Meritage Homes CORP - Annual Report: 2007 (Form 10-K)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

 

Commission File Number 1-9977

 

(Exact Name of Registrant as Specified in its Charter)

 

 

(480) 515-8100

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, $.01 par value              New York Stock Exchange

 

Securities registered pursuant to Section 12(g) of the Act:  None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes   o  No   x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes  o    No  x

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  x    No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by  reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x       Accelerated Filer  o       Non-accelerated filer  o        Smaller reporting company  o

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o    No  x

 

The aggregate market value of common stock held by non-affiliates of the registrant (23,838,180 shares) as of June 29, 2007, was $637,671,315, based on the closing sales price per share as reported by the New York Stock Exchange on such date.

 

The number of shares outstanding of the registrant’s common stock on February 19, 2008 was 26,291,900.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions from the registrant’s Proxy Statement relating to the Annual Meeting of Stockholders to be held on May 15, 2008 have been incorporated by reference into Part III, Items 10, 11, 12 , 13 and 14.

 

 

MERITAGE HOMES CORPORATION
FORM 10-K
TABLE OF CONTENTS

 

PART I
		Item 1.		Business
		Item 1A.		Risk Factors
		Item 1B.		Unresolved Staff Comments
		Item 2.		Properties
		Item 3.		Legal Proceedings
		Item 4.		Submission of Matters to a Vote of Security Holders
PART II
		Item 5.		Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
		Item 6.		Selected Financial Data
		Item 7.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
		Item 7A.		Quantitative and Qualitative Disclosures About Market Risk
		Item 8.		Financial Statements and Supplementary Data
		Item 9.		Changes in and Disagreements With Accountants on Accounting and Financial Disclosure
		Item 9A.		Controls and Procedures
		Item 9B.		Other Information
PART III
		Item 10.		Directors, Executive Officers and Corporate Governance
		Item 11.		Executive Compensation
		Item 12.		Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
		Item 13.		Certain Relationships and Related Transactions, and Director Independence
		Item 14.		Principal Accountant Fees and Services
PART IV
		Item 15.		Exhibits and Financial Statement Schedules
SIGNATURES

 

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PART I

 

Item 1. Business

 

The Company

 

Meritage Homes is a leading designer and builder of single-family attached and detached homes in the historically high-growth southern and western United States, based on the number of home closings. We offer a variety of homes that are designed to appeal to a wide range of homebuyers, including first-time, move-up, luxury and active adult buyers. We have operations in three regions:  West, Central and East, which are comprised of 12 metropolitan areas in six states.  These three regions are our principal business segments.  Please refer to Note 13 of the consolidated financial statements for information regarding our operating and reporting segments.

 

Our homebuilding and marketing activities are conducted under the names Meritage Homes, Monterey Homes and Legacy Homes. At December 31, 2007, we were actively selling homes in 220 communities, with base prices ranging from approximately $100,000 to $1,060,000.

 

Available Information; Corporate Governance

 

Meritage Homes Corporation was incorporated in 1988 as a real estate investment trust in the State of Maryland. At December 31, 1996, through a merger, we acquired the homebuilding operations of our predecessor company. We currently focus exclusively on homebuilding and related activities and no longer operate as a real estate investment trust.

 

Information about our company and communities is provided on our Internet website at www.meritagehomes.com. Our periodic and current reports, including any amendments, filed or furnished pursuant to section 13(a) or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) are available, free of charge, on our website as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission (“SEC”). The information contained on our website is not considered part of this Annual Report on Form 10-K.

 

Meritage operates within a comprehensive plan of corporate governance for the purpose of defining responsibilities and setting high standards for ethical conduct. Our Board of Directors has established an audit committee, executive compensation committee and nominating/governance committee. The charter of each of these committees is available on our website, along with our Code of Ethics and our Corporate Governance Principles and Practices. Our committee charters, Code of Ethics and Corporate Governance Principles and Practices are also available in print, free of charge, to any stockholder who requests any of them by calling us or by writing to us at our principal executive offices at the following address:  Meritage Homes Corporation, 17851 North 85^th Street, Suite 300, Scottsdale, Arizona 85255, Attention:  Legal Department. Our telephone number is (480) 515-8100.

 

Recent Industry and Company Developments

 

The industry continues to be challenged by the difficult homebuilding market downturn.  Based on U. S. Census Bureau data, single family home starts in the United States dropped to their lowest level since 1991 and for 2007, there were fewer than 800,000 units sold, a 57% decrease from their annualized peak in January 2006.  Although inventory of new homes available for sale at December 31, 2007 has dropped to below 500,000 units in the United States for the first time since late 2005, this balance still represents 9.6 months’ supply.  Demand for homes continues to be low due to the lack of consumer confidence and the reduced availability of mortgage financing as a result of the tightening of underwriting standards and a weakening of credit markets.  Based on research conducted by Inside Mortgage Finance Publications, total mortgages originated in 2007 decreased approximately 18% from 2006, with decreases ranging from 30-70% for Alt A, subprime and ARM originations for the same time period.

 

For us, as well as for the industry as a whole, excess new and existing home supply, including those homes available as a result of increased foreclosure activity, has led to increased competition and margin compression. We believe that home buyers are and will continue to defer purchasing decisions until they believe the price declines have reached bottom.  Additionally, for those buyers motivated to take advantage of current competitive pricing conditions, the tightening of mortgage financing, as well as difficulty in selling their existing homes, are causing high cancellation rates and lower net

 

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orders. As the competitive pressures in the industry have increased, homebuilders have offered additional incentives and discounts, which has exacerbated the industry’s performance.

 

Markets and Products

 

We currently build and sell homes in the following markets:

 

Markets		Year Entered
Phoenix, AZ		1985
Dallas/Ft. Worth, TX		1987
Austin, TX		1994
Tucson, AZ		1995
Houston, TX		1997
San Francisco Bay Area, CA		1998
Sacramento, CA		1998
Las Vegas, NV		2002
San Antonio, TX		2003
Los Angeles (Inland Empire), CA		2004
Denver, CO		2004
Orlando, FL		2004
Reno, NV		2005	*
Ft. Myers/Naples, FL		2005	*

 

The chart above reflects the dates our predecessor companies entered our Texas and Arizona markets.

 

*  Our operations in these markets consist only of selling and completing existing inventory and providing warranty and customer care support to our homeowners.  At this time, it is not our intention to acquire and commence any new projects in these markets.

 

Our homes range from entry level to semi-custom luxury, with base prices ranging from approximately $100,000 to $1,060,000. A summary of activity by region as of and for the year ended December 31, 2007 follows (dollars in thousands):

 

		Year Ended December 31, 2007					At December 31, 2007
		# of Homes Closed		Average Closing Price			Homes in Backlog		$  Value of Backlog			Home Sites Controlled (1)		# of Actively Selling Communities
West Region
California		908		$	463.9		164		$	81,532		2,267		27
Nevada		261		340.4			64		18,660			1,057		11
West Region Total		1,169		436.3			228		100,192			3,324		38
Central Region
Arizona		1,718		330.6			390		120,558			6,904		36
Texas		4,164		250.5			1,472		384,351			14,192		127
Colorado		160		375.4			53		18,137			592		6
Central Region Total		6,042		276.6			1,915		523,046			21,688		169
East Region
Florida		476		321.4			145		46,747			1,103		13
Total Company		7,687		$	303.6		2,288		$	669,985		26,115		220

 

(1) “Home Sites Controlled”  is the estimated number of homes that could be built on lots we control, both on lots available for sale and on land expected to be developed into lots.

 

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Land Acquisition and Development

 

Our goal is to maintain an approximate four-year supply of lots, which we believe provides an appropriate planning horizon to address regulatory matters and land development.  During the current downturn in the homebuilding industry, we have significantly limited any additional purchases of land or lots and expect such restrictions to persist until the pace of home sales stabilizes and land purchase prices have reached levels that we deem acceptable.  We generally acquire land only after necessary entitlements have been obtained so that development or construction may begin as market conditions dictate. The term “entitlements” refers to development agreements and tentative maps or recorded plats, depending on the jurisdiction within which the land is located. Entitlements generally give the developer the right to obtain building permits upon compliance with conditions that are ordinarily within the developer’s control. Even though entitlements are usually obtained before land is purchased, we are still required to secure a variety of other governmental approvals and permits prior to and during development. The process of obtaining such approvals and permits can substantially delay the development process. We may consider, on a limited basis, the purchase of unentitled property when we can do so in a manner consistent with our business strategy.  Historically, we have developed parcels ranging from 100 to 300 lots.  However, in order to achieve and maintain an adequate lot inventory, we have also purchased larger parcels, in some cases with joint venture partners. In some cases, these joint ventures purchase undeveloped land and develop the land themselves.

 

We select land for development based upon a variety of factors, including:

 

·                  demographic factors, based on extensive marketing studies;

 

·                  suitability for development, generally within a one to four-year time period from the beginning of the development process to the delivery of the last home;

 

·                  financial feasibility of the proposed project, including projected profit margins, returns on capital employed, and the capital payback period;

 

·                  the ability to secure governmental approvals and entitlements;

 

·                  results of environmental and legal due diligence;

 

·                  proximity to local traffic corridors and amenities; and

 

·                  management’s judgment as to the real estate market and economic trends, and our experience in particular markets.

 

We acquire land through options and land purchase contracts. Purchases are generally financed through our corporate borrowings or working capital. Acquiring our land through option contracts allows us to control the timing and volume of lot and land purchases from the third parties who own or buy properties on which we plan to build homes. We enter into option contracts to purchase finished lots at pre-determined prices during a specified period of time from these third parties, usually structured to approximate the time home construction begins. These contracts are generally non-recourse and typically require the payment of non-refundable deposits of 5% to 15% of the sales price. We believe the use of options limits the market risks associated with land ownership by allowing us to re-negotiate option terms or terminate options in the event of declines in land value and/or market downturns.  As market conditions change, we may attempt to re-negotiate the option or purchase contracts to achieve terms that are more in line with market conditions.  Such adjustments can include deferment or reduction in lot takedown requirements or price concessions.  If we are unsuccessful in these re-negotiations, we may determine that a project is no longer feasible or desirable and cancel these contracts, usually resulting in the forfeiture of our option deposits.

 

During 2007, we terminated options on over 12,500 lots and wrote off option deposits and pre-acquisition costs of $131.6 million.  At December 31, 2007, we had approximately 15,700 lots under option or contract for a total purchase price of approximately $790.3 million, with $92.2 million in cash deposits and $18.1 million in letters of credit deposits.  Additional information relating to our impairments is discussed in Note 2 – Real Estate and Capitalized Interest, and information related to lots and land under option is presented in Note 3 – Variable Interest Entities and Consolidated Real Estate Not Owned in the accompanying consolidated financial statements.

 

Once we secure land, we generally initiate development through contractual agreements with subcontractors. These activities include site planning and engineering, as well as constructing road, sewer, water, utilities, drainage, recreation facilities and other improvements and refinements. We frequently build homes in master-planned communities with home sites that are along or near major amenities, such as golf courses or recreation facilities.

 

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We develop a design and marketing concept tailored to each community, which includes the determination of size, style and price range of homes. We also typically determine street layout, individual lot size and layout, and overall community design for these projects. The product lines offered depend upon many factors, including the housing generally available in the area, the needs of a particular market, and our lot costs for the project, though we are sometimes able to use standardized design plans for a product line.

 

The following table presents information as of December 31, 2007 (dollars in thousands):

 

		Number of Lots Owned (1)			Number of Lots Under Contract or Option (1)(2)			Total Number of Lots Controlled
West Region
California		1,201			1,066			2,267
Nevada		738			319			1,057
West Region Total		1,939			1,385			3,324
Central Region
Arizona		3,836			3,068			6,904
Texas		3,915			10,277			14,192
Colorado		235			357			592
Central Region Total		7,986			13,702			21,688
East Region
Florida		469			634			1,103
Total Company		10,394			15,721			26,115
Total book cost (3)		$	624,119		$	92,176		$	716,295

 

(1)           Excludes lots with finished homes or homes under construction. The number of lots is estimated and is subject to change.

 

(2)           There can be no assurance that we will actually acquire any lots under option or properties in which we have entered into a variety of contractual relationships, including purchase agreements with customary conditions precedent and other similar arrangements. These amounts do not include about 200 lots under contract with refundable earnest money deposits of approximately $100,000, for which we have not completed due diligence and, accordingly, have no money at risk and are under no obligation to perform under the contract, and approximately 1,300 lots under contract with minimal non-refundable earnest money deposits of $2.2 million, which are still in the due diligence process. However, these amounts do include about 2,600 lots under option contracts with joint ventures in which we are a member.

 

(3)           For Lots Owned, book cost primarily represents land, development, interest and common costs. For Lots under Contract or Option, book cost primarily represents earnest and option deposits.

 

Investments in Unconsolidated Entities - Joint Ventures

 

We participate in several joint ventures with independent third parties (12 active joint ventures at December 31, 2007) relating to the purchase and development of land. We have less than a controlling interest in our joint ventures. We typically enter into these joint ventures with other homebuilders, land sellers or other real estate investors to provide us and the other joint venture partners with a means of accessing larger parcels and lot positions, expanding our market opportunities, managing our risk profile and leveraging our capital base. The typical joint venture acquires raw land and processes the property through the entitlement process and, in some cases, develops the property into partially or fully finished lots. These joint ventures are usually obligated to sell all or a part of the property or lots to the joint venture members (at the respective member’s option), generally at prevailing fair market values (either at the time of acquisition or the time of sale). In some cases, part of the property is sold to non-member homebuilders, commercial developers and other third parties. Our participation in these types of joint ventures is an important part of our business model, and we expect it to continue in the future.

 

In connection with these types of joint ventures, we and/or our joint venture partners provide certain types of guarantees, indemnification arrangements with surety and performance bond providers and environmental indemnities. Reference is made to Part II, Item 8 in this Annual Report, “Financial Statements and Supplementary Data – Note 1 – Business and Summary of Significant Accounting Policies” for a detailed discussion of these items.

 

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We also participate in seven mortgage and two title business joint ventures.  The mortgage joint ventures are engaged in mortgage brokerage activities, and they originate and provide services to both our clients and other homebuyers.  The mortgages originated by these ventures are primarily funded by third-party mortgage lenders with limited recourse back to us or our joint ventures.

 

At December 31, 2007, we had approximately $25.5 million invested in joint ventures involved in the purchase, development and/or sale of land. We also had approximately $1.1 million invested in mortgage brokerage and title service joint ventures. In 2007, we reported pre-tax losses of $45.7 million related to our share of the earnings of our land joint ventures and $5.5 million in income related to our share of the earnings of our mortgage-brokerage and title service joint ventures.  The land joint venture losses include $57.9 million of impairments recorded against our venture investments. For our land joint ventures, we do not recognize profits on lots or land that we acquire from the joint venture, but instead defer any profits until we sell the related homes to third party homebuyers.

 

Construction Operations

 

We act as the general contractor for our projects and typically hire subcontractors on a project-by-project or reasonable geographic-proximity basis to complete construction at a fixed price. We usually enter into agreements with subcontractors and materials suppliers on an individual basis after receiving competitive bids. We obtain information from prospective subcontractors and suppliers with respect to their financial condition and ability to perform their agreements before formal bidding begins. Occasionally, we enter into longer-term contracts with subcontractors and suppliers if we can obtain more favorable terms to minimize costs of construction. Our project managers and field superintendents coordinate and supervise the activities of subcontractors and suppliers, subject the development and construction work to quality and cost controls, and monitor compliance with zoning and building codes. At December 31, 2007, we employed approximately 490 construction operations personnel.

 

We specify that quality, durable materials be used in construction of our homes and we do not maintain significant inventories of construction materials, except for work in process materials for homes under construction. When possible, we negotiate price and volume discounts and rebates with manufacturers and suppliers on behalf of our subcontractors to take advantage of production volume. Historically, access to our principal subcontracting trades, materials and supplies has been readily available in each of our markets. Prices for these goods and services may fluctuate due to various factors, including supply and demand shortages that may be beyond the control of our vendors. We believe that we have good relationships with our suppliers and subcontractors.

 

We generally build and sell homes in clusters or phases within our larger projects, which we believe creates efficiencies in land development and home construction operations and cash management, and improves customer satisfaction by reducing the number of vacant lots surrounding a completed home. Our homes are typically completed within four to nine months from the start of construction, depending upon the geographic location and the size and complexity of the home. Construction schedules may vary depending on the availability of labor, materials and supplies, product type, location and weather. Our homes are usually designed to promote efficient use of space and materials, and to minimize construction costs and time. We typically have not entered into any derivative contracts to hedge against weather or materials fluctuations as we do not believe they are particularly advantageous to our operations.

 

Marketing and Sales

 

We believe that we have an established reputation for developing high quality homes, which helps generate interest in each new project. We also use advertising and other promotional activities, including our website at www.meritagehomes.com, magazine and newspaper advertisements, brochures, direct mailings and the placement of strategically located signs in the vicinities around our developments.

 

We use furnished model homes as a tool to demonstrate to prospective homebuyers the advantages of the designs and features of our homes. We generally employ or contract with interior and landscape designers who are responsible for creating attractive model homes and complexes with many built-in options for each product line within a project. We generally build between one and four model homes for each actively selling community, depending upon the number of homes to be built in the project and the products to be offered.  When possible, we sell our model homes to, and lease them back from, institutional investors who purchase the homes for investment purposes or from individual buyers who do not intend to occupy the home immediately. At December 31, 2007, we owned 192 and leased 254 model homes and had an additional 36 models under construction. As of December 31, 2007, monthly payments for our leased models were

 

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approximately $303,000, of which approximately $119,000 is accounted for as interest on debt related to our model lease program. See Note 5 to the accompanying consolidated financial statements for further detail.

 

Our homes generally are sold by full-time or part-time, commissioned employees who typically work from a sales office located in one of the model homes for each project. At December 31, 2007, we had approximately 530 sales and marketing personnel. Our goal is to ensure that our sales force has extensive knowledge of our operating policies and housing products. To achieve this goal, we train our sales associates and conduct regular meetings to update them on sales techniques, competitive products in the area, financing availability, construction schedules, marketing and advertising plans and the available product lines, pricing, options and warranties offered. Our sales associates are licensed real estate agents where required by law. Independent brokers may also sell our homes, and are usually paid a sales commission based on the price of the home. Our sales associates assist our customers in selecting upgrades or in adding available customization features to their homes, which we design to appeal to local consumer demands.  We may also offer various sales incentives, including price concessions, assistance with closing costs, and landscaping or interior upgrades, to attract buyers. The use and type of incentives depends largely on economic and local competitive market conditions. Given market conditions over recent periods, we have offered extensive incentives, which negatively impacted our revenues and margins.

 

Backlog

 

Historically, a sales contract was signed for a home prior to the start of construction; however, our recent high cancellation rates have generated a higher volume of finished or under-construction homes in inventory without a sales contract.  Our contracts require cash deposits and are usually subject to certain contingencies such as the buyer’s ability to qualify for financing. Homes covered by such sales contracts but not yet closed are considered “backlog.”  Sales contingent upon the sale of a customer’s existing home are not included as new sales contracts until the contingency is removed. We do not recognize revenue upon the sale of a home until it is delivered to the homebuyer and other criteria for sale and profit recognition are met. In limited cases, we build homes before obtaining a sales contract or a customer may cancel an existing sales contract after construction has commenced on their home.  These homes are excluded from backlog until a sales contract is signed and are referred to as unsold or “spec” inventory. At December 31, 2007, of our homes in inventory, 20.6% were under construction without sales contracts and 19.9% were completed homes without sales contracts. Of these homes without sales contracts, a substantial majority resulted from cancelled home sale contracts as opposed to our building a home before obtaining a sales contract.  We believe that during 2008 we will deliver to customers substantially all homes in backlog at December 31, 2007 under existing or, in the case of cancellations, replacement sales contracts.

 

Our backlog decreased to 2,288 units with a value of approximately $670.0 million at December 31, 2007 from 3,685 units with a value of approximately $1.2 billion at December 31, 2006. These decreases are due to deteriorating market conditions during 2007, which resulted in lower sales volumes and selling prices and higher cancellation rates than those experienced during 2006.

 

Customer Financing

 

We attempt to help qualified homebuyers who require financing to obtain loans from mortgage lenders that offer a variety of financing options. We have entered into several joint venture arrangements with established mortgage brokers in most of our markets, which allow those ventures to act as preferred mortgage broker to our buyers to help facilitate the sale and closing process as well as generate additional fee income. In some markets we use unaffiliated preferred mortgage lenders. We may pay a portion of the closing costs and discount mortgage points to assist homebuyers with financing. We do not underwrite, fund or service the mortgages obtained by our homebuyers, and therefore do not assume the risks associated with a mortgage banking business. Since many customers use long-term mortgage financing to purchase homes, the current decrease of availability of mortgage loans, tighter underwriting standards and the fallout from the sub-prime loan market failures may reduce the availability of such loans to our homebuyers.  Additionally, general adverse economic conditions, rising mortgage interest rates and increases in unemployment may deter or reduce the number of potential homebuyers.

 

Customer Relations, Quality Control and Warranty Programs

 

We believe that positive customer relations and an adherence to stringent quality control standards are fundamental to our continued success, and that our commitment to buyer satisfaction and quality control has significantly contributed to our reputation as a high quality builder.

 

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A Meritage project manager or project superintendent and a customer relations representative generally oversee compliance with quality control standards for each community. These representatives perform the following tasks:

 

·                  oversee home construction;

 

·                  oversee subcontractor and supplier performance;

 

·                  review the progress of each home and conduct formal inspections as specific stages of construction are completed; and

 

·                  regularly update buyers on the progress of their homes and coordinate the closing process.

 

We generally provide for each home a one- to two-year limited warranty on workmanship and building materials.  Some states in which we build homes also have laws providing statutory warranties related to structural defects that generally range in duration from 8 to 10 years.  We generally require our subcontractors to provide an indemnity and a certificate of insurance before beginning work, which means that claims relating to workmanship and materials are generally the subcontractors’ responsibility. Reserves for future warranty costs are established based on our and industry-wide historical experience within each division or region, and are recorded when the homes are closed. Reserves generally range from 0.8% to 1.5% of a home’s sale price. Historically, these reserves have been sufficient to cover warranty repairs.

 

Competition and Market Factors

 

The development and sale of residential property is a highly competitive industry. We compete for sales in each of our markets with national, regional and local developers and homebuilders, existing home resales, and to a lesser extent, condominiums and rental housing. Some of our competitors have significantly greater financial resources and may have lower costs than we do. Competition among both small and large residential homebuilders is based on a number of interrelated factors, including location, reputation, amenities, design, quality and price. We believe that we compare favorably to other homebuilders in the markets in which we operate due to our:

 

·                  experience within our geographic markets which allows us to develop and offer new products;

 

·                  ability to recognize and adapt to changing market conditions, including from a capital and human resource perspective;

 

·                  ability to capitalize on opportunities to acquire land on favorable terms; and

 

·                  reputation for outstanding service and quality products.

 

Government Regulation and Environmental Matters

 

We acquire most of our land after entitlements have been obtained. Construction may begin almost immediately on such entitled land upon compliance with and receipt of specified permits, approvals and other conditions, which generally are within our control. The time needed to obtain such approvals and permits affects the carrying costs of unimproved property acquired for development and construction. The continued effectiveness of permits already granted is subject to factors such as changes in government policies, rules and regulations, and their interpretation and application. To date, the government approval processes discussed above have not had a material adverse effect on our development activities, although there is no assurance that these and other restrictions will not adversely affect future operations.

 

Local and state governments have broad discretion regarding the imposition of development fees for projects under their jurisdictions. These fees are normally established when we receive recorded maps or plats and building permits. Communities may also require concessions or may require the builder to construct certain improvements to public places such as parks and streets.  In addition, communities occasionally impose construction moratoriums. Because most of our land is entitled, construction moratoriums generally would not affect us in the near term unless they arose from health, safety or welfare issues, such as insufficient water, electric or sewage facilities. In the long term, we could become subject to delays or may be precluded entirely from developing communities due to building moratoriums, “no growth” or “slow growth” initiatives or building permit allocation ordinances, which could be implemented in the future.

 

We are also subject to a variety of local, state, and federal statutes, ordinances, rules and regulations concerning the protection of health and the environment. In some markets, we are subject to environmentally sensitive land ordinances that

 

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mandate open space areas with public elements in housing developments, and prevent development on hillsides, wetlands and other protected areas. We must also comply with flood plain restrictions, desert wash area restrictions, native plant regulations, endangered species acts and view restrictions. These and similar laws may result in delays, cause substantial compliance and other costs, and prohibit or severely restrict development in certain environmentally sensitive regions or areas. To date, compliance with such ordinances has not materially affected our operations, although it may do so in the future.

 

We usually will condition our obligation to acquire property on, among other things, an environmental review of the land. To date, we have not incurred any unanticipated liabilities relating to the removal of unknown toxic wastes or other environmental matters. However, there is no assurance that we will not incur material liabilities in the future relating to toxic waste removal or other environmental matters affecting land currently or previously owned.

 

Employees, Subcontractors and Consultants

 

At December 31, 2007, we had approximately 1,330 full-time employees, including approximately 310 in management and administration, 530 in sales and marketing, and 490 in construction operations. Our employees are not unionized, and we believe that we have good employee relationships. We pay for a substantial portion of our employees’ insurance costs, with the balance contributed by the employees. We also have a 401(k) savings plan, which is available to all employees who meet the plan’s participation requirements.

 

We act solely as a general contractor, and all construction operations are supervised by our project managers and field superintendents who manage third party subcontractors. We use independent consultants and contractors for architectural, engineering, advertising and legal services, and we strive to maintain good relationships with our subcontractors and independent consultants and contractors.

 

Item 1A. Risk Factors

 

Risk Factors Related to our Business

 

If the current downturn becomes more severe or continues for an extended period of time, it would have continued negative consequences on our operations, financial position and cash flows.

 

Continued weakness in the homebuilding market could have an adverse effect on us.  It could require that we write off more assets, dispose of assets, reduce operations, restructure our debt and/or raise new equity to pursue our business plan, any of which could have a detrimental effect on our current stakeholders.

 

Mortgage availability and interest rate increases may make purchasing a home more difficult and may cause an increase in the number of new and existing homes available for sale.

 

In general, housing demand is adversely affected by the unavailability of mortgage financing and increases in interest rates.  Increased cancellations could increase the available homes inventory, which may reduce prices and reduce the availability of future financing for home buyers.  Most of our buyers finance their home purchases through third-party lenders providing mortgage financing.  If mortgage interest rates increase and, consequently, the ability of prospective buyers to finance home purchases is adversely affected, home sales, gross margins and cash flow may also be adversely affected and the impact may be material.  Long-term interest rates currently remain at low levels; however, rates have generally increased during the last couple of years from historically low levels and it is impossible to predict future increases or decreases in market interest rates.

 

Homebuilding activities depend, in part, upon the availability and costs of mortgage financing for buyers of homes owned by potential customers, as those customers (move-up buyers) often must sell their residences before they purchase our homes.  Mortgage lenders have recently become subject to more intense underwriting standards by the regulatory authorities which oversee them as a consequence of the sub-prime mortgage market failures.  More stringent underwriting standards could have a material adverse effect on our business if certain buyers are unable to obtain mortgage financing.

 

If home prices continue to decline, potential buyers may not be able to sell their homes, which may negatively impact our sales.

 

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As a participant in the homebuilding industry, we are subject to market forces beyond our control.  In general, housing demand is impacted by the affordability of housing.  Many homebuyers need to sell their existing homes in order to purchase a new home from us, and a weakening of the home resale market or a decrease or leveling in home sale prices could adversely affect that ability.  A continued decline in home prices would have an adverse effect on our homebuilding business margins and cash flows.

 

Continued high cancellation rates may negatively impact our business.

 

Our backlog reflects the number and value of homes for which we have entered into a sales contract with a customer but have not yet delivered the home.  Although these sales contracts typically require a cash deposit and do not make the sale contingent on the sale of the customer’s existing home, in some cases a customer may cancel the contract and receive a complete or partial refund of the deposit as a result of local laws or as a matter of our business practices.  If home prices decline, interest rates increase, or if the national or local homebuilding economic decline does not abate, homebuyers may have an incentive to cancel their contracts with us, even where they might be entitled to no refund or only a partial refund.  Significant cancellations have had, and could have, a material adverse effect on our business as a result of lost sales revenue and the accumulation of unsold housing inventory.

 

The value of our real estate inventory may continue to decline, leading to additional impairments and reduced profitability.

 

Some of our owned land was purchased at prices that reflected the strong homebuilding and real estate markets of the past several years.  As such, in most of these circumstances, we wrote down the value of certain inventory during 2006 and 2007 to reflect current market conditions or have abandoned such projects.  To the extent that we still own or have options/purchase agreements related to such land parcels, the continued decline in the homebuilding market may require us to re-evaluate the value of our land holdings and we could incur additional impairment charges, which would decrease both the book value of our assets and stockholders’ equity.  We also incur various land development improvement costs for a community prior to the commencement of home construction.  Such costs include infrastructure, utilities, taxes and other related expenses.  Reductions in home absorption rates increases the associated holding costs and our time to recover such costs. Continued declines in the homebuilding market may also require us to evaluate the recoverability of these costs.

 

Reduced levels of sales may impair our ability to recover pre-acquisition costs and may cause further impairment charges.

 

We extensively use options to acquire land.  Such options generally require a cash deposit that will be forfeited if we do not exercise the option.  During 2006 and 2007, we forfeited deposits and wrote off related pre-acquisition costs related to projects we no longer deemed feasible, as they were not generating acceptable returns.  A continued downturn in the homebuilding market may cause us to re-evaluate the feasibility of other optioned projects, which may result in additional writedowns that would reduce our assets and stockholders’ equity.

 

Our joint ventures with independent third parties may be illiquid, and we may be adversely impacted by our joint venture partners’ failure to fulfill their obligations.

 

We participate in several land acquisition and development joint ventures with independent third parties, in which we have less than a controlling interest.  Our participation in these types of joint ventures has increased over the last few years and we expect to continue to use joint ventures in the foreseeable future, although during 2007, due to current market conditions and the reduced need for lots, we have reduced our involvement in such ventures.  These joint ventures provide us with a means of accessing larger parcels and lot positions and help us expand our marketing opportunities and manage our risk profile.  However, these joint ventures often acquire parcels of raw land without entitlements and as such are subject to a number of development risks that our business does not face directly.  These risks include the risk that anticipated projects could be delayed or terminated because applicable governmental approvals cannot be obtained at reasonable costs, if at all.  In addition, the risk of construction and development cost overruns can be greater for a joint venture where it acquires raw land compared to our typical acquisition of entitled lots.  These increased development and entitlement risks could have a material adverse effect on our financial position or results of operations if one or more joint venture projects is delayed, cancelled or terminated or we are required, whether contractually or for business reasons, to invest additional funds in the joint venture to facilitate the success of a particular project.

 

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Our joint venture investments are generally very illiquid both because we lack a controlling interest in the ventures and because most of our joint ventures are structured to require super-majority or unanimous approval of the members to sell a substantial portion of the joint venture’s assets or for a member to receive a return of their invested capital.  Our lack of a controlling interest also results in the risk that the joint venture will take actions that we disagree with, or fail to take actions that we desire, including actions regarding the sale of the underlying property.  In the ordinary course of our business, we obtain letters of credit and performance, maintenance and other bonds in support of our related obligations with respect to the development of our projects.  In limited cases, we may also offer pro-rata limited repayment guarantees on our portion of the venture debt or other debt repayment guarantees that are only triggered if the joint venture files for voluntary bankruptcy or similar liquidation or reorganization actions (“bad boy” guarantees). Our limited repayment and bad boy guarantees were $34.2 million and $88.2 million as of December 31, 2007, respectively.

 

With respect to our joint ventures, we and our joint venture partners may be obligated to complete land development improvements if the joint venture does not perform the required development, which could require significant expenditures.  In addition, we and our joint venture partners sometimes agree to indemnify third party surety providers with respect to performance bonds issued on behalf of certain of our joint ventures.  In the event the letters of credit or bonds are drawn upon, we, and in the case of a joint venture, our joint venture partners, would be obligated to reimburse the surety or other issuer of the letter of credit or bond if the obligations the bond or guarantee secures are not performed by us (or the joint venture).  If one or more bonds, letters of credit or other guarantees were drawn upon or otherwise invoked, our obligations could be significant, individually or in the aggregate, which could have a material adverse effect on our financial position or results of operations.  We cannot guarantee that such events will not occur or that such obligations will not be invoked.

 

If we are unable to successfully compete in the highly competitive homebuilding industry, our financial results and growth may suffer.

 

The homebuilding industry is highly competitive.  We compete for sales in each of our markets with national, regional and local developers and homebuilders, existing home resales and, to a lesser extent, condominiums and available rental housing.  Some of our competitors have significantly greater financial resources or lower costs than we do.  Competition among both small and large residential homebuilders is based on a number of interrelated factors, including location, reputation, amenities, design, quality and price.  Competition is expected to continue and become more intense, and there may be new entrants in the markets in which we currently operate and in markets we may enter in the future.  If we are unable to successfully compete, our financial results and growth could suffer.

 

We face reduced coverage and increased cost of insurance.

 

Recently, lawsuits have been filed against builders asserting claims of personal injury and property damage caused by the presence of mold in residential dwellings.  Some of these lawsuits have resulted in substantial monetary judgments or settlements.  We believe that we have maintained adequate insurance coverage to insure against these types of claims for homes completed before October 1, 2003.  As of October 1, 2003, our insurance policy began excluding mold coverage.  If our reserves are not sufficient to protect against these types of claims or if we are unable to obtain adequate insurance coverage, a material adverse effect on our business, financial condition, results of operations and cash flows could result if we are exposed to claims arising from the presence of mold in the homes that we build.

 

We are subject to construction defect and home warranty claims arising in the ordinary course of business, which may lead to additional reserves or expenses.

 

Construction defect and home warranty claims are common in the homebuilding industry and can be costly.  While we maintain general liability insurance and generally require our subcontractors and design professionals to indemnify us for liabilities arising from their work, we cannot assure that these insurance rights and indemnities will be adequate to cover all construction defect and warranty claims for which we may be held liable.  For example, we may be responsible for applicable self-insured retentions, which have increased recently, and certain claims may not be covered by insurance or may exceed applicable coverage limits.

 

Our income tax provision and other tax liabilities may be insufficient if taxing authorities are successful in asserting tax positions that are contrary to our position.  Additionally, continued loss from operations in future reporting periods may require us to adjust the valuation allowance against our deferred tax assets.

 

In the normal course of business, we are audited by various federal, state and local authorities regarding income tax matters.  Significant judgment is required to determine our provision for income taxes and our liabilities for federal, state, local and other taxes.  Our audits are in various stages of completion; however, no outcome for a particular audit can be determined with certainty prior to the conclusion of the audit, appeal and, in some cases, litigation process.  Although we

 

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believe our approach to determining the appropriate tax treatment is supportable and in accordance with relevant accounting literature, it is possible that the final tax authority will take a tax position that is materially different than ours.  As each audit is conducted, adjustments, if any, are appropriately recorded in our consolidated financial statements in the period determined.  Such differences could have a material adverse effect on our income tax provision or benefit, or other tax reserves, in the reporting period in which such determination is made and, consequently, on our results of operations, financial position and/or cash flows for such period.

 

Our deferred tax assets should be reduced by a valuation allowance, if, based on the weight of available evidence, it is more-likely-than-not that some portion or all of the deferred tax assets will not be realized.  In determining the more-likely-than-not criterion, we evaluate all positive and negative evidence as of the end of each reporting period.  Future adjustments, either increases or decreases, to our deferred tax asset valuation allowance will be determined based upon changes in the expected realization of our net deferred tax assets.  The realization of our deferred tax assets ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under the tax law.  Due to significant estimates utilized in establishing the valuation allowance and the potential for changes in facts and circumstances, it is reasonably possible that we will be required to record adjustments to the valuation allowance in future reporting periods.  Our results of operations would be impacted negatively if we determine that increases to our deferred tax asset valuation allowance are required in a future reporting period.

 

As a participant in the homebuilding industry, we are subject to its fluctuating cycles and other risks that can adversely impact the demand for, cost of and pricing of our homes.

 

The homebuilding industry is cyclical and is significantly affected by changes in economic and other conditions such as employment levels, availability of financing, interest rates, and consumer confidence.  These factors can negatively affect demand for and cost of our homes.  We are also subject to various risks, many of which are outside of our control, including delays in construction schedules, cost overruns, changes in governmental regulations (such as “no-growth” or “slow-growth” initiatives), availability of land, availability of land option financing, increases in inventories of new and existing homes, increases in real estate taxes and other local government fees, and raw materials and labor costs.

 

We are also subject to the potential for significant variability and fluctuations in the cost and availability of real estate.  Although historically we have generally developed parcels ranging from 100 to 300 lots, in order to achieve and maintain an adequate inventory of lots, we have, in recent years, acquired larger parcels with joint venture partners. Impairments of our real estate and write-offs of purchase and option contract deposits and pre-acquisition costs, including costs related to our joint ventures, were recorded during 2007, and if market conditions continue to deteriorate such impairments and write-offs may again be required in the future.

 

The loss of key personnel may negatively impact us.

 

Our success largely depends on the continuing services of certain key employees, including our Chief Executive Officer, Steven J. Hilton, and our ability to attract and retain qualified personnel.  We have an employment agreement with Mr. Hilton but we do not have employment agreements with certain other key employees.  We believe that Mr. Hilton possesses valuable industry knowledge, experience and leadership abilities that would be difficult in the short term to replicate.  In addition, Mr. Hilton has cultivated key contacts and relationships with important participants in the land acquisition process in our various markets across the country.  The loss of the services of Mr. Hilton and other key employees could harm our operations and business plans.

 

Shortages in the availability of sub-contract labor may delay construction schedules and increase our costs.

 

We conduct our construction operations only as a general contractor.  Virtually all architectural, construction and development work is performed by unaffiliated third-party subcontractors.  As a consequence, we depend on the continued availability of and satisfactory performance by these subcontractors for the design and construction of our homes.  We cannot assure you that there will be sufficient availability of and satisfactory performance by these unaffiliated third-party subcontractors.  In addition, inadequate subcontractor resources could have a material adverse affect on our business.

 

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Our lack of geographic diversification could adversely affect us if the homebuilding industry in our market declines.

 

We have operations in Texas, Arizona, California, Nevada, Colorado and Florida.  Our limited geographic diversification could adversely impact us if the homebuilding business in our current markets should decline, since there may not be a balancing opportunity in a stronger market in other geographic regions.

 

Our future operations may be adversely impacted by high inflation.

 

We, like other homebuilders, may be adversely affected during periods of high inflation, mainly by higher land and construction costs.  Also, higher mortgage interest rates may significantly affect the affordability of mortgage financing to prospective buyers.  Inflation increases our cost of financing, materials and labor and could cause our financial results or growth to decline.  We attempt to pass cost increases on to our customers through higher sales prices.  Although inflation has not historically had a material adverse effect on our business, recently the cost of some of the materials we use to construct our homes has increased.  Sustained increases in material costs would have a material adverse effect on our business if we are unable to increase home sale prices.

 

We experience fluctuations and variability in our operating results on a quarterly basis and, as a result, our historical performance may not be a meaningful indicator of future results.

 

We historically have experienced, and expect to continue to experience, variability in home sales and results of operation on a quarterly basis.  As a result of such variability, our historical performance may not be a meaningful indicator of future results.  Factors that contribute to this variability include:

 

·              timing of home deliveries and land sales;

 

·              delays in construction schedules due to strikes, adverse weather, acts of God, reduced subcontractor availability and governmental restrictions;

 

·              our ability to acquire additional land or options for additional land on acceptable terms;

 

·              conditions of the real estate market in areas where we operate and of the general economy;

 

·              the cyclical nature of the homebuilding industry, changes in prevailing interest rates and the availability of mortgage financing; and

 

·              costs and availability of materials and labor.

 

Our substantial level of indebtedness may adversely affect our financial position and prevent us from fulfilling our debt obligations.

 

The homebuilding industry is capital intensive and requires significant up-front expenditures to secure land and begin development and construction. Accordingly, we incur substantial indebtedness to finance our homebuilding activities. At December 31, 2007, we had approximately $729.9 million of indebtedness and other borrowings. If we require working capital greater than that provided by operations or available under our Credit Facility, we may be required to seek additional capital in the form of equity or debt financing from a variety of potential sources, including bank financing and securities offerings. There can be no assurance we would be able to obtain such additional capital on terms acceptable to us, if at all. The level of our indebtedness could have important consequences to our stockholders, including the following:

 

·                  our ability to obtain additional financing for working capital, capital expenditures, acquisitions or general corporate purposes may be impaired;

 

·                  we must use a substantial portion of our cash flow from operations to pay interest and principal on our indebtedness, which reduces the funds available to us for other purposes such as capital expenditures;

 

·                  we have a higher level of indebtedness than some of our competitors, which may put us at a competitive disadvantage and reduce our flexibility in planning for, or responding to, changing conditions in our industry, including increased competition; and

 

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·                  we may be more vulnerable to economic downturns and adverse developments in our business than some of our competitors.

 

We expect to generate cash flow to pay our expenses and to pay the principal and interest on our indebtedness from cash flow from operations. Our ability to meet our expenses thus depends on our future performance, which will be affected by financial, business, economic and other factors. We will not be able to control many of these factors, such as economic conditions in the markets where we operate and pressure from competitors.

 

We cannot be certain that our cash flow will be sufficient to allow us to pay principal and interest on our debt and meet our other obligations. If we do not have sufficient funds, we may be required to refinance all or part of our existing debt, sell assets or borrow additional funds. We cannot guarantee that we will be able to do so on terms acceptable to us, if at all. In addition, the terms of existing or future debt agreements may restrict us from pursuing any of these alternatives.

 

Our financial leverage may place burdens on our ability to comply with the terms of our debt and may restrict our ability to complete certain transactions.

 

The indentures for our senior and subordinated notes and the agreement for our Credit Facility impose significant operating and financial restrictions on us. These restrictions limit our ability and the ability of our subsidiaries, among other things, to:

 

·                  incur additional indebtedness or liens;

 

·                  pay dividends or make other distributions;

 

·                  repurchase our stock;

 

·                  make investments (including investments in joint ventures); or

 

·                  consolidate, merge or sell all or substantially all of our assets.

 

In addition, the indentures for our 7.0% senior notes and the agreement for our Credit Facility require us to maintain a minimum consolidated tangible net worth and our Credit Facility requires us to maintain other specified financial ratios, including the amount and types of land, speculative housing and model homes that we may own at any given time. We cannot assure you that these covenants will not adversely affect our ability to finance our future operations or capital needs or to pursue available business opportunities. A breach of any of these covenants or our inability to maintain the required financial ratios could result in a default in respect of the related indebtedness. If a default occurs, the affected lenders could elect to declare the indebtedness, together with accrued interest and other fees, to be immediately due and payable.

 

We may need to amend our existing debt instruments or raise new equity in order to fund our future operations.

 

Although we recently amended our senior unsecured credit facility (our “Credit Facility”) to give us more operational flexibility with respect to our debt covenants, if market conditions continue to deteriorate or continue for a significant period, we may be unable to comply with these covenants and may need to seek further amendments, waivers or forbearance, in respect of our Credit Facility, or may need to refinance the facility.  We may also need to raise new equity to fund our business plan.  There can be no assurance that we will be able to obtain any amendments, waivers or forbearance when, as and if needed, nor can there be any assurance that we would be able to raise new equity or find new lenders willing to refinance on terms acceptable to us, or at all.  Any amended facilities could be on terms that are both more expensive and more restrictive than our current facility.

 

We may also seek to increase our equity through the issuance of additional equity.  Any issuance would dilute the interests of current stockholders, which could adversely affect our stock price.

 

We may not be successful in integrating prior or future acquisitions.

 

We may continue to consider growth or expansion of our operations in our current markets or in other areas of the country.  Our expansion into new or existing markets could have a material adverse effect on our cash flows and/or profitability.  The magnitude, timing and nature of any future expansion will depend on a number of factors, including suitable acquisition candidates, the negotiation of acceptable terms, our financial capabilities and general economic and business conditions.  New acquisitions may result in the incurrence of additional debt.  Acquisitions also involve numerous

 

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risks, including difficulties in the assimilation of the acquired company’s operations, the incurrence of unanticipated liabilities or expenses, the diversion of management’s attention from other business concerns, risks of entering markets in which we have limited or no direct experience and the potential loss of key employees of the acquired company.  Our expansion into Reno and our acquisition of Colonial Homes in Ft. Myers were not successful due to the dramatic downturn in the homebuilding industry, and we are currently winding down operations in these markets.

 

We are subject to extensive government regulations that could cause us to incur significant liabilities or restrict our business activities.

 

Regulatory requirements could cause us to incur significant liabilities and costs and could restrict our business activities.  We are subject to local, state and federal statutes and rules regulating certain developmental matters, as well as building and site design.  We are subject to various fees and charges of government authorities designed to defray the cost of providing certain governmental services and improvements.  We may be subject to additional costs and delays or may be precluded entirely from building projects because of “no-growth” or “slow-growth” initiatives, building permit ordinances, building moratoriums, or similar government regulations that could be imposed in the future due to health, safety, welfare or environmental concerns.  We must also obtain licenses, permits and approvals from government agencies to engage in certain activities, the granting or receipt of which are beyond our control and could cause delays in our homebuilding projects.

 

We are also subject to a variety of local, state and federal statutes, ordinances, rules and regulations concerning the protection of health and the environment.  Environmental laws or permit restrictions may result in project delays, may cause substantial compliance and other costs and may prohibit or severely restrict development in certain environmentally sensitive regions or geographic areas.   Environmental regulations can also have an adverse impact on the availability and price of certain raw materials, such as lumber.

 

Acts of war may seriously harm our business.

 

Acts of war or any outbreak or escalation of hostilities between the United States and any foreign power, including the conflict with Iraq, may cause disruption to the economy, our company, our employees and our customers, which could impact our revenue, costs and expenses and financial condition.

 

Our business may be negatively impacted by natural disasters.

 

We have homebuilding operations in Texas, California and Florida.  Some of our markets in Texas and Florida occasionally experience extreme weather conditions such as tornadoes and/or hurricanes.  California has experienced a significant number of earthquakes, wildfires, flooding, landslides and other natural disasters in recent years.  We do not insure against some of these risks.  These occurrences could damage or destroy some of our homes under construction or our building lots, which may result in losses that exceed our insurance coverage.  We could also suffer significant construction delays or substantial fluctuations in the pricing or availability of building materials.  Any of these events could cause a decrease in our revenue, cash flows and earnings.

 

Risks Related to Ownership of Our Securities

 

Our issuance of equity could result in a lowering of our stock price.

 

To finance our business or future expansion, we may issue additional shares of common stock.  The potential future issuance of additional shares could result in a lower price for our common stock.  We may also seek to issue a different class of stock, if allowed, which could further dilute the common stockholders’ interests in our company.

 

Our charter and bylaws and ownership structure could prevent a third party from acquiring us or limit the price investors might be willing to pay for shares of our common stock.

 

Existing provisions of our charter and bylaws may have the effect of delaying or preventing a merger with or acquisition of us, even where the stockholders may consider it to be favorable, and could also prevent or hinder an attempt by stockholders to replace our directors. They include: (i) a classified board of directors; (ii) a provision that directors may only be removed for cause; (iii) a limitation on the maximum number of directors; (iv) a limitation on the ability of stockholders to call a special meeting of stockholders; (v) a provision that only the directors can amend the bylaws; and (vi) advance notice

 

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requirements for nominations for election to the board of directors or for proposing matters that can be acted on by stockholders at a stockholders meeting.

 

We are subject to the Maryland Business Combination Act. The Maryland Business Combination Act restricts the ability of Maryland corporations to enter into certain business combination transactions with 10% or more stockholders without prior board of director approval of such status, for a period of five years.

 

Our stock price is volatile and could decline substantially.

 

The stock market has, from time to time, experienced extreme price and volume fluctuations that are unrelated to the operating performance of particular companies. In addition, our common stock has recently been subject to extreme price fluctuations. Over the course of the last fiscal year, the price of our common stock has ranged from $12.00 to $47.73 per share. The market price of our common stock may fluctuate in response to many factors including:

 

·                  our operating results failing to meet the expectations of securities analysts or investors in a particular period;

 

·                  write-offs of our assets, including our deferred tax assets;

 

·                  changes in analysts’ recommendation and projections;

 

·                  changes in general valuations for homebuilding companies;

 

·                  material announcements by us or our competitors;

 

·                  the market’s perception of our prospects and the prospects of the homebuilding industry in general;

 

·                  changes in general market conditions or economic trends, such as increasing interest rates; and

 

·                  broad market fluctuations.

 

Any of these factors could have a material adverse effect on your investment in our common stock and our common stock may trade at prices significantly below the offering price. As a result, you could lose some or all of your investment.

 

Special Note of Caution Regarding Forward-Looking Statements

 

In passing the Private Securities Litigation Reform Act of 1995 (“PSLRA”), Congress encouraged public companies to make “forward-looking statements” by creating a safe-harbor to protect companies from securities law liability in connection with forward-looking statements. We intend to qualify both our written and oral forward-looking statements for protection under the PSLRA.

 

The words “believe,” “expect,” “anticipate,” “forecast,” “plan,” “estimate,” and “project” and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. All statements we make other than statements of historical fact are forward-looking statements within the meaning of that term in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Exchange Act. Forward-looking statements in this Annual Report include statements concerning our belief that we are positioned, and that we will be able, to capitalize on opportunities when the market stabilizes; our belief that buyers will defer purchasing decisions until prices stabilize; our belief that cancellations will stabilize as prices and inventory stabilize; our plans or goals for unsold homes inventory reduction, lot supply reduction, generating positive cash flow and using it for debt reduction, as well as management’s intention to operate conservatively, strengthen the balance sheet and improve liquidity to take advantage of future opportunities; management estimates regarding future impairments and joint venture exposure, including actions that we may pursue or that may result from defaults of indebtedness of certain joint ventures, whether certain guarantees relating to our joint ventures will be triggered and our belief that reimbursements due from lenders to our joint ventures will be repaid; expectations regarding our industry and our business in 2008; the significance of buyer confidence, home prices and sales, and a decrease in cancellations signaling a turnaround in the market; the demand for and the pricing of our homes; the growth potential of the markets we operate in; our land and lot acquisition strategy and our belief that we have land in desirable locations; demographic and other trends related to the homebuilding industry in general and our ability to capitalize on these trends; the future supply of housing inventory in our markets and the homebuilding industry in general; our expectation that existing letters of credit and performance and

 

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surety bonds will not be drawn on; the adequacy of our insurance coverage and warranty reserves; our ability to deliver existing backlog; the expected outcome of legal proceedings against us; the sufficiency of our capital resources to support our business strategy; our ability and willingness to acquire land under option or contract; the future impact of deferred tax assets or liabilities; the impact of new accounting pronouncements and changes in accounting estimates; our belief that sales prices, sales orders and gross margins may continue to decrease and that inventories may increase; our future cash needs; the viability of certain large land parcels we own or control; our future compliance with debt covenants and actions we may take with respect thereto; and actions we may take to amend our debt and/or raise equity capital and the availability of such capital on terms acceptable to us.

 

Important factors currently known to management that could cause actual results to differ materially from those in forward-looking statements, and that could negatively affect our business are discussed in this report under the heading “Risk Factors.”

 

Forward-looking statements express expectations of future events. All forward-looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and they are subject to numerous known and unknown risks and uncertainties that could cause actual events or results to differ materially from those projected. Due to these inherent uncertainties, the investment community is urged not to place undue reliance on forward-looking statements. In addition, we undertake no obligations to update or revise forward-looking statements to reflect changed assumptions, the occurrence of unanticipated events or changes to projections over time. As a result of these and other factors, our stock and note prices may fluctuate dramatically.

 

Item 1B. Unresolved Staff Comments

 

None.

 

Item 2. Properties

 

Our corporate offices are leased properties located in Scottsdale, Arizona. The lease expires in March 2014.

 

We lease an aggregate of approximately 350,000 square feet of office space in our markets for our operating divisions, corporate and executive offices.

 

Item 3. Legal Proceedings

 

We are involved in various routine legal and regulatory proceedings, including claims or litigation alleging construction defects.  In general, the proceedings are incidental to our business, and some are covered by insurance. With respect to the majority of pending litigation matters, our ultimate legal and financial responsibility, if any, cannot be estimated with certainty and, in most cases, any potential losses related to these matters are not considered probable. At December 31, 2007, we had approximately $2.9 million in accrued legal expenses and settlement costs reserved for losses related to litigation and asserted claims where our ultimate exposure is considered probable and the potential loss can be reasonably estimated. Most of these matters relate to correction of home construction defects, foundation issues and general customer claims. We believe that none of these matters will have a material adverse impact upon our consolidated financial condition, results of operations or cash flows.

 

Item 4. Submission of Matters to a Vote of Security Holders

 

No matters were submitted to a vote of security holders during the quarter ended December 31, 2007.

 

Executive Officers of the Registrant

 

The executive officers of the Company are elected each year at a meeting of the Board of Directors, which follows the annual meeting of the stockholders, and at other Board of Directors meetings as appropriate.

 

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The names, ages, positions and business experience of our executive officers are listed below (all ages are as of March 1, 2008). There are no understandings between any of our executive officers and any other person pursuant to which any executive officer was selected to his office.

 

Name		Age		Position
Steven J. Hilton		46		Chairman of the Board and Chief Executive Officer
Larry W. Seay		52		Chief Financial Officer and Executive Vice President
C. Timothy White		47		General Counsel, Executive Vice President and Secretary
Steven M. Davis		49		Executive Vice President of National Home Building Operations

 

Steven J. Hilton co-founded Monterey Homes in 1985, which merged with our predecessor in December 1996. Mr. Hilton served as Co-Chairman and CEO from July 1997 to May 2006 and has been the Chairman and Chief Executive Officer since May 2006.

 

Larry W. Seay has been Chief Financial Officer since December 1996 and was appointed Executive Vice President in October 2005. Mr. Seay served as Secretary from 1997 to October 2005.

 

C. Timothy White has been General Counsel, Executive Vice President and Secretary since October 2005 and served on our Board of Directors from December 1996 until October 2005.  Mr. White served as our outside counsel from 1991 through September 2005.

 

Steven M. Davis has been Executive Vice President of National Home Building Operations since October 2006.  From 2000 to September 2006, Mr. Davis was employed by KBHome as a Regional General Manager, with various other management roles at KBHome from 1995 to 2000.

 

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PART II

 

Item 5. Market For Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

 

Our common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol “MTH”. The high and low sales prices per share of our common stock for the periods indicated, as reported by the NYSE, follow.

 

		2007						2006
Quarter Ended		High			Low			High			Low
March 31		$	47.73		$	30.66		$	67.91		$	52.42
June 30		$	38.72		$	26.54		$	68.34		$	45.35
September 30		$	26.97		$	13.88		$	47.80		$	34.44
December 31		$	17.98		$	12.00		$	51.11		$	41.00

 

The following Performance Graph and related information shall not be deemed “soliciting material” or to be filed with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that we specifically incorporate it by reference into such filing.

 

 

		2002		2003		2004		2005		2006		2007
Meritage Homes Corp		100		197		335		374		284		87
S&P 500 Index		100		126		137		142		161		167
Dow Jones US Home Construction Index		100		195		265		305		242		107

 

On February 19, 2008, the closing sales price of our common stock as reported by the NYSE was $13.13 per share. At that date, there were approximately 352 owners of record and approximately 7,000 beneficial owners of common stock.

 

The transfer agent for our common stock is BNY Mellon Shareowner Services, 480 Washington Blvd, Jersey City, NJ 07310 (www.bnymellon.com/shareowner/isd).

 

We have not declared cash dividends for the past ten years, nor do we intend to declare cash dividends in the foreseeable future. We plan to retain our earnings to finance the continuing development of the business. Future cash dividends, if any, will depend upon our financial condition, results of operations, capital requirements, compliance with certain restrictive debt covenants, as well as other factors considered relevant by our Board of Directors. Certain of our debt instruments contain restrictions on the payment of cash dividends. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” and Note 6 — Senior Notes, in the accompanying consolidated financial statements.

 

Reference is made to Note 9 in the accompanying consolidated financial statements for a description of our equity compensation plans.

 

Reference is made to Part I, Item 1A, of this Annual Report for risks relating to ownership of our common stock.

 

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Issuer Purchases of Equity Securities:

 

We did not acquire any shares of our common stock during the three months ended December 31, 2007.  In October 2007, we completed a tender offer and purchased 665,000 options to purchase shares of our common stock that were previously granted to our employees and directors for an aggregate cash payment of $997,500, or $1.50 per option.

 

In November 2004, we announced that the Board of Directors had approved a new stock buyback program, authorizing the expenditure of up to $50 million to repurchase shares of our common stock.  The program was completed in February 2006, with the repurchase of 601,000 shares at an average price of $59.21.

 

On February 21, 2006, we announced that the Board of Directors approved a new stock repurchase program, authorizing the expenditure of up to $100 million to repurchase shares of our common stock.  In August 2006, the Board of Directors authorized an additional $100 million under this program.  There is no stated expiration date for this program.  In the first quarter of 2006, we repurchased 255,000 shares at an average price of $53.77 under this program.  In the second quarter of 2006, we repurchased 1,000,000 shares from John R. Landon, our former Co-CEO and Co-Chairman, for $52.19 per share.  In August 2006, we repurchased 100,000 shares at an average price of $38.96 per share.  As of December 31, 2007, we had approximately $130.2 million available to repurchase shares under this program.  We have no plans to purchase additional shares under this program in the foreseeable future.

 

Reference is made to Note 5 and 6 of the consolidated financial statements included in this Annual Report on Form 10-K.  These notes discusses limitations on our ability to pay dividends.

 

Item 6. Selected Financial Data

 

The following table presents selected historical consolidated financial and operating data of Meritage Homes Corporation and subsidiaries as of and for each of the last five years ended December 31, 2007. The financial data has been derived from our audited consolidated financial statements and related notes for the periods presented.  This table should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and related notes included elsewhere in this Annual Report. These historical results may not be indicative of future results.

 

The data in the table includes the operations of Citation Homes, Colonial Homes and Greater Homes since their dates of acquisition, January 2004, February 2005 and September 2005, respectively.

 

		Historical Consolidated Financial Data
		Years Ended December 31,
		($ in thousands, except per share amounts)
		2007			2006			2005			2004			2003
Statement of Operations Data:
Total closing revenue		$	2,343,594		$	3,461,320		$	3,001,102		$	2,040,004		$	1,471,001
Total cost of closings		(1,990,190		)	(2,670,422		)	(2,294,112		)	(1,631,534		)	(1,178,484		)
Impairments		(340,358		)	(78,268		)	—			—			—
Gross profit		13,046			712,630			706,990			408,470			292,517
Commissions and other sales costs		(196,464		)	(216,341		)	(160,114		)	(116,527		)	(92,904		)
General and administrative expenses		(106,161		)	(164,477		)	(124,979		)	(79,257		)	(53,929		)
Goodwill related impairments		(130,490		)	—			—			—			—
(Loss)/Earnings from unconsolidated entities, net (1)		(40,229		)	20,364			18,337			2,788			1,743
Interest expense		(6,745		)	—			—			—			—
Other income, net		10,561			11,833			7,468			9,284			4,033
Loss on extinguishment of debt		—			—			(31,477		)	—			—
(Loss)/Earnings before income taxes		(456,482		)	364,009			416,225			224,758			151,460
Benefit/(Provision for) income taxes		167,631			(138,655		)	(160,560		)	(85,790		)	(57,054		)
Net (loss)/earnings		$	(288,851	)	$	225,354		$	255,665		$	138,968		$	94,406

 

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		Historical Consolidated Financial Data Years Ended December 31,
		($ in thousands, except per share amounts)
		2007			2006			2005			2004			2003
(Loss)/Earnings per common share: (2)
Basic		$	(11.01	)	$	8.52		$	9.48		$	5.33		$	3.62
Diluted		$	(11.01	)	$	8.32		$	8.88		$	5.03		$	3.42
Balance Sheet Data (December 31):
Real estate		$	1,267,879		$	1,530,602		$	1,390,803		$	867,218		$	678,011
Total assets		$	1,748,381		$	2,170,525		$	1,971,357		$	1,265,394		$	954,539
Senior notes, loans payable and other borrowings		$	729,875		$	733,276		$	592,124		$	471,415		$	351,491
Total liabilities		$	1,018,217		$	1,163,693		$	1,120,352		$	742,839		$	542,644
Stockholders’ equity		$	730,164		$	1,006,832		$	851,005		$	522,555		$	411,895
Cash Flow Data:
Cash (used in) provided by:
Operating activities		$	(20,613	)	$	(21,964	)	$	72,243		$	63,869		$	(50,302	)
Investing activities		(9,677		)	(57,720		)	(247,427		)	(85,502		)	(35,812		)
Financing activities		1,257			70,582			193,120			64,710			84,313

 

(1)          Loss from unconsolidated entities in 2007 includes $57.9 million of joint venture investment impairments.  Refer to Notes 1 and 4 of our consolidated financial statements for more detail.

 

(2)          2003 and 2004 amounts have been adjusted to reflect a 2-for-1 stock split in the form of a stock dividend that occurred in January 2005. There were no cash dividends paid during 2003-2007.

 

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Overview and Outlook

 

Industry Conditions

 

The industry continues to be challenged by the difficult homebuilding market downturn.  Based on U. S. Census Bureau data, single family home starts in the United States dropped to their lowest level since 1991 and for 2007, there were fewer than 800,000 units sold, a 57% decrease from their annualized peak in January 2006.  Although inventory of new homes available for sale at December 31, 2007 has dropped to below 500,000 units in the United States for the first time since late 2005, this balance still represents 9.6 months’ supply.  Demand for homes continues to be low due to the lack of consumer confidence and the reduced availability of mortgage financing as a result of the tightening of underwriting standards and a weakening of credit markets.  Based on research conducted by Inside Mortgage Finance Publications, total mortgages originated in 2007 decreased approximately 18% from 2006, with decreases ranging from 30-70% for Alt A, subprime and ARM originations for the same time period.

 

For us, as well as for the industry as a whole, excess new and existing home supply, including those homes available as a result of increased foreclosure activity, has led to increased competition and margin compression. We believe that home buyers are and will continue to defer purchasing decisions until they believe the price declines have reached bottom.  Additionally, for those buyers motivated to take advantage of current competitive pricing conditions, the tightening of mortgage financing, as well as difficulty in selling their existing homes, are causing high cancellation rates and lower net orders. As the competitive pressures in the industry have increased, homebuilders have offered additional incentives and discounts, which has exacerbated the industry’s performance.

 

Summary Company Results

 

Our results for the year ended December 31, 2007 reflect this deterioration in the homebuilding and credit industries over the past several quarters.

 

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Total home closing revenue was $2.3 billion for the year ended December 31, 2007, decreasing 32.2% from $3.4 billion for 2006 and 23.3% from $3.0 billion in 2005. We incurred a net loss for 2007 of ($288.9) million compared to earnings of $225.4 million in 2006 and $255.7 million in 2005. The net loss was primarily due to $130.5 million (pre-tax) of goodwill-related impairments and $398.3 million (pre-tax) of real estate-related impairments recorded in 2007.  We incurred $78.3 million of real-estate impairments in 2006, and none in 2005.  Additionally, lower average home prices from competitive pressures and the increased use of incentives over the last two years lowered gross margins generated on home closings to 1.1% in 2007, from 20.7% and 23.6%, respectively, in 2006 and 2005.

 

At December 31, 2007, our backlog of approximately $670.0 million was down 44.2% from $1.2 billion at December 31, 2006.  Our December 31, 2005 backlog was $2.2 billion.  Fewer home sales, compounded by increased price concessions and incentives, were primarily responsible for these declines.  Our average sales price for homes in backlog decreased from $341,200 at December 31, 2005 to $325,700 at December 31, 2006 and $292,800 at December 31, 2007. Our cancellation rate on sales orders was 37%, 35% and 24%, respectively, as a percentage of gross sales, for the years ended December 31, 2007, 2006 and 2005.  We expect that cancellation rates will begin to stabilize as the excess supply of home inventory is absorbed and home prices return to normalized levels.

 

Company Actions and Positioning

 

In response to industry conditions, we are focusing on the following initiatives:

 

·                  Consolidating overhead functions at our divisions to reduce our general and administrative cost;

 

·                  Reducing unsold home inventory and significantly limiting construction of speculative homes;

 

·                  Reducing our total lot supply by renegotiating or opting out of lot purchase and option contracts;

 

·                  Reducing our inventory levels of unsold homes caused by late-stage cancellations by focusing our sales efforts on those homes;

 

·                  Reducing direct construction costs by renegotiating with our subcontractors where possible;

 

·                  Stopping or limiting spending for mid- to long-range land development projects;

 

·                  Increasing sales and marketing efforts to generate additional traffic;

 

·                  Monitoring our customer satisfaction scores and making improvements based on the results of these surveys; and

 

·                  Reducing our debt levels and interest cost.

 

In September 2007, we amended our Credit Facility, which matures in 2011. Although the amendment permanently decreased our capacity under the Credit Facility from $850 million to $800 million, it allows for a reduction in the minimum interest coverage ratio, our most restrictive covenant, providing additional flexibility to sustain ourselves during the downturn and take advantage of opportunities as the industry emerges from its recession.  During the fourth quarter of 2007, we paid down a substantial amount of the debt under our Credit Facility from cash generated by operations, reducing the outstanding balance from $234.5 million at September 30, 2007 to $82.0 million at December 31, 2007.

 

Despite current market conditions, we believe we are positioned to weather the current homebuilding industry downturn, and to take advantage of opportunities as the market improves. Continuing population growth in our key regions, our supply of inventory of entitled land in desirable locations, and regulations that constrain the development of raw land in many of these key markets, favor our geographic position.  Coupled with this strong inventory position, we believe that our product diversification, respected brands, solid balance sheet and management experience position us for future growth when the homebuilding market stabilizes.

 

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Critical Accounting Policies

 

We have established various accounting policies that govern the application of United States generally accepted accounting principles (“GAAP”) in the preparation and presentation of our consolidated financial statements. Our significant accounting policies are described in Note 1 of the consolidated financial statements. Certain of these policies involve significant judgments, assumptions and estimates by management that may have a material impact on the carrying value of certain assets and liabilities, and revenue and costs. We are subject to uncertainties such as the impact of future events, economic, environmental and political factors and changes in our business environment; therefore, actual results could differ from these estimates. Accordingly, the accounting estimates used in the preparation of our financial statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. Changes in estimates are revised when circumstances warrant. Such changes in estimates and refinements in methodologies are reflected in our reported results of operations and, if material, the effects of changes in estimates are disclosed in the notes to the consolidated financial statements. The judgments, assumptions and estimates we use and believe to be critical to our business are based on historical experience, knowledge of the accounts and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgments and assumptions we have made, actual results may differ from these judgments and estimates, which could have a material impact on the carrying values of assets and liabilities and the results of our operations, particularly as related to our ability to accurately estimate stock-based compensation, accruals, or impairments of real estate or goodwill that could result in charges, or income, in future periods, which relate to activities or transactions in a preceding period.

 

The accounting policies that we deem most critical to us, and involve the most difficult, subjective or complex judgments, are as follows:

 

Revenue Recognition

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 66, Accounting for Sales of Real Estate, we recognize revenue from home sales when title passes to the homeowner, the homeowner’s initial and continuing investment is adequate to demonstrate a commitment to pay for the home, the receivable, if any, from the homeowner is not subject to future subordination and we do not have a substantial continuing involvement with the sold home.  These conditions are typically achieved when a home closes.

 

Revenue from land sales is recognized when a significant down payment is received, the earnings process is relatively complete, title passes and collectibility of the receivable is reasonably assured.

 

Real Estate

 

Real estate is stated at cost unless the community is determined to be impaired, at which point the inventory is written down to fair value as required by the guidance of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.  Inventory includes the costs of land acquisition, land development and home construction, capitalized interest, real estate taxes and direct overhead costs incurred during development and home construction that benefit the entire community.  Land and development costs are typically allocated to individual lots on a relative value basis. The costs of these lots are transferred to homes under construction when construction begins.  Home construction costs are accumulated on a per-home basis.  Cost of home closings includes the specific construction costs of the home and all related land acquisition, land development and other common costs (both incurred and estimated to be incurred) based upon the total number of homes expected to be closed in each community or phase.  Any changes to the estimated total development costs of a community are allocated on a relative value basis to the remaining homes in the community.  When a home closes, we may have incurred costs for goods and services that have not yet been paid.  Therefore, an accrual to capture such obligations is recorded in connection with the home closing and charged directly to cost of sales.

 

Typically, our building cycle ranges from four-to-five years, commencing with the acquisition of the entitled land and continuing through the land development phase and concluding with the sale, construction and closing of the homes.  Actual community lives will vary, based on the size of the community and the associated absorption rates.  Master-planned communities encompassing several phases and super-block land parcels may have significantly longer lives.  Additionally, the current slow-down in the housing market has negatively impacted our sales pace, thereby also extending the lives of certain communities.

 

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In accordance with SFAS No. 144, land inventory and related real-estate assets are reviewed for recoverability when impairment indicators are present, as our inventory is considered “long-lived” in accordance with U.S. generally accepted accounting principles.  SFAS No. 144 requires that impairment charges are to be recorded if the fair value of such assets is less than their carrying amounts.  Our determination of fair value is based on projections and estimates.  Changes in these expectations may lead to a change in the outcome of our impairment analysis.  Our analysis is completed on a quarterly basis at community level; therefore, changes in local conditions may effect one or several of our communities.  For those assets deemed to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets.

 

Existing and continuing communities:  When projections for the remaining income expected to be earned from existing communities are no longer positive, the underlying real-estate assets are deemed not fully recoverable, and further analysis is performed to determine the required impairment.  The fair value of the communities’ assets is determined using various valuation techniques, including discounted cash flow models with impairments charged to cost of home closing in the period during which the fair value is less than the assets’ carrying amount.  Our key estimates in deriving fair value are (i) home selling prices in the community adjusted for current and expected sales discounts and incentives, (ii) costs related to the community - both land development and home construction - including costs spent to date and budgeted remaining costs to spend, (iii) projected absorption rates, reflecting any product mix change strategies implemented to stimulate the sales pace, and (iv) alternative land uses including disposition of all or a portion of the land owned.

 

Option deposits and pre-acquisition costs: We also evaluate assets associated with future communities for impairments on a quarterly basis.  Using similar techniques described in the existing communities section above, we determine if the contributions to be generated by our future communities are acceptable to us.  If the projections indicate that the communities are still profitable and generating acceptable margins, the assets are determined to be fully recoverable and no impairments are required.  In cases where we determine to abandon the project, we will fully impair all assets related to such project and will expense and accrue any additional costs that we are contractually obligated to incur.  We may also elect to continue with a project that may not be generating an accounting profit due to expected future cash flow that may be generated or other factors.  In such cases, we will impair our pre-acquisition costs and deposits, as necessary, to record an impairment to bring the book value to fair value.

 

During 2007, we recorded $266.7 million of such impairment charges related to our home and land real estate inventories and real-estate-related joint venture investments.  Additionally, we wrote off $131.6 million of deposits and pre-acquisition costs relating to projects that were no longer feasible.  The impairment charges were based on our fair value calculations, which are affected by current market conditions, assumptions and expectations, all of which are highly subjective and may differ significantly from actual results if market conditions change.

 

Goodwill

 

We test goodwill for impairment annually or more frequently if an event occurs or circumstances change that may reduce the value of a reporting unit below its carrying value.  For purposes of goodwill impairment testing, we compare the fair value of each reporting unit with its carrying amount, including goodwill.  Our operations in each state are considered a reporting unit.  The fair value of reporting units is determined using various valuation methodologies, including discounted future cash flow models and enterprise value computations.  If the carrying amount of a reporting unit exceeds its fair value, goodwill is considered impaired.  If goodwill is considered impaired, the impairment loss to be recognized is measured by the amount by which the carrying amount of the goodwill exceeds implied fair value of that goodwill.

 

Inherent in our fair value determinations are certain judgments and estimates, including projections of future cash flows, the discount rate reflecting the risk inherent in future cash flows, the interpretation of current economic indicators and market valuations and our strategic plans with regard to our operations.  A change in these underlying assumptions may cause a change in the results of our analysis.  In addition, to the extent that there are significant changes in market conditions or overall economic conditions or our strategic plans change, it is possible that our conclusion regarding goodwill impairment could change, which could have a material adverse effect on our financial position and results of operations.

 

Our goodwill has been assigned to reporting units in different geographic locations.  Therefore, potential goodwill impairment charges resulting from changes in local market and/or local economic conditions or changes in our strategic plans may be isolated to one or a few of our reporting units.  However, a widespread decline in the homebuilding industry or a significant deterioration of general economic conditions could have a negative impact on the estimated fair value of several or all of our reporting units.

 

25

 

During 2007, we estimated the fair value of our reporting units based on a discounted projection of future cash flows, supported with a market based valuation of our company as a whole, and concluded that an impairment loss was probable and could be reasonably estimated for our reporting units.  Based on these results, the goodwill balance was impaired $129.4 million in 2007, resulting in a full write-down of all of our remaining goodwill.  There were no such impairments in 2006 or 2005.  See Note 7 for additional information.

 

Warranty Reserves

 

We use subcontractors for nearly all aspects of home construction.  Although our contracts generally require subcontractors to repair and replace any product or labor defects, we are generally responsible for such repairs.  As such, warranty reserves are recorded to cover potential costs for materials and labor as they relate to warranty-type claims expected to be incurred subsequent to the delivery of a home to the homeowner.  Reserves are determined based on our and industry-wide historical data and trends with respect to product types and geographical areas.

 

At December 31, 2007, our warranty reserve was $36.6 million, reflecting 0.8% to 1.5% of a home’s sale price.  A 10% increase in our warranty reserve rate would have increased our accrual and corresponding cost of sales by $2.3 million in 2007.  While we believe that the warranty reserve is sufficient to cover our projected costs, there can be no assurances that historical data and trends will accurately predict our actual warranty costs.  Furthermore, there can be no assurances that future economic or financial developments might not lead to a significant change in the reserve.

 

Off-Balance Sheet Arrangements

 

We invest in entities that acquire and develop land for sale to us in connection with our homebuilding operations or for sale to third parties. Our partners generally are unaffiliated homebuilders, land sellers and financial or other strategic partners.

 

All of the unconsolidated entities through which we acquire and develop land are accounted for by the equity method of accounting because the criteria for consolidation set forth in FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (FIN 46R) have not been met. We record our investments in these entities in our consolidated balance sheets as “Investments in unconsolidated entities” and our pro rata share of the entities’ earnings or losses in our consolidated statements of earnings as “(Loss)/earnings from unconsolidated entities, net.”

 

We use our business judgment to determine if we are the primary beneficiary of, or have a controlling interest in, an unconsolidated entity.  Factors considered in our determination include the profit/loss sharing terms of the entity, experience and financial condition of the other partners, voting rights, involvement in day-to-day capital and operating decisions and continuing involvement.

 

As of December 31, 2007, we believe that the equity method of accounting is appropriate for our investments in unconsolidated entities where we are not the primary beneficiary, we do not have a controlling interest, and our ownership interest exceeds 20%.  At December 31, 2007, our equity investments of $26.6 million related to unconsolidated entities with total assets of $690.1 million and total liabilities of $496.8 million.  See Note 4 in the accompanying consolidated financial statements for additional information related to these investments.

 

We also enter into option or purchase agreements to acquire land or lots, for which we generally pay non-refundable deposits. We analyze these agreements under FIN 46R to determine whether we are the primary beneficiary of the variable interest entity (“VIE”), if applicable, using a model developed by management. If we are deemed to be the primary beneficiary of the VIE, we will consolidate the VIE in our consolidated financial statements. See Note 3 in the accompanying financial statements for additional information related to our off-balance sheet arrangements.  In cases where we are the primary beneficiary, we consolidate these purchase/option agreements and reflect such assets and liabilities as “Real estate not owned” in our consolidated balance sheets.  The liabilities related to consolidated VIEs do not impact our debt covenant calculations.

 

Valuation of Deferred Tax Assets

 

We account for income taxes using the asset and liability method, which requires that deferred tax assets and liabilities be recognized based on future tax consequences of both temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are

 

26

 

measured using enacted tax rates expected to apply in the years in which the temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period when the changes are enacted.

 

SFAS No. 109, Accounting for Income Taxes, requires a reduction of the carrying amounts of deferred tax assets by a valuation allowance, if based on the evidence available, it is more-likely-than-not that such assets will not be realized.  In making the assessment under the more-likely-than-not standard, appropriate consideration must be given to all positive and negative evidence related to the realization of the deferred tax assets.  This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the duration of statutory carryforward periods by jurisdiction, unitary versus stand alone state tax filings, the company’s experience with loss carryforwards not expiring unutilized, and all tax planning alternatives that may be available.

 

In making the determination of whether we are in a cumulative loss position under SFAS No. 109, we use a a four-year measurement period and base the determination on net income or loss before income taxes for the current and prior three years.

 

At December 31, 2007, our net deferred tax asset was $139.1 million of which $10.0 million related to the net state deferred tax asset after a valuation allowance of $8.5 million.  Based on our assessment, it appears more-likely-than-not that the net federal deferred tax asset of $129.1 million will be fully realized and does not require a valuation allowance.  At the state level, a valuation allowance was determined to be necessary due to the magnitude of loss in non-unitary states, no carry back of loss being allowed at the state level, and shorter carry forward periods in a few of the states where we are doing business.

 

Share-Based Payments

 

We have stock options and restricted common stock (“nonvested shares”) outstanding under two stock compensation plans.  Per the terms of these plans, the exercise price of our stock options may not be less than the closing market value of our common stock on the date of the grant.  Additionally, no options granted under the plans may be exercised within one year from the date of the grant.  Thereafter, exercises are permitted in pre-determined installments based upon a vesting schedule established at the time of grant.  Each stock option expires on a date determined at the time of the grant, but not to exceed seven years from the date of the grant.

 

Prior to January 1, 2006, we accounted for stock option awards granted under our compensation plans in accordance with the recognition and measurement provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations, as permitted by SFAS No. 123, Accounting for Stock-Based Compensation.  Share-based employee compensation expense was not recognized in our consolidated statements of earnings prior to January 1, 2006, as our stock options had an exercise price equal to or greater than the market value of our common stock on the date of the grant and therefore, no intrinsic value.  On January 1, 2006, we adopted the provisions of SFAS No. 123 (revised 2004), Share-Based Payment, (“SFAS No. 123R”) using the modified-prospective-transition method.  Under this transition method, our compensation expense recorded since January 1, 2006 includes both charges related to the vesting of options and restricted stock granted since the adoption of SFAS No. 123R as well as compensation cost related to the unvested portions of options granted prior to January 1, 2006.  For all compensation cost recorded, fair value of the options was determined using the provisions of SFAS No. 123R.  In accordance with the modified-prospective-transition method, results for prior periods have not been restated.

 

The calculation of employee compensation expense involves estimates that require management judgements.  These estimates include determining the value of each of our stock options on the date of grant using a Black-Scholes option-pricing model discussed in Note 9 in the accompanying consolidated financial statements.  The fair value of our stock options, which typically vest ratably over a five-year period, is expensed on a straight-line basis over the vesting life of the options.  Expected volatility is based on a composite of historical volatility of our stock and implied volatility from our traded options.  The risk-free rate for periods within the contractual life of the stock option award is based on the rate of a zero-coupon Treasury bond on the date the stock option is granted with a maturity equal to the expected term of the stock option.  We use historical data to estimate stock option exercises and forfeitures within our valuation model.  The expected life of our stock option awards is derived from historical experience under our share-based payment plans and represents the period of time that we expect our stock options to be outstanding.

 

27

 

Home Closing Revenue, Home Orders and Order Backlog – Segment Analysis

 

The tables provided below show operating and financial data regarding our homebuilding activities (dollars in thousands).

 

		Years Ended December 31,
		2007			2006			2005
Home Closing Revenue
Total
Dollars		$	2,334,141		$	3,444,286		$	2,996,946
Homes closed		7,687			10,487			9,406
Average sales price		$	303.6		$	328.4		$	318.6
West Region
California
Dollars		$	421,220		$	820,583		$	947,228
Homes closed		908			1,471			1,627
Average sales price		$	463.9		$	557.8		$	582.2
Nevada
Dollars		$	88,837		$	244,343		$	201,907
Homes closed		261			620			541
Average sales price		$	340.4		$	394.1		$	373.2
West Region Totals
Dollars		$	510,057		$	1,064,926		$	1,149,135
Homes closed		1,169			2,091			2,168
Average sales price		$	436.3		$	509.3		$	530.0
Central Region
Arizona
Dollars		$	567,888		$	1,102,662		$	873,137
Homes closed		1,718			3,355			3,122
Average sales price		$	330.6		$	328.7		$	279.7
Texas
Dollars		$	1,043,160		$	996,739		$	787,204
Homes closed		4,164			4,263			3,576
Average sales price		$	250.5		$	233.8		$	220.1
Colorado
Dollars		$	60,069		$	40,875		$	2,809
Homes closed		160			112			8
Average sales price		$	375.4		$	365.0		$	351.1
Central Region Totals
Dollars		$	1,671,117		$	2,140,276		$	1,663,150
Homes closed		6,042			7,730			6,706
Average sales price		$	276.6		$	276.9		$	248.0
East Region
Florida
Dollars		$	152,967		$	239,084		$	184,661
Homes closed		476			666			532
Average sales price		$	321.4		$	359.0		$	347.1

 

28

 

		Years Ended December 31,
		2007			2006			2005
Home Orders
Total
Dollars		$	1,804,065		$	2,462,747		$	3,580,855
Homes ordered		6,290			7,778			10,571
Average sales price		$	286.8		$	316.6		$	338.7
West Region
California
Dollars		$	372,936		$	529,435		$	976,921
Homes ordered		846			983			1,646
Average sales price		$	440.8		$	538.6		$	593.5
Nevada
Dollars		$	85,772		$	139,668		$	249,104
Homes ordered		268			328			653
Average sales price		$	320.0		$	425.8		$	381.5
West Region Totals
Dollars		$	458,708		$	669,103		$	1,226,025
Homes ordered		1,114			1,311			2,299
Average sales price		$	411.8		$	510.4		$	533.3
Central Region
Arizona
Dollars		$	341,140		$	611,266		$	1,174,452
Homes ordered		1,203			1,833			3,558
Average sales price		$	283.6		$	333.5		$	330.1
Texas
Dollars		$	845,348		$	1,069,437		$	983,579
Homes ordered		3,427			4,299			4,264
Average sales price		$	246.7		$	248.8		$	230.7
Colorado
Dollars		$	59,423		$	47,836		$	14,631
Homes ordered		168			125			40
Average sales price		$	353.7		$	382.7		$	365.8
Central Region Totals
Dollars		$	1,245,911		$	1,728,539		$	2,172,662
Homes ordered		4,798			6,257			7,862
Average sales price		$	259.7		$	276.3		$	276.3
East Region
Florida
Dollars		$	99,446		$	65,105		$	182,168
Homes ordered		378			210			410
Average sales price		$	263.1		$	310.0		$	444.3

 

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