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 September 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 November 4, 2008:  30,693,856

 

 

 



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MERITAGE HOMES CORPORATION

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2008

 

TABLE OF CONTENTS

 

PART I.

FINANCIAL INFORMATION

 

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

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

 

 

 

 

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

 

 

 

 

 

Item 2.

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

 

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

 

 

 

 

 

 

Item 4.

Controls and Procedures

 

 

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

 

 

Item 1.

Legal Proceedings

 

 

 

 

 

 

Item 1A.

Risk Factors

 

 

 

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

 

 

 

 

 

 

Item 3.

Not Applicable

 

 

 

 

 

 

Item 4.

Not Applicable

 

 

 

 

 

 

Item 5.

Not Applicable

 

 

 

 

 

 

Item 6.

Exhibits

 

 

 

 

 

SIGNATURES

 

 

 

 

 

INDEX OF EXHIBITS

 

 

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PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

MERITAGE HOMES CORPORATION AND SUBSIDIARIES
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

 

 

 

September 30,

 

December 31,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

119,027

 

$

27,677

 

Income tax receivables

 

60,415

 

67,424

 

Other receivables

 

38,010

 

56,079

 

Real estate

 

1,049,530

 

1,267,879

 

Real estate not owned

 

14,228

 

13,629

 

Deposits on real estate under option or contract

 

69,032

 

87,191

 

Investments in unconsolidated entities

 

20,788

 

26,563

 

Property and equipment, net

 

26,378

 

30,973

 

Deferred tax asset, net

 

31,336

 

139,057

 

Intangibles, net

 

6,622

 

8,181

 

Prepaid expenses and other assets

 

18,378

 

23,728

 

 

 

 

 

 

 

Total assets

 

$

1,453,744

 

$

1,748,381

 

 

 

 

 

 

 

Liabilities:

 

 

 

 

 

Accounts payable

 

$

48,185

 

$

59,680

 

Accrued liabilities

 

150,153

 

202,790

 

Home sale deposits

 

14,430

 

19,484

 

Liabilities related to real estate not owned

 

6,367

 

6,388

 

Loans payable and other borrowings

 

792

 

101,073

 

Senior and senior subordinated notes

 

628,926

 

628,802

 

 

 

 

 

 

 

Total liabilities

 

848,853

 

1,018,217

 

 

 

 

 

 

 

Stockholders’ Equity:

 

 

 

 

 

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

 

 

 

Common stock, par value $0.01. Authorized 125,000,000 shares; issued and outstanding 38,585,106 and 34,144,924 shares at September 30, 2008 and December 31, 2007, respectively

 

386

 

341

 

Additional paid-in capital

 

435,267

 

347,796

 

Retained earnings

 

358,003

 

570,789

 

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

 

(188,765

)

(188,762

)

 

 

 

 

 

 

Total stockholders’ equity

 

604,891

 

730,164

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

1,453,744

 

$

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 amounts)

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

 

 

 

 

 

 

 

 

 

 

Home closing revenue

 

$

372,907

 

$

574,667

 

$

1,118,486

 

$

1,718,530

 

Land closing revenue

 

1,859

 

3,902

 

5,007

 

6,156

 

Total closing revenue

 

374,766

 

578,569

 

1,123,493

 

1,724,686

 

 

 

 

 

 

 

 

 

 

 

Cost of home closings

 

(325,172

)

(489,412

)

(973,541

)

(1,437,637

)

Cost of land closings

 

(1,846

)

(3,814

)

(4,930

)

(5,708

)

Home impairments

 

(40,949

)

(147,538

)

(113,810

)

(243,437

)

Land impairments

 

(13,063

)

(847

)

(19,693

)

(847

)

Total cost of closings and impairments

 

(381,030

)

(641,611

)

(1,111,974

)

(1,687,629

)

 

 

 

 

 

 

 

 

 

 

Home closing gross profit/(loss)

 

6,786

 

(62,283

)

31,135

 

37,456

 

Land closing loss

 

(13,050

)

(759

)

(19,616

)

(399

)

Total closing gross (loss)/profit

 

(6,264

)

(63,042

)

11,519

 

37,057

 

 

 

 

 

 

 

 

 

 

 

Commissions and other sales costs

 

(33,840

)

(49,598

)

(101,274

)

(145,003

)

General and administrative expenses

 

(20,735

)

(21,308

)

(52,481

)

(76,385

)

Goodwill and related impairments

 

 

(45,000

)

 

(72,952

)

Earnings/(loss) from unconsolidated entities, net

 

1,322

 

(14,441

)

(14,296

)

(9,495

)

Interest expense

 

(5,835

)

(2,319

)

(17,034

)

(2,638

)

Other income, net

 

3,770

 

3,291

 

7,040

 

10,413

 

 

 

 

 

 

 

 

 

 

 

Loss before income taxes

 

(61,582

)

(192,417

)

(166,526

)

(259,003

)

(Provision)/benefit for income taxes

 

(82,431

)

73,865

 

(46,260

)

98,991

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(144,013

)

$

(118,552

)

$

(212,786

)

$

(160,012

)

 

 

 

 

 

 

 

 

 

 

Loss per common share:

 

 

 

 

 

 

 

 

 

Basic and diluted

 

$

(4.69

)

$

(4.52

)

$

(7.37

)

$

(6.10

)

 

 

 

 

 

 

 

 

 

 

Weighted average number of shares:

 

 

 

 

 

 

 

 

 

Basic and diluted

 

30,690

 

26,249

 

28,872

 

26,216

 

 

See accompanying notes to condensed consolidated financial statements

 

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

 

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(212,786

)

$

(160,012

)

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

 

 

 

 

 

Depreciation and amortization

 

9,785

 

13,457

 

Real estate related impairments

 

133,503

 

244,284

 

Goodwill-related impairments

 

 

72,952

 

Decrease/(increase) in deferred taxes

 

1,496

 

(81,424

)

Deferred tax asset valuation allowance

 

106,225

 

 

Stock-based compensation

 

4,045

 

6,735

 

Excess income tax benefit from stock-based awards

 

 

(346

)

Equity in losses from unconsolidated entities (includes $20.8 million and $24.5 million of impairments to joint ventures in 2008 and 2007, respectively)

 

14,296

 

9,495

 

Distributions of earnings from unconsolidated entities

 

7,724

 

12,229

 

Changes in assets and liabilities:

 

 

 

 

 

Decrease/(increase) in real estate

 

87,206

 

(147,413

)

Decrease in deposits on real estate under option or contract

 

8,612

 

16,003

 

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

 

27,217

 

(24,919

)

Decrease in accounts payable and accrued liabilities

 

(76,117

)

(110,650

)

Decrease in home sale deposits

 

(5,054

)

(12,324

)

Net cash provided by/(used in) operating activities

 

106,152

 

(161,933

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Investments in unconsolidated entities

 

(14,293

)

(25,851

)

Distributions of capital from unconsolidated entities

 

2,326

 

32,910

 

Purchases of property and equipment

 

(5,216

)

(10,739

)

Proceeds from sales of property and equipment

 

704

 

732

 

Net cash used in investing activities

 

(16,479

)

(2,948

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Net (repayments)/borrowing under Credit Facility

 

(82,000

)

8,000

 

Repayments of loan payable and other borrowings

 

 

(1,309

)

Proceeds from issuance of senior subordinated notes

 

 

150,000

 

Debt issuance costs

 

 

(5,428

)

Excess income tax benefit from stock-based awards

 

 

346

 

Purchase of treasury stock

 

(3

)

 

Proceeds from stock option exercises

 

905

 

1,859

 

Proceeds from issuance of common stock, net of transaction fees

 

82,775

 

 

Net cash provided by financing activities

 

1,677

 

153,468

 

 

 

 

 

 

 

Net increase/(decrease) in cash and cash equivalents

 

91,350

 

(11,413

)

Cash and cash equivalents at beginning of period

 

27,677

 

56,710

 

 

 

 

 

 

 

Cash and cash equivalents at end of period

 

$

119,027

 

$

45,297

 

 

See supplemental disclosures of cash flow information at Note 10.

 

See accompanying notes to condensed consolidated financial statements

 

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2008 AND 2007

 

NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION

 

Organization. Meritage Homes is a leading designer and builder of single-family detached and attached homes in the historically high-growth regions of the western and southern United States based on the number of home closings. We offer first-time, move-up, active adult and luxury homes to our targeted customer base. We have operations in three regions:  West, Central and East, which are comprised of 12 metropolitan areas in Arizona, Texas, California, Nevada, Colorado and Florida. Through our successors, we commenced our homebuilding operations in 1985. Meritage Homes Corporation was incorporated in 1988 in the State of Maryland.

 

Our homebuilding and marketing activities are conducted under the name of Meritage Homes in each of our markets, except for Arizona, where we also operate under the name of Monterey Homes, and in Texas, where we also operate as Legacy Homes and Monterey Homes. At September 30, 2008, we were actively selling homes in 207 communities, with base prices ranging from approximately $112,000 to $1,077,000.

 

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

 

Real Estate. Real estate is stated at cost unless the community or land is determined to be impaired, at which point the inventory is written down to fair value as required by Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (“SFAS No. 144”)Inventory includes the costs of land acquisition, land development, 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) that are allocated based upon the total number of homes expected to be closed in each community or phase.  Any changes to the estimated total development costs of a community or phase are allocated 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, the associated sales absorption rates and whether the land purchased was raw or finished lots.  Master-planned communities encompassing several phases and super-block land parcels may have significantly longer lives.

 

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 an asset is less than its carrying amount.  Our determination of fair value is based on projections and estimates.  Changes in these expectations may lead to a change in the outcome of our impairment analysis.  Our analysis is completed on a quarterly basis at a community level with each community or land parcel evaluated individually.  For those assets deemed to be impaired, the impairment recognized is measured as the amount by which the assets’ carrying 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 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

 

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intend to sell or that are in the preliminary development stage and product types have not yet been finalized.  Impairments are charged to cost of home closing in the period during which it is determined that the fair value is less than the assets’ carrying amount.  If a market-based approach is used, we determine fair value based on recent comparable purchase and sale activity in the local market, adjusted for known variances as determined by our knowledge of the region and general real estate expertise. Our key estimates in deriving fair value under our cash flow model are (i) home selling prices in the community adjusted for current and expected sales discounts and incentives, (ii) costs related to the community - both land development and home construction - including costs spent to date and budgeted remaining costs to spend, (iii) projected sales absorption rates, reflecting any product mix change strategies implemented to stimulate the sales pace, (iv) alternative land uses including disposition of all or a portion of the land owned and (v) our discount rate, which is currently 14% for all projects exceeding nine months.  These assumptions vary widely across different communities and geographies and are largely dependent on local market conditions.  Due to the number of possible outcomes that would be generated by changes to these assumptions for each community, we do not believe it is possible to provide a sensitivity analysis for these discounted cash flow models that would provide meaningful data to a user of our financial statements.  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.  Impairments are allocated on a straight-line basis to all lots within a project.

 

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 contribution margins to be generated by our future communities are acceptable to us.  If the projections indicate that a community is still meeting our internal investment guidelines and is generating a profit, those assets are determined to be fully recoverable and no impairments are required.  In cases where we decide to abandon 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 due to other strategic factors.  In such cases, we will impair our pre-acquisition costs and deposits, as necessary, to record an impairment to bring the book value to fair value.

 

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 provide 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 September 30, 2008, we had approximately $173.2 million of surety bonds outstanding subject to these indemnity arrangements, of which only $51.9 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.

 

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

 

 

 

At
September 30, 2008

 

At
December 31, 2007

 

Accruals related to real estate development and construction activities

 

$

43,496

 

$

91,607

 

Payroll and other benefits

 

19,129

 

29,604

 

Accrued taxes

 

13,686

 

2,962

 

Warranty reserves

 

34,119

 

36,633

 

Other accruals

 

39,723

 

41,984

 

Total

 

$

150,153

 

$

202,790

 

 

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

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Balance, beginning of period

 

$

34,276

 

$

30,986

 

$

36,633

 

$

28,437

 

Additions to reserve

 

3,390

 

3,658

 

8,180

 

14,370

 

Warranty claims and expenses

 

(3,547

)

(4,005

)

(10,694

)

(12,168

)

Balance, end of period

 

$

34,119

 

$

30,639

 

$

34,119

 

$

30,639

 

 

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
September 30, 2008

 

At
December 31, 2007

 

 

 

 

 

 

 

Homes under contract under construction (1)

 

$

316,834

 

$

327,416

 

Finished home sites and home sites under development

 

499,470

 

596,752

 

Unsold homes, completed and under construction

 

149,992

 

236,099

 

Model homes

 

59,928

 

61,172

 

Model home lease program

 

792

 

19,073

 

Land held for development

 

22,514

 

27,367

 

 

 

$

1,049,530

 

$

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 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.  Based on these reviews of all our communities, we recorded the following real-estate and joint-venture impairment charges during the three- and nine-month periods ended September 30, 2008 and 2007 (in thousands):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Terminated option/purchase contracts:

 

 

 

 

 

 

 

 

 

West

 

$

838

 

$

34,273

 

$

16,318

 

$

46,484

 

Central

 

5,441

 

12,699

 

7,625

 

17,449

 

East

 

 

746

 

1,303

 

19,904

 

Total

 

$

6,279

 

$

47,718

 

$

25,246

 

$

83,837

 

 

 

 

 

 

 

 

 

 

 

Real estate inventory impairments (1):

 

 

 

 

 

 

 

 

 

West

 

$

10,681

 

$

63,299

 

$

40,644

 

$

111,821

 

Central

 

19,755

 

22,844

 

34,966

 

28,890

 

East

 

4,234

 

13,677

 

12,954

 

18,889

 

Total

 

$

34,670

 

$

99,820

 

$

88,564

 

$

159,600

 

 

 

 

 

 

 

 

 

 

 

Impairments of joint venture investments:

 

 

 

 

 

 

 

 

 

West

 

$

1,070

 

$

1,680

 

$

2,692

 

$

2,800

 

Central

 

 

21,689

 

14,762

 

21,689

 

East

 

 

 

3,305

 

 

Total

 

$

1,070

 

$

23,369

 

$

20,759

 

$

24,489

 

 

 

 

 

 

 

 

 

 

 

Impairments of land held for sale:

 

 

 

 

 

 

 

 

 

West

 

$

2,843

 

$

 

$

8,394

 

$

 

Central

 

10,220

 

847

 

11,299

 

847

 

East

 

 

 

 

 

Total

 

$

13,063

 

$

847

 

$

19,693

 

$

847

 

 

 

 

 

 

 

 

 

 

 

Total impairments:

 

 

 

 

 

 

 

 

 

West

 

$

15,432

 

$

99,252

 

$

68,048

 

$

161,105

 

Central

 

35,416

 

58,079

 

68,652

 

68,875

 

East

 

4,234

 

14,423

 

17,562

 

38,793

 

Total

 

$

55,082

 

$

171,754

 

$

154,262

 

$

268,773

 

 


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

 

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Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Individual home impairments:

 

 

 

 

 

 

 

 

 

West

 

$

7,713

 

$

16,441

 

$

26,259

 

$

22,490

 

Central

 

9,648

 

3,958

 

18,337

 

5,758

 

East

 

2,551

 

6,814

 

9,172

 

9,530

 

Total

 

$

19,912

 

$

27,213

 

$

53,768

 

$

37,778

 

 

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

 

 

 

Three Months Ended September 30, 2008

 

 

 

Number of Communities
Impaired

 

Impairment
Charges

 

Fair Value of Communities Impaired
(Carrying Value less Impairments)

 

 

 

 

 

 

 

 

 

West

 

7

 

$

2,968

 

$

69,174

 

Central

 

10

 

10,107

 

43,500

 

East

 

3

 

1,683

 

15,631

 

Total

 

20

 

$

14,758

 

$

128,305

 

 

 

 

Three Months Ended September 30, 2007

 

 

 

Number of Communities
Impaired

 

Impairment
Charges

 

Fair Value of Communities Impaired
(Carrying Value less Impairments)

 

 

 

 

 

 

 

 

 

West

 

29

 

$

46,858

 

$

292,469

 

Central

 

15

 

18,886

 

83,559

 

East

 

6

 

6,863

 

27,294

 

Total

 

50

 

$

72,607

 

$

403,322

 

 

 

 

Nine Months Ended September 30, 2008

 

 

 

Number of Communities
Impaired

 

Impairment
Charges

 

Fair Value of Communities Impaired
(Carrying Value less Impairments)

 

 

 

 

 

 

 

 

 

West

 

20

 

$

14,385

 

$

161,526

 

Central

 

27

 

16,629

 

108,904

 

East

 

5

 

3,782

 

22,208

 

Total

 

52

 

$

34,796

 

$

292,638

 

 

 

 

Nine Months Ended September 30, 2007

 

 

 

Number of Communities
Impaired

 

Impairment
Charges

 

Fair Value of Communities Impaired
(Carrying Value less Impairments)

 

 

 

 

 

 

 

 

 

West

 

33

 

$

89,331

 

$

339,371

 

Central

 

22

 

23,132

 

114,483

 

East

 

10

 

9,359

 

38,062

 

Total

 

65

 

$

121,822

 

$

491,916

 

 

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

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Capitalized interest, beginning of period

 

$

36,835

 

$

45,514

 

$

41,396

 

$

33,016

 

Interest incurred

 

13,103

 

16,459

 

37,568

 

47,095

 

Interest expensed

 

(5,835

)

(2,319

)

(17,034

)

(2,638

)

Interest amortized to cost of home closings and written off for terminated projects

 

(7,233

)

(12,601

)

(25,060

)

(30,420

)

Capitalized interest, end of period

 

$

36,870

 

$

47,053

 

$

36,870

 

$

47,053

 

 

At September 30, 2008, approximately $1.5 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 non-refundable option deposits and any capitalized pre-acquisition costs.  Often, we are at risk for items over budget related to land development on property we have under option.  In these cases, we have contracted to complete development at a fixed cost on behalf of the land owner and are only liable for expenditures in excess of the fixed cost.  In limited situations, our option deposits may be refundable to us if certain contractual conditions are not performed by the party selling the lots.

 

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The table below presents a summary of our lots under option or contract at September 30, 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)

 

672

 

$

14,228

 

$

7,861

 

$

 

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

 

9,786

 

461,149

 

39,095

 

9,701

 

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

 

1,185

 

97,189

 

28,214

 

327

 

Total committed (on and off balance sheet)

 

11,643

 

572,566

 

75,170

 

10,028

 

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

 

337

 

8,311

 

363

 

 

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

 

436

 

22,783

 

1,360

 

 

Total uncommitted

 

773

 

31,094

 

1,723

 

 

Total lots under option or contracts

 

12,416

 

$

603,660

 

$

76,893

 

$

10,028

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total option contracts not recorded on balance sheet

 

11,744

 

$

589,432

 

$

69,032

(5)

$

10,028

 

 


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

 

(2)                                  The purpose and nature of these consolidated lot option contracts (VIEs) is to provide us the option to purchase these lots in the future, in anticipation of entering into sales contracts and beginning home construction on these lots. 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 sheet in the line item “Deposits on real estate under option or contract” as of September 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

 

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

 

We also participate in 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 investments in mortgage and title joint ventures as of September 30, 2008 and December 31, 2007 were $1.3 million and $1.1 million, respectively.

 

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For land development joint ventures, we, and in some cases our joint venture partners, usually receive an option or other similar arrangement to purchase portions of the land held by the joint venture. Option prices are generally negotiated prices that approximate market value when we enter into the option contract. For these ventures, our share of the joint venture profit relating to lots we purchase from the joint ventures is deferred until homes are delivered by us and title passes to a homebuyer. Therefore, we allocate the portion of such joint venture profit to the land acquired by us as a reduction in the basis of the property.

 

Repayment Guarantees.  We and/or our 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 September 30, 2008, our share of these limited pro rata repayment guarantees was approximately $29.4 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 secured lender’s remedies with respect to its mortgage or other secured lien on the joint venture or the joint venture’s underlying property.  To date, no such guarantees have been invoked and we believe that the actions that would trigger a guarantee would generally be disadvantageous to the joint venture and to us, and therefore are unlikely to occur; however, there can be no assurances that certain of our ventures will not elect to take actions that could trigger a bad boy guarantee, as it may be considered in their economic best interest to do so.  At September 30, 2008, we had outstanding guarantees of this type totaling approximately $72.5 million.  We believe these guarantees, as defined, unless invoked as described above, are not considered guarantees or indebtedness under our Credit Facility or senior and senior subordinated indentures.

 

Other Guarantees.  We and our joint venture partners are also typically obligated to the project lender(s) 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 other guarantees are either not applicable or not material to our financial results.

 

Surety Bonds.  We and our joint venture partners also indemnify third party surety providers with respect to performance bonds issued on behalf of certain of our joint ventures.  If a joint venture does not perform its obligations, the surety bond could be called.  If these surety bonds are called and the joint venture fails to reimburse the surety, we and our joint venture partners would be obligated to make such payments.  These surety indemnity arrangements are generally joint and several obligations with our joint venture partners.  Although a majority of the required work may have been performed, these bonds are typically not released until all development specifications have been met.  As of September 30, 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

 

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Table of Contents

 

relative ownership percentage.  In the limited cases where our venture partners, some of whom are homebuilders or developers who may be experiencing financial difficulties as a result of current market conditions, may be unable to fulfill their pro rata share of a joint venture obligation, we may be fully responsible for these commitments if such commitments are joint and several.  We continue to monitor these matters and reserve for these obligations if and when they become probable and can be reasonably estimated.  As of September 30, 2008, we did not have any such reserves.

 

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

 

 

 

At
September 30, 2008

 

At
December 31, 2007

 

Assets:

 

 

 

 

 

Cash

 

$

7,245

 

$

11,494

 

Real estate

 

556,381

 

648,972

 

Other assets

 

17,150

 

29,664

 

Total assets

 

$

580,776

 

$

690,130

 

 

 

 

 

 

 

Liabilities and equity:

 

 

 

 

 

Accounts payable and other liabilities

 

$

12,047

 

$

24,280

 

Notes and mortgages payable

 

398,395

 

472,538

 

Equity of:

 

 

 

 

 

Meritage (1)

 

50,525

 

59,990

 

Others

 

119,809

 

133,322

 

Total liabilities and equity

 

$

580,776

 

$

690,130

 

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenues

 

$

5,993

 

$

85,550

 

$

17,614

 

$

133,810

 

Costs and expenses

 

(3,698

)

(68,693

)

(11,200

)

(107,247

)

Net earnings of unconsolidated entities

 

$

2,295

 

$

16,857

 

$

6,414

 

$

26,563

 

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

 

$

2,392

 

$

8,937

 

$

6,463

 

$

15,076

 

 


(1)

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

 

 

(2)

The joint venture financial statements above represent the most recent information available to us. For joint ventures where we have impaired our investment, the joint venture partners may have not yet reached a consensus or finalized the write-down amount and, therefore, the financial statements of the ventures may not yet reflect any real estate charges. We believe, in some cases, that the fair values of the ventures may be less than the related debt. For the three and nine months ended September 30, 2008, we performed an independent analysis and recorded $1.1 million and $20.8 million, respectively, of impairments related to our joint venture investments. Such impairments were $23.4 million and $24.5 million for the three and nine months ended September 30, 2007. As our portion of pre-tax earnings is recorded on the accrual basis and included both actual earnings reported to us as well as accrued expected earnings for the period noted above not yet provided to us by our joint venture partners, our relative portion of total net earnings of the unconsolidated joint ventures in the table may reflect a different time frame than that represented by the joint venture financials. See Note 2, “Real Estate and Capitalized Interest”, for detail of our joint venture-related impairments.

 

 

(3)

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

 

In addition to the $1.1 million and $20.8 million of impairments recorded for the three and nine months ended September 30, 2008, respectively, our investments in unconsolidated entities includes $2.1 million and $2.3 million at September 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

 

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respective joint ventures are sold.  We amortized approximately $104,000 and $875,000 of such assets in the first nine months of 2008 and 2007, respectively.

 

Of the balances reflected in the joint venture table, approximately $405.2 million and $305.3 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 September 30, 2008.  This venture comprises $60.6 million of our “bad boy” guarantees.

 

Of the remaining balance of joint venture assets and liabilities, $52.7 million and $36.7 million, respectively, relate to two joint ventures in which we have interests ranging from 20% - 50%.  Of our “bad boy” debt guarantees, $11.9 million relates 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 noted in the table above primarily represent our other active land ventures, financial ventures and various inactive ventures in which we have a total investment of $22.5 million.  As of September 30, 2008, the debt of these ventures is in compliance with their respective agreements, and except for $4.7 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, and one has since dis-possessed of its assets in a trustee sale during the current quarter.  Subsequent to such trustee sale, the lender filed suit against the joint venture and its members alleging liability under the completion guarantees excuted severally by each of the members and their parent company, including Meritage.  We dispute the allegations contained in the lawsuit and intend to vigorously defend our position that no amounts are due under the completion guarantees.  We continue to believe that 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 the joint venture that disposed of its holdings, and at September 30, 2008 and December 31, 2007, our investment in the other venture was $0.8 and $1.7, respectively.  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.

 

NOTE 5 - LOANS PAYABLE AND OTHER BORROWINGS

 

Loans payable consists of the following (in thousands):

 

 

 

September 30,
2008

 

December 31,
2007

 

$500 million unsecured revolving credit facility maturing May 2011 with extension provisions, and interest payable monthly at LIBOR (3.72% at September 30, 2008) plus 2.25% or prime (5.0% at September 30, 2008) (1)

 

$

 

$

82,000

 

 

 

 

 

 

 

Model home lease program, with interest in the form of lease payments payable monthly approximating 4.99% at September 30, 2008 (2)

 

792

 

19,073

 

 

 

 

 

 

 

Total loans payable and other borrowings

 

$

792

 

$

101,073

 

 


(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 point depending on the Company’s leverage ratio (as defined in the Credit Agreement), and (v) modify various other terms.

 

(2)           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

 

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obligation, to purchase these homes. Although we have no legal obligation to repay any amounts received from the third-party owner due to the structure of this arrangement, 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 right 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 had an original maturity of one to three years. During the first nine months of 2008, $18.3 million of such leases were exercised or terminated, $5.3 million of which were in the third quarter of 2008.

 

NOTE 6 - SENIOR AND SENIOR SUBORDINATED NOTES

 

Senior and senior subordinated notes consist of the following (in thousands):

 

 

 

September 30,
2008

 

December 31,
2007

 

7.73% senior subordinated notes due 2017

 

$

150,000

 

$

150,000

 

6.25% senior notes due 2015. At September 30, 2008 and December 31, 2007, there was approximately $1.1 and $1.3 million in unamortized discount, respectively

 

348,877

 

348,746

 

7.0% senior notes due 2014. At September 30, 2008, and December 31, 2007, there was approximately $49 and $56 in unamortized premium, respectively

 

130,049

 

130,056

 

 

 

$

628,926

 

$

628,802

 

 

Our senior unsecured credit facility (“Credit Facility”) and indentures for all our senior and senior subordinated notes contain covenants that require maintenance of certain levels of tangible net worth and compliance with certain minimum financial ratios, place limitations on the payment of dividends and redemptions of equity, and limit the incurrence of additional indebtedness, asset dispositions, mergers, certain investments and creations of liens, among other items. As of and for the quarter ended September 30, 2008, we were in compliance with our covenants. After considering our most restrictive bank covenants at September 30, 2008, we have additional borrowing availability under the Credit Facility of $337.7 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
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Basic weighted average number of shares outstanding

 

30,690

 

26,249

 

28,872

 

26,216

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Stock options and restricted stock (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted weighted average shares outstanding

 

30,690

 

26,249

 

28,872

 

26,216

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(144,013

)

$

(118,552

)

$

(212,786

)

$

(160,012

)

 

 

 

 

 

 

 

 

 

 

Basic and diluted loss per share (1)

 

$

(4.69

)

$

(4.52

)

$

(7.37

)

$

(6.10

)

 

 

 

 

 

 

 

 

 

 

Anti-dilutive stock options not included in the calculation of diluted loss per share

 

2,300

 

2,279

 

2,300

 

2,279

 

 


(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 - 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 1,362,493 shares remain available for grant at September 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:

 

 

 

Nine Months Ended September 30,

 

 

 

2008

 

2007

 

Expected volatility

 

55.36

%

42.61

%

Expected dividends

 

0

%

0

%

Expected term (in years)

 

4.50

 

4.56

 

Risk-free interest rate

 

3.06

%

4.89

%

Weighted average grant date fair value of options granted

 

$

8.03

 

$

20.49

 

 

As of September 30, 2008, we had $12.0 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 respective vesting periods, which we expect to be recognized over a weighted-average period of 3.52 years. For the three months ended September 30, 2008 and 2007, our total stock-based compensation expense was $1.9 million ($1.4 million net of tax) and $2.5 million ($1.9 million net of tax), respectively. For the nine months ended September 30, 2008 and 2007, our total stock-based compensation expense was $4.0 million ($2.7 million net of tax) and $6.7 million ($5.1 million net of tax), respectively. We granted 366,376 options during the first nine months of 2008.

 

NOTE 9 - INCOME TAXES

 

Components of the income tax provision/(benefit) are (in thousands):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Federal

 

$

81,270

 

$

(63,731

)

$

45,810

 

$

(86,162

)

State

 

1,161

 

(10,134

)

450

 

(12,829

)

Total

 

$

82,431

 

$

(73,865

)

$

46,260

 

$

(98,991

)

 

Our unrecognized tax benefits were $6.0 million at September 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 September 30, 2008.  The total amount of interest and penalties on uncertain tax positions included in income tax expense for the three and nine months ended September 30, 2008 was $0.1 million and $0.2 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 Internal Revenue Service (“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.

 

In accordance with SFAS No. 109, “Accounting for Income Taxes” (SFAS No. 109), we evaluate our deferred tax assets, including net operating losses, to determine if a valuation allowance is required.  SFAS No. 109 requires that companies assess whether a valuation allowance should be established based on the consideration of all available evidence

 

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using a “more likely than not” standard with significant weight being given to evidence that can be objectively verified.   Our current and prior year losses present the most significant negative evidence as to whether we need to reduce our deferred tax assets with a valuation allowance. Given the continued downturn in the homebuilding industry in the current quarter, the recent acceleration of the economic crisis, the current instability and deterioration of the financial markets, and the resulting uncertainty in projections of our future taxable income, we believe the cumulative weight of the negative evidence exceeds that of the positive evidence at this time and that it is more likely than not that we will not be able to utilize all of our deferred tax assets.  Therefore, we have recorded a valuation allowance, which increased losses from continuing operations by $106.2 million, or $(3.46) per share, during the three months ended September 30, 2008.

 

Based on our assessment, including the implementation of certain tax planning strategies, the realization of the remaining net deferred tax assets of $31.3 million as of September 30, 2008 is more likely than not.  The valuation allowance may be increased or decreased as conditions change or if we are unable to implement certain tax planning strategies.   The realization of our net deferred tax assets ultimately depends on future reversals of existing taxable temporary differences or through a loss carryback to 2006.  We currently have $418.8 million of taxable income available from 2006 for offsetting losses.

 

NOTE 10 - SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION

 

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

 

 

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

38,022

 

$

45,970

 

Income taxes

 

$

 

$

31,645

 

Non-cash operating activities:

 

 

 

 

 

Real estate not owned

 

$

599

 

$

28,793

 

FIN 48 adoption – unrecognized tax benefits

 

$

 

$

2,962

 

Non-cash investing activities:

 

 

 

 

 

Distributions from unconsolidated entities

 

$

7,580

 

$

27,562

 

Non-cash financing activities:

 

 

 

 

 

Changes in model home lease program

 

$

(18,281

)

$

(6,164

)

 

NOTE 11 — 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). We have aggregated our operating segments into three reporting segments based on similar long-term economic characteristics and geographical proximity. Our reporting segments are as follows:

 

West:

California and Nevada

Central:

Texas, Arizona and Colorado

East:

Florida

 

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Management’s evaluation of segment performance is based on segment operating (loss)/income, 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, including impairments. Each reporting 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. The following is our segment information (in thousands):

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Revenue (1):

 

 

 

 

 

 

 

 

 

West

 

$

71,587

 

$

129,806

 

$

242,594

 

$

368,123

 

Central

 

276,450

 

409,675

 

805,995

 

1,234,514

 

East

 

26,729

 

39,088

 

74,904

 

122,049

 

Consolidated total

 

$

374,766

 

$

578,569

 

$

1,123,493

 

$

1,724,686

 

 

 

 

 

 

 

 

 

 

 

Operating (loss)/income (2):

 

 

 

 

 

 

 

 

 

West

 

$

(20,272

)

$

(104,484

)

$

(83,079

)

$

(175,477

)

Central

 

(28,058

)

(6,788

)

(31,059

)

53,843

 

East

 

(5,724

)

(17,252

)

(16,896

)

(42,820

)

 

 

 

 

 

 

 

 

 

 

Segment operating loss

 

(54,054

)

(128,524

)

(131,034

)

(164,454

)

Corporate and unallocated (3)

 

(6,785

)

(5,424

)

(11,202

)

(19,877

)

Goodwill and related impairments

 

 

(45,000

)

 

(72,952

)

Earnings/(loss) from unconsolidated entities, net

 

1,322

 

(14,441

)

(14,296

)

(9,495

)

Interest expense

 

(5,835

)

(2,319

)

(17,034

)

(2,638

)

Other income, net

 

3,770

 

3,291

 

7,040

 

10,413

 

 

 

 

 

 

 

 

 

 

 

Loss before income taxes

 

$

(61,582

)

$

(192,417

)

$

(166,526

)

$

(259,003

)

 

 

 

At September 30, 2008

 

 

 

West

 

Central

 

East

 

Corporate and
Unallocated (4)

 

Total

 

Deposits on real estate under option or contract

 

$

6,523

 

$

60,844

 

$

1,665

 

$

 

$

69,032

 

Real estate

 

250,941

 

743,787

 

54,802

 

 

1,049,530

 

Investments in unconsolidated entities

 

1,359

 

18,885

 

216

 

328

 

20,788

 

Other assets

 

15,472

 

77,891

 

7,192

 

213,839

 

314,394

 

Total assets

 

$

274,295

 

$

901,407

 

$

63,875

 

$

214,167

 

$

1,453,744

 

 

 

 

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 September 30, 2008 - $1,859 in the Central Region; three months ended September 30, 2007 - $3,902 in the Central Region, nine months ended September 30, 2008 - $63 in the West Region and $4,944 in the Central Region; and nine months ended September 30, 2007 - $6,156 in the Central Region.

 

 

(2)

See Note 2 of this quarterly report on Form 10-Q for a breakout of real estate-related impairments by region.

 

 

(3)

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

 

 

(4)

Balance consists of intangibles and other corporate assets not allocated to the reporting 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 third quarter of 2008, the financial crisis and slowing economy damaged buyer confidence and resulted in declines in home sales and asset values.  In addition, our Texas markets, which have been less impacted than others over the past two years of this homebuilding downturn, experienced a slowdown in sales pace as well and were also temporarily impacted by the aftermath of Hurricane Ike.  Competition for home buyers remained intense with existing home foreclosures, and the availability of mortgage financing remained limited.  Concern about the state of the economy and the job market further deteriorated consumer confidence and, 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.  The combined impact of these market forces led to further diminished asset values, and for the three and nine months ended September 30, 2008, we recorded $55.1 million and $154.3 million of real estate-related impairments, respectively.

 

Based on the impact of the financial crisis on our business and the increased uncertainty as to the timing of an eventual recovery in the homebuilding industry, we concluded this quarter that a valuation allowance against our deferred tax assets was warranted and recorded $106.2 million of such charges.

 

We continue to focus on our goals of 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 cautiously take advantage of unique opportunities in select markets as they arise.

 

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 all of our divisions to reduce 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) re-engineering product offering to reduce sales prices and address pricing concerns echoed by consumers, (5) exercising tight control over cash flows, (6) increasing sales and marketing efforts to generate additional traffic, (7) renegotiating construction costs with our subcontractors where possible and (8) 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 conditions, 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 $372.9 million for the three months ended September 30, 2008, decreasing 35% from $574.7 million for the same period last year. Net loss for the third quarter of 2008 further declined $25.5 million to a loss of ($144.0) million from a loss of ($118.6) million in the same period last year. This decrease is primarily due to a $106.2 million deferred tax valuation allowance recorded in the current quarter, partially offset by lower volumes of impairments, with $55.1 million (pre-tax) of real estate-related impairments recorded in the third quarter of 2008 as compared to $216.8 million of real-estate and goodwill impairments in the same period of 2007. For the nine months ended September 30, 2008, home closing revenue and net loss were $1.1 billion and $(212.8) million, respectively, down $600.0 million and $52.8 million, respectively, from the same time in the prior year. The revenue decline is due to the lower average home prices from competitive pressures and the increased use of incentives, as well as the protracted decrease in demand.  The net loss increase is primarily due to the declining revenue previously noted, and the $106.2 million deferred tax valuation allowance recorded in the current quarter, partially offset by $154.3 million (pre-tax) of real-estate related impairments in 2008 as compared to $341.7 million (pre-tax) of real estate-related and goodwill-related impairments for the first three quarters of 2007.

 

At September 30, 2008, our backlog of approximately $612.9 million decreased 40% or $401.1 million when compared to September 30, 2007. These decreases are due to the significant declines in demand, compounded by increased price concessions and incentives, as the average sales price in backlog decreased from $300,100 at September 30, 2007 to $270,100 at September 30, 2008. In the third quarter of 2008, our cancellation rate on sales orders was 40% of gross orders as

 

20



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compared to 41% in the same period a year ago, and 29% for the three months ended June 30, 2008.

 

Consistent with the trends reported by our peers in the homebuilding industry, we have seen substantial decreases in traffic and sales during September, which continued into October.  Our September net sales were about 30% lower than the July-August pace, and our cancellation rate jumped to 45% for the month of September in the wake of the recent crisis in the financial markets.

 

Critical Accounting Policies

 

The accounting policies we deem most critical to us and that involve the most difficult, subjective or complex judgments include revenue recognition, real estate, goodwill, warranty reserves, off-balance-sheet arrangements, valuation of deferred tax assets and share-based payments. There have been no significant changes to our critical accounting policies during the three months ended September 30, 2008 compared to those disclosed in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in our 2007 Annual Report on Form 10-K, as updated by our Quarterly Report on Form 10-Q for the period ended June 30, 2008.

 

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Table of Contents

 

The tables below present operating and financial data that we consider most critical to managing our operations (dollars in thousands):

 

Home Closing Revenue

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Total

 

 

 

 

 

 

 

 

 

Dollars

 

$

372,907

 

$

574,667

 

$

1,118,486

 

$

1,718,530

 

Homes closed

 

1,423

 

1,894

 

4,139

 

5,548

 

Average sales price

 

$

262.1

 

$

303.4

 

$

270.2

 

$

309.8

 

West Region

 

 

 

 

 

 

 

 

 

California

 

 

 

 

 

 

 

 

 

Dollars

 

$

52,530

 

$

104,989

 

$

187,357

 

$

306,380

 

Homes closed

 

131

 

229

 

456

 

631

 

Average sales price

 

$

401.0

 

$

458.5

 

$

410.9

 

$

485.5

 

Nevada

 

 

 

 

 

 

 

 

 

Dollars

 

$

19,057

 

$

24,817

 

$

55,174

 

$

61,743

 

Homes closed

 

71

 

71

 

205

 

174

 

Average sales price

 

$

268.4

 

$

349.5

 

$

269.1

 

$

354.8

 

West Region Totals

 

 

 

 

 

 

 

 

 

Dollars

 

$

71,587

 

$

129,806

 

$

242,531

 

$

368,123

 

Homes closed

 

202

 

300

 

661

 

805

 

Average sales price

 

$

354.4

 

$

432.7

 

$

366.9

 

$

457.3

 

Central Region

 

 

 

 

 

 

 

 

 

Arizona

 

 

 

 

 

 

 

 

 

Dollars

 

$

75,226

 

$

119,600

 

$

205,094

 

$

422,624

 

Homes closed

 

297

 

373

 

772

 

1,229

 

Average sales price

 

$

253.3

 

$

320.6

 

$

265.7

 

$

343.9

 

Texas

 

 

 

 

 

 

 

 

 

Dollars

 

$

186,023

 

$

263,504

 

$

560,634

 

$

759,592

 

Homes closed

 

783

 

1,038

 

2,311

 

3,024

 

Average sales price

 

$

237.6

 

$

253.9

 

$

242.6

 

$

251.2

 

Colorado

 

 

 

 

 

 

 

 

 

Dollars

 

$

13,342

 

$

22,669

 

$

35,323

 

$

46,142

 

Homes closed

 

37

 

64

 

101

 

125

 

Average sales price

 

$

360.6

 

$

354.2

 

$

349.7

 

$

369.1

 

Central Region Totals

 

 

 

 

 

 

 

 

 

Dollars

 

$

274,591

 

$

405,773

 

$

801,051

 

$

1,228,358

 

Homes closed

 

1,117

 

1,475

 

3,184

 

4,378

 

Average sales price

 

$

245.8

 

$

275.1

 

$

251.6

 

$

280.6

 

East Region

 

 

 

 

 

 

 

 

 

Florida

 

 

 

 

 

 

 

 

 

Dollars

 

$

26,729

 

$

39,088

 

$

74,904

 

$

122,049

 

Homes closed

 

104

 

119

 

294

 

365

 

Average sales price

 

$

257.0

 

$

328.5

 

$

254.8

 

$

334.4

 

 

Companywide. Home closing revenue for the quarter ended September 30, 2008 decreased 35% to $372.9 million from $574.7 million for the same time period a year ago as a result of a 25% decrease in homes closed and a 14% decrease in average sales price. Our deliveries in the first nine months of 2008 dropped 1,409 units and $600.0 million when compared to the same time in the prior year.  These decreases reflect successive quarters of lower demand as a result of the homebuilding industry and economic downturns, which amplified the pressure on sales prices, which continued to decline as a result of the increased volumes of foreclosure in the marketplace.  In certain communities, we also selectively reduced prices as a targeted effort to bring our unsold home inventory levels to our desired range of 1-3 homes per active community, which we believe is the level required to sustain normal operations.

 

West.  The West Region’s 45% or $58.2 million decrease in home closing revenue for the third quarter of 2008 as compared to 2007 is due primarily to lower sales prices and closings volume in California.  The 13% decrease in average

 

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sales price and 98 fewer deliveries for California in the current quarter as compared to the same time last year reflect the significant decline in demand and the continuing use of discounts and incentives necessary to attract home buyers in this difficult and highly competitive market.  For the nine months ended September 30, 2008, home closing revenue was $242.5 million, down $125.6 million or 34% from the first nine months of 2007.  The Region’s year-to-date decreases reflect the market’s response to the rapid price appreciation experienced over the prior several years, exacerbated by the oversupply of inventory now available and the limited availability of mortgage financing.  We expect that these lower sales prices will continue and will affect closings in California and Nevada throughout the remainder of 2008 and into 2009.

 

Central.  During the three months ended September 30, 2008, the Central Region reported a $131.2 million decrease to $274.6 million of home closing revenue as compared to the prior year due to a 24% decrease in number of homes closed and average sales price decrease of 11% to $245,800 in 2008 as compared to $275,100 average sales price in 2007.  Although Texas still remains our strongest market with 783 homes closed in the third quarter of 2008, we have experienced noticeable slowing, as closing dollars decreased 29% from the same period of 2007, comprising 59% of the Region’s total revenue decline.  The declines in some of our Texas markets reflect the temporary impact of the immediate effects of Hurricane Ike, the third most destructive hurricane to ever hit the United States, but are now also being impacted by the financial crisis.   Arizona, which continued to struggle as excess inventory of new and existing homes locally and the lack of buyer confidence resulted in increasing sales price incentives, reported $75.2 million in home closing revenue in the third quarter of 2008 as compared to $119.6 million in the third quarter of 2007.  For the nine months ended September 30, 2008, home closing revenue was $801.1 million for the Region, down $427.3 million or 35% from the first nine months of 2007 due primarily to poor performance in Arizona and declines in Texas, as noted.

 

East.  In the East Region, we generated closing revenue of $26.7 million on 104 homes closed for the quarter ended September 30, 2008, decreases of 32% and 13%, respectively, versus the same quarter in the prior year.  For the nine months ended September 30, 2008, home closing revenue was $74.9 million, down $47.1 million or 39% from the first nine months of 2007.  These results were primarily due to declines in average sales prices and the prolonged declines in demand discussed above.  Additionally, for the nine months ended September 30, 2008, the declines are also attributable to lower closing volume from our Ft. Myers operation, which is currently winding down and nearly closed out.

 

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Home Orders

 

 

 

Three Months Ended
September 30,

 

Nine Months Ended
September 30,

 

 

 

2008

 

2007

 

2008

 

2007

 

Total

 

 

 

 

 

 

 

 

 

Dollars

 

$

254,381

 

$

390,366

 

$

1,061,394

 

$

1,532,448

 

Homes ordered

 

1,013

 

1,435

 

4,120

 

5,242

 

Average sales price

 

$

251.1

 

$

272.0