Table of Contents

 

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

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

 

For the quarterly period ended June 30, 2008

 

or

 

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

 

Commission File Number 1-9977

 

MERITAGE HOMES CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

 

Maryland

 

86-0611231

(State or Other Jurisdiction

 

(I.R.S. Employer

of Incorporation or Organization)

 

Identification No.)

 

 

 

17851 North 85th Street, Suite 300

 

 

Scottsdale, Arizona

 

85255

(Address of Principal Executive Offices)

 

(Zip Code)

 

(480) 515-8100

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x No o

 

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

 

Large accelerated filer x

Accelerated filer o

 

 

Non-accelerated filer o

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

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, 2008: 30,686,856.

 

 

 



Table of Contents

 

MERITAGE HOMES CORPORATION
FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2008

 

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

3

 

 

 

Item 1.

Financial Statements

3

 

 

 

 

 

 

Unaudited Condensed Consolidated Balance Sheets as of June 30, 2008 and December 31, 2007

3

 

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2008 and 2007

4

 

 

 

 

 

 

Unaudited Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2008 and 2007

5

 

 

 

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

6

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

20

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

37

 

 

 

 

 

Item 4.

Controls and Procedures

37

 

 

 

 

PART II. OTHER INFORMATION

38

 

 

 

 

 

Item 1.

Legal Proceedings

38

 

 

 

 

 

Item 1A.

Risk Factors

38

 

 

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

38

 

 

 

 

 

Item 3.

Not Applicable

 

 

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

38

 

 

 

 

 

Item 5.

Not Applicable

 

 

 

 

 

 

Item 6.

Exhibits

39

 

 

 

 

SIGNATURES

40

 

 

INDEX OF EXHIBITS

41

 



Table of Contents

 

PART I - - FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

MERITAGE HOMES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

 

 

June 30,

 

December 31,

 

 

 

2008

 

2007

 

 

 

(unaudited)

 

 

 

Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

115,153

 

$

27,677

 

Income tax receivables

 

27,175

 

67,424

 

Other receivables

 

46,532

 

56,079

 

Real estate

 

1,120,311

 

1,267,879

 

Real estate not owned

 

14,636

 

13,629

 

Deposits on real estate under option or contract

 

71,003

 

87,191

 

Investments in unconsolidated entities

 

21,429

 

26,563

 

Property and equipment, net

 

28,932

 

30,973

 

Deferred tax asset, net

 

148,080

 

139,057

 

Intangibles, net

 

7,137

 

8,181

 

Prepaid expenses and other assets

 

19,422

 

23,728

 

 

 

 

 

 

 

Total assets

 

$

1,619,810

 

$

1,748,381

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

Accounts payable

 

$

51,446

 

$

59,680

 

Accrued liabilities

 

162,514

 

202,790

 

Home sale deposits

 

17,615

 

19,484

 

Liabilities related to real estate not owned

 

6,465

 

6,388

 

Loans payable and other borrowings

 

6,091

 

101,073

 

Senior and senior subordinated notes

 

628,885

 

628,802

 

 

 

 

 

 

 

Total liabilities

 

873,016

 

1,018,217

 

 

 

 

 

 

 

Stockholders’ Equity:

 

 

 

 

 

Preferred stock, par value $0.01. Authorized 10,000,000 shares; none issued and outstanding at June 30, 2008 and December 31, 2007

 

 

 

Common stock, par value $0.01. Authorized 125,000,000 shares; issued and outstanding 38,578,106 and 34,144,924 shares at June 30, 2008 and December 31, 2007, respectively

 

386

 

341

 

Additional paid-in capital

 

433,157

 

347,796

 

Retained earnings

 

502,016

 

570,789

 

Treasury stock at cost 7,891,250 and 7,891,068 shares at June 30, 2008 and December 31, 2007, respectively

 

(188,765

)

(188,762

)

 

 

 

 

 

 

Total stockholders’ equity

 

746,794

 

730,164

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

1,619,810

 

$

1,748,381

 

 

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 data)

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Home closing revenue

 

$

373,923

 

$

567,748

 

$

745,579

 

$

1,143,863

 

Land closing revenue

 

1,375

 

919

 

3,148

 

2,254

 

Total closing revenue

 

375,298

 

568,667

 

748,727

 

1,146,117

 

 

 

 

 

 

 

 

 

 

 

Cost of home closings

 

(322,143

)

(479,298

)

(648,369

)

(948,225

)

Cost of land closings

 

(1,397

)

(748

)

(3,084

)

(1,894

)

Real estate impairments

 

(35,142

)

(78,862

)

(79,491

)

(95,899

)

Total cost of closings and impairments

 

(358,682

)

(508,908

)

(730,944

)

(1,046,018

)

 

 

 

 

 

 

 

 

 

 

Home closing gross profit

 

23,268

 

9,588

 

24,349

 

99,739

 

Land closing gross (loss)/profit

 

(6,652

)

171

 

(6,566

)

360

 

Total closing gross profit

 

16,616

 

9,759

 

17,783

 

100,099

 

 

 

 

 

 

 

 

 

 

 

Commissions and other sales costs

 

(33,669

)

(48,067

)

(67,434

)

(95,405

)

General and administrative expenses

 

(10,453

)

(28,414

)

(31,746

)

(55,077

)

Goodwill and related impairments

 

 

(27,952

)

 

(27,952

)

(Loss)/earnings from unconsolidated entities, net

 

(2,089

)

1,800

 

(15,618

)

4,946

 

Interest expense

 

(5,538

)

(319

)

(11,199

)

(319

)

Other income, net

 

973

 

3,989

 

3,270

 

7,122

 

 

 

 

 

 

 

 

 

 

 

Loss before benefit for income taxes

 

(34,160

)

(89,204

)

(104,944

)

(66,586

)

Benefit for income taxes

 

10,692

 

32,628

 

36,171

 

25,126

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(23,468

)

$

(56,576

)

$

(68,773

)

$

(41,460

)

 

 

 

 

 

 

 

 

 

 

Loss per common share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.79

)

$

(2.16

)

$

(2.46

)

$

(1.58

)

Diluted

 

$

(0.79

)

$

(2.16

)

$

(2.46

)

$

(1.58

)

 

 

 

 

 

 

 

 

 

 

Weighted average number of shares:

 

 

 

 

 

 

 

 

 

Basic

 

29,594

 

26,232

 

27,953

 

26,199

 

Diluted

 

29,594

 

26,232

 

27,953

 

26,199

 

 

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,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(68,773

)

$

(41,460

)

Adjustments to reconcile net loss to net cash provided by/(used in) operating activities:

 

 

 

 

 

Depreciation and amortization

 

6,564

 

9,044

 

Real estate-related impairments

 

79,491

 

95,899

 

Goodwill-related impairments

 

 

27,952

 

Increase in deferred taxes

 

(9,023

)

(32,503

)

Stock-based compensation

 

2,057

 

4,222

 

Excess income tax benefit from stock-based awards

 

 

(346

)

Equity in losses/(earnings) from unconsolidated entities (includes $19.7 and $1.1 million of impairments to joint ventures in 2008 and 2007, respectively)

 

15,618

 

(4,946

)

Distributions of earnings from unconsolidated entities

 

5,361

 

8,768

 

Changes in assets and liabilities:

 

 

 

 

 

Decrease/(increase) in real estate

 

74,686

 

(151,735

)

Decrease in deposits on real estate under option or contract

 

6,560

 

21,159

 

Decrease/(increase) in receivables and prepaid expenses and other assets

 

51,699

 

(7,540

)

Decrease in accounts payable and accrued liabilities

 

(60,615

)

(88,807

)

Decrease in home sale deposits

 

(1,869

)

(6,215

)

Net cash provided by/(used in) operating activities

 

101,756

 

(166,508

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Investments in unconsolidated entities

 

(13,431

)

(19,693

)

Distributions of capital from unconsolidated entities

 

1,862

 

16,210

 

Purchases of property and equipment

 

(4,371

)

(8,254

)

Proceeds from sales of property and equipment

 

105

 

360

 

Net cash used in investing activities

 

(15,835

)

(11,377

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Net borrowings/(repayments) under Credit Facility

 

(82,000

)

25,000

 

Repayments of loans payable and other borrowings, net

 

 

(1,309

)

Proceeds from issuance of senior subordinated notes

 

 

150,000

 

Debt issuance costs

 

 

(3,043

)

Excess income tax benefit from stock-based awards

 

 

346

 

Purchase of treasury stock

 

(3

)

 

Proceeds from stock option exercises

 

783

 

1,859

 

Proceeds from issuance of common stock, net of transaction fees

 

82,775

 

 

Net cash provided by financing activities

 

1,555

 

172,853

 

 

 

 

 

 

 

Net increase/(decrease) in cash and cash equivalents

 

87,476

 

(5,032

)

Cash and cash equivalents at beginning of period

 

27,677

 

56,710

 

Cash and cash equivalents at end of period

 

$

115,153

 

$

51,678

 

 

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, 2008 AND 2007

 

NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION

 

Organization.  Meritage Homes is a leading designer and builder of single-family attached and detached homes in the historically high-growth regions of the southern and western United States based on the number of home closings.  We offer first-time, move-up, luxury and active adult 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, 2008, we were actively selling homes in 213 communities, with base prices ranging from approximately $112,000 to $1,068,000.

 

Basis of Presentation.  The accompanying consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles 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 the interim periods presented.

 

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 SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”)Inventory includes the costs of land acquisition, land development and home construction, capitalized interest, real estate taxes and direct overhead costs incurred during development and home construction that benefit the entire community.  Land and development costs are typically allocated to individual lots on a relative value basis. The costs of these lots are transferred to homes under construction when construction begins.  Home construction costs are accumulated on a per-home basis.  Cost of home closings includes the specific construction costs of the home and all related land acquisition, land development and other common costs (both incurred and estimated to be incurred) based upon the total number of homes expected to be closed in each community or phase.  Any changes to the estimated total development costs of a community or phase are allocated on a relative value basis 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, our building cycle ranges from four to five years, commencing with the acquisition of the entitled land and continuing through the land development phase and concluding with the sale, construction and closing of the homes.  Actual community lives will vary based on the size of the community and the associated sales absorption rates.  Master-planned communities encompassing several phases and super-block land parcels may have significantly longer lives.

 

In accordance with SFAS No. 144, 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.   SFAS No. 144 requires impairment charges to be recorded if the fair value of such assets is less than their carrying amounts.  Our determination of fair value is based on projections and estimates.  Changes in these expectations may lead to a change in the outcome of our impairment analysis.  Our analysis is completed on a quarterly basis at a community level with each community or land parcel evaluated individually.  For those assets deemed to be impaired, the impairment to be recognized is measured by the amount by which the assets’ carrying amount exceeds their fair value.

 

Existing and continuing communities When projections for the remaining income expected to be earned from existing communities are no longer positive, the underlying real estate assets are deemed not fully recoverable, and further analysis is performed to determine the required impairment.  The fair value of the communities’ assets is determined using either a discounted cash flow model for projects we intend to build out or a market-based approach for projects we intend to

 

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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 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% for all projects exceeding nine months.  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.

 

Option deposits and pre-acquisition costsWe 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 contributions to be generated by our future communities are acceptable to us.  If the projections indicate that a community is still profitable and generating acceptable margins, those assets are determined to be fully recoverable and no impairments are required.  In cases where we decide to abandon the project, we will fully impair all assets related to such project and will expense and accrue any additional costs that we are contractually obligated to incur.  We may also elect to continue with a project because it has positive cash flows, even though it may not be generating an accounting profit, or because of 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.

 

Off-Balance-Sheet Arrangements – Joint Ventures.  We participate in about a dozen active 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 also enter into mortgage and title business joint ventures.  The mortgage joint ventures are engaged in mortgage brokerage activities, and they originate and provide services to both our clients and other homebuyers.  See Note 4 for additional information.

 

Off-Balance-Sheet Arrangements – Other.  We often acquire finished building lots from various development entities pursuant to option and purchase agreements.  The purchase price typically approximates the market price at the date the contract is executed.  See Note 3 for further discussion.

 

We obtain letters of credit and performance, maintenance and other bonds in support of our related obligations with respect to the development of our projects.  The amount of these obligations outstanding at any time varies depending on the stage and level of our development activities.  In the event a letter of credit or bond is drawn upon, we would be obligated to reimburse the issuer of the letter of credit or bond.  Although a majority of the required work may have been performed, these bonds are typically not released until all development specifications have been met.  As such, as of June 30, 2008, we had approximately $182.7 million of surety bonds outstanding subject to these indemnity arrangements, of which only $50.5 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.

 

Intangibles, Net.  In accordance with AICPA Statement of Position 98-1, “Accounting for Costs of Computer Software Developed or Obtained for Internal Use,” we have capitalized software costs at June 30, 2008 with a cost basis of $5.5 million, which is net of accumulated amortization of $8.3 million.  In the first six months of 2008, amortization expense was approximately $0.8 million related to the capitalized software costs and is expected to be approximately $0.8 million for the remaining six months of 2008 and $1.6 million, $1.6 million, $1.2 million and $0.3 million in 2009, 2010, 2011 and 2012, respectively.  We also have $0.1 million of capitalized software costs that are still in the application stage.

 

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Other intangible assets consist primarily of non-compete agreements acquired in connection with our September 2005 acquisition of Greater Homes.  These intangible assets were valued at the acquisition date utilizing accepted valuation procedures and are being amortized over their estimated useful lives.  The cost and accumulated amortization of our intangible assets was $7.4 million and $5.9 million, respectively, at June 30, 2008.  In the first six months of 2008, amortization expense was $0.4 million.  Amortization expense is expected to be approximately $0.4 million in the remaining six months of 2008 and $0.7 million and $0.4 million in 2009 and 2010, respectively.

 

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

 

 

 

At
June 30, 2008

 

At
December 31, 2007

 

Accruals related to real estate development and construction activities

 

$

44,897

 

$

91,607

 

Payroll and other benefits

 

16,278

 

29,604

 

Accrued taxes

 

13,926

 

2,962

 

Warranty reserves

 

34,276

 

36,633

 

Other accruals

 

53,137

 

41,984

 

Total

 

$

162,514

 

$

202,790

 

 

Warranty Reserves.  We have certain obligations related to post-construction warranties and defects related to homes closed.  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 reserve and adjust it, 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,

 

 

 

2008

 

2007

 

2008

 

2007

 

Balance, beginning of period

 

$

35,742

 

$

30,319

 

$

36,633

 

$

28,437

 

Additions to reserve

 

2,876

 

4,350

 

4,790

 

10,712

 

Warranty claims and expenses

 

(4,342

)

(3,683

)

(7,147

)

(8,163

)

Balance, end of period

 

$

34,276

 

$

30,986

 

$

34,276

 

$

30,986

 

 

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.

 

Recently Issued Accounting Pronouncements.  In May 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 162, The Hierarchy of Generally Accepted Accounting Principles (“SFAS No. 162”).  SFAS No. 162 identifies the sources of accounting principles and the framework for selecting the principles used in the preparation of financial statements that are presented in accordance with accounting principles generally accepted in the United States.  This statement will be effective 60 days following the Securities and Exchange Commission’s approval of the Public Company Accounting Oversight Board amendments to AU Section 411, “The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles.”  We do not expect the adoption of SFAS No. 162 to have a material impact on our financial condition, results of operations, and disclosures.

 

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities (“SFAS No. 161”).  This standard revises the presentation of and requires additional disclosures to an entity’s derivative instruments, including how derivative instruments and related hedged items are accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, and how derivative instruments and related hedged items affects its financial position, financial performance and cash flows.  The provisions of SFAS No. 161 are effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  We do not believe the adoption of SFAS No. 161 will have a material impact on our consolidated financial statements.

 

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NOTE 2 – REAL ESTATE AND CAPITALIZED INTEREST

 

Real estate consists of the following (in thousands):

 

 

 

At
June 30, 2008

 

At
 December 31, 2007

 

 

 

 

 

 

 

Homes under contract under construction (1)

 

$

357,304

 

$

327,416

 

Finished lots and land under development

 

544,191

 

596,752

 

Unsold homes, completed and under construction

 

137,785

 

236,099

 

Model homes

 

59,551

 

61,172

 

Model home lease program

 

6,091

 

19,073

 

Land held for development

 

15,389

 

27,367

 

 

 

$

1,120,311

 

$

1,267,879

 


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

 

As previously noted, in accordance with SFAS No. 144, 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 environment, we evaluate all of our real estate assets for impairment on a quarterly basis.  SFAS No. 144 requires that impairment charges are to be recorded if the fair value of such assets is less than their carrying amounts.  Our determination of fair value is based on projections and estimates.  Based on these reviews of all our communities, we recorded real-estate and joint-venture impairment charges during the three- and six-month periods ended June 30, 2008 and 2007 as follows (in thousands):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Terminated option/purchase contracts:

 

 

 

 

 

 

 

 

 

West

 

$

2,806

 

$

6,784

 

$

15,480

 

$

12,211

 

Central

 

589

 

2,970

 

2,184

 

4,750

 

East

 

943

 

10,408

 

1,303

 

19,158

 

Total

 

$

4,338

 

$

20,162

 

$

18,967

 

$

36,119

 

 

 

 

 

 

 

 

 

 

 

Real estate inventory impairments (1):

 

 

 

 

 

 

 

 

 

West

 

$

15,869

 

$

48,522

 

$

29,963

 

$

48,522

 

Central

 

5,584

 

5,748

 

15,211

 

6,046

 

East

 

2,721

 

4,430

 

8,720

 

5,212

 

Total

 

$

24,174

 

$

58,700

 

$

53,894

 

$

59,780

 

 

 

 

 

 

 

 

 

 

 

Impairments of joint venture investments:

 

 

 

 

 

 

 

 

 

West

 

$

168

 

$

1,120

 

$

1,622

 

$

1,120

 

Central

 

400

 

 

14,762

 

 

East

 

3,305

 

 

3,305

 

 

Total

 

$

3,873

 

$

1,120

 

$

19,689

 

$

1,120

 

 

 

 

 

 

 

 

 

 

 

Impairments of land held for sale:

 

 

 

 

 

 

 

 

 

West

 

$

5,551

 

$

 

$

5,551

 

$

 

Central

 

1,079

 

 

1,079

 

 

East

 

 

 

 

 

Total

 

$

6,630

 

$

 

$

6,630

 

$

 

 

 

 

 

 

 

 

 

 

 

Total impairments:

 

 

 

 

 

 

 

 

 

West

 

$

24,394

 

$

56,426

 

$

52,616

 

$

61,853

 

Central

 

7,652

 

8,718

 

33,236

 

10,796

 

East

 

6,969

 

14,838

 

13,328

 

24,370

 

Total

 

$

39,015

 

$

79,982

 

$

99,180

 

$

97,019

 


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

 

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Table of Contents

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Individual home impairments (in thousands):

 

 

 

 

 

 

 

 

 

West

 

$

9,936

 

$

6,049

 

$

18,546

 

$

6,049

 

Central

 

5,473

 

1,800

 

8,689

 

1,800

 

East

 

1,811

 

3,642

 

6,621

 

4,424

 

Total

 

$

17,220

 

$

11,491

 

$

33,856

 

$

12,273

 

 

The tables below reflect the number of communities with real estate inventory impairments, excluding home-specific impairments (as noted above) and the remaining fair value of these communities for the three- and six-month periods ended June 30, 2008 and 2007 (dollars in thousands):

 

 

 

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

 

 

 

 

Three Months Ended June 30, 2007

 

 

 

Number of Communities
Impaired

 

Impairment
Charges

 

Fair Value of Communities Impaired
(Carrying Value less Impairments)

 

 

 

 

 

 

 

 

 

West

 

18

 

$

42,473

 

$

185,608

 

Central

 

4

 

3,948

 

40,366

 

East

 

3

 

788

 

19,890

 

Total

 

25

 

$

47,209

 

$

245,864

 

 

 

 

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

 

 

 

 

Six Months Ended June 30, 2007

 

 

 

Number of Communities
Impaired

 

Impairment
Charges

 

Fair Value of Communities Impaired
(Carrying Value less Impairments)

 

 

 

 

 

 

 

 

 

West

 

18

 

$

42,473

 

$

185,608

 

Central

 

4

 

4,246

 

40,366

 

East

 

3

 

788

 

19,890

 

Total

 

25

 

$

47,507

 

$

245,864

 

 

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

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Capitalized interest, beginning of period

 

$

38,478

 

$

38,929

 

$

41,396

 

$

33,016

 

Interest incurred

 

10,543

 

16,751

 

24,465

 

30,636

 

Interest expensed

 

(5,538

)

(319

)

(11,199

)

(319

)

Interest amortized to cost of home closings

 

(6,648

)

(9,847

)

(17,827

)

(17,819

)

Capitalized interest, end of period

 

$

36,835

 

$

45,514

 

$

36,835

 

$

45,514

 

 

At June 30, 2008, approximately $1.4 million of the capitalized interest is related to our joint venture investments and is a component of “Investments in unconsolidated entities” on our condensed consolidated balance sheets.

 

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

 

FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (“FIN 46R”) requires the consolidation of entities in which an enterprise absorbs a majority of the entity’s expected losses, 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 FIN 46R, 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 as outlined in FIN 46R.  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 do not impact our debt covenant calculations.

 

We have applied FIN 46R by developing 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 our option deposit and any capitalized pre-acquisition costs.  Often, we are at risk for items over budget related to land development on property we have under option.  In these cases, we have contracted to complete development at a fixed cost on behalf of the land owner.  Some of our option deposits may be refundable if certain contractual conditions are not performed by the party selling the lots.

 

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The table below presents a summary of our lots under option or contract at June 30, 2008 (dollars in thousands):

 

 

 

 

 

 

 

Option/Earnest
Money Deposits

 

 

 

Number
of Lots

 

Purchase
Price

 

Cash

 

Letters
of Credit

 

Option contracts recorded on balance sheet as real estate not owned (1)(2)

 

686

 

$

14,636

 

$

8,171

 

$

 

 

 

 

 

 

 

 

 

 

 

Option contracts not recorded on balance sheet – non-refundable deposits, committed (1)

 

10,499

 

502,315

 

41,176

 

14,259

 

Purchase contracts not recorded on balance sheet – non-refundable deposits, committed (1)

 

1,185

 

97,152

 

28,214

 

357

 

Total committed (on and off balance sheet)

 

12,370

 

614,103

 

77,561

 

14,616

 

Option contracts not recorded on balance sheet – non-refundable deposits, uncommitted (1)(3)

 

337

 

8,311

 

363

 

 

Purchase contracts not recorded on balance sheet – refundable deposits, uncommitted (4)

 

172

 

9,099

 

1,250

 

 

Total uncommitted

 

509

 

17,410

 

1,613

 

 

Total lots under option or contract

 

12,879

 

631,513

 

79,174

 

14,616

 

 

 

 

 

 

 

 

 

 

 

Total option contracts not recorded on balance sheet

 

12,193

 

$

616,877

 

$

71,003

(5)

$

14,616

 


(1)     Deposits are non-refundable unless 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 with the option to purchase these lots in anticipation of building homes on these lots in the future.  Specific performance contracts, if any, are included in this balance.

 

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

 

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

 

(5)     Amount is reflected in our condensed consolidated balance sheets in the line item “deposits on real estate under option or contract” as of June 30, 2008.

 

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

 

NOTE 4 - INVESTMENTS IN UNCONSOLIDATED ENTITIES

 

We participate in land development joint ventures from time to time as a means of accessing larger parcels of land and lot positions, expanding our market opportunities, managing our risk profile and leveraging our capital base.  Based on the structure of these joint ventures, they may or may not be consolidated into our results.  Our joint venture partners generally are other homebuilders, land sellers or other real estate investors.  We generally do not have a controlling interest in these ventures, which means our joint venture partners could cause the venture to take actions we disagree with, or fail to take actions we believe should be undertaken, including the sale of the underlying property to repay debt or recoup all or part of the partners’ investments.  As of June 30, 2008, we had about a dozen active land ventures.

 

We also enter into mortgage and title business joint ventures.  The mortgage joint ventures are engaged in mortgage brokerage activities, and they originate and provide services to both our clients and other homebuyers.  The mortgages originated by these ventures are primarily funded by third-party mortgage lenders with limited recourse back to us or our joint ventures.  Our aggregate investment in eight mortgage and title joint ventures as of June 30, 2008 and December 31, 2007 was $1.1 million.

 

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Table of Contents

 

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 any profit from such joint venture earnings to the land acquired by us as a reduction in the basis of the property.

 

Repayment Guarantees.  We and/or our joint venture partners occasionally provide limited repayment guarantees on a pro rata basis on the debt of the land development joint ventures.  If such a guarantee were ever to be called, the actual payment due would generally be computed as 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, 2008, our share of these limited pro rata repayment guarantees was approximately $28.7 million, of which $24.7 million are “bad boy” guarantees in nature (see below for a discussion about “bad boy” guarantees); however, as the other joint venture partners could trigger the guarantee without our consent, we have classified them 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 respective secured lender’s remedies with respect to its mortgage or other secured lien on the joint venture’s underlying property.  To date, no such guarantees have been invoked and we believe that the actions that would trigger the guarantee would generally be disadvantageous to the joint venture and to us; however, there can be no assurances that certain of our ventures will not elect to take actions that could trigger a bad boy guarantee, as it may be considered in their economic best interest to do so.  At June 30, 2008, we had outstanding guarantees of this type totaling approximately $71.9 million.  We believe these guarantees, as defined, unless invoked as described above, are not considered guarantees or indebtedness under our revolving credit facility or senior and senior subordinated indentures.

 

Other Guarantees.  We and our joint venture partners are also typically obligated to the project lenders to complete land development improvements if the joint venture does not perform the required development.  Provided we and the other joint venture partners are in compliance with these completion obligations, the project lenders are generally obligated to fund these improvements through any financing commitments available under the applicable joint venture development and construction loans.  In addition, we and our joint venture partners have from time to time provided unsecured indemnities to joint venture project lenders.  These indemnities generally obligate us to reimburse the project lenders only for claims and losses related to matters for which such lenders are held responsible and our exposure under these indemnities is limited to specific matters such as environmental claims.  As part of our project acquisition due diligence process to determine potential environmental risks, we generally obtain, or the joint venture entity generally obtains, an independent environmental review.  Per the guidance of FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others, we believe these guarantees are either not applicable or not material to our financial results.

 

Surety Bonds.  We and our joint venture partners sometimes agree to indemnify third party surety providers with respect to performance bonds issued on behalf of certain of our joint ventures.  If a joint venture does not perform its obligations, the surety bond could be called.  If these surety bonds are called and the joint venture fails to reimburse the surety, we and our joint venture partners would be obligated to indemnify the surety.  These surety indemnity arrangements are generally joint and several obligations with our other joint venture partners.  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, 2008, we had approximately $3.2 million of surety bonds outstanding subject to these indemnity arrangements, of which only $0.5 million of work remains 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, 2008, we did not have any such reserves.

 

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Table of Contents

 

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

 

 

 

At
June 30, 2008

 

At
December 31, 2007

 

Assets:

 

 

 

 

 

Cash

 

$

8,631

 

$

11,494

 

Real estate

 

564,502

 

648,972

 

Other assets

 

16,962

 

29,664

 

Total assets

 

$

590,095

 

$

690,130

 

 

 

 

 

 

 

Liabilities and equity:

 

 

 

 

 

Accounts payable and other liabilities

 

$

15,778

 

$

24,280

 

Notes and mortgages payable

 

401,306

 

472,538

 

Equity of:

 

 

 

 

 

Meritage (1)

 

45,086

 

59,990

 

Others

 

127,925

 

133,322

 

Total liabilities and equity

 

$

590,095

 

$

690,130

 

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenues

 

$

5,673

 

$

34,874

 

$

11,621

 

$

48,260

 

Costs and expenses

 

(2,831

)

(28,588

)

(7,502

)

(38,554

)

Net earnings of unconsolidated entities

 

$

2,842

 

$

6,286

 

4,119

 

$

9,706

 

Meritage’s share of pre-tax earnings (2) (3)

 

$

1,786

 

$

1,850

 

4,075

 

$

5,019

 

 


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

 

(2)           The joint venture financial statements above represent the most recent information available to us.  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 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, 2008, we performed an independent analysis and recorded $3.9 million and $19.7 million, respectively, of impairments related to our joint venture investments.  There were no such impairments for the same period a year ago.  As our portion of pre-tax earnings is recorded on the accrual basis and included both actual earnings reported to us as well as accrued expected earnings for the period noted above not yet provided to us by our joint venture partners, our relative portion of total net earnings of the unconsolidated joint ventures in the table may reflect a different time frame than that represented by the joint venture financials.  See Note 2, “Real Estate and Capitalized Interest”, for detail of our joint venture-related impairments.

 

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

 

In addition to the $3.9 million and $19.7 million of impairments recorded for the three and six months ended June 30, 2008, respectively, our investments in unconsolidated entities includes $2.0 million and $2.3 million at June 30, 2008 and December 31, 2007, 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 $104,000 and $261,000 in the first six months of 2008 and 2007, respectively.

 

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Table of Contents

 

Of the balances reflected in the joint venture table, approximately $396.3 million and $303.5 million of assets and liabilities, respectively, relate to our single largest joint venture, in which we are a 20% member.  Our investment in this venture has been fully impaired, and we have also fully reserved for our only other obligation related to this venture, our interest payments secured by a letter of credit.  The debt of this joint venture is non-recourse to us, and the venture is in compliance with all of its loan covenants as of June 30, 2008.  This venture comprises $60.2 million of our “bad boy” guarantees.

 

Of the remaining balance of joint venture assets and liabilities, $77.6 million and $52.1 million, respectively, relate to three joint ventures in which we have interests ranging from 20% - 50%.  Of our “bad boy” debt guarantees, $11.7 million relate to one 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, as all debt for these ventures is non-recourse to the partners and all investments have been fully impaired, at this time we believe there is limited, or no further, exposure to us from these investments.

 

The other venture assets and liabilities primarily represent our six other active land ventures and various inactive ventures in which we have a total investment of $17.8 million.  As of June 30, 2008, the debt of these ventures is in compliance with their respective agreements, and except for $4.0 million of our limited repayment guarantees, the debt is non-recourse to us.  These ventures have no “bad boy” guarantees.

 

In addition to joint ventures accounted for under the equity method summarized in the above table, our investments in unconsolidated entities include two joint ventures recorded under the cost method.  These joint ventures were formed to acquire large parcels of land, to perform off-site development work and to sell lots to the joint venture members and other third parties.  Our ownership percentage in these ventures is between 3% - 4%.  Both ventures have been notified of default events on their debt; however, the debt on both ventures is non-recourse to the partners and is only payable under a “bad boy” guarantee.  We have fully impaired our investment in one of these ventures and at June 30, 2008 and December 31, 2007, our investment in the other venture was $1.8 and $1.7, respectively.  Both ventures also have partner completion guarantees.  The remaining $24.7 million of our limited repayment guarantees relate to these two joint ventures which, as noted, are bad boy guarantees that may be triggered without our consent as previously discussed.

 

NOTE 5 - LOANS PAYABLE AND OTHER BORROWINGS

 

Loans payable consists of the following (dollars in thousands):

 

 

 

June 30,

 

December 31,

 

 

 

2008

 

2007

 

$800 million unsecured revolving credit facility maturing May 2011 with extension provisions, and interest payable monthly at LIBOR (2.47% at June 30, 2008) plus 1.75% or Prime (5.00% at June 30, 2008) plus 0.25% (1)

 

$

 

$

82,000

 

 

 

 

 

 

 

Model home lease program, with interest in the form of lease payments payable monthly approximating 4.97% at June 30, 2008

 

6,091

 

19,073

 

 

 

 

 

 

 

Total loans payable and other borrowings

 

$

6,091

 

$

101,073

 

 

The construction costs and related debt associated with certain model homes that are owned and leased to us by others and that we use to market our communities are required to be included on our balance sheet.  We do not legally own these model homes, but we are reimbursed by the owner for our construction costs and we have the right, but not the obligation, to purchase these homes.  Although we have no legal obligation to repay any amounts received from the third-party owner, such amounts are recorded as debt and are typically deemed repaid when we simultaneously exercise our option to purchase the model home and sell it to a third-party home buyer.  Should we elect not to exercise our rights to purchase these model homes, the model home costs and related debt under the model lease program will be eliminated upon the termination of the lease, which generally has a maturity date of one to three years, from the origination of the lease.  During the first six months of 2008, $13.0 million of such leases were exercised or terminated, $9.1 million of which were exercised or terminated in the second quarter of 2008.

 


(1)  On July 18, 2008, we amended our Credit Facility to: (i) provide additional cushion by relaxing the minimum interest coverage, maximum leverage and tangible net worth covenants, (ii) reduce the borrowing capacity to $500 million from $800 million, (iii) increase the applicable interest rate by up to 100 basis points, (iv) increase the unused commitment fee by 10 basis points depending on the Company’s leverage ratio (as defined in the Credit Agreement), and (v) modify various other terms.

 

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NOTE 6 - SENIOR AND SENIOR SUBORDINATED NOTES

 

Senior notes consist of the following (dollars in thousands):

 

 

 

June 30,
2008

 

December 31,
2007

 

7.73% senior subordinated notes due 2017

 

$

150,000

 

$

150,000

 

6.25% senior notes due 2015. At June 30, 2008 and December 31, 2007, there was approximately $1.2 million and $1.3 million in unamortized discount, respectively

 

348,833

 

348,746

 

7.0% senior notes due 2014. At June 30, 2008, and December 31, 2007, there was approximately $0.1 million in unamortized premium

 

130,052

 

130,056

 

 

 

$

628,885

 

$

628,802

 

 

Our senior unsecured credit facility (“Credit Facility”) and indentures for all of our senior and senior subordinated notes contain covenants that require maintenance of certain levels of tangible net worth and compliance with certain minimum financial ratios, place limitations on the payment of dividends and redemptions of equity, and limit the incurrence of additional indebtedness, asset dispositions, mergers, certain investments and creations of liens, among other items. As of and for the quarter ended June 30, 2008, we were in compliance with our financial covenants. After considering our most restrictive bank covenants at June 30, 2008, we have additional borrowing availability under the Credit Facility of approximately $408.3 million, as determined by borrowing base limitations defined by our Credit Facility agreement.

 

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

 

NOTE 7 – LOSS PER SHARE

 

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

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Basic weighted average number of shares outstanding

 

29,594

 

26,232

 

27,953

 

26,199

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Stock options and restricted stock (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted weighted average shares outstanding

 

29,594

 

26,232

 

27,953

 

26,199

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(23,468

)

$

(56,576

)

$

(68,773

)

$

(41,460

)

 

 

 

 

 

 

 

 

 

 

Basic loss and diluted loss per share (1)

 

$

(0.79

)

$

(2.16

)

$

(2.46

)

$

(1.58

)

 

 

 

 

 

 

 

 

 

 

Antidilutive stock options not included in the calculation of diluted loss per share

 

2,391

 

2,424

 

2,391

 

2,424

 

 


(1)           For periods with a net loss, basic weighted average shares outstanding are used for diluted calculations as required by accounting principles generally accepted in the United States.  For such periods, all options and non-vested shares outstanding are considered anti-dilutive.

 

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NOTE 8 – STOCKHOLDERS’ EQUITY

 

                On April 23, 2008, we closed a public offering of 4,000,000 shares of our common stock at $20.50 per share.  We had also granted our underwriters an option to purchase up to an additional 600,000 shares within a 30-day period to cover over allotments, of which 297,544 were exercised on April 25, 2008.  We plan to use the proceeds received from this offering for working capital and other general corporate purposes.  The net proceeds from this offering were $82.8 million.

 

NOTE 9 - STOCK-BASED COMPENSATION

 

We have two stock compensation plans (together, the “Plans”), which were approved by our stockholders and are administered by our Board of Directors.  After giving effect to the 900,000 increase in common shares authorized for issuance as approved by our shareholders at our annual meeting held on May 15, 2008, the Plans authorize awards to officers, key employees, non-employee directors and consultants for up to 7,500,000 shares of common stock, of which 1,278,293 shares remain available for grant at June 30, 2008.  We believe that such awards provide a means of performance-based compensation to attract and retain qualified employees and better align the interests of our employees with those of our stockholders.  Generally, option awards are granted with an exercise price equal to the closing market price of Meritage stock on the date of grant, a five-year ratable vesting period and a seven-year contractual term.

 

The fair values of option awards are estimated using a Black-Scholes option pricing model that uses the assumptions noted in the following table:

 

 

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

Expected volatility

 

54.52

%

42.60

%

Expected dividends

 

0

%

0

%

Expected term (in years)

 

5

 

5

 

Risk-free interest rate

 

3.01

%

4.90

%

Weighted average grant date fair value of options granted

 

$

7.79

 

$

20.51

 

 

As of June 30, 2008, we had $13.7 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the Plans that will be recognized on a straight-line basis over the remaining vesting periods, which we expect to be recognized over a weighted-average period of 3.75 years.  For the three months ended June 30, 2008 and 2007, our total stock-based compensation expense was $0.7 million ($0.4 million net of tax) and $1.9 million ($1.6 million net of tax), respectively.  For the six months ended June 30, 2008 and 2007, our total stock-based compensation expense was $2.1 million ($1.3 million net of tax) and $4.2 million ($3.2 million net of tax), respectively.  We granted 332,876 options during the first six months of 2008.

 

NOTE 10 - INCOME TAXES

 

Components of the provision for income taxes are (in thousands):

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Federal

 

$

(11,255

)

$

(28,729

)

$

(35,460

)

$

(22,431

)

State

 

563

 

(3,899

)

(711

)

(2,695

)

Total

 

$

(10,692

)

$

(32,628

)

$

(36,171

)

$

(25,126

)

 

Our unrecognized tax benefits were $5.9 million at June 30, 2008 and include interest and penalties related to uncertain tax positions.  There have been no material changes in unrecognized tax benefits during the quarter ended June 30, 2008.  The total amount of interest and penalties on uncertain tax positions included in income tax expense for the three and six months ended June 30, 2008 was $0.1 million and $0.1 million, respectively, of interest accrued on continuing positions.    We currently have approximately $3.1 million in unrecognized tax benefits related to the deduction of executive compensation that will be affected by expiring statutes of limitations within the next twelve months.

 

We conduct business and are subject to tax in the U.S. and several states.  With few exceptions, we are no longer subject to U.S. federal, state, or local income tax examinations by tax authorities for years prior to 2003.  Our U.S. income tax return for one of our wholly-owned Texas limited partnership entities for 2004 has been examined by the IRS.  The examination was completed in the first quarter of 2008, and there were no material changes to report.  The IRS has commenced the audit of our consolidated U.S. tax return and refund claim for 2007.  The audit is in the early stages and there are no adjustments to report at this time.

 

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NOTE 11 - SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

 

The following presents certain supplemental cash flow information (in thousands):

 

 

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

23,519

 

$

27,066

 

Income taxes

 

$

 

$

31,581

 

Non-cash operating activities:

 

 

 

 

 

Real estate not owned

 

$

1,007

 

$

24,312

 

FIN 48 adoption – unrecognized tax benefits

 

$

 

$

2,962

 

Non-cash investing activities:

 

 

 

 

 

Distribution of assets from unconsolidated entities

 

$

7,580

 

$

13,531

 

Non-cash financing activities:

 

 

 

 

 

Changes in model home lease program

 

$

(12,982

)

$

3,720

 

 

NOTE 12 — OPERATING AND REPORTING SEGMENTS

 

As defined in SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, we have six operating segments (the six states in which we operate).  The operating segments aggregating into our three reporting segments have been determined to have similar economic characteristics, geographical proximity and product types.  Our reportable homebuilding segments are as follows:

 

 

West:

California and Nevada

 

Central:

Texas, Arizona and Colorado

 

East:

Florida

 

Management’s evaluation of segment performance is based on segment operating income/(loss), which we define as homebuilding and land revenues less cost of home construction, commissions and other sales costs, land development and other land sales costs and other costs incurred by or allocated to each segment.  Each reportable segment follows the same accounting policies described in Note 1, “Organization and Basis of Presentation,” to the consolidated financial statements in our 2007 Annual Report on Form 10-K.  Operating results for each segment may not be indicative of the results for such segment had it been an independent, stand-alone entity for the periods presented.  The following segment information is in thousands:

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenue (1):

 

 

 

 

 

 

 

 

 

West

 

$

80,790

 

$

120,905

 

$

171,007

 

$

238,317

 

Central

 

270,842

 

404,664

 

529,544

 

824,839

 

East

 

23,666

 

43,098

 

48,176

 

82,961

 

Consolidated total

 

375,298

 

568,667

 

748,727

 

1,146,117

 

 

 

 

 

 

 

 

 

 

 

Operating (loss)/income (2):

 

 

 

 

 

 

 

 

 

West

 

(28,863

)

(63,441

)

(62,807

)

(70,993

)

Central

 

2,565

 

21,060

 

(3,001

)

60,631

 

East

 

(4,150

)

(17,477

)

(11,172

)

(25,568

)

 

 

 

 

 

 

 

 

 

 

Segment operating loss

 

(30,448

)

(59,858

)

(76,980

)

(35,930

)

Corporate and unallocated (3)

 

2,942

 

(34,816

)

(4,417

)

(42,405

)

(Loss)/earnings from unconsolidated entities, net

 

(2,089

)

1,800

 

(15,618

)

4,946

 

Interest expense

 

(5,538

)

(319

)

(11,199

)

(319

)

Other income, net

 

973

 

3,989

 

3,270

 

7,122

 

 

 

 

 

 

 

 

 

 

 

Loss before income taxes

 

$

(34,160

)

$

(89,204

)

$

(104,944

)

$

(66,586

)

 

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At June 30, 2008

 

 

 

West

 

Central

 

East

 

Corporate and
Unallocated (4)

 

Total

 

Deposits on real estate under option or contract

 

$

3,639

 

$

65,708

 

$

1,656

 

$

 

$

71,003

 

Real estate

 

271,861

 

777,686

 

70,764

 

 

1,120,311

 

Investments in unconsolidated entities

 

2,141

 

18,338

 

46

 

904

 

21,429

 

Other assets

 

22,828

 

77,702

 

4,189

 

302,348

 

407,067

 

Total assets

 

$

300,469

 

$

939,434

 

$

76,655

 

$

303,252

 

$

1,619,810

 

 

 

 

At December 31, 2007

 

 

 

West

 

Central

 

East

 

Corporate and
Unallocated (4)

 

Total

 

Deposits on real estate under option or contract

 

$

12,281

 

$

72,059

 

$

2,851

 

$

 

$

87,191

 

Real estate

 

380,340

 

800,345

 

87,194

 

 

1,267,879

 

Investments in unconsolidated entities

 

4,163

 

20,763

 

811

 

826

 

26,563

 

Other assets

 

30,485

 

79,524

 

3,835

 

252,904

 

366,748

 

Total assets

 

$

427,269

 

$

972,691

 

$

94,691

 

$

253,730

 

$

1,748,381

 


(1)   Revenue includes the following land closing revenue, by segment (in thousands): three months ended June 30, 2008 - $1,375 in Central Region; three months ended June 30, 2007 - $919 in Central Region; six months ended June 30, 2008 - $63 in the West Region; six months ended June 30, 2008 - $3,085 in Central Region; six months ended June 30, 2007 - $2,254 in Central Region.

 

(2)   See Note 2 for a breakout of real estate-related impairments by region.

 

(3)   Balance consists primarily of corporate costs and numerous shared service functions such as finance, legal and treasury that are not allocated to the operating segments.

 

(4)   Balance consists of intangibles and other corporate assets not allocated to the segments.

 

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Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Industry Outlook and Company Actions

 

During the second quarter of 2008, we continued to experience weak demand, although our Texas markets have been less impacted than others.  Competition for home buyers remained intense with existing home foreclosures and the continued limited availability of mortgage financing impacting consumer confidence. As a result, we believe that home buyers remain reluctant to make purchasing decisions until they are comfortable that the price declines are near bottom.  As a continuing result of these conditions, for the three and six months ended June 30, 2008, we recorded $39.0 million and $99.2 million of real estate-related impairments, respectively.

 

We have addressed our immediate goals during the last several quarters of the homebuilding industry downturn by generating cash flow and reducing debt.  We are maintaining ample liquidity to provide us with flexibility should the current market conditions persist for a longer time and be more pronounced than originally anticipated, but also allowing us to take advantage of our opportunities when the market begins to recover.

 

We are now focused on returning our operations to profitability by targeting the following initiatives: (1) winding down under-performing operations and consolidating overhead functions at other divisions to reduce our general and administrative cost burden, (2) reducing our total lot supply by renegotiating or opting out of lot purchase and option contracts, (3) reducing unsold home inventory, (4) exercising tight control over cash flows, (5) increasing sales and marketing efforts to generate additional traffic, (6) renegotiating construction costs with our subcontractors where possible and (7) monitoring our customer satisfaction scores and making improvements based on the results of the surveys.

 

Although we maintain our long-standing position of a built-to-order move-up builder, we are also now re-positioning some of our product to increase affordability appeal to customers at lower price points.  We are also reducing or eliminating certain standard features from our base home models to re-align them with current market requirements, while continuing to provide a wide selection of upgrade options, allowing our customers to customize their new home with the features they consider most important.  All divisions are also actively re-negotiating material and subcontract labor contracts to achieve further cost savings.

 

Summary Company Results

 

Total home closing revenue was $373.9 million for the three months ended June 30, 2008, decreasing 34% from $567.7 million for the same period last year. Net loss for the second quarter of 2008 was $23.5 million, a $33.1 million improvement, from a loss of $56.6 million in the same period last year. The current quarter loss is primarily due to the $39.0 million (pre-tax) of real estate-related impairments as compared to $80.0 million of real estate-related impairments in the same period of 2007. Although we continue to terminate certain option positions and further impair selected inventory, charges from these items have trended much lower over the last three quarters.  The current quarter loss and revenue decline also stem from continuing pressure on average home prices from competitive pressures and the increased use of incentives, and lower closing volumes due to weaker sales levels over the past year.

 

For the six months ended June 30, 2008, home closing revenue and net loss were $745.6 million and $68.8 million, respectively, down $398.3 million and $27.3 million from the same time in the prior year.  The revenue decline is due to the lower average home prices resulting from competitive pressures and the increased use of incentives, as well as the sales mix of homes closed as the lower average prices in Texas now comprise a larger portion of our total deliveries.  In the first half of 2008, we recorded $99.2 million (pre-tax) of real estate-related impairments as compared to $125.0 million of real estate-related and goodwill impairments for the first half of 2007.

 

At June 30, 2008, our backlog of approximately $731.4 million shows a decrease of 39% when compared to June 30, 2007, but increased 9.2% in dollars and 17.1% in units compared to December 31, 2007. The decrease from June 2007 is due to a weaker sales pace, compounded by increased price concessions and incentives, as the average sales price in backlog decreased from $312,200 at June 30, 2007 to $277,000 at March 31, 2008 to $273,000 at June 30, 2008. In the second quarter of 2008, our cancellation rate on sales orders was 29% of gross orders as compared to 37% in the same period a year ago, and 27% for the three months ended March 31, 2008.  While the current cancellation rate is still higher than our historical target of 20-25%, the 2008 cancellation rate represents a moderate improvement over those experienced in most of 2006 and 2007.

 

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Critical Accounting Policies

 

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

 

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

 

Revenue Recognition

 

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

 

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

 

Real Estate

 

Real estate is stated at cost unless the community or land is determined to be impaired, at which point the inventory is written down to fair value as required by SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”)Inventory includes the costs of land acquisition, land development and home construction, capitalized interest, real estate taxes and direct overhead costs incurred during development and home construction that benefit the entire community.  Land and development costs are typically allocated to individual lots on a relative value basis. The costs of these lots are transferred to homes under construction when construction begins.  Home construction costs are accumulated on a per-home basis.  Cost of home closings includes the specific construction costs of the home and all related land acquisition, land development and other common costs (both incurred and estimated to be incurred) based upon the total number of homes expected to be closed in each community or phase.  Any changes to the estimated total development costs of a community or phase are allocated on a relative value basis 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.  In such cases, an accrual to capture such obligations is recorded in connection with the home closing and charged directly to cost of sales.

 

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

 

In accordance with SFAS No. 144, 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.   SFAS No. 144 requires impairment charges to be recorded if the fair value of such assets is less than their carrying amounts.  Our determination of fair value is based on projections and estimates.  Changes in these expectations may lead to a change in the outcome of our impairment analysis.  Our analysis is completed on a quarterly basis at a community level with each community or land parcel evaluated individually.  For those assets deemed to be impaired, the impairment to be recognized is measured by the amount by which the assets’ carrying amount 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.  With each community or land parcel evaluated individually, the fair value of each 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 closings in the period during which 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 sales 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% for all projects exceeding nine months.  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, and are, therefore, closely evaluated by our division personnel in their creation of the discounted cash flow models.  The models are also evaluated by the 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.  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.

 

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 contributions to be generated by our future communities are acceptable to us.  If the projections indicate that a community is still profitable and generating acceptable margins, those assets are determined to be fully recoverable and no impairments are required.  In cases where we decide to abandon the project, we will fully impair all assets related to such project and will expense and accrue any additional costs that we are contractually obligated to incur.  We may also elect to continue with a project because it has positive future cash flows, even though it may not be generating an accounting profit, or because of 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.

 

During the three and six months ended June 30, 2008, we recorded $34.7 million and $80.2 million, respectively, of such impairment charges related to our home and land real estate inventories and real estate-related joint venture investments.  Additionally, for the three and six months ended June 30, 2008, we wrote off $4.3 million and $19.0 million, respectively, of deposits and pre-acquisition costs relating to projects that were no longer feasible.  Refer to Note 2 of these condensed, consolidated financial statements in this Quarterly Report on Form 10-Q for further discussion regarding these impairments and the associated remaining fair values of impaired communities.

 

Due to the uncertainties related to our operations and our industry as a whole, as further discussed in our Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2007, as supplemented from time to time, we are unable to determine at this time if and to what extent continuing changes in our local markets will result in future impairments.

 

Goodwill

 

During the second quarter of 2007, we impaired our goodwill by $26.9 million, relating to goodwill originally recorded in connection with our acquisition of Colonial Homes in Florida in 2005.  During the latter half of 2007, we re-assessed the fair value of our reporting units using various valuation techniques supported with a market valuation of our company as a whole, and concluded that based upon external observable inputs, such as the recent declines in the price of our common stock and resulting decline of our market capitalization, the carrying value of our reporting units exceeded their fair value and therefore could not support any goodwill.  As such, an impairment loss was probable and could be reasonably estimated for all of our reporting units.  Therefore, the goodwill balance was impaired a total of $129.4 million in 2007, resulting in a full write-down of all of our remaining goodwill.

 

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

 

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

 

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

 

Warranty Reserves

 

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

 

At June 30, 2008, our warranty reserve was $34.3 million, reflecting 0.2% to 1.1% of a home’s sale price.  A 10% increase in our warranty reserve rate would have increased our accrual and corresponding cost of sales by $374,000 and $746,000 for the three and six months ended 2008, respectively.  While we believe that the warranty reserve is sufficient to cover our projected costs, there can be no assurances that historical data and trends will accurately predict our actual warranty costs.  Furthermore, there can be no assurances that future economic or financial developments might not lead to a significant change in the reserve.

 

Off-Balance Sheet Arrangements

 

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

 

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

 

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

 

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As of June 30, 2008, we believe that the equity method of accounting is appropriate for our investments in unconsolidated entities where we are not the primary beneficiary, we do not have a controlling interest, and our ownership interest exceeds 20%.  At June 30, 2008, our equity investments of $21.4 million related to unconsolidated entities with total assets of $590.1 million and total liabilities of $417.1 million.  See Note 4 in the accompanying consolidated financial statements for additional information related to these investments.

 

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

 

Valuation of Deferred Tax Assets

 

We account for income taxes using the asset and liability method, which requires that deferred tax assets and liabilities be recognized based on future tax consequences of both temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply in the years in which the temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period when the changes are enacted.

 

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

 

In making the determination of whether we are in a cumulative loss position under SFAS No. 109, we use a four-year measurement period and base the determination on net income or loss before income taxes for the current and prior three years.  Our cumulative loss measurement period is based on the length of swings in historical real estate industry cycles, which have traditionally averaged four to six years between upward and downward swings, and which mirror our expected building and profitability cycles. In addition, the homebuilding industry does not produce a product which is subject to obsolescence and accordingly we believe the industry will recover to its normal profit levels as the temporary factors which are now negatively impacting the industry such as credit availability and excess housing supply are gradually resolved.  Furthermore, we believe that we have sufficient financial resources to weather the normal long homebuilding business cycle and return to normal profitability levels when the market begins to recover in the future.  Therefore, we believe that our policy with regard to the cumulative loss measurement period of four years is both appropriate and reasonable.

 

At June 30, 2008, our net deferred tax asset was $148.1 million of which $10.9 million related to the net state deferred tax asset after a valuation allowance of $9.8 million.  We believe it is more likely than not that the net federal deferred tax asset of $137.1 million will be fully realized and does not require a valuation allowance.  In this regard, we have already disposed of or sold a significant amount of real estate in 2008 that has been impaired and expect to continue to do so throughout the remainder of 2008, which should allow us to carry back any resulting losses to offset our profits from 2006.  Based on the federal tax rate of 35%, it will require $391.7 million of past and future taxable income to realize the $137.2 million of federal deferred tax assets.    We currently have $418.8 million of taxable income available from 2006 for offsetting losses.  We are also allowed to carry forward our losses for 20 years and apply against future taxable income to further realize our deferred tax assets.  As of June 30, 2008, we are not in a cumulative loss position. We have taken major steps towards the return to profitability by revising our product offerings, reducing construction costs, minimizing overhead, negotiating lower lot acquisition costs, and maintaining a strong balance sheet with positive cash flow and ample liquidity.  We will continue to monitor and review the need for a valuation allowance on the federal deferred tax asset each quarter and will record a valuation allowance, if necessary, when conditions indicate that it is warranted.  If the current adverse market conditions continue and future events change the outlook for our return to profitability, we will be in a cumulative loss position sooner than expected and a valuation allowance on the federal deferred tax asset may be required at that time. At the state level, a valuation allowance continues to be necessary due to the magnitude of loss in non-unitary states, no carry back of loss being allowed at the state level, and shorter carry forward periods in a few of the states in which we do business.

 

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Share-Based Payments

 

We have stock options and restricted common stock units (“nonvested shares”) outstanding under two stock compensation plans.  Per the terms of these plans, the exercise price of our stock options may not be less than the closing market value of our common stock on the date of grant, nor may options granted under the plans be exercised within one year from the date of the grant.  After one year, exercises are permitted in pre-determined installments based upon a vesting schedule established at the time of grant.  Each stock option expires on a date determined at the time of the grant, but not to exceed seven years from the date of the grant.

 

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

 

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The data provided below presents operating and financial data regarding our homebuilding activities (dollars in thousands):

 

Home Closing Revenue

 

 

 

Three Months Ended
June 30,

 

Six Months Ended
June 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Total

 

 

 

 

 

 

 

 

 

Dollars

 

$

373,923

 

$

567,748

 

$

745,579

 

$

1,143,863

 

Homes closed

 

1,388

 

1,858

 

2,716

 

3,654

 

Average sales price

 

$

269.4

 

$

305.6

 

$

274.5

 

$

313.0

 

 

 

 

 

 

 

 

 

 

 

West Region

 

 

 

 

 

 

 

 

 

California

 

 

 

 

 

 

 

 

 

Dollars

 

$

64,548

 

$

99,256

 

$

134,827

 

$

201,391

 

Homes closed

 

152

 

208

 

325

 

402

 

Average sales price

 

$

424.7

 

$

477.2

 

$

414.9

 

$

501.0

 

Nevada

 

 

 

 

 

 

 

 

 

Dollars

 

$

16,242

 

$

21,649

 

$

36,117

 

$

36,926

 

Homes closed

 

61

 

58

 

134

 

103

 

Average sales price

 

$

266.3

 

$

373.3

 

$

269.5

 

$

358.5

 

West Region Totals

 

 

 

 

 

 

 

 

 

Dollars

 

$

80,790

 

$

120,905

 

$

170,944

 

$

238,317

 

Homes closed

 

213

 

266

 

459

 

505

 

Average sales price

 

$

379.3

 

$

454.5

 

$

372.4

 

$

471.9

 

 

 

 

 

 

 

 

 

 

 

Central Region

 

 

 

 

 

 

 

 

 

Arizona

 

 

 

 

 

 

 

 

 

Dollars

 

$

68,432

 

$

120,735

 

$

129,868

 

$

303,024

 

Homes closed

 

266

 

358

 

475

 

856

 

Average sales price

 

$

257.3

 

$

337.2

 

$

273.4

 

$

354.0

 

Texas

 

 

 

 

 

 

 

 

 

Dollars

 

$

191,839

 

$

273,200

 

$

374,611

 

$

496,088

 

Homes closed

 

789

 

1,074

 

1,528

 

1,986

 

Average sales price

 

$

243.1

 

$

254.4

 

$

245.2

 

$

249.8

 

Colorado

 

 

 

 

 

 

 

 

 

Dollars

 

$

9,197

 

$

9,810

 

$

21,981

 

$

23,473

 

Homes closed

 

26

 

28

 

64

 

61

 

Average sales price

 

$

353.7

 

$

350.4

 

$

343.5

 

$

384.8

 

Central Region Totals

 

 

 

 

 

 

 

 

 

Dollars

 

$

269,468

 

$

403,745

 

$

526,460

 

$

822,585

 

Homes closed

 

1,081

 

1,460

 

2,067

 

2,903

 

Average sales price

 

$

249.3

 

$

276.5

 

$

254.7

 

$

283.4

 

 

 

 

 

 

 

 

 

 

 

East Region

 

 

 

 

 

 

 

 

 

Florida

 

 

 

 

 

 

 

 

 

Dollars

 

$

23,665

 

$

43,098

 

$

48,175

 

$

82,961

 

Homes closed

 

94

 

132

 

190

 

246

 

Average sales price

 

$

251.8

 

$

326.5