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Meritage Homes Corporation (NYSE:MTH)

Q1 2008 Earnings Call Transcript

April 29, 2008 11:00 am ET

Executives

Brent Anderson – VP, IR

Steve Hilton – Chairman and CEO

Larry Seay – EVP and CFO

Analysts

Robert ManowitzRBS

David GoldbergUBS Securities

Rob HansenDeutsche Bank

Susan BerlinerBear Stearns

Joel LockerFBN Securities

Carl ReichardtWachovia Securities

Tim Jones – Wasserman & Associates

Shaumo Sadhukhan – Lotus Partners

Chris HusseyGoldman Sachs & Co.

Nicole Terraco – Babson Capital

Jim WilsonJMP Securities

Operator

Good morning. My name is Brandy and I will be your conference operator today. At this time I would like to welcome everyone to the Meritage Homes First Quarter 2008 Earning Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks there will be a question and answer session. (Operator instructions)

I would now like to turn the call over to Brent Anderson, Vice President, Investor Relations. Please go ahead sir.

Brent Anderson

Thank you, Brandy. Good morning everyone. I would like to welcome you to the Meritage Homes first quarter earnings call and webcast.

Our quarter ended on March 31 and we issued a press release with our preliminary results on April 3. After the market closed yesterday we issued a release with our final results for the quarter. If you need copies of either of those you can find them on our Web site at www.meritagehomes.com on the investor relations page along with the slides that accompany our webcast today.

Please refer to slide two of our presentation. Our statements during this call and the accompanying materials contain projections and forward looking statements which are the current opinions of management and subject to change. We undertake no obligation to update these projections or opinions. Additionally our actual results may be materially different than our expectations due to various risk factors. For a discussion of risk factors, please see our press release and our most recent filings with the Securities and Exchange Commission especially our 2007 Annual Report on Form 10-K.

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

With me today are Steve Hilton, Chairman and CEO of Meritage Homes, and Larry Seay, Executive Vice President and CFO of Meritage.

I'll now turn the call over to Mr. Hilton to review our first quarter results. Steve?

Steve Hilton

Thank you, Brent. Good morning and welcome to our call this morning. For those of you following on the webcast, we are starting on slide four.

The preliminary results we reported on April 3 showed weaker year-over-year operating results. While Meritage faced the same weaker conditions that other builders have, we are very pleased to report that we've made significant progress on our initiatives again this quarter, strengthening our balance sheet and improving our liquidity as a result. We reduced our inventory of unsold homes, kept our total lot purchases under option contracts below our new home starts, generated significant positive cash flow, paid off nearly all of our bank debt and further reduced our total lot supply and maintained compliance with all of our debt covenants.

We believe we've demonstrated disciplined financial management with the tremendous strides we've made over the last nine months. In addition we completed a stock offering just last week which raised $83 million cash and further strengthened our capital position. The additional liquidity we obtained through this equity offering further strengthens our balance sheet and provides us additional flexibility to take advantage of lower cost lots if and when we determine they are opportunities to generate attractive returns.

I'll go into a little more detail regarding the progress on our initiatives and provide some color on what we are seeing on our primary markets. Later on then we'll discuss our net results and changes in our balance sheet.

Slide five, normal seasonality in the home building industry is historically meant that we borrow against our bank line in the first two quarters of the year to fund construction homes started during the spring selling season. As we complete and close those homes later in the year we collect cash and pay down the bank debt again.

This year by contrast we generated approximately $81 million of positive cash flow from operations during this first quarter driven mainly by net reductions in inventory and tax refunds collected in the quarter. We use this cash to pay down the balance of our outstanding debt under our credit facility, just $2 million at quarter end. This was a reduction of $80 million from December 31, 2007.

The first quarter of 2008 culminated a nine month period in which we repaid more than a quarter billion dollars of debt. It was also a dramatic improvement from the first quarter of 2007 when our cash flow from operations was a negative $83 million.

Slide six, we sold a net of 339 homes from our inventory of unsold homes in the beginning of the quarter which was a 31% reduction. We ended the first quarter with 768 unsold homes in inventory half of which were completed homes. Considering that we have 215 active selling communities at the end of this quarter, we are now within our desired range of three to four spec homes, unsold homes per community with less than two of these completed and unsold. I commend our sales teams for achieving this during very difficult market conditions.

Slide seven, we purchased just under 889 lots under option contracts during the quarter while starting 1,135 new homes. Just about a 60% reduction on lot take downs year-over-year for the company as a whole. 65% of those lots were in Texas which is no less than impacted by the housing downturn. That's pretty well in line with our first quarter sales close to the backlogs in Texas.

Our objective is to limit our investment and our supply of own lots by selling and starting more homes than we are purchasing under option contracts. We brought our total lot supply down to 24,591 in March 31, 2008. Approximately 40% of these are owned and 60% are optioned. A year ago our total lot supply was 41,936 so we've reduced the total by 41% in just the last year.

Slide eight, our total lots under our control at March 31 represented about 3.4 years of supply based on 12-month deliveries. With two years of that supply under option contracts this is within our target range of three or four years supply of lots. Approximately 55% of our total lots are in Texas consistent with our recent sales close to the backlog percentages there. Arizona has a higher lot supply due partly to our active adult communities there which require a larger number of lots to support the greater amenities in these communities.

Slide nine, we recorded about a $60 million free-tax non-cash charge for real estate impairments and lot option terminations during the quarter. Our impairment charges were the result of the lower home prices in some markets and greater incentives we offered on unsold homes in order to recapture our investment in that inventory. Although those price concessions were very effective in reducing our inventory and generating cash, they also resulted in further impairments caused by reduced valuations on remaining inventory in those communities.

California and Arizona together accounted for about two-thirds of the total write-offs in the quarter. The $60 million JV impairments included a $40 million charge related to a joint venture the Chrysler proving grounds in Northwest Phoenix. Considering that we've now greatly reduced our spec homes in most active communities to our target levels, we expect less aggressive pricing on both specs and new orders new homes built to order. This should help to reduce our future impairments.

I now turn the call over to Larry Seay our Chief Financial Officer and I would now prepare remarks with a few closing thoughts before Q&A. Larry?

Larry Seay

Thank you, Steve. On slide ten, our first quarter 2008 home closing revenue declined 35% year-over-year, on 26% fewer homes closed and a 13% reduction in average closing price. The decline in closings reflect weak demand in the second half of 2007 which were almost 30% lower year-over-year. Our central region experienced the greatest declines in the first quarter of this year primarily driven by Arizona closings and revenue which were lower than the prior year's first quarter by 58% and 66% respectively. As expected, due to seasonal patterns, first quarter closings and revenue were also significantly lower than the fourth quarter 2007.

However, our sales and backlog were sequentially higher this quarter compared to last quarter also reflecting seasonality of our business. Our ending units in backlog at March 31 2008 increased 13% from the end of 2007, from 2,288 to 2,594 homes under contract even though high cancellations and slower sales pace throughout most of 2007 have reduced our first quarter backlog by 35% year-over-year.

Slide 11, homebuilding gross margins contracted in the first quarter primarily due to real estate related charges of $44 million in 2008 compared to $17 million in 2007. Excluding these non-cash charges, normalized home building gross margins for the first quarter contracted to 12.2% in 2008 from 18.6% in 2007 reflecting weak demand and lower average sales prices.

We have successfully reduced structure to keep our G&A expenses in line with revenues. Of course while revenues our seasonal most G&A costs are not so the percentages will vary quarter to quarter. Our first quarter 2008 G&A was about 5 million lower than last year and about 1% higher as a percent of revenues.

Slide 12, we reported a net loss for the first quarter 2008 of $45 million or $1.72 per share compared to net earnings of $15 million or $0.57 per diluted share in the first quarter of 2007. Excluding our 60 million of pre-tax impairment charges, our pre-tax loss from operations was $11 million. By comparison our first quarter 2007 pre-tax earnings were $40 million before $17 million of pre-tax impairments.

Slide 13. Net orders were off 21% from the prior years first quarter after a cancellation rate of 27% in both periods. This was dramatically lower than the 47% rate in the fourth quarter of 2007. While would expect the first quarter cancellation rate to be lower due to seasonality we also believe our overall rate for 2008 will be lower than 2007.

Slide 14. Based on the first quarter results we've seen reported so far, we believe that our strong Texas franchises is becoming a clear differentiating factor for Meritage when compared to other home builders. For the same or similar period, Meritage's net orders were stronger and year over year order declines less severe than several large builders. Texas will continue to outperform other areas of the country for reasons we explained previously and we expect that it will continue to help differentiate Meritage in 2008.

Slide 15. We brought down our total real estate inventory by another $104 million during the first quarter to $1,160,000,000 at the quarter end. This is almost a $400 million reduction year-over-year and was primarily due to a reduction in unsold homes as well as lot and land under development both in terms of absolute numbers and the post impairment balances of these assets.

Slide 16. We collected $76 million in tax refunds in the first quarter realized by carrying back 2007 losses to offset 2005 taxable income under the 2-year NOL carry-back rule. Our deferred tax assets at March 31 2008 was $148 million, a slight increase from year end 2007 due to this quarter's loss. We expect to collect another $40 million to $60 million of cash refunds in the first quarter of 2009 by carrying back 2008 losses to 2006. If the NOL carry-back rules are modified to allow for a 4-year carry back we may realize additional tax refunds earlier than we would under the existing 20-year carry forward rule.

Slide 17. We completed an offering of 4.3 million shares of common stock at $20.50 per share on April 25, 2008. Approximately 300,000 of these shares were granted for over-allotments which in total yielded net proceeds of approximately $83 million in cash after all underwriter's commissions and fees. These proceeds will increase both cash and stockholders equity in the second quarter.

On a pro-forma basis after taking these proceeds into account, on March 31 2008 net debt-to-capital ratio would have been 41% compared to our actual net debt-to-capital ratio of 47%. At December 31, 2007 our net debt-to-capital ratio was 49%.

Slide 18. We were in compliance with all of our debt covenants on March 31 2008. Since impairment charges are primarily on cash they are excluded in the calculation of our interest coverage debt covenant. We had available borrowing capacity of $377 million under our $800 million revolving credit facility after considering this facility's borrowing base availability in most restrictive covenants. Our interest coverage ratio is 1.6 times interest incurred based on trailing 4 quarters adjusted EBITDA. We're now in the temporary reduction period as defined by the September 2007 amendments to our credit facility. The reduction period provides release under interest coverage covenant and we appreciate our bank groups' willingness to work with us on that amendment.

Now that we've paid off the outstanding balance under that facility and have additional cash on our balance sheet from the equity offering our liquidity will offer greatest flexibility going forward.

I'll now turn it back to Steve for final comments.

Steve Hilton

Thank you Larry. While total inventory on resell homes nationally remain high, relative to the recent pace of sales, we believe we'll begin to see less significant declines in new home prices. Most large home builders have aggressively reduced their spec inventories closer to desired levels. Stabilize in prices should help improve buyer confidence over the next several quarters and lead to improve in demand in 2009 and beyond.

With regard to mortgage availability, a larger percentage of our buyers are utilizing traditional agency back mortgage financing. Recently increased loan limits have made SHA loans available to more buyers with the advantage of easier qualification and conventional loans. We believe that home buyers will recognize their great values available on homes today should be able to obtain acceptable financing for their purchases from these more traditional sources. Our primary objectives in managing through this downturn is to strengthen our balance sheet by reducing the inventory and debt and to build liquidity to take advantage of future opportunities.

I'm pleased of significant progress we've made over the last three quarters, and plan to continue our efforts on all of our initiatives. We are hopeful the government led actions to assist both current homeowners and prospective homebuyers will help bring about a recovery in home building sooner that we otherwise do realize. Until then we will continue to focus our responsible balance sheet management while prudently seeking attractive opportunities to generate superior returns in coming years. I will now open up for questions, the operator will remind you of the instructions for Q&A. Operator?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes form the line of Robert Manowitz with UBS.

Robert Manowitz – UBS

Hi, good morning. On the fourth quarter conference call you gave some color on the first quarter take downs. And I was wondering at this point if you'd provide a little bit of a color at least maybe in terms of number of lots and dollar value for the remainder of the year.

Larry Seay

We took down about a little over 1,100, excuse me, we took down a little under 900 lots for the quarter and started a little over 1,100. We think what would generally be running in the average around 1,000 lots for the quarter. We do have a couple of take downs and final on final lot options where we take a block down because we have deposits buildup which may round up first quarter or the second quarter up a little bit. But it is really a non-cash purchase because we are offsetting that against option deposits. But generally speaking, for the amount we are paying cash for, we are running about 900 to 1,000 a quarter.

Steve Hilton

Yeah, precisely we took down 889 [ph] and we started at 1,135 new homes. So, we started more than we purchased and 65% of the lots we purchased were in Texas. We'll talk a little bit about that on slide seven.

Robert Manowitz – UBS

Right, excellent. And my next question is more on the seasonality and kind of thinking through April, May, June. You seem to be taking a little bit of a different pricing strategy in the second quarter now that you've gotten your specs down. What should we expect in terms of the seasonality? Will April can all look kind of flattish to March?

Steve Hilton

Yeah, I think it will probably flat with March. I don't expect any improvement in April. Most builders, most larger public builders are now starting to try to hold on to prices and we are doing the same. And it will take some time for buyers to recognize that and get some confidence back. So, I don't expect to see a lot of improvement in Q2 over Q1.

Robert Manowitz – UBS

If I could speak in one last question, I think it is a quick one. You had provided a balance sheet target, I guess, in that you had thought you would be out of your revolver by year end but said it could happen more quickly under certain circumstances which you did. Would you have an updated target either in terms of cash flow or where you expect end?

Steve Hilton

No, we said in the previous call that we expect to be out of it by Q3and maybe, if maybe we are hopeful by Q2 or we did in Q1. But I think – cant give you any guidance on cash flow, going forward particularly since we are going to be more aggressive on holding prices but we do expect to generate positive cash flow for the remainder of the year but I'm not going to give a number.

Larry Seay

Okay Rob, our intent would be continue to run off lots that we own and start more houses than we are buying lots which would generate cash. It is just a matter of how quickly we can do that. And then at some point in time, we are going to start to see some opportunities out there that will start to redeploy a cash we are generating from getting rid of those old lots into new lower priced lots and so we don't know when that may start to happen either.

Robert Manowitz – UBS

Right, well keep up the good work and thank you.

Larry Seay

Okay, thank you.

Operator

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

David Goldberg – UBS

Good morning.

Steve Hilton

Good morning, Dave.

David Goldberg – UBS

If I could kind of start, could you give me an idea where land prices are maybe in the market now relative to where have to be for you guys to be able to pencil deals and what gives you the confidence, having raised some capital that land price decline is going to occur over, let say, the next 9 to 12 months.

Steve Hilton

Well, we are seeing lots for example in the Central Valley and East Bay division in Northern California. We previously paid $125,000 for seller's lots that we are able to buy now for $45,000 to $50,000. And although we are not seeing a lot of them yet, we are starting to see some deals that are looking interesting. Pricings come down on many communities that we are in on lots by 50%. And we expect in the second half of this year to see a lot more deal flow as a lot of the private builders now are losing their land positions back to the banks, and the banks are beginning to dispose of those assets. So, we are very optimistic that we are going to be able to build to buy lots at lower prices going forward.

David Goldberg – UBS

So, I guess what I'm trying to do is to reconcile that thought, that the banks are getting more aggressive with the small privates and you expect to see land prices coming down in the second half of the year, with the idea that you feel like your impairments are mostly behind you and that because the big publics are generally holding their prices, which I don't [ph] absolutely agree with, you're not going to see more home price deterioration from the small private builders and the impact then on the market. Can you maybe help me understand the way you're thinking about that a little better?

Steve Hilton

Well, a lot of the small private builders can't lower their prices any more because they have secured bank financing. And the values of the homes are less than their financing release prices. So, the only way those homes and lots are going to be released are when they go back in the banks. And relative to the publics, the private guys just don't have a lot of inventory in pure numbers. Most of the larger markets that we are in, the publics dominate 60% to 70% of the market. And I just don't see the private guys having an impact on the public. So I think once the banks get some of these assets back this inventory will able to be cleared. But the public guys have already cleared their inventory for the most part.

David Goldberg – UBS Securities

So to say it correctly, the banks bringing those assets back on the market is not going to impact the home prices on the overall market? That's what you're trying to say?

Steve Hilton

Yes. I mean most might have a mild impact with a smattering of spec houses they're going to get back that the privates couldn't sell because the release prices were too high. But from the lot perspective it is going to be able to feed us lots at lower prices that we are going to be able to make a profit on and, amongst other builders, that's where we are going to find finished lots. Another public builder is not going to sell us finished lots at a price low enough for us to make a profit on, because they would just build through them themselves. Where we are going to find those lots is from banks and land developers who need to sell them.

David Goldberg – UBS Securities

And then if I could just get a quick follow-up to that. I guess if you could give me some ideas looking forward about how you think about the option-focused model, the availability of financing on the land development side or on the for somebody who's stuck in between [ph], whether it is land bankers or somebody else how do you see the model potentially changing, given what's an increased perceived risk in holding land now? And maybe the cost for you guys to be able to have somebody else take that risk with an option-focused model in holding land?

Steve Hilton

Well, I'll take part of it and Larry, you take a little part of it. But essentially, the way we are looking at it is there's a lot of money out there today chasing land. A lot of what we call "vulture" funds and we think some of this capital is going to get deployed. And we think builders are going to be adopting more of a land-life strategy, as we have. And a lot of these "vultures" or investors will be selling lots on terms or on options. And we won't be able to maybe go back to some of the land bankers we did business previously, but they'll be new entrants into the market in terms of some of these investor funds that will be buying these lots and then selling them on more terms or option-type deals. And some of our land bankers are quite healthy and made it through the market pretty well and we expect them to be in business going forward. Larry, did you want to add to that anything?

Larry Seay

Yes. We have several land bankers that called us up and are looking for new business that were well capitalized and minimize lot losses and they just figure this is one downturn that they have to ride through. And they've been in business for 20 years and plan to be in business for another 20 years. Having said that, the terms may be a little more expensive, or more onerous, and we'll have to weigh that against putting things on our balance sheet. I would say we probably won't get up to the 90/10 ratio we had where 90% of our lots were optioned, but we still plan to use a land-life strategy and use options to the extent available and that they make economic sense.

David Goldberg – UBS Securities

Perfect. I appreciate it.

Operator

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

Rob Hansen – Deutsche Bank

Okay. This is actually Rob Hansen on for Nishu. Was there any benefit from prior impairments in the gross margin?

Larry Seay

I'm sure that that's the case. Part of our impairments related to option deals we walked [ph], which obviously doesn't benefit future margins, but some of that did relate to lots and houses owned, although we don't break that number out and I can't tell you what that number is precisely.

Rob Hansen – Deutsche Bank

Okay. And just kind of read-through on the impairments with the unsold home prices coming down and kind of driving the lower spec levels, does this mean you are impairing the construction-in-progress? And how much in general in the past have been in the construction-in-progress?

Larry Seay

We are I think you'll see more, a higher percentage of our impairments be owned property versus impairments of options, to start with, because we have already terminated and gotten rid of so many options. And most of our options outside of Texas are not around anymore. As Steve said, like about 65% of our purchases of lot options were in Texas. Now, when it comes to the breakout of housing, yes, we are because of aggressive pricing in the first quarter we did write down some work-in-process, as well as that lower pricing impacted lots we own. So it is a combination of those. I don't have the specific breakout on whether it is a house or the lot sitting next to the house that's still un-built. But we think even though we may have some additional impairments we think that with the hold-the-price line that we'll be able to minimize those impairments going forward, so that you'll gradually see them continue to taper off. But I can't give you that specific breakout because we don't have that number right here at my fingertips.

Rob Hansen – Deutsche Bank

Okay, thanks.

Operator

Your next question comes from Susan Berliner with Bear Stearns.

Susan Berliner – Bear Stearns

Morning. I was wondering if you could help us on the joint venture. I know it was notable impairment this quarter and I guess I was just trying to figure out going forward what do you think is going to happen with the joint ventures? And if you can give us color on what you're seeing out there on the joint ventures?

Steve Hilton

Larry, go ahead.

Larry Seay

Well, the one impairment we took was to write off the remaining balance on one large project up in northwest Phoenix, and that either wrote off or reserved any further capital commitment we had to that venture. So at the end of the quarter we are down to only $21 million in investment in all of our joint ventures. So from Meritage's point of view we think the exposure is fairly minimal for the as we talked about previously, we have four or five joint ventures that we have fully impaired. The last one that we wrote off was fully impairing a fifth joint venture. Beyond that, we don't believe we have a lot of additional exposure because the seven remaining equity-method joint ventures are all kind of immaterial individually and are doing pretty well. They're in cities or states that seem to be holding up, for example, Texas. And beyond that, we've minimized our guarantees. We've talked about that where we don't really have much in the way of additional guarantees or support to the ventures, so if one other venture did have a significant problem it would be an immaterial impairment. Overall, I can't speak for the rest of the homebuilding industry, but I think Meritage has done a pretty good job isolating joint venture problems from the parent company.

Susan Berliner – Bear Stearns

Great. Thanks. And just one follow-up I was wondering if you could give any color on I guess the LCs outstanding on your bank line and where your tangible net worth cushion is?

Larry Seay

Yes. We have about 30 or 40, I don't have the specific number, of LCs still outstanding. And at the end of the quarter before our offering, we had about $60 million after-tax cushion. We get in the bank facility a 50% credit for the equity, so that brought it up to around $110 million on a I meant to say after-tax number. So you would multiply that or divide that by the tax rate and it would multiply into a number significantly greater than that, somewhere in the $170 million range. So we feel pretty comfortable that we have adequate tangible net worth cushion at this point.

Susan Berliner – Bear Stearns

That's great. Thanks very much.

Operator

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

Joel Locker – FBN Securities

Good morning. Just on Texas, in general obviously it is your strongest region right now, but saw the order price sequentially drop 7.5%. Just was wondering if that was more of a mix issue or anything else behind that?

Steve Hilton

I think primarily it was mix. I think we probably are certainly gave them some concessions there. But I would chalk a majority of it up to mix. Would you agree, Larry?

Larry Seay

Yes. Yes.

Joel Locker – FBN Securities

So that's just and then it might pop back up or ?

Steve Hilton

Yes.

Joel Locker – FBN Securities

Depending on the size of the house or okay. So then also just on the gross margin front, I guess it was pretty significant that you actually stabilized them sequentially on a Company basis, but just was curious about what your gross margins are, ballpark figure, in Texas right now?

Steve Hilton

Larry?

Larry Seay

Well, we don't typically break out state ones, but our Texas gross margins are significantly better than the Company average. Obviously in some places like California our gross margins are very, very low. Generally speaking, our gross margins in Texas are kind of in the mid-to-high-20s, depending upon which project we are in. So if that gives you

Steve Hilton

Mid-to-high teens you mean, Larry.

Larry Seay

Yes. Mid-to-high teens, excuse me. I misspoke.

Joel Locker – FBN Securities

Right. Mid-to-high teens. All right. That's it. Thanks a lot.

Operator

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

Carl Reichardt – Wachovia Securities

Steve, I'm curious in your theoretical Central Valley example of $45,000 to $50,000 a lot relative to $125,000 before. If you were looking at a project like, what kind of operating margins would that generate for you? And how would you think about the pro forma on sort of are these quick-delivery lots, something you could put up in a hurry?

Steve Hilton

Yes. I wouldn't say it is theoretical, because I think these are lots we are actually thinking about buying. And we are thinking about building smaller houses. Before we were building houses on these lots that were probably averaging like 2,800 feet, so we are probably thinking about building houses that might average 1,800 feet. So 1,000 feet less, with less features, where we can bring the average price down into the 2's, where originally they were approaching $500,000. So there's a real compelling opportunity really to find a broader audience. And at $280,000 or $275,000 if we pay $45,000 cash for these lots, they're fully improved, we can make a 20% gross margin, which should lead, with some volume, to 10% net.

Carl Reichardt – Wachovia Securities

Okay. Then your commentary earlier about the variety of entities out there looking at land right now, if this opportunity is so sort of obvious and in front of you, isn't it your sense that other builders who have liquidity, of which there are some obviously, and the vulture funds themselves would be looking at similar transactions? And how are we to be confident that that pricing will stay so attractive for a long period of time if there's all this capital looking at deals currently?

Steve Hilton

Well, I think inherently builders can pay more than vultures for finished lots. So I think public builders will probably be the ones that will be buying those lots versus the vultures that will be more focused on the periphery, on more of the outside-the-loop locations. And then I don't think all builders are in a position to buy any lots. I think there's a lot of builders that are going to be on the sidelines for quite some time because they don't have the balance sheet to buy lots of they just have too many lots that they're still working through. So I don't think the competition is going to be as keen as you might suspect. Private guys aren't going to be able to get credit and not all the public guys are going to be able to participate.

Carl Reichardt – Wachovia Securities

Okay, great. Appreciate the color. Thanks, Steve.

Operator

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

Tim Jones – Wasserman & Associates

Yes. Good morning. Couple of questions first of all, I'm wondering why your subdivisions, given the fact that business has slowed down so much, are still the average subdivisions are basically flat? With Texas I can understand being up, but I'm curious about especially Nevada being almost double last year's average subdivisions. Could you address that, please?

Larry Seay

Are you talking about community count?

Tim Jones – Wasserman & Associates

Yes, community counts.

Steve Hilton

Well, we had several large communities come on line last year in Nevada, which increased our community count, but they had been planned for quite some time. And about 120 of our communities, out of our 215 approximately, are in Texas and that community count really hasn't changed. I think you'll see in the latter part of this year our community count really start to decline. I can't give you a number, but I can tell you we are going to finish the year below 200. And it should start to decline at a pretty good clip over the next couple quarters.

Larry Seay

I would add to Steve's comment about Nevada, that Nevada had an unusually low community count beginning in 2007 because it had sold out a lot of communities very fast and these newer communities hadn't yet come on line. So it was unusually low.

Tim Jones – Wasserman & Associates

So you are comfortable with I mean, Nevada's a very tough market, I don't have to tell you. And you're comfortable with the level of communities you have there?

Steve Hilton

Yes. We have about 1,000 lots, plus or minus, in Nevada and we are not opening any new communities other than what we've got right now in the large joint ventures up there, one called Inspirada and other one called Providence. And we are just going to work our way through those. We're certainly not buying any lots in Nevada and we are comfortable with where we are.

Tim Jones – Wasserman & Associates

Okay. The second question is, just a second. Oh. You implied that you were going to try to hold prices. Now, over the last year or so Standard Pacific first tried it, then D.R. Horton, and most recently KMB. All of them after showed precipitous declines in sales and had to reverse their attempts. What makes you think that you can do it now?

Steve Hilton

Well, I don't know that the builders that announced it in this last quarter, KMB specifically and a couple others, have really changed courses. What I see in the ground in the field is builders continuing to be disciplined to hold prices because builders like ourselves and KMB have the balance sheets to be able to do that. A builder like Standard Pacific doesn't have the ability to do that. And if I were Standard Pacific I would never have came out and said I needed to hold prices. So we are two years into this, or more than two years in some markets. We need to instill confidence in buyers. We've burned off all a lot of our unsold home inventory and I don't think we have the motivation to continue to sell houses at very low prices. And we'll do what we need to do to maintain a proper amount of sales to cover the infrastructure and organization, but we are not going to continue allowing a freefall in housing prices.

Larry Seay

I think the builders have seen that they've dropped prices far enough and so far that it obviously today in many cases doesn't make sense to start a new-build house on a vacant lot if the cash you're going to generate from building that house and selling the house and getting a recovery of cash out of the lot that you've already made is just a fraction of the value of the lot of the original value. So people are making the economic decision that the residual lot value is at a point with prices where they are now that they don't want to continue to drop prices because the cash flow generation gets to be too minimal to be worth the effort. So people have the economic incentive today to hold prices because of that.

Steve Hilton

Tim, that's a key point. I mean it is just you're in a much different situation when you've got a lot of inventory, lot of specs to sell, than when you only have lots. And I think Larry did a good job of articulating that. The cash return is just not substantive enough that you want to take the risk to go build another house when you're not getting much money. So

Tim Jones – Wasserman & Associates

Well, a lot of builders are having to do it, just to they have two choices, sell the land at $0.20 on the dollar or build the house and lose maybe, lose on the land, get 80% of the land price.

Steve Hilton

Yes, but if you have a good balance sheet and you're really not getting much for the land, then why would you if you had a house that was $400,000 and now it is $300,000 and you were getting $100,000 for the lot and now you've got to sell it for $270,000 and you're only going to get $20,000 for the lot, you might think twice about doing it.

Tim Jones – Wasserman & Associates

Oh, I agree with you. There's a (inaudible).

Steve Hilton

Yes. Yes. Okay, do you have a follow-up question or was that it?

Tim Jones – Wasserman & Associates

I guess you talked about overhead. What's your headcount and what was it versus the peak?

Steve Hilton

Larry, at peak it was like 2,300 and today we are probably under 1,300 does that sound right, Larry?

Larry Seay

That's about right. We don't have the specific numbers at year-end compiled yet, but that's pretty close.

Steve Hilton

Quarter end, yes.

Tim Jones – Wasserman & Associates

Okay. Thank you so much.

Larry Seay

Did I say year end?

Operator

Your next question comes from the line of Shaumo Sadhukan with Lotus Partners.

Shaumo Sadhukhan – Lotus Partners

Hi. Can you talk about the 889 lots that you bought this quarter? What are margins like on those lots?

Steve Hilton

It varies, because some of them are in Texas where the margins are still good. And others are in Arizona, California, and Nevada, where the margins aren't as good and there might not be much of a margin, but there's a good cash margin. And it is different in every community. Larry, do you want to ?

Larry Seay

Yes. An example would be, say, in California where the market's pretty tough we may have a zero accounting margin and but yet because of the deposit, because of marketing, model costs

Steve Hilton

(inaudible).

Larry Seay

We may recover 10% of the sales price in cash, so we look at that and go, gosh in that case we are making a zero accounting margin but we are making a 10% cash margin. It probably makes sense for us to go ahead and build through that and recover that cash. On the other hand, if our cash margin was just 2%, we wouldn't buy that lot. We would go gee, it is not worthwhile for us to continue through the subdivision, buying lots from a land banker, building out the houses to only make a 2% cash return. But 8%, 10% cash is probably kind of the low end of our range of continuing to buy lots to recover the cash we had to spend.

Steve Hilton

It would also depend on how many lots we had on our balance sheet already in that community. If we have a lot of lots, we probably wouldn't be buying them as aggressively if we didn't have any, or a very small number.

Shaumo Sadhukhan – Lotus Partners

So I guess what I'm trying to understand is so right now you have 9,900 owned lots and 14,700 option lots. How many of those option lots will you probably end up taking down at low accounting margin but high cash margin because you think it just makes sense for you to take them down? Where are we in terms of kind of thinking about that issue at this point?

Steve Hilton

Well, we are getting close to the end of the option terminations. I'm looking for the (inaudible)

Larry Seay

Well, first of all two-thirds of those option lots are in Texas, which are still making relatively good margins. So you're only talking about a third of the option lots being outside of Texas, and those are spread out in communities where today most of them meet that minimum cash return criterion or else we would have terminated them already.

Steve Hilton

So maybe 4,000 low margin lots.

Shaumo Sadhukhan – Lotus Partners

Okay. So that's within the 9,900 that you own there's some low-margin lots and maybe 4,000 low-margin lots in the options, in the option piece? Is that a good way to think about it?

Larry Seay

Well, on the option side I think you've got it right. I would have to think about what you said on the owned lots.

Steve Hilton

Well the owned lots we are looking at cash return. In addition to margin we are also looking at the cash return for the lot. So we really look at those as a return of some capital.

Shaumo Sadhukhan – Lotus Partners

Okay. But I guess my point is, so then, just to sort of think about how this will develop over time, once you work out those lots, right, so that, if I did the math right, maybe it is 8,000 total lots between the owned and optioned part, sort of your legacy lots that you have to work through where you're not really making much accounting margin once you work through those lots at the current pace maybe it takes you, say, a year to work through those lots. Maybe it is a year and a half, who knows? But once you work through those lots, then you can start recapturing margin back as a company? Is that the correct way to think about it?

Steve Hilton

Well, sure. If we bought some lots today I'm not saying that we are doing this, but if we were to buy some today they would hit our income statement on the second half of next year. So as the opportunities start to become available, and as we feel comfortable that the sales are there at the prices to match the lot prices, we'll start to gravitate into some new inventory to kind of average our cost down. But it won't hit our income statement until later next year.

Larry Seay

Because it takes a while to get the subdivision up and running. But that's exactly the point we attempt to make, is that because we have a short lot position, we can work through these legacy lots, as you call them, that have lower margins and start to reload with newer, lower priced lots more quickly than maybe other builders. But that really won't start to happen until, at least in earnest, until the latter half of '09.

Steve Hilton

This is absent any housing appreciation. If we have housing appreciation it will be beneficial to all the lots, but, assuming we don't have any, we could still make a profit in the back half of next year on newer lots.

Shaumo Sadhukhan – Lotus Partners

Right. And so these lots that you're talking about in California, where the prices have fallen by more than half, let's imagine you were to buy them and there was a little bit of price depreciation still to come in those markets and you're at current pace. Can you still make this 20% gross margin, 10% net margin, operating net margin before tax? Can you still make those at current pace even if prices decline a little bit, or are we talking (inaudible) ?

Steve Hilton

No. If we buy those lots and we calculate wrong and we underrate them at 20% gross margin and the price declined from there, then we are going to make less. So to the extent that they decline, but we can't be out there buying lots if we don't think prices have stabilized.

Shaumo Sadhukhan – Lotus Partners

Okay. I guess my question is can you do it at current pace? That's really the key question. Can you make those types of margins if you were to buy those lots today if price held, but could you do it at current pace, meaning do you need pace to pick up to get those types of margins back or can you recapture margin even at current pace?

Steve Hilton

Well, there are builders, including ourselves and others, that have some subdivisions that are selling pretty high volumes. When you there are buyers out there for homes at the right price. So if we can ascertain what the correct velocity is, matching up to the correct price if it is four a month or five a month or three a month and we can hit that pace, then we can make money. But we can't go into a community and achieve the pace that we are achieving on average in all of our communities today and be profitable. So we need to get a more realistic what level of volume to achieve a reasonable return.

Larry Seay

And again, it is not 0% or 10%. It is a continuum and if you're selling at a slower pace with a well priced, low priced lot you can make money. You just won't make quite as much money as if you were selling at a higher volume to cover your fixed overhead for that project. But I guess I would come back to California and our example. We only own about somewhere between 900 to 1,000 lots in California. That's it. So in these very difficult markets, we don't own very many lots. We've terminated most of our options. So our total exposure in California is not that large and we can start this process in California as we start to see the opportunities arise pretty quickly.

Shaumo Sadhukhan – Lotus Partners

All right. Thanks, that's really helpful.

Operator

Your next question comes from the line of Joshua Pollard with Goldman Sachs.

Chris Hussey – Goldman Sachs & Co.

Hi. It is Chris Hussey, Goldman. Good morning, guys. Question on Texas, if we were to hearken back a couple of years, builders never talked about Texas as being the most terrific market to be in? When you think about your long-term strategy I can understand sort of hiding out in Texas, but when you think about the long-term strategy for you guys, is Texas really just a great housing market or is it just a great place to hide out until the great housing market comes back?

Steve Hilton

I've never heard anybody describing it as hiding out before. But I can tell you, Texas is one of the greatest housing markets in the country, because it is got some of the best job growth in the country. And you've got larger cities like Houston and Dallas that are near the tops in job growth year in and year out. Now the margins are lower there because there's a lot more supply. And there's a lot less restrictions to growth. But it is very stable and demand doesn't go up and down in Texas like it does in other markets, so if you're willing to accept lower margins it is a place you can sell a lot of houses. And if you're very disciplined about your business and you run a tight ship, and you have great sales teams, and you have great construction people that know how to buy materials and know how to subcontract, and you're good at buying land and you don't design away your profits, you can make good money in Texas year in and year out. And I would not describe it as we are hiding out there. We're just it just happens to be one of the few places in the country that hasn't been as affected by the downturn as the coastal markets have.

Chris Hussey – Goldman Sachs & Co.

Going forward, do you guys envision yourselves with maybe 50% or greater of your business coming out of Texas?

Steve Hilton

No. No, certainly as the other markets recover it'll probably drop down more to about one-third, which is where it was a few years back. And we are very comfortable having one-third of our business in Texas and two-thirds in the other five states. Today, because the other five states have been more dramatically affected by the downturn, we are a little more than half in Texas, but we expect that to turn over time.

Chris Hussey – Goldman Sachs & Co.

That's fair. On the joint venture, the old Chrysler property, is it your intention to walk away from that property, or are you guys going to stay in that joint venture, you've just written it down to zero?

Steve Hilton

No. We're not Toll is managing it. We have 18 months to go on the loan and we'll just see where we are in 18 months. We're completing the entitlements right now and haven't made any definitive plans what's going to happen there.

Chris Hussey – Goldman Sachs & Co.

But, if there's a capital call within that 18 months you guys would …

Steve Hilton

Well, there won't be.

Chris Hussey – Goldman Sachs & Co.

Okay. There won't be. And then finally, could you maybe talk a little bit about the owned lots? What's the investment that you require in those owned lots to get them so you could build a house on them?

Steve Hilton

Larry?

Larry Seay

Yes. That varies and I don't have the number of what it would take to complete every single lot we own to a finished state. Most of our lots we own are already finished. There's a portion of them that aren't, roughly about 2,800 that we own that aren't completed. But I don't have the number that obviously we are holding back on development costs and only spending the dollars when we need to start building on the lots, so it is not something that we'd have to have this big CapEx number we'd have to spend today in order to get houses built.

Chris Hussey – Goldman Sachs & Co.

Okay. So the bulk of your investment then, going forward, is going to be buying out these option lots rather than investing in your lots.

Larry Seay

Right. There obviously is some of that, but it is not a huge number.

Chris Hussey – Goldman Sachs & Co.

Great, thanks guys.

Operator

Your next question comes from the line of Nicole Terraco [ph] with Babson Capital.

Nicole Torraco – Babson Capital

Hi. Good morning. Just a couple of follow-ups on your JVs can you give us an updated number on what your guarantees are at this point on the JV debt?

Larry Seay

Well, we have very little in the way of direct guarantees. That number I believe is about $5 million. The other significant group of guarantees we have are what we call bad-boy guarantees, which only spring into place if the venture partners were to file a voluntary bankruptcy in most cases.

Nicole Torraco – Babson Capital

Wait. Do you have that number?

Larry Seay

Well, I don't have the precise number right now, but last quarter it was $88 million and I don't expect it to change a whole lot from last quarter.

Nicole Torraco – Babson Capital

Okay. In terms of your debt covenants, do you have a leverage covenant right now or is it just the coverage and the tangible net worth?

Larry Seay

Yes, we do have a leverage covenant and, generally speaking, that number's around 2 times, or 2.25 times, depending upon which indenture we are talking about. But the bank indenture, or the bank document does tighten down as our interest coverage floor lowers, so at the worst point in our modified bank facility we have a debt-to-equity tangible equity ratio of 1.4 times. And currently with our current equity position and our current debt position, we don't perceive that to be an issue for us.

Nicole Torraco – Babson Capital

Okay. Great. And one last question on your adjusted EBITDA calculation for the first quarter of 2008, you're including this other income expense item. Do you know what's in that line item?

Larry Seay

Yes. Generally speaking well, other first of all there's a loss in other income today, which is really the $16 million of impairments we took on our JVs. So if you back that out, there's also interest expense on that number of about $5.6 million, $5.7 million. So those are expensed items running through there, but if you look at the other income side of it, excluding those negative loss numbers you would have mortgage and title JV income of about $2.5 million. And you'd have a miscellaneous number of about another $2.4 million, which consists mainly of forfeiture income from people walking away from purchase contracts and us retaining their deposit.

Nicole Torraco – Babson Capital

Okay. Thank you.

Operator

Management, would you like to take one last question?

Steve Hilton

Yes, one last question, please.

Operator

Your final question comes from the line of Jim Wilson with JMP Securities.

Steve Hilton

Good morning, Jim.

Jim Wilson – JMP Securities

I think you've answered pretty much everything, but I was just wondering kind of, as you're discussing prices and where you think you're beginning to hold them, if you could kind of put it in perspective in your various markets how much they've dropped and which of those markets you feel you're closest to being the market conditions suggest you're closest to being in a position to start holding prices?

Steve Hilton

Well, I think in California net prices have dropped probably 30% to 40%, in Arizona 25% to 30%, Las Vegas 25% to 35%, Orlando 25%, 30%. Now I think in all those markets we are pushing hard this quarter to hold prices. We have very few completed spec homes and we are going to try to hold prices on new dirt sales.

Jim Wilson – JMP Securities

So really all of them you think, with this kind of drop, are in a position to start holding prices?

Steve Hilton

That's right.

Jim Wilson – JMP Securities

All right, that makes sense. All right, thanks a lot.

Steve Hilton

Okay. Thank you very much everybody. We'll look forward to talking to you again in Q2. Good day. Thank you.

Operator

This concludes today's Meritage Homes first quarter 2008 earnings conference call. You may now disconnect.

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Source: Meritage Homes Corporation Q1 2008 Earnings Call Transcript
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