Meritage Homes Corp (MTH) 2006 Q3 法說會逐字稿

Good day ladies and gentlemen and welcome to the Third Quarter 2006 Meritage Homes Corporation Earnings Conference Call. My name is Shirelle and I will be your facilitator for today. [OPERATOR INSTRUCTIONS] I would now like to turn the presentation over to Brent Anderson, Director Investor Relations. You may proceed, sir.

Thank you, Shirelle and good morning everyone. I'd like to welcome you to the Meritage Homes Third Quarter 2006 Earnings call and webcast. We issued our earnings release yesterday. If you don't have it yet you can access it at the website, 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 these risk factors, please refer to our press release and most recent filings with the Securities and Exchange Commission, especially our 10-K and 10-Q's.

We refer 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 and the final page of the slides.

Participating on the call with me 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 third quarter and the first nine months of 2006 and our outlook for the full year. At the end of their prepared remarks we'll take questions from the listening audience. I will now turn the call over to Steve Hilton and refer you to Slide 4 of our presentation. Steve?

Thank you, Brent. To all of you listening on line or on the phone, thank you for joining us this morning and thanks for your support of Meritage Homes. We are all aware that the U.S. housing market has slowed since last year and homebuilders' results are showing the effects of that slowdown. The question on everyone's mind is whether we've reached the bottom yet and when things will improve. No one knows exactly when and how things will turn so we're operating more conservatively until we see tons of improvement.

We reported record third quarter closing revenue for Meritage in 2006 yet sales were down year-over-year for the last four quarters and earnings have begun to show the effects of weaker markets. This quarter's order results show that Florida has experienced the greatest weakness, Arizona and Las Vegas have slowed considerably and California was down moderately, while Texas, again, posted the strongest sales; although even Texas slowed this quarter on a year-over-year basis. We are planning for current conditions to continue for the remainder of this year into next until the markets can work through the excess inventories and begin to stabilize. I'll hit some of the highlights of the quarter and let you know what we're doing in response to the turbulent conditions we're experiencing and then Larry will go through the numbers in more detail.

Beginning on Slide 5, we closed 2,636 homes for a total of $876 million in the third quarter of this year representing increases of 14 and 16% respectively over third quarter closings and revenue last year. These closings were record third quarter results for Meritage and resulted from closing 45% of beginning backlog with a modest 2% increase in average price. We generated net earnings of $60 million for diluted EPS of $2.25 this quarter. That's 6% lower than the $2.40 we reported last year. Earnings declined as a result of higher cost of sales combined with higher selling costs. Higher cost of sales included higher lot cost and a $9 million charge -- $9 million of charges related to the forfeited lot deposits - lot option deposits - and inventory valuation write- downs caused by price declines in certain markets. Earnings were also impacted by stock compensation expense and severance related costs in 2006 quarter that weren't in 2005. Larry will detail these but I'll just note that excluding these items, our diluted EPS this quarter would have been $2.33, only a 3% decline over last year.

On Slide 6, for the first nine months of the year 2006 home closings increased 27% and closing revenue increased 34% over 2005 driving a 48% increase in diluted earnings per share or 32% excluding the 2005 refinancing charge.

Let's look at our order trends on Slide 7. Net orders for the third quarter 2006 declined 36% year-over-year to 1,870 homes reflecting a slower sales pace across the board. Our weakest markets as I said earlier were in Florida, where the total value of cancellations exceeded the total value of new orders, although California, Arizona and Nevada had a greater absolute dollar impact from a total decline in sales. As you can see, Meritage order trends are consistent with the trends experienced by the largest 14 public homebuilders, highlighting the similar impact of the largest housing markets on the public homebuilders.

Slide 8 - Cancellations occurred at an all-time quarterly high of 37% of Meritage gross orders in the third quarter or 19% of beginning backlog cancelled compared to 12% of the beginning backlog in the third quarter of 2005. We believe cancellations are up due to a lack of buyer confidence and the difficulties our buyers are experiencing selling their existing homes. Higher cancellations are resulting in lower net orders, higher unsold inventories, more costly incentives and lower margins as we resell these homes. It is important to note that our increased inventories are not due to overbuilding. Our strategy is to build-to-order, rather than building spec inventory. The order cancellations are converting presold inventory into spec inventory.

Slide 9 - Net sales per community fell from 17 one year ago to 9 this quarter due to slower sales and an increase in active communities. The chart on Slide 9 shows a four quarter moving average of sales per community which smoothes out the seasonal peaks and valleys. After this adjustment period, we would expect sales to return to a more normal historical average of 12 to 13 sales per community per quarter.

Slide 10 - During the quarter, our community count increased by 9 to 213, mainly due to the opening of eight new communities in Texas. Our community count has continued to grow as we open new communities from our development pipeline while the communities that were to have been replaced have not yet sold out. As these earlier communities close, we can see a decline in active communities, especially if sales pick up. As a result of slower sales, higher cancellations and increased closings in the last 12 months, our backlog has declined 33% year-over-year in both units and dollar value.

Slide 11 - We are responding to weaker conditions across many of our markets by making tactical adjustments to maintain a stronger balance sheet, improve our margins and position ourselves for a better market. We are increasing sales and marketing efforts through additional sales training and increased advertising. We're increasing the frequency of customer contact to manage our backlog and aggressively work to reduce unsold inventory of homes. We are managing lot take-downs to minimize the lot inventory risk on our balance sheet. Larry will go into greater detail on how we've managed our total lot position but I point out that we've limited our total growth outside of Texas in recent quarters and we expect to reduce it more until demand picks up.

We are reevaluating lot option contracts based on recent sales price pace and prices and renegotiating or terminating them when necessary. We're rebidding construction contracts and actively managing our overhead costs. Unfortunately, we had to shrink our employee base in many markets where we're seeing weaker volume. These tactics are intended to maintain profitability and preserve and strengthen our balance sheet and put us in the best position to grow and expand our market share as the home building market recovers. We are confident in the long-term growth demographics for the industry, confident in our strategy and I'm confident Meritage has the team in place to achieve that strategy.

Before I turn it over to Larry, I'd also like to note that we've recently added a new member to our Meritage team. We've appointed Steve Davis, our new EVP of National Homebuilding Operations, on October 16th. Steve has 24 years of experience and success in the homebuilding industry and will help us improve our operations and serve as a key member of my management team.

Now I'll turn it over to Larry for more in-depth review of our results and balance sheet. Larry?

Thanks, Steve. Turning to Slide 12, I'll begin with some of the more subtle points affecting earnings before focusing on the balance sheet.

As Steve noted, Texas had our strongest market -- was our strongest market, again, this quarter even though sales softened there during the quarter. Texas rose as a proportion of total home orders to 61% from 45% a year ago in the third quarter and to 50% of total order value from 31%. While stronger Texas markets are helping to offset declines in other markets, the average home prices in Texas are considerably lower which reduces Meritage's average sales price and average gross profit. In fact, the average sales price on orders this quarter was 6% lower year-over-year and 5% lower year-to-date due to product mix and price concessions.

As you can see in the operating data table this quarter, we've raised our reporting to present homebuilding operations in regional reporting segments classified as West representing the aggregation of California and Nevada; Central representing the aggregation of Arizona, Texas and Colorado; and East comprised of Florida. We are currently in the process of amending our 2005 Form 10-K and our 2006 Form 10-Q's to reflect this change. We should have these amendments filed in early November. We believe these changes are consistent with what other public builders are doing however they have no impact on the financial results or condition of the Company.

On Slide 13 gross margins were impacted by higher incentives that reduced home closing revenue while our cost of sales rose due to higher lot costs and inventory write-downs. The write-offs of $9 million this quarter reduced gross margins by 103 basis points or nearly one-third of the total 330 basis point decline year-over-year. About half of that amount related to complete write-off of two land bank option deposits with a balance relating to write-downs of three owned projects.

Commissions and other selling costs increased due to increased spending on advertising, marketing and co-brokered sales. Our total general and administrative expenses increased slightly year-over-year reflecting our cost containment effort. As Steve alluded to earlier, third quarter 2006 G&A included $2 million stock based compensation expense related to the adoption of SA-- SFAS123R and $1.1 million of severance related costs. Excluding these expenses, G&A would have improved to 3.6% of revenue from 4.2% in the prior period. I will also point out that we're still at or above our long-term gross and pre-tax margin targets.

Moving onto Slide 14 - Cancellations are more than double the percentage of unsold homes in inventory from our typical levels. We entered the quarter with 363 unsold completed homes and another 981 unsold homes under construction representing 7% and 18% respectively of total sold and unsold inventory of homes. While that still means we have 75% of total home inventory under contract, it would normally be closer to 90% under our build-to-order strategy. Our total specs per active community were just 6.3 homes. I think you'll find this compares favorably to most of our competitors.

On Slide 15, the net increase in our total real estate inventory of only 13% since the beginning of the year was due to increases in spec inventory and finished lots caused by slowing sales and higher [cans]. These increases more than offset the decreases in model home inventory and presold homes under construction.

Turning to a familiar view of our lot supply in Slide 16, we reduced our total lot supply by more than 2,100 since the beginning of the year to about 52,000 lots as of September 30, 2006 with approximately 88% controlled under purchase agreements or option contracts.

Looking at Slide 17, we now have 4,200 fewer lots outside of Texas than when we entered the year. We've added new land positions in Texas where demand has been relatively strong. We expect to further reduce our total lot supply by as many as 2,500 lots by year-end.

Some key balance sheet metrics are shown on Slide 18. We maintained a strong balance sheet and liquidity throughout the quarter reporting net debt to capital ratio of 41.7% at September 30, 2006 compared to 45.3% one year earlier. We believe we have sufficient liquidity to fund future operations with total funds available under Meritage's expanded bank credit facility of $468 million at September 30, 2006 after considering the most restrictive covenants. We repurchased 100,000 shares of our stock this quarter at an average cost of $38.96 per share or about $3.9 million in total. But we're taking a bit more conservative stance on repurchases considering we've already repurchased almost 2 million shares this year.

Showing improvements in a couple of more key related debt metrics on Slide 19, debt to EBITDA improved to 1.3 from 1.7 times year-over-year and the Company's interest coverage ratio improved to 11.5 from 9.4 times in the third quarter, 2006, compared to 2005.

And wrapping up Slide 20, our after tax return on assets improved year-over-year to approximately 15.5% from 13.8% and return on equity improved approximately 35.9% from 33.6% based on trailing four quarters results this year compared to one year ago. We're focused on keeping these measures at or near the top of our peer group as we have done historically.

I'll now turn it back over to Steve for some concluding comments.

Our strategy is to limit financial risk by subcontractor home construction, managing relatively low levels of debt, maximizing the benefits of options and controlling land and building relatively few spec homes have helped us produce some of the best returns in the industry while simultaneously managing a very strong balance sheet.

As we've stated previously and this quarter's results demonstrated, we expect sales and earnings trends will be weaker until cancellation is normalized and stability returns to our markets. Based on our reduced backlog, higher cancellations and slow order trends, we expect total revenue of $3.4 to $3.5 billion in 2006 and diluted earnings per share of $9.00 to $9.50. Additional write-offs of option deposits and inventory may be necessary this next quarter if we experience further deterioration of market conditions. Because of these uncertainties, we are not in a position to provide specific guidance for 2007 at this time.

Slide 22 - In summary, we're taking a proactive approach to changing market conditions. By intensifying our focus on making and keeping sales, reducing our overhead and construction costs wherever possible, aggressively managing our balance sheet to provide strong risk adjusted returns and maintain strong credit and liquidity to take position or to take advantage of and position ourselves of upcoming opportunities when market conditions improve. We are confident in our strategy and our leadership team and committed to positioning Meritage to maximize future growth and stockholder returns.

We'll now open it up to questions at this time.

Thank you. [OPERATOR INSTRUCTIONS] First question will come from the line of Stephen Kim from Citigroup. You may proceed.

Thanks. I guess my first question relates to your subcount. Can you remind me what your expectations are for subcount over the next few quarters in terms of growth?

Steve, I think over the last couple of quarters we've indicated that we'd probably get up to about 215 to 220.

Mhh-hmm.

We may be, as of the end of the year, and I think we're just about there now and I think you're starting to see us kind of get to a peaking point in the inventory and that depends on how the market develops. When and if -- well, when -- we will -- but it's just a matter of when we'll start to crank up the new projects and start to fill the development pipeline back up.

And then building on that your -- I'm interested in forecasting your gross orders per community, your absorption rates on a gross order basis and trying to treat cancellations separately. Looking back, it looks like you had a pretty significant decline in the rate of gross order increase that you had in the fourth quarter versus third. Which is another way of saying you face a much easier comp year-over-year in your gross orders, if you just look at the orders. And if you look at it on a per subdivision basis or an absorption rate basis it would seem that if you did anything close to the roughly 14 gross orders per sub you did this quarter, in the fourth quarter - you do the same rate - your, again, your gross orders would not decline nearly as much as they did this third quarter. So my question is, is it reasonable to expect that if conditions stay the same in 4Q versus 3Q, that your absorption rate would be pretty similar or they're seasonal factors which make your fourth quarter generally have slower absorptions on a gross basis than in the third quarter.

Larry, I'll let you jump in here in a minute but I think the seasonal factor is the key factor. I think it's too much to expect that the rate of sales will continue from the third quarter into the fourth quarter and we're already seeing --

Can you give us a sense for a magnitude?

I can't tell you specifically, but I've got a pretty good feeling that it's going to be less than 14.

Okay. So like you're talking maybe 12 or something --? Would that sort of strike you --?

I'd say between 10 and 12.

10 and 12. Okay.

Would be my expectation somewhere in there.

Okay. Got it. And if you had roughly 215 subs, that tells me that basically that's a gross order trend of about 22, negative 22% year-on-year. So that's --

And then you've got a couple -- you've got to put the cancellations on top of that.

Oh, yes. No.

This could be the final hurrah for cancellations for people that are still in the backlog that bought as long ago as a year ago.

That's right.

So we're bracing ourself but we're hoping we're going to be able to keep as many of those as possible.

Well, even if you put all of that together and you put a negative 22% gross orders change and you kept your cancellation rate as a percentage of your backlog basically the same, it looks to me like in the fourth quarter your net orders will actually, still, not be down as much as they were this quarter. Close, but not quite as much even if your can rate as a percentage of backlogs stayed the same.

Hopefully it works out that way.

Okay. Great. Thanks a lot.

Steve, I think you're seeing that California went into a downturn - Northern California went into a downturn - in the Fall of last year, so you're going to start to see positive comparisons or at least better, easier comparisons in comparison to some of the prior year's quarters now. So we're into the point where we - all the builders - will start to see easier comparisons year-over-year.

Can I just throw in one other question relating to your margins and backlog? Can you give us a sense for whether or not, excluding any potential write-offs, whether your backlog gross margin -- roughly how much lower you think it might be than what we saw this quarter excluding write-offs?

Yes. Our guidance that we provided for the quarter excluding write-offs -- it depends what cancellations are and what resell margins are, but I think it's a kind of a range of somewhere between a low of -- of the low end of the guidance of maybe 18.5% gross margin to 20% which is relatively flat to where we were this quarter.

I think your gross margin ex write-offs was about 21.3% this quarter.

Oh, yes. Ex write-offs. Yes.

So your 18 to 20 that you're saying was an ex write-off number in 4Q, so down anywhere from 330 to 130 basis points sequentially. Is that what you're saying?

Yes.

Okay. Great. Thanks.

And they do put write-offs on top of that.

Sure. Absolutely. Okay. Thank you.

Thank you.

[OPERATOR INSTRUCTIONS] Our next question comes from the line of Dan Oppenheim from Banc of America. You may proceed.

Thanks very much. Wondering what you're doing as you look at the current environment in terms of the slower sales per community. Are there any levels at which you would be more aggressive on pricing to pick up the pace of sales? How does it look within a region, is there a minimum at which you'd want to see sales before you alter your pricing strategy? If you would just talk through that.

Well, your typical community we think the minimum acceptable absorption level is somewhere between three and four sales per month. Below that it gets hard to cover your fixed overhead so -- because we don't own a lot of land and we're not a spec home builder, we don't see -- we don't have a desire to try to monetize land holdings by selling homes for little or no profit. So our strategy is quite a bit different than some of the other larger builders and we think if we can keep a sales pace of three to four a month and create some positive profits, that's really what we're going to do.

Great. Thanks. And if you could give us any sense in terms of the trends that you're seeing through the quarter either in terms of orders or margins and also what you're seeing at the start of October. That would be great.

Start of October continues to be weak, pretty much in line with the last quarter; maybe even not quite as good because we're going into a slower time of the year. But I think you may be able to make an argument that we've hit the bottom in California although I'm not quite sure. Arizona and Nevada and Florida continue to be weak. I don't think we're at the bottom yet although there are some signals that the inventory of resale housing is starting to level off. But we're just not seeing it in the sales office yet and Texas is now beginning to get a little bit weaker. It's getting to be a little tougher environment there than we've seen over the last couple of quarters. Not nearly to the degree that we see in other markets but it is concerning.

Thanks very much.

The next question comes from the line of Margaret Whelan from UBS. You may proceed.

Thank you. It's actually Dave Goldberg on for Margaret. Steve, I was wondering -- you've said before that you plan to be an acquirer in the downturns. If you could give us an idea what you're seeing on the M&A side. A -- what you're seeing now and then what kind of -- what markets would you be expanding into -- what kind of metrics you are looking at and what would have to change before you started pursuing deals more aggressively?

We're not seeing much yet, I can tell you. Not a lot of deals are coming across my desk and nor are we really out there looking hard to dig up some deals. I think before we're going to be an acquirer, maybe anybody else is going to be an acquirer, we're going to have to see some kind of stability in the market and have some kind of visibility going forward which we really don't have yet. It may come soon, may come sooner than later, but today we don't have it.

We have a lot of room to continue to grow our business in our existing markets and I don't think acquisitions are going to be our first and foremost strategy or certainly as big a priority as they've been over the last several years. But places that we're interested continue to be Florida, continue to be the southeast region and markets out there.

And what kind of returns are you looking for on deals when you're trying to pencil them? I mean, is it just product [inaudible] you're trying change or new markets or are there kind of specific return hurdles that you --?

I don't want to get into specific numbers, but we're looking for an acquisition that would be strategic, that would bring us management and assets in a market that maybe we're not in first and foremost or that would help us fill out a market that we're maybe still a small player in?

Mhh-hmm.

But there's a whole variety of dynamics that we're looking for.

And if I could just get another question. Larry, you mentioned that some of the land deals you walked away were within the land banks -- were within land banks, walked away from option deals. Can you talk a little bit more about those where the deals were with the land bankers or if you've taken down any lots in the communities at this point? Do you have any other deals with these land bankers?

Yes. One deal was in Florida and one was in Arizona. And the one in Arizona is with somebody we have multiple projects with and we continue to reiterate that these are options and we've been paying a premium for the land holder, the land banker, taking the market risk and this downturn is severe enough and in certain geographic areas or submarkets where prices have fallen so that the land banker is bearing that risk and we're either renegotiating those deals or we're prepared to walk on them.

And these were deals where you hadn't started -- hadn't taken on any options in the communities yet?

Correct.

What do you think it was that made the land banker less willing to negotiate with you on these specific deals? Just kind of letting you walk away?

Well, in some cases we may be still having conversations but we've gone ahead and written off the deposit either thinking that the deposit, even with a renegotiated deal, would not be recoverable or the probability of getting a renegotiation done may be not likely.

So you haven't necessarily walked away from [communities]?

Well, but we are prepared to. I guess I'm saying - yes - if we don't get a renegotiation successfully done, we would; and --

We may strike a lower price on the lots that would precipitate our deposit being gone, so if we had a 10% deposit and the price is 20% lower, that means we ate 10% and the land banker ate 10%. So those -- even though we've technically walked on some deals, we're still working with the land bankers to preserve the relationship and to come to a positive outcome as best is possible for both parties but many deals --

Do you think if you [inaudible] walk it would affect other deals you have with the land bankers?

Not necessarily.

[inaudible].

We have many deals right now that are under renegotiation, most of which have successfully been completed. But we still have others that we are continuing to renegotiate to lower the prices, delay the take-downs and extend the terms.

Yes. I think the key is we're working in a cooperative fashion and we're willing to share a little pain by accepting a somewhat lower margin than a standard margin, but the land banker has to be willing to accept the fact that prices have declined and they need to accept part of that decline too.

We have a variety of different kind of land bankers. We have some large institutional land bankers that have unsecured financing that have more flexibility that really look more at a bigger picture. And we have some smaller, individual investor land bankers that have fixed financing that are kind of limited to what they can do by their lenders. So it's not the same rules that apply to everybody.

Okay. Thank you.

Next question comes from the line of Alex Barron from JMP Securities. You may proceed.

Yes. Thanks. Good job on the quarter, guys.

Thank you.

Steve, I wanted to see if you could talk about Florida a little bit -- what happened there, what you guys are seeing in both of those markets and, I guess, any potential for writing off one or both of the -- or part of the acquisitions you bid there last year.

We're still making money in Florida, so we don't expect that we're going to have to write-off any goodwill there. We're aggressively renegotiating a lot of option contracts. The Ft. Myer-Naples market has certainly been hit the hardest; very much a seasonal market. It's very much dependent upon buyers who are making an elective decision to buy a home. There was no season last spring; of course the summer is never a good time to sell homes in southwest Florida. So some inventory has been moved out over the summer at substantially lower prices and we expect this fall, as the buyers start to come back from the Midwest and Northeast they're going to see some great opportunities, some values that they can't refuse and they're -- we're going to sell some homes along with our competitors. So -- unfortunately I think we made our entry into Florida at the peak of the market and we're suffering the consequences of that right now.

Alex, it's a long-term impairment issue and we consider that 1) we're in Florida for the long-term and plan to, as the market recovers, continue to grow in Florida. And that this downturn will be a short-lived phenomenon. It's not going to extend for several years. It will be for a few quarters. And because of that we don't think our goodwill acquired in those acquisitions is permanently impaired.

But I mean when you say you're still profitable there, you mean on closings? What about on new orders?

Yes. We are profitable on new orders particularly -- maybe not as much in Ft. Myers and Naples, but in Orlando certainly. Houses that were selling today, we still have a nice profit margin built into them.

So the fact that you had two units, does that imply maybe you had positive orders in Orlando and negative orders in Ft. Myers? Something like that? They just [inaudible].

Yes. That was probably a reasonable estimation of what was going on.

Okay. And then I guess my second question is - and this probably applies more to Florida and maybe other markets as well - some builders have said that they're going to pursue volume at the expense of margins and appear to be cutting prices pretty aggressively and you guys have said you're going to be more build-to-order. So I'm just trying to understand how you guys are responding in the cases where you're going head to head to --

Well, it's different strategies for -- different strategies for different companies and because we're heavily oriented towards options - we don't own a lot of land - there's not a lot to try to monetize. I guess we could monetize our option deposits but relative to our total balance sheets, it's a very small percentage. So we don't have the same motivations that a Lennar, Horton or Centex would because we don’t have these huge land bases -- investments in land - that we need to try to recover. So we're looking for -- we're still looking for a return on capital, not just a return of capital. And we're going to do the best we can to compete with these guys when they are selling houses at little or no profit. It makes it difficult, but we still think we can be competitive.

And just if I could ask another one. I mean, which markets are you guys kind of having the toughest times or where do you see, I guess, your profits declining most; not on a unit basis, just on a margin or pricing basis?

Well, certainly the big three are in the West - California, Nevada. I mean, all the markets are really the same to some degree other than Texas. I think things in California -- Southern California are still okay. They are not great but we're still making okay margins there. I think in Vegas, although they weren't what they used to be, we're still making pretty good margins in Las Vegas. Northern California the margins have shrunk substantially. Phoenix, the market margins are shrinking substantially and certainly Florida, we already talked about.

Got it. All right. Well, thanks a lot.

Okay. Thanks.

The next question comes from the line of Stephen East from SIG. You may proceed.

Good morning, guys. Steve, if I could just follow on one other Florida question, if you would. From a strategic perspective do you think, as you look over the next couple of years, do you need to do anything differently? I don't know if that means just get a greater size, different markets, etc., or can you have a pretty successful business with the current footprint you have and the current strategy you have?

Well, we're still a really small player in Florida and the strategy for the short-term is just to get our costs down, right-size our organization and hunker down and make it through this turbulent time. When the clouds start to go away and the sun starts to shine a little bit more, then we'll think about what our strategy for growth is there and figure out how to rebuild our organization and get into some new markets; but right now we've consolidated our two operations in Orlando, we've closed our regional office, we've let quite a few people go there, right-sized our business and trying to be as lean and mean as we possibly can to ride out the storm.

Okay. And just looking at the market, are you seeing or hearing anecdotally any of the private builders or smaller builders getting into distress yet?

Maybe a few but I haven't seen that to be -- everybody is pretty well heeled down there. People have made a lot of money over the years and the private builders are still pretty strong so I haven't seen evidence to that yet.

Okay. And then just a different question, maybe this is for Larry. You all talked about lot costs impacting your EPS. On a gross margin perspective, how much did it hit year-over-year and where do you see that going over the next several quarters?

Well, generally speaking, we've always been saying that as older lots that were acquired four of five years ago eventually roll-off that that's going to cause our lot cost to gradually creep up and I think that is still happening. It's been overshadowed by some of the soft market conditions, demand wise. I can't give you a specific number. I think generally speaking it could be in the 1 to 2% of sales range and, also, as you're discounting houses that has an impact because your overall sales price is decreasing which has the effect of gradually increasing the percentage of lot that's total sales price. So you have two factors in play.

Okay. So is it fair then, maybe a little bit more than a third of your gross margin decline was associated with land costs?

I'm not saying that that was this quarter. I'm saying over time I think you'll see maybe a 1 to 2% margin impact; I'm not certain it was that large this quarter.

Okay. All right. Thanks a lot.

You're welcome.

Thank you.

Next question comes from the line of Robert Manowitz from UBS. You may proceed.

Yes. Hi. Good morning.

Good morning.

Just one question, and that is I think the financial flexibility that the options provide you is fairly well understood and documented. I'm wondering if you have a perspective on what's happening with the land bankers themselves, your partners in here? Your warehousing entities? That as the land comes back at them - right? - billions and billions of dollars are being cancelled on and I'm wondering sort of what position that puts the land bankers in?

Well, I don't know that's really the case, Rob. I don't know that billions and billions of dollars are getting cancelled. I mean, some deals that were purchased in the last year to two years are being renegotiated and I think we're renegotiating far, far, far as an industry in excess of what we're actually canceling. It's -- land bankers are pretty smart. They know what's going on. They are seeing the sales trends. They're -- we communicate with them on a regular basis so the last thing they want is the property back. And only in rare situations where sometimes you're dealing with maybe a single entrepreneur who has cobbled together a couple doctors and lawyers and is doing a land bank deal and doesn't really get it what's going on, are you going to have a situation where you might not -- and he's tied to his bank -- where you might not be able to renegotiate it. The sophisticated land bankers that are -- have pension money and really know the business, we're working together with them hand in hand to come up with a successful outcome for both of us as much as possible.

Yes -- most --

But in the end we're looking out for our shareholders and these are true options and we won't hesitate to walk it -- walk an option and forfeit our deposit if that's what's in the best interests of our shareholders.

Yes. Most of the -- I think where people have just walked, is on purchase contracts where there's a lot [less] up and that they're a lot earlier in the process of going through the development pipeline. And there I think there's much less of an established relationship with land sellers as opposed to land bankers. And in Steve's example, if prices have gone down 20% and we realize we have to write-off our deposit or -- and they have to take a decrease in sales price, we're working together to do that so we can be writing off a deposit even though we are renegotiating.

Right. But at the end of the day there is some negative financial impact. But your sense is that the financial where-with-all of the land banking community is strong enough to absorb that impact. Is that kind of the net of it?

Absolutely.

Great. Excellent. Well, thank you.

Next question comes from the line of Greg Gieber from A.G. Edwards. You may proceed.

Morning gentlemen. I wonder on these homes that get cancelled and you have to resell them, could you give us some rough idea what margin impact or margin loss you have on these resales?

Well, the margins on a lot of these homes were quite high to begin with. Gross margins were, in some cases, 30% or more. So -- and depending on how much of an incentive or discount we need to offer could be as much as 10 to 20%. We'll still make some money; but it certainly won't be the level that we originally had hoped for.

Are most of the cancellations in the product that really did have these rather high gross margins?

Yes. Most of the cancellations are people that bought quite some time ago at the peak of the market and - when we had a lot of pricing power - so they're seeing that they haven't been able to sell their home; even if we give them a substantial discount which we're going back to our backlog and offering that to a lot of the buyers, they're still -- they still can't make it work and that's when we get the home back.

Okay. Now your subdivisions or communities did show good count year-over-year. Do you have any sense that some of your drop in sales philosophy per community might come simply because you're sort of cannibalizing from yourself in a suddenly much worse market than you anticipated?

Well, we're not cannibalizing ourself because we don't have a lot of communities that are close to each other. I mean, we have a lot of -- our communities are quite spread out and in very unique submarkets and niches but if we were -- some of the bigger builders - I won't mention their names - but a lot of them have communities that are adjacent to each other or very close by and there may be some cannibalism there but I don't think that's the case with us. It's just lower demand and higher cancellations.

Okay. Finally could you entice me on Florida, as I look forward to going to Florida in the first quarter, just how much less I'd have to pay for the same house I would have a year ago? And should I bring my checkbook?

Probably 15 or 20%.

Okay. Thank you very much.

That's a pretty good deal.

Yes.

Next question comes from the line of Joel Locker from SBN. You may proceed.

Hi guys. Just want to get the breakdown of inventory on the $1.58 billion in real estate on the balance sheet right now?

Yes. There's actually - in the presentation - Slide 15 breaks that out specifically by type of homes under construction, presolds by development.

Must have missed that one but I'm -- just -- and your comment on California just kind of surprised me of how it might have finally hit bottom and just it seems like with the negative cash flow and a lot of speculators it seems stuck that will eventually have to be worked out and almost be forced to sell just because maybe the rental equivalency is about 50% of what their notes are. It just kind of -- just seems like it's so -- with the affordability so stretched, it has something to do with interest rates. So if interest rates go back up 50 base points, all of a sudden demand dries up because people are just priced out.

I don't know if that's the case. People have a lot of equity in California because there's been so much appreciation over the last decade.

Right.

And I don't think we're the first builder to say that Sacramento might be at the bottom. Now that doesn't mean it's spiking back up or -- the big question -- is this a "U" or a "V"? But I think some of the Northern California markets that went into this now a year ago are starting to see some stability albeit at much lower absorption levels.

Right. I'm just --

Southern California is a different story.

I mean from a personal visit out there it just seemed like -- I met numerous people that started with one home in 2000 and now they just rolled it into 20 and they're trying to rent out 15 of them or --

Yes.

And it just seems like if they are forced because of negative cash flow, all of a sudden - boom - the existing inventory spikes back up. And I know I've seen homes that sell for $1.2 million and you can rent them out for $2,500, same unit next door.

Yes. I don't --

That's just -- it seems like what's -- comes into place where 65% being ARM's and the reset rate and things like that, it just surprised me -- seem like other markets would bottom before California.

I think the difference between California and other markets is that entitlements are hard to come by and supply is still tight. You just -- Phoenix supply is a lot more ample than it is in the San Francisco Bay Area.

Right. Thanks a lot. I'll get back in the queue.

Okay.

Next question comes from the line of Timothy Jones from Wasserman and Associates. You may proceed.

Yes, good morning.

Good morning.

A couple of questions, I was pulled off the conference call for about ten minutes on a call. But did you give the spec units that you had completed and under construction for last year and give me -- is that number on the units under construction for both periods?

Yes. We did go over that but the under construction units at 9/30 of '06, 981 versus -- and then the completed specs of 6 - excuse me - 363 percentage-wise of total.

I mean for the year before.

And then for the year before it was the -- the under construction was 613 and the completed was 98.

And what was the value or the total -- I mean, the number of total homes under construction both periods?

The denominator is 5,330 for total whip units for '06 and for the prior year's period was 6,325.

And, Tim, if you get time go on line. It's on Slides 14 and 15.

Okay. I was having trouble picking them up but thanks, Brent. Are the other -- just a question since I'm in Naples, how is this Fiddler -- this development near Fiddler's Creek. That's the only thing you have in Naples, isn't it?

Yes. We don't have much in Naples. We have some things up in Ft. Myers. We have some projects coming up in Benita that we're working on but we're not really actually in Naples, per se.

And lastly, did you also give out the breakdown of your 47 -- 6,000 options? How much is that -- is the dollar value of the options and the dollar value of the pre-acquisition cost attached to them?

We haven't really disclosed ever the total dollar purchase price control that -- in any specific terms. And then our option deposit level is going to be disclosed in our Q. So when that gets filed -- but we haven't talked about it and I don't have those numbers to go over here on the call.

Okay. Thank you very much.

Thanks.

Next question comes from the line of [Sharmu Fotokynes] from Lewis Partners. You may proceed.

Hi. I just wanted to get a sense of to what extent right now you might be taking down lots where they -- if you could sort of go back in time you may not be taking them down right now. So what -- you may not want to take them down right now given the economics. So what I mean is, perhaps, you started a community six months ago, you have an agreement to take down lots on a certain schedule and now you are halfway through the community and you're having to take down lots that may be sort of uneconomic or lots you wouldn't want to take down right now given the margins for returns out there but you have to take them down because you're in the middle of a community and pricing has gone south in that community but you still have to take lots down for another six months or a year. Just generally --

Well, there's an economic analysis on every community. It depends on where you are in the community, what your margin is, what your pricing power is and generally communities that we're deeper into have older lot basis'; we still have positive profit contribution. Even if we're not making a profit, if we can turn the inventory so we don't have to lose our deposit it makes economic sense for us to continue with that project and maybe put a few lots on our balance sheet.

Communities that are brand new where prices have fallen dramatically or they're not -- they are no longer economically viable because we bought at the peak of the market and the pro forma no longer works, then we're not going to put those lots on our balance sheet and we're going to put the stop sign out as fast as we can and go back and either renegotiate the take down price or walk the option.

Right.

And the ones that we -- the options that we have walked and we will walk in the future are under the most intense negotiations are communities that we bought last - last year. And that's where the biggest challenges are.

And how long does that sort of shift take to turn? To the point where -- because you may be in some situations now where you're in a community and the market has turned while you are working on that community. How long will it be until the market - let's say the market stabilizes - how long does it generally take to where you don't have that problem really anymore?

I don't know the answer to that. I mean, we're underwriting every community based on today's absorption level assuming there's no improvement from where we are today. If we continue at the absorption level that we've had over the last quarter to -- are these communities viable? And does it make sense to buy lots? So I don't know when the market is going to turn around and how quick it's going to get better but I know what it is the last 60 days and I've got to -- we've got to look at every community based on what's happened over the last couple few months.

Okay. A no-go or go-decision is based on today's facts, not some assumed improvement next year.

Right. Okay. The other question, in terms of the backlog as it now stands, how much of the cancellation activity of people sort of buying at the peak has now already come out of the backlog? Meaning, is the backlog as it now stands -- because a lot of the cancellation activity -- is that already occurring or are there two or three more rounds to go of a large number of people who bought at the peak likely to cancel within the existing backlog?

Well, I think generally speaking we're coming to the final hurrah. Okay? And I think we're getting to a point where most people that bought at the peak are either going to be closing this quarter or they're already out of the backlog and now we're into this sort of new generation of buyers that are seeking value and they may have sold their houses and we're not going to have the kind of cancellations going into next year that we had this year.

On the other hand, we still have some other larger builders - I'm not going to mention their names but you know who I'm talking about - who are continuing to lower prices. And to the extent that we have to compete with them, some of our buyers are in jeopardy and they want to cancel and go down the street and buy from them.

Right.

Because they can buy a house over there for cost. And until these guys wise up and try to help us all by stabilizing the market and not continuing to lower prices and precipitating this problem that we have, it's going to be tough.

Right. Okay. Thank you. Great quarter.

Okay. Thanks.

Next question is a follow-up from the line of Margaret Whelan from UBS. You may proceed.

Hey, Steve.

Hey.

I just have a question for you, really. We have been talking to a lot of the private builders in different markets and some are hurting a lot more than others. And it's our view that there's not going to be much of a spring selling season because there's a lot of inventory in the system and, obviously, it's market by market basis but it seems in a lot of these private companies already the stress if they don't get any orders in the spring and any potential to generate cash in those [inaudible], are you seeing blood in the street yet? I know Dave asked the question, I just want to ask more specifically in any of the markets if you agree with that and if you're already seeing compelling opportunities yet or what is it that you're waiting for?

I'm just not seeing it. My phone is not ringing.

Okay.

I mean, your bankers, other bankers, they're not calling me with deals that we need to be jumping on.

Yes. I can [inaudible] anecdotally though the way I [inaudible]?

No. I mean, I know the builders -- let's say I know the builders here in Phoenix the best because this is where I live.

Mhh-hmm.

But the four of five big private builders that I know --

They're happy.

They're pretty seas -- strong.

Yes.

And they got off the personal guarantees; they've got a lot of equity in their business. Everybody's got land for sale but no one is buying it. But I don't think we're there yet.

There are probably some small guys who got into the market a year or two ago and those guys are probably having stress but they're so small they really don't have any impact.

And we don't want those guys. That's not what we're-- that's not part of our strategy going forward. It may have been different two or three or four years ago but today I'm just not going to buy a builder that's doing 200 houses a year; or 300 houses a year.

Even in some of the smaller Florida markets where 500 houses a year is a couple percent?

Yes. It's just --

[inaudible] too much hassle?

It just -- it's too hard to integrate them and we've learned a lot about integration along the way and our profile of who we're looking for is different than it was a few years ago.

Okay. What's Steve Davis' role going to be? Is he coming in as a COO?

No. He is Executive Vice President of National Homebuilding Operations and he's going to be part of our senior management team with Larry Seay and Tim White, our General Counsel, and Sandy Carman our EVP of HR and he's going to be focused on customer satisfaction, help improving our customer satisfaction scores, working with the divisions on national purchasing, design centers, mortgage company joint ventures and a whole host of other operating systems just to align our operations and to be a facilitator of best practices and integrator acquisitions and refine our whole organization. He's got tremendous experience in that area.

Yes.

I think he's going to be a good part of our team.

I agree. And then finally, you slowed down the buybacks a bit. Is it because the stock has moved or what's the --?

A big part of it is it doesn't look as compelling as it did when it was 10 points lower, but we also want to keep -- predominantly we want to keep our powder dry so if these acquisitions -- opportunities do come for us and we want to keep our debt to cap down. We want to keep our borrowings low and as we've had to build more specs and put some lots on our balance sheet, that's probably eliminated our ability to be as aggressively -- stock buybacks as maybe we wanted to be.

Okay. Thank you very much.

Okay. Thank you.

Gentlemen, we're currently at the end of our hour. Do we have any time for one last question?

Sure. Go ahead.

Our final question will come from the line of John Kohler from Oppenheimer and Co. You may proceed.

Thanks for taking the call. I just wanted to get a quick run down, if I could, by region of the deposits you're taking -- if they've declined, and if so by how much, say over last year?

The deposits that we're taking on -- for new sales?

Exactly.

I would say they didn't decline much in the last year. They've been lower; they are generally 3 to 5%. Did that answer your question?

The gentlemen is no longer in queue at this time.

Okay. We'll take one more question.

[OPERATOR INSTRUCTIONS] We have one additional question and we'll take that question from the line of Peter [Reefe] from [NAS] Capital Management. You may proceed.

Good morning. I was wondering if you could give us a little color on what the growth margins might look like in Texas for the orders you are currently taking or maybe how that compares to some of your other regions?

Larry --

We haven't really -- go ahead, Steve.

No, go ahead. You take it.

I said we haven't really stepped forward or talked about specific gross margins in different states.

Mhh-hmm.

But we will be disclosing -- we talked about our new segment reporting for our West, Central and East regions when we refile our 10-Q so I would ask you to kind of wait and see what those look like and you'll be able to get regionalized gross margin and net -- pre-tax net income numbers from that.

Yes. I'm [inaudible] too specific, I would tell you that our margins in Texas are probably up a little bit from last year.

Okay.

And we expect them to stay up there and we haven't seen any retreat from where they are right now.

Well, thank you very much and have a -- congratulations on a great quarter.

Okay. Thank you for joining us for our third quarter 2006 earnings call and we look forward to speaking with you again next quarter. Thank you.

Ladies and gentlemen, thank you for your attendance in today's conference. This concludes the presentation. You may now disconnect and have a most pleasant day.