Meritage Homes Corporation
Q4 2007 Earnings Call Transcript

Published: 4 Feb 2008

[Operator:]

Good morning. My name is Tina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Meritage Homes fourth quarter 2007 conference call. (Operator Instructions) Mr. Anderson, you may begin your conference.

[Brent Anderson:]

Thank you, Tina, and good morning to everyone. Welcome to our conference call today. Our quarter ended on December 31 and we issued a press release with our preliminary results on January 17. After the market closed yesterday, we issued a release with our final results for the quarter and the full year. If you don’t have those yet, you can find them on our website at www.meritagehomes.com on the Investor Relations page. That will also have the slides that accompany this webcast. Please refer now to slide 2 of our presentation. Our statements during this call and the accompanying materials contain projections and forward-looking statements which are the current opinions of management and subject to change. We undertake no obligation to update these projections or opinions. Additionally, our actual results may be materially different than our expectations due to various risk factors. For a discussion of those risk factors, please see our press release and our most recent filings with the Securities and Exchange Commission, especially our most recent quarterly report on Form 10-Q and our 2006 annual report on Form 10-K. With me today are Steve Hilton, Chairman and CEO of Meritage Homes; and Larry Seay, Executive Vice President and CFO. I’ll now turn it over to Mr. Hilton to review our results for the quarter.

[Steven J. Hilton:]

Thank you, Brent. I’d like to welcome everyone to our call this morning. 2007 was certainly the most difficult year for home builders in more than 25 years. We experienced slowing sales, weak prices, high cancellation rates, inflated inventories in homes for sale and a credit crunch caused by fallout from the subprime market, all in one year. In addition, we saw large inventory impairments, a sharp drop in home starts and builders reporting losses after years of strong earnings growth. Balance sheet management and cash flow are now to the focal points of the industry. Despite this difficult environment, Meritage generated significant positive cash flow during the fourth quarter and used it reduce our debt by more than $150 million. We made good progress in reducing our unsold homes inventory, lot options, joint venture, real estate assets and strengthened our balance sheet in the process. We also streamlined operations and reduced overhead, commensurate with the declines in sales that we experienced. We are hopeful that the Fed’s actions and changes proposed by the government will help home buyers by reducing mortgage interest rates, raising loan limits and allowing more buyers access to loans from FHA, VA or Fannie Mae and Freddie Mac programs, which will allow lower down payments and have more flexible underwriting standards. Those may in turn help the home building industry but the effects of those actions are uncertain and their timing’s unpredictable. So we must manage through this downturn using our own experience and perseverance. We are focused on protecting our balance sheet and maintaining liquidity to both weather this downturn and better position Meritage for the future. I will briefly summarize our results for the quarter and the year and address the progress we made on our operating initiatives before I turn it over to Larry Seay, our Chief Financial Officer. He will walk through our financials as we normally do, and then we’ll take your questions. Slide 5

[Larry W. Seay:]

Thank you, Steve. Slide 18

[Steven J. Hilton:]

Thank you, Larry. This has been the most difficult year we experienced in home building in more than 25 years and we currently expect 2008 will also be challenging. Although we may incur additional impairments if market conditions deteriorate further, we believe the great majority of these are behind us, based on the relative strength of our Texas markets and the significant impairments and option terminations we have taken in other markets. We believe that buyer confidence must return in order for home sales and home building markets to improve. We look for stabilization in home prices, sales activity and lower cancellation rates to signal a recovery. We’re optimistic that the Fed and government programs will help the home building industry by adding liquidity to the mortgage market and allowing consumers to buy with confidence again. In the meantime, we plan to continue to operate conservatively, protecting our balance sheet and maintaining liquidity to weather the downturn. I appreciate the efforts of our employees that have worked so diligently to address the daily challenges and opportunities we’ve faced with an optimistic attitude toward better time ahead. Additionally, I’d like to recognize two executives who’ve done an exceptional job defending Meritage’s balance sheet over the last year. Larry Seay, our Chief Financial Officer, who has been our CFO for almost 12 years, has worked extra hard this past year to position our company for future success. Tim White, our General Council, who has been associated with Meritage since 1991, has been a tremendous resource in helping us navigate through legal complexities that manifest themselves in these challenging markets. Meritage is extremely grateful for both these gentlemen’s leadership during these stressful times. Our primary focus in 2008 is to strengthen our balance sheet and maintain liquidity. We’re committed to protecting shareholder value as we manage the company through this downturn, delivering high-quality homes and meeting the expectations of our buyers to strengthen Meritage for the future. We’ll now open it up to questions. The operator will remind you of the instructions for the Q&A.

[Operator:]

Your first question comes from the line of David Goldberg - UBS.

[David Goldberg:]

If you could maybe start by talking about how comfortable you are with the liquidity position that your land bankers have and just give some general ideas of how the land banks adjust; how that’s financed and any concerns that you might have about liquidity problems for the bankers.

[Larry W. Seay:]

Yes, we have leans recorded on the assets that are controlled by the land bankers. So we have Memorandums of Option recorded and so that gives us lean rights to the extent that those lean rights are subordinated to first lenders of the land bankers. We typically get some tri-party agreement and a recognition agreement where the lender agrees to honor the option agreement even if the loan is in default because the land banker’s defaulted. Accordingly, we think we’re very well protected from issues that land bankers themselves might have regarding the liquidity.

[Steven J. Hilton:]

I’ll just add to that, David, we haven’t had any situations that we can recall, where we wanted to buy a lot and we couldn’t because the land banker couldn’t deliver it to us.

[David Goldberg:]

That’s great. And my follow up question was, Steve, you mentioned the four JVs that have gotten notices of default?

[Steven J. Hilton:]

Yes.

[David Goldberg:]

I was wondering if you could give us an idea of the potential scenarios, how that might play out? Is there any chance you might end up just consolidating it and buying the JVs out? And maybe just how the negotiations are structured and what the possible outcomes are?

[Larry W. Seay:]

We think we’re well protected on the legal side from somehow that debt ever becoming recourse and us having to pay it off and having to consolidate the venture. On the other hand, there may be occasions where we think it’s the best interest to Meritage two potentially buy the lots out of a venture. I don’t think that’s going to be a scenario that happens often, but it could be a potential scenario.

[David Goldberg:]

So it’s not clear how those four are going to work out, if we just look forward?

[Steven J. Hilton:]

I think it’s pretty clear. It’s pretty clear and we really tried to make it clear with the slides and the presentation that we made today that the risk of us making a significant investment in any of those ventures is pretty minimal.

[David Goldberg:]

And then I could maybe sneak one more in. Just wondering what timing for the take downs of options that are outstanding now? If you have any deals coming up in ‘08, option take downs where you want to stay in the contract and so you’ll be forced to take on options even though you might normally pass on it and try to postpone it a bit?

[Steven J. Hilton:]

No we don’t have any of those that we believe are very significant that would have a negative impact on our cash flow.

[Operator:]

The next question comes from the line of Carl Reichardt - Wachovia Securities.

[Carl Reichardt:]

You mentioned thinking about shrinking the community count down by 20% in 2008 versus 2007, Steve. You’re expecting that to be a market exit type of shrinkage or more of a broad-scale across the footprint type of shrinkage? And could you give us a little more detail on those plans?

[Steven J. Hilton:]

As you know right now about half of our communities are in Texas and we don’t expect our community count to change too much in Texas over the next year. But we do expect our community count through natural attrition to decrease pretty significantly, particularly in places like California where our community count − unless we buy more land, which we don’t intend to at the moment − reduce by probably almost half by the end of this year. Same for Arizona, less so for Nevada and Orlando. We’re not planning on exiting any markets this year. We still have work to do in all the markets that we’re in, and we evaluate them on a quarter-by-quarter basis. But the communities outside of Texas will decline at a much larger rate than the company average.

[Carl Reichardt:]

And then secondly, the finished goods inventory and the unit basis is flat with last year, which is better than the industry which is up, but can you talk to me a little bit about any specific marketing or inventory flush plans you might have for the first quarter as we head into the selling season? What are you doing to get your salespeople jacked up and excite some buying here when you know you’re going to have traffic?

[Steven J. Hilton:]

You just focus more on the blocking and tackling. We’re looking at every single community; doing our competitive market analysis, seeing how we stack up against the competition, if there’s anything we can do to change up our product or to increase or decrease our features; fine-tune our incentives and just focus harder on individual communities. We do have two multi-family projects, one on Fort Meyers and one in Las Vegas that we expect to be able to liquidate this quarter, which will have some impact on our balance of unsold homes, probably about 50 to 60 homes combined. And then we have some other communities that we’re putting some extra focus on that we expect also to help us reduce our balance of unsold homes in this first quarter and roll into the second quarter.

[Operator:]

Your next question comes from the line of Nitin Dahiya - Lehman Brothers.

[Nitin Dahiya:]

Looking at the cash flow target that you mentioned about paying off the bank debt by the third quarter, if you take out the tax refund, then you’re essentially saying you’re going to probably generate at least $10 million of free cash over the first three quarters. And should we expect any meaningful lumpiness in that this year? Obviously there’s a seasonality, but then, this year being a little different?

[Steven J. Hilton:]

I think we’re going to do much better than that. But I don’t want to commit to a bigger cash flow number. But you’re right, after you subtract out the tax payments, that’s not a lot of cash flow, so I think we’re setting the expectations low and hoping to significantly exceed that. But certainly the first quarter of the year is a slower selling quarter than the second and third quarter, so it’ll be harder to make progress earlier in the year, and as we get more into the year, we expect to accelerate our efforts.

[Nitin Dahiya:]

I see, so your own internal target is probably some time even by the end of the second quarter or early third quarter you could report that you have paid that off?

[Steven J. Hilton:]

Possibly.

[Nitin Dahiya:]

Fair enough. And how much of the cash flow projection reflects expectation of reduction in the spec inventory? Is there a target you have for spec or how much are you factoring in when you look at your cash projection?

[Steven J. Hilton:]

We certainly have internal targets. We’re not going to come out and say we expect to sell x number of specs this quarter. A lot of it has to do with the cancellation rate. If we can manage the cancellation rate better, we’ll create less accidental specs and we’ll have more success in reducing the total number of specs outstanding, particularly the finished spec portion.

[Nitin Dahiya:]

And lastly, I was a little surprised in your comments when you said that you do not expect future impairments, obviously with pricing...

[Steven J. Hilton:]

No I didn’t say we didn’t expect future impairments. We said we expect the worst of the impairments are behind us and the impairments going forward should be a lot less than what we’ve experienced in the past.

[Nitin Dahiya:]

Okay, fair enough. But are you factoring in any incremental price declines when you tested for impairment at the end of fourth quarter?

[Larry W. Seay:]

Yes, we run pro formas every month on our communities if not more often so the impairments that were taken at year-end reflect our current pricing and a lot of times as we’re going into the impairment process the divisions are a little more aggressive in instituting price reductions or additional incentives just to make sure they get them in that quarter’s impairments. So I think we’ve already been pretty aggressive in the fourth quarter price reductions although, again, we’ve said in this market it is hard to tell if there’ll be further price reductions and further impairments due to additional competition.

[Operator:]

Your next question comes from the line of Joel Locker – FTN Securities.

[Joel Locker:]

I was curious about your land options, you terminated around $48 million of them but the actual drop from the third quarter to the fourth quarter was around $20 million. So I was wondering if the other $28 million was partially letters of credit that were off balance sheet that maybe you converted to cash or what was behind that?

[Larry W. Seay:]

There are other items like letters of credit that could be sitting over in accrued liabilities and have not been drawn yet as a deposit. The other thing is there could be pre-acquisition costs that are also being impaired, too.

[Joel Locker:]

And pre-acquisition costs, would that be in other assets?

[Larry W. Seay:]

No, that typically is just in inventory.

[Joel Locker:]

And then your other assets fell about $81 million sequentially. What was the reason?

[Larry W. Seay:]

I think that’s just got to be a classification issue. I’d have to go look into that. I don’t recall right off the top of my head.

[Joel Locker:]

I’ll catch up after the call. And the lot count went from held steady, the owned lot count at 10,400 sequentially but you took down I think 1,040 or so and closed 2,100 homes. So that was about 1,100 that could have dropped off. But was it just a factor of some of the owned lots that decreased in backlog? Because I think you separate the actual owned lots versus owned lots that are in backlog.

[Larry W. Seay:]

The lots we have houses sitting on are not in our lot count. Those are in WIP and don’t get counted in lot count. Obviously each quarter we took about 1,000 lots down. We start houses and that’s typically the main item. I have to check in to see what else is going on that would cause your reconciliation not to exactly tie out but basically...

[Joel Locker:]

Right, it seems like it would make sense if your backlog went from 3,379 to 2,288 so there went 1,000 of the closings right there. And then the other 1,000 were taken from owned lots and then put into the new backlog and then you purchased a 1,000 or so. So those numbers work to keep owned lots at 10,400.

[Steven J. Hilton:]

Yes, I think we started a few more houses, 100 or 200 more houses than we actually purchased. So as we go through this year, we’re expecting to be able to continue to start more than we purchase, to start to nominally bring down the number of lots in the owned category down.

[Joel Locker:]

And do you have an idea of how many options you want to purchase in the first quarter?

[Steven J. Hilton:]

We hope to be consistent with what we’ve done in the second half of 2007 and maybe in some respects even be able to buy less. We’re negotiating every deal and it’s very hard for us to give you a real projection because it’s going to depend on what the market conditions are. And in some cases we’re buying lots on an as-needed, as-we-make-sales basis.

[Joel Locker:]

So lastly, if you closed on a typical conversion rate of 1,200 homes or so, would you expect your actual exercise of lot options to be 1,000 or lower like they were in the fourth quarter?

[Steven J. Hilton:]

I wouldn’t expect that we’d be buying more than 1,000 lots in any quarter this year.

[Operator:]

Your next question comes from the line of Nishu Sood - Deutsche Bank.

[Nishu Sood:]

Following up on that previous question. Steve, last year, in the first half of the year when you were taking down more lots than you were delivering out in your backlog and your specs, you talked about still continuing to adhere to your longer term strategy, taking down lots where you still saw some profit potential, but generally from your comments, just on that last question, it sounds like your outlook has changed, much greater focus on cash flow and less focus let’s say on future potential profit. Is that accurate?

[Steven J. Hilton:]

Yes, unless somebody’s been living in a cave, things have dramatically changed from spring of 2007 to today. Not only do we have the debacle of the credit crunch of last summer, but housing prices have declined dramatically in many of the markets that we are in, particularly in the West. What we were practicing in the first half of the year is completely out the window and we are in much more of a defensive position today and those subdivisions I talked about that were profitable in the first half of 2007 are not as profitable today, and we are just focused on paying down debt and generating cash. I want to have a significant cash balance in this company at the end of this year so that we can take advantage of some of these distressed lots out there that we can buy at lower prices when the market turns around, and that may not be this year, it may be next year, or it may be later, but as business continues our balance sheet continues to liquidate and we will pay down debt and generate cash.

[Nishu Sood:]

Looking at some of the figures you gave here, the lot purchases that you reduced and I think the numbers you had the given were $55 million and about 650 fewer lots. If you look at the per lot value there you come out to about $85,000 or a pretty high number. I know that doesn’t work exactly that way, but where are you walking away from more of your contracts. I know you have said that you are focusing a lot more on Texas, so is it mostly in Arizona and California?

[Steven J. Hilton:]

One of the reasons I’m very bullish is that we won’t have a lot of impairments going forward, particularly as it relates to option terminations, because we have walked away from so many already, and we just don’t have that many more. Particularly in California, Arizona and Nevada, we just do not have that many options outstanding today. Larry, you might be able to give more color on what we did this last quarter, but I know we walked away on a couple of larger deals in Orlando, and we terminated some small deals in Texas. To date, there’s been relatively few impairments or option terminations in Texas, but on the other hand we don’t expect to see a significant number of option terminations or impairments in the Texas market. So, Larry, do you want to add anything?

[Larry W. Seay:]

I’d point out that if you look at the land bank deposits remaining, we only have about $7 million of land bank deposits remaining in Arizona and only $10 million in California, so we’re down to the point where you just don’t have that many land bank deals out there anymore. And most of the deposits, as you see in land bank and developer carrier are in Texas, where again we just don’t see the market getting as soft as it’s gotten in other places. I would add that we will continue to take lots down because we still have a bunch of communities that are profitable, that don’t have a lot of lots on the ground or maybe have no lots on the ground, so every time we sell a house and want to start one, we can take a lot down. People ask us why are we taking any lots down, well it’s because a great majority of our communities we need to continue to take lots down to be able to start houses. So that 1,000 number was not going to go to zero; it might go to 800, but we still need to take lots down every quarter to be able to start profitable houses.

[Nishu Sood:]

And then a quick housekeeping question, Larry, there was $5 million of interest that you weren’t able to capitalize this quarter, so I was just wondering if you could give us some color on that.

[Larry W. Seay:]

Yes. We are in a position now where our inventory under development has shrunk, either because we have now classified some projects as not under development, or just the total balance because of the lowering of the level of business has shrunk, so we’re not able to capitalize 100% of our interest incurred to the asset balance. And accordingly, we’re starting to expense that every quarter. So until we get our debt paid down some more and business starts to pick up, you’ll probably see a little bit of interest expense roll through the income statement directly instead of being capitalized and rolling through cost of sales.

[Nishu Sood:]

And thanks a lot for all the detailed disclosures as well; it’s always very helpful.

[Operator:]

Your next question comes from the line of Jim Wilson - JMP Securities.

[Jim Wilson:]

My two questions, first we’ve talked a lot about your lot position now, what concentration in Texas with all the write-downs, but Larry do you have the number, I’m sure it will be in the K, of the percentage of assets now in dollars given all the write-downs in other places that is Texas versus a percentage of the total?

[Larry W. Seay:]

Yes, we do that on slide 13 for owned real estate and option deposits. So we have a total between owned lots, not counting pre-sold inventory or specs or houses but just speaking of lots, we have about $180 million of owned lots or land in Texas and then another about $37 million of option deposits for a total of about $215 in land or land-related assets; that is about 30% of the total.

[Jim Wilson:]

And then the second question on your four JVs that are in default, can you characterize the partners? Are they other public builders? Are they private guys that might have some of their own financial issues or, characterize who’s in there with you?

[Larry W. Seay:]

Yes, they’re a combination of private and public guys and everybody has their own issues they’re dealing with. These are joint ventures that for one reason or another they’re not working out right and because of discussions with lenders we’re having going on, I don’t think it is appropriate to really comment much father than that.

[Jim Wilson:]

Okay. Thanks.

[Larry W. Seay:]

Somebody on the call asked about other assets going down so significantly and most of that is goodwill decreasing from the $120 or so we had on the books at the beginning of the year to $0 at the end of the year so that’s the answer to that question, by the way.

[Operator:]

Your next question comes from the line of Keith Wiley - Goldman Sachs.

[Keith Wiley:]

Quick questions on the joint venture details you provided. The slide indicates that you have an obligation to fund interest payments of up to $11 million. Would that be total or is that on an annual basis?

[Larry W. Seay:]

That’s the total commitment we have for the venture and at that point we have no other equity contribution requirements. That number already shows up as a contingent liability because it’s supported by an $11 million letter of credit so that number is already in our letter of credit contingent liability disclosure.

[Keith Wiley:]

And then the other question is just on these “bad boy” guarantees, my understanding is that they’re not really troublesome unless the mezzanine financing is collateralized by equity. Do you have any of these and if so, can you provide an update on that situation?

[Larry W. Seay:]

Yes, we have discussed, we have a couple of mezzanine facilities and we’ve discussed those situations and the protections we have in the mezz lender documents with our attorneys and think that we are well protected. And again, I don’t think it’s appropriate for me to go into any more detail than that.

[Operator:]

Your next question comes from the line of Ben Mackovjak - Rivanna Capital.

[Ben Mackovjak:]

Can you break out the other assets?

[Larry W. Seay:]

Not off the top of my head, but the Q will have further detail on that.

[Ben Mackovjak:]

And then do you have any cash flow from operations number you can share with us?

[Larry W. Seay:]

We do not have that schedule finalized yet, and again that will be in the Q, but obviously the debt reduction goes a long way to explaining what our cash flow from operations is and obviously there’s a few differences but the number should be close to the debt reduction number.

[Operator:]

Your next question comes from the line of Dan Oppenheim - Banc of America Securities.

[Dan Oppenheim:]

Just wanted to follow up on some of the comments you’ve made on Texas. If you could talk a little more about your sales and pricing strategy there going forward, understanding that things have held up relatively better in those markets, we’ve still seen backlog come down quite a bit. If it continues to come down is there somewhere where you look to get a bit more aggressive?

[Steven J. Hilton:]

I think we’re being a little more aggressive on our price so we can maintain our volume there, but we’re still very profitable in all the markets. I’d say not as much in San Antonio, but certainly the other three markets we’re real profitable and we’re real comfortable with our position there, and we don’t expect 2008 to be that much different than 2007.

[Dan Oppenheim:]

And then just on the deferred tax assets, I was wondering if you could walk through some of the assumptions there on not taking a reserve against the remaining balance. Just looking at the sizable loss in 2007 there, it seems like it would be tough to avoid a cumulative three loss period. Can you just talk about what the basis is there? And we’ve seen accountants be a bit more aggressive on pushing for charges with some other builders.

[Larry W. Seay:]

Yes. I think managements of the different companies have different perspectives and I also think the accounting firms have different perspectives. We believe that the home building industry is certainly a cyclical industry that has large peaks and valleys and that a three-year measurement period is too short for the home building industry. I think that there are other builders who agree with that and who have discussed that with their accountants and have been able to use a longer period, maybe a four-year period. I know that in some cases, people are looking out and projecting what a future period might look like. Some people say it shouldn’t be based on projections; it should be based on actual experience. So whether you look towards what you expect to have happen in 2008 or just what has happened in 2007, has an impact on whether you would take a reserve. But beyond that what I would point out is that of the $141 million tax asset we have, we’re going to collect we believe, our trigger, around $40 to $60 million in 2008, which can be carried back to 2006 where we have plenty of profits, and would be collected in 2009, and the balance of $80 to $100 would be the balance that would have to be carried forward to points in time where we would expect to be profitable again. And I think at this point in time it would be premature to assume that we’ll never make money over the next 20 years that probably in the next year or two or three, some point we don’t know exactly when, we’ll become profitable again and get back to normal and we will be able to carry that loss generated in 2007 and 2008 forward to those years. So at this point in time, we think it’s appropriate to not be reserving that asset.

[Dan Oppenheim:]

The $40 to $60 million is that through your projected closings and where the impairments actually lay and realizing that unlocking those assets or held for sale of land, or?

[Larry W. Seay:]

Yes. It’s all the above. In some cases it’s option terminations that we weren’t able to formally terminate in 2007 that will be formally terminated in 2008 and the rest of it would be land sales and house sales, those kinds of things. So it is an estimate. That’s why we use a broad range of $40 million to $60 million.

[Operator:]

Your next question is a follow-up from Joel Locker – FTN Securities

[Joel Locker:]

Just on the capitalized interest front. What was the balance at the end of 2007 and end of 2006, if you have it?

[Larry W. Seay:]

Yes. The beginning balance at the end of 2007 was $33 million; at the end of the year it’s $41 million, but I would point out that at the beginning of the quarter it was $47 million. So we peaked at the end of the third quarter and we’re now starting to bring that number down.

[Joel Locker:]

Right, through the interest expense that you’re reporting.

[Larry W. Seay:]

Right. And as inventory shrinks, you would think that the interest contained in that inventory would also run off, too, which it is.

[Operator:]

Your next question comes from the line of Ramin Kamali - Credit Suisse.

[Ramin Kamali:]

Both my questions have been answered but just a couple questions on the JVs. Do you provide any completion guarantees at all for any of these equity or cash joint ventures?

[Larry W. Seay:]

Yes, we do have some completion guarantees, not in all cases. A lot of times the land may be raw land without a development plan, but in some cases we have completion guarantees. And in most cases, if there are completion guarantees, it requires a lender to continue to fund in order for us to be held to doing the work. Not in all cases but in most cases.

[Ramin Kamali:]

Have you attempted to potentially quantify what this can be?

[Larry W. Seay:]

No, right now we don’t think there’s anything that should be accrued for accounting purposes and because either the joint ventures are performing or we have good defenses in the ones that aren’t.

[Operator:]

We have now reached the allotted time for the question and answer session. I will now turn the call back over to the presenters for closing remarks.

[Steven J. Hilton:]

Thank you for joining us this quarter and we look forward to updating you on our results at the end of the first quarter and we look forward to talking to you then. Thank you.