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Meritage Homes (NYSE:MTH)

Q4 2007 Earnings Call

January 29, 2008 11:00 am ET

Executives

Brent Anderson – Vice President, Investor Relations

Steven J. Hilton - Chairman and Chief Executive Officer

Larry W. Seay - Executive Vice President of Finance and Chief Financial Officer

Analysts

David Goldberg - UBS

Carl Reichardt - Wachovia Securities

Nitin Dahiya - Lehman Brothers

Joel Locker – FTN Securities

Nishu Sood - Deutsche Bank

James Wilson - JMP Securities

Keith Wiley - Goldman Sachs

Ben Mackovjak - Rivanna Capital

Daniel Oppenheim - Banc of America Securities

Ramin Kamali - Credit Suisse

Operator

Good morning. My name is Tina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Meritage Homes fourth quarter 2007 conference call. (Operator Instructions) Mr. Anderson, you may begin your conference.

Brent Anderson

Thank you, Tina, and good morning to everyone. Welcome to our conference call today. Our quarter ended on December 31 and we issued a press release with our preliminary results on January 17. After the market closed yesterday, we issued a release with our final results for the quarter and the full year.

If you don’t have those yet, you can find them on our website at www.meritagehomes.com on the Investor Relations page. That will also have the slides that accompany this webcast.

Please refer now to slide 2 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 a discussion of those risk factors, please see our press release and our most recent filings with the Securities and Exchange Commission, especially our most recent quarterly report on Form 10-Q and our 2006 annual report on Form 10-K.

With me today are Steve Hilton, Chairman and CEO of Meritage Homes; and Larry Seay, Executive Vice President and CFO. I’ll now turn it over to Mr. Hilton to review our results for the quarter.

Steven J. Hilton

Thank you, Brent. I’d like to welcome everyone to our call this morning. 2007 was certainly the most difficult year for home builders in more than 25 years. We experienced slowing sales, weak prices, high cancellation rates, inflated inventories in homes for sale and a credit crunch caused by fallout from the subprime market, all in one year.

In addition, we saw large inventory impairments, a sharp drop in home starts and builders reporting losses after years of strong earnings growth. Balance sheet management and cash flow are now to the focal points of the industry. Despite this difficult environment, Meritage generated significant positive cash flow during the fourth quarter and used it reduce our debt by more than $150 million.

We made good progress in reducing our unsold homes inventory, lot options, joint venture, real estate assets and strengthened our balance sheet in the process. We also streamlined operations and reduced overhead, commensurate with the declines in sales that we experienced.

We are hopeful that the Fed’s actions and changes proposed by the government will help home buyers by reducing mortgage interest rates, raising loan limits and allowing more buyers access to loans from FHA, VA or Fannie Mae and Freddie Mac programs, which will allow lower down payments and have more flexible underwriting standards.

Those may in turn help the home building industry but the effects of those actions are uncertain and their timing’s unpredictable. So we must manage through this downturn using our own experience and perseverance. We are focused on protecting our balance sheet and maintaining liquidity to both weather this downturn and better position Meritage for the future.

I will briefly summarize our results for the quarter and the year and address the progress we made on our operating initiatives before I turn it over to Larry Seay, our Chief Financial Officer. He will walk through our financials as we normally do, and then we’ll take your questions.

Slide 5: One highlight of the fourth quarter was that we reduced the outstanding balance on our bank line by over $150 million, a major accomplishment after we turned the corner of the third quarter and started to generate positive cash flow.

We generated cash primarily from seasonally strong closings of pre-sold homes and a 10% reduction in unsold homes inventory and curtailed spending through the reducing lot purchases under pre-existing option contracts by $55 million, along with other various operating efficiencies.

We used this cash to reduce our bank line by $153 million and ended the year with a remaining balance of $82 million in our credit facility. Our goal is to bring the credit facility balance down to $0 by the third quarter this year.

We collected about $24 million in tax refunds already this year and expect to collect an additional $52 million in the first quarter of 2008, which will help towards achieving this goal.

Slide 6: We reported a net loss of $129 million or $4.91 cents per share for the fourth quarter. This compares to the net earnings of $9 million or $0.34 per diluted share for the fourth quarter of 2006.

Fourth quarter 2007 home closing revenue decreased 25% year-over-year to an 18% decline in homes closed and 9% decline in average closing price.

Our GAAP loss in the fourth quarter 2007 is explained by three major items that had little or no impact on cash, on a pre-tax basis. Number one, the largest impact was the result of the $130 million of charges for valuation adjustments that related to real estate and joint venture inventory. Market conditions in the fourth quarter weakened further, prompting us to write down inventories or cancel projects that were no longer viable.

Number two: second in the order of significance we wrote off the remainder of our goodwill taking a charge of $58 million to leave us with no goodwill assets on our balance sheet at year end.

Number three and third, we incurred $11 million charge in connection with a tender offer for significantly out-of-money stock options, which would provide little, if any, future benefit to our employees. This action accelerated the related non-cash compensation expense that would have been incurred over the next four to five years.

We recorded one of our small impairments of $3 million on our only two golf courses that we own in our active adult communities in Arizona. These were fixed assets on our books and are now assets being held for sale.

By comparison, we incurred $63 million of pre-tax charges in the fourth quarter of 2006 for real estate valuation adjustments, but not goodwill or other write-offs. Excluding the fourth quarter 2007 charges, which had the combined after-tax effect to reduce our net earnings by $133 million, we operated at a small profit for the quarter.

Slide 7: Arizona has the largest decline in home closings off 48% due to fewer actively-selling communities and a more competitive selling environment and difficult comparisons to the fourth quarter of 2006, when closings in Arizona were still quite strong, only 13% lower than their peak in the fourth quarter of 2005.

Conversely, home closings were off 9% in California and 20% in Florida, and up 6% in Nevada, benefiting from easier comparisons to the prior year’s closings. These markets were some of the first to slow and reported much larger declines to a year ago.

Slide 8: We also reported a net loss for the full year 2007 of $289 million or $11.01 per share, compared to net earnings of $225 million or $8.32 per diluted share for the full year 2006.

Full year home closing revenue for 2007 was $2.3 billion, nearly one third lower than 2006, our all time record year for home closings in revenue. The decline in home closing revenue was due to an 8% decline in average sales prices, compounded by a 27% drop in homes sold.

We experienced the greatest declines and closings for the year in Nevada, off 58%; in Arizona off 49% due to weak housing markets there. Our home closings in Texas declined only 2% year-over-year and Colorado closings increased 43% where we’re building from a start-up operation in 2006.

The full year 2007 loss is explained by the same types of non-cash charges in the fourth quarter. Inventory valuation adjustments, goodwill write offs, and the stock option tender offer. Together these reduced net earnings by $344 million after tax.

Excluding these charges, which were primarily non-cash in nature, we operated at a profit of about $55 million for the full year 2007, compared to a profit of about $274 million in 2006, excluding the effects of $78 million in pre-tax inventory valuation adjustments.

The net effect of our 2007 loss was a 28% decrease in our book value per share from year end 2006 to $27.81 at the end of 2007.

Slide 9: We started the fourth quarter with 1,233 unsold homes in inventory and ended the year with 1,107, a net reduction of 10% or 126 homes despite a 47% cancellation rate that negatively impacted our net sales and inventory reductions.

We believe the high cancellations were due to buyers’ inability to sell their existing homes or obtain financing in some cases, and many backed out of contracts thinking that the home would decline further in price.

Many of the cancellations were also at later stages, meaning that we had more completed or nearly completed homes added to our unsold inventory. Looking at it another way, we had one home added back to unsold inventory for every two homes that we sold.

Once the cancellation rate begins to come down, we expect to see a much larger reduction in unsold homes and a similar increase in net sales. In spite of the high cancellation rate, I’m pleased with our progress. We expect to continue to lower our unsold inventory in the first half of this year.

Slide 10: In addition to generating cash as we delivered homes, we reduced our lot purchases under options by approximately $55 million, acquiring about 650 fewer lots in the fourth quarter than we did in the third. The great majority of our total lot purchases in the fourth quarter were in communities where we had limited inventory of owned lots and home sales were generating acceptable margins.

We plan to continue aggressively targeting reductions in our inventory of unsold homes and limiting lot purchases whenever possible with a goal of reducing our credit facility debt to $0 by the third quarter this year and then starting to accumulate cash reserves.

Slide 11: We have successfully reduced our total lot supply of sales volumes and expectations have declined. We’ve cancelled many projects that were not economically viable and renegotiated others relative to our adjusted expectations.

We cancelled options for almost 4,500 more lots this quarter, reducing our total lot supply to about 26,000 at year end. That represents a 52% reduction from our peak in the third quarter of 2005. Our own lot inventory principally represents active communities which have come down slightly from their peak at June 30, 2007.

We expect our active community count to come down about 20% by the end of 2008 as we sell out of communities with fewer new ones in the development pipeline that will begin active sales in the future.

We owned or controlled a total of 26,115 lots at year-end, representing a 3.5 to 4 year supply of lots. Since that’s fewer years of supply than most builders, our balance sheet is land light which believe is a lower risk by comparison.

Of that total we own about 40% compared to a low of less than 10% just two years ago. Our own lot percentage has increased mainly as we’ve aggressively reduced our lots controlled through options during the housing market slow down.

Accordingly, we’ve also reduced our cash option deposits to $87 million, half of what they were at the end of 2006.

Slide 13: A large portion of our total lot supply is in Texas where we believe there is a lower risk of significant impairments. Texas accounts for nearly two-thirds of our option lots at year-end, and almost 40% of our option deposits, and more than a third of our own lots.

Home building markets in Texas have been, and remain today, stronger than other parts of the country, partially because homes there did not generally experience the significant price appreciation seen in other markets, and because supply and demand remain more in balance over the last decade.

We also have a high percentage of developer or seller carry options in Texas, which provides more flexible terms than land bank options. Considering that we have less than a two-year supply of owned lots which we already impaired to reflect today’s home prices and the fact that a large percentage of our lot supply is in Texas, we believe our risk of significant future impairments is limited and the worst is behind us.

There have been a great deal of concern about homebuilder’s joint ventures in the last several months so I’ll address our JVs now. As you’ll see, they are not significant relative to our total operations or financial positions. We use JVs for two purposes: one is to provide our customers with mortgage or title service; the other is to acquire and develop land.

Slide 14: We are involved in a total of nine JVs with mortgage brokers and title companies. The JVs do not originate or hold mortgages but serve as loan brokers. Our partners in the JVs do the underwriting and the administration of the loans and Meritage simply refers customers to them.

These relationships help us avoid delays in closings and deliver a home to a customer while generating additional income. We have invested only about $1 million in capital in these JVs and the liabilities of these JVs are generally non-recourse to Meritage, so our exposure is minimal.

Slide 15: On the land side we are actively involved in 14 JVs, 12 accounted for on the equity method and two on the cash method. We have reduced our investment in the 12 equity method JVs to about $22 million after the impairments we recorded in 2007, and we believe that we have little additional exposure in these joint ventures.

The debt of our equity joint ventures that is not on our balance sheet is generally non-recourse to Meritage, except where we provide limited pro rata guarantees. Our pro rata share of those is about $5 million for repayment guarantees, and $88 million in “bad boy” guarantees.

We believe the risks associated with these “bad boy” and repayment guarantees are not significant. Should we decide to terminate our involvement in one of these projects and walk away, we would fully impair our equity investments and have little other exposure to the project as the “bad boy” guarantees spring into effect only if we try to block the lender from taking control of the assets in the joint venture.

We have in fact, fully impaired our investment in four of these JVs, which together account for about one-quarter of the total assets and liabilities of the 12. The lenders have provided notices of default on the debt of these JVs and the JV partners are currently in discussions with lenders regarding these issues.

Slide 16: The other two land JVs are accounted for on a cash method of accounting. These are very large JVs with many partners and Meritage is less than a 4% investor in them. Because the lenders have provided notices of default on the debt of these two JVs, the partners in control are discussing options with the lenders to find a resolution.

We have totally impaired our investment in one and partially impaired it in the other, leaving our investment at just $2 million. These JVs also have “bad boy” guarantees and our limited pro rata portion of the guarantees totals $29 million.

We believe the risk of these guarantees being triggered is minimal and we have no obligation under these JVs. The bottom line is we believe our off balance sheet risk is limited.

Slide 17: We have worked hard at managing our cost structure. We’ve consolidated and streamlined our operations wherever possible, reducing our staff to match our sales and construction activity and reduced overhead commensurate with our revenue.

Despite the difficult home building environment, I am pleased with the progress we were able to achieve on our operational plans and other non-financial objectives. We reduced our unsold inventory and lots under control, continued to shrink overhead costs and generated significant positive cash flow in the second half of 2007.

We also improved our sales training, marketing and customer relations, including significant increases in our customer satisfaction ratings during 2007.

We completed the implementation of a new management software across all divisions, recognized substantial savings in purchasing and made many improvements in our human resources and benefits systems. Each of these improved our organizational efficiency or abilities to better serve our customers.

Larry?

Larry W. Seay

Thank you, Steve. Slide 18: Net orders for the full year 2007 fell 19% due to turmoil in the mortgage and credit markets, rising inventories and intense competition in new and existing home prices. While year-over-year comparisons were negative, the rates of decline in home sales were less pronounced than in last year’s across most of our divisions.

Our backlog value was down 44% from 2006 at December 31, 2007, reflecting a 10% decline in average sales price on 38% fewer homes in backlog. The decrease in homes in backlog is explained by lower sales, higher cancellations and a strong conversion of beginning backlog to 2007 closings.

Lower quantities of homes in backlog in Arizona, Texas and Florida accounted for most of the total decline in backlog value.

Slide 19: High cancellations reduced both our net orders and backlog. We have experienced higher than normal cancellation rates for the last two years and our cancellation rate was 47% in the fourth quarter when cancellation rates are also seasonally higher.

Slide 20: As Steve noted, we recorded a non cash charge of $130 million of pre-tax real estate related and joint venture valuation adjustments in the fourth quarter. Terminations, inventory write-downs, and joint ventures each comprised about a third of this charge with a balance related to lots held for sale.

Our total impairments for 2007 are shown in slide 20; about half of the total represented write-downs of inventory impaired projects; another third was for the cancellations of about 212,600 lots under option; and the remainder was related to impairments of our joint venture investments and land held for sale.

The write-offs were concentrated mainly in California and Arizona where we had a large presence and where prices have fallen dramatically. These two states account for about two-thirds of our total real estate related charges in 2007 while Texas accounted for less than 2% of the total.

Slide 21: During the quarter we wrote off all $58 million of goodwill that remained on our balance sheet at September 30, which was associated with Nevada, Arizona and Texas. We had already written off goodwill in Florida and California by the end of the third quarter 2007.

The write-off was driven by the fact that our market capitalization didn’t support the value assigned to goodwill and is not a reflection of our outlook for those markets.

Slide 22: Fourth quarter home building gross margins were reduced by lower selling prices and real estate related charges of $84 million in 2007 and $63 million in 2006. Excluding these charges, adjusted home building gross margins contracted to 12.1% in 2007 from 19.8% in 2006, reflecting more aggressive pricing strategy.

Average sales prices in the fourth quarter of 2007, as compared to the fourth quarter of 2006, declined 20% in Florida, 18% in California, 17% in Nevada and 13% in Arizona, with a 5% increase in Texas and a 14% increase in Colorado.

We still have many communities that are selling homes at acceptable margins though they may be lower than we originally projected. In many cases, however, we are looking for cash returns where we have inventories of homes or lots that represent some cost to us. We are more aggressively marketing these to reduce our inventories and generate cash.

Slide 23: General and administrative expenses of $30 million in the fourth quarter 2007 included an $11 million non-cash charge related to a stock option tender offer with no similar expense in 2006. Excluding this item, we reduced general and administrative expenses by $17 million or 48% from the fourth quarter 2006, to 3.1% of fourth quarter 2007 total revenue, from 4.4% of fourth quarter 2006 revenue.

Slide 24: Including work force reductions made in January of this year, we have reduced our employee base by almost 40% in total. More than 54% outside of Texas from our peak in mid-2006 and we have sized our operations to reflect current market conditions.

We’ve also been able to realize savings in every department through tighter budget controls or efficiencies gained by consolidating or reorganizing work. Commissions and other selling costs were 14% lower than the prior year although slightly higher as a percentage of total revenue due to the more competitive selling environment.

Slide 25: We have already received $24 million in tax refunds in 2008 and expect to receive an additional $52 million of cash from tax refunds in the first quarter of this year as we carry back tax losses incurred in 2007 to recover taxes paid in 2005. The anticipated tax refund is already reflected in our receivables balance.

We expect to trigger the realization for tax purposes of approximately $40 to $60 million of the deferred tax assets in 2009 and the balance in 2010 and beyond. We currently believe the tax asset is recoverable.

Considering this expectations and others that Steve noted regarding our inventory reduction plans, we look forward to reporting further progress in generating cash and reducing our debt in the coming quarters.

Slide 26: We’re in compliance with all of our debt covenants at year-end and have available borrowing capacity of $381 million under our revolving $800 million credit facility at December 31, 2007, after consuming the facility’s borrowing base availability and most restrictive covenants.

Our interest coverage was about 2.3 times interest incurred compared to our 2.0 times covenant requirement based on trailing four quarters adjusted EBITDA. As previously announced, we amended our credit facilities in September 2007 to relax this covenant for a time while our earnings are being negatively impacted by market forces.

This modification allows us to drop our interest coverage ratio below two times coverage for a period of nine quarters and as low as 0.5 times for three quarters.

Our net debt-to-capital ratio was 49% as of December 31, 2007, compared to 40% at December 31, 2006. Despite a slight reduction in our total debt, the percentage increased due to reduction of equity from the 2007 net loss.

Our credit facility extends to 2011 and the earliest maturities in our long-term debt are in 2014 and beyond. Our current tangible net worth covenant is at $609 million and as of December 31, we have a cushion of approximately $102 million.

Our current leverage is 1.1 times compared to a maximum allowable leverage of 2.25 times, subject to reduction to as low as 1.4 times if our interest coverage has dropped below two times level.

I’ll turn it back over to Steve now to summarize.

Steven J. Hilton

Thank you, Larry. This has been the most difficult year we experienced in home building in more than 25 years and we currently expect 2008 will also be challenging. Although we may incur additional impairments if market conditions deteriorate further, we believe the great majority of these are behind us, based on the relative strength of our Texas markets and the significant impairments and option terminations we have taken in other markets.

We believe that buyer confidence must return in order for home sales and home building markets to improve. We look for stabilization in home prices, sales activity and lower cancellation rates to signal a recovery.

We’re optimistic that the Fed and government programs will help the home building industry by adding liquidity to the mortgage market and allowing consumers to buy with confidence again.

In the meantime, we plan to continue to operate conservatively, protecting our balance sheet and maintaining liquidity to weather the downturn. I appreciate the efforts of our employees that have worked so diligently to address the daily challenges and opportunities we’ve faced with an optimistic attitude toward better time ahead.

Additionally, I’d like to recognize two executives who’ve done an exceptional job defending Meritage’s balance sheet over the last year. Larry Seay, our Chief Financial Officer, who has been our CFO for almost 12 years, has worked extra hard this past year to position our company for future success.

Tim White, our General Council, who has been associated with Meritage since 1991, has been a tremendous resource in helping us navigate through legal complexities that manifest themselves in these challenging markets. Meritage is extremely grateful for both these gentlemen’s leadership during these stressful times.

Our primary focus in 2008 is to strengthen our balance sheet and maintain liquidity. We’re committed to protecting shareholder value as we manage the company through this downturn, delivering high-quality homes and meeting the expectations of our buyers to strengthen Meritage for the future.

We’ll now open it up to questions. The operator will remind you of the instructions for the Q&A.

Question-and-Answer Session

Operator

Your first question comes from the line of David Goldberg - UBS.

David Goldberg - UBS

If you could maybe start by talking about how comfortable you are with the liquidity position that your land bankers have and just give some general ideas of how the land banks adjust; how that’s financed and any concerns that you might have about liquidity problems for the bankers.

Larry W. Seay

Yes, we have leans recorded on the assets that are controlled by the land bankers. So we have Memorandums of Option recorded and so that gives us lean rights to the extent that those lean rights are subordinated to first lenders of the land bankers.

We typically get some tri-party agreement and a recognition agreement where the lender agrees to honor the option agreement even if the loan is in default because the land banker’s defaulted. Accordingly, we think we’re very well protected from issues that land bankers themselves might have regarding the liquidity.

Steven J. Hilton

I’ll just add to that, David, we haven’t had any situations that we can recall, where we wanted to buy a lot and we couldn’t because the land banker couldn’t deliver it to us.

David Goldberg - UBS

That’s great. And my follow up question was, Steve, you mentioned the four JVs that have gotten notices of default?

Steven J. Hilton

Yes.

David Goldberg - UBS

I was wondering if you could give us an idea of the potential scenarios, how that might play out? Is there any chance you might end up just consolidating it and buying the JVs out? And maybe just how the negotiations are structured and what the possible outcomes are?

Larry W. Seay

We think we’re well protected on the legal side from somehow that debt ever becoming recourse and us having to pay it off and having to consolidate the venture. On the other hand, there may be occasions where we think it’s the best interest to Meritage two potentially buy the lots out of a venture. I don’t think that’s going to be a scenario that happens often, but it could be a potential scenario.

David Goldberg - UBS

So it’s not clear how those four are going to work out, if we just look forward?

Steven J. Hilton

I think it’s pretty clear. It’s pretty clear and we really tried to make it clear with the slides and the presentation that we made today that the risk of us making a significant investment in any of those ventures is pretty minimal.

David Goldberg - UBS

And then I could maybe sneak one more in. Just wondering what timing for the take downs of options that are outstanding now? If you have any deals coming up in ‘08, option take downs where you want to stay in the contract and so you’ll be forced to take on options even though you might normally pass on it and try to postpone it a bit?

Steven J. Hilton

No we don’t have any of those that we believe are very significant that would have a negative impact on our cash flow.

Operator

The next question comes from the line of Carl Reichardt - Wachovia Securities.

Carl Reichardt - Wachovia Securities

You mentioned thinking about shrinking the community count down by 20% in 2008 versus 2007, Steve. You’re expecting that to be a market exit type of shrinkage or more of a broad-scale across the footprint type of shrinkage? And could you give us a little more detail on those plans?

Steven J. Hilton

As you know right now about half of our communities are in Texas and we don’t expect our community count to change too much in Texas over the next year. But we do expect our community count through natural attrition to decrease pretty significantly, particularly in places like California where our community count − unless we buy more land, which we don’t intend to at the moment − reduce by probably almost half by the end of this year.

Same for Arizona, less so for Nevada and Orlando. We’re not planning on exiting any markets this year. We still have work to do in all the markets that we’re in, and we evaluate them on a quarter-by-quarter basis. But the communities outside of Texas will decline at a much larger rate than the company average.

Carl Reichardt - Wachovia Securities

And then secondly, the finished goods inventory and the unit basis is flat with last year, which is better than the industry which is up, but can you talk to me a little bit about any specific marketing or inventory flush plans you might have for the first quarter as we head into the selling season? What are you doing to get your salespeople jacked up and excite some buying here when you know you’re going to have traffic?

Steven J. Hilton

You just focus more on the blocking and tackling. We’re looking at every single community; doing our competitive market analysis, seeing how we stack up against the competition, if there’s anything we can do to change up our product or to increase or decrease our features; fine-tune our incentives and just focus harder on individual communities.

We do have two multi-family projects, one on Fort Meyers and one in Las Vegas that we expect to be able to liquidate this quarter, which will have some impact on our balance of unsold homes, probably about 50 to 60 homes combined.

And then we have some other communities that we’re putting some extra focus on that we expect also to help us reduce our balance of unsold homes in this first quarter and roll into the second quarter.

Operator

Your next question comes from the line of Nitin Dahiya - Lehman Brothers.

Nitin Dahiya - Lehman Brothers

Looking at the cash flow target that you mentioned about paying off the bank debt by the third quarter, if you take out the tax refund, then you’re essentially saying you’re going to probably generate at least $10 million of free cash over the first three quarters.

And should we expect any meaningful lumpiness in that this year? Obviously there’s a seasonality, but then, this year being a little different?

Steven J. Hilton

I think we’re going to do much better than that. But I don’t want to commit to a bigger cash flow number. But you’re right, after you subtract out the tax payments, that’s not a lot of cash flow, so I think we’re setting the expectations low and hoping to significantly exceed that.

But certainly the first quarter of the year is a slower selling quarter than the second and third quarter, so it’ll be harder to make progress earlier in the year, and as we get more into the year, we expect to accelerate our efforts.

Nitin Dahiya - Lehman Brothers

I see, so your own internal target is probably some time even by the end of the second quarter or early third quarter you could report that you have paid that off?

Steven J. Hilton

Possibly.

Nitin Dahiya - Lehman Brothers

Fair enough. And how much of the cash flow projection reflects expectation of reduction in the spec inventory? Is there a target you have for spec or how much are you factoring in when you look at your cash projection?

Steven J. Hilton

We certainly have internal targets. We’re not going to come out and say we expect to sell x number of specs this quarter. A lot of it has to do with the cancellation rate. If we can manage the cancellation rate better, we’ll create less accidental specs and we’ll have more success in reducing the total number of specs outstanding, particularly the finished spec portion.

Nitin Dahiya - Lehman Brothers

And lastly, I was a little surprised in your comments when you said that you do not expect future impairments, obviously with pricing...

Steven J. Hilton

No I didn’t say we didn’t expect future impairments. We said we expect the worst of the impairments are behind us and the impairments going forward should be a lot less than what we’ve experienced in the past.

Nitin Dahiya - Lehman Brothers

Okay, fair enough. But are you factoring in any incremental price declines when you tested for impairment at the end of fourth quarter?

Larry W. Seay

Yes, we run pro formas every month on our communities if not more often so the impairments that were taken at year-end reflect our current pricing and a lot of times as we’re going into the impairment process the divisions are a little more aggressive in instituting price reductions or additional incentives just to make sure they get them in that quarter’s impairments.

So I think we’ve already been pretty aggressive in the fourth quarter price reductions although, again, we’ve said in this market it is hard to tell if there’ll be further price reductions and further impairments due to additional competition.

Operator

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

Joel Locker – FTN Securities

I was curious about your land options, you terminated around $48 million of them but the actual drop from the third quarter to the fourth quarter was around $20 million. So I was wondering if the other $28 million was partially letters of credit that were off balance sheet that maybe you converted to cash or what was behind that?

Larry W. Seay

There are other items like letters of credit that could be sitting over in accrued liabilities and have not been drawn yet as a deposit. The other thing is there could be pre-acquisition costs that are also being impaired, too.

Joel Locker – FTN Securities

And pre-acquisition costs, would that be in other assets?

Larry W. Seay

No, that typically is just in inventory.

Joel Locker – FTN Securities

And then your other assets fell about $81 million sequentially. What was the reason?

Larry W. Seay

I think that’s just got to be a classification issue. I’d have to go look into that. I don’t recall right off the top of my head.

Joel Locker – FTN Securities

I’ll catch up after the call. And the lot count went from held steady, the owned lot count at 10,400 sequentially but you took down I think 1,040 or so and closed 2,100 homes. So that was about 1,100 that could have dropped off. But was it just a factor of some of the owned lots that decreased in backlog? Because I think you separate the actual owned lots versus owned lots that are in backlog.

Larry W. Seay

The lots we have houses sitting on are not in our lot count. Those are in WIP and don’t get counted in lot count. Obviously each quarter we took about 1,000 lots down. We start houses and that’s typically the main item. I have to check in to see what else is going on that would cause your reconciliation not to exactly tie out but basically...

Joel Locker – FTN Securities

Right, it seems like it would make sense if your backlog went from 3,379 to 2,288 so there went 1,000 of the closings right there. And then the other 1,000 were taken from owned lots and then put into the new backlog and then you purchased a 1,000 or so. So those numbers work to keep owned lots at 10,400.

Steven J. Hilton

Yes, I think we started a few more houses, 100 or 200 more houses than we actually purchased. So as we go through this year, we’re expecting to be able to continue to start more than we purchase, to start to nominally bring down the number of lots in the owned category down.

Joel Locker – FTN Securities

And do you have an idea of how many options you want to purchase in the first quarter?

Steven J. Hilton

We hope to be consistent with what we’ve done in the second half of 2007 and maybe in some respects even be able to buy less. We’re negotiating every deal and it’s very hard for us to give you a real projection because it’s going to depend on what the market conditions are. And in some cases we’re buying lots on an as-needed, as-we-make-sales basis.

Joel Locker – FTN Securities

So lastly, if you closed on a typical conversion rate of 1,200 homes or so, would you expect your actual exercise of lot options to be 1,000 or lower like they were in the fourth quarter?

Steven J. Hilton

I wouldn’t expect that we’d be buying more than 1,000 lots in any quarter this year.

Operator

Your next question comes from the line of Nishu Sood - Deutsche Bank.

Nishu Sood - Deutsche Bank

Following up on that previous question. Steve, last year, in the first half of the year when you were taking down more lots than you were delivering out in your backlog and your specs, you talked about still continuing to adhere to your longer term strategy, taking down lots where you still saw some profit potential, but generally from your comments, just on that last question, it sounds like your outlook has changed, much greater focus on cash flow and less focus let’s say on future potential profit. Is that accurate?

Steven J. Hilton

Yes, unless somebody’s been living in a cave, things have dramatically changed from spring of 2007 to today. Not only do we have the debacle of the credit crunch of last summer, but housing prices have declined dramatically in many of the markets that we are in, particularly in the West.

What we were practicing in the first half of the year is completely out the window and we are in much more of a defensive position today and those subdivisions I talked about that were profitable in the first half of 2007 are not as profitable today, and we are just focused on paying down debt and generating cash.

I want to have a significant cash balance in this company at the end of this year so that we can take advantage of some of these distressed lots out there that we can buy at lower prices when the market turns around, and that may not be this year, it may be next year, or it may be later, but as business continues our balance sheet continues to liquidate and we will pay down debt and generate cash.

Nishu Sood - Deutsche Bank

Looking at some of the figures you gave here, the lot purchases that you reduced and I think the numbers you had the given were $55 million and about 650 fewer lots. If you look at the per lot value there you come out to about $85,000 or a pretty high number. I know that doesn’t work exactly that way, but where are you walking away from more of your contracts. I know you have said that you are focusing a lot more on Texas, so is it mostly in Arizona and California?

Steven J. Hilton

One of the reasons I’m very bullish is that we won’t have a lot of impairments going forward, particularly as it relates to option terminations, because we have walked away from so many already, and we just don’t have that many more. Particularly in California, Arizona and Nevada, we just do not have that many options outstanding today.

Larry, you might be able to give more color on what we did this last quarter, but I know we walked away on a couple of larger deals in Orlando, and we terminated some small deals in Texas.

To date, there’s been relatively few impairments or option terminations in Texas, but on the other hand we don’t expect to see a significant number of option terminations or impairments in the Texas market. So, Larry, do you want to add anything?

Larry W. Seay

I’d point out that if you look at the land bank deposits remaining, we only have about $7 million of land bank deposits remaining in Arizona and only $10 million in California, so we’re down to the point where you just don’t have that many land bank deals out there anymore.

And most of the deposits, as you see in land bank and developer carrier are in Texas, where again we just don’t see the market getting as soft as it’s gotten in other places. I would add that we will continue to take lots down because we still have a bunch of communities that are profitable, that don’t have a lot of lots on the ground or maybe have no lots on the ground, so every time we sell a house and want to start one, we can take a lot down.

People ask us why are we taking any lots down, well it’s because a great majority of our communities we need to continue to take lots down to be able to start houses. So that 1,000 number was not going to go to zero; it might go to 800, but we still need to take lots down every quarter to be able to start profitable houses.

Nishu Sood - Deutsche Bank

And then a quick housekeeping question, Larry, there was $5 million of interest that you weren’t able to capitalize this quarter, so I was just wondering if you could give us some color on that.

Larry W. Seay

Yes. We are in a position now where our inventory under development has shrunk, either because we have now classified some projects as not under development, or just the total balance because of the lowering of the level of business has shrunk, so we’re not able to capitalize 100% of our interest incurred to the asset balance. And accordingly, we’re starting to expense that every quarter.

So until we get our debt paid down some more and business starts to pick up, you’ll probably see a little bit of interest expense roll through the income statement directly instead of being capitalized and rolling through cost of sales.

Nishu Sood - Deutsche Bank

And thanks a lot for all the detailed disclosures as well; it’s always very helpful.

Operator

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

Jim Wilson - JMP Securities

My two questions, first we’ve talked a lot about your lot position now, what concentration in Texas with all the write-downs, but Larry do you have the number, I’m sure it will be in the K, of the percentage of assets now in dollars given all the write-downs in other places that is Texas versus a percentage of the total?

Larry W. Seay

Yes, we do that on slide 13 for owned real estate and option deposits. So we have a total between owned lots, not counting pre-sold inventory or specs or houses but just speaking of lots, we have about $180 million of owned lots or land in Texas and then another about $37 million of option deposits for a total of about $215 in land or land-related assets; that is about 30% of the total.

Jim Wilson - JMP Securities

And then the second question on your four JVs that are in default, can you characterize the partners? Are they other public builders? Are they private guys that might have some of their own financial issues or, characterize who’s in there with you?

Larry W. Seay

Yes, they’re a combination of private and public guys and everybody has their own issues they’re dealing with. These are joint ventures that for one reason or another they’re not working out right and because of discussions with lenders we’re having going on, I don’t think it is appropriate to really comment much father than that.

Jim Wilson - JMP Securities

Okay. Thanks.

Larry W. Seay

Somebody on the call asked about other assets going down so significantly and most of that is goodwill decreasing from the $120 or so we had on the books at the beginning of the year to $0 at the end of the year so that’s the answer to that question, by the way.

Operator

Your next question comes from the line of Keith Wiley - Goldman Sachs.

Keith Wiley - Goldman Sachs

Quick questions on the joint venture details you provided. The slide indicates that you have an obligation to fund interest payments of up to $11 million. Would that be total or is that on an annual basis?

Larry W. Seay

That’s the total commitment we have for the venture and at that point we have no other equity contribution requirements. That number already shows up as a contingent liability because it’s supported by an $11 million letter of credit so that number is already in our letter of credit contingent liability disclosure.

Keith Wiley - Goldman Sachs

And then the other question is just on these “bad boy” guarantees, my understanding is that they’re not really troublesome unless the mezzanine financing is collateralized by equity. Do you have any of these and if so, can you provide an update on that situation?

Larry W. Seay

Yes, we have discussed, we have a couple of mezzanine facilities and we’ve discussed those situations and the protections we have in the mezz lender documents with our attorneys and think that we are well protected. And again, I don’t think it’s appropriate for me to go into any more detail than that.

Operator

Your next question comes from the line of Ben Mackovjak - Rivanna Capital.

Ben Mackovjak - Rivanna Capital

Can you break out the other assets?

Larry W. Seay

Not off the top of my head, but the Q will have further detail on that.

Ben Mackovjak - Rivanna Capital

And then do you have any cash flow from operations number you can share with us?

Larry W. Seay

We do not have that schedule finalized yet, and again that will be in the Q, but obviously the debt reduction goes a long way to explaining what our cash flow from operations is and obviously there’s a few differences but the number should be close to the debt reduction number.

Operator

Your next question comes from the line of Dan Oppenheim - Banc of America Securities.

Dan Oppenheim - Banc of America Securities

Just wanted to follow up on some of the comments you’ve made on Texas. If you could talk a little more about your sales and pricing strategy there going forward, understanding that things have held up relatively better in those markets, we’ve still seen backlog come down quite a bit. If it continues to come down is there somewhere where you look to get a bit more aggressive?

Steven J. Hilton

I think we’re being a little more aggressive on our price so we can maintain our volume there, but we’re still very profitable in all the markets. I’d say not as much in San Antonio, but certainly the other three markets we’re real profitable and we’re real comfortable with our position there, and we don’t expect 2008 to be that much different than 2007.

Dan Oppenheim - Banc of America Securities

And then just on the deferred tax assets, I was wondering if you could walk through some of the assumptions there on not taking a reserve against the remaining balance. Just looking at the sizable loss in 2007 there, it seems like it would be tough to avoid a cumulative three loss period. Can you just talk about what the basis is there? And we’ve seen accountants be a bit more aggressive on pushing for charges with some other builders.

Larry W. Seay

Yes. I think managements of the different companies have different perspectives and I also think the accounting firms have different perspectives. We believe that the home building industry is certainly a cyclical industry that has large peaks and valleys and that a three-year measurement period is too short for the home building industry.

I think that there are other builders who agree with that and who have discussed that with their accountants and have been able to use a longer period, maybe a four-year period. I know that in some cases, people are looking out and projecting what a future period might look like. Some people say it shouldn’t be based on projections; it should be based on actual experience.

So whether you look towards what you expect to have happen in 2008 or just what has happened in 2007, has an impact on whether you would take a reserve. But beyond that what I would point out is that of the $141 million tax asset we have, we’re going to collect we believe, our trigger, around $40 to $60 million in 2008, which can be carried back to 2006 where we have plenty of profits, and would be collected in 2009, and the balance of $80 to $100 would be the balance that would have to be carried forward to points in time where we would expect to be profitable again.

And I think at this point in time it would be premature to assume that we’ll never make money over the next 20 years that probably in the next year or two or three, some point we don’t know exactly when, we’ll become profitable again and get back to normal and we will be able to carry that loss generated in 2007 and 2008 forward to those years. So at this point in time, we think it’s appropriate to not be reserving that asset.

Dan Oppenheim - Banc of America Securities

The $40 to $60 million is that through your projected closings and where the impairments actually lay and realizing that unlocking those assets or held for sale of land, or?

Larry W. Seay

Yes. It’s all the above. In some cases it’s option terminations that we weren’t able to formally terminate in 2007 that will be formally terminated in 2008 and the rest of it would be land sales and house sales, those kinds of things. So it is an estimate. That’s why we use a broad range of $40 million to $60 million.

Operator

Your next question is a follow-up from Joel Locker – FTN Securities

Joel Locker – FTN Securities

Just on the capitalized interest front. What was the balance at the end of 2007 and end of 2006, if you have it?

Larry W. Seay

Yes. The beginning balance at the end of 2007 was $33 million; at the end of the year it’s $41 million, but I would point out that at the beginning of the quarter it was $47 million. So we peaked at the end of the third quarter and we’re now starting to bring that number down.

Joel Locker – FTN Securities

Right, through the interest expense that you’re reporting.

Larry W. Seay

Right. And as inventory shrinks, you would think that the interest contained in that inventory would also run off, too, which it is.

Operator

Your next question comes from the line of Ramin Kamali - Credit Suisse.

Ramin Kamali - Credit Suisse

Both my questions have been answered but just a couple questions on the JVs. Do you provide any completion guarantees at all for any of these equity or cash joint ventures?

Larry W. Seay

Yes, we do have some completion guarantees, not in all cases. A lot of times the land may be raw land without a development plan, but in some cases we have completion guarantees. And in most cases, if there are completion guarantees, it requires a lender to continue to fund in order for us to be held to doing the work. Not in all cases but in most cases.

Ramin Kamali - Credit Suisse

Have you attempted to potentially quantify what this can be?

Larry W. Seay

No, right now we don’t think there’s anything that should be accrued for accounting purposes and because either the joint ventures are performing or we have good defenses in the ones that aren’t.

Operator

We have now reached the allotted time for the question and answer session. I will now turn the call back over to the presenters for closing remarks.

Steven J. Hilton

Thank you for joining us this quarter and we look forward to updating you on our results at the end of the first quarter and we look forward to talking to you then. Thank you.

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Source: Meritage Homes Q4 2007 Earnings Call Transcript
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