu Sood - Deutsche Bank

Got it. So, this is really a strategy for the foreclosure saturated markets where you need to compete more effectively.

Steve Hilton

Exactly.

Nishu Sood - Deutsche Bank

Got it. Okay. A related question. Reloading of the lots at distressed prices in these markets, where you are going to be picking up these distressed lots? I mean a lot of these lots are going to be have been entitled and developed with a larger floor plan in mind or larger footprint of a home. How did it affect the kind of dynamics of the building just in terms of the entitlement? How does it affect everything that you're going to be putting up a much smaller product on these lots?

Steve Hilton

Well, it generally doesn't have too much of an impact I mean there is not many communities, where they require to build a large home or certain square footage. I mean some communities may have some architectural requirements for the front elevation and the setbacks and the garage's door exposure. But beyond that I mean there is no law that says you can't build a 1,500 square foot home versus a 3,000 square foot home.

So, we are very sensitive to making sure there are homes fitting with the existing, community. But with the same token, we want to deliver exceptional value to our buyers. We can do that by bringing the right product to the market.

Operator

Your next question comes from the line of Dan Oppenheim from Credit Suisse. Your line is now open.

Russell Lane - Credit Suisse

This is Russell on for Dan. I was hoping just to get a quick follow-up actually to one of Nishu's questions. If you could just specifically and I appreciate the commentary about the [both] price homes you're rolling out, but if you could just kind of specifically talk about the California market. We saw a significant drop in orders there but noticed that, prices were up on year-over-year basis. So, basically wondering what drove that? What are you doing going forward there?

Steve Hilton

Larry, do you want to take that?

Larry Seay

Yes. One you have to recognize that we really only have about four or so actively selling communities in Southern and Northern. So, a total of about eight or so. Mix issues then have significant impacts when you only have that smallest scale. The point is we have dramatically dropped prices in California and we have instituted redesign product. We are actively looking to replace these lots that we've either terminated because lot of our options or lots were control through option in California by buying these well priced deeply discounted lots.

So, that's really how we're going to turn California around. The only thing you're seeing there is just a slight mix issue from quarter-to-quarter because the sample size is so small.

Steve Hilton

Yeah. I'd also add, we had three communities in Southern California that were very high priced in full communities. That were two or more around the $1 million and one of them was in the $600,000 price range. We have not changed the product there. When Larry talks about the mix issues that’s had a substantial impact on the mix and we move several homes in those communities in the last quarter, and that's had that mix impact.

Russell Lane - Credit Suisse

Just one quick follow-on. Just as we look through the cycle, you've talked about that land opportunity and especially, we appreciate the detail on Phoenix. But as we look through this cycle, where would you like to expand your presence in terms of what you think is a healthy geographic balance for your company? Are there any new markets that you would like to be in?

Steve Hilton

No, I don’t think our emphasis is going to be on any new markets. We're really focused on markets that we're in. I think we want to be more balanced with Texas being one of the 35% to 40% of our total deliveries, which means we need to rebuild California. We think in long-term, California is a market that we want to have a bigger footprint in. Certainly Denver, Phoenix, Tucson, Orlando are all markets where we have an opportunity to increase our market share and rebuild our community count. Then maintain our market share and continue to expand our market share on the Texas market. So I think the focus is going to be on organic in market growth, the markets we're currently building in.

Operator

Your next question comes from the line of Carl Reichardt from Wachovia. Your line is now open.

Carl Reichardt - Wachovia Capital Markets

Larry or Steve, I'm curious you talk about kind of the 20% minimum gross margin as the base for looking at new lots that you might take down from banks or others. What kind of absorption paces would you expect to get in a minimum basis on lots like that?

Steve Hilton

Three to four sales a month.

Carl Reichardt - Wachovia Capital Markets

So, just kind of back to a normal, traditional pace, okay.

Steve Hilton

Correct.

Carl Reichardt - Wachovia Capital Markets

Then just quickly and then I have one other. Active adult is what percentage of your business now? Is that going to hold through in the next 12 to 18 months or so if trend continue?

Steve Hilton

Larry?

Larry Seay

Yeah, active adult hasn't changed a whole lot, it's still down on the kind of 5%, little bit high 5% to 7% range. We have three or four depending on how you slice your communities in Arizona. At this point, we're continuing to build through those and we have plenty of lots to continue to build there. So we have a several year supply and we are looking for opportunities for lots even in active adult.

So, we hope that we find some very attractive re-price active adult lots.

And I might add to your first question, I think that we are performing lots, our absorption at a bit lower than that 3 to 4, although we certainly today, but we certainly can make money and make good margins at that, maybe 2 to 3 absorption rate. I don’t want to imply that that we are being overly optimistic in our underwriting today.

Steve Hilton

We won't again buy a new deal unless we could convince ourselves we can do at least three a month.

Larry Seay

Correct.

Carl Reichardt - Wachovia Capital Markets

Okay. And then I am sorry, just one other question. You guys in your past have been utilizer of the, what's term the land banking industry. I am just kind of interested Steve in your comments on the structure of that business and what you are seeing out there among the partners you traditionally work with on in that frame and whether or not their continued involvement in the business or their lack of involvement is going to impact you and your strategy going forward?

Steve Hilton

Well, certainly there is no land banking available today from what we consider to be third party land bankers that we brought into purchase land for us and sell it back to us on a rolling option. But there are many lots available particularly in Texas from developers that we can buy lots from on rolling option terms or seller carry terms.

In the market today though, most of the great opportunities that we are seeing are lots being sold by vendors, by banks, and/or land bankers in conjunction with our vendors, as you know short sales for lots and the terms on those are cash and I think that's the way it's going to be for a while.

One of my concerns is though particularly when I was driving around Texas over the last couple weeks as I noticed that there is a lot of private developers that aren't able to access the credit to finish the next phase of lots to build out their lot positions. And that's going to affect our ability to some degree to buy lots on rolling options because I think the lot of developers are going to be very, very credit constraint.

So I think in the short-term, it's going to be cash-and-carry. But over the long-term, I think some of the hedge funds or some of the investors that have bought lots to get the returns they wanted, they are going to have sell them on a rolling option or adjusted time basis.

Operator

Your next question comes from the line of Joshua Pollard from Goldman Sachs. Your line is now open.

Joshua Pollard - Goldman Sachs

Hi, my question is on the pricing front. You've got a mix of different data between Case-Shiller and what's coming out on a couple of different other indices. Can you guys talk about any areas of the country or any products or price points where you're seeing prices actually stabilized along that type of question when you look at those Arizona purchases that you made, how much further of a price decline did you guys bake in into your models for those purchases?

Steve Hilton

I think we're seeing prices stabilize in select sub markets in Orlando, in Denver, in Phoenix, in California. It's really a localized analysis we have to do. You have to look at the competition, the lot supply in the areas from other builders. You have to look at what the foreclosures are in that sub market, and a market like Phoenix for example there maybe eight to 10 different sub markets and you can't just paint the entire market with a broad brush.

Some areas certainly like Los Vegas, there are still price declines coming. But we wouldn't buy a new community or new lot position in an area where we saw there was a substantial risk of further price declines.

So we're not baking into our pro forma's additional price declines or really underwriting these communities to the current market and making sure we get healthy enough market that if there is slight price decline than we can observe that.

Joshua Pollard - Goldman Sachs

Okay great. My follow-up is just on cash flow. Is there any reason that Meritage should be cash flow negative in any quarter in 2009?

Larry Seay

The only reason why we would be as we noted that we think our spec level is a little bit low, and to the extent, we do increase our spec count a little bit that would obviously be a use of cash. But we'd hope that our continued reputation of lot inventory would offset that and not had a negative cash flow quarter. But because there is an interplay between a positive and a negative, I can't guarantee of that if we had a moderate increase of specs next quarter that might not drive us to be slightly negative.

Joshua Pollard - Goldman Sachs

And one last quick follow-up for guys for the time is, you mentioned 200 to 225 as a target for ASP. How quickly do you guys plan to get there?

Steve Hilton

I think we can give you exact timeframe, but it's our goal over the next year to try to get in that range.

Operator

Your next question comes from the line of Timothy Jones from Wasserman & Associates. Your line is open.

Timothy Jones - Wasserman & Associates

First question is, you were talking about this 1,200 lot deal that you have in Phoenix. Is that the deal that you have with the state?

Steve Hilton

Correct.

Timothy Jones - Wasserman & Associates

Why would you think if getting out of that deal given the fact that you have a lot of flexibility well over the normal option with the state?

Steve Hilton

Well, we are still evaluating it. It is not our intention to get out of it. We are negotiating with the state to get some further flexibility from them. We are continuing to evaluate the market conditions in that submarket. It's probably one of the best locations you could find in the Phoenix metropolitan area. It is right on the Scottsdale, Phoenix line, and so very desirable place where people want to live.

So, we have a substantial investment there of course, but we had not made the decision yet to start development or start moving dirt and get houses going, but we are going to continue evaluate over the next few quarters and make a decision hopefully by year-end.

Timothy Jones - Wasserman & Associates

Is the state getting a less flexible or is it just market conditions?

Steve Hilton

I won’t say looking in less flexible, but I think there is somewhat constrain by state statues and what they can do for us and having to work through those issues.

Timothy Jones - Wasserman & Associates

Second question is, you talked up in your release about taking steps to protect your NOLs and that you have done it. Since a couple of number of builders have actually lost their NOLs, can you be a more specific on what you did and why didn’t some of the other builders do the same thing?

Steve Hilton

Larry?

Larry Seay

Well, I think several builders have changed their bylaws and they have had special elections to get approval from their shareholders to change their bylaws and articles to prohibit somebody from owning 4.9% or more than 4.9% of their shares and we did that in a special meeting earlier in the quarter. As we disclosed, it is, I forget the exact numbers around $340 million, $350 million of future profits that is protected by that move.

So, it is a pretty big savings of tax assets in $132 million range. So, it is very important for us to do that, and I think several other builders have done that. Unfortunately, a few other builders because of their financial issues weren't able to take those kinds of steps.

Operator

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

Jim Wilson - JMP Securities

I was just wondering, Larry, could you give any comment on what backlog or what margins are quite in backlog or perspective just what the recent sales and what those look like?

Larry Seay

There are in the 12% to 13% range and we get also this kind of margin question routinely, and I think the point here is that we can't tell precisely what margins are going to be in next quarter's closings. I continue to kind of give that 12% to 13% answer as you can see historically we have kind of settled in to that point and I have also said going forward as we reload, we would expect to see that increase, but I can't predict that next quarter we're going to see a big increase.

I think, you will see a gradual improvement. Also, if you look at the margin chart that we provided, you see a little bit of seasonality to it. So, we tend to gradually have improving margins through the year, because some of the construction costs that are in cost of sales are fixed cost.

So, I would think that you will gradually see a bit of improvement through the year and as we can reload lots, you will gradually see our margins return over a period of a couple or three years to our normal level.

Jim Wilson - JMP Securities

All right. Makes sense. Then I had another question just on this note repurchase deal and you talked about where you are repricing the product. Could you kind of give a little idea on new products, what size homes these are and in the neighborhood what kind of hard costs you anticipate you are seeing in building these smaller units out?

Steve Hilton

These are going to be homes in this particular community that we mentioned probably between 1,800 and 2,500 feet and maybe some a little bit bigger available, but I think the predominantly average buyers are going to be around 2,000, 2,200 feet.

Our hard costs are going to probably be under $40 a foot, and this is in neighborhood where the homes were selling 450,000 to 550,000 and they were probably averaging 3,000 square feet.

Jim Wilson - JMP Securities

Okay. Great. The $40 number for a lot, the new small product you are bringing out, is that a reasonable (inaudible)?

Steve Hilton

Yeah. I mean, I think some of our houses that we are building are as low as $35 a foot on some of larger square footage, but I think we are trying to push all of our hard cost down to that $40average or lower.

Operator

(Operator Instructions) Your next question comes from Joel Locker from FBN Securities. Your line is now open.

Joel Locker - FBN Securities

Just wanted to ask you about your backlog conversion rate is the highest in the last decade at around 73% and lot of that was selling the finish [backs]. But wondering if you could keep that up just in the second quarter or third quarter seeing that your finish back account is still somewhat high?

Steve Hilton

Well, probably not, because our finish backs are much lower than they have been for the last year-and-a-half down to 550 or so. So, I don’t think we are going to keep that high. On the other hand by building homes quicker and reducing our cycle times, it will help us keep that number higher. But I don’t expect to repeat that number in the second quarter.

Joel Locker - FBN Securities

Just on the California orders, obviously, are down 73% year-over-year as mentioned and a lot of that was community count, but did you see any uptick in the March-month based on the tax credit?

Steve Hilton

We did have a little uptick in sales in March and a little bit in April, but again we are talking about really small numbers in California …

Joel Locker - FBN Securities

And a lot of that…

Steve Hilton

I don’t know that we are at good parameter for the market. Also considering few of our communities are at that higher price point, again, we are not the best parameter for what's happening in the state of California.

Joel Locker - FBN Securities

But that margin April, that might have just been a seasonal uptick from what you see?

Larry Seay

I don't know if it's seasonal. I mean we adjusted prices and just got more competitive and got to the end of the some communities, so we have more close outs. We continue to put our figure on any one particular factor in California.

Operator

Your last question comes from the line of Bose George from KBW. Your line is now open.

Bose George - KBW

First question, do you have a weighted gauge, the percentage of your buyers that will be able benefit from the national tax credit? How big driver do you think that is for your buyers?

Steve Hilton

I think it’s a pretty big driver between the third and half of our buyers right now. I just spent last week touring around Texas and talking to our people on the ground there. They said that's had a pretty big impact on their business. I know in Phoenix, we have some lower priced communities that have had pretty strong sales success over the last couple of months. I think one of the reasons is the tax credit that expires at the end of the November.

So we're certainly trying to put ourselves in a position to take advantage of those as much as we can. Maybe Congress administration will think about it, you know, expanding that credit, but I do think it's having some impact. I only wish it was larger and wider because it's unfortunate, it’s limited only to first-time home buyers.

Bose George - KBW

Just actually switching to financing, can you just discuss how most of your buyers are financing themselves as FHA continues to be the main source of funding?

Steve Hilton

I think Larry; you have some stats on that right?

Larry Seay

Yes. Certainly there is a large portion today that's using FHA lending kind of in the 40% to 50% although there is still a large group using conventional too, although most of the conventional kind of meets the FHA, VA, at least the FHA requirements.

From a down payment perspective, you kind of have two groups. One down in kind of that 3% or so range, which is the government, and then [which] is really conventional there is another range that's in the 20% range. So you have two kinds of distributions on the average down payments kind of running around 11% or so.

Steve Hilton

I'll just add on to it, Larry. 98% of our buyers are using some type of government-sponsored programs. So it's either FHA, VA, Fannie Mae or Freddie Mac. It would be 98% of our buyers, there is very few non-conforming loans.

Okay. I think that wraps up our questions. We thank you very much for your support and look forward to talking to you again next quarter. Good day.

Operator

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

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Source: Meritage Homes Corporation Q1 2009 Earnings Call Transcript
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