Meritage Homes CORP - Quarter Report: 2009 September (Form 10-Q)

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

 

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)

 

Not Applicable

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

 

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 a checkmark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No 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):

 

 

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 4, 2009:  31,789,108

 

 

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MERITAGE HOMES CORPORATION

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2009

 

TABLE OF CONTENTS

 

PART I.	FINANCIAL INFORMATION		3
	Item 1.	Financial Statements	3
		Unaudited Condensed Consolidated Balance Sheets as of September 30, 2009 and December 31, 2008	3
		Unaudited Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2009 and 2008	4
		Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2009 and 2008	5
		Notes to Unaudited Condensed Consolidated Financial Statements	6
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	23
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk	35
	Item 4.	Controls and Procedures	36
PART II.	OTHER INFORMATION		36
	Item 1.	Legal Proceedings	36
	Item 1A.	Risk Factors	37
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	37
	Item 3.	Not Applicable
	Item 4.	Not Applicable	37
	Item 5.	Not Applicable
	Item 6.	Exhibits	38
SIGNATURES			39
INDEX OF EXHIBITS			40

 

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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,
		2009			2008
Assets:
Cash and cash equivalents		$	346,951		$	205,923
Restricted cash		18,604			—
Income tax receivables		2,125			111,508
Other receivables		27,063			31,046
Real estate		718,438			859,305
Real estate not owned		11,588			5,762
Deposits on real estate under option or contract		12,309			51,658
Investments in unconsolidated entities		12,311			17,288
Property and equipment, net		17,454			22,692
Intangibles, net		3,942			5,023
Prepaid expenses and other assets		12,854			16,044
Total assets		$	1,183,639		$	1,326,249
Liabilities:
Accounts payable		$	29,956		$	31,655
Accrued liabilities		86,463			125,101
Home sale deposits		11,641			8,486
Liabilities related to real estate not owned		10,052			4,833
Senior and senior subordinated notes		604,968			628,968
Total liabilities		743,080			799,043
Stockholders’ Equity:
Preferred stock, par value $0.01. Authorized 10,000,000 shares; none issued and outstanding at September 30, 2009 and December 31, 2008		—			—
Common stock, par value $0.01. Authorized 125,000,000 shares; issued and outstanding 39,672,025 and 38,588,536 shares at September 30, 2009 and December 31, 2008, respectively		397			386
Additional paid-in capital		459,823			436,739
Retained earnings		169,112			278,854
Treasury stock at cost, 7,891,250 shares at September 30, 2009 and December 31, 2008		(188,773		)	(188,773		)
Total stockholders’ equity		440,559			527,206
Total liabilities and stockholders’ equity		$	1,183,639		$	1,326,249

 

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,
		2009			2008			2009			2008
Home closing revenue		$	231,816		$	372,907		$	683,208		$	1,118,486
Land closing revenue		—			1,859			1,285			5,007
Total closing revenue		231,816			374,766			684,493			1,123,493
Cost of home closings		(198,279		)	(325,172		)	(594,816		)	(973,541		)
Cost of land closings		—			(1,846		)	(1,195		)	(4,930		)
Real estate impairments		(10,354		)	(40,949		)	(86,943		)	(113,810		)
Land impairments		(281		)	(13,063		)	(540		)	(19,693		)
Total cost of closings and impairments		(208,914		)	(381,030		)	(683,494		)	(1,111,974		)
Home closing gross profit		23,183			6,786			1,449			31,135
Land closing loss		(281		)	(13,050		)	(450		)	(19,616		)
Total closing gross profit/(loss)		22,902			(6,264		)	999			11,519
Commissions and other sales costs		(18,382		)	(33,840		)	(55,625		)	(101,274		)
General and administrative expenses		(14,269		)	(20,735		)	(41,913		)	(52,481		)
(Loss)/earnings from unconsolidated entities, net		(899		)	1,322			1,350			(14,296		)
Interest expense		(8,853		)	(5,835		)	(28,515		)	(17,034		)
Other income, net		1,862			3,770			6,512			7,040
Gain on extinguishment of debt		—			—			9,390			—
Loss before income taxes		(17,639		)	(61,582		)	(107,802		)	(166,526		)
Provision for income taxes		(146		)	(82,431		)	(1,940		)	(46,260		)
Net loss		$	(17,785	)	$	(144,013	)	$	(109,742	)	$	(212,786	)
Loss per common share:
Basic and diluted		$	(0.56	)	$	(4.69	)	$	(3.52	)	$	(7.37	)
Weighted average number of shares:
Basic and diluted		31,718			30,690			31,197			28,872

 

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,
		2009			2008
Cash flows from operating activities:
Net loss		$	(109,742	)	$	(212,786	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		6,547			9,785
Real estate and land impairments		87,483			133,503
Decrease in deferred taxes		—			1,496
Deferred tax asset valuation allowance		—			106,225
Stock-based compensation		4,512			4,045
Gain on early extinguishment of senior subordinated debt, net of transaction costs		(9,390		)	—
Equity in (earnings)/losses from unconsolidated entities (includes $2.8 million and $20.8 million of impairments to joint ventures in 2009 and 2008, respectively)		(1,350		)	14,296
Distributions of earnings from unconsolidated entities		5,341			7,724
Changes in assets and liabilities:
Decrease in real estate		87,589			87,206
Decrease in deposits on real estate under option or contract		7,131			8,612
Decrease in income tax receivables		107,573			80,543
Decrease/(increase) in receivables and prepaid expenses and other assets		9,576			(53,326		)
Decrease in accounts payable and accrued liabilities		(40,991		)	(76,117		)
Increase/(decrease) in home sale deposits		3,155			(5,054		)
Net cash provided by operating activities		157,434			106,152
Cash flows from investing activities:
Investments in unconsolidated entities		(1,218		)	(14,293		)
Distributions of capital from unconsolidated entities		1,153			2,326
Purchases of property and equipment		(2,128		)	(5,216		)
Proceeds from sales of property and equipment		128			704
Increase in restricted cash		(18,604		)	—
Net cash used in investing activities		(20,669		)	(16,479		)
Cash flows from financing activities:
Net repayments under Credit Facility		—			(82,000		)
Purchase of treasury stock		—			(3		)
Proceeds from issuance of common stock, net of transaction fees		—			82,775
Proceeds from stock option exercises		4,263			905
Net cash provided by financing activities		4,263			1,677
Net increase in cash and cash equivalents		141,028			91,350
Cash and cash equivalents at beginning of period		205,923			27,677
Cash and cash equivalents at end of period		$	346,951		$	119,027

 

See supplemental disclosures of cash flow information at Note 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 THREE MONTHS ENDED SEPTEMBER 30, 2009 AND 2008

 

NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION

 

Organization. Meritage Homes is a leading designer and builder of single-family 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, although our current emphasis is the first time and first move-up segment of the market, as we believe they represent the largest demographic of buyers.  We have operations in three regions:  West, Central and East, which are comprised of 12 metropolitan areas in Arizona, Texas, California, Nevada, Colorado and Florida. Through our predecessors, 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 Arizona, where we also operate under the name of Monterey Homes, and in Texas, where we also operate as Legacy Homes and Monterey Homes. At September 30, 2009, we were actively selling homes in 162 communities, with base prices ranging from approximately $100,000 to $967,000.

 

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 routine and recurring adjustments necessary for the fair presentation of our results for the interim periods presented.  Certain reclassifications related to the change in income tax receivables have been made to the prior year’s consolidated statement of cash flows in order to conform to the current year presentation.

 

Subsequent Events.  We evaluated subsequent events through the time of filing this Quarterly Report on Form 10-Q on November 6, 2009.  We are not aware of any significant events that occurred subsequent to the balance sheet date but prior to the filing of this report that would have a material impact on our condensed consolidated financial statements.

 

Restricted Cash.  Restricted cash consists of amounts held in restricted accounts as collateral for our letter of credit arrangements that were established to replace those previously available under our Credit Facility.  See Note 5 for additional discussion.

 

Real Estate. Real estate is stated at cost unless the community or land is determined to be impaired, at which point the inventory is written down to fair value as required by Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Subtopic 360-10, Property, Plant and Equipment.  Inventory includes the costs of land acquisition, land development, home construction, capitalized interest, real estate taxes, direct overhead costs incurred during development and home construction that benefit the entire community and impairments, if any.  Land and development costs are typically allocated and transferred to homes under construction when home 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) that are allocated 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 or phase are allocated to the remaining homes in the community or phase.  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, a community’s life cycle ranges from three 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, the sales absorption rate and whether the land purchased was raw or finished lots.  Master-planned communities encompassing several phases and super-block land parcels may have significantly longer lives and projects involving smaller finished lot purchases may be significantly shorter.

 

All of our 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.   Impairment charges are recorded if the fair value of an asset is less than its carrying amount.  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 a community level with each community or land parcel evaluated individually.  For those assets deemed to be impaired, the impairment recognized is measured as the amount by which the assets’ carrying value exceeds their fair value.

 

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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 community’s assets is determined using either a discounted cash flow model for projects we intend to build out or a market-based approach for projects we intend to sell or that are in the preliminary development stage and product types have not yet been finalized.  Impairments are charged to cost of home closing in the period during which it is determined that the fair value is less than the assets’ carrying amount.  If a market-based approach is used, we determine fair value based on recent comparable purchase and sale activity in the local market, adjusted for known variances as determined by our knowledge of the region and general real estate expertise. Our key estimates in deriving fair value under our cash flow model 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 sales absorption rates, reflecting any product mix change strategies implemented to stimulate the sales pace, (iv) alternative land uses including disposition of all or a portion of the land owned and (v) our discount rate, which is currently 14-16% and varies based on the perceived risk inherent in the community’s other cash flow assumptions.  These assumptions vary widely across different communities and geographies and are largely dependent on local market conditions.  Community-level factors that may impact our key estimates include:

 

·                       The presence and significance of local competitors, including their offered product type and competitive actions;

 

·                       Economic and related demographic conditions for the population of the surrounding community; and

 

·                       Desirability of the particular community, including unique amenities or other favorable or unfavorable attributes.

 

These local circumstances may significantly impact our assumptions and the resulting computation of fair value. We typically do not project market improvements in our discounted cash flow models, but may do so in limited circumstances in the latter years of a long-lived master planned community.  The models are also evaluated by regional and corporate personnel for consistency and integration, as decisions that affect pricing or absorption at one community may have resulting consequences for neighboring communities.  Impairments are allocated on a straight-line basis to all lots within a project.

 

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 and continuing communities section above, we determine if the contribution margins to be generated by our future communities are acceptable to us.  If the projections indicate that a community is still meeting our internal investment guidelines and is generating a profit, those assets are determined to be fully recoverable and no impairments are required.  In cases where we decide to abandon a 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 because it has positive cash flows, even though it may not be generating an accounting profit, or due to other strategic 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.  Refer to Note 2 of these consolidated financial statements for further information regarding our impairments.

 

Deposits. Deposits paid related to land options and contracts to purchase land are capitalized when incurred and classified as deposits on real estate under option or contract until the related land is purchased. Deposits are reclassified to a component of real estate at the time the deposit is used to offset the acquisition price of the lots based on the terms of the underlying agreements. To the extent they are non-refundable, deposits are charged to expense if the land acquisition is terminated or no longer considered probable.  As the Company’s liability associated with these non-refundable deposits is limited to the deposit amount, the Company does not consider the options a contractual obligation.  The review of the likelihood of the acquisition of contracted lots is completed in conjunction with the real estate impairment analysis noted above.  Our deposits were $12.3 million and $51.7 million as of September 30, 2009 and December 31, 2008 respectively.

 

Off-Balance-Sheet Arrangements — Joint Ventures.  Historically, we have participated in land development joint ventures 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.  We currently have three such active ventures.  We also participate in seven 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 customers and other homebuyers.  See Note 4 for additional information.

 

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Off-Balance-Sheet Arrangements — Other.  We often acquire 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.  See Note 3 for further discussion.

 

We provide letters of credit and performance, maintenance and other bonds in support of our related obligations with respect to the development of both our on- and off-balance-sheet projects.  These letters of credit and bonds are typically provided to government agencies in which certain of our communities are being developed to guarantee our performance of the construction and development activities for those projects and are in lieu of cash deposits.  The amount of these obligations outstanding at any time varies depending on the stage and level of our development activities.  In the event a letter of credit or bond is drawn upon, we would be obligated to reimburse the issuer of the letter of credit or bond.  Although a majority of the work may have been performed, these bonds and letters of credit are typically not released until all development specifications have been met.  At September 30, 2009, we had approximately $11.3 million in outstanding letters of credit and $104.4 million of surety bonds outstanding subject to these indemnity arrangements, of which only $37.0 million of work remains to be completed.  We believe it is unlikely that any significant amounts of these letters of credit or bonds will be drawn upon.

 

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

 

		At September 30, 2009			At December 31, 2008
Accruals related to real estate development and construction activities		$	22,218		$	35,494
Payroll and other benefits		6,957			13,702
Accrued taxes		3,026			2,913
Warranty reserves		29,502			28,891
Other accruals		24,760			44,101
Total		$	86,463		$	125,101

 

Warranty Reserves.  We have certain obligations related to post-construction warranties and defects for closed homes.  With the assistance of an actuary, we have estimated these reserves based on the number of home closings, historical data and trends with respect to similar product types and geographic areas.  We regularly review our warranty reserves and adjust them, as necessary, to reflect changes in trends as information becomes available.  A summary of changes in our warranty reserves follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2009			2008			2009			2008
Balance, beginning of period		$	28,596		$	34,276		$	28,891		$	36,633
Additions to reserve from new home deliveries		716			3,390			2,105			8,180
Warranty claims		(1,549		)	102			(3,617		)	(5,091		)
Adjustments to pre-existing reserves		1,739			(3,649		)	2,123			(5,603		)
Balance, end of period		$	29,502		$	34,119		$	29,502		$	34,119

 

Warranty reserves are included in accrued liabilities on the accompanying condensed consolidated balance sheets, and additions to the reserves are included in cost of sales within the accompanying condensed consolidated statements of operations.

 

There has recently been publicity about homes constructed with allegedly defective drywall manufactured in China (“Chinese drywall”).  During the first quarter of 2009, we became aware (from customer inquiries) that a limited number of the homes we constructed in the Ft. Myers, Florida area in 2005 and 2006 are exhibiting symptoms typical of the potentially defective Chinese drywall.  As of September 30, 2009, Meritage has been named as a defendant in a single lawsuit with three home owner plaintiffs regarding Chinese drywall in their homes.  It is possible that we may in the future become subject to additional litigation.

 

Currently we have confirmed that approximately 60 of the homes we constructed in the Ft. Myers, Florida area have exhibited symptoms of and thus are suspected of containing defective Chinese drywall.  The defective drywall was delivered and installed in those homes during 2006.  We have notified these home owners of our intent to repair these homes.  We believe there may be up to an additional 30 homes in the Ft. Myers area that had drywall installed during the same time period that we are still inspecting and believe it is possible that some of those homes may also contain defective Chinese drywall.  We are continuing our investigation of homes constructed during the relevant time period to determine whether there are homes that we have not yet inspected that contain defective Chinese drywall. We will offer to repair any additional homes found to contain the defective Chinese drywall. Based on our investigation to date, we do not believe defective Chinese drywall was used in homes constructed by us in other areas of Florida or in our other markets outside of Florida.

 

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The $29.5 million of warranty reserves available at September 30, 2009 represent reserves for post-construction warranties and defects for closed homes.  These reserves are intended to cover costs associated with our contractual and statutory warranty obligations, which include, among other items, claims involving defective workmanship and materials.  We maintain general liability insurance, subject to a self-insured retention obligation, that we believe would cover a portion of certain of our warranty claims, including the defective Chinese drywall exposure.  We believe that these reserves are sufficient to cover the costs associated with the repair of the homes identified with defective Chinese drywall after taking into account anticipated insurance proceeds from our insurance carrier and those of other responsible parties and reserving for our insurance deductible. As of September 30, 2009, we have not established any reserves for any additional homes that may contain the defective drywall, although based on the number of homes ultimately identified with Chinese drywall, our net insurance proceeds and our final determination of our required warranty accrual based on management’s review and our actuary’s analysis, we may have additional capacity under our warranty reserves or our insurance proceeds to absorb at least a portion of such costs, if any. 

 

We are currently unable to reasonably estimate our total possible loss or exposure relating to Chinese drywall because, among other reasons: determining the number of homes that contain potentially defective Chinese drywall is difficult as we are still in the process of doing so; we did not directly purchase the drywall materials used to construct our Ft. Myers area homes, rather, our subcontractors purchased and provided that drywall; the possible means and related costs to remedy any defective conditions is still being evaluated; the group of other potentially responsible parties, including, but not limited to, manufacturers, subcontractors, retailers, wholesalers, distributors, and their legal obligations for the problem and remedy, together with their financial resources, have not been determined; and the extent of our insurance coverage for defective Chinese drywall resulting charges and related costs and claims is still being determined.

 

The outcome of our investigation and analysis may result in the need to establish additional warranty reserves; however, we do not currently expect the total charge to have a material adverse effect on our operations as we believe our exposure is limited due to the relatively limited number of our homes that appear to be impacted, our existing warranty reserves and available insurance.

 

Recently Issued Accounting Pronouncements.  In August 2009, the FASB issued Accounting Standards Update (ASU) 2009-05 to provide guidance on measuring the fair value of liabilities under ASC Subtopic 820-10, Fair Value Measurement and Disclosure.  This guidance is effective for fiscal years and interim periods beginning after issuance.  We do not expect the adoption of ASU 2009-05 to have a material impact on our consolidated financial statements.

 

In June 2009, the FASB issued ASC Subtopic 105-10, Generally Accepted Accounting Principles (ASC 105-10).  This Statement establishes FASB Accounting Standards Codification as the source of authoritative accounting principles to be applied by all non-governmental entities.  ASC 105-10 is effective for interim and annual periods ending after September 15, 2009.  The adoption of this subtopic did not have a material impact on our financial records and only resulted in modifications in accounting references in our footnotes and disclosures.

 

In May 2009, the FASB issued ASC Subtopic 810-10, Consolidation (ASC 810-10).  This Statement amends prior guidance and revises accounting and reporting requirements for entities’ involvement with variable interest entities. The provisions of ASC 810-10 are effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2009.  We are currently evaluating what impact, if any, the adoption of the subtopic will have on our consolidated financial statements.

 

In May 2009, the FASB issued ASC Subtopic 860-10, Transfers and Servicing (ASC 860-10).  This Statement amends prior guidance and revises accounting and reporting requirements for the transfers of financial assets, the transferor’s continuing involvement (if any) in the transferred financial assets and how such transfers affect the transferor’s financial position, financial performance and cash flows.  The provisions of ASC 860-10 are effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2009.  We do not believe the adoption of ASC 860-10 will have a material impact on our consolidated financial statements.

 

In May 2009, the FASB issued ASC Subtopic 855-10, Subsequent Events (ASC 855-10), to establish general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. The new disclosure requirement is effective for interim reporting periods ending after June 15, 2009.  The adoption of this subtopic resulted in additional quarterly disclosures only.

 

In April 2009, the FASB issued ASC Subtopic 825-10-50, Financial Instruments (ASC 825-10-50) to require disclosures about the fair value of financial instruments during interim reporting periods. The new disclosure requirements are effective for interim reporting periods ending after June 15, 2009.  The adoption of this subtopic resulted in additional quarterly disclosures only.

 

In April 2009, the FASB issued ASC Subtopic 820-10, Fair Value Measurement and Disclosures (ASC 820-10), which provides further clarification for prior guidance regarding measurement of fair values of assets and liabilities when the market activity has significantly decreased and in identifying transactions that are not orderly.  ASC 820-10 is effective for interim and annual reporting periods ending after June 15, 2009. The adoption of this subtopic did not have a material impact on our financial results.

 

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In December 2007, the FASB issued ASC Subtopic 810-10, Consolidation (ASC 810-10).  This statement amends prior guidance and revises accounting and reporting requirements for noncontrolling interests (formerly minority interests) in a subsidiary and for the deconsolidation of a subsidiary.  Upon its adoption, noncontrolling interests will be classified as equity, and income attributed to the noncontrolling interest will be included in the Company’s income.  The provisions of this standard are applied retrospectively upon adoption.  We adopted this pronouncement on January 1, 2009, and it did not have a material impact on our consolidated results.

 

In December 2007, the FASB issued ASC Subtopic 805-10, Business Combinations (ASC 805-10).  ASC 805-10 clarifies and amends the accounting guidance for how an acquirer in a business combination recognizes and measures the assets acquired, liabilities assumed, and any noncontrolling interest in the acquiree.  The provisions of ASC 805-10 are effective for us for any business combinations occurring on or after January 1, 2009, and the adoption did not have a material impact on our financial statements.

 

NOTE 2 – REAL ESTATE AND CAPITALIZED INTEREST

 

Real estate consists of the following (in thousands):

 

		At September 30, 2009			At December 31, 2008
Homes under contract under construction (1)		$	191,699		$	170,347
Unsold homes, completed and under construction (1)		67,917			158,378
Model homes (1)		37,552			48,608
Finished home sites and home sites under development		364,716			455,048
Land held for development or sale		56,554			26,924
		$	718,438		$	859,305

 

(1)  Also includes the allocated land and land development costs associated with each lot for these homes.

 

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As previously noted, each of our land inventory and related real estate assets is reviewed for recoverability when impairment indicators are present, as our inventory is considered “long-lived” in accordance with U.S. generally accepted accounting principles.  Due to the current economic environment, we evaluate all of our real estate and joint venture assets for impairment on a quarterly basis.  If an asset is deemed not recoverable, impairment charges are 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.  Based on these reviews of all our communities, we recorded the following real-estate and joint-venture impairment charges during the three- and nine-month periods ended September 30, 2009 and 2008 (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2009			2008			2009			2008
Terminated option/purchase contracts and related pre-acquisition costs:
West		$	—		$	838		$	5,922		$	16,318
Central		3,224			5,441			59,213			7,625
East		—			—			544			1,303
Total		$	3,224		$	6,279		$	65,679		$	25,246
Real estate inventory impairments (1):
West		$	2,385		$	10,681		$	10,882		$	40,644
Central		2,453			19,755			6,807			34,966
East		2,292			4,234			3,575			12,954
Total		$	7,130		$	34,670		$	21,264		$	88,564
Impairments of joint venture investments:
West		$	55		$	1,070		$	274		$	2,692
Central		2,556			—			2,556			14,762
East		—			—			—			3,305
Total		$	2,611		$	1,070		$	2,830		$	20,759
Impairments of land held for sale:
West		$	—		$	2,843		$	323		$	8,394
Central		281			10,220			217			11,299
East		—			—			—			—
Total		$	281		$	13,063		$	540		$	19,693
Total impairments:
West		$	2,440		$	15,432		$	17,401		$	68,048
Central		8,514			35,416			68,793			68,652
East		2,292			4,234			4,119			17,562
Total		$	13,246		$	55,082		$	90,313		$	154,262

 

(1)          Included in the real estate inventory impairments are impairments of individual homes in a community where the underlying community was not also impaired, as follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2009			2008			2009			2008
Individual home impairments (in thousands):
West		$	535		$	7,713		$	7,410		$	26,259
Central		1,420			9,648			5,503			18,337
East		876			2,551			2,159			9,172
Total		$	2,831		$	19,912		$	15,072		$	53,768

 

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The tables below reflect the number of communities with real estate inventory impairments for the three- and nine-month periods ended September 30, 2009 and 2008, excluding home-specific impairments (as noted above) and the fair value of these communities as of September 30, 2009 and 2008 (dollars in thousands):

 

		Three Months Ended September 30, 2009
		Number of Communities Impaired		Impairment Charges			Fair Value of Communities Impaired (Carrying Value less Impairments)
West		4		$	1,850		$	11,750
Central		6		1,033			6,482
East		3		1,416			9,505
Total		13		$	4,299		$	27,737

 

		Three Months Ended September 30, 2008
		Number of Communities Impaired		Impairment Charges			Fair Value of Communities Impaired (Carrying Value less Impairments)
West		7		$	2,968		$	69,174
Central		10		10,107			43,500
East		3		1,683			15,631
Total		20		$	14,758		$	128,305

 

		Nine Months Ended September 30, 2009
		Number of Communities Impaired		Impairment Charges			Fair Value of Communities Impaired (Carrying Value less Impairments)
West		6		$	3,472		$	12,599
Central		8		1,304			7,868
East		3		1,416			9,505
Total		17		$	6,192		$	29,972

 

		Nine Months Ended September 30, 2008
		Number of Communities Impaired		Impairment Charges			Fair Value of Communities Impaired (Carrying Value less Impairments)
West		20		$	14,385		$	161,526
Central		27		16,629			108,904
East		5		3,782			22,208
Total		52		$	34,796		$	292,638

 

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Subject to sufficient qualifying assets, we capitalize interest incurred during the development and construction of real estate.  All non-capitalized interest is expensed directly to the statement of operations during the periods incurred.  Capitalized interest is allocated to qualified real estate assets as incurred and charged to the statement of operations as a component of closing costs. A summary of our capitalized interest is as follows (in thousands):

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2009			2008			2009			2008
Capitalized interest, beginning of period		$	19,584		$	36,835		$	29,779		$	41,396
Interest incurred		11,414			13,103			36,419			37,568
Interest expensed		(8,853		)	(5,835		)	(28,515		)	(17,034		)
Interest amortized to cost of home, land closings and impairments		(4,540		)	(7,233		)	(20,078		)	(25,060		)
Capitalized interest, end of period		$	17,605		$	36,870		$	17,605		$	36,870

 

 

At September 30, 2009, approximately $0.8 million of the capitalized interest is related to our joint venture investments and is a component of “Investments in unconsolidated entities” on our condensed consolidated balance sheets.

 

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

 

ASC Subtopic 810-10, Consolidation, requires the consolidation of entities in which an enterprise absorbs a majority of the entity’s expected losses, or receives a majority of the entity’s expected residual returns if no party absorbs the majority of expected losses, as a result of ownership, contractual or other financial interests in the entity.

 

Based on the provisions of the relevant accounting guidance, we have concluded that when we enter into an option or purchase agreement to acquire land or lots from an entity 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.  If we are the primary beneficiary of the VIE, based on the entity’s expected profits and losses and the cash flows associated with changes in the fair value of land under contract, we will consolidate the VIE in our financial statements and reflect such assets and liabilities as “Real estate not owned.”  The liabilities related to consolidated VIEs are computed as the purchase price of the asset less the cash deposits for such land and are excluded from our debt covenant calculations.

 

We have developed a methodology to determine whether 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 in the development costs associated with the property.  Although we believe that our accounting policy 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 non-refundable option deposits 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 to us if certain contractual conditions are not performed by the party selling the lots.

 

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The table below presents a summary of our lots under option or contract at September 30, 2009 (dollars in thousands):

 

							Option/Earnest Money Deposits
		Number of		Purchase						Letters of
		Lots		Price			Cash			Credit
Option contracts recorded on balance sheet as real estate not owned (1), (2)		377		$	11,588		$	1,536		$	—
Option contracts not recorded on balance sheet – non-refundable deposits, committed (1)		2,983		140,097			10,734			4,978
Purchase contracts not recorded on balance sheet – non-refundable deposits, committed (1)		1,424		28,900			1,250			—
Total committed (on and off balance sheet)		4,784		180,585			13,520			4,978
Option contracts not recorded on balance sheet – non-refundable, uncommitted (1)(3)		250		3,120			50			—
Purchase contracts not recorded on balance sheet – refundable deposits, uncommitted (4)		134		10,344			275			—
Total uncommitted		384		13,464			325			—
Total lots under option or contracts		5,168		194,049			13,845			4,978
Total option contracts not recorded on balance sheet		4,791		$	182,461		$	12,309	(5)	$	4,978

 

(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 us the option to purchase these lots in the future, in anticipation of building homes on these lots in the future. Specific performance contracts, if any, are included in this balance.  All contracts that are not specific performance contracts are not considered to be firm contractual obligations.

 

(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 condensed consolidated balance sheet in the line item “Deposits on real estate under option or contract” as of September 30, 2009.

 

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 elect to purchase lots at an absorption level that exceeds our sales and home starts pace needed to meet the pre-established minimum number of lots or to restructure our original contract terms that more accurately reflect our current sales pace expectations.

 

NOTE 4 - INVESTMENTS IN UNCONSOLIDATED ENTITIES

 

Historically, we have entered into homebuilding and land development joint ventures 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.  As of September 30, 2009, we had three active land ventures.  Due to the current homebuilding environment, although we view our involvement with land joint ventures to be beneficial, we do not view such involvement as critical to the success of our homebuilding operations.

 

We also participate in seven 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 our joint ventures. Our investments in mortgage and title joint ventures as of September 30, 2009 and December 31, 2008 were $1.2 million and $1.4 million, respectively.

 

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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 these ventures, our share of the joint venture profit 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 the portion of such joint venture profit to the land acquired by us as a reduction in the basis of the property.

 

Repayment Guarantees.  We and/or our land development joint venture partners occasionally provide limited repayment guarantees on a pro rata basis on the debt of the land development joint ventures.  If such a guarantee were ever to be called, the maximum exposure to Meritage would generally be only our pro-rata share of the amount of debt outstanding that was in excess of the fair value of the underlying land securing the debt.  At September 30, 2009 and December 31, 2008, our share of these limited pro rata repayment guarantees was approximately $8.5 million, of which $7.1 million are “bad boy” guarantees (see below for a discussion about “bad boy” guarantees); however, as the other joint venture partners could trigger such guarantees without our consent, we have classified this $7.1 million as repayment guarantees.

 

“Bad Boy” Guarantees.  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 secured lender’s remedies with respect to its mortgage or other secured lien on the joint venture or the joint venture’s underlying property.  To date, no such guarantees have been invoked and we believe that the actions that would trigger a guarantee would generally be disadvantageous to the joint venture and to us, and therefore are unlikely to occur; 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, 2009 and December 31, 2008, we had outstanding guarantees of this type totaling approximately $60.9 million and $72.5 million, respectively.  We believe these guarantees, as defined, unless invoked as described above, are not considered guarantees of indebtedness under our senior and senior subordinated indentures.

 

Other Guarantees.  We and our joint venture partners are also typically obligated to the project lender(s) to complete construction of the 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.  Per guidance of ASC Subtopic 460-10, Guaranties, we believe these other guarantees are either not applicable or not material to our financial results.

 

Surety Bonds.  We and our joint venture partners also 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 make such payments.  These surety indemnity arrangements are generally joint and several obligations with our joint venture partners.  Although a majority of the required work may have been performed, these bonds are typically not released until all development specifications have been met.  As of September 30, 2009, we had approximately $1.6 million of surety bonds outstanding subject to these indemnity arrangements, of which approximately $52,000 of work remains to be completed.  At December 31, 2008, we had approximately $2.4 million of such surety bonds with $0.5 million of work remaining to be completed.  None of these bonds have been called to date and we believe it is unlikely that any of these bonds will be called or if called, that any such amounts would be material to us.

 

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 may 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 the limited 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 reserve for these obligations if and when they become probable and can be reasonably estimated.  As of September 30, 2009 and December 31, 2008, we did not have any such reserves.

 

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

 

		At September 30, 2009			At December 31, 2008
Assets:
Cash		$	7,875		$	6,817
Real estate		510,058			528,433
Other assets		4,731			11,356
Total assets		$	522,664		$	546,606
Liabilities and equity:
Accounts payable and other liabilities		$	8,308		$	11,166
Notes and mortgages payable		359,563			381,228
Equity of:
Meritage (1)		37,328			47,871
Others		117,465			106,341
Total liabilities and equity		$	522,664		$	546,606

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2009			2008			2009			2008
Revenues		$	6,527		$	5,993		$	14,510		$	17,614
Costs and expenses		(24,552		)	(3,698		)	(28,796		)	(11,200		)
Net (loss)/earnings of unconsolidated entities		$	(18,025	)	$	2,295		(14,286		)	$	6,414
Meritage’s share of pre-tax (loss)/earnings (2) (3)		$	(3,259	)	$	2,392		$	(1,162	)	$	6,463

 

(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 condensed consolidated balance sheets due to the following reconciling 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) differences in timing or amounts of joint-venture asset impairments recorded by us and the joint venture.

 

(2)          The joint venture financial statements above represent the most recent information available to us. For joint ventures where we have impaired our investment, the joint venture partners may have not yet reached a consensus or finalized the write-down amount or reached that conclusion in a different accounting period than us and, therefore, the financial statements of the ventures may not yet reflect any real estate impairment charges or reflect them in a different quarter or fiscal year. For the three and nine months ended September 30, 2009, we recorded $2.6 million and $2.8 million, respectively, of such impairments. For the three and nine months ended September 30, 2008, we recorded $1.1 million and $20.8 million, respectively, of impairments related to our joint venture investments. The majority of the 2009 losses reported by the joint ventures is related to one joint venture that had disposed of its land holdings through a trustee sale during the current quarter.  Our investment in this joint venture was fully impaired during 2007.  As our portion of pre-tax earnings is recorded on the accrual basis and included 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. See Note 2, “Real Estate and Capitalized Interest”, for detail of our joint venture-related impairments.

 

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

 

Our investments in unconsolidated entities includes $1.4 million and $1.6 million at September 30, 2009 and December 31, 2008, 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 wrote off approximately $0.5 million of such investments in the first nine months of 2009 with no such write offs during 2008.  We also amortized approximately $71,000 and $104,000 of these assets in the first nine months of 2009 and 2008, respectively.

 

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