================================================================================ SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 1-9977 MERITAGE CORPORATION ------------------------------------------------------ (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) MARYLAND 86-0611231 - --------------------------------- ------------------- (STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 6613 NORTH SCOTTSDALE ROAD, SUITE 200 SCOTTSDALE, ARIZONA 85250 - ---------------------------------------- ---------- (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) (602) 998-8700 --------------------------------------------------- (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE) MONTEREY HOMES CORPORATION --------------------------------------------------- (FORMER NAME, FORMER ADDRESS AND FORMAL 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 [ ]. AS OF NOVEMBER 1, 1998; 5,326,273 SHARES OF MERITAGE CORPORATION COMMON STOCK WERE OUTSTANDING. ================================================================================ MERITAGE CORPORATION AND SUBSIDIARIES FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 1998 TABLE OF CONTENTS PAGE NO. PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS: Consolidated Balance Sheets as of September 30, 1998 and December 31, 1997........................................... 3 Consolidated Statements of Earnings for the Three and Nine Months ended September 30, 1998 and 1997.................... 4 Consolidated Statements of Cash Flows for the Nine Months ended September 30, 1998 and 1997............... 5 Notes to Consolidated Financial Statements.................. 6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS......................... 10 PART II. OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS......... 15 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K............................ 15 SIGNATURES.............................................................. S-1 2 MERITAGE CORPORATION AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (UNAUDITED) SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------ ------------ ASSETS Cash and cash equivalents $ 5,735,477 $ 8,245,392 Real estate under development 105,388,053 63,955,330 Option deposits 6,341,102 3,070,420 Other receivables 1,605,082 985,708 Residual interests -- 1,421,754 Deferred tax asset 10,370,000 10,404,000 Goodwill 12,424,017 5,970,773 Property and equipment, net 2,469,404 2,046,026 Other assets 824,053 534,101 ------------ ------------ Total Assets $145,157,188 $ 96,633,504 ============ ============ LIABILITIES Accounts payable and accrued liabilities $ 23,054,436 $ 21,171,301 Home sale deposits 12,808,356 6,204,773 Notes payable 45,167,907 22,892,250 ------------ ------------ Total Liabilities 81,030,699 50,268,324 ------------ ------------ STOCKHOLDERS' EQUITY Common stock, par value $.01 per share; 50,000,000 shares authorized; issued and outstanding - 5,317,173 shares at September 30, 1998, and 5,255,440 shares at December 31, 1997 53,172 52,554 Additional paid-in capital 98,753,822 97,819,584 Accumulated deficit (34,680,505) (51,096,675) Treasury stock - 53,046 shares at December 31, 1997 -- (410,283) ------------ ------------ Total Stockholders' Equity 64,126,489 46,365,180 ------------ ------------ Total Liabilities and Stockholders' Equity $145,157,188 $ 96,633,504 ============ ============ See accompanying notes to consolidated financial statements. 3 MERITAGE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF EARNINGS (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 1998 1997 1998 1997 ---- ---- ---- ---- Home sales revenues $68,416,768 $42,685,170 $160,538,271 $79,802,114 Cost of home sales 54,447,139 36,005,313 129,771,511 67,833,859 ----------- ----------- ------------ ----------- Gross profit 13,969,629 6,679,857 30,766,760 11,968,255 Residual and real estate loan interest income -- 3,388,410 5,230,549 4,538,522 Commissions and other sales costs (3,661,365) (2,191,576) (8,555,753) (4,190,286) General and administrative expense (3,062,087) (2,450,862) (7,242,025) (4,726,331) Interest expense (119,030) (109,372) (314,624) (109,372) Other income 434,298 119,000 720,705 424,748 Minority interest in net income of consolidated subsidiaries (1,395,443) -- (1,395,443) -- ----------- ----------- ------------ ----------- Earnings before income taxes 6,166,002 5,435,457 19,210,169 7,905,536 Income taxes 1,898,000 356,482 2,794,000 580,155 ----------- ----------- ------------ ----------- Net earnings $ 4,268,002 $ 5,078,975 $ 16,416,169 $ 7,325,381 =========== =========== ============ =========== Basic earnings per share $ 0.80 $ 0.98 $ 3.09 $ 1.54 Diluted earnings per share $ 0.70 $ 0.86 $ 2.68 $ 1.43
See accompanying notes to consolidated financial statements. 4 MERITAGE CORPORATION AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) NINE MONTHS ENDED SEPTEMBER 30, 1998 1997 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net earnings $ 16,416,169 $ 7,325,381 Adjustments to reconcile net earnings to net cash used in operating activities: Depreciation and amortization 963,540 149,735 Deferred tax expense 1,534,000 -- Stock option compensation expense 1,040,342 1,093,351 Gain on sale of residual interest (5,180,046) (2,713,808) Increase in real estate under development (32,675,132) (16,492,427) Increase in option deposits (2,580,682) (1,874,245) (Increase) decrease in other receivables and other assets (579,583) 430,930 Increase in home sale deposits 6,030,740 5,023,258 (Increase) decrease in accounts payable and accrued liabilities (556,159) 737,317 ------------- ------------ Net cash used in operating activities (15,586,811) (6,320,508) ------------- ------------ CASH FLOWS FROM INVESTING ACTIVITIES: Cash acquired in merger/acquisition 785,403 1,306,998 Cash paid for merger/acquisition (6,914,706) (1,418,346) Increase in goodwill (4,596,728) (872,737) Increase in property and equipment (986,598) (458,764) Proceeds from sale of residual interest 6,600,000 3,100,000 Principal payments received on real estate loans -- 2,124,544 Real estate loans funded -- (428,272) Decrease in short term investments -- 4,696,495 ------------- ------------ Net cash provided by (used in) investing activities (5,112,629) 8,049,918 ------------- ------------ CASH FLOWS FROM FINANCING ACTIVITIES: Borrowings 120,341,231 45,753,834 Repayment of borrowings (102,456,502) (58,131,617) Stock options exercised 304,796 118,592 Dividends paid -- (194,330) ------------- ------------ Net cash provided by (used in) financing activities 18,189,525 (12,453,521) ------------- ------------ Net decrease in cash and cash equivalents (2,509,915) (10,724,111) Cash and cash equivalents at beginning of period 8,245,392 15,567,918 ------------- ------------ Cash and cash equivalents at end of period $ 5,735,477 $ 4,843,807 ============= ============ See accompanying notes to consolidated financial statements 5 MERITAGE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS SEPTEMBER 30, 1998 AND 1997 (UNAUDITED) NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION Meritage Corporation (previously Monterey Homes Corporation, see Item 4 of Management's Discussion and Analysis of Financial Condition and Results of Operations) (the "Company") designs, builds and sells distinctive single-family homes ranging from first time move-up to semi-custom luxury in Arizona, Texas and now in California through the recent acquisition of Sterling Communities (See Note 4). The Company operates in the Phoenix and Tucson, Arizona metropolitan markets under the Monterey Homes brand name, in the Dallas/Fort Worth, Austin and Houston, Texas markets as Legacy Homes and in the San Francisco Bay and Sacramento, California markets as Meritage Homes of Northern California. The Company has undergone significant growth in recent periods and is pursuing a strategy of expanding the geographic scope of its operations. BASIS OF PRESENTATION. The consolidated financial statements include the accounts of Meritage Corporation and its wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation and certain prior period amounts have been reclassified to be consistent with current financial statement presentation. Results for the three and nine months ended September 30, 1997 include the operations of Legacy Homes from July 1, 1997, the date Legacy was combined into the Company. The results of California operations are included from July 1, 1998, the date of acquisition, to September 30, 1998. In the opinion of Management, the unaudited consolidated financial statements reflect all adjustments, consisting only of normal recurring adjustments, necessary to fairly present the Company's financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of results to be expected for a full fiscal year. NOTE 2 - REAL ESTATE UNDER DEVELOPMENT AND CAPITALIZED INTEREST The components of real estate under development are as follows (in thousands): (UNAUDITED) SEPTEMBER 30, 1998 DECEMBER 31, 1997 ------------------ ----------------- Homes under contract, in production $ 54,523 $29,183 Finished lots and lots under development 39,836 28,471 Model homes and homes held for resale 11,029 6,301 -------- ------- $105,388 $63,955 ======== ======= The Company capitalizes certain interest costs incurred on homes in production and lots under development. Such capitalized interest is allocated to real estate under development and included in cost of home sales in the accompanying statements of earnings when the units are delivered. The following tables summarize interest capitalized and interest expensed (in thousands): QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 1998 1997 1998 1997 ---- ---- ---- ---- Beginning unamortized capitalized interest $ 2,130 $1,166 $ 1,890 $ -- Interest capitalized 1,608 930 3,092 2,516 Interest amortized in cost of home sales (1,199) (346) (2,443) (766) ------- ------ ------- ------- Ending unamortized capitalized interest $ 2,539 $1,750 $ 2,539 $ 1,750 ======= ====== ======= ======= Interest incurred $ 1,727 $1,039 $ 3,406 $ 2,625 Interest capitalized (1,608) (930) (3,092) (2,516) ------- ------ ------- ------- Interest expense $ 119 $ 109 $ 314 $ 109 ======= ====== ======= ======= 6 MERITAGE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) NOTE 3 - NOTES PAYABLE Notes payable consist of the following (in thousands): (UNAUDITED) SEPTEMBER 30, DECEMBER 31, 1998 1997 ---- ---- $50 million bank construction line of credit, interest payable monthly approximating prime (8.25% at September 30, 1998), or LIBOR (30 day LIBOR 5.4% at September 30, 1998) plus 2.25% payable at the earlier of close of escrow, maturity date of individual homes within the line or January 1, 1999, secured by first deeds of trust on homes $ 19,928 $ 4,664 $50 million bank construction line of credit, interest payable monthly approximating prime, or LIBOR plus 2.5% payable at the earlier of close of escrow, maturity date of individual homes within the line or July 31, 1999, secured by first deeds of trust on homes 13,672 9,769 $20 million bank acquisition and development credit facility, interest payable monthly approximating prime or LIBOR payable at the earlier of funding of construction financing, the maturity date of individual projects within the line or June 19, 2000, secured by first deeds of trust on land 4,435 2,394 Other acquisition and development credit facilities totaling $4.5 million, interest payable monthly ranging from prime to prime plus .25%; payable at the earlier of funding of construction financing or the maturity date of the individual projects, secured by first deeds of trust on land. 2,533 -- Senior subordinated unsecured notes payable, maturing October 15, 2001, annual interest of 13%, payable semi-annually, principal payable at maturity date (See Note 7) 4,555 6,000 Other 45 65 ------- ------- Total $45,168 $22,892 ======= ======= NOTE 4 - COMBINATIONS AND ACQUISITIONS LEGACY HOMES On May 29, 1997, the Company signed a definitive agreement to combine with Legacy Homes, Ltd. and Legacy Enterprises, Inc. (together, "Legacy Homes"), which included the homebuilding and related mortgage service business of Legacy Homes Ltd. and its affiliates. This transaction (the "Legacy Combination" or "Combination") was effective on July 1, 1997. Legacy Homes designs, builds and sells entry-level and move-up homes, is headquartered in the Dallas/Forth Worth metropolitan area and was founded in 1988 by its current President, John Landon. 7 MERITAGE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) In connection with the Legacy Combination, John Landon entered into a four-year employment agreement with the Company and is currently a Managing Director of the Company and President and Chief Executive Officer of the Company's Texas division. Mr. Landon was also granted an option to purchase 166,667 shares of the Company's common stock and was appointed to the Company's Board of Directors. STERLING COMMUNITIES On June 15, 1998, the Company signed a definitive agreement with Sterling Communities, S.H. Capital, Inc., Sterling Financial Investments, Inc., Steve Hafener and W. Leon Pyle (together, the "Sterling Entities"), to acquire substantially all of the assets of Sterling Communities ("Sterling"), a northern California homebuilding business with operations in the San Francisco Bay and Sacramento areas. The transaction was effective as of July 1, 1998. The consideration for the assets and stock acquired, and certain liabilities assumed, consisted of $6.9 million in cash (paid out of working capital) and deferred contingent payments for the four years following the close of the transaction. The deferred contingent payments will be equal to 20% of the pre-tax income of the Northern California division of the Company and will be expensed as earned. Unpaid contingent amounts were approximately $242,000 at September 30, 1998. The assets purchased from the Sterling Entities principally consist of real property and other residential homebuilding assets located in the San Francisco Bay and Sacramento areas of California. The Company will continue the operations of Sterling under the name Meritage Homes of Northern California. In connection with the transaction, Steve Hafener has entered into a four-year employment agreement with the Company, pursuant to which he has been appointed Vice President and Division Manager of the Company's newly acquired Northern California operations. NOTE 5 - EARNINGS PER SHARE A summary of the reconciliation from basic earnings per share to diluted earnings per share for the three and nine months ended September 30, 1998 and 1997 follows (in thousands, except for per share amounts): THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 1998 1997 1998 1997 ---- ---- ---- ---- Net earnings $4,268 $5,079 $16,416 $7,325 Basic EPS - Weighted average shares outstanding 5,317 5,197 5,313 4,751 ------ ------ ------- ------ Basic earnings per share $ 0.80 $ 0.98 $ 3.09 $ 1.54 ====== ====== ======= ====== Basic EPS - Weighted average shares outstanding 5,317 5,197 5,313 4,751 Effect of dilutive securities: Contingent shares 129 149 150 88 Stock options 622 550 660 278 ------ ------ ------- ------ Dilutive EPS - Weighted average shares outstanding 6,068 5,896 6,123 5,117 ------ ------ ------- ------ Diluted earnings per share $ 0.70 $ 0.86 $ 2.68 $ 1.43 ====== ====== ======= ====== 8 MERITAGE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) NOTE 6 - INCOME TAXES The components of income tax expense are (in thousands): QUARTER ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 1998 1997 1998 1997 ---- ---- ---- ---- Current: Federal $ 99 $ 93 $ 325 $ 135 State 265 263 935 445 ------ ------ ------ ------ 364 356 1,260 580 ------ ------ ------ ------ Deferred Federal 1,534 -- 1,534 -- State -- -- -- -- ------ ------ ------ ------ 1,534 -- -- -- ------ ------ ------ ------ Total $1,898 $ 356 $2,794 $ 580 ====== ====== ====== ====== Deferred tax assets and liabilities have been recognized in the consolidated balance sheets due to temporary differences and carryforwards as follows (in thousands): SEPTEMBER 30, 1998 DECEMBER 31, 1997 ------------------ ----------------- Net operating loss carryforward $ 8,645 $13,895 Residual interest basis differences -- 970 Real estate basis differences 379 590 Debt issuance costs 246 310 Deductible merger/acquisition costs 355 260 AMT credit 545 220 Other 250 80 ------- ------- 10,420 16,325 Valuation allowance -- (5,891) ------- ------- 10,420 10,434 Deferred tax liabilities (50) (30) ------- ------- Net deferred tax asset 10,370 10,404 ======= ======= Management of the Company believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the net deferred tax asset. CARRYFORWARDS At September 30, 1998, the Company had federal and state net operating loss carryforwards of $24 million and $500,000, respectively. The federal and state carryforwards expire beginning in 2007 and 1998, respectively. NOTE 7 - SUBSEQUENT EVENTS On October 2, 1998, the Company issued $15 million of senior unsecured notes in a private placement transaction at an effective interest rate of 9.17%. The notes, due September 1, 2005, require quarterly interest payments, and $5M principal payments are to be made on September 1, 2003 and 2004. The notes also include various Company covenants, including, but not restricted to limitations on indebtedness, minimum consolidated net worth, restrictions on investments and limitations on land and lots. 9 MERITAGE CORPORATION AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) On October 30, 1998, the $4,555,000 balance of the senior subordinated unsecured notes payable was paid in full, along with a premium of approximately $296,000 and interest of approximately $28,000. ---------------------------------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q contains forward-looking statements. The words "believe," "expect," "anticipate," and "project" and similar expressions identify forward-looking statements, which speak only as of the date the statement was made. Such forward-looking statements are within the meaning of that term in Section 27A of the Securities Act of 1993, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may include, but are not limited to, projections of revenues, income or loss, capital expenditures, plans for future operations, financing needs or plans, the impact of inflation, the impact of changes in interest rates, plans relating to products or services of the Company, potential real property acquisitions, and new or planned development projects, as well as assumptions relating to the foregoing. Statements in Exhibit 99 to this Quarterly Report on Form 10-Q and in the Company's Annual Report on Form 10-K, including the Notes to the Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations," describe factors, among others, that could contribute to or cause such differences. Additional factors that could cause actual results to differ materially from those expressed in such forward-looking statements are set forth in "Business" and "Market for the Registrant's Common Stock and Related Stockholder Matters" in the Company's December 31, 1997 Annual Report on Form 10-K. RESULTS OF OPERATIONS The following discussion and analysis provides information regarding the results of operations of the Company and its subsidiaries for the three and nine months ended September 30, 1998 and September 30, 1997. All material balances and transactions between the Company and its subsidiaries have been eliminated. The 1997 results include the operations of Legacy Homes from July 1, 1997, the Combination date, to September 30, 1997. The 1998 results include the operations of the Northern California division from July 1, 1998, the acquisition date, to September 30, 1998. This discussion should be read in conjunction with the Company's Annual Report on Form 10-K for the year ended December 31, 1997. In the opinion of management, the data reflects all adjustments, consisting only of normal recurring adjustments, necessary to fairly present the Company's financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of results to be expected for a full fiscal year. HOME SALES REVENUES Home sales revenue is the product of the number of units closed during the period and the average sales price per unit. The following table presents comparative third quarter and first nine months 1998 and 1997 housing revenues for the total Company, and the Arizona, Texas and California divisions individually (dollars in thousands): 10 MERITAGE CORPORATION AND SUBSIDIARIES
QUARTER ENDED DOLLAR/UNIT PERCENTAGE NINE MONTHS ENDED DOLLAR/UNIT PERCENTAGE SEPTEMBER 30, INCREASE INCREASE SEPTEMBER 30, INCREASE INCREASE 1998 1997 (DECREASE) (DECREASE) 1998 1997 (DECREASE) (DECREASE) ---- ---- ---------- ---------- ---- ---- ---------- ---------- TOTAL Dollars $68,416 $42,685 $25,731 60% $160,538 $79,802 $80,736 101% Units Closed 346 202 144 71% 874 307 567 185% Average Sales Price $ 197.7 $ 211.3 $ (13.6) (6%) $ 183.7 $ 259.9 $ (76.2) (29%) TEXAS* Dollars $34,766 $19,658 $15,108 77% $ 93,613 $39,728 $53,885 136% Units Closed 255 136 119 88% 681 409 272 67% Average Sales Price $ 136.3 $ 144.5 $ (8.2) (6%) $ 137.5 $ 97.1 $ 40.4 42% ARIZONA Dollars $19,911 $23,027 $(3,116) (14%) $ 53,186 $60,144 $(6,958) (12%) Units Closed 59 66 (7) (11%) 161 171 (10) (6%) Average Sales Price $ 337.5 $ 348.9 $ (11.4) (3%) $ 330.3 $ 351.7 $(21.40) (6%) CALIFORNIA Dollars $13,739 N/A N/A N/A $ 13,739 N/A N/A N/A Units Closed 32 N/A N/A N/A 32 N/A N/A N/A Average Sales Price $ 429.3 N/A N/A N/A $ 429.3 N/A N/A N/A
* Nine month 1997 Texas information includes pre-combination results and is for comparative purposes only. The increase in total home sales revenue was primarily driven by an increase in unit deliveries and the addition of California operations. Lower average sales price in 1998 is due to the delivery of an increased number of lower priced homes in the Texas market, where the Company's focus is on entry-level and move-up homes. The decrease in Arizona closings for the third quarter and first nine months was caused primarily by construction delays due to unseasonably wet weather in the first part of the year. GROSS PROFIT Gross profit equals home sales revenue net of cost of home sales, which includes developed lot costs, unit construction costs, amortization of common community costs (such as the cost of model complex and architectural, legal and zoning costs), interest, sales tax, warranty, construction overhead and closing costs. The following table presents comparative third quarter and first nine months 1998 and 1997 housing gross profit (dollars in thousands):
QUARTER ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, --------------------------- ------------------------------- DOLLAR PERCENTAGE DOLLAR PERCENTAGE 1998 1997 INCREASE INCREASE 1998 1997 INCREASE INCREASE ---- ---- -------- -------- ---- ---- -------- -------- TOTAL Dollars $13,970 $6,680 $7,290 109% $30,767 $11,968 $18,799 157% Percentage of housing Revenues 20% 16% 4% 25% 19% 15% 4% 27%
The dollar increase in gross profit for the three and nine months ended September 30, 1998, is attributable to gross margin improvements in certain of the Company's markets, along with the continuation of strong overall market conditions. 11 MERITAGE CORPORATION AND SUBSIDIARIES SELLING, GENERAL AND ADMINISTRATIVE EXPENSES Selling, general and administrative (SG&A) expenses as a percentage of homebuilding revenues were 9.8% for the three months ended September 30, 1998 compared to 10.9% for the same period in the prior year. For the nine month period ended September 30, 1998, SG&A expenses were 9.8% of homebuilding revenues compared to 11.2% for the same period in the prior year. The percentage decreases are principally due to the inclusion of revenues from the Legacy Combination and Sterling Acquisition, without corresponding increases in Corporate overhead. In addition, Legacy Homes has traditionally operated at a somewhat lower overhead burden as a percent of home sales revenue than the Arizona division. INCOME TAXES The effective tax rate increased to 31% for the quarter ended September 30, 1998 compared to 7% for the third quarter of the previous year. This increase resulted from deferred tax expense recorded in connection with the full reduction of the Company's valuation allowance. In future periods the Company expects to have an effective tax rate approximating the statutory federal and state tax rates. MINORITY INTEREST The increase in minority interest for the three and nine months ended September 30, 1998 is due to the acquisition by the Company of Sterling Communities, which included two 50% owned limited partnership interests which are controlled by the Company. The minority interest partners' share of net income has been recorded as an expense by the Company. The limited partnerships are expected to be dissolved by December 31, 1998. LIQUIDITY AND CAPITAL RESOURCES The Company's principal uses of working capital are land purchases, lot development and home construction. The Company uses a combination of borrowings and funds generated by operations to meet its working capital requirements. At September 30, 1998, the Company had available short-term secured revolving construction loan facilities totaling $100 million and acquisition and development facilities totaling $24.5 million, of which approximately $36.1 and $7 million were outstanding, respectively, with $12.8 million of unborrowed funds available, supported by approved collateral. The Company also had outstanding $4.6 million in unsecured, senior subordinated notes due October 15, 2001, which were paid off in October 1998 (See Note 7). Management believes that the Company's current borrowing capacity and cash on hand at September 30, 1998 are sufficient to meet liquidity needs for the foreseeable future. There can be no assurance, however, that amounts available in the future from the Company's sources of liquidity will be sufficient to meet the Company's future capital needs and the amount and types of indebtedness that the Company may incur may be limited by the terms of the indenture governing its senior subordinated notes and the credit agreements. NET ORDERS Net orders represent the number of units ordered by customers (net of units canceled) multiplied by the average sales price per units ordered. The following table presents comparative third quarter and first nine months 1998 and 1997 net orders (dollars in thousands): 12 MERITAGE CORPORATION AND SUBSIDIARIES
QUARTER ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30, --------------------------- ------------------------------- DOLLAR/UNIT PERCENTAGE DOLLAR/UNIT PERCENTAGE INCREASE INCREASE INCREASE INCREASE 1998 1997 (DECREASE) (DECREASE) 1998 1997 (DECREASE) (DECREASE) ---- ---- ---------- ---------- ---- ---- ---------- ---------- TOTAL Dollars $65,327 $55,526 $9,801 18% $225,455 $109,467 $115,988 106% Units ordered 309 270 39 14% 1,196 439 757 172% Average sales price $ 211.4 $ 205.7 $ 5.7 3% $ 188.5 $ 294.4 $ (105.9) (36%) TEXAS Dollars $36,007 $26,704 $9,303 35% $134,440 $ 53,349 $ 81,091 152% Units ordered 234 195 39 20% 934 574 360 63% Average sales price $ 153.9 $ 136.9 $ 17.0 12% $ 143.9 $ 92.9 $ 51.0 55% ARIZONA Dollars $28,687 $28,822 (135) ** $ 90,382 $ 82,763 $ 7,619 9% Units ordered 74 75 (1) ** 261 244 17 7% Average sales price $ 387.6 $ 384.3 $ 3.3 ** 346.3 $ 339.2 $ 7.1 2% CALIFORNIA Dollars $ 633 N/A 633 N/A $ 633 N/A 633 N/A Units ordered 1 N/A 1 N/A 1 N/A 1 N/A Average sales price $ 633 N/A 633 N/A $ 633 N/A 633 N/A
* Nine month 1997 Texas information includes pre-combination results and is for comparative purposes only. ** Less than 1% Total net orders increased in the third quarter of 1998 compared to 1997 due to the increase in first time move-up sales, as well as improvements in overall market conditions. The Company does not include sales which are contingent on the sale of the customer's existing home as orders until the contingency is removed. Historically, the Company has experienced a cancellation rate of less than 16% of gross sales. NET SALES BACKLOG Backlog represents net orders of the Company which have not closed. The following table presents comparative 1998 and 1997 net sales backlog for the total Company and the Arizona, Texas and California divisions individually (dollars in thousands): DOLLAR/UNIT PERCENTAGE AT SEPTEMBER 30, INCREASE INCREASE TOTAL 1998 1997 (DECREASE) (DECREASE) ---- ---- ---------- ---------- Dollars $182,461 $117,780 $64,681 55% Units in backlog 835 555 280 50% Average sales price $ 218.5 $ 212.2 $ 6.3 3% TEXAS Dollars $ 82,857 $ 50,183 $32,674 65% Units in backlog 557 362 195 54% Average sales price $ 148.8 $ 136.6 $ 12.2 9% ARIZONA Dollars $ 94,142 $ 67,597 $26,545 39% Units in backlog 268 193 75 39% Average sales price $ 351.3 $ 350.2 $ 1.1 * CALIFORNIA Dollars $ 5,462 N/A N/A N/A Units in backlog 10 N/A N/A N/A Average sales price $ 546.20 N/A N/A N/A * Less than 1% 13 MERITAGE CORPORATION AND SUBSIDIARIES Total dollar backlog at September 30, 1998 increased 55% over the previous year due to a increase in units ordered along with a slight increase in average sales price. Texas dollar and unit backlog at September 30, 1998 is up 65% and 54%, respectively, over the prior year due to increased orders, expansion into the Houston market and the successful introduction of new product offerings in the Austin market designed to meet the current demand. YEAR 2000 ISSUE The year 2000 presents potential concerns for business computing due to calculation problems from the use of a two-digit format as the year changes from 1999 to 2000. The problem affects certain computer software, hardware, and other systems containing processors and embedded chips. Consequently, information technology ("IT") systems and non-IT systems (collectively, "Business Systems") may not be able to accurately process certain transactions before, during, or after January 1, 2000. As a result, business and governmental agencies are at risk for potential disruption to their business from Business Systems malfunctions or failures. This is commonly referred to as the Year 2000 ("Y2K") issue. The Company could be impacted by failures of its own Business Systems as well as those of its suppliers and business partners, and is in the process of implementing its Y2K compliance program that consists of Business Systems identification, testing and remediation, assessments of critical suppliers, and contingency planning. The first component of the compliance program is to identify the Business Systems of the Company for purposes of evaluating for Y2K compliance. This phase is complete as the critical computer programs, hardware, and other equipment have been identified for evaluation to determine which systems are compliant and which systems will be replaced or remediated. The second part of the program is the evaluation and replacement or remediation of the Company's Business Systems that are not Y2K compliant. The Company is in the process of converting to a new version of the homebuilding database system currently in use by the Company, which has reduced the scope of the compliance program, and expects the conversion to be completed by the end of 1998. The Company believes the replacement or remediation of the critical Business Systems will be substantially complete by June 1, 1999. Critical suppliers and business partners ("Key Business Partners") have been identified and steps are being taken to ascertain their Y2K readiness. These steps include interviews, questionnaires and other types of inquiries. Because of the number of Business Systems used by Key Business Partners and the varying levels of Y2K readiness, it is difficult to assess the likelihood and impact of a malfunction due to this issue. The Company is not currently aware of any business relationships with Key Business Partners that it believes will likely result in a significant disruption of its business. However, a Y2K failure could occur and have an adverse impact on the Company. Management currently believes its greatest risk is with suppliers, banking and financial institutions, and suppliers of telecommunications services, all of which are operating within the United States. Potential consequences of the Company or its Key Business Partners Business Systems not being Y2K compliant include delays in receiving inventory and supplies. Concurrent with the remediation and evaluation of the Business Systems of the Company and its Key Business Partners, contingency plans are being developed to mitigate the risks that could occur in the event of a Y2K related business disruption. Contingency plans may include increasing inventory levels, securing additional financing or other actions deemed prudent. Estimated costs associated with developing and implementing contingency measures are expected to be minimal. 14 MERITAGE CORPORATION AND SUBSIDIARIES It is currently estimated that the remediation and testing of the Company's Business Systems will cost approximately $100,000 and will be expensed in the period incurred and funded through cash flows from operations. Expenses to date have approximated $35,000. The financial impact is not expected to be material to the Company's financial position or results of operations. The scheduled completion dates and costs associated with the various components of the Y2K compliance program described above are estimated and are subject to change. PART II. OTHER INFORMATION ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) On September 16, 1998, the Company held a Special Meeting of Shareholders, at which the name Monterey Homes Corporation was changed to Meritage Corporation. Voting results are as follows: APPROVAL OF AMENDMENT TO CHANGE CORPORATE NAME --------------------- Shares FOR 5,023,137 Shares AGAINST 39,723 Shares ABSTAINED 10,174 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits Exhibit Number Description Page or Method of Filing ------ ----------- ------------------------ 2.1 Agreement of Purchase and Sale of Assets, Incorporated by reference dated as of May 20, 1997, by and among to Exhibit 2 of the Form the Company, Legacy Homes, Ltd., 8-K/A dated June 18, 1997. Legacy Enterprises, Inc., and John and Eleanor Landon 3.1 Amendment to Articles of Incorporation Filed herewith. 3.2 Restated Articles of Incorporation of Filed herewith. the Company 3.4 Amended and Restated Bylaws of the Incorporated by reference Company to Exhibit 3.3 to the Form S-3 Registration Statement No. 333-58793 ("S-3 #333-58793"). 15 MERITAGE CORPORATION AND SUBSIDIARIES 4.1 Note Purchase Agreement Filed herewith. 27 Financial Data Schedule and Restated Filed herewith. 1997 Financial Data Schedule 99 Private Securities Reform Act of 1995 Filed herewith. Safe Harbor Compliance Statement for Forward-Looking Statements (b) Reports filed on Form 8-K A Current Report on Form 8-K, dated July 15, 1998 was filed with the Securities and Exchange Commission. This report related to the acquisition of Sterling Communities, a California homebuilder. 16 MERITAGE CORPORATION SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on behalf by the undersigned thereunto duly authorized. MERITAGE CORPORATION A MARYLAND CORPORATION November 13, 1998 By: /s/ LARRY W. SEAY -------------------------------- Larry W. Seay Vice President of Finance & Chief Financial Officer S-1