Meritage Homes CORP - Quarter Report: 2009 June (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)

 

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 August 4, 2009:  31,672,922

 

 

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MERITAGE HOMES CORPORATION

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

 

TABLE OF CONTENTS

 

PART I.	FINANCIAL INFORMATION		3
	Item 1.	Financial Statements	3
		Unaudited Condensed Consolidated Balance Sheets as of June 30, 2009 and December 31, 2008	3
		Unaudited Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2009 and 2008	4
		Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 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	38
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	39
	Item 3.	Not Applicable
	Item 4.	Submission of Matters to a Vote of Security Holders	39
	Item 5.	Not Applicable
	Item 6.	Exhibits	40
SIGNATURES			41
INDEX OF EXHIBITS			42

 

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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)

 

		June 30,			December 31,
		2009			2008
Assets:
Cash and cash equivalents		$	385,310		$	205,923
Income tax receivables		2,146			111,508
Other receivables		25,864			31,046
Real estate		710,129			859,305
Real estate not owned		8,043			5,762
Deposits on real estate under option or contract		16,436			51,658
Investments in unconsolidated entities		14,416			17,288
Property and equipment, net		19,217			22,692
Intangibles, net		4,350			5,023
Prepaid expenses and other assets		14,739			16,044
Total assets		$	1,200,650		$	1,326,249
Liabilities:
Accounts payable		$	25,501		$	31,655
Accrued liabilities		98,298			125,101
Home sale deposits		10,561			8,486
Liabilities related to real estate not owned		6,869			4,833
Senior and senior subordinated notes		604,926			628,968
Total liabilities		746,155			799,043
Stockholders’ Equity:
Preferred stock, par value $0.01. Authorized 10,000,000 shares; none issued and outstanding at June 30, 2009 and December 31, 2008		—			—
Common stock, par value $0.01. Authorized 125,000,000 shares; issued and outstanding 39,559,272 and 38,588,536 shares at June 30, 2009 and December 31, 2008, respectively		396			386
Additional paid-in capital		455,975			436,739
Retained earnings		186,897			278,854
Treasury stock at cost, 7,891,250 shares at June 30, 2009 and December 31, 2008		(188,773		)	(188,773		)
Total stockholders’ equity		454,495			527,206
Total liabilities and stockholders’ equity		$	1,200,650		$	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 June 30,						Six Months Ended June 30,
		2009			2008			2009			2008
Home closing revenue		$	220,414		$	373,923		$	451,392		$	745,579
Land closing revenue		1,125			1,375			1,285			3,148
Total closing revenue		221,539			375,298			452,677			748,727
Cost of home closings		(193,340		)	(322,143		)	(396,537		)	(648,369		)
Cost of land closings		(1,044		)	(1,397		)	(1,195		)	(3,084		)
Real estate impairments		(66,158		)	(28,512		)	(76,589		)	(72,861		)
Land impairments		(222		)	(6,630		)	(259		)	(6,630		)
Total cost of closings and impairments		(260,764		)	(358,682		)	(474,580		)	(730,944		)
Home closing gross (loss)/profit		(39,084		)	23,268			(21,734		)	24,349
Land closing gross (loss)		(141		)	(6,652		)	(169		)	(6,566		)
Total closing gross (loss)/profit		(39,225		)	16,616			(21,903		)	17,783
Commissions and other sales costs		(18,098		)	(33,669		)	(37,243		)	(67,434		)
General and administrative expenses		(13,775		)	(10,453		)	(27,644		)	(31,746		)
Earnings/(loss) from unconsolidated entities, net		852			(2,089		)	2,249			(15,618		)
Interest expense		(11,332		)	(5,538		)	(19,662		)	(11,199		)
Other income, net		3,099			973			4,650			3,270
Gain on extinguishment of debt		6,585			—			9,390			—
Loss before income taxes		(71,894		)	(34,160		)	(90,163		)	(104,944		)
(Provision)/benefit for income taxes		(1,708		)	10,692			(1,794		)	36,171
Net loss		$	(73,602	)	$	(23,468	)	$	(91,957	)	$	(68,773	)
Loss per common share:
Basic and diluted		$	(2.37	)	$	(0.79	)	$	(2.97	)	$	(2.46	)
Weighted average number of shares:
Basic and diluted		31,055			29,594			30,933			27,953

 

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)

 

		Six Months Ended June 30,
		2009			2008
Cash flows from operating activities:
Net loss		$	(91,957	)	$	(68,773	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		4,544			6,564
Real estate related impairments		76,848			79,491
Increase in deferred taxes		—			(9,023		)
Stock-based compensation		2,293			2,057
Gain on early extinguishment of senior subordinated debt, net of transaction costs		(9,390		)	—
Equity in (earnings)/losses from unconsolidated entities (includes $0.2 million and $19.7 million of impairments to joint ventures in 2009 and 2008, respectively)		(2,249		)	15,618
Distributions of earnings from unconsolidated entities		3,905			5,361
Changes in assets and liabilities:
Decrease in real estate		104,197			74,686
Decrease in deposits on real estate under option or contract		5,876			6,560
Decrease in income tax receivable		107,660			78,152
Decrease/(increase) in receivables and prepaid expenses and other assets		8,063			(26,453		)
Decrease in accounts payable and accrued liabilities		(33,611		)	(60,615		)
Increase/(decrease) in home sale deposits		2,075			(1,869		)
Net cash provided by operating activities		178,254			101,756
Cash flows from investing activities:
Investments in unconsolidated entities		(1,151		)	(13,431		)
Distributions of capital from unconsolidated entities		1,109			1,862
Purchases of property and equipment		(1,572		)	(4,371		)
Proceeds from sales of property and equipment		114			105
Net cash used in investing activities		(1,500		)	(15,835		)
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		2,633			783
Net cash provided by financing activities		2,633			1,555
Net increase in cash and cash equivalents		179,387			87,476
Cash and cash equivalents at beginning of period		205,923			27,677
Cash and cash equivalents at end of period		$	385,310		$	115,153

 

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 JUNE 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. 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 June 30, 2009, we were actively selling homes in 178 communities, with base prices ranging from approximately $99,900 to $966,900.

 

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.  Certain reclassifications related to the change in income tax receivable 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 August 5, 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.

 

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 Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (Accounting Standards Codification (“ASC”) Sub-Topic 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 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%.  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 recorded as 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.  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 $16.4 million and $51.7 million as of June 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 eight 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.

 

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.

 

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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.  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.  At June 30, 2009, we had approximately $12.7 million in outstanding letters of credit and $118.2 million of surety bonds outstanding subject to these indemnity arrangements, of which only $40.2 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 June 30, 2009			At December 31, 2008
Accruals related to real estate development and construction activities		$	27,195		$	35,494
Payroll and other benefits		7,034			13,702
Accrued taxes		2,988			2,913
Warranty reserves		28,596			28,891
Other accruals		32,485			44,101
Total		$	98,298		$	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 June 30,						Six Months Ended June 30,
		2009			2008			2009			2008
Balance, beginning of period		$	27,490		$	35,742		$	28,891		$	36,633
Additions to reserve from new home deliveries		1,760			2,876			3,628			4,790
Warranty claims		(410		)	(3,193		)	(2,068		)	(5,193		)
Adjustments to pre-existing reserves		(244		)	(1,149		)	(1,855		)	(1,954		)
Balance, end of period		$	28,596		$	34,276		$	28,596		$	34,276

 

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 June 30, 2009, Meritage has not been named as a defendant in any lawsuit pertaining to Chinese drywall, although it is possible that we may in the future become subject to such litigation.

 

As of June 30, 2009, we have confirmed that 44 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 44 homes during an approximate six-month period in 2006.  We believe there may be up to an additional 50 homes in the Ft. Myers area that had drywall installed during the same time period 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. 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.

 

The above established reserves 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 believe that the $28.6 million warranty reserve we have as of June 30, 2009 is sufficient to cover the costs associated with the repair of the 44 homes identified with defective Chinese drywall after taking into account anticipated insurance proceeds from our insurance carrier and those of other responsible parties.  As of June 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

 

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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 maintain general liability insurance, subject to a self-insured retention obligation, that we believe would cover a portion of our ultimate defective Chinese drywall exposure.

 

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; homes containing defective Chinese drywall seem to be exhibiting different levels of symptoms attributed to defective Chinese drywall and may dictate different repair or remedial efforts; 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 June 2009, the Financial Accounting Standards Board (“FASB”) issued FASB Statement of Accounting Standards No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles (“SFAS No. 168”) (ASC sub-topic 105-10, Generally Accepted Accounting Principles (ASC 105-10)).  This Statement replaces SFAS No. 162 and establishes The FASB Accounting Standards Codification as the source of authoritative accounting principles to be applied by all non-governmental entities.  SFAS No. 168 (ASC 105-10) is effective for interim and annual periods ending after September 15, 2009.  The adoption of this Statement is not expected to have a material impact on our financial results.

 

In May 2009, the FASB issued SFAS No. 167, Amendments to FASB Interpretation No. 46(R) (“SFAS No. 167”) (ASC Subtopic 810-10, Consolidation (ASC 810-10)).  This Statement amends FIN 46(R) and revises accounting and reporting requirements for entities’ involvement with variable interest entities. The provisions of SFAS No. 167 (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 Statement will have on our consolidated financial statements.

 

In May 2009, the FASB issued SFAS No. 166, Accounting for Transfers of Financial Assets-an amendment of FASB SFAS No. 140 (“SFAS No. 166”) (ASC Subtopic 860-10, Transfers and Servicing (ASC 860-10)).  This Statement amends SFAS No. 140 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 SFAS No. 166 (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 SFAS No. 166 (ASC 860-10) will have a material impact on our consolidated financial statements.

 

In May 2009, the FASB issued Staff Position No. 165, Subsequent Events (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 staff position resulted in additional quarterly disclosures only.

 

In April 2009, the FASB issued Staff Position No. 107-1 and APB 28-1 (“FSP FAS 107-1”), which amends SFAS No. 107, Disclosures about Fair Value of Financial Instruments and APB Opinion NO. 28, Interim Financial Reporting (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 staff position resulted in additional quarterly disclosures only.

 

In April 2009, the FASB issued Staff Position No. 157-4 (“FSP FAS 157-4”), Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (ASC Subtopic 820-10, Fair Value Measurement and Disclosures (ASC 820-10)), which provides further clarification for guidance provided by SFAS No. 157, Fair Value Measurements, regarding measurement of fair values of assets and liabilities when the market activity has significantly decreased and in identifying transactions that are not orderly.  FSP FAS 157-4 (ASC 820-10) is effective for interim and annual reporting periods ending after June 15, 2009. The adoption of this staff position did not have a material impact on our financial results.

 

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In December 2007, the FASB issues SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements — an Amendment of ARB 51 (ASC Subtopic 810-10. Consolidation (ASC 810-10)).  This statement amends ARB 51 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 SFAS No. 141 (revised 2007), Business Combinations, (“SFAS No. 141(R)”) (ASC Subtopic 805-10, Business Combinations (ASC 805-10)).  SFAS No. 141(R) (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 SFAS No. 141(R) (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 June 30, 2009			At December 31, 2008
Homes under contract under construction (1)		$	160,649		$	170,347
Finished home sites and home sites under development		375,015			455,048
Unsold homes, completed and under construction		78,654			158,378
Model homes		40,855			48,608
Land held for development or sale		54,956			26,924
		$	710,129		$	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 six-month periods ended June 30, 2009 and 2008 (in thousands):

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2009			2008			2009			2008
Terminated option/purchase contracts and related pre-acquisition costs:
West		$	5,855		$	2,806		$	5,922		$	15,480
Central		55,403			589			55,989			2,184
East		—			943			544			1,303
Total		$	61,258		$	4,338		$	62,455		$	18,967
Real estate inventory impairments (1):
West		$	2,888		$	15,869		$	8,497		$	29,963
Central		1,340			5,584			4,354			15,211
East		672			2,721			1,283			8,720
Total		$	4,900		$	24,174		$	14,134		$	53,894
Impairments of joint venture investments:
West		$	219		$	168		$	219		$	1,622
Central		—			400			—			14,762
East		—			3,305			—			3,305
Total		$	219		$	3,873		$	219		$	19,689
Impairments of land held for sale:
West		$	323		$	5,551		$	323		$	5,551
Central		(101		)	1,079			(64		)	1,079
East		—			—			—			—
Total		$	222		$	6,630		$	259		$	6,630
Total impairments:
West		$	9,285		$	24,394		$	14,961		$	52,616
Central		56,642			7,652			60,279			33,236
East		672			6,969			1,827			13,328
Total		$	66,599		$	39,015		$	77,067		$	99,180

 

(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 June 30,						Six Months Ended June 30,
		2009			2008			2009			2008
Individual home impairments (in thousands):
West		$	1,266		$	9,936		$	6,875		$	18,546
Central		1,072			5,473			4,083			8,689
East		672			1,811			1,283			6,621
Total		$	3,010		$	17,220		$	12,241		$	33,856

 

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

 

		Three Months Ended June 30, 2009
		Number of Communities Impaired		Impairment Charges			Fair Value of Communities Impaired (Carrying Value less Impairments)
West		3		$	1,622		$	6,038
Central		1		268			1,072
East		—		—			—
Total		4		$	1,890		$	7,110

 

		Three Months Ended June 30, 2008
		Number of Communities Impaired		Impairment Charges			Fair Value of Communities Impaired (Carrying Value less Impairments)
West		11		$	5,933		$	72,564
Central		3		111			3,353
East		2		910			8,706
Total		16		$	6,954		$	84,623

 

		Six Months Ended June 30, 2009
		Number of Communities Impaired		Impairment Charges			Fair Value of Communities Impaired (Carrying Value less Impairments)
West		3		$	1,622		$	6,038
Central		2		271			1,401
East		—		—			—
Total		5		$	1,893		$	7,439

 

		Six Months Ended June 30, 2008
		Number of Communities Impaired		Impairment Charges			Fair Value of Communities Impaired (Carrying Value less Impairments)
West		20		$	11,417		$	153,123
Central		18		6,522			57,595
East		2		2,099			8,706
Total		40		$	20,038		$	219,424

 

Subject to sufficient qualifying assets, we capitalize interest incurred during the development and construction of real estate. 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 June 30,						Six Months Ended June 30,
		2009			2008			2009			2008
Capitalized interest, beginning of period		$	26,629		$	38,478		$	29,779		$	41,396
Interest incurred		13,352			10,543			25,004			24,465
Interest expensed		(11,332		)	(5,538		)	(19,662		)	(11,199		)
Interest amortized to cost of home, land closings and impairments		(9,065		)	(6,648		)	(15,537		)	(17,827		)
Capitalized interest, end of period		$	19,584		$	36,835		$	19,584		$	36,835

 

At June 30, 2009, approximately $1.3 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.

 

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

 

FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (“FIN 46R”) (ASC 810-10) 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 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.

 

The table below presents a summary of our lots under option or contract at June 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)		343		$	8,043		$	1,174		$	—
Option contracts not recorded on balance sheet – non-refundable deposits, committed (1)		4,151		177,148			16,284			5,983
Purchase contracts not recorded on balance sheet – non-refundable deposits, committed (1)		—		—			—			—
Total committed (on and off balance sheet)		4,494		185,191			17,458			5,983
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)		217		18,583			102			—
Total uncommitted		467		21,703			152			—
Total lots under option or contracts		4,961		206,894			17,610			5,983
Total option contracts not recorded on balance sheet		4,618		$	198,851		$	16,436	(5)	$	5,983

 

(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.

 

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(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 June 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.

 

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 June 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 eight 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 June 30, 2009 and December 31, 2008 were $0.8 million and $1.4 million, respectively.

 

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 June 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 June 30, 2009 and December 31, 2008, we had outstanding guarantees of this type totaling approximately $72.5 million.  We believe these guarantees, as defined, unless invoked as described above, are not considered guarantees of indebtedness under our Credit Facility or senior and senior subordinated indentures.

 

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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 the guidance of FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others (ASC Subtopic 460-10,  Guaranties (ASC 460-10), 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 June 30, 2009, we had approximately $1.7 million of surety bonds outstanding subject to these indemnity arrangements, of which only $0.3 million of work remains to be completed.  At December 31, 2008, we had approximately $2.4 million of such surety bonds with only $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.

 

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 June 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 June 30, 2009			At December 31, 2008
Assets:
Cash		$	4,333		$	6,817
Real estate		549,272			528,433
Other assets		7,228			11,356
Total assets		$	560,833		$	546,606
Liabilities and equity:
Accounts payable and other liabilities		$	5,810		$	11,166
Notes and mortgages payable		383,806			381,228
Equity of:
Meritage (1)		47,096			47,871
Others		124,121			106,341
Total liabilities and equity		$	560,833		$	546,606

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2009			2008			2009			2008
Revenues		$	4,442		$	5,673		$	7,983		$	11,621
Costs and expenses		(2,143		)	(2,831		)	(4,244		)	(7,502		)
Net earnings of unconsolidated entities		$	2,299		$	2,842		3,739			$	4,119
Meritage’s share of pre-tax earnings (2) (3)		$	676		$	1,786		$	2,097		$	4,075

 

(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) 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. 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 and, therefore, the financial statements of the ventures may not yet reflect any real estate impairment charges. We believe, in some cases, that the fair values of the ventures may be less than the related debt. For the three and six months ended June 30, 2009, we recorded $0.2 million of such impairments. For the three and six months ended June 30, 2008, we recorded $3.9 million and $19.7 million, respectively, of impairments related to our joint venture investments. 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 “Earnings/(loss) 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 June 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 amortized approximately $71,000 and $104,000 of such assets in the first six months of 2009 and 2008, respectively.

 

Of the balance of joint venture assets and liabilities, $500.2 million and $362.4 million, respectively, relate to four joint ventures in which we have interests ranging from 20% - 50%.  Of our “bad boy” debt guarantees, the entire $72.5 million related to two of these ventures.  These ventures own assets in difficult markets and are currently in default of their debt agreements.  Although we and our joint venture partners continue to work with the respective lenders to renegotiate the debt or reach other satisfactory alternatives, all debt for these ventures is non-recourse to the partners and the investment in three of the ventures has been fully impaired and is $2.4 million in the fourth venture as of June 30, 2009.  At this time we believe there is limited exposure to us from these investments.

 

The other venture assets and liabilities noted in the table above primarily represent our other active land ventures, financial ventures and various inactive ventures in which we have a total investment of $12.0 million.  As of June 30, 2009, the debt of these ventures is in compliance with their respective agreements, and except for $1.5 million of our limited repayment guarantees, the debt is non-recourse to us.  These ventures have no “bad boy” guarantees.

 

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