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Meritage Homes Corporation (NYSE:MTH)

Q3 2010 Earnings Call

October 28, 2010 11:00 am ET

Executives

Brent Anderson - VP of IR

Steve Hilton - Chairman & CEO

Larry Seay - EVP & CFO

Analysts

Joshua Pollard - Goldman Sachs

Dan Oppenheim - Credit Suisse

Ivy Zelman - Zelman Associates

Robert Hansen - Deutsche Bank

Stephen East - Ticonderoga Securities

Jade Rahmani - KBW

Josh Levin - Citigroup

Carl Reichardt - Wells Fargo

David Goldberg - UBS

Jim Wilson - JMP Securities

Alex Barron - Housing Research Center

Operator

Greetings and welcome to the Meritage Homes third quarter 2010 conference call. (Operator Instructions). It is now my pleasure to introduce your host Mr. Brent Anderson, Vice President of Investor Relations for Meritage Homes. Thank you Mr. Anderson you may begin.

Brent Anderson

Thank you, Manny. Good morning. I would like to welcome you to the Meritage Home’s Third Quarter 2010 Earnings Call and web cast. Our quarter ended on September 30 and we issued a press release with our results from the quarter after the market closed yesterday. If you need a copy of the release or the slides that accompany our web cast today, you can find them on our website at investors.meritagehomes.com or by selecting the Investors link at the top of our homepage.

I will refer you 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 the 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 Vice President and CFO. We expect our call to run about an hour this morning, and a replay of this 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'll now turn it over to Mr. Hilton to review our third quarter results. Steve?

Steve Hilton

Thank you, Brent. I'd like to welcome everyone to our call today. I'll begin with an overview of our third quarter operating results and recap our progress on our strategic initiatives which we are still in for the last couple of years. Before turning it over to Larry, for a more detailed review of our financial results.

Let’s begin on slide four. I’m pleased to report that we were profitable again this quarter making it four quarters in a row of positive net income and three quarters of positive income before tax benefits.

We generated net income of $1.2 million or earnings of $0.04 per share on $234 million of closing revenue which was a big improvement over last year when we reported a third quarter loss of $17.8 million or $0.56 per share on revenue of $232 million. One big difference is that we had less than $1 million in impairments this year compared to $13 million of impairments last year.

Please turn to slide 5, our home closing revenue increased slightly despite a 16% decline in home closings due to a 21% increase in our average closing price which I will explain. Our average closing price rose to 275,700 per home, the third quarter of 2010 from 228,400 a year ago. The year-over-year increase reflects a couple of shifts in our mix of homes closed. Resident actual home price appreciation in our communities.

More of our closings came from states and communities with higher average prices, for example California, Colorado and Florida, currently we have the highest average prices of the states we operate in. Together they made up 28% of the total homes to be closed in the third quarter this year compared to 16% of our closings in the third quarter of last year. Our total closings in those three states were up more than 15% year-over-year.

On the other hand, Texas made up 15% of our third quarter closures this year compared to 60% last year as a result of the intentional rebalancing of our markets. On average closing prices in Texas are approximately 253,000 in 2010 was much lower than our average prices in California, Colorado and Florida which were approximately 391,000, 323,000 and 283,000 respectively.

In addition to the mix shifts between states, we are also experiencing the shift in our mix of buyers. We had a larger percentage of move up buyers this year compared to more first time home buyers at lower price points last year. Over last few years many home buyers removed the product offerings down the price spectrum believing there is less opportunity in the move-up market this time. While we also pursue the strategy recently we had good success acquiring close in move-up lots in eight locations which other builders may have passed on.

Due to our lower acquisition price and construction costs we are currently able to sell homes in these communities at dramatically lower prices then we were able to just a few years ago offering tremendous value and opportunity for Home buyers. Slide six, the increase in our third quarter net income was primarily driven by margin improvement.

Our third quarter reported gross margins on home closings were 18.2% in 2010 versus 10% in 2009 after impairments or 18.5% versus 14.5% excluding impairments in both years respectively. The year-over-year improvement was a result of system wide cost reductions that were achieved through our Meritage forward strategic initiatives as well as higher margins we’re achieving in newer communities built on lower price logs.

Those gains have helped offset margin depression from additional concessions we made in some communities. We made continued progress in replacing our older communities with newer ones opened on lots we’ve acquired since the beginning of last year. Homes closer to our newer communities generated approximately 600 basis points higher margins in the third quarter than we averaged in our older communities.

The improved margins we’re achieving in our new communities are the result of success in each through our major initiatives. Our lot costs are lower due to excellent acquisitions based on strategic market research. Our construction costs are lower due to simplified designs improvements in purchasing and greater construction efficiencies which have reduced both material and labor cost.

And our new plans allow us to build deliver homes faster without sacrificing quality. Approximately 44% of our sales and 31% of our closings in the third quarter of 2010 came from communities we acquired since the beginning of last year. By comparison new communities accounted for 13% of our sales and 6% of our closings in the third quarter 2009. We have opened 16 new communities on recently acquired lots during the third quarter.

We already own or have on a contract an additional 29 new communities we planned to open over the next several quarters. Slide 7, our new communities include several state-of-the-art extreme energy efficient green communities in Arizona. I spoke about our Lions Gate community in Gilbert Arizona last quarter.

It was the first of its kind in the nation and generated great deal of interest by the media contractors, public officials and even many of our competitors. Customers find these high energy efficient green homes very compelling. We built several similar communities in Phoenix and Tucson already.

Collectively they have been some of our best selling communities since they have opened and have been selling to significantly higher average sales space in our other communities as well as our competitor communities. We call them extreme energy efficient green homes because they offer up to 80% energy savings over the average existing homes in the US. We design them from ground up to offer fully integrated system of standard features used in the latest energy efficient technologies which is much more effective that built on features sold as options in other homes.

We achieve cost efficiencies by standardizing these features in very home within these communities and no additional charge to our buyers. You know we talk about this often as we are very excited about what we are doing to be the leader energy efficient home building. I believe as one of the most important strategic initiatives and that has the potential to be a real games changer within the home building industry. Slide 8, our sales in the third quarter were 36% lower than the prior year and our cancellation rate was 24% compared to 20% 2009. The decline in sales was partially due to 12% decline in our average active communities. We had an average of 149 active selling communities in the third quarter 2010 compared to a 170 in the same quarter last year. That is the main reason for the 42 decline in our Texas sales, a 24% fewer communities on average in the third quarter of this year then last year in Texas.

We closed down many older marginal communities in Texas over the last year and are beginning to reload on newer communities there. Majority of our new communities in the last seven quarters have been added in other states like California, where the average active communities increased 19% over the third quarter of 2009 and Arizona which has 10% more active communities on the average then a year ago. In addition, the fewer communities in total our sales per community fell to 4.7 in the third quarter this year from 6.1 in the second quarter and 6.5 in the third quarter of 2009. All those are well short of where we would like to be increasing our sales pace represents our greatest opportunity to increase earnings by leveraging our current infrastructure.

All we've reduced our overhead this quarter and could reduce it further if business running in slow, we will prefer to grow our revenue and earnings by increasing our sales pace and growing our community count over time.

We can nearly double our sales from revenue with very little additional overhead by getting our sales per community back to the nine to 10 per quarter range where it was before the housing boom.

We had a 12% increase in our average sales price year-over-year for the reason I described early which partially offset the 36% decline in homes sold. The increases by state range from 3% in Las Vegas to 32% in Arizona. Even though our average sales price in Arizona is slightly lower than our company wide average.

The light of the lower sales levels we have experienced in the last couple quarters in a lack of forward visibility we would anticipate lower closing revenue in the fourth quarter which could make it more challenging to maintain profitability in the next quarter. We have taken additional steps to control our cost both direct and indirect while retaining our organizational talent and advancing our strategic initiatives. It’s difficult to predict when our confidence will return, the market will strengthen but we are optimistic that we will see some improvement next year.

Now I will turn it over to Larry Seay, our CFO, to review some additional details of results for the quarter.

Larry Seay

I’ll pick it up on slide nine, commissions and other sales costs increased as a percent of revenue due to additional marketing expenses, some of which related to opening 60 new committees as well as some initial costs associated with new deconstructed models and the related educational materials for our extreme energy efficient communities. These deconstructed models are a key selling point for these communities as they provide a behind the walls view of all the energy saving features. Our G&A expenses were sequentially lower in the third quarter than they were in the second quarter by a little more than 1 million, primarily due to some staff reductions we have made during the third quarter. Compared to last year out total G&A expenses were up 1.4 million due to bonus accruals booked in the third quarter this year that we’re recorded in the fourth quarter of last year.

As Steve pointed out, we have a significant opportunity to leverage our existing overhead by increasing our sales per community and revenues which has a power to reduce our SG&A percentage and increase our earnings.

Slide 10, for the first nine months of 2010 our home closing revenue climbed 6% on a 1% increase in home closings combined with a 5% increase in our average sales price for the reasons Steve explained previously. We have achieved gains in a number of homes closed in California, Florida and Colorado which were up 48%, 49% and 5% respectively with the addition of higher average prices closing revenue in California and Florida increased 51% and 79% respectively. We close 6% fewer homes in Texas year-to-date partially due to 15% fewer actively selling communities on average in the first three quarters of 2010 compared to 2009. The reported net income of $8 million or $0.25 per diluted share for the first nine months of 2010 compared to a net loss of approximately $110 million or $3.52 per share in the first nine months of 2009.

Much of the improvement was due to lower impairment charges which were less than $2 million in 2010 compared to more than $90 million 2009. Partially offsetting the year-over-year improvement was a $3.5 million loss on the early extinguishment of debt in 2010 compared to a $9.4 million gain on early extinguishment of debt in 2009.

A $13 million swing in total, excluding those items our adjusted pre-tax income improved to $13 million for the first nine months of 2010 compared to a pre-tax loss of $27 million for the first nine months of 2009. Our differed tax assets which are fully reserved totaled $88.4 million at September 30, 2010 and are available to offset Federal and State income taxes on an estimated total of approximately $230 million of future taxable income.

That estimate may change going forward to the various state and Federal limitations on use of NOL carry forwards. Slide 11, we continue to replenish our pipeline of lots as we replace older communities with new ones. We purchased approximately 1600 lots for a total of $65 million during the quarter. We added new communities in every state we operate in accept for Nevada.

Eight of those communities and a majority of the new lots were in Texas where we are looking to replace those older communities we’ve already closed or expect to close out in the coming quarters. We now control approximately 14,500 total lots as of September 30, 2010 equivalent to a 3.6 year supply base on trailing to old months closings, still one of the lost in the industries. We own approximately 79% of those compared to owning approximately 63% of our total 13,200 lots at the same time a year ago.

We have acquired approximately half of those 14,500 lots since the beginning of 2009 and about a third of our actively selling communities are comprised of those recently acquired lots. Slide 12, our balance sheet is strong with the high cash balance and one of the lowest net debt to capital ratios in the company’s history. We ended the quarter with $420 million in total cash, cash equivalents restricted cash and short term investments.

That’s about 22 million lower than the end of last quarter and it’s the first quarter in the last year that our cash generated from operations do not outpace the total amount we invested in new lots and homes during the quarter. Considering that we expect to generate less cash in closings over the next couple of quarters based on slower sales recently. We could show a modest use of cash during that time as we continued to purchase new lots to replace those being sold.

Our net debt to capital ratio improved to 27% at September 30, 2010 from 35% at September 30, 2009. We ended the quarter with 591 total specs less than 4 per community of which 371 were completed. We generated approximately 40% of our sales in the quarter from specs versus new homes sorted under contract which also drove our conversion rate of 81% of beginning back log. We would expect our conversion rate to continue to be higher that in the past since we are focused on providing more spec homes that we can deliver quickly to compete effectively with the resales.

One final note we received a number of enquiries about our potential exposure to mortgage repurchases based on our recent concerns about the banks having to repurchase loans. We have very little exposure if any due to the fact that we have no captive mortgage operations and never have had any. The only exposure we have is a very small investment in three mortgaged JV’s approximately $1 million in total Meritage has never had to repurchase a mortgage nor have any of these JV’s.

Now I will turn it back over to Steve.

Steve Hilton

Thank you Larry. With the low prices and interest rates available to home buyers today affordability is very high which makes this one of the few times in history when you’d actually be able to own a home for less than the cost of renting.

Mortgage rates have already begun to move up slightly and inventories of homes to some of the best areas are shrinking. So the best one of opportunity may soon pass us. We are confident in our strategy and pleased with our accomplishments to this more challenging time for home builders. We are one of the first builders to return to profitability. We have a strong balance sheet with a relatively light supply of land, no near term debt maturities and significant liquidity which is enabling us to replace communities with lower price lots as we closed out our older communities. We have reduced our direct cost in offering and are offering new series of value priced homes that we can build much faster to compete more successfully with existing home market.

At the same time we are achieving high margins of sales velocity in our new communities. And I confidently could say that we are leading industry with most synergy efficient green homes available from any production home builder today.

Meritage is well positioned to be a strong competitor in the home building industry and I believe the successful execution of our strategic initiatives, this drives a sustainable competitive advantages from Meritage.

Thank you for your attention today we will now open it up for questions. Operator?

Questions-and-Answer Session

Operator

Thank you. Ladies and gentlemen we will now be conducting a question-and-answer session. (Operator Instructions). Our first question is from the line of Joshua Pollard with Goldman Sachs. Please go ahead.

Joshua Pollard - Goldman Sachs

First question is around your community town. The first thing I noticed is that you guys opened 16 new communities. That's relative to eight, last quarter. We're seeing this across a number of builders in this space, an increase in the number of new communities opened into a slightly more bearish environment. I'm trying to understand the rationale behind opening further communities in this environment. If you could shed any light on that, I'd really appreciate it.

Steve Hilton

We were land-light builder. At the peak of the market, 90% of the lots we controlled were on option. And as you know, we terminated a lot of those options and wrote off the option deposits which resulted in significant impairments. So, we dramatically dropped our lot count from around 50,000 to under 10,000. So we literally just ran out of inventory. I mean our shells were just literally bearish when compares to a store, and the only way we can sustain our business model is to replace these old communities that we got rid of with new communities.

We are little different than other builders who have loan legacy land positions and really don’t need to buy any lots to continue to have lots to build on. So for us, it’s more of a necessity, and it’s also part of our strategy to return to profitability because the profits are new lots you can generate from building homes are much greater than they are old lots because we are buying the new lots for a lot cheaper. You cannot impair your old lots or I should say most builders have not impaired their legacy lots to today’s market prices for the lots. So I think it has been pretty effective. We would have lost a lot of money if we hadn’t started buying lots early last year, because the profits on those are pretty high.

Larry Seay

Josh, I’d add in the quarter too, our community count really was pretty much stable and so is lot count. So, we aren’t necessarily bolting up on a lot of new lots and growing our community count rapidly. We are really focused on maintaining and gradually where it is prudent growing, but at that slow pace particularly considering the current environment.

Steve Hilton

I mean up to now it’s been more of a replacement strategy to replace the old with the new that we can get higher margins, there are better locations and we can generate higher absorption rates.

Joshua Pollard - Goldman Sachs

My second question is just around what you guys are seeing in October relative to September, and I'd love if you guys could talk about within your markets what you're seeing for new homes versus existing homes. We're starting to hear a little bit in the channel that some of the myth around the mortgage putback and foreclosure moratoriums shifted some sentiment back towards new homes. I was wondering if you'd seen that, and then the second part of that question is 40% of your sale is coming from spec, you often talk about the difference between new versus old communities, but I'd love to understand at this stage of the downturn, what's the difference in profitability between your specs and your dirt sales? Thanks a lot guys.

Steve Hilton

Well, let me take the last part of your question first. If you manage your specs strategy correctly, there shouldn’t be a big difference between spec sales and dirt sales. And we are building more specs today than we had before, because a lot of the buyers today want a house immediately. Either they’re renters that don’t have a house to sell, they are looking to move or the people that have already sold their house and they need to move in the new house quickly or they’re relos. So, having more specs today in this environment is an advantage and we are trying to take advantage of that market dynamic.

Relative to our sales as everybody reported, I think our summer was dismal, pretty anemic we didn’t see significant change in sales, month to month from may until September. September actually, I think dipped a little bit down. We were pretty disappointed with what we saw in September. We thought September was going to be better. October is looking a little bit better certainly than September. There has been a little bit of improvement, but not enough for us to get excited and see that the winds are really changing. We have not seen anything specific from the foreclosure headlines that we have seen lately, but we can point to where there’s a shift in the market, it’s been pretty flat for the last several months, but a slight uptick in October. Operator, next caller?

Operator

Thank you. Our next question is from the line of Dan Oppenheim with Credit Suisse. Please go ahead.

Dan Oppenheim - Credit Suisse

Well. I’m just wondering, just about the thoughts in terms of shifting to do more in terms of move-up. You guys have been very good in terms of shifting from some Southwestern markets into Texas from move-up to first time, picking up new land. Just how much of a shift should we think about this now in terms of sort of the higher price points and how much land are you looking for in terms of accomplishing that?

Steve Hilton

We are just trying to be more opportunistic. So, if we can find a suburban infield that we think is a double-A location and there’s going to be a lot of demand for, and there is no competition, even though it might be a little higher priced we are going to take advantage of it. But I can give you guidance on emerging trends as to where it’s going to go. We are still trying to drive our average price down although it’s jumped up significantly because of those acquisitions we’ve made recently. But Larry, what can we say there?

Larry Seay

Yeah, I guess I would add that we have said that we want to drive about two-thirds of our business to be entry level and first time move-up, and I guess I would emphasis more of the first time move-up than entry level of the 65 to 70% of our deliveries this quarter that were in those two categories. Two-thirds of that 65 to 70% were first time move-ups. So, I think we have to be careful that people aren’t hearing entry level too much and they recognize that still most of our business is first time move-up, although certainly the second time and third time move-up has dropped dramatically and is today only around 25 to 30% of our business.

Dan Oppenheim - Credit Suisse

And just a quick follow-up. I was wondering in terms of, you talked about the absorption of the newer communities being better and also those having higher margins. If you think about the older communities with the slower absorption there and sort of the drag, what do you think about in terms of pricing given with, I mean in terms of sales per community, those right now are sort of being below the average. Are you going to be more aggressive to try to work through those older communities?

Steve Hilton

Well, I don’t think we are motivated to try to trigger our impairments and dis-cap those houses. It’s not like we need to generate more cash because we can have some debt. We have some use of the cash and we still have a heft cash position in our balance sheet. So there is not a lot of motivation as long as we are breaking even to plough through those committees at a faster pace. There is just not a lot of strategic advantage to doing that at this time, and I think as long as we can maintain a list of breakeven sales pace on those older communities we’ll model our way through till the market improves.

Operator

Our next question is from the line of Ivy Zelman with Zelman Associates. Please go ahead.

Ivy Zelman - Zelman Associates

The questions I have really kind of just feedbacking a little bit on Dan, your sales pace right now in terms of this quarter would be obviously less than the sales you generated in the prior quarter and you were able to basically make a million bucks in this quarter. So, as we think about your breakeven, it looks like we're looking at 1.6 houses a month, a little bit maybe making money on that. But what can you do to reduce the breakeven and continue, if anything, to take out costs? And I guess the good news, Steve, is that you are not really looking to discount and further reduce pricing. It sounds like the industry is being more rational. But if sales don't improve and is it possible that you can wind up losing money again if we don't see an improvement given the weakness in demand right now, or are there more costs to come out?

Steve Hilton

I think most of the costs have been taken out and there is not lot of cost left to get out unless we are forced to reduce costs even further. I think our strategy is to continue to try to bring on new communities with higher gross margins, which in essence lowers our breakeven point as we increase our gross margins.

Back to the earlier part of my response, we can always reduce costs, but I think it’s our strategy just to try to keep our team together, keep our important people on the field and expand our revenues as the opportunities present themselves. Larry, you want to jump on that?

Larry Seay

Yes. Our breakeven point for the quarter is around 800 to 810 homes and because we did have some cost cuts during the quarter we are just going to all fully impact the quarter I believe that breakeven point now is down below 800, probably in the high 700s. So, we can cut costs, it is possible. We are taking the position in the fourth quarter of waiting to kind see how the spring selling season turns out, and if that turns out not being a little bit of a bump up, we could be forced, as Steve said, to start taking cuts back. We are not planning in the next couple of quarters to start cutting. We are going to focus on increasing sales and not cutting costs.

Steve Hilton

We did actually have a lay-off in September. I think we reduced our headcount to 7 or 8%.

Ivy Zelman - Zelman Associates

Well, it’s a tough environment and certainly you guys are outperforming your peers. Just to ask a more specific question on spec. Can you give us the numbers relative to 2Q and what they are for community, and I am recognizing that hopefully we are moving through a lot of that but where are you guys in those numbers please?

Larry Seay

Are you asking what our total spec count was last quarter, compared to this quarter?

Ivy Zelman - Zelman Associates

Yes.

Larry Seay

Yes. Our total specs at the end of last quarter was 630 or 579 specs versus 591 at the end of the third quarter. And of those, 303 were finished last quarter and 371 were finished this quarter.

Ivy Zelman - Zelman Associates

So Larry, just as Steven finishing on that thought about pricing pressure, it sounds like the industry is being more disciplined. Would you say that that's the case and even with specs still out there that we're not seeing discounting as much as you would have expected in the weak environment we're in? What’s your general thoughts on pricing?

Steve Hilton

I think that’s a fair statement. I think generally most of builders are being pretty disciplined and pulling the line on pricing. I think we are seeing some discounting, and some locations would tend to be more the farther out, more remote locations. But generally, we are not seeing the heavy price cuts that some people may have predicted right now.

Larry Seay

We are also being very, very careful in starting the right specs in the right place. We are starting specs that tend be a lower price, we are not putting a lot of options in them. We are making sure that the model types were starting in each community are the model types that are in demand. So we are being very, very careful about what specs we start, that’s the spec strategy that Steve talked about earlier.

Operator

Thank you. Our next question is from the line of Nishu Sood with Deutsche Bank. Please go ahead.

Robert Hansen - Deutsche Bank

It's actually Robert Hansen on for Nishu. Just in terms of your geographic mix, Texas has come down a lot, and you mentioned you've got the higher price points elsewhere in the country. When do you expect Texas to ramp back up in terms of a share of closings?

Steve Hilton

Well, I don’t think it’s our strategy to increase Texas’ share of closings. I think as the market tailed down, Texas became a higher percentage of our sales and closing because the market in the Texas wasn’t affected as much, as well as in other markets. So we are really trying to rebalance our deliveries across all of our regions and with a heavier emphasis on rebuilding our business and certainly in California and Arizona and in Florida. So, we are going to replace a lot of our low absorption communities in Texas with newer higher absorption communities, but I don’t think it’s our goal to dramatically increase community count there.

Robert Hansen - Deutsche Bank

And now that you're going to be profitable pretty much for the whole year, have you begun to have any discussions with your auditor about putting the DTA back on the balance sheet?

Steve Hilton

Larry?

Larry Seay

Yes. We have had discussions and I think all of the builders are having discussions, but there’s still no clear strong profitability trend out there that has had people start to grow our lines, and they are saying when they could book them. I still think it’s going to be at least a couple of three quarters sometime next year, I think that people will start to rebook these. But it marks my conversation with our CFOs within the industry. I haven’t heard anybody saying, oh gee! We think we are going to book them right around the corner. So, I think it still .little weighs off. I think we need to book clear profit trends and the industry as a whole needs to show a little bit more improvement before that happens.

Operator

Thank you. Our next question is from Stephen East with Ticonderoga Securities. Please go ahead.

Stephen East - Ticonderoga Securities

If we talk about the communities a little bit, I know you're not looking for a lot of growth. In ‘11 and ‘12, will we see any type of growth at all, I mean would we see a mid single-digit type growth out of it? And then, what type of crossover should we expect on communities from old to new, and then also how many energy-efficient communities do you have out there and is there any change in profitability from those versus your other ones, different selling prices, et cetera?

Steve Hilton

Well let me try to take few of those, if I miss one, come back to me. I don’t want to give guidance on what our new community growth rate is going to be, but if we do plan to grow communities next year, probably in the back half of next year and into 2012. So, community count should start to increase, of course that depends on what the market conditions are and if the market cooperates with us, but if market begins to gradually improve next year, our community count will grow with it

Regarding the energy efficient homes, we have four versions of energy efficient homes. Version 1 is what we are building in all of our communities right now, which makes them energy star qualified, and has eight different components and we are doing that in every community across cost of country. Version 2, when we take it up a notch and we include a spray form installation which dramatically reduces the hertz rating and makes the home significantly more energy efficient than version 1. We are doing that in every new community that we are starting January 1 in every market across the country.

In Arizona we’ve piloted what we call version 4, which is the super high energy efficient home. We have solar included as a standard feature amongst several other features which drops the energy costs by almost 80% against [reseller] homes. We are beginning to pilot those in every one of markets throughout the nation and we should have one or two communities open in every market by the end of first quarter of next year. And we will start gradually roll that throughout the entire system as we work in new communities in 2011 and 2012.

Stephen East - Ticonderoga Securities

Are those communities more profitable, the number four that you were talking about?

Steve Hilton

I wouldn’t say they are more profitable on a per unit basis. But I could the absorptions are higher. We are selling two to three times faster than our other non-extreme hires, are you associating communities than our competitors. So, we are now making more money because we are able to leverage our overhead and reduce our interest cost, because we are moving to the communities at a much faster pace.

Now again, we don’t have a lot of history because we’ve only been doing this since June, but in the communities we’ve got here in the Phoenix area, and we have four of them open here now, the absorption rates are much faster.

Stephen East - Ticonderoga Securities

Okay. And then you had mentioned that you had about 44% of your sales from new communities. As we look out over the next year, the changeover from old to new, what should we assume there as you replace the old communities?

Larry Seay

We’ve thrown a number out before last quarter. For the end of the year we were thinking we‘ll be at 40 to 45. We’ve exceeded that goal by getting to 44 in the third. So, we are hopeful we get to the 45 to 50 by the end of the year this year, and then next year we have gone out 65 to 70% goal. So we would hope to have almost two-thirds of our community is switched over to new lots, newly acquired lots with new designs by the end of next year.

Stephen East - Ticonderoga Securities

And then Steve, just one last question, could you give us an update on the land market and what you're seeing in the tact that you're taking in some of these areas that you want to grow?

Steve Hilton

Well, we are still buying lots and land. We are trying to be cautious. The market has softened slightly in most markets are been recent stopped going up. Prices have stabilized a bit. There seems to be a lot of situations, sort of stand-off between buyers and sellers as to what the values are, but we are still finding a very significant number of opportunities that we find compelling and to the extent that we have the capital and we like the asset and we are pursuing it.

Stephen East - Ticonderoga Securities

Are they primarily finished?

Steve Hilton

Yes, but I’d say we are buying more, we are partially finished in undeveloped lots now than we were certainly a few quarters ago, and the better buys are in the undeveloped or partially developed lots than they are in the finished lots.

Operator

Thank you. Our next question is from the line of Jade Rahmani with KBW. Please go ahead.

Jade Rahmani - KBW

I know you touched on the rep and warranty issues the mortgage industry is dealing with and your limited exposure, but I wanted to see if you could provide a sense for what historical delinquencies or foreclosures have been like at Meritage communities, and how you think these compare with existing homes in the areas where you're located?

Steve Hilton

We don’t we keep those stats. I have no way of telling you what the foreclosures would be in our communities. We unscientifically drive around and look at some of this For Sale signs, but I couldn’t give you any numbers that will be reliable. I sure they are probably in line with what you maybe seeing for most of the other public homebuilders, but again, we are only a mortgage broker. And these are our JV's, and our JV partner has all the liability for any mortgage putbacks and we've taken a loan back, and we don’t expect that we ever will.

Jade Rahmani - KBW

And just do you have a general sense that Meritage communities specifically or new homes in general perform better than the mortgages on existing home properties or is that not the case?

Steve Hilton

Yes, I think it would be hard to make that as a blanket statement. I think certainly since a higher volume of our business has been in Texas and there’s less foreclosures in Texas than there are in other places. We probably have less foreclosures in our communities than maybe other builders because 50% of business has been in Texas for quite a while now, and certainly there has been foreclosures in a lot of our communities in Arizona and California and Las Vegas like everybody else. But I wouldn’t say generally there is something better about our communities that makes them foreclosure-resistant.

Larry Seay

If I might add because about half of our communities are new now and they were purchased since the beginning of ’09. Certainly those new sales, there really aren’t foreclosures in those communities because they weren’t bought at that. I think all the foreclosures are coming from the older communities, and because we have changed over our communities faster than other builders, I think we have less competition within our existing communities and then some other builders that are still selling out of a community that’s been in place for many years.

Jade Rahmani - KBW

And then secondly, just on land acquisitions. Do you guys consider distressed sales or acquisitions of loans, and are you working with banks to acquire any of their portfolios, or is that not something you look at?

Steve Hilton

We have been working on these specific portfolios. We’ve looked at some portfolios but we are really more focused on individual assets, individual communities and we are talking to banks, a lot of different banks on a daily basis in all of our markets.

Operator

Thank you. Out next question is from the line of Josh Levin with Citigroup. Please go ahead.

Josh Levin - Citigroup

I noticed maybe there are two opposing forces that are going to impact your gross margin over the next few quarters. On the one hand you have these new higher margin communities; on the other hand you might have to increase incentives a little bit if the market stays weak. What should we think about in the terms of the trajectory of your gross margin going forward? Is it stable? Is it going up? Is it compressing a little bit?

Steve Hilton

I am taking more stable. I don’t really see it going up or down in the next couple few quarters.

Larry Seay

Certainly with the sales being weak over the last few months that has kept for the trajectory that would normally occur upward from new communities from happening, and that’s why the last couple of quarters we’ve been a little flat. Last quarter I said I thought it would be flat and I think for the next couple of quarters we think it would be flatter. But the long-term trend once the market stabilizes and maybe improves a bit, should resume back to that improvement caused by our newer communities coming online.

Josh Levin - Citigroup

Okay. A separate question. I know it's very difficult to make predictions right now, but I was curious to hear your thought. If the job situation is unchanged, meaning it's no better or worse from here for the next several quarters, how much better do you think your sales can get in the spring relative to where they are now? Is it changing consuming confidence by itself, without a change in the job situation, enough to get a real bump up in sales in the spring?

Steve Hilton

I think that consumer confidence is everything. It’s not 10 or 15% of the people who don’t have jobs, its 20 or 30 or 40% of the people who think they might be losing their jobs that are affecting our ability to sell homes. So, if we can get that segment of the economy feeling better about where things are going, then I think we can have a meaningful impact on our sales. So, I do think that can turn relatively quick.

Operator

And our next question is from the line of Carl Reichardt with Wells Fargo. Please go ahead.

Carl Reichardt - Wells Fargo

Just in terms of this ASP increase this quarter, and obviously I know you’ve move up mix shift, but also you've got a better quality land mix shift here. It looks like this quarter too. I'm just trying to figure out which was the more important driver. Was it the total square footage of the box on the lot or was it the higher quality lot that drove that ASP up? I'm still confused as to which was more important.

Steve Hilton

Well, it’s both. It’s, number one, we are buying these, in some cases lots in custom home communities and we are building production houses in formerly $700,000, $800,000, $900,000 custom home communities. We are going in there, building a 300,000 or 400,000 house, but we are also giving people 4,000 square feet, they’re getting a big home for a low dollar per square foot, and that’s part of our strategy as to create a very compelling value proposition, where you can get a home and get a community on a large lot for $60 a square foot, and those are opportunities that people can’t pass up even in a lousy selling environment that we are in today.

Carl Reichardt - Wells Fargo

And then just on the 99-day delivery strategy. I know it's not in all your communities. Could you give me a sense of how many it is in and whether or not this impacts your margins, how it may impact your absorption rates? Are you doing spec on the 99 days that helps make sure you can guarantee a delivery, and what happens if you don't get done in 99 days?

Steve Hilton

Well, it’s only about half of our communities. And if we don’t get it done in 90 days, we will make a payment to the buyer, a penalty fee they get. And it’s not designed for specs. It’s designed for new builds. So if you come in our sales office today and sign a contract, we’ll have the house ready for you to close on in 99 days, and it’s certainly hoping our cycle-time, just reducing our cycle-times and it’s playing well with realtors because they get paid quicker, and it’s helping us convert potential spec home buyers into buyers whom we can build a home for or renters that want a home relatively quick. So, it’s been a positive strategy for us. Certainly it’s more effective on a more entry level on a first time buyers than it is on the larger homes that we are building.

Carl Reichardt - Wells Fargo

Sure. And then just last, real quick. What's the can rate for the quarter? I didn't see that anywhere.

Steve Hilton

24%.

Operator

Thank you. Our next question is from the line of David Goldberg with UBS. Please go ahead.

David Goldberg - UBS

My first question, if I've done my math right, it seems to me like the 600 point discrepancy, the basis point discrepancy between the new and the older communities implies that new communities are doing about 23% in gross margins, if the math is right. And I just want to get an idea of how that compares to how you guys have pro forma the deals, is it kind of inline with what you thought you were going to get, maybe a little bit better? And if it is a little better, which maybe it is, how do you reconcile that with kind of the overall environment maybe being a little bit worse than you had thought before?

Steve Hilton

Why don’t you take it, Larry?

Larry Seay

Yes, that’s a pretty fair estimate on the new projects and that is a couple of points above where our target margin is. So, what's happened is some of those deliveries were coming from the lots we bought at the depths of the bottom of the market back last spring where the market was just frozen up. So I got some extraordinary buys on those. So that has shot some of those margins past our targets because of that.

On the other hand, the newer stuff we bought over the last few quarters is more hitting our targets or slightly exceeding our gross margin targets. So on average, as maybe some of those really great buys go away and that will hurt the margin on our new communities, what’s going to offset that is more new communities will come online that will be at our target. So you’ll see that blend continue to happen and that’s why we don’t feel we’ll have a decrease in our margin on our newer communities because we will continue to just add more communities which will offset those extra ordinary buys as they gradually sell out. Does that answer your question?

David Goldberg - UBS

Absolutely. It just means the margins on the new stuff come down a little bit, but it's a greater percentage. So, in net-net to margin, there's not a lot of margin pressure unless things get worse.

Larry Seay

Exactly.

David Goldberg - UBS

The second question I had and it's great to hear you guys talking about the success of the green product and the sales pace that that achieves, but I'm trying to get an idea of how sustainable that advantage is for you. Are you starting to find your competitors realizing? I mean, we've heard from a lot of public builders that they're trying to become greener and offer a greener product because that's selling well with consumers. And I'm wondering when you look out is that, that Meritage gets the reputation of being a green builder, and so that gives you a longer term and a sustainable brand or is it that this is something that eventually everyone kind of copies and it becomes the norm and the advantages that you're having from a selling perspective start to ease a little bit?

Steve Hilton

I think it’s both, but I think that’s a win-win either way. We are not doing anything that we can patent or is proprietary. I think overtime most builders are going to gravitate towards the strategy and we will be doing something similar if not the same, but I think we do have a first mover advantage. Some of the things we are doing, I think other guys have not thought about until now, but I think over a long term, it’s a win-win for our entire industry because I think if we are all doing this. It makes new homes a more compelling proposition against re-sales, and that’s because if you can buy a new home it is going to cost you a lot less to operate that home versus a used home. You might do wanting to pay more for a new home or if things are more equal you’d be more focused on buying a new home than you were on re-sale. Certainly we’ve got to get supply back into balance with foreclosure situation, but over time as the foreclosure start to wind and we want to make new homes more compelling, we can do this by lowering the operating costs, the utility cost of a new home versus a used home.

Operator

Mr. Hilton, we have two more questions in queue. Would you like to receive them?

Steve Hilton

Sure.

Operator

Our next question is from the line of Jim Wilson with JMP Securities. Please go ahead.

Jim Wilson - JMP Securities

Most of my questions have been answered. You got a lot in this morning. I was wondering though, I'm looking at with your new community category being 44% on orders for the quarter. I was wondering what percentage of communities opened are new? I'm assuming besides higher margins they also have a higher sales base because they're better located and better priced, but I'm just trying to put that into context.

Steve Hilton

It’s a third Larry?

Larry Seay

Yes, about a third of our communities of our 150 communities are the new communities.

Jim Wilson - JMP Securities

Okay. And 44% of sales, alright.

Steve Hilton

Actually 53 to be exact.

Jim Wilson - JMP Securities

So then when you talk about next year, I just want to be clear, when you said 60 to 70% should be new, is that just 60, 70% of communities opened?

Steve Hilton

Of sales.

Jim Wilson - JMP Securities

Oh, of sales. Okay. So maybe somewhere around 50% of actual communities opened should be in the new category?

Steve Hilton

40 to 50%.

Jim Wilson - JMP Securities

That's what I was wondering. That's what I thought. That's really all I had left. Thanks a lot.

Steve Hilton

Operator, last question.

Operator

The final question is from the line of Alex Barron with Housing Research Center. Please go ahead.

Alex Barron - Housing Research Center

I wanted to ask you, I think you guys have done a good job as far as reducing SG&A and reaching profitability at the operating level much more than other builders, but at the same time there’s still this interest expense below the operating line. So I'm kind of wondering about your thoughts as far as maybe not holding so much cash and reducing some of the debt to lower that interest expense versus holding on to it for I guess other opportunities? What are your thoughts on that? And then I have a follow-up on your green homes.

Steve Hilton

Well, Alex, you know other builders they don’t have bank lines, and so we don’t have a source of short-term liquidity of the cash that we are carrying. So, we need to keep that liquidity around, so when the market turns we were able to take advantage of it. But certainly, it’s something we think about everyday. If the market was to be pretty negative and no improvement for a long period of time, paying down debt might be something we should be thinking more about, but at this time we still think it’s a prudent strategy to keep our liquidity, to be able to take advantage as the opportunities present themselves here over the next year or two and to grow our business back.

Alex Barron - Housing Research Center

Okay. And then on the new green homes, I actually went to visit the one you mentioned in Gilbert. I saw that you guys were advertising like $50,000 worth of value. I was just kind of wondering how much is it really costing you, and do you guys get any sort of rebates from the government for building those kinds of homes?

Steve Hilton

We get rebates from three or four different sources, and we get rebates from utility companies, we get rebates from state and federal governments. In some cases there’s rebates from city governments, so we’d take advantage of all that to mitigate the cost. We don’t really want to share what our costs are with our competitors. We are not releasing those costs. I would sure like to tell our competitors that we’re making any money on those homes and we are just doing it because we want to be green, but you know that’s not the truth. And we are actually doing quite well in the profitability on those houses, and considering the absorption rates are much faster, it’s actually a net benefit, our net increase over a traditional non-green community.

Alex Barron - Housing Research Center

Got it. Okay. Well, thanks a lot.

Steve Hilton

Thank you Alex. Okay. Well, thank you very much for sharing your time with us today on our call, and we look forward to talking to you again next quarter. Have a good day.

Operator

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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