Meritage Homes CORP - Quarter Report: 2007 September (Form 10-Q)

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2007

 

or

 

o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

Commission File Number 1-9977

 

MERITAGE HOMES CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

 

 

(480) 515-8100

(Registrant’s Telephone Number, Including Area Code)

 

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 whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large Accelerated Filer x

Accelerated Filer o

Non-Accelerated Filer o

 

Indicate by a checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes o No x

 

Common shares outstanding as of November 7, 2007: 26,249,296.

 

 

MERITAGE HOMES CORPORATION

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2007

 

TABLE OF CONTENTS

 

PART I.	FINANCIAL INFORMATION
	Item 1.		Financial Statements
			Unaudited Condensed Consolidated Balance Sheets as of September 30, 2007 and December 31, 2006
			Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2007 and 2006
			Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2007 and 2006
			Notes to Unaudited Condensed Consolidated Financial Statements
	Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.		Quantitative and Qualitative Disclosures About Market Risk
	Item 4.		Controls and Procedures
PART II.	OTHER INFORMATION
	Item 1.		Legal Proceedings
	Item 1A.		Risk Factors
	Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds
	Item 3.		Not Applicable
	Item 4.		Not Applicable
	Item 5.		Not Applicable
	Item 6.		Exhibits
SIGNATURES
INDEX OF EXHIBITS

 

 

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

MERITAGE HOMES CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

 

		September 30,			December 31,
		2007			2006
Assets:
Cash and cash equivalents		$	45,297		$	56,710
Receivables		93,573			68,725
Real estate		1,504,137			1,530,602
Real estate not owned		34,062			5,269
Deposits on real estate under option or contract		106,768			167,132
Investments in unconsolidated entities		57,387			114,250
Property and equipment, net		37,143			40,712
Deferred tax asset, net		110,390			28,119
Goodwill		57,538			129,659
Intangibles, net		8,099			9,492
Prepaid expenses and other assets		21,074			19,855
Total assets		$	2,075,468		$	2,170,525
Liabilities:
Accounts payable		$	79,641		$	117,443
Accrued liabilities		206,729			266,683
Home sale deposits		29,698			42,022
Liabilities related to real estate not owned		22,575			4,269
Loans payable and other borrowings		255,167			254,640
Senior and senior subordinated notes		628,760			478,636
Total liabilities		1,222,570			1,163,693
Stockholders’ Equity:
Common stock, par value $0.01. Authorized 125,000,000 shares; issued and outstanding 34,140,364 and 34,035,084 shares at September 30, 2007 and December 31, 2006, respectively		341			340
Additional paid-in capital		341,691			332,652
Retained earnings		699,628			862,602
Treasury stock at cost, 7,891,068 shares		(188,762		)	(188,762		)
Total stockholders’ equity		852,898			1,006,832
Total liabilities and stockholders’ equity		$	2,075,468		$	2,170,525

 

See accompanying notes to condensed consolidated financial statements

 

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2007			2006			2007			2006
Home closing revenue		$	574,667		$	875,743		$	1,718,530		$	2,624,968
Land closing revenue		3,902			2,453			6,156			15,159
Total closing revenue		578,569			878,196			1,724,686			2,640,127
Cost of home closings		(489,412		)	(689,648		)	(1,437,637		)	(1,998,048		)
Cost of land closings		(3,814		)	(2,232		)	(5,708		)	(13,809		)
Home impairments		(147,538		)	(8,308		)	(243,437		)	(15,603		)
Land impairments		(847		)	—			(847		)	—
Total cost of closings and impairments		(641,611		)	(700,188		)	(1,687,629		)	(2,027,460		)
Home closing gross (loss)/profit		(62,283		)	177,787			37,456			611,317
Land closing gross (loss)/profit		(759		)	221			(399		)	1,350
Total closing gross (loss)/profit		(63,042		)	178,008			37,057			612,667
Commissions and other sales costs		(49,598		)	(55,934		)	(145,003		)	(156,810		)
General and administrative expenses		(21,308		)	(34,347		)	(76,385		)	(128,413		)
Goodwill and related impairments		(45,000		)	—			(72,952		)	—
(Loss)/earnings from unconsolidated entities, net		(14,441		)	4,238			(9,495		)	15,077
Interest expense and other income, net		972			2,482			7,775			7,867
(Loss)/earnings before income taxes		(192,417		)	94,447			(259,003		)	350,388
Benefit/(provision) for income taxes		73,865			(34,908		)	98,991			(134,058		)
Net/(loss) earnings		$	(118,552	)	$	59,539		$	(160,012	)	$	216,330
(Loss)/earnings per common share:
Basic		$	(4.52	)	$	2.28		$	(6.10	)	$	8.15
Diluted		$	(4.52	)	$	2.25		$	(6.10	)	$	7.94
Weighted average number of shares:
Basic		26,249			26,087			26,216			26,554
Diluted		26,249			26,490			26,216			27,259

 

See accompanying notes to condensed consolidated financial statements

 

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

		Nine Months Ended September 30,
		2007			2006
Cash flows from operating activities:
Net (loss)/earnings		$	(160,012	)	$	216,330
Adjustments to reconcile net (loss)/earnings to net cash used in operating activities:
Depreciation and amortization		13,457			15,272
Real estate related impairments		244,284			16,233
Goodwill-related impairments		72,952			—
Increase in deferred taxes		(81,424		)	—
Stock-based compensation		6,735			9,397
Excess income tax benefit from stock-based awards		(346		)	(11,190		)
Loss/(income) from earnings from unconsolidated entities (includes $24.5 million of impairments to joint ventures in 2007)		9,495			(15,077		)
Distributions of earnings from unconsolidated entities		12,229			13,958
Changes in assets and liabilities:
Increase in real estate		(147,413		)	(192,132		)
Decrease/(increase) in deposits on real estate under option or contract		16,003			(35,410		)
Increase in receivables and prepaid expenses and other assets		(24,919		)	(26,844		)
Decrease in accounts payable and accrued liabilities		(110,650		)	(39,158		)
Decrease in home sale deposits		(12,324		)	(19,018		)
Net cash used in operating activities		(161,933		)	(67,639		)
Cash flows from investing activities:
Investments in unconsolidated entities		(25,851		)	(43,057		)
Distributions of capital from unconsolidated entities		32,910			15,563
Purchases of property and equipment		(10,739		)	(21,328		)
Proceeds from sales of property and equipment		732			1,006
Net cash used in investing activities		(2,948		)	(47,816		)
Cash flows from financing activities:
Net borrowings under line of credit agreement		8,000			206,400
Proceeds from loans payable and other borrowings		—			1,214
Repayments of loan payable and other borrowings		(1,309		)	—
Proceeds from issuance of senior subordinated notes		150,000			—
Debt issuance costs		(5,428		)	—
Purchase of treasury stock		—			(105,384		)
Payments of senior notes		—			(1,254		)
Excess income tax benefit from stock-based awards		346			11,190
Proceeds from stock option exercises		1,859			12,913
Net cash provided by financing activities		153,468			125,079
Net decrease/(increase) in cash and cash equivalents		(11,413		)	9,624
Cash and cash equivalents at beginning of period		56,710			65,812
Cash and cash equivalents at end of period		$	45,297		$	75,436

 

See supplemental disclosures of cash flow information at Notes 7 and 11.

 

See accompanying notes to condensed consolidated financial statements

 

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006

 

NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION

 

Organization. Meritage Homes is a leading designer and builder of single-family attached and detached homes in the historically high-growth regions of the western and southern United States based on the number of home closings. We offer first-time, move-up, active adult and luxury homes to our targeted customer base. We have operations in three regions:  West, Central and East, which are comprised of 14 metropolitan areas in Arizona, Texas, California, Nevada, Colorado and Florida. Through our successors, we commenced our homebuilding operations in 1985. Meritage Homes Corporation was incorporated in 1988 in the State of Maryland.

 

Our homebuilding and marketing activities are conducted under the name of Meritage Homes in each of our markets, except for certain communities in Arizona, where we also operate under the name of Monterey Homes, and in Texas, where we also operate in certain communities as Legacy Homes and Monterey Homes. At September 30, 2007, we were actively selling homes in 221 communities, with base prices ranging from approximately $114,000 to $1,007,000.

 

Basis of Presentation. The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States and include the accounts of Meritage Homes Corporation and those of our consolidated subsidiaries, partnerships and other entities in which we have a controlling financial interest, and of variable interest entities (see Note 3) in which we are deemed the primary beneficiary (collectively, “us”, “we”, “our” and the “Company”). Intercompany balances and transactions have been eliminated in consolidation. In the opinion of management, the accompanying financial statements include all adjustments necessary for the fair presentation of our results for the interim periods presented.

 

The unaudited condensed statements of operations for the three and nine months ended September 30, 2007 are not necessarily indicative of the results to be expected for the full year. These condensed consolidated financial statements should be read in conjunction with our 2006 Annual Report on Form 10-K.

 

Real Estate. Real estate is stated at the lower of cost or fair value and includes the costs of land acquisition, land development and home construction, capitalized interest, real estate taxes and direct overhead costs incurred during development and 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 expected to be incurred) based upon the total number of homes expected to be closed in each community. 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 is closed, we generally have not yet paid all costs incurred to complete it. At the time of close, we record a liability and a charge to cost of sales for the amount we expect will ultimately be paid to complete the home.

 

In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS No. 144”), land inventory and related communities under development are reviewed for potential write-downs annually or when impairment indicators are present. SFAS No. 144 requires that in the event the undiscounted cash flows projected for those assets are less than their carrying amounts, an impairment charge is recorded to bring the assets to fair value. Our determination of fair value is based on projections and estimates, including future sales prices, construction costs and absorption rates. Changes in these expectations may lead to a change in the outcome of our impairment analysis. Our analysis is completed at the community level; therefore, changes in local conditions may affect one or several of our communities. For those assets deemed to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount exceeds the fair value of the assets.

 

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The real-estate and joint-venture impairment charges recorded during the three- and nine-month periods ended September 30, 2007 and September 30, 2006 were as follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2007			2006			2007			2006
Terminated option/purchase contracts
West		$	34,273		$	—		$	46,484		$	2,364
Central		12,699			1,724			17,449			1,795
East		746			2,911			19,904			3,311
Total		$	47,718		$	4,635		$	83,837		$	7,470
Real estate inventory impairments
West		$	63,299		$	3,673		$	111,821		$	7,384
Central		22,844			—			28,890			749
East		13,677			—			18,889			—
Total		$	99,820		$	3,673		$	159,600		$	8,133
Impairments of joint venture investments
West		$	1,680		$	—		$	2,800		$	—
Central		21,689			—			21,689			—
East		—			—			—			—
Total		$	23,369		$	—		$	24,489		$	—
Impairments of land held for sale
West		$	—		$	—		$	—		$	—
Central		847			—			847			—
East		—			—			—			—
Total		$	847		$	—		$	847		$	—
Total impairments
West		$	99,252		$	3,673		$	161,105		$	9,748
Central		58,079			1,724			68,875			2,544
East		14,423			2,911			38,793			3,311
Total		$	171,754		$	8,308		$	268,773		$	15,603

 

The impairment charges were based on our fair value calculations, which are affected by current market conditions, such as the continued downturn of the homebuilding market, assumptions and expectations, all of which are highly subjective and may differ significantly from actual results if market conditions change.

 

Off-Balance-Sheet Arrangements – Joint Ventures. We participate in homebuilding and land development joint ventures from time to time as a means of accessing larger parcels of land and lot positions, expanding our market opportunities, managing our risk profile and leveraging our capital base. Based on the structure of these joint ventures, they may or may not be consolidated into our results. Our joint venture partners generally are other homebuilders, land sellers or other real estate investors. We generally do not have a controlling interest in these ventures, which means the venture could fail to take actions we believe should be undertaken, including the sale of the underlying property to repay debt or recoup all or part of the partners’ investments, and in some cases take actions with which we disagree.

 

We and/or our joint venture partners occasionally provide limited repayment guarantees on a pro rata basis on the debt of the land development joint ventures. At September 30, 2007, our share of these limited pro rata repayment guarantees was approximately $39.7 million.

 

In addition, we and/or our joint venture partners occasionally provide guarantees that are only applicable if and when the joint venture directly, or indirectly through agreement with its joint venture partners or other third parties, causes the joint venture to voluntarily file a bankruptcy or similar liquidation or reorganization action or take other actions that are fraudulent or improper (commonly referred to as “bad boy guarantees”). These types of guarantees typically are on a pro rata basis among the joint venture partners and are designed to protect the respective secured lender’s remedies with respect to its mortgage or other secured lien on the joint venture’s underlying property. To date, no such guarantees have been invoked and we believe that the actions

 

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that would trigger the guarantee would generally be disadvantageous to the joint venture and to us; however, there can be no assurances that certain of our ventures will not elect to take actions that could trigger a bad boy guarantee, as it may be considered in their economic best interest to do so. At September 30, 2007, we had outstanding guarantees of this type totaling approximately $91.7 million. We believe these guarantees, as defined, unless invoked as described above, are not considered guarantees or indebtedness under our revolving credit facility or senior and senior subordinated indentures.

 

We and our joint venture partners are also typically obligated to the project lenders to complete land development improvements if the joint venture does not perform the required development.  Provided we and the other joint venture partners are in compliance with these completion obligations, the project lenders are generally obligated to fund these improvements through any financing commitments available under the applicable joint venture development and construction loans.  In addition, we and our joint venture partners have from time to time provided unsecured indemnities to joint venture project lenders.  These indemnities generally obligate us to reimburse the project lenders only for claims and losses related to matters for which such lenders are held responsible and our exposure under these indemnities is limited to specific matters such as environmental claims.  As part of our project acquisition due diligence process to determine potential environmental risks, we generally obtain, or the joint venture entity generally obtains, an independent environmental review from outside consultants.

 

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. If a joint venture does not perform its obligations, the surety bond could be called. If these surety bonds are called and the joint venture fails to reimburse the surety, we and our joint venture partners would be obligated to indemnify the surety. These surety indemnity arrangements are generally joint and several obligations with our other joint venture partners. As of September 30, 2007, we had approximately $45.3 million of surety bonds outstanding subject to these indemnity arrangements. None of these bonds have been called to date and we believe it is unlikely that any of these bonds will be called.

 

The joint venture obligations, guarantees and indemnities discussed above are generally provided by us or one or more of our subsidiaries. In joint ventures involving other homebuilders or developers, support for these obligations is generally provided by the parent companies of the joint venture partners. In connection with our periodic real estate impairment reviews, we accrue for any such commitments where we believe our obligation to pay is probable and can be reasonably estimated. In such situations, our accrual represents the portion of the total joint venture obligation related to our relative ownership percentage. In cases where our venture partners, some of whom are homebuilders or developers who may be experiencing financial difficulties as a result of current market conditions, may be unable to fulfill their pro rata share of a joint venture obligation, we may be fully responsible for these commitments if such commitments are joint and several. We continue to monitor these matters and will reserve for those obligations if and when they become probable and can be reasonably estimated.

 

Off-Balance-Sheet Arrangements – Other. We often acquire finished building lots from various development entities pursuant to option and purchase agreements. The purchase price typically approximates the market price at the date the contract is executed. We believe this lot acquisition strategy reduces the financial requirements and risks associated with direct land ownership and land development. Under these option and purchase agreements, we are usually required to make deposits in the form of cash or letters of credit, which may be forfeited if we fail to perform under the applicable agreements. As of September 30, 2007, we had entered into option and purchase agreements with an aggregate purchase price of approximately $1.3 billion and had made deposits of approximately $118.3 million ($106.8 million excluding our projects designated as real estate not owned) in the form of cash and approximately $31.1 million in letters of credit.

 

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. The amount of these obligations outstanding at any time varies depending on the stage and level of our development activities. In the event the letters of credit or bonds are drawn upon, we would be obligated to reimburse the issuer of the letter of credit or bond. At September 30, 2007, we had approximately $37.1 million in outstanding letters of credit and $248.4 million in performance bonds for such purposes. We believe it is unlikely that any significant amounts of these letters of credit or bonds will be drawn upon.

 

Intangibles, Net. Intangible assets consist primarily of non-compete agreements acquired in connection with our September 2005 acquisition of Greater Homes. These intangible assets were valued at the acquisition date utilizing accepted valuation procedures and are being amortized over their estimated useful lives. The cost and accumulated amortization of our intangible assets was $7.4 million and $5.4 million, respectively, at September 30, 2007. In the first nine months of 2007, amortization expense was $0.8 million. Amortization expense is expected to be approximately $0.2 million in the remaining three months of 2007 and $0.7, $0.7 and $0.4 million per year in 2008, 2009 and 2010, respectively.

 

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Additionally, in accordance with AICPA Statement of Position 98-1, “Accounting for Costs of Computer Software Developed or Obtained for Internal Use,” we have capitalized software costs at September 30, 2007 with a basis of $5.4 million, which is net of accumulated amortization of $7.2 million. In the first nine months of 2007, amortization expense was approximately $1.8 million related to the capitalized software costs and is expected to be approximately $0.3 million for the remaining three months of 2007 and $1.3, $1.3, $1.3, $1.0 and $0.2 million in 2008, 2009, 2010, 2011 and 2012, respectively. Additionally, we have $0.7 million of capitalized software costs that are still in the application stage.

 

Accrued Liabilities. Accrued liabilities consist of the following (in thousands):

 

		At September 30, 2007			At December 31, 2006
Accruals related to real estate development and construction activities		$	94,419		$	120,604
Payroll and other benefits		32,795			54,893
Accrued taxes		2,962			9,112
Warranty reserves		30,639			28,437
Other accruals		45,914			53,637
Total		$	206,729		$	266,683

 

Warranty Reserves. As is customary in the homebuilding industry, we have obligations related to post-construction warranties and defects related to homes closed. We have established reserves for these obligations based on historical data and trends with respect to similar product types and geographic areas. Warranty reserves are included in accrued liabilities on the accompanying consolidated balance sheets. Additions to warranty reserves are included in cost of sales within the accompanying consolidated statements of earnings. We periodically review the adequacy of our warranty reserves, and believe they are sufficient to cover potential costs for materials and labor related to post-construction warranties and defects. A summary of changes in our warranty reserves follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2007			2006			2007			2006
Balance, beginning of period		$	30,986		$	26,494		$	28,437		$	25,168
Additions to reserve		3,658			6,075			14,370			16,468
Warranty claims and expenses		(4,005		)	(5,428		)	(12,168		)	(14,495		)
Balance, end of period		$	30,639		$	27,141		$	30,639		$	27,141

 

Recently Issued Accounting Pronouncements. There were no new accounting pronouncements issued during the quarter ended September 30, 2007 that are expected to have a material effect on our operating results or financial position.

 

FIN 48.    We adopted FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN 48”) on January 1, 2007. FIN 48 clarifies the accounting and reporting for uncertainties in income tax law. This interpretation prescribes a comprehensive model for the financial statement recognition, measurement, presentation and disclosure of uncertain tax positions taken or expected to be taken in a company’s income tax returns. The cumulative effect of adopting FIN 48 was an increase in tax reserves and a decrease of $3.0 million to the January 1, 2007 retained earnings balance.

 

At January 1, 2007, our unrecognized tax benefits were $19.2 million, which would, if recognized, provide a benefit to us of $6.5 million and decrease our effective tax rate. We record interest and penalties related to uncertain tax positions in income tax expense. At January 1, 2007, approximately $1.9 million of the unrecognized tax benefits represents potential interest and penalties on uncertain tax positions. The decrease in unrecognized tax benefits during the first nine months of 2007 was $13.5 million and includes $0.8 million of interest. There are currently no unrecognized tax benefits that relate to items which would be affected by expiring statutes of limitation within the next 12 months.

 

We conduct business and are subject to tax in the U.S. and several states. With few exceptions, we are no longer subject to U.S. federal, state, or local income tax examinations by tax authorities for years prior to 2002. Our U.S. income tax return for 2003 has been examined by the IRS. The examination was completed in the second quarter of 2007, and there were no material changes to report. In the third quarter, the IRS commenced examination of one of our wholly-owned Texas limited partnership entities for the year 2004. At this time, there are no adjustments.

 

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NOTE 2 – REAL ESTATE AND CAPITALIZED INTEREST

 

Real estate consists of the following (in thousands):

 

		At September 30, 2007			At December 31, 2006
Homes under contract under construction		$	535,405		$	589,241
Finished home sites and home sites under development		624,098			592,949
Unsold homes, completed and under construction		255,334			271,559
Model homes		59,237			39,131
Model home lease program		20,667			26,831
Land held for development		9,396			10,891
		$	1,504,137		$	1,530,602

 

Subject to sufficient qualifying assets, we capitalize development period interest costs incurred in connection with the development and construction of real estate. Capitalized interest is allocated to qualified real estate assets as incurred and charged to cost of home closings when the associated revenue is recognized. Certain information regarding capitalized interest follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2007			2006			2007			2006
Capitalized interest, beginning of period		$	45,514		$	27,835		$	33,016		$	23,939
Interest incurred		16,459			13,874			47,095			38,049
Interest expensed		(2,319		)	—			(2,638		)	—
Interest amortized to cost of home closings		(12,601		)	(12,508		)	(30,420		)	(32,787		)
Capitalized interest, end of period		$	47,053		$	29,201		$	47,053		$	29,201

 

At September 30, 2007, approximately $2.7 million of the capitalized interest is related to our joint venture investments and is a component of “Investments in unconsolidated entities” on our balance sheet.

 

NOTE 3 - VARIABLE INTEREST ENTITIES AND CONSOLIDATED REAL ESTATE NOT OWNED

 

FASB Interpretation No. 46 (as revised), “Consolidation of Variable Interest Entities” (“FIN 46R”) requires the consolidation of entities in which an enterprise absorbs a majority of the entity’s expected losses, receives a majority of the entity’s expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Prior to the issuance of FIN 46R, entities were generally consolidated when an enterprise had a controlling financial interest through ownership of a majority voting interest in the entity.

 

Based on the provisions of FIN 46R, we have concluded that when we enter into an option or purchase agreement to acquire land or lots and pay a non-refundable deposit, a variable interest entity, or VIE, may be created because we are deemed to have provided subordinated financial support that will absorb some or all of an entity’s expected losses if they occur. For each VIE created, we compute expected losses and residual returns based on the probability of future cash flows as outlined in FIN 46R. If we are the primary beneficiary of the VIE, we will consolidate the VIE in our financial statements.

 

We have applied FIN 46R by developing a methodology to determine whether or not we are the primary beneficiary of the VIE. Part of this methodology requires the use of estimates in assigning probabilities to various future cash flow possibilities relative to changes in the fair value and changes in the development costs associated with the property. Although we believe that our methodology properly identifies our primary beneficiary status with these VIEs, changes in the probability and other estimates could produce different conclusions.

 

In most cases, creditors of the entities with which we have option agreements have no recourse against us and the maximum exposure to loss in our option agreements is limited to our option deposit and any capitalized pre-acquisition costs. Often, we are at risk for items over budget related to land development on property we have under option. In these cases, we have contracted to complete development at a fixed cost on behalf of the land owner. Some of our option deposits may be refundable if certain contractual conditions are not performed by the party selling the lots to us.

 

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The table below presents a summary of our lots under option or contract at September 30, 2007 (dollars in thousands):

 

									Option/Earnest Money Deposits
		Number of Lots			Purchase Price				Cash				Letters of Credit
Option contracts recorded on balance sheet as real estate not owned (1), (2)		1,059			$	34,062			$	11,487			$	—
Option contracts not recorded on balance sheet – non-refundable deposits, committed (1)		17,474				927,083				74,729				30,660
Purchase contracts not recorded on balance sheet – non-refundable deposits, committed (1)		2,212			109,212				28,534				409
Total committed (on and off balance sheet)		20,745			1,070,357				114,750				31,069
Option contracts not recorded on balance sheet – non-refundable, uncommitted (1)(3)		1,554			74,490				3,255				—
Purchase contracts not recorded on balance sheet – refundable deposits, uncommitted (4)		3,356			121,902				250				—
Total uncommitted		4,910			196,392				3,505				—
Total lots under option or contracts			25,655		$		1,266,749		$		118,255		$	31,069
Total option contracts not recorded on balance sheet		24,596			$	1,232,687			$	106,768		(5)	31,069

 

(1)           Deposits are non-refundable except if certain contractual conditions are not performed by the selling party.

 

(2)           The purpose and nature of these consolidated lot option contracts (VIEs) is to provide the Company the option to purchase these lots in anticipation of building homes on these lots in the future. Specific performance contracts are included in this balance.

 

(3)           Although we have made minimal non-refundable deposits, we have not completed our acquisition evaluation process and we have not internally committed to purchase these lots.

 

(4)           Deposits are refundable at our sole discretion. We have not completed our acquisition evaluation process and we have not internally committed to purchase these lots.

 

(5)           Amount is reflected in our balance sheet in the line item “deposits on real estate under option or contract” as of September 30, 2007.

 

Generally, our options to purchase lots remain effective so long as we purchase a pre-established minimum number of lots each month or quarter, as determined by the respective agreement. Although the pre-established number is typically structured to approximate our expected rate of home construction starts, during a weakened homebuilding market as we are currently experiencing, we may purchase lots at an absorption level that exceeds our sales and home starts pace.

 

NOTE 4 - INVESTMENTS IN UNCONSOLIDATED ENTITIES

 

We participate in homebuilding and land development joint ventures from time to time as a means of accessing larger parcels of land and lot positions, expanding our market opportunities, managing our risk profile and leveraging our capital base. Based on the structure of these joint ventures, they may or may not be consolidated into our results. Our joint venture partners generally are other homebuilders, land sellers or other real estate investors. We generally do not have a controlling interest in these ventures, which means our joint venture partners could cause the venture to take actions we disagree with, or fail to take actions we believe should be undertaken, including the sale of the underlying property to repay debt or recoup all or part of the partners’ investments.

 

We also enter into mortgage and 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. Our mortgage and title joint venture investment as of September 30, 2007 was $1.8 million.

 

For land development joint ventures, we, and in some cases our joint venture partners, usually receive an option or other similar arrangement to purchase portions of the land held by the joint venture. Option prices are generally negotiated prices that approximate market value when we enter into the option contract. For homebuilding and land development joint

 

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ventures, our share of the joint venture earnings relating to lots we purchase from the joint ventures is deferred until homes are delivered by us and title passes to a homebuyer. Therefore, we allocate such joint venture earnings to the land acquired by us as a reduction in the basis of the property.

 

See Note 1 “Off Balance Sheet Arrangements—Joint Ventures” section for additional discussion related to our joint ventures and off-balance sheet obligations and guarantees.

 

Summarized condensed financial information related to unconsolidated joint ventures that are accounted for using the equity method follows (in thousands):

 

		At September 30, 2007			At December 31, 2006
Assets:
Cash		$	10,796		$	14,392
Real estate		623,266			723,753
Other assets		27,988			25,722
Total assets		$	662,050		$	763,867
Liabilities and equity:
Accounts payable and other liabilities		$	18,344		$	26,639
Notes and mortgages payable		465,027			471,197
Equity of:
Meritage (1)		59,105			93,792
Others		119,574			172,239
Total liabilities and equity		$	662,050		$	763,867

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2007			2006			2007			2006
Revenues		$	85,550		$	26,933		$	133,810		$	72,865
Costs and expenses		(68,693		)	(13,923		)	(107,247		)	(31,588		)
Net earnings of unconsolidated entities		$	16,857		$	13,010		$	26,563		$	41,277
Meritage’s share of pre-tax earnings (2) (3)		$	8,937		$	4,353		$	15,076		$	15,883

 

(1)           Balance represents Meritage’s interest, as reflected in the financial records of the respective joint ventures. This balance may differ from the balance reflected in our consolidated balance sheets due to the following items:  (i) timing differences for revenue and distributions recognition, (ii) step-up basis and corresponding amortization, (iii) income deferrals as discussed in Note 3 below and (iv) joint-venture asset impairments recorded only in our financial statements.

 

(2)           The joint venture financial statements above represent the most recent information available to us. As our portion of pre-tax earnings is recorded on the accrual basis and includes both actual earnings reported to us as well as accrued expected earnings for the period noted above not yet provided to us by our joint venture partners, our relative portion of total net earnings of the unconsolidated joint ventures in the table may reflect a different time frame than that represented by the joint venture financials. Additionally, during the three and nine months ended September 30, 2007, we recorded $23.4 million and $24.5 million, respectively, of impairments related to our joint venture assets. See Note 1 “Real Estate” for detail of our joint-venture-related impairments.

 

(3)           Our share of pre-tax earnings is recorded in “Earnings from unconsolidated entities, net” on our consolidated statements of operations. Our share of pre-tax earnings excludes joint venture earnings related to lots we purchased from the joint ventures. Those earnings are deferred until homes are delivered by us and title passes to a homebuyer.

 

At September 30, 2007 and December 31, 2006, our investments in unconsolidated entities includes $3.7 million and $2.8 million, respectively, related to the difference between the amounts at which our investments are carried and the amount of underlying equity in net assets. These amounts are amortized as the assets of the respective joint ventures are sold. We amortized approximately $614,000 and $169,000 in the third quarters of 2007 and 2006, respectively. We amortized approximately $875,000 and $932,000 in the first nine months of 2007 and 2006, respectively.

 

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The Notes and mortgages payable balances noted in the table above represent the total debt of our unconsolidated joint ventures. Approximately $8.3 million of this debt, related to a single joint venture, matured on October 17, 2007. This joint venture is negotiating with its lender to allow the joint venture to attempt to consummate a sale of the joint venture's real estate securing such debt. Our investment in the property is less than $400,000 and the associated debt is non-recourse to the joint venture and its partners. An additional $21.5 million of the debt in the table above relates to another joint venture for which the venture received a non-payment default notice subsequent to September 30, 2007. The joint venture disputes that a default has occurred and is negotiating with its lender to resolve the matter, as well as seek the payment by the lender of approximately $2.0 million in construction draws related to development of the joint venture's real estate assets. Our investment related to this joint venture at September 30, 2007 was less than $800,000, which could be at risk if this matter is not resolved in our favor. This loan is also non-recourse to the venture and its partners but does have joint and several completion guarantees from the joint venture partners.

 

Subsequent to September 30, 2007, our joint venture partner in another venture informed us that they do not have the financial ability to continue to perform under the joint venture agreement, including continuing to purchase lots, make additional capital contributions or perform under guarantees or indemnities. We are now discussing these matters with our joint venture lenders. Our investment in this venture at September 30, 2007 was less than $400,000 and the debt of this venture (included in the table above) was $37.3 million with a first lender position and $24.6 million with a mezzanine lender.  Except for the existence of springing “bad day” guarantees, all of this debt is non-recourse to the partners. We are working with the lenders to restructure this joint venture, although it may be in our best interest to unwind the joint venture and bring a portion of the assets and associated debt on balance sheet.

 

We and our joint-venture partners are actively pursuing a successful resolution to these matters, including renegotiating the terms of the debt, a sale of the joint venture's assets, or unwinding the venture and bringing its assets onto our balance sheet. If we are unsuccessful in resolving the matters discussed above, we may need to further impair these assets. As the ventures’ debt obligations are non-recourse, our losses will be limited to the remaining investment balance, although we may have completion or other ancillary guarantees as discussed in Note 1.

 

In addition to joint ventures accounted for under the equity method summarized in the above table, our investments in unconsolidated entities include joint ventures recorded under the cost method. These joint ventures were formed to acquire large parcels of land, to perform off-site development work and to sell lots to the joint venture members and other third parties. At September 30, 2007, and December 31, 2006, our investments in unconsolidated entities recorded under the cost method were $10.0 and $17.7 million, respectively.

 

At September 30, 2007, our total investment in unconsolidated joint ventures of $57.4 million is primarily comprised of $14.1 million in our West Region and $39.7 million in our Central Region. At December 31, 2006, our total investment in unconsolidated joint ventures of $114.3 million was primarily comprised of $35.2 million in our West Region and $74.7 million in our Central Region.

 

NOTE 5 - LOANS PAYABLE AND OTHER BORROWINGS

 

Loans payable consists of the following (in thousands):

		September 30,			December 31,
		2007			2006
$800 million unsecured revolving credit facility maturing May 2011 with extension provisions, and interest payable monthly at LIBOR (5.72% at September 30, 2007) plus 1.25% or prime (7.75% at September 30, 2007)		$	234,500		$	226,500
Model home lease program, with interest in the form of lease payments payable monthly approximating 8.25% at September 30, 2007		20,667			26,831
Other borrowings, acquisition and development financing		—			1,309
Total loans payable and other borrowings		$	255,167		$	254,640

 

In September 2007, we amended our senior unsecured credit facility (the “Credit Facility”) with Guaranty Bank and various other financial institutions to (i) reduce the total borrowing capacity to $800 million from $850 million, (ii) modify the applicable interest rate by 20.0 to 27.5 basis points, depending on the Company’s Leverage Ratio (as defined), (iii) reduce the Interest Coverage Ratio (as defined) for a period of up to nine consecutive quarters, and (iv) to further reduce the Interest Coverage Ratio for a period of up to three consecutive quarters.

 

In May 2007, we amended our Credit Facility with Guaranty Bank to extend the maturity to May 18, 2011 and make changes to certain covenants and definitions, including (i) changing certain aggregate asset-type limitations within the borrowing base, (ii) increasing the minimum consolidated tangible net worth requirement to $600 million plus 50% of consolidated net income (as defined) for each full fiscal quarter ending after December 31, 2006, plus an amount equal to 50% of the aggregate increases in consolidated tangible net worth (as defined) after December 31, 2006 by reason of the issuance and sale of equity interests, plus an amount equal to the net worth of any person that becomes a guarantor after December 31, 2006 by reason of merger or acquisition and (iii) changing the covenants relating to restrictions on the total land and unsold units that we may own.

 

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The construction costs and related debt associated with certain model homes that are owned and leased to us by others and that we use to market our communities are required to be included on our balance sheet. We do not legally own these model homes, but we are reimbursed by the owner for our construction costs and we have the right, but not the obligation, to purchase these homes. Although we have no legal obligation to repay any amounts received from the third-party owner, such amounts are recorded as debt and are typically deemed repaid when we simultaneously exercise our option to purchase the model home and sell it to a third-party home buyer. Should we elect not to exercise our rights to purchase these model homes, the model home costs and related debt under the model lease program will be eliminated upon the termination of the lease, which generally has a maturity date of one to three years from the origination of the lease. During the first nine months of 2007, $6.2 million of such leases were exercised or terminated, $2.5 million of which were exercised or terminated in the third quarter of 2007.

 

NOTE 6 - SENIOR AND SENIOR SUBORDINATED NOTES

 

Senior notes consist of the following (in thousands):

 

		September 30, 2007			December 31, 2006
7.73% senior subordinated notes due 2017		$	150,000		$	—
6.25% senior notes due 2015. At September 30, 2007 and December 31, 2006, there was approximately $1.3 and $1.4 million in unamortized discount, respectively		348,702			348,571
7.0% senior notes due 2014. At both September 30, 2007, and December 31, 2006, there was approximately $0.1 million in unamortized premium		130,058			130,065
		$	628,760		$	478,636

 

Our Credit Facility and indentures for all our senior and senior subordinated notes contain covenants that require maintenance of certain levels of tangible net worth and compliance with certain minimum financial ratios, place limitations on the payment of dividends and redemptions of equity, and limit the incurrence of additional indebtedness, asset dispositions, mergers, certain investments and creations of liens, among other items. As of and for the quarter ended September 30, 2007, we were in compliance with these covenants. After considering our most restrictive bank covenants at September 30, 2007, we have additional borrowing availability under the Credit Facility of $442.4 million. The Credit Facility and indentures relating to our senior and senior subordinated notes restrict our ability to pay dividends, and at September 30, 2007, our maximum permitted amount available to pay dividends was $323.2 million.

 

Obligations to pay principal and interest on the Credit Facility and senior and senior subordinated notes are guaranteed by all of our subsidiaries (collectively, the “Guarantor Subsidiaries”), each of which is directly or indirectly 100% owned by Meritage Homes Corporation. Such guarantees are full and unconditional, and joint and several. We do not provide separate financial statements of the Guarantor Subsidiaries because Meritage (the parent company) has no independent assets or operations, the guarantees are full and unconditional and joint and several and there are no non-guarantor subsidiaries. There are no significant restrictions on the ability of the Company or any Guarantor Subsidiary to obtain funds from their respective subsidiaries, as applicable, by dividend or loan.

 

NOTE 7 - GOODWILL

 

Goodwill represents the excess of the purchase price of our acquisitions over the fair value of the assets acquired. The changes in the carrying amount of goodwill for the nine months ended September 30, 2007, follow (in thousands):

 

		Corporate			West			Central			East			Total
Balance at December 31, 2006		$	1,323		$	37,277		$	53,970		$	37,089		$	129,659
Goodwill impairment		—			(24,890		)	(10,000		)	(36,996		)	(71,886		)
Non-cash amortization of excess tax basis		—			(88		)	(54		)	(93		)	(235		)
Balance at September 30, 2007		$	1,323		$	12,299		$	43,916		$	—		$	57,538

 

Analysis of the potential impairment of goodwill requires a two-step process, as stated in SFAS No. 142, “Goodwill and Other Intangible Assets”. The first step is the estimation of the fair value of each reporting unit. If step one indicates that impairment potentially exists, the second step is performed to measure the amount of the impairment, if any. Goodwill impairment exists when the estimated fair value of goodwill is less than its carrying value. At September 30, 2007, we completed the first step of our goodwill impairment analysis.

 

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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 balances were impaired as noted in the table above. The total impact of the goodwill impairments in the three months ended September 30, 2007 were $45.0 million and $71.9 million in the first nine months of 2007. There were no such impairments in 2006.

 

We are still in the process of finalizing our goodwill analysis and expect to complete the full evaluation during the fourth quarter of fiscal 2007. Any adjustments to our analysis, further deterioration in the homebuilding market or decline in our stock price could result in additional impairments or other adjustments to our preliminary estimates once the second step of the goodwill impairment analysis is further refined and completed. These impairments and adjustments could be material. Any further adjustments to our preliminary estimates as a result of completing this evaluation will be recorded in the financial statements and disclosed in our annual report on Form 10-K for the year ending December 31, 2007.

 

NOTE 8 – (LOSS) EARNINGS PER SHARE

 

Basic and diluted earnings per common share are presented in conformity with SFAS No. 128, “Earnings per Share”. The following table presents the calculation of basic and diluted earnings per common share (in thousands, except per share amounts):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2007			2006			2007			2006
Basic weighted average number of shares outstanding		26,249			26,087			26,216			26,554
Effect of dilutive securities:
Stock options and restricted stock (1)		—			403			—			705
Diluted weighted average shares outstanding		26,249			26,490			26,216			27,259
Net (loss) earnings		$	(118,552	)	$	59,539		$	(160,012	)	$	216,330
Basic (loss) earnings per share		$	(4.52	)	$	2.28		$	(6.10	)	$	8.15
Diluted (loss) earnings per share (1)		$	(4.52	)	$	2.25		$	(6.10	)	$	7.94

 

(1)           For periods with a net loss, basic weighted average shares outstanding are used for diluted calculations as required by accounting principles generally accepted in the United States.

 

At September 30, 2007, all 2.3 million outstanding stock options were anti-dilutive. For the three and nine months ended September 30, 2006, approximately 965,000 and 645,000 stock options, respectively, were anti-dilutive.

 

NOTE 9 - STOCK-BASED COMPENSATION

 

We have two stock compensation plans (together, the “Plans”), which were approved by our stockholders and are administered by our Board of Directors. The Plans authorize awards to officers, key employees, non-employee directors and consultants for up to 6,600,000 shares of common stock, of which 604,674 shares remain available for grant at September 30, 2007. We believe that such awards provide a means of performance-based compensation to attract and retain qualified employees and better align the interests of our employees with those of our stockholders. Generally, option awards are granted with an exercise price equal to the market price of Meritage stock at the date of grant, a five-year ratable vesting period and a seven-year contractual term.

 

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