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Executives

Brent Anderson - VP IR

Steve Hilton - Chairman of the Board and CEO

Larry Seay, Executive VP and CFO

Analysts

Nishu Sood - Deutsche Bank

Josh Levin - Citigroup

Stephen East - Ticonderoga Securities

Jade Romani - Keefe, Bruyette and Woods

Carl Reichardt - Wells Fargo Securities

Joshua Pollard - Goldman Sachs

Alan Ratner - Zelman Associates

David Goldberg - UBS

Dan Oppenheim - Credit Suisse

Jim Wilson - JMP Securities

Jay McCanless - Guggenheim Partners

Michael Kim - CRT Capital Group

Joel Locker - FBN Securities

Meritage Homes Corporation (MTH) Q2 2010 Earnings Conference Call July 28, 2010 11:30 AM ET

Operator

Greetings and welcome to the Meritage Homes Second Quarter 2010 Conference Call. At this time, all participants are in a listen only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce to your host Brent Anderson, Vice President Investor Relations. Thank you, Mr. Anderson you may begin.

Brent Anderson

Thank you, Rob. Good morning, I would like to welcome you to the Meritage Home second quarter 2010 earnings call and webcast. Our quarter ended on June 30 and we issued a press release with our results for the quarter after the market closed yesterday. A new copy of the press release or the slides that accompanying our webcast today, you can find them on our website at investors.meritagehomes.com or by selecting the investor's link at the top of our homepage.

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 these risk factors please see our press release and most recent filings with the Securities and Exchange Commission specifically our 2009 annual report on Form 10-K and subsequent quarterly reports on Form 10-Q. Today's presentation also includes certain non-GAAP financial measures as defined by the SEC. to comply with the SEC's rules we have provided a reconciliation of these non-GAAP measures in our earnings press release. With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage Homes and Larry Seay, our Executive VP and CFO.

We expect our call to run about an hour this morning and replay of the call should be available on our website within an hour or so after we conclude the call. It will remain active for 30 days. I will now turn it over to Mr. Hilton to review our second quarter results. Steve?

Steve Hilton

Thank you, Brent. I would like to welcome everyone to our call today. I will begin with an overview of our second quarter 2010 operating results as shown on slide 4. When we reported our final result for 2009, we stated that our number one goal for 2010 was to return new profitability as soon as possible and to be profitable for the entire year. We achieved the first part of that goal last quarter as we are one of the first publicly traded home builders to report profit for the first quarter of 2010.

We just reported our second profitable quarter and are successfully executing our strategy to achieve our goal of profitability for the entire year. We generated net income of $4 million against the prior year net loss of $74 million which include $67 million of real estate impairments in 2009 compared to only about $300,000 of impairment in the second quarter of this year. Our net income in 2010 was reduced by $3.5 million loss on the early extinguishment of debt associated with the refinancing of approximately $200 million of our senior notes in the second quarter.

Our second quarter 2009 net loss benefited from $6.5 million gain on the early extinguishment of debt associated with our stock for debt exchange last year. If we exclude the effects of the impairments and our gains or losses is associated with the financing transactions, our adjusted pre-tax income for the second quarter of 2010 was approximately $8 million, reversing a pre-tax loss of approximately $12 million for the same period last year.

The increase in our second quarter net income was largely driven by improved margins on an increased numbers of closing. We close 36% more homes in the prior year second quarter resulted in the 32% increase in home closing revenue as average price on closing were 3% lower than 2009. We believe the increase in closing was partially due to acceleration of closings to meet the initial June 30th deadline for the home buyer tax credit as well as stronger sales in our first quarter.

Florida closed 88% more homes year-over-year, California closings were up 66% with Arizona coming in third with the 40% year-over-year increase. We nearly doubled our gross profit on that greater number of home closings generating $53 million in gross profit for the second quarter of 2010, compared to $27 million gross profit before impairments and last years second quarter.

Including the effect of the impairments in the prior years second quarter 2009, reported a gross loss of $39 million closed in which translates to a $92 million improvement in gross margins year-over-year.

Please turn to slide five, our strategy to improve profitability centers around increasing our gross margins by reducing our cost and opening new communities on lower price lots. We increased our home closing gross margin by approximately 600 basis points over the second quarter of 2009, bringing it to 18.3% from 12.3% excluding impairments from the cost of sales.

Next to the 19.2% gross margin reported last quarter; this was the second highest adjusted gross margin we achieved in the last three years and close to our target of approximately 20%. We offered less than sales concessions during the first quarter when demand was stronger, where as we increased the concessions offered in few of our new higher margin communities in the later half of the second quarter to increase absorptions and offset some of the impact of the exploration of the tax credit. Additionally we had more closings from some lower margin communities during the second quarter which explain the sequential decline in our average margin. A margin improvement compared to this prior year's second quarter was a result of savings in our construction cost and additional closing and communities built on lower price logs, we have acquired since the start of 2009.

Our newer communities are driving the margin improvements we've been achieving over the last five quarters. Approximately 20% of the second quarter 2000 and closes in related revenue came from our newer communities. Our margins on those homes were approximately 600 basis points higher than the margins we earned on our older communities demonstrating the continuous success of our strategy and improved profitability.

We opened eight new communities in the second quarter, replacing nine of our older communities that had below average margins. One of our newly opened communities with very special project named Lyon's Gate in Gilbert, Arizona. I'll come back to that in a couple of minutes. We have another 20 to 30 communities in the pipeline that targeted opening day in the last half of 2010 or early 2011 are currently projecting approximately 35% to 40% of our sales and 30% to 35% of our closings will be coming from our new communities by the end of this year.

Our net new orders in the second quarter of 2010 were 22% lower than the prior year partially due to a 15% decline in our average active communities. In addition to a generally softer market after the April 30th tax credit contract signing deadline. The decline in sales fallowing the exploration of the home buyer tax credit was more significant than we expected and surprising because we didn't experience a significant increase in spring sales until the last few weeks of April. However, we're hopeful for a relatively short hangover effect similar to what the auto industry experience with the cash for Clunkers program.

Based on our second quarter sales, we're anticipating lower third quarter closings and looking for improving sales in the later part of the year. Despite external factors which are beyond our control, we're continuing to execute our strategy by opening new communities in good locations replace older and lower performing communities differentiate Meritage as the industry leader in energy efficient home construction, ensuring that our plant selections and model presentations are inviting and properly matched to our target by its preferences and training equipment sales people to be the best in the business.

Although we can predict when the market will improve, we are confident that it will improve we are positioning Meritage Homes to be one of the best in the business but now and in the future. We had 25% fewer communities in Texas than our average in the second quarter of 2009 this was by choice not by chance since part of our plan to improve margins and profitability includes closing our communities with lower margins and redeploying assets into new communities but we are achieving higher margins in sales.

We sold out at more communities in Texas during the second quarter than anywhere else. As we reported previously, many of these are the best opportunities we found over the last couple of years have been in California, Florida and Arizona which have resulted in some rebalancing of our active communities from Texas to these other markets.

Primarily due to the 25% lower average community count in Texas our homes sales were 30% lower than in the second quarter of 2009. Accordingly, Texas comprised 51% of the company's total home sold comparative to 57% a year earlier. While California and Florida represented a larger percentage of our total home sold during the quarter. Due to slowing sales in the quarter as previously discussed, our average sales per communities for the second quarter for 2010 was 6.1 which was slightly lower than our average of 6.6 sales per community in the second quarter of 2009 and 7.0 in the first quarter of this year.

California and Florida achieved the higher absorption rates, nearly all of our communities in those markets have been opened in the last couple of years, our new lock positions with new product lines offering another proved points of the success of our strategy. Partially offsetting the 23% decline in total home sold, our average sales prices were up 11% over the prior year in the second quarter resulting in total order value decreasing by less than 13% year-over-year. Our average sales prices for the second quarter of 2010 were approximately $254,000 compared to $229,700 in 2009.

This reflects an increase share of sales from many of our newer closer end communities which command higher prices and some of our older communities as well as growth in our higher average price markets like California and Florida. Our second quarter cancellation rate was 20% in 2010 compared to 23% in 2009, just slightly below our historical average in the low to mid-20%. Turning to slide seven, just last month we opened a new community at Lyon's Gate in Gilbert, Arizona one of the best markets in the Phoenix metro area.

This community is a prototype for future high energy efficiency communities and to the extent it is successful as we expect it will be, we planned to open additional communities based upon this model. While we are already 100% energy star qualified in all of our communities, our homes in Lyon's Gate go far beyond that, incorporating the latest energy efficient technology in every home and no additional charge to the buyer, the prices starting under $180,000.

The homes are designed to save homeowners up to 80% on their home utility bills compares to a typical existing home as published by the US Department of Energy. Not only is that great for the homeowner, the community and the utility company but it also great for our country, is a great selling point for Meritage. Buyers can save and consume lot of money on operating cost with our new homes compared to used homes or other new homes that don't this energy saving features. All of our homes in Lyon's Gate include a full set of state-of-the-art materials and equipment that are designed to compliment each other for the greatest efficiency and energy use and cost. Those features include an advance solar, electric and thermal system, a high performance wall system, spray foam insulation, electronic home management system and weather sensing irrigation and water management systems, these are demonstrated in our learning center and sales office at the community you could also read more about them on our website.

A key differentiator for Meritage is that they are included as standard feature in every home not options. We have to select separately and pay extra for which many builders are offering today. We believe that this is the competitive advantage for Meritage to help us to sell more homes. I am now turning it over to Larry Seay, our CFO, and I will return with prepared remarks and a few closing thoughts before Q&A. Larry?

Larry Seay

Thanks, Steve. Moving to slide eight, as Steve stated; we accelerated deliveries in the second quarter to meet the June 30 closing deadlines for the home buyer tax credit. We converted 89% of our beginning backlog into second quarter closings in 2010 with approximately 40% of those closing from specs and ended the quarter with approximately 580 total specs or 3.9 per community. 52% of those were finished. We were careful not to overbuild specs in anticipation of increased demand due to the tax credits, so we are comfortable with the level of specs or currently carrying in our communities. Our ending backlog at June 30, 2010 totaled 144 homes valued at $293 million which was 23% less than our total backlog value at the end of the second quarter of 2009 partially due to the accelerating closings into the second quarter.

Because of cycle times have come down and we have implemented a 99 day delivery guarantee in many of our communities to compete with resells and attract renters. Our backlog converting rates have been trending higher. We would expect it to remain above our historical levels as a result of executing our strategy to shorten the cycle times although we're likely to be less than 89% in future quarters.

Slide nine, we have been very diligent in controlling our overhead as a percentage of revenue during this downturn and have one of the lowest SG&A percentages in the industry. The absolute level of G&A expenses increased by approximately $3 million year-over-year in the second quarter but declined approximately 500 basis points as a percent of revenue to 5.7% in the second quarter of 2010 compared to 6.2% in the same period last year.

Much of the variance from last year's second quarter was due to various items in 2010 which are not operational in nature such as legal expenses and extensions of subleases with negative spreads as well as some compensation really increases in certain areas.

Assuming total ongoing G&A expenses remained in the vicinity of $15 million to $16 million for the next quarter or so, we may see temporary increases in G&A as a percent of revenue based on the second quarter sales and ending backlog. However, we will continue to be diligent in managing overhead expenses and reducing them wherever possible. As we have said before, we're primarily focused on growing revenues to bring our G&A percentage down.

Slide 10, for the first half of 2010, our total home closings were 11% higher with 9% higher closing revenue in 2009. We achieved gains in every state except Nevada despite 15% fewer average communities in total year-to-date. Steve addressed the reasons for these trends earlier in his comments. We reported net income of $7 million or $0.21 per share for the first half of 2010 compared to a net loss of $92 million or a negative $2.97 per share in the first half of 2009. We incurred less than $1 million of pretax real estate related impairment charges to date in 2010 compared to $77 million of impairment in the first six months of 2009.

However, we reported a $3.5 million loss on early extinguishment of debt in 2010 versus a $9.4 million gain on early extinguishment of debt in 2009. Excluding the effects of the impairments and gains and losses resulting from our financing transactions our adjusted pretax income was approximately $11 million for the first half of 2010 reversing a pretax loss of $22 million in the first half of 2009.

Our deferred tax assets totaled approximately $89 million as of June 30, 2010. These tax assets are reserved and therefore not on our balance sheet are available to offset federal and state income tax liabilities on estimated $234 million of future taxable income. That estimate may change going forward due to various state in federal limitations on use of NOL carry forwards.

Slide 11, we continue to generate more cash from closings and we reinvested during the quarter. We generated $15 million of cash flow from operations even after using $55 million to purchase approximately 1100 lots during the quarter. We entered the quarter with $442 million in total cash and cash equivalence, restricted cash in short-term investments which reduced our net debt to total capital ratio to 24.8% at June 30, 2010 from 32.6% at June 30, 2009.

Last year we have changed some stock for a portion of our debt in the first half of the year. Additionally in the second quarter of this year, we refinanced another portion of our debt and effectively pushed out on maturities by five to six years. In April, 2010 we issued $200 million of senior notes due in 2020 with a coupon of 7.15% price to yield 7.5% to maturity, we used the proceeds to retire an entire $130 million senior note due in 2014 plus an additional $65 million of our notes due in 2015.

The transaction resulted in $3.5 million loss on early extinguishment of debt as noted in operating statements. We believe we have one of the best balance sheets in the industry with the highest balance of cash and lowest net debt to capital ratio in the company's history. No debt maturities until 2015 and one of the lowest supplies over high priced lots within the public home builder group.

Slide 12, since we have a relatively light lot supply, we must continually replenish our pipeline as we sell and close out of communities. Approximately 45% of our lots as of June 30 have been acquired in the last 18 months and historically low prices, which are helping us to achieve higher margins while at the same time lowering our risk of impairments and maintaining flexibility to respond to changing market conditions. We believe this differentiates Meritage from other home builders who were carrying a larger supplies of lots at higher legacy prices which may constrain our margins and ability to grow profits are reducing the returns on assets.

We are continuing to find and acquire new communities and helping some markets using our leading market research and experienced land managers which we believe is a strategic advantage to Meritage.

While increased competition has a driven up lot prices from the low levels, we were able to take advantage of last year, we are still finding an adequate supply of available lots and good locations and acquiring lots at price we believe will allow us to earn near normal margins and attractive returns without assuming any inflation in home prices. Replenishing our pipeline this quarter with lots that need our normal underwriting criteria we have contracted for approximately 2400 lots and 28 communities, 22 of which are new communities and 6 additions to the existing communities during the quarter. 58% of those were in our Texas markets but we haven't tied up as much in the way of new lot positions in the last year or two since land prices hadn't contracted as much there as they had in other markets.

As lot prices have become more attractive and we have succeeded in closing out in number of our older communities in Texas, we have been acquiring some watch that were available in better locations as indicated by our market research. We also added significant number of lots in Orlando, Northern and Southern California, Phoenix and Denver, so to begin with 2009 we have contracted for more than 1800 new lots as of June 30th 2010 controlled approximately 14,460 lots equivalent to 3.4 year supply based on our 12 and 12 months closings.

We own approximately 71% of those lots with the remaining 29% under option contract of one type or another. About 80% of our auction lots are in Texas, where auctions are still available at reasonable prices. Now I will turn it back over to Steve.

Steve Hilton

Thank you, Larry. We have been executing very deliberate set of strategies designed to get us back to profitability and position the company best for the long term. We believe that these strategies provide sustainable competitive advantages and have already seen positive results from our strategic initiatives.

We were one of the first home builders to return to profitability in 2010. We have constructed a strong balance sheet with the a relatively light supply of land and no near term debt maturities providing us the flexibility to reload with the lower priced lots as their opportunities are identified through our market research. We have introduced a new series of simply smart home designed to compete better with resale's, they are more efficient to build so we can price them lower and reduced our direct cost to our Meritage forward initiative allowing us to earn near normal margins on those homes.

And we've reduced our incentives while maintaining prices thereby expanding our margins while our sales losses increase within our newer communities in a 99 day guaranteed delivery system in many of those communities. We just wrapped up our 2010 Meritage leadership institute or more than 100 of leaders gathered to assess our progress, set new goals, share best practices and ensure alignment throughout our organization.

Based on what I saw and heard, I'm confident that we have some of the best talent in the industries at Meritage Homes. I'm very excited about the successes we will achieve in the future. Appreciate your support and attention today. We'll now open up for your questions. The operator will remind you of the instructions. Operator?

Question-and-Answer Session

Operator

Thank you. We'll now be conducting a question-and-answer session. (Operator Instructions) Thank you. Our first question is coming from the line of Nishu Sood with Deutsche Bank. Please proceed with your question.

Nishu Sood - Deutsche Bank

Steve, I wanted to just get some clarity on your kind of current thinking on 2010 profitability. You mentioned that you're still comfortable with the idea of putting out the return to profitability in 2010. I know this is the question on everyone's mind, does that mean then that you think that profitability will persist in the second half of the year?

Steve Hilton

I do. But I certainly believe its going to be modest. Sales have been weak throughout the summer and they'll be harder to be profitable in the second half of the year than we thought certainly few months ago. But still believe that we can convert our backlog and be profitable in the third and the fourth quarter.

Nishu Sood - Deutsche Bank

And the second question I wanted to ask was you have historically been one of the most return on capital focused builders out there. Which is obviously great, shareholders obviously appreciate that. I wanted to understand the shifts that may have happened in your gross margin targeting since you have become more land owner rather than land auctioneer. And so in other words, internally are you targeting higher gross margins? Because obviously you would need a higher gross margin to offset the higher capital carry. And as we should on the outside investors be looking at your gross margins and saying they should have higher gross margins than they have had historically because of the market being forced to carry a little bit more land?

Steve Hilton

We are targeting higher gross margins than we were, when we are doing predominately well in options. We are reputing internal charge when we carry land as if we had a land banker carry it for us, we are just taking that cost and imputing on our own income statement. So, the answer is yes, we are trying to achieve a higher gross margin since we carry more land because land banking is not available today.

Nishu Sood - Deutsche Bank

So that the 20 that you mentioned that you're roughly targeting right now, that was say what 17 or 18 a couple years ago or during the boom?

Steve Hilton

Let's say 18.

Operator

Our next question is coming from the line of Josh Levin, Citigroup. Please proceed with your question.

Josh Levin - Citigroup

If demand stays at the current levels, do you think that will affect your plans for rolling out new communities?

Steve Hilton

No, I think it's more important than ever for us to get in the new communities because we are seeing even in the slower times over the last couple of months, the newer communities are performing dramatically better than older communities. So it's still very important for us to get into new lots at lower price points with more finely tuned product that we can complete with the resale housing market. So I think we are going to be prudent and careful not to overpay for lots and not to get caught up in any lot buying fever but, it's still very important for us to replace older lots with newer lower priced lots.

Josh Levin - Citigroup

Okay. And last question. Can you share any information about traffic and trends in July relative to June?

Steve Hilton

I'd say July was pretty much on par with June disappointingly. We haven't seen significant improvement in our July sales rate.

Josh Levin - Citigroup

Okay, but it hasn't been worse than June?

Steve Hilton

No.

Operator

Our next is coming from the line of Stephen East with Ticonderoga Securities. Please proceed with your question.

Stephen East - Ticonderoga Securities

If we can talk just following on Josh's question a little bit about community growth. Sort of clumping of questions around. What you expect the rest of this year, and when you look at those new communities, in addition to the gross margin bump do you have a different SG&A profile, I'm thinking really selling expense there? And when you talk about your normal margins, are you talking about from a gross margin perspective or the OP margin perspective?

Steve Hilton

Stephen our strategy really is more quality over quantity and what we want do is replace older communities that are having, experiencing very low absorption rates with newer communities where we get much higher absorption rate. So we can increase our volumes just by replacing these older communities not necessarily adding a lot of communities. So with that said, I think our community count will start to trend north but very modestly because we still have a lot of older well margin weak performing communities to get through and replace, and we are targeting certainly the higher margin we talked about. Larry you want to add on to that?

Larry Seay

Sure I would add two things on the gross margin side of things one of the reasons why our gross margins in our newer communities are out performing the older communities are not only the [lot] prices we are getting which is much lower, but its is because of that additional capital charge that we are factoring into cover having that asset on balance sheet. On the overhead side of the subdivision, since we are getting better absorptions from that newer, subdivision certainly as a percent of revenue we would see the overhead covered better on new subdivisions too. So that would result in a better and operating margin to from covering the G&A better.

Stephen East - Ticonderoga

When you talk about near normal margins is that from a gross perspective or margin perspective?

Larry Seay

Its more from the gross perspective obviously we still have to as we said earlier in our comments we need to focus on growing revenue to better cover true G&A at the division and corporate level and also cover our interest expense better at the company wide level. So, we still need to grow revenue to cover those items better.

Stephen East - Ticonderoga

And then Steve, you had mentioned that trends postings at the end of the quarter were similar to June. Are you seeing the need to accelerate concessions on pricing? And then how much lower was June as you went through the quarter, say versus April?

Steve Hilton

Well, I would say May, June, July were kind of all very close to each other. We haven't seen a modest decrease there. It was increase or decrease, haven't seen a significant increase or decrease since we experienced a significant drop in activity in May. So it's been pretty flat for the last three months. We are selectively incentivizing certain communities to help us maintain volume level so we can lease leverage some of our overhead but we're being very careful not to dramatically cut prices across the board.

Operator

Our next question is from Bose George with Keefe, Bruyette and Woods. Please proceed with your question.

Jade Romani - Keefe, Bruyette and Woods

This is Jade Romani on for Bose George. Can you provide any color on your tax segment, including sub markets, as well as any possible impact from the oil spill?

Steve Hilton

We're not seeing a direct impact in Houston from oil spill. I would say all of the markets in Texas right now are performing similarly I wouldn't say there's a one market that's doing dramatically better than the others, again certainly some of our newer closer end locations we are able to buy lots of deep discounts and are doing better but I would say just Texas is pretty consistent market-to-market.

Jade Romani - Keefe, Bruyette and Woods

And is it possible to quantify the impact of community closeouts on the gross margin? And if you expect this trend to continue in the second half of the year?

Steven Hilton

Larry do you want to take that one?

Larry Seay

Sure. Well we do thing that adding the new subdivisions and selling out of the old subdivisions will trend our margins up, on the other hand with their sales being slow that may offset the impact of that somewhat so we are not as positive as seeing a continuing trend of things may be more stable for a while but over the long run where the new communities replace the older one we would definitely expect to see a trend upward in gross margins.

Operator

Your next question is coming from Carl Reichardt of Wells Fargo. Please proceed with your question.

Carl Reichardt - Wells Fargo Securities

My first question just a follow-up on [positives] in terms of the sequential decline in gross margin which you said is a function of fixed and lower margin stores was that purposeful knowing that the tax credit was going to expire? You had a chance to actually build out and sell through some of the older communities and accelerate the turnover, or was that something you weren't expecting?

Steve Hilton

No, there was by design. We didn't expect the gross margin to come down that much but we do want to get out as these older stores and be able to concentrate or overheard into this newer communities and move forward that always been our strategy and we probably build some more specs selling into the tax credit but again as we said earlier, we are comfortable with the level of specs we have today. When you are competing heavily against the resale market I think it's important to have those and so yes that's definitely part of our strategy.

Carl Reichardt - Wells Fargo Securities

Then just on the 2400 or so lots you added during the quarter. What percentage of those are finished now or will be by the time you take them down versus requiring you to invest development dollars? And then just as you're looking out at the land market, it seems to have altered a bit in the last quarter or so. Are you actually seeing now more finished lot deals that makes some sense or still a good size proportion that are going to require some capital guide?

Steve Hilton

Well, it's actually just the opposite. I mean we are starting to see less finish lot deals and we are pursuing more development opportunities because we think that's where the better buys are going forward. With that said I don't know that we bought a lot of undeveloped lots in the quarter. Larry, I don't know if you have that number?

Larry Seay

I don't have the number but the great, great majority were finished lots.

Steve Hilton

I can tell you of all the lots that we own or control, only 11% of them required development, is that right Larry?

Larry Seay

Correct. That's overall number of the 14,000 we control.

Operator

The next question is from the line of Joshua Pollard with Goldman Sachs. Please proceed with your question.

Joshua Pollard - Goldman Sachs

Steve, what do you think is a breakeven number of deliveries in a quarter to get you to bottom line profitability, given your overhead profile?

Steve Hilton

It depends on our pricing and our margin but on the first quarter of this year, we believe we delivered 808 homes and we were just slightly above breakeven so I say its 800 to 850 range that we can deliver somewhere in there depending on what the mix is and what happens with prices you should be able to breakeven there and above that's profit.

Joshua Pollard - Goldman Sachs

When you think about that mix, is there anything in that mix that is regional? I mean, just look at your community count, sort of down 25 in Texas, up 18 in Florida. I recognize that that's a function of where you guys are opening new. But are there material differences in your margins across the regions right now?

Steve Hilton

Only to the extent that in certain states we have more new news and old. So, California is almost new, so to the extent we can deliver home in California margins are going to be higher, and then it goes from there so in those markets we've got rid of older legacy lots the margins are going to be higher.

Joshua Pollard - Goldman Sachs

Where are the longest majority of your older communities, I am assuming Texas but?

Steve Hilton

Texas, Larry I mean.

Larry Seay

Well Texas, Nevada and Arizona.

Joshua Pollard - Goldman Sachs

Okay and then the last follow-up is when you think about closing out of communities are the close out communities of level of gross margins greater than that 500 to 600 discount you said with respect to old communities versus new and if you can also, give us a sense of how many communities you plan to close out of in the back half of this year you gave the sort of 20 to 25 number for the number you want to open?

Steve Hilton

Larry, do you want to take that?

Larry Seay

Sure, I will take the first question or the last question, we will be closing out at about equivalent number of communities that we are adding so we don't expect our community count to go up by much maybe it will be stable or go up a little bit and as far as the margins, in some cases, we do have a close out community where we decide to go ahead and build up the last few odds and maybe accept a little lower margin but that's not completely true, but in certain instances it is, but as a whole I'm not certain of those last close out communities definitely get lower margins than the other older communities that probably happens in some cases but it's not a given.

Joshua Pollard - Goldman Sachs

Okay. Can I sneak one last one in?

Steve Hilton

Sure.

Joshua Pollard - Goldman Sachs

If we are at this pace for the next call it two or three months, do you start to re-enter the potential write-down cycle for some of your older communities? I know price is a bigger determinant. But if you start to come in well below what you guys were thinking when you did your last round to write downs, which is I'll call it fourth quarter of '09, that can pace alone drive you to a smaller write-down cycle?

Steve Hilton

I don't think so. I think we have to be longer than two or three months before we be impairments again.

Larry Seay

But our pace has an impact but not as soon as in impact prices more of the factor. And we've also in our newer communities we are buying these at normal kind of underwriting standards. So there's a huge cushion our entire margin before we would start to have any impairment on those. And then even on our older communities where we've been able to put new product on and improve the community, we've built up a cushion on the margin there even though it's not a strong as the new communities. So, there have to be pretty significant price erosion before we've seen material impairments again. And could I clarify one thing? On the 11% of lots that are not finished, that's actually 11% of the communities we own, the lot percentage is somewhat higher because of the active adult communities that have longer term phases that are undeveloped. So 11% relates to the number of communities we own that are undeveloped.

Operator

Our next question is coming from Alan Ratner, Zelman Associates. Please proceed with your question.

Alan Ratner - Zelman Associates

I am not to be a dead horse here but I was hoping just kind of walk through some of the math on the gross margins. So if you assume your guidance of getting to about 35% of sales or closings by fourth quarter come from new communities that should give you about a 100 basis point mix benefit on the gross margin.

Kind of thinking about the next two quarters, would you expect obviously this sequential decline is a bit surprising to us. Would you expect that margin based on what you know on price and the cuts that you've had to make in June and July to support some volume, would you expect that 100 basis point mix shift is enough to keep margins relatively flat or at least may be a little bit higher for a year, or have the price cuts been enough on a corporate scale that you might see some deterioration?

Steve Hilton

We would hope that it would be enough, I mean one of the things that we are finding strictly over the several weeks is our new communities are performing dramatically better than our older communities and the mix of new communities is higher so I think we are thinking our July sales about 50% of our sales are coming from new communities even though, new communities only represent about a 30% of our total communities.

So hopefully the volume is coming from the new communities will offset the potential decline in some prices. Larry, do you want to add to that?

Larry Seay

That's what we certainly are expecting and hoping for although in this environment, it's very difficult to say what sale trending are going to be over the next few months and how that may impact margin but as I said earlier we would hope that, we would at least be stable and as we continue to add these new communities that would again start to drive up our margins overall.

Alan Ratner - Zelman Associates

Okay. So in terms of the price concessions you've had to make so far, that has not been enough to kind of offset that expected benefit you see. So any decline would have to come from incremental price cuts that you make in the back half of the year? Is that kind of the best way to talk about it?

Steve Hilton

Yes, that's fair statement, we have not made that much concessions to-date, we have been relatively minor.

Operator

Our next question is from David Goldberg with UBS. Please proceed with your question.

David Goldberg - UBS

I was hoping we could spend a little bit of time talking about the Lyon's Gate community and getting a better idea how you evaluate the success of that community. Is it just sales rate? Is it a pricing benefit that you get?

And with that, I'm kind of hoping we could also talk about, Steve, you said in the prepared remarks, you see there is a competitive advantage, because you guys offered standard in the community and a lot of people offer it as an upgrade. Certainly, a lot of the public builders are starting to think about the environmental and the green movement and integrating that into their offerings more.

So, I guess the first part of the question is how are you evaluating the success of that community relative? And the second part of that first question is really about, how sustainable you think that competitive advantage is relative to your peers?

Steve Hilton

Well let me take it from high level, we like other builders are thinking of everyday about how we can compete with resale. 92% of the homes are sold in this country today are resale or I like to call them used home and we got to figure out how to take some of that market share back and one of the ways I believe that we can do that is by offering a product that has lowering operating cost, higher energy efficiency lower utility bills etcetera.

So if we can build green and or high energy efficient communities that get us above average absorption rates and margins that are comparable within our underwriting standards and within our expectations and I think it's a success.

So you know at Lyon's Gate sales pace and absorption rate is going to be the critical thing that we are looking at it's a good in flow market there in Gilbert that's very competitive, we have other national builders within the same community within close proximity and as we can capture more market share then I think it will be successful and we will pilot it in other places and continue to explore pushing that strategy.

David Goldberg - UBS

Just to summarize, make sure I understand, it's fair to say that you feel like you're taking market share maybe from other builders but more importantly from the existing home market as you kind of sell total payment to the buyer?

Steve Hilton

Yes. I mean absolutely its hard to quantify, where you are getting the buyer from, but certainly you can see we are selling seven or eight houses a month and grant [axis] next door and their selling two houses a month there's got be a difference and difference maybe in the energy efficiency component and so that's a positive on the other hand, if we don't have a lot of new home competition around us and some more little pilot here and we've giving you above the average absorption rates, then clearly, we're taking new home business or taking resale home buyers and turning them into new home buyers.

David Goldberg - UBS

I know we kind of talked about this. You talked about it in your opening remarks and in the Q&A session. But I want to put a little more fine line on the question of this concept of protecting profitability and not offering more incentives and maybe sacrificing some sales volumes. Do you have some kind of metrics that you look at where you say look if we fall below this level of sales or this kind of activity then we need to start matching incentives?

Because it seems like the way this goes, it's like one builder starts offering incentives, the other builders in the area kind of lose some sales and so everyone kind of has to follow. I'm just trying to get an idea how long you can kind of stay out of playing that game against everybody else. And how you evaluate that from your perspective?

Steve Hilton

Well I don't know if everybody is out there wholesale discounting their home. Not yet and they be not at all but we will see but I think the metric that we're looking at is break even. We want to stay in the black and to the extent that we can discount and stay in the black. Well, that's what I have to do. But beyond that, we can do is keep our losses to a minimum. We're just managing the profitability and covering our overheads and it's pretty simple in a way looking at I think.

Larry Seay

David, at some point too, we'll start looking at the overhead and starting to make adjustments there to bring down or break even point.

Steve Hilton

And we already are but because like we said earlier we didn't expect to drop off to be as big as then and so we have to adjust our strategy to that.

Operator

Next question is from Dan Oppenheim with Credit Suisse. Please proceed with your question.

Dan Oppenheim - Credit Suisse

I was wondering if you can talk a little bit more in terms of the absorption. You mentioned that the communities are about 30% of the communities but close to 50% of the current orders. That would seem then that the absorption is basically more than twice as high for those and that the older ones are very low in terms of the absorption right now, thinking about where you are in terms of the May, June, July pace of sales. What do you think about in terms of just needing what sort of pace per community do you need in terms of the older communities before you start to try to move through those more quickly?

Steve Hilton

Well, we need to keep them at a pace that we are selling houses and not creating impairments. If we can sell one to two houses a month in older communities and get through them. I think and be possibly profitable, I think we would take that.

Dan Oppenheim - Credit Suisse

And secondly, in terms of land, when you're looking at new land purchases right now, are you able to get the numbers to work using the current sort of June, July pace of order trends or do you have to use something more normalized?

Steve Hilton

Well we are benchmarking underwriting new land purchases based upon the performance of our new communities in June, July and then in the August. So, we still have communities that we purchase that are achieving acceptable absorption rate. So, we are very focused on studying very current data on the resale housing market, and looking at trends and what's happening in the last six, seven, eight weeks in the resale housing market with prices and underwriting our new acquisition to those numbers.

Larry Seay

Dan, the out performance of the new subdivisions, is what's giving us more confidence that our market research and analysis is correct. Because they haven't been as impacted by the sales slowdown as the older communities have. So it just reinforces our sale lot of old and get to new as soon as possible.

Operator

The next question is coming from Jim Wilson with JMP Securities. Please proceed with your question.

Jim Wilson - JMP Securities

I was wondering, you gave a good breakdown Q2 lots acquired and where they were. Larry, do you have P&D of the (inaudible) you required in the last 18 months, roughly what that geographic breakdown has been?

Larry Seay

I don't have that of the top of my head. But it's been more in California, Arizona, Colorado and Florida and none in Vegas and some in Texas.

Steve Hilton

We will try to give you more detail on that certainly next quarter for sure.

Jim Wilson - JMP Securities

Okay, great. And just wondering, of any of your submarkets whether the sales pace is any better or worse. And I guess secondly, how much I guess on the margin going forward the geographic mix of communities might change further. Sounds like in Q2 you did start to pick up more in Texas. So if we look at the end of the year, would the geographic mix of community locations be fairly stable?

Steve Hilton

The only thing we can really say to that is again the newer communities from the culture and locations where the difference between today's housing prices and the previous peak prices is greater are doing better and but there is no one market or two markets and that are doing significantly better than others for any other reason, other than we may have more communities in those market, we got newer communities in those markets.

Larry Seay

I'd add to that I do think longer term you will see more market, more of our sales in closing shifts outside the Texas. So Texas will become a smaller portion of our total business as for the other market recover more so that's a long term trend you should see.

Steve Hilton

Let me just add there Larry its really important, we convey the message that we are very focused on maintaining our market share in Texas. Even though we are diversifying into other markets we still want maintain our share in those markets particularly our dominant shares number two or three builder in Dallas and Houston and that's important, we don't tend to give that up.

Larry Seay

It isn't as if Texas was falling if the other one growing back faster?

Operator

Our next question is from (inaudible) of Housing Research Center. Please proceed with your question.

Unidentified Analyst

I wanted to see if you could elaborate a little bit further on Texas just wondering if you are seeing more competition, from the bigger guys there in terms of them being more aggressive cutting prices or raising broker commission that kind of thing.

Steve Hilton

I wouldn't say anything different than it was in the first quarter. We certainly those from time-to-time become more aggressive in the pricing strategy but I haven't seen any kind of real shift in the market today versus it was in earlier in the year.

Unidentified Analyst

Okay. And the other thing I wanted to when we talk about profitability through the back half of the year, is that just at the operating level or at the EPS level also?

Steve Hilton

At the EPS level.

Operator

Our next question is from Jay McCanless of Guggenheim Partners. Please proceed with your question.

Jay McCanless - Guggenheim Partners

Couple of housekeeping question and a strategic question. First one, what was the spec count at the end of 2Q?

Steve Hilton

I believe it was 540, 580 total specs.

Jay McCanless - Guggenheim Partners

And then, on the incentives, can you give me the average dollar value or what percentage of the sales price was given then incentives for 2Q?

Steve Hilton

I don't know that off the top of my head. It varies from subdivision to subdivision.

Jay McCanless - Guggenheim Partners

The strategic question is assuming that the pain that the public builders are showing from the slow sales paced right now is translating down at the private level is the deals flow for potentially buying from some private builders and accessing some lots in a quicker fashion or are you seeing more that? Are you seeing getting more calls from people who are willing to sell out right now?

Steve Hilton

No. And frankly, this isn't a lot of private builders could buy. They don't have anything that a lot of people be interested in. so, I just don't see going forward volume of public buying privates to be significant. I think most of privates that publics are interested is going out of business. We are getting there a lots in other ways from the lenders. I just don't think that and also I think that even though things have slowed down the two or three months we are not seeing whole price cuts on loss from lots sellers whether they be land developers or lenders that people kind of holding on.

Jay McCanless - Guggenheim Partners

Is that ultimately you think are going to you guys to at least look at some of these FDIC deals or doing more from the banks than you are already doing?

Steve Hilton

Probably not I mean those FDIC deals include a lot of different things commercial properties, and home loans and broken down development deals and they include a lot of things but generally we are not interested in. So, we would like to get pieces of some of those deals but its probably not our strategy to form this time to form an entity to pursue those kind of deals.

Operator

Our next question is from the line of Michael Kim with CRT Capital Group. Please proceed with your questions.

Michael Kim - CRT Capital Group

During the second quarter you purchased roughly 1100 lots an average price of $50,000 per lot. Can you talk about pricing on a per lot basis by regions of these takedowns? I know you mentioned Orlando, Northern California, Denver, and Phoenix and also any color on pricing trends year-to-date would also be helpful?

Steve Hilton

I don't want to get that specific on exactly what we paid in each individual region I mean that's pretty granular but as I said on a previous call, the previous question opportunities

are presenting themselves this quarter, we didn't see last quarter because of the slowdown but we are not seeing significantly lower prices. Prices, they are kind of holding up, that would certainly see some of our peers pulling back and fewer deals been done.

Larry Seay

So the average price is up from last quarter simply because we bought a few more lots proportionately in California which generally are more expensive even we bought more lots last quarter in Arizona and markets were less expensive. So that's why that increase is happening. I won't read anything into that particularly about overall lot pricing.

Michael Kim - CRT Capital Group

And Steve, you mentioned you're seeing better value in unfinished, undeveloped lots. Do you have any interest in joint venture activity for these land parcels or do you see the JV structure coming back at all?

Steve Hilton

We pursue selected joint ventures with land developers who are the builders but I think we certainly learned some lessons with respect to joint ventures from the past and we are going to be careful not to make the same mistakes again but structured correctly we would be interested.

Steve Hilton

So we are taking two more questions, operator.

Operator

Our next question is from the line of Joel Locker with FBN Securities. Please proceed with your question.

Joel Locker - FBN Securities

Just got your total spec count. Do you have a finished spec count?

Steve Hilton

Well 52% of those are finished.

Joel Locker - FBN Securities

Okay. Just one more quick item on the customer deposits. Do you have that, what it was at the end of the quarter versus backlog?

Larry Seay

Now, I probably have it around here some place, sits about $8 million of the top on my head but I have to check that, it's in $7 million- $8 million range.

Joel Locker - FBN Securities

Just one theoretical question on the California tax credit. Should expire around the September period. That'll be the first time in about 18 months that they haven't had any credit or may 15 months or so. And just was wondering if you are doing anything internal to prepare for that or that was even on the radar?

Steve Hilton

I am open to suggestion what we could do.

Joel Locker - FBN Securities

Or just maybe buying less land or just preparing in anyway benefit?

Steve Hilton

Yes. I mean probably we are doing some things on the marketing side promotion wise to try compensate for that, we are very careful what we buy in California, Some of the recent buys we made last quarter were very bullish about because they were very well located in sites that we think are going to have very well received when they come to market.

Joel Locker - FBN Securities

Alright thanks a lot guys.

Steve Hilton

Deposit number $8.7 million.

Joel Locker - FBN Securities

$8.7 million thanks.

Operator

Thank you, gentlemen there are no further questions in the queue at this time, I would like to turn the call back to management for closing comments.

Steve Hilton

Well thank you very much we appreciate your participation and you following Meritage and we look forward talking to you next quarter. Good day.

Operator

This concludes today's teleconference; you may disconnect your line at this time, thank you for your participation.

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Source: Meritage Homes Corporation Q2 2010 Earnings Call Transcript
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