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Executives

Steven J. Hilton - Chairman of the Board, Chief Executive Officer

Larry W. Seay - Chief Financial Officer, Executive Vice President

Brent Anderson - Vice President - Investor Relations

Analysts

David Goldberg - UBS

Joel Locker - FBN Securities

Nishu Sood - Deutsche Bank Securities

[Neethan Dia] - Lehman Brothers

Daniel Oppenheim - Credit Suisse

Lee Brading - Wachovia Capital Markets, LLC

[Shamo Fadugen]

Carl Reichardt - Wachovia Capital Markets, LLC

[Nicole Sirocco - Babson Capital]

Eric Landry - MorningStar

Meritage Homes Corporation (MTH) Q2 2008 Earnings Call July 28, 2008 2:00 PM ET

Operator

Welcome everyone to the Meritage Homes 2008 second quarter results conference call. (Operator Instructions) I will now turn the call over to Brent Anderson, Vice President, Investor Relations.

Brent Anderson

I’d like to welcome you to the Meritage Homes second quarter 2008 earnings call and webcast. Our quarter ended on June 30 and we issued a press release for the results of the quarter and the first half of the year after the market closed yesterday. If you need a copy of the release, you can find it on our website 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 those 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 10K. Today’s presentation also includes certain non-GAAP financial measures as defined by the SEC. To comply with these rules, we have provided a reconciliation of the non-GAAP measures in our earnings press release.

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

Steven J. Hilton

I’d like to welcome everyone to our call today. We’ve experienced three years of dramatically lower sales, softening prices, tightening credit for homebuyers, and rising inventories. More recently we’ve been impacted by increased foreclosures and an uncertain economic outlook. However, our impairment charges have trended lower over the past three quarters and we continue to benefit from our relatively stronger position in Texas, which once again had the best sales amongst all of our markets this past quarter.

Our second quarter net orders declined 15% year-over-year and total order cancellation rates were lower than the prior year at 29% of gross orders in the second quarter 2008 compared to 37% in the same quarter in 2007. Our orders in Texas were down just 4% compared to a decrease of 28% in markets outside of Texas. The housing market in Texas has slowed in the last couple years but much less than most other markets across the country. Texas is the number one state in the country in terms of population growth spending at two times the national average. It’s also number one in employment growth with about 237,000 jobs added in the last year and number one in total home building permits which were over 110,000 for the 12 months ended February 2008 according to government sources. Strong [inaudible] climates, lower cost of living, and robust growth are factors that contributed to Houston, Dallas-Fort Worth, Austin and San Antonio being four of the top 10 fastest growing metro areas in the United States last year. Meritage has a large and established presence in these [inaudible]. Although some builders have experienced weaker results, we have gained market share in the largest Texas markets over the last year. According to reports from independent housing market analysts, Meritage is the top 10 builder in all four major markets in Texas and has moved up the list in the top three markets during the last year.

Turning to Slide Six for those of you following along on the Slide show, our second quarter 2008 home closing revenue declined 34% year-over-year as a result of 25% fewer home closures [inaudible] our average closing price. [Inaudible] lower than the second half of 2006. Many of our closings this quarter were from that period. Despite lower revenues we reported a small loss for the second quarter 2008 than we did a year ago. I’m also pleased to report that we achieved continued progress on our key financial and operating goals this past quarter, which I’ll discuss later.

Slide Seven; we reported a net loss of $23 million or $0.79 per share in the second quarter compared to a net loss of $57 million or $2.16 per share in the second quarter compare to a net loss of $57 million or $2.16 per share in the second quarter of last year. Our pretax loss of $34 million in the second quarter of 2008 included $39 million of charges related to real estate and JV impairments. By comparison our second quarter of 2007 pretax loss was $89 million which included $80 million of real estate related charges and $28 million of goodwill impairments. We were profitable in the second quarters of both years before impairment charges with pretax income of approximately $5 million in 2008 and $19 million in 2007. The battle that homebuilders have been fighting since the beginning of this down cycle is all about protecting our balance sheets, reducing assets to generate cash and pay down debt. We’ve been successful in achieving these objectives and we’ll review our continued progress this quarter in a few minutes. Now we’re turning our attention towards improving our profitability, which is our focus for the remainder of 2008 and beyond.

Slide Eight; we remained a build-to-order homebuilder appealing primarily to move up buyers and we’re repositioning many of our communities to attract buyers at lower price points. In response to buyers’ demands for more affordable homes, we are focusing more on the first-time move-up and entry level buyers with homes at lower price points that can more easily attain government-backed financing and in many cases don’t have homes to sell. In some cases that means offering smaller homes with fewer standard features while still allowing customers the flexibility to upgrade from a good selection of options and make the home distinctively their own.

On a much broader scale, we’re going through a top rents value engineering process that we expect will have a significant impact on our business and our success. We’re re-evaluating all of our models, leveraging those that are the best sellers while redesigning or eliminating others and removing features that customers don’t value. We are aggressively rebidding all construction contracts and have been able to achieve considerable savings with a combination of these efforts. Based on the strategy I just discussed, we’ve reduced our cost of construction more in the first six months of 2008 than in all of 2007. Our divisions outside of Texas are targeting a home construction cost reduction of 20% to 25% from their peak levels. Several divisions already accomplished this goal. We expect to see the benefits of these value engineering processes and meaningful margin improvement by the middle of next year.

We continue to cut our overhead expenses and reduce our inventories to regain our operating profitability and obtain a strong balance sheet and generate significant positive cash flow. Our financial management for the first part of the cycle positions us well to capitalize on opportunities if the market begins to recover.

Slide Nine; we continued to generate positive cash flow in the second quarter of 2008. The first half of the year has traditionally been cash flow negative due to increased construction activity and the related costs as we start homes sold in the spring selling season. Following this seasonal pattern, our first half of 2007 cash flow was a -$167 million. Inversely we generated $12 million positive cash flow during the second quarter of this year or $102 million in the first half of the year. In addition to positive cash flow from operations during the quarter, we completed a stock offering of 4.3 million shares on April 25, 2008 raising $83 million to end the quarter with $115 million in cash and no bank debt.

Continuing our long-established asset light strategy, we reduced our lot and land inventory by $26 million during the quarter despite the modest low-price land acquisitions. We reduced our total inventory of unsold homes by $24 million during the quarter representing a 48% total reduction from the peak in 2007. We ended the quarter with a total 725 unsold homes and of those only 297 were completed. That puts us at an average of a little more than three specs per community with only one completed, which is about what we need to sustain operations at the current levels. Unsold homes represented only 27% of our total homes under construction at June 30, down from 30% at the end of the previous quarter and up from 40% at the beginning of the year.

Slide 11; we also continued to reduce our total lot supply control bringing down another 11% in the second quarter, a reduction of about 2,700 lots despite the acquisition of about 500 new lots this quarter. We’ve reduced our total lot supply by 60% in the peak in September 2005 and cut our total lots in our option by 75% in that same timeframe.

Slide 12; at the end of the second quarter approximately 67% of all the lots we control were in Texas which had some of the best performing markets in the country for the last year and accounts for about 73% of all of our option lots. We estimate that we have approximately a 3.2 year supply of lots in total but are down to a 1.7 year supply in California and less than a year’s supply in Florida since we terminated most of our options and put almost no lots in our control from those markets in the last couple years. We are actively assessing opportunities to acquire discount lots in those markets.

Slide 13; although our community count decreased to 213 at quarter end down slightly from 220 communities at the beginning of the year, approximately 40% of our communities outside of Texas have fewer than 25 lots remaining for sale. As these older lower-margin lots are sold our active community count should come down over the next several quarters. It is our intent to take some of the cash we generate from closing out these projects and redeploy it into [inaudible]. We plan to do that by acquiring and building on lower priced lots where we believe we can earn a near-normal return at today’s home prices. We do not plan to increase our balance sheet leverage by purchasing long land positions. That has never been our strategy. Instead we are looking for select opportunities to acquire small numbers of finished lots at deeply distressed prices where we can sell homes at near-normal margins and improve our profitability. In some cases we’ve been able to purchase lots at or below the cost of improvements with $0 or negative residual land value. We have recently purchased lots at one-third to one-half of their original cost and we believe these will allow us to earn good margins selling homes at today’s home prices, which are substantially lower than the prices were at their peak.

I’ll now turn it over to Larry Seay, our Chief Financial Officer, and end our prepared remarks with a few closing thoughts before Q&A.

Larry W. Seay

Turning to Slide 14, we have reduced our total real estate inventory by about $500 million over the last 12 months from $1.6 billion at June 30, 2007 to $1.1 billion at June 30, 2008. As Steve explained, a good portion of this relates to inventory impairments but a large part of the decrease was also achieved by a reduction in unsold home inventory as well as lots and land under development. Our ending inventories are much lower than they were a year ago, both in terms of the absolute number of units and the post impaired values of those assets. Additionally we further reduced our exposure to joint ventures shrinking our investment in JVs to $21 million at the end of the second quarter. Although joint ventures remain a source of concern related to homebuilders, we believe they currently represent little real risk to Meritage as our exposure under guarantees of JV debt is limited.

Slide 15. We recorded about $39 million in pre-tax non-cash charges for real estate impairments and lot option terminations during the second quarter of 2008, which are broken out on Slide 15. A little more than half of our impairments on lots and homes this past quarter were in California. Our California markets have been the most negatively impacted over the course of this downturn which is evident, turning to Slide 16.

Since we began incurring impairment charges, California has accounted for more than 40% of our cumulative real estate related charges through the second quarter of 2008. Arizona has also been hard hit in the downturn and accounts for about 25% of our cumulative charges to date. However, you can see that impairment charges have come down dramatically over the last several quarters after they peaked in the third quarter of last year. We have terminated the great majority of our underperforming options and have very little remaining inventory in many of our markets as Steve has pointed out. We therefore expect impairments to be much lower this year than last with less negative impact on our earnings and book value.

Slide 17. Due to lower impairment charges included in cost of sales, our homebuilding gross margins increased to 6.2% in the second quarter 2008 over the prior year’s 1.7%. Excluding the real estate charges from the cost of sales in both years, our adjusted second quarter gross margins were 13.8% in 2008 compared to 15.6% in 2007. The tighter adjusted margins reflect lower prices driven by weak demand and intense competition which were partially offset by the construction cost reductions we’ve already achieved. We reduced our second quarter general administrative expenses by 27% year-over-year from $28 million in 2007 to $21 million in 2008 as a result of continued cost controls. The $7 million of total savings in overhead was before the impact of a $10 million legal settlement that we collected during the second quarter of this year, which further reduced G&A expenses. In other words, we held G&A expenses to about 5.5% of total revenue in the second quarter of 2008 excluding the favorable impact of the settlement compared with 5% in the second quarter in 2007.

Slide 18. Our increased cash generation from operations, along with our stock offering and debt reduction, resulted in a lower net debt to capital ratio of 41% at June 30, 2008 down from 49% at the beginning of the year and 47% at June 30, 2007. We have no bond maturities until 2014 and our credit facility extends to 2011. At June 30, 2008 we had no borrowings outstanding under our credit facility. Our liquidity consisting of borrowing capacity and cash was $408 million after considering the most restrictive covenants in place at that time. We were in compliance with all of our debt covenants as of June 30, 2008. Since impairment charges are primarily non-cash, they are excluded in the calculation of most of our debt covenants. Our interest coverage ratio was 1.6 times interest incurred based on trailing four quarter suggested EBITDA.

In July we and our bank group amended our credit facility to loosen its most restrictive borrowing covenants and modify its pricing structure. These modifications provide additional covenant relief by relaxing the minimum interest coverage ratio, intangible net worth covenants, as well as the maximum leverage ratio covenant. These modifications are intended to provide us greater flexibility to manage through this home building cycle. In the event that the housing recession is longer or deeper than expected, this additional cushion will help us maintain flexibility in our operating and strategic decisions. The credit facility was also reduced in size to $500 million which we believe will be sufficient to support our operations for the foreseeable future. We also reduced our lines of credit to $42 million at the end of the quarter from $50 million at the end of last year and further reduced the total amount of surety and performance bonds to $186 million from $249 million at the beginning of the year. Only about $50 million of the performance bond amount represents work that is yet to be completed so our actual exposure is much less than the face amount of the bond.

With regard to our deferred tax asset, we do not believe a reserve is warranted at this time. If we believe a reserve is warranted in the future, our credit facility has been modified to provide sufficient covenant relief for that impact.

Now I’ll turn it back over to Steve.

Steven J. Hilton

Despite an extremely challenged housing market for homebuilders, we are pleased that Meritage has made significant progress over the last several quarters. We’ve been able to reduce our inventory and debt, cut costs, generate positive cash flow, and strengthen our balance sheet. At the same time we’ve significantly improved our customer satisfaction, enhanced our marketing and sales effectiveness, and increased operating efficiencies. Based on the success we’ve achieved in protecting our balance sheet to date, we’re not focusing on improving our profitability going forward. As we continue to close out of lower margin communities, we expect to generate approximately $75 million to $100 million of cash before any new land acquisitions in the last six months of this year. We are looking for opportunities to reinvest our capital and increase earnings and we believe that the combination of stronger financial management, well located markets, and enhanced operating capabilities will enable Meritage to compete successfully through this cycle and the next.

We’ll now open it up for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from David Goldberg - UBS.

David Goldberg - UBS

My question was really about the decision to move towards the entry level buyer. And what I’m trying to get an idea of is in the current land position that you have in the 3.2 years or the 4 years of land that you have now, how hard is it to transition the plans that you have to focus more on the entry level and the first move-up in those communities and I guess maybe taking that from a regulatory kind of entitlement aspect, but also from a sales aspect since you bought the land intending to sell it to multi-move-up buyers?

Steven J. Hilton

Selling the land that we have is geared to entry level but you’re right, most of it is geared to move-up buyers. I think more than new land though what we’re going to be purchasing going forward will be probably geared more towards entry level. There’s sort of a fine line between entry level and first move-up or a fuzzy line and there’s an overlap there. But I think some of the change will be to just change our product. We’ve written some of our land down so far that we can now build entry level houses on it by just changing the house product and we’re literally revamping almost all of our plans right now in the West to get our costs down to make our houses smaller and to remove some of the features that a lot of buyers they just don’t value.

Larry W. Seay

David, where it does make sense to do that because we have so few lots left. Also we’re working on just de-spec’ing the product, pulling out standard features and making them optional so we can bring the price down even in our existing product. And we’re also as Steve said rebidding a lot so we’re bringing prices down on existing product by rebidding aggressively.

David Goldberg - UBS

Are you finding, Larry, that when you make those what used to be standard products optional that buyers are willing to come in and pay the premium to have those upgrades?

Steven J. Hilton

In some cases yes, but in a lot of cases they’re just not taking it and getting a house that’s less expensive.

Larry W. Seay

That’s the critical. People are much more buyer sensitive now than they were a year or two ago. Price sensitive.

Steven J. Hilton

A covered patio for example in some markets used to be essential but today maybe it’s not for some people.

David Goldberg - UBS

I was wondering if you could give me some more details. You’d mentioned the target of getting the 20% to 25% reduction in hard costs in each of the markets and I’m wondering, in the markets where you’re seeing that being achieved, how much of that is renegotiating pricing, how much of it is just simplification of product? Can you just give me a breakdown of how you’re kind of achieving the 20% to 25%?

Larry W. Seay

I think Steve may be having technical difficulties. I would say 5% to 10% is rebidding and pulling out options or excuse me standard features is maybe another 5% and then to the extent that we are reducing the cost to build the home by redesigning the home, that’s another 5% or 10% and that kind of makes up the 25%.

David Goldberg - UBS

So it’s split pretty evenly between them with the rebidding and the simplification efforts kind of taking the bigger end of it.

Larry W. Seay

Certainly that has the most immediate impact across all of our subdivisions because every place we can do that whereas we’re not necessarily redesigning every place.

Operator

Our next question comes from Joel Locker - FBN Securities.

Joel Locker - FBN Securities

I just wanted to see on the gross margins, there was a 340 basis point sequential jump and I wanted to see if you thought that was something that was sustainable or there was some one-time higher margin homes that were sold or just a little bit more about the gross margin?

Larry W. Seay

The gross margin actually for the quarter from last quarter went down and that’s just because of -

Joel Locker - FBN Securities

I’m saying excluding impairments or if you take both the impairments out of 15.6% on home sales versus 12.2% in the first quarter of 08.

Larry W. Seay

Oh I see what you’re saying. Compared to 08 sequentially. There are some fixed costs in construction, particularly construction over even though that’s amortized, capitalized and amortized, so I think some of that’s coming from just a lower closing quarter in the first quarter. And again some of the impairments do wind up improving the margin some although to a greater extent the impairments are caused because prices decrease so that tends to offset. So we aren’t necessarily projecting continued increases. It’s very hard in this environment to say whether that improvement we gained in the second quarter sequentially is sustainable. We don’t see margins decreasing dramatically. On the other hand we don’t see them going up. It’s just hard to tell although generally speaking during the year we do see some margin improvement as volumes increase as we get to our stronger fall closing season.

Joel Locker - FBN Securities

One question on the large loss on a land sale versus the capital, where was the sale?

Larry W. Seay

Those are impairments we took on land that we did make a decision not to build through but to sell and most of that was from California, two projects in California, and we impaired those this quarter and then we’ll eventually sell them over the next quarter or two. Again I think one of the things we’re attempting to do is where we do have a few pieces of land where it makes sense for us to sell them, we are working to try to trigger the tax offs this year so we can carry it back to a year. We still have plenty of profits to get that tax refund in the first quarter of next year to be as large as possible.

Steven J. Hilton

You will see us doing a little bit of that although because of the way our land strategy works, we’re not going to have a whole bunch of that happen.

Joel Locker - FBN Securities

What part of the $24.2 million ran through the land sales of the impairment?

Larry W. Seay

I’m not quite certain I understand your question, but of the total impairments taken about $6.6 million were land sales impairments.

Operator

Our next question comes from Nishu Sood - Deutsche Bank Securities.

Nishu Sood - Deutsche Bank Securities

I wanted to ask Steve about some of these lots that you have been picking up in some of the harder hit markets. I think you mentioned a third to a half of development costs you mentioned.

Steven J. Hilton

A third to a half of the original purchase price, original sale price and as low as the actual development costs.

Nishu Sood - Deutsche Bank Securities

Got it. I was curious as to what, because obviously in those sorts of markets that’s a fairly, prices have fallen so much that it’s hard to pencil these lots in the hardest hits area at any price, so I was just curious if you could just kind of describe to us some of the opportunities you’ve picked up, like what sorts of locations there are, grade-wise perhaps, and what your assumptions are or what you expect to get back in the current pricing environment on a gross margin basis, what absorptions, just those sorts of things?

Steven J. Hilton

Well we won’t buy lots unless we think we can make a 19% or 20% gross or better in today’s market which should translate to an 8%, 9% or 10% net profit. So primarily what we’re looking for is lots less than $50,000 or $50,000 or less in say the Phoenix market, in the California market, Vegas market maybe $60,000 to $70,000 lots, but generally nothing more than that. We’re not going to do like a $100,000+ lot that we bought before. We want to deliver houses and in California under $300,000 and in Arizona it’s close to $200,000 that’s possible and in many cases under $200,000. So we’re finding some lots out there that we can buy for what the cost of the actual improvements were with very little or no residual or even negative residual for the land. And we’re finding those opportunities and when we can find those in nice master planned communities or in other communities that are in good locations, we’re going to take advantage of those to the extent that we can and our capital permits us.

Larry W. Seay

These are relatively close-end lots. These aren’t lots that are way out. They’re finished lots, they aren’t raw land. And this is particularly where the house redesign program comes in because we’re designing less expensive smaller houses to go on these less expensive lots, which make the economics work better than if we tried to build a bigger more expensive house on those less expensive lots.

Nishu Sood - Deutsche Bank Securities

The second question I wanted to ask was, your strategy your kind of returning to Texas or concentrating on Texas has worked out very well for you folks from an absorption and margin perspective. Two-thirds of your communities now are in Texas. If you kind of look at a downside scenario for the housing market overall, if you’re projecting this out, you’re going to end up being basically a Texas builder with a few satellite operations. So what I wanted to ask you was, is that the direction we’re headed if that scenario happens?

Steven J. Hilton

We’re only two-thirds in Texas because the rest of our business has been so soft. We were one-third in Texas at one time. And as the rest of our business recovers and we’re able to reload these lower priced lots, the percentage of our business in Texas will go down. We’re not by design trying to become a Texas builder and have satellite operations in other markets. We have a very light land position now in California, a very small land position in Florida, and as we see opportunities to reload and make money on new lots, we will beef up our positions in those markets and start to restore some volume in the business that we had in those markets previously. But in the meantime, more than half of our business is in Texas and knock on wood that’s been a good market for us and it’s been fortunate that we’ve been there. But it’s not our strategy to be dominantly a Texas builder.

Nishu Sood - Deutsche Bank Securities

Your disclosures overall have always been very, very good. If I could ask again just about the amount of how much impairments have helped your gross margins? It’s becoming a very, very large issue for a lot of the publics, 700 to 800 basis points in the order of magnitude. I would imagine that if you were to disclose that number it would look better because of your option-heavy strategy. I was just hoping we could get some quantification of that, either in the dollar amount that it helped your gross margin or the basis points?

Larry W. Seay

I just don’t have that number. The way we compile the impairments, it’s difficult to add them all up and I just can’t give you any guidance on that. I do agree with you. I think it’s probably less than other builders, but to us the focus is getting back to buying the small lot positions where we can make more normal margins. And as we disclosed, 40% of our projects outside of Texas only have 25 lots left or less. So it’s real important that we start to reload and start getting new subdivisions that are more normal margin oriented and that’s really the key to our story going forward.

Operator

Our next question comes from [Neethan Dia - Lehman Brothers].

[Neethan Dia - Lehman Brothers]

You talked about the $75 million to $100 million cash generation in the back half of the year and absent any acquisition that would bring you to about $200 million of cash by the end of the year considering there is no prepaid debt. My question is really, what is the minimum cash level if you like that you’d like to maintain going forward considering you’ve paid back most of your debt?

Steven J. Hilton

I don’t think we have a minimum number that we’re kind of targeting. I think it’s our goal to try to stay out of our bank lines at least until the market recovers and we start making good earnings again. But I don’t think we’re really quoting a specific number. Larry, do you agree?

Larry W. Seay

I agree. Certainly we’re saying during the next few quarters until things get better, we don’t want to be in our bank lines and it depends on the number of good opportunities we see and how much of the excess cash we’re generating that we would commit to new projects. We certainly don’t want to scrimp on having adequate liquidity during the rest of the downturn.

[Neethan Dia - Lehman Brothers]

So acquisition opportunities will not, you’re not going to pursue them at the cost of if you like liquidity or having to draw on the revolver?

Larry W. Seay

Correct. As we said we don’t plan to lever up to buy lots. We plan to take some of the cash that we’re generating from these older projects and redeploy it.

[Neethan Dia - Lehman Brothers]

On the Texas in looking at the new orders, it looks like the ESP was up some sequentially. Now are you seeing a stabilization in the prices in that market on the new order side or is that just a reflection of mix there?

Steven J. Hilton

I think it’s a little of both. I think it’s probably mostly mix. But on the other hand I wouldn’t say prices are really declining substantively in Texas. Maybe certain communities are feeling a little bit of pressure but generally overall prices are holding.

Operator

Our next question comes from Daniel Oppenheim - Credit Suisse.

Daniel Oppenheim - Credit Suisse

I was wondering if you could talk a bit more in terms of your strategy where you were talking about going down in price points in some of the markets. Is that something you’re going to apply to all areas where you could do some of that in Texas as well? And then another question about Texas, I was wondering if you could talk about trends there over the course of the quarter if you saw any shift in demand and also what you see in price points there?

Steven J. Hilton

It’s not something we’re actively pursuing in Texas but it’s something that we’re pursuing in all other markets we’re doing business in. Trends in Texas, it’s gotten a little more challenging. On the other hand we have some new communities we’ve opened up, some larger communities particularly in Fort Worth that are doing exceptionally well. Business in our Houston Central division is doing very well and we’re having some strength in some of our Dallas communities. On the other hand it’s a little bit soft in San Antonio and individual communities within other markets are feeling some pressure. But generally the market in Texas is holding up better than other markets.

Daniel Oppenheim - Credit Suisse

I was just wondering about how you’re looking at the deferred tax assets in terms of evaluating whether to keep those on the balance sheet. What is the process you’re using for that?

Larry W. Seay

As you know, as we’ve disclosed we had a four-year historic look-back period for the cumulative loss and we’re monitoring when we would trip that and it just depends on the level of profitability or the level of losses going forward. So it could happen in the next few quarters. It’s possible too, I don’t know if it’s likely but it’s possible that if we return to profitability sooner rather than later and we can put a few quarters of profits on the books before we trip the cumulative loss that would be a very strong factor for not impairing the tax asset at all. So while it’s certainly likely we could impair the tax asset over the next few quarters, it’s possible in some stronger circumstances we might not have to at all. So we’re still monitoring that. I can’t give you any specific guidance on which quarter because it just depends on what future actual results are.

I guess I would point out too that when we modified our credit facility, we did take into account the potential for doing that and factored into all of our covenants appropriate cushion in case that has to be done. So if that happens, that’s already been taken care of in our recent credit facility amendment.

Operator

Our next question comes from Lee Brading - Wachovia Capital Markets, LLC.

Lee Brading - Wachovia Capital Markets, LLC

I wondered if you can expand on the community count aspect? I know you mentioned that for example 40% of communities have 25 or less remaining lots which is roughly I guess 85 based on your community count today. And I think, I looked back at my notes and in Q407 you guys were giving guidance expecting to be down 20% in 08 versus 07 from a count standpoint. I’m just trying to get a ballpark to see in the next several quarters where this number goes. Are you still counting your same thoughts from the end of 07?

Larry W. Seay

Well first of all, that’s 40% outside of Texas have less than 25, so that’s not necessarily true of Texas.

Lee Brading - Wachovia Capital Markets, LLC

Oh that’s right. Sorry about that.

Larry W. Seay

So if you look at the amount we have in Texas, overall you’re talking about another over the next several quarters approximately 40 communities decreasing. So I think we talked previously about maybe seeing community count go down 20% to 25% and depending upon how those kind of on-the-cuffs communities roll off, it’s still potential that by the time we get to the end of the year we could see that kind of reduction over the full year.

Steven J. Hilton

And as we go into next year we’ll start to rebuild that community count by purchasing new communities. We’ve already bought a few.

Lee Brading - Wachovia Capital Markets, LLC

On the new community or the acquisition you said you did monitor that acquisition a lot over the past quarter. Is that coming from your JVs or is that going out new outside the JVs or a combination of both?

Steven J. Hilton

No JVs. We’re not doing any new JVs.

Lee Brading - Wachovia Capital Markets, LLC

I mean land takedowns from JVs that you currently have?

Larry W. Seay

That number represents brand new contracts that we tied up and closed on during the quarter so it’s not anything that was previously tied up. We are still making normal option takedowns from options and joint ventures where we have options under the previous commitment. So that number doesn’t include purchases we would have done in the normal course of business under old existing options.

Lee Brading - Wachovia Capital Markets, LLC

From the standpoint you talked about, and I know we looked at it from the JV standpoint, it’s fairly materials but from the big picture and especially relative to the others, but how much at the end of this past quarter was your pro rata guarantee portion? I think last time it was pretty relatively significant, only about $30 million or so.

Larry W. Seay

Yes, the total full what we consider and classify as full guarantees is about $29 million at the end of the quarter down slightly, but of that number about $25 million represents bad boy guarantees that we don’t have full control over so we count them as full guarantees. So if you exclude those, you’re only talking about $4 million or $5 million or so of real true direct guarantees. And since we’re talking about guarantees, our bad boy guarantees that we disclose but don’t count as full guarantees dropped by about $18 million from the end of the first quarter to the end of the second quarter and now is about $71 million. And that just today represents only two loans and as we disclosed in the past, the joint venture we have called Surprise Grand Vista by itself represents $60 million of the $71 million. And we’ve talked about that guarantee as well as the other guarantee. We have full control over the bad boy event and don’t believe that there are any circumstances where those guarantees would ever be triggered.

Operator

Our next question comes from [Shamo Fadugen].

[Shamo Fadugen]

My question is about the new lots that you’re buying. In some of the markets that you say you’re buying those lots in, from what I’m seeing from the banks that have loans in those markets, they’re still expecting home prices in those areas to fall another 10% or 20%. What gives you the confidence that you buy those lots now and those markets won’t soften further in the coming months and then you can’t make the margin that you’re targeting? You guys seem pretty confident about that, so I’m just trying to understand the disconnect there.

Steven J. Hilton

[Inaudible] because they’re just damn cheap. I mean when you can buy a lot for $20,000 that costs $35,000 to put the horizontal improvements in, land with another $30,000 on top of that, maybe it’s going to go down another $5,000 but I don’t think you’d get hurt too bad. It feels a lot like 1990 to 1991, we were buying lots for less than their improvement costs and we’re not going out and taking big bets and big land positions on lots that need to be improved. We’re talking about finished lots in small quantities, $100,000 or less, some as low as $50,000, some we’re getting on terms, some we’re getting on options, some we’re paying cash. And I know there’s a risk that home prices are going to continue to fall, but I think in some cases these land prices are at or near the bottom. And I’m seeing a lot of activity out there right now from investors from a few other builders that have stepped into the market and are also out making offers and aggressively pursuing lots. And I think the time is either now or right in front of us and we need to be prepared to take advantage of those opportunities.

[Shamo Fadugen]

In those communities, what are absorptions running? Normally in the old days you would run one house per community per week was typically considered pretty good. So you’d sell 50 houses in a community per year. What types of absorption rates are you seeing?

Steven J. Hilton

We happen to have a community for example in Phoenix that’s in a somewhat of a peripheral location where we’ve been selling seven or eight houses a month for the last six months. It’s an entry level community, doing very well, with the right price point, and we’re running out of lots there and we’re able to buy some lots in close vicinity to that community at about what it cost to put the improvements in. So we’re just going to pack up our community and move down the street to these new lots and hopefully continue the success we’re having there at seven or eight lot sales a month. On the other hand we’re not pro forming that. When we pro form a new community, we’re generally trying to get at least one sale per week. And if we can pro form it at that level of absorption with a 20% gross margin with a small quantity of lots at or near improvement costs, and we don’t’ see a competitor in the close vicinity that’s going to be dumping a bunch of lots on the market or a bank or a lender who’s going to put a lot of lots out there cheap, those are things we look at when we make the acquisition decision, then we feel comfortable.

[Shamo Fadugen]

So I guess the risk that as an investor you would be worried about is that you would go buy lots and you would buy them at less than improvement value and then sales would completely dry up and so even though you’d bought a lot for $20,000 or $25,000, you still had to hold that lot for a couple years before the market would come back. This is not a risk that you really see as a big problem here when you’re buying these lots strategically like you’re buying them?

Steven J. Hilton

Sales are pretty dry in most locations right now. I mean we’re not putting up big numbers. Sales are historically low level so it’s hard to imagine sales are going to get much lower than they are today. I think the risk is that we might not make the profit that we hope to make and we end up building more houses for close to break-even or very little profit. I don’t think there’s a risk of impairment on these new lots that we’re buying.

Operator

Our next question comes from Carl Reichardt - Wachovia Capital Markets, LLC.

Carl Reichardt - Wachovia Capital Markets, LLC

I’m curious about the land banking industry and if you were the utilizer of their products more so than some others. I’m curious Steve what you think about future of that business in particular if you’re able to regrow your business at a rapid rate, is your expectation that the traditional economics of land banking will come back and you’ll have those partners to work with or are you envisioning some different form of financing off balance sheet or otherwise that’ll help you regrow at the rate you grew at previously?

Steven J. Hilton

It’s hard to tell right now but I do believe over the long term land bankers will come back into the market. I mean we actually are getting proposals today from land bankers. The pricing’s not something that we’re interested in, the terms aren’t necessarily something that we’re interested in, but I think in the long term there will be land bankers, I think there will be people that invest in land today that are investors that will not be able to sell their lots for cash in two or three years from now and they will end up selling those lots to future land bankers. They may not come in the same shapes or forms they did in the past but I do think they will be there in the future, maybe not the short-term future but more the long-term future.

Carl Reichardt - Wachovia Capital Markets, LLC

As far as more recent news, can you talk a little bit about your exposure and your closings this quarter or this year so far to the down payment assistance programs and what your take is on whether or not you’d be able to walk away from those when and if the programs expire as they sound like they’re going to or disappear and what you’ll replace them with if anything?

Steven J. Hilton

We’re still unclear of some of the particulars of the housing build, but we do understand the down payment assistance is probably going to go away October 1. About 14% to 15% of the homes that we’ve sold or the homes we closed I should say this last quarter were with down payment assistance. We’re hopeful that the first-time buyer packs credit as part of the bill will help offset or alleviate those buyers that got the down payment assistance. We think that most of the buyers that took advantage of that but closed this last quarter were entry level buyers for us. So we think that’s going to soften the blow but it’s still too early for us to tell.

Operator

Our next question comes from the line of [Nicole Sirocco - Babson Capital].

[Nicole Sirocco - Babson Capital]

Most of my questions have been answered. Just if you could tell us where you are at the end of the quarter in terms of your leverage coverage and net worth as it relates to your covenants?

Larry W. Seay

Well that’s changing because of our modifications. The covenants that were in existence at 6/30 have now been modified, so we would feel that we have plenty of room. But to give you an idea on the new covenants, not on the old covenants, the minimum tangible net worth covenant was reduced to $500 million which would give us a cushion of about $230 million. And then on top of that if we did ever have to take a deferred tax asset impairment, that $500 million would be lowered up to a maximum lowering of about $125 million. So we have a pretty good tangible net worth cushion built in. The leverage ratio now runs depending upon where interest coverage is from 1.5 to 2.15 times, so considering where we are at the end of the quarter at 0.82 times, we have plenty of cushion under that ratio today. And then interest coverage, we were at about 1.5 and we can go down to as low as 0.5. That low floor got extended out for a couple more quarters but then we have two additional alternate tests built in. One is a cash flow coverage and then one is if we couldn’t meet either the interest coverage or the cash flow coverage, we have a kind of fail safe as long as we have $125 million reserves under our bank facility for cash if our interest coverage is less than 1 time, those covenants don’t apply as long as we meet that minimal liquidity. And if we’re above 1 but below 2, we have to have $50 million of liquidity. So we feel like we’ve designed covenants that are pretty fair covenants for us and give us a lot of room to handle a lot of different business environments going forward.

Operator

Our final question comes from Eric Landry - MorningStar.

Eric Landry - MorningStar

I want to get back to this 40% of your land sales out of Texas. If I do the math, that’s less than 1,800 lots. Is that somewhere in the ballpark there?

Steven J. Hilton

40% of our communities I believe. Larry, is that right?

Larry W. Seay

Yes. That’s not 4,800 lots but -

Eric Landry - MorningStar

If I take a third of the communities and multiply that by 4, it’s about 1,800 or so. I multiplied it by 25.

Larry W. Seay

I’m not quite certain how the math is working and I guess I would encourage you to call me, but I would think that - Oh, I see what you’re saying. Yes, there are a bunch of communities that have very few lots left. There’s no question about it. And I don’t know if 1,800 is right or 2,500 but it’s probably something in that range.

Eric Landry - MorningStar

So then am I correct in assuming that it’s going to be a priority to sort of work through those and sell those at basically whatever you can sell them at just to get rid of them? Is that sort of a priority?

Steven J. Hilton

Yes, pretty much. We’re trying to close those stores up because the absorption level is not up to par and the overhead is clicking away and we want to get out of those and get into some new communities we can make money on.

Larry W. Seay

On the other hand don’t interpret that that means we’re going to have a bunch of impairments on those communities. We’re going to continue to try to sell three or four a month. If we get to the point where we’re down to the last five, we might build a couple more specs so we can close up the construction trailer early. But don’t necessarily interpret that to be a bunch of impairments coming from those subdivisions.

Eric Landry - MorningStar

So should I interpret this to be somewhere over a several quarter event or will you likely be out of those in four quarters, six quarters, any hazard to guess on that?

Steven J. Hilton

Yes, there could be six or seven lots left to 25 lots left so those are going to meter out over the next say four quarters or so.

Thank you very much for joining us this quarter and we look forward to sharing our results with you again in October. Thank you very much.

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Source: Meritage Homes Corporation Q2 2008 Earnings Call Transcript
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