Meritage Homes Corp (MTH) 2006 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Meritage Homes Corporation 2006 second quarter earnings conference call. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I will now turn the presentation over to your host for today's call, Brent Anderson, Director of Investor Relations. Please proceed, sir.

Thank you, Leticia. I'd like to welcome everyone to the Meritage Homes second quarter 2006 earnings call and webcast. We issued our earnings release yesterday. If you haven't received it yet, you can access it on our web site at www.meritagehomes.com, along with the slides that accompany this webcast.

Our statements during this call and the accompanying materials contain projections and forward-looking statements for which I refer you to Slides 2 and 3 of our presentation. These projections and other forward-looking statements are the current opinions of management. As such, they may change, and 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 most recent filings with the Securities and Exchange Commission, especially our 10-K and 10-Qs. We refer you to certain non-GAAP financial measures such as EBITDA in our comments, and have provided a description and reconciliation of these in the earnings release.

Participating on the call today are Steve Hilton, Chairman and Chief Executive Officer of Meritage Homes, and Larry Seay, our Chief Financial Officer. They will discuss our results for the second quarter and the first six months of 2006, and our outlook for the future. At the end of their prepared remarks, we will take questions from the listening audience. I will now turn the call over to Steve Hilton and refer you to Slide 5 of our presentation. Steve?

Thank you, Brent. I'd like to welcome everyone to our conference call and webcast today. I am sure that most of you have already seen the results that we issued in our press release yesterday. I will recap some of the highlights and comment on what we were experiencing in our markets, then turn it over to Larry to walk through the numbers. Beginning with Slide 5, we reported second quarter 2006 results yesterday.

Home closing and revenue, net earnings and diluted earnings per share each set quarter records for Meritage, and were second only to the fourth quarter 2005 results as the best quarter in our history. We reported diluted earnings per share of $2.82 for the quarter, 38% higher than a year ago, mostly driven by better than expected gross margins. We closed 2722 homes, up 30% over a year ago. Our home closing revenue grew 39% to $903 million, with a 7% increase in average sales price. Pretax earnings increased 32%, even after including approximately $21 million in expenses related to severances, FAS123R implementation, and handful of write-offs which Larry will discuss later.

Moving on to Slide 6, our year-over-year comparisons for the first half of 2006 are even better. The number of home closings were up 35%. Home closing revenue was up 45%, and net earnings were up 52%, excluding the refinancing charge from 2005 results. Including that charge, net earnings were up 88% over last year. Our second quarter and first-half 2006 results were largely due to closings that were sold last year in an environment of robust demand and strong pricing power. On Slide 7, you will see while current market conditions are now weaker in many markets, our record results from the past two years have allowed us to strengthen our financial position greatly.

For example, we have more than doubled stockholders' equity since mid 2004. We have deleveraged the Company, and improved our debt ratios. For example, our net debt-to-capital ratios improved to 42% versus 50% just two years ago. We are covering our annual interest cost by 12.7 time versus 7.9 times one year ago. And our debt level is only 1.2 times EBITDA on a trailing 12-month basis, as compared to 1.7 times at this time last year.

On Slide 8, you will see we have broadened our geographic footprint by reinvesting in new lot and land positions, to diversify our asset base and revenue streams. We now have 22 divisions in 14 markets and in six states, coast to coast. We have returned over $151 million to stockholders by repurchasing nearly 3.2 million shares of Meritage stock since 2004. That is about 12% of the shares that we had outstanding at the beginning of 2004. In addition to producing superior earnings growth, we believe these balance sheet improvements put us in a very solid position today to manage the Company through the current slowdown in demand, while maintaining flexibility to take advantage of future growth opportunities.

Please go to Slide 9 now. In the second quarter, Texas sales were up year-over-year with a 10% increase in homes ordered, and a 10% increase in average sales price, combined to produce 21% order value growth. Our markets in Texas are strong and represented about 42% of our total order value this quarter. Like other builders, we experienced much softer market conditions in many of our other divisions.

Sales in most of our markets outside of Texas have continued to decline in recent months. In fact, we have experienced a sharp pullback in some areas due to decreasing demand from investors and speculative buyers, increasing cancellations and inventories in many of our communities, and increasing price concessions in many of our markets.

In addition, we have faced difficult comparisons this quarter to last year's sales, when strong demand drove total orders to an all-time high in the second quarter of 2005, and rapid price appreciation combined to drive a 44% year-over-year increase in total order value. I am on Slide 10 right now. We very well sell into a high demand at that time, but those commissions are not sustainable long term. These conditions not only increase competition for home builders, but also make it much more difficult for buyers to sell their existing homes, resulting in higher order cancellations this quarter.

On Slide 11, for example, our gross sales were down 17% compared to the previous year's quarter, but increased cancellation rates reduced net orders by 28% for the same period. We believe our Northern California markets, which first began slowing in the fall of last year, have begun to stabilize with cancellation rates decreasing in July to the low 20% range; however, Arizona, Nevada and Florida began weakening early in 2006 and are still in transition, with cancellations running on average in the 30% to 40% range during the second quarter. These changing conditions across our markets make it difficult to accurately predict our demand going forward.

Slide 12. While we continue to focus on our long-term strategy, we are incorporating a number of initiatives to respond to changing market conditions. Firstly, we are actively reassessing our land positions in every market, prudently increasing landowner control in stronger areas and curbing additional investments in slowing markets until they show signs of stabilization and recovery. Secondly, we are carefully managing lot takedowns and the dollar exposure we take on to our balance sheet in the form of unsold lots.

Next, we are reducing overhead in many markets experiencing a slowdown, to more closely match current and projected revenue levels. And lastly, we are continuing to monitor changing market conditions to ensure that we are able to compete successfully and maximize your operating profits. With that I will turn the call over to Larry Seay, our Chief Financial Officer, for additional review of our results.

Thank you, Steve. As Steve noted, our 30% increase in earnings this quarter was largely driven by sales made in the latter half of 2005, on the tail end of a period of high demand and pricing power, which drove stronger margins. You'll see in Slide 13 that gross margins on home closed increased to 24.3% in the quarter, about 90 basis points higher than the 23.4% in the second quarter of 2005 and were down on a sequential basis from 25.3% in the first quarter of this year. We believe our first quarter margins will be the high watermark for Meritage for some time.

Gross profit this quarter was reduced by 7.3 million per write-offs, which reduced gross margin by about 80 basis points. We re-evaluate our projects each quarter to assess whether current market conditions, [main us assay] additional writedowns of assets. And based on current market conditions, we do not believe further writedowns will be warranted. Second quarter 2006 pretax earnings were impacted by severance and other employee related departure cost of 11.7 million, as well as an additional 2.4 million of stock based compensation expense related to the implementation of Financial Accounting Standard 123R, which was not effective in 2005.

The 11.7 million primarily consists of payments made under our former CEO's employment agreement, and include some severance payments made pursuant to other staffing adjustments. Excluding the impact of the stock option and severance charges, [TNA] expenses as a percent of total revenue would have remained flat in comparison to the prior year’s second quarter at 4.1%. In addition, excluding the impact of these two charges and the asset write-offs, all of which total 21.4 million, pretax margin would have improved over the prior year's quarter to 16% from 13.7%.

Moving to Slide 14. During the quarter, our increase in the number of communities helped offset a lower sales pace. We had 204 actively selling communities at June 30, 2006, 25% more than one year ago. We plan to end the year with approximately 215 to 220 actively selling communities, as projects in our pipeline begin sales activity.

While average sales prices on closings this quarter were up 7%, average sales prices on orders were down 4%. Most of this decrease was a result of a shift in sales mix, with more orders coming from Texas. Average prices in Texas are about $251,000, compared to our Company average of $328,000; however, average sales prices were also pressured by lower demand, increased competition and sales incentives.

Referring to Slide 15, the combination of more sales from lower priced markets like Texas, and reduced margins in higher priced markets like California, will tend to reduce our gross margins for the Company as a whole in the future, as we previously noted. We have experienced historically high gross margins over the last two quarters, but we emphasize that we fully expect margins to decline over the next several quarters.

On Slide 16, from an asset management perspective, we are working on several initiatives. We've curbed our investment in new properties and held our lot supply to roughly five years. Lots under control at June 30, 2006 were approximately 52,900, down 2% from the beginning of the year, and we continue to control a large portion of these lots, 89% at June 30, through lot options. We feel this is a particularly important part of our strategy in this transitional period.

As you can see on Slide 17, spec inventory levels are up due to cancellations, not due to planned spec building. Even so, we have less than 1300 total specs, 286 completed specs, and the rest under construction.

While this is about double our norm at around 18% of houses under construction, it is still at a very manageable level and we are working hard to resell these homes. We are also working to improve inventory cycle times that had lengthened during the last couple of years as robust demand outstripped production capacity. As part of this initiative, we are also working with our subcontractors and suppliers to reduce construction cost as their workloads lighten.

These factors, coupled with slower demand, are having an overall positive impact on asset growth. We have limited growth and total assets since the beginning of the year to 8%, while revenues for the first six months of this year have increased 45% from the first half of last year.

We plan to continue to look at ways to improve asset efficiency during this transition period. Advancing to Slide 18, we expect that cash flow from our operations will increase as we control asset growth that could be used to maintain or reduce leverage, or for future share repurchases.

Of course we will continue to look for opportunities to properly grow our business as appropriately priced and timed investments are identified. During the quarter, we entered into a revised and amended credit facility to provide ample liquidity to meet our future needs.

We increased our facility by $250 million, to a total of $850 million at the end of the quarter, and we had remaining borrowing capacity of $496 million after considering our most restrictive covenants. Thank you for your attention and I will now turn the call back over to Steve.

Thanks, Larry. I will pick up again at Slide 19. Our strategy is not growth for the sake of growth, but rather growth to deliver superior profitability for our investors within a managed risk profile. We will continue to open new communities where we believe demand is sufficient for us to generate good returns.

For that reason, we don't build a lot of spec homes in a period of slower demand. That tends to create an oversupply of homes and greater discounting, which doesn't benefit homeowners or builders. We believe we can be competitive without undermining the markets in which we operate for the sake of short-term gains.

Looking at Slide 20, our after tax return on assets improved this quarter to approximately 17% from 13% a year ago, and return equity improved to approximately 40% from 31% a year ago. Considering that we are now a $3 million-plus Company with a track record of 18 consecutive years of top and bottom line growth, these are clearly superior returns relative to the market, even within our own industry.

Our earnings performance for the first half of 2006 surpassed our expectations and positions us to achieve our 19th consecutive year of record revenue and net earnings. However, as demand continued to slow during the second quarter in certain key markets, we expect that earnings trends will be weaker for the next several quarters. We expect revenues for 2007 will be somewhat lower than achieved in 2006.

Moving to Slide 21, based on our reduced backlog, higher cancellations and slow order trends, we now expect total revenue of 3.5 to $3.6 billion in 2006, and diluted EPS of $10 to $10.25. This implies a year-over-year increase of 5% to 7% in earnings per share, excluding the 2005 refinancing charge, and approximately a 25% return on equity for our stockholders in 2006. For the third quarter, we expect home closing revenues of approximately 875 to $900 million.

We also anticipate earnings of $2.15 to $2.40 per diluted share, in line or just slightly down from the third quarter of 2005. While the market transitions to more sustainable sales levels, we remain committed to growing our market share, while carefully managing our balance sheet to produce superior returns for our stockholders. With that, we will conclude our prepared remarks, and now open the floor up to questions. Operator?

[Operator Instructions] Your first question comes from the line of Alex Barron with JMP Securities. Please proceed.

Thanks, guys. Good job on the quarter. I wanted to ask you if you could tell us what the impact of your incentives was on margins this quarter.

Alex, this is Larry. It is difficult to break those out, because incentives are given in many ways. So we tend to look at our net pricing and don't really tend to look at what the gross price is net of margins. Steve, I don't know if you want to add to that and try to give Alex --

The impact would be pretty nominal for this quarter, because it would only be impacting homes that we resold from cancellations at lower prices than we had previously sold them at. So, I don't believe it to be real substantive this quarter, but I believe as the quarters start to roll forward, we will definitely be closing more houses at -- with lower margins.

So maybe then a better question would be, what do you think on the new orders, the impact of these incentives are?

Well Larry, are we giving that kind of specific guidance?

Again, Alex, the way we give incentives is in many, many ways, and oftentimes it doesn't show up as a dollar reduction of the sales price. Sometimes it is a free incentive.

And we have, in some ways, tracked those, but in other ways it is more difficult to track them. So I don't want to hazard to give you an approximation on something that I am not comfortable with.

But I would tell you, Alex, that in some of the markets that are more challenging outside of Texas, incentives are ranging between 3 and 15%. So as those margins start to normalize, our gross margin is going to come down, and we could easily see gross margins heading back down into the low 20s from the mid 20s.

Okay, got it. I guess my second question has to do with your option strategy. I am kind of wondering what percent -- I know the overall percent is like 90% of your total lots are option, but how does that break down between, sort of, options with finished lots with land developers versus options with land bankers?

Alex, our true land banker options are running about 19,000 of our total 52,000. So, that percentage is around -- kind have been in the, kind of 35 to 40% range. You know beyond that, we control a lesser number through developer options, probably in the, kind of, 8,000 kind of range.

So that, on a percentage basis, around 15. And then we own about -- as we said, about 10%. And the rest are either controlled through purchase contracts, which generally will be in the kind of 15 to 20,000 range too, and then there is a small number controlled through joint ventures. So I hope that kind of gives you a little bit of perspective.

Yeah, that's helpful. And lastly, the write-offs you guys took this quarter. What type were those? And in what markets?

Go ahead, Steve.

They were a combination of land deals that we had under contract that we decided were no longer feasible going forward into the current market conditions. They were writedowns of existing operating communities that weren't meeting the minimum profit expectation; and they were writedowns of option deposits that may or may not be viable going forward.

Okay. In which markets?

There was some in California. There was some in -- a little bit in Florida. There was some in Colorado. Not any one particular market.

Okay. Great. Thanks, I will get back in the queue.

Thank you.

Your next question comes from the line of Stephen Kim with Citigroup. Please proceed.

Thanks, guys. Good quarter, considering the environment.

Thank you.

I guess my first question relates to the SG&A. You indicated that x-ing out a couple of sort of unusual items, that you were actually flat year-on-year, in the sort of 4.1, or low 4 as percentage of sales. Can you give us a sense for whether or not, on the G&A side, that's a pretty good number to ratio to use going forward, or if for some reason that would be elevated from there?

I'd expect it to go up a little bit because it is very hard to cut your overhead as fast as your sales are declining. With that said though, we are making great efforts to match our expenses to our revenues, but I do expect over the next few quarters that that's going to increase somewhat. Would you agree, Larry?

I think it will go up because, as you said, it is hard to cut back quite as quickly as revenues may cut back. You know, our guidance, Steve, is kind of based upon a total SG&A net of other income, kind of in the 10 to 10.5% range. So, if that gives you some idea in answering your question.

Say that one more time, a total SG&A in the 10.5 range?

Yes, net of other income, 10 to 10.5 range.

For this year or sort of on going?

That is for the next couple of quarters.

Got it, okay. Great. Second question I had related to your inventory. Do you mind giving us a breakdown of the inventory, the way you generally provide it in the Q, or at least give us some rough idea of what those categories look like?

Steve, I don't have that number to give you over the phone. We will certainly have that in our 10-Q, but I don't have it today.

Okay. Would it be fair to say that the land portion of that inventory grew a little bit this quarter? Or do you think it dropped?

Yeah, I will say that generally speaking, we should -- as our business kind of flattens out and slows a bit, you will see presold inventories come down a bit, and you will see finished lot inventory or land under development go up a bit.

Oh, I see, okay.

I think land will go up as we buy lots, put them on our balance sheet, to keep certain options that we believe are very financially viable, alive. At the same token, we are not buying as much land, so deposits on land will, overtime, start to decline, so I think the net result is the increase in our assets should be very modest.

Okay. Can I ask you a sort of a general question? One of the questions that I field fairly often from investors is one which sort of tries to get at the relationship between builders such as yourselves, and the land sellers. You know there is some confusion as to why -- there has been some confusion over the years why a land seller would option lots to a builder in the first place. I think there are some things there that you can probably shed some light on for people.

But now that we have entered a new chapter, the way that thinking or that confusion is starting to sort of manifest itself, is that people don't understand why the builders are in a position where they truly can, quote unquote, "stick it" to the land sellers, because obviously these land sellers are people whom they have long term relationships with, and they're going to be very reluctant to, sort of, really try to get aggressive. But obviously we are seeing builders walking away from options and renegotiating things. Can you just help us sort of qualitatively understand why that relationship with land sellers isn't one that really handcuffs you in this environment where you have to go back to them and try to renegotiate?

Well, Steve, it is a good question, but it is all relative to supply and competition. In a market like Texas, where there is an abundance of lots and it is very easy to bring lots to the market and get them entitled, developers compete with each other, and the way they increase their market share is by offering builders terms and options. And markets like Arizona or California, where lot supply isn't as abundant, it is cash and carry, because the lots are very -- much harder to come by and very much more competitive.

Now with that said, I think as time goes on in some of the outlying markets in Arizona and California and in Florida, you may see a return of developer options. And that may be the difference in how land sellers compete with each other and liquidate their inventories by offering builders the incentive of a rolling option. Hopefully that answered your question.

And Steve, and on the purchase contracts where you are actually buying land from a land seller like the farmer or a developer, people tie up land all the time and don't necessarily close, and I think you are just seeing that people go through their due diligence, the builders do, and they decide not to proceed, and I think you are just seeing an increase in that. And an increase and at times now where the money -- deposit money has gone hard.

Where as before, in better times, in the reevaluation of the project tied up under a purchase contract, essentially it still looked good. Now they are reevaluating before they close, after the money has gone hard, and deciding not to proceed. I think the sellers are used to seeing that kind of thing occasionally, and I think that they will just recognize that is part of the market today.

Okay. Great, thanks, guy

Thank you.

Your next question comes from the line of Margaret Whelan with UBS. Please proceed.

Hey, guys.

Hi, Margaret.

Can you give me a sense of the 2.1 billion on your balance sheet? What is the dollar number for option deposits and for Pre Aq cost?

I am going to have to look this up, but I think that our total deposits -- this is just from memory, is around 225 or 30 million, including letters of credit.

Okay.

And then the number -- I am pulling out a sheet here --

Actually Larry, I think it's -- I don't know the letter -- $172 million without.

Without the letters of credit.

Without the letter of credit.

I am just checking here, yes it's 172 without, and there's another 50 or 60 million of letters of credit, bring it up to like 230.

Okay; and then the Pre Aq?

Pardon me?

The preacquisition costs?

Well those are in our land under development category.

Okay.

And they typically are minimal legal costs and zoning type cost, et cetera.

Less than 10 million.

Yes, that's what it looked like, 1.3 million in the first quarter. I am just trying to get a sense for the risks to your balance sheet in the event that the market get's worse or there is impairment or that -- I assume you would walk away from all the options [cost] if the market got worse than it is now.

I think that is almost an impossibility.

Okay. Good.

That we would walk away from even a significant portion of that 172 million, because a lot of that 172 million is securing of land that we've had under control for quite some time, at very favorable pricing, that is still delivering very high margins to us in our houses. So the risk of a big write-down of that 172 million we believe is very low.

Good. And then relative to the number of years of land that you control and your asset turn, how long do you think you are holding the land for, in average, in terms of years? Or are you controlling so that you are getting appreciation?

Somewhere around two years. It is not quite -- five years divided by two would be two and a half, but because we have been growing, we have tied up more land more recently. So it is probably in the two-year range.

Okay. The second question I had was just, some of your peers are getting letters from the SEC requesting segment profits. Would we be getting that from Meritage this year?

We are evaluating what is happening to other builders and looking at how they are responding to the SEC, and we will, no doubt, adopt whatever the new standard becomes within the industry.

Okay.

It is still undecided on what -- how these are going to all shake out, and how many people are actually going to start breaking out more information from a segment perspective.

Yeah. It seems it will be more likely than not, though, before the end of the year. I was just wondering if you were going to be proactive or just wait for that.

I think our perspective here is to -- we certainly don't want to be disclosing less than what the industry is, but it is not clear what the standard is going to become. So we would prefer to kind of wait and see what the standard is, and then follow that.

Okay, thanks. And then, the market is fairly very challenging, but your balance sheet is solid and there are opportunities in some markets you are not in yet. At what point would you start using cash for smaller acquisitions, or to buy land in new markets, or even to increase your position, maybe in Florida?

I think when the pricing adjusts for both acquisitions and land, then we will be more predisposed to use our balance sheet to make those kind of investments, versus buying back our stock. I think our stock looks like a better buy today than a lot of other builders and a lot of land deals.

So I think we are very comfortable doing what's best for the shareholders, and that is to be disciplined about pursuing those opportunities until people get real about their prices.

The market stabilizes.

Yes. I still think there is a lot of land sellers and a lot of builders who just don't get it. And they haven't lowered their expectations as to what their values are, and I can see the screen every day. I see what our price is and I see that as a pretty good opportunity to buy your own Company back at about book value.

Based on our conversations with some of the private companies, though, they are using, this year, the fact that the public are selling land as an opportunity to buy land. Do you see that?

Yes, I see that though, but the publics aren't really selling any really good land.

I know, but the privates don't always have that luxury. I am just trying to figure out if land prices are either going to crack that much, or if they're just going to plateau for awhile.

You know, I don't know. I think it is a byproduct of what demand for housing does. And if this is a very short-lived correction, then prices won't come down.

Okay, thank you, guys.

Thanks.

Thanks.

Your next question comes from the line of Stephen East with SIG. Proceed proceed.

Good afternoon, guys. Larry, maybe I will address this to you. Some of the other companies have been talking about successive write-offs over the next several quarters. How do you all look at it? Are you expecting more to come down the pike? And, I guess, your writedowns on communities; where did that occur also?

As Steve said earlier, we had a handful in California and a couple in Colorado and Florida, but not a significant number; very isolated. And the great, great majority of our subdivisions still have very strong margins. But we evaluated all of our subdivisions and all of our land under control, based upon our market conditions we are seeing today and based upon that, we don't see further writedowns.

If things got tougher, maybe some more could come down the pike. But we have been -- we have tried to be very conservative and approach this by making the error of thinking things are a little worse than what they are, in order to make sure we nip it in the bud and take our medicine now. So that's how we approached it.

Okay. And then on the community growth that you all are looking at. Steve, I think you said Northern California has really finally settled down, and I think you are the first builder that I've heard say that. I guess, where are we seeing community growth, and are we seeing any of it in California, that type thing?

I think the community growth for us is going to be more in Southern California than in Northern California. The good news and the bad news is we haven't bought much land in Northern California in the last year to 18 months, particularly in Sacramento. The bad news is that will prevent us from opening up a lot of new communities there, in the short term.

So, as a Company, we have a lot of community growth coming in Florida. We have some in Texas, and across all of our markets. But I don't think you are going to see any one particular market have a big increase in communities.

Okay. And then the last one sort of goes back to what Margaret was talking about with your cash. What do you expect as far as free cash flow, if any, this year and then in '07; and your uses, how you prioritize between share repurchase and debt reduction, that type thing?

Larry?

Yes. We -- as we said, we are holding asset growth down, so we think a larger percentage of our net income is going to be available for either deleveraging the Company or doing share buybacks.

I can't give you a specific number, but in the past, we plowed the great majority of our net income free cash flow back into growing the balance sheet to further grow the business, and as we go through this transition period, you will see the growth slack up a bit. And, you will see us either being more aggressive and buying shares back or deleveraging the Company a bit. I can't give you a specific number on what that is, though.

Do you have a preference which you would allocate toward first?

I would just say, we have most of our debt is long term. We don't have a lot of bank debt as we go through the cycle -- go through the seasonality of the year and we get towards the end of the year, we expect a lot of our bank debt will be paid down.

So, if we are not buying land and we're not buying other builders and we don't want to have a bunch of cash sitting on our balance sheet, the next best thing would be to buy back stock. So I think that is going to be -- and with a debt-to-capital of about 42%, I think that is going to be our long-term predisposition.

Okay, thanks.

Your next question comes from the line of Jeffrey Bernstein with [Schroeders]. Please proceed.

Thank you, just following on, I think most of my questions have been answered. Just in terms of leverage and free cash flow question, you are still showing your target as one and a half to two times, measured by debt EBITDA. Is that still relevant, is that still a target? And what would things look like for you to go into the upper range of that target?

Yes, I guess those are long-term targets, so I want to say that just because we are, for a short period of time, deleveraging our balance sheet or maybe we'll have free cash flow to buy shares back, or will, that we are changing our long-term targets at this point. It is not -- it hasn't been the Company's goal to change our balance sheet structure so that we would be shooting to quickly go to a investment grade rating. So, I think we are comfortable staying in the high 30 to low 40 debt-to-capital range.

As we go into more of a growth mode again when the market stabilizes, then we may be more aggressive with our balance sheet and go more into that higher end of that range, but in the short term, that is not the plan.

So if I heard correctly, shorter term, high 30s, low 40s debt-to-cap, more longer term, 40 to 50 range?

Yes, mid-40s.

You know, there is seasonality too, so in normal, higher growth period, at the end of the year we would probably be in the low 40s, and during the middle of the year when we are seasonally growing our balance sheet, we'd be up in the higher end of the 40 range. But certainly at year end, when our balance sheet is traditionally the lowest, we still want to have a goal of being in the low 40 range.

Okay.

And what you are seeing is because of the slower growth. At the end of the year we are probably more in the high 30 range.

Okay. Thank you.

You are welcome.

And your next question comes from the line of Jordan Sherman with Satellite Asset Management. Please proceed.

Yes, hi, gentlemen. I wanted to follow up on the question that Alex and Steve asked about about options, because I think there has been a lot of concern about the fact that you guys are fairly active in optioning land from land bankers. And I think the concern is that those are options that you wouldn't walk away from because of the relationships, even if really theoretically you should. And I just wanted to follow up on that. Do you agree with that statement? Or is that -- are those options that you would walk away from as well if they were -- if that made sense?

Well, I think that is a very broad-brushed statement. I think every deal has to stand on its own. And the accounting rules require us to evaluate every deal, every quarter. And we did write-down some options that we have with land bankers this quarter. Now does that mean we are going to just pack up our bags and turn the keys over to land banker? No.

We are going to negotiate the deals to create the best win-win situation we can for our Company, to protect our stockholders, and to preserve our relationship with our land bankers. But those may require us to write-down -- write off or write-down some of those option deposits because the margins are substandard. We have a lot of constituents to be concerned about, our homeowners and our land bankers and our stockholders. But if we have to write some of those options down and renegotiate them, we will.

And we have, and we have been actively working with all of our land bankers to keep them completely informed as to what current market conditions are, where we stand with our projects, and what needs to be done in terms of takedown requirements and pricing to Meritage to make them viable for us and for them.

Okay. So -- what I hear -- what I think I hear you saying is that the fears that those would unusually handcuff you, are a bit overdone?

I think that is an accurate statement.

Any update on the stock -- the rest of the stock for John [Landon]?

We are not aware of what his plans or dispositions of that stock are or have been. He is under 5%, so doesn't have to do any filings to sell his shares. For all I know, for all we know, he may have sold them all already, but we are not privy to that information.

Okay, so no update yet. How bad is Florida?

Well, it's different in different places. I would say certainly we are in the southwestern part of Florida, from Ft. Myers down to Marco Island. You know that market is very rough right now. Not a lot of demand, particularly with the fact that it is summertime, and buyers have taken a wait-and-see kind of attitude.

In Orlando, lower price points, more affordable housing is doing quite well. And higher priced communities, where there is maybe more competition and less motivation, aren't doing as well. But there is still business to be done in Orlando. We'll have to see what happens in the southwest part of Florida when the selling season starts to come back this fall. We are crossing our fingers and hoping that these new lower prices are going to attract some buyers who want to take advantage of the opportunity.

Terrific. Thanks very much.

Your next question comes from the line of Timothy Jones with Wasserman & Associates. Please proceed.

Good afternoon. A couple of questions: as far as those write-offs of the options, did you walk away from them or did you renegotiate them?

We are renegotiating some of those, but we have taken the aggressive step of, even prior to completing the renegotiations, writing down some of our option deposits.

So you haven't walked away from a whole bunch of them. You just [inaudible] .

We did walk away from some purchase contracts.

On the purchase contracts, do you have any -- are they really true options? Or do you have some contingent liabilities on them?

No, our liability was only the extent of what we recorded on our balance sheet as our deposit, and what other -- what predevelopment cost we had already capitalized to those projects. So this is land that we had under contract in escrow that we hadn't closed on, and we basically wrote off those expenses.

And secondly, you gave your 1300 homes -- spec homes, that was on a base of how many homes under construction? And can you give me the same numbers for last year, the specs completed and homes under construction?

Ah, yes. Hold on here. Let me pull that up. It's essentially, our total whip, units in whip are about 5500 units.

Okay.

And the specs under construction was about 975, round numbers. And a year ago that number was about 490. So that's why we are saying it's about doubled, and the whip number was about 5100. So the percentage kind of grew from about 9 or 10% to up to 18%.

That's still very low. And then, what did you have completed last year?

We had 110 versus 286.

Very conservative. Good job. I never say that, but I have to say this time. It is probably one of the very few times I ever say it.

Thank you.

Your next question comes from the line of Dan Oppenheim with Banc of America Securities. Please proceed.

Thanks. I just wanted to talk more about your thoughts on looking for volume growth. You said it doesn't make sense to continue to grow volume as the market is slowing. I think that is a great strategy. I was wondering if we are to think about community count plans for the remainder of the year. We are into '07. What should we model in at this point?

Well I think we mentioned -- what did we say, Larry, 210 to 220?

215 to 220, which why that numbers continues to go up from where we are today, as we have projects in our pipeline that are coming on and starting to actively sell. So that's an actively selling number, so that's going to continue to go up for a while, but as we get into '07, that number will not grow as fast and it may even come down a bit.

Okay. Then talking about Northern California, you had said that was stabilizing with cancellation rate coming down. Did you say that in terms of the order trends over the three months of the quarter? Or was that improving for the year-over-year trends there?

It is really just the last few weeks.

No, I would say it's the last couple of months, Larry.

Okay.

If you look at orders for the last six, seven, eight weeks, they are really starting to come more in line with our long-term expectation, which is one sale per week per community. We are operating at about 25, 26 communities in California, I believe that is correct, Larry. And we are selling, last couple of months, 100-plus houses a month. And that's what I consider to be a stable market. That pales in comparison to what we did a year ago or even two years ago, but we have to put those expectations in the rear-view mirror and get more to what reality is, and that is one to one and a quarter sales per week.

That is net sales, right?

Net sales per community. And you can -- we will also mention that our cancellation rate in California has come down from the 30, 40% rate, to the low 20s in the last six, seven, eight weeks. So we are very encouraged by that.

Thank you.

And your next question comes from the line of Joel Locker with SBN. Please proceed.

Hi, guys. Strong quarter. I just wanted to say that first.

Thank you.

Thank you.

Just on your tax rate going forward and how should we model it. It's kind of been jumping around, and now it looks like it is coming back down, but -- I mean, should it come down at its 38% mark or 37.5 as it was last year?

I think a 38 is a pretty good number to use. It has jumped around because of the 199, section 199. It's also jumped around because of some 162M issues that we finally have worked out. So I think you will see that kind of settle in at about 38%.

Right. And also on the -- I mean you guys are in pretty good shape with that 480 million 6 to 6.45% or so. I wonder if you guys might issue a little more debt, maybe 100, $150 million just to take advantage of low rates or just to lock it in and not forget about it -- or forget about it, I should say.

At this point in time I think we are comfortable with our mix of fixed-to-variable debt and we have plenty of room under our revolver and don't really think we need to lock in. There is always the chance we might, but I don't think it is something we are actively pursuing too hard.

And what was the interest rate you were paying on the revolver in the second quarter or just currently, maybe today?

Based upon our new restructured pricing matrix, we would be at LIBOR plus one, 125 or 112.5. I forget which one it is.

So it's still around 6.5%.

Yes, it's a pretty reasonable rate.

Alright, I will just jump back in the queue. Thanks.

Thank you.

Your next question comes as a follow-up from the line of Alex Barron with JMP Securities. Please proceed.

Yes, thanks. I was hoping you could give us some sort of update on your delivery expectations for the year by region.

We really haven't provided that level of detail, Alex, so I am not certain we want to get into that with you.

Okay. Well, let's see, the other question I had was -- well, can you at least give us a ballpark for the whole year? A total number?

Well, our guidance, the midpoint of our third quarter guidance is 888 million, and that would imply the revenue number from the midpoint we are on the balance, that the revenue for the fourth quarter we have about 913 million. And if you do the math and say average sales prices are 330 or 325, based upon what is either in backlog or current sales average prices, you kind of come up with around 2700 units in each quarter, deliveries, maybe a bit more, maybe up to 28. It all kind of depends on what average sales price assumption you use.

Okay, got it.

It's relatively flat from third to fourth quarter in revenue terms, a little bit up in the fourth.

Okay. I guess the second question I had was a little bit more general in nature. I am just trying to get a feel for your philosophy in terms of how to manage severe downturn. In terms of, if you had a certain number of lots or certain number of expectations for community openings and specs, kind of what is your thought process there and how do you handle that if the downturn is more severe than you originally thought, or lasts longer?

Well, we don't really see us having to be in a position to liquefy or to turn our land holdings into cash, because we don't own a lot of land and the land that we do control, we have at pretty favorable prices. And, we believe it is more prudent to just manage our inventory and manage our sales pace to a degree that we can make each individual subdivision profitable, even if it has had only two or three sales per month.

So, we are going to continue to open communities that we have in our pipeline, that we've been processing for the last two or three years, and we will only look to increase our community count when new communities as we deem them viable at today's absorption rates.

But you wouldn't necessarily shrink the community count?

Not intentionally. I don't think we have an intentional plan to lower the number of communities that we have. If the community count shrinks just because we can't find additional opportunities for new communities, that may happen. But we don't have any designs to reduce our community counts, or we are not looking to pull out of certain markets, and redeploy our capital on to other markets. That is not our strategy at this time.

Okay. And in terms of the specs, the reason they are up this quarter, is that sort of by design because you are trying to liquidate out of certain communities, or is that just due to increased cancellations?

It's purely a result of the cancellation, and I would say in a few minor circumstances, we had communities that were near the end, one specifically in Sacramento where we had, I think, 15 or 20 lots left and we just decided to spec the rest of them out and try to move them before the end of the year. But that has generally not been our strategy.

We are not looking to even flow production and keep the production line going through spec home building, like some of our bigger competitors are doing, and we think that only leads to lower margins, lower return on capital, which isn't in the best interest of the stockholders at the end of the day. We don't agree that land is completely fungible and easily replaceable in a lot of markets. So why liquidate it?

Okay, that makes sense to me. And lastly, would you consider paying a dividend since you don't have any, as opposed to share buybacks?

I think right now we are more focused on share buybacks. And I think in the long term we still see ourselves as a growth Company, and we are going to grow, and a dividend strategy is not 100% consistent with that. So, we will keep our eye on it and continue to think about it and study it, but it is not in our short-term plans.

Okay, thanks, Steve.

Thank you.

Ladies and gentlemen, we are now approaching the end of our teleconference. Mr. Hilton, would you like to take one more question?

Sure.

Okay, and your next question comes from the line of Stephen East with SIG. Please proceed.

Steve, there is a school of thought out there that says that because you all have a high percentage of land optioned, and in particular with bankers, that in slower times your margins get squeezed more than other builders, all else being equal, because your cost of carry, et cetera. I guess, could you just talk a little bit about your thoughts on that and whether that's got validity, et cetera?

I think our margins are probably less than some other builders who are developing and entitling their own land in good times just as they are in bad times, because there is an extra cost associated with optioning land, particularly when you use third-party land bankers. So, I don't know that it really makes a difference whether the market is good or the market is bad.

I know if you go back a couple of years our gross margins did not expand as nearly as quickly as some other builders, because a lot of that related to escalating land prices, which we were able to capture because we controlled the land, but, again, we didn't own as much land. So, I don't believe that to be the case.

Okay. And just one last question. You talked about Florida. Could you talk a little bit about Phoenix and the environment that you are seeing there?

It's pretty rough in Phoenix right now, although this month sales have been better. We have been a lot more aggressive about our incentives and that has had a direct impact on our sales activity. But relative to a couple months ago, where the west side of Phoenix was performing better than the east, I think the entire market has now got the summertime softness. It is very hot out here.

If you are out on a Saturday or Sunday looking at a house in July or August, you are a live buyer and if you are a prudent salesperson, you are not going to let them get out of the office when it's 115 or 118 degrees outside. But long-term, I think we're one-third to one-half of the way into the market correction here, and I think as we approach the fall selling season into the first quarter next year, the market will stabilize and the well located subdivisions will begin to pick up and will do well.

Okay. I appreciate it. Thanks a lot. Great quarter.

Thank you.

Ladies and gentlemen, this now concludes our question-and-answer session. At this time, I will turn the call over to Steve Hilton for closing remarks.

Thank you for joining us for our second quarter 2006 earnings call. We look forward to speaking with you again next quarter. Thank you.

Thank you for your participation in today's conference. This concludes the presentation.