Meritage Homes Corp (MTH) 2006 Q4 法說會逐字稿

Good day, ladies and gentlemen and welcome to the Fourth Quarter 2006 Meritage Homes Corporation Earnings Conference Call. My name is Towanda, and I will be your coordinator for today. At this time all participants are in a listen-only mode. We will facilitate a question-and-answer session towards the end of the conference. [OPERATOR INSTRUCTIONS]. As a reminder, this conference is being recorded for replay purposes. I would now like to turn the call over to Mr. Brent Anderson, Director of Investor Relations. Please proceed.

Thank you, Towanda and good morning everyone. I would like to welcome you to the Meritage Homes Fourth Quarter 2006 Earnings Call and Webcast. We completed our fourth quarter at -- on December 31, and we announced our final results in our earnings release yesterday. If you don't have that release yet, you can access it on our website at www.meritagehomes.com along with the slides that accompany this webcast.

Please refer to Slides 2 and 3 of our presentation now.

Our statements during this call and the accompanying materials contain projections and forward-looking statements, which are the current opinions of management and subject to change. We undertake no obligation to update these projections or opinions. Additionally, our actual results may be materially different than our expectations due to various risks factors. For a discussion of these risk factors, please see our press release and most recent filings with the Securities and Exchange Commission, especially our most recent reports on Forms 10K/A and 10Q.

In our comments and slides as well as in our press release, we refer to certain non-GAAP financial measures such as EBITDA and earnings excluding certain charges. And we have provided descriptions and reconciliations of these items in the earnings release.

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 fourth quarter and full year 2006. 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 want to welcome all of you participating in our call this morning and thank you for your interest in Meritage. We achieved record home closings and revenue for 2006 and reported net earnings that place 2006 as the second-best year in Meritage's history, only $30 million less than our 2005 record earnings. Even after land-related charges we recorded due to depressed market conditions. Our net sales for the year were down 26% in units and 31% in dollar value although gross orders before cancellations declined only 13%. I will review how we achieved these results and how we are managing through much weaker markets today before I turn over to Larry to go through our results in more detail.

Slide 6. We ended the year with a record backlog of almost 6,400 homes, valued at approximately $2.2 billion. Our 2006 beginning backlog resulted from sales of 10,571 homes in 2005, an all-time record in terms of sales. Building on the strength of that beginning backlog, we delivered 10,487 homes at an average price of $328,000 for a total of $3.4 billion in home closing revenue for 2006. This compared to 9,406 homes closed in 2005, at an average price of $319,000 for a total of revenue of $3 billion. With respective increases of 11% and 15%, 2006 became our 19th consecutive year of record home closing revenue.

Slide 7. We saw only moderate margin erosion for the year. Especially relative to many other builders, our gross margin for the year was 20.6% compared to 23.6% for 2005 and was 22.8% 2006 before the impact of land-related charges that increased our cost of sales by $78 million. Gross margins have also trended down due to price concessions, forced by weaker market conditions across the southern and western United States, where we operate.

Slide 8. Compared to our industry peers, our margins were relatively strong. There are several contributing factors to our margins strength. Number one, our build-to-order strategy helped preserve margins on homes sold in 2005, but delivered in 2006.

Number two, our strategy to provide lots just in time to build up -- to build helps protect us from larger impairments and right now it is our own land. Limiting our losses to our option deposits and pre-acquisition costs in many cases.

And number three, our large presence and experience in Texas, where closing revenue grew 27% in 2006 over 2005, helped to offset declines in other markets. Meritage is celebrating 20 years of home building in Texas this year and was named 'Builder of the Year' by the Texas Association of Builders for the fifth time in the last six years.

Slide number 9. While weaker demand resulted in lower gross orders, cancellations were much higher in 2006 than our historical averages, resulting in much larger declines in net orders. These cancellations were both buyer initiated and company initiated in cases where the buyers were not performing as required under the sales contracts.

Land-related charges also reduced our 2006 net earnings. When real estate values are impaired by weak market conditions, accounting rules require us to write down the affected land and inventory. This resulted in $24 million in write-offs during 2006, the first in our history. In other cases when we were unable to renegotiate terms with our land bankers, we elected not to exercise options and roll up the associated deposits and pre-acquisition costs, which amounted to $54 million in total.

In situations where we forfeited our options, we had determined that home selling prices and market conditions had deteriorated to the point where it was no longer economically feasible to build. Therefore, we protected the company from further losses by effectively canceling the option contracts. Together these write-offs reduce net earnings by $48 million or $1.78 per diluted share.

Slide 11. We reported net earnings of $225 million or $8.32 per diluted share for 2006, just $30 million short of our record 2005 earnings of $256 million or $8.88 per share. The land-related charges reduced net earnings by $48 million; if not for those charges, we would have recorded our 19th record -- 19th consecutive record year of net earnings for 2006.

Excluding the debt refinancing charges in 2005 and land related charges in 2006, diluted earnings per share would have increased 6% to 10.10%.

Despite the challenges for 2006, we strengthened our balance sheet and positioned the company to take advantage of future opportunities. We managed our debt to capital ratio to 40% while we repurchased 2 million shares of stock this year. We also expanded our credit facility from $600 million to $850 million in 2006 to enhance our liquidity and build shareholders equity to over $1 billion at year-end.

Based on the results reported by other builders today, we believe Meritage has outperformed our industry group in 2006. Considering results net of all charges, our return on assets of 11% and return on equity of 24% should still place us among the best performers in the industry; and we believe these are testaments to the success of our strategy, our diversification and our management team.

I am pleased to report that Meritage was again selected for the Forbes Platinum 400 list of America's best big companies for the fourth consecutive year in 2006. This selection was based on rankings within our peer group for 5-year and 12-months sales and earnings growth, total return to shareholders, consensus forecast for long-term earnings growth and debt to capital ratios.

Superior returns, balance sheet management and liquidity will remain our focus going forward. Turning now to our fourth quarter results for a more current update on conditions.

Slide 13. Demand remained weak in most markets. Gross orders were down 24% before cancellations. The net orders were down 42% after cancellations representing 48% of gross orders in the quarter, as I previously discussed. We ended the year with a backlog of 3,685 homes valued at $1.2 billion, down from 6,394 homes, valued at $2.2 billion at December 31, 2005.

Based on our reduced backlog and weak order trends over the last few quarters, we expect that 2007 is going to be a difficult year.

Slide 14. We will continue to manage our business conservatively until we will see conditions improve enough to enable us to be more aggressive. In response to slower market conditions, we are slowing new investments in land, renegotiating construction contracts on existing projects and aggressively managing our overhead. At the same time we are intensifying our sales efforts to be even more competitive in today's challenging market conditions. I will now hand it over to Larry Seay for a more detailed discussion of our results.

Thank you, Steve. I will cover some additional fourth quarter results and focus more on the strength of our balance sheet.

Slide 15. Meritage delivered 2,601 homes at an average sales price of approximately $315,000 in the fourth quarter of 2006, a 19% decrease in volume coupled with a 3% decrease in price, which reflects mainly a change in mix. These results compare to 3,214 homes closed at an average price of -- excuse me $324,000 in the fourth quarter of 2005.

Quarterly home closing revenue declined 21% to $819 million from $1 billion reported last year. And we reported lower fourth quarter closings in all divisions except those in Texas and Colorado. Nevada's decrease is primarily due to the early sellout of a couple of key communities. New communities expected to open there in 2007 should help Nevada results. Arizona's strong increase in average selling price was due to a greater mix of higher priced product despite the price concessions we have experienced in this market. As we've discussed previously, Florida's results are split with Orlando's stronger relative results being overshadowed by Fort Myers, which is one of the weakest markets in the nation.

In Texas, home closings were up 4% for a total revenue increase of 11% over last year's fourth quarter. Meritage is one of the largest builders in the State with 121 actively selling communities that contributed 34% of our total home closings revenue in the fourth quarter of 2006. We believe our large presence and successful history in Texas are advantages for us in comparison to other builders. All in all, our quarterly results reflected weaker housing demand in most markets during 2006.

Slide 16 shows that fourth quarter 2006 total revenues and net earnings were $821 million and $9 million or $0.34 per diluted share, well under the $1 billion total revenue and net earnings results of $102 million or $3.53 per diluted share for the fourth quarter 2005.

Slide 17. These results reflect lower demand and lower average sales price in most of our markets which reduced our quarterly gross margin to 12.2% from 24.6% last year including land related charges in 2006. These land related charges reduced fourth quarter 2006 gross margins by 763 basis points and reduced net earnings by $42 million or $1.56 per diluted share. Excluding these charges, gross margin for the fourth quarter 2006 would have been 19.8% with a diluted earnings per share of a $1.90.

Total selling, general and administrative expenses were flat in the fourth quarter 2006 compared to 2005. Although management has been successful in controlling overhead, these reductions were more than offset by higher sales and marketing costs targeted at approving Meritage's competitiveness in more challenging market conditions. SG&A costs also reflect $2.2 million pretax expense for stock based compensation in the fourth quarter of 2006 related to the adoption of FAS 123(R) and $3 million for the right off of intangible assets related to a trade name acquired in a prevision acquisition, which we no longer plan to use.

Our 2005 margins were unsustainable. Our margins excluding the write downs in the fourth quarter of 2006 were more typical of our historic gross and net operating margins.

Slide 18. Meritage had 213 active communities open for sales at year end compared to 184 at year 2005 and 213 and September 30, 2006. While total communities remained flat in the fourth quarter, lower absorption rates kept many communities from selling out as expected in 2006. We expect our active community count to grow more slowly in 2007 than it has in past years.

Slide 19. Despite the land related write-offs and impairments in 2006, which on an after-tax basis represented just 5% of shareholders equity at December 31, 2006, the Company maintained a strong balance sheet and ample liquidity. At year-end net debt to capital ratio was 40.2% in 2006 compared to 38.2% in 2005, significantly better than other BA2, BA minus rated home builders and comparable to many investment-grade homebuilders. Total funds available under Meritage's existing bank credit facility stood at $449 million at December 31, 2006, after considering the facility's borrowing base availability.

Slide 20. We maintained strong interest coverage in debt to EBITDA ratios in 2006. I should point out that we did not adjust EBITDA to remove land related charges and even though these are non-cash and could be considered one-time charges, these ratios would have been much better had we excluded these charges. Late stage cancellations, which were more prevalent in 2006, affected these ratios by reducing our revenues while we simultaneously keeping our debt and interest higher until we can resell the homes and convert this inventory to cash.

Slide 21. Our total assets grew by $2.2 billion during the year from $2 billion at the end of last year as slowing sales resulted in $144 million increase in real estate inventory. This included an increase in finished lots and land that we acquired to keep our options active and an increase in unsold homes due to cancellations partially offset by lower pre-sold homes under construction at year-end 2006. Although we are primarily a build-to-order homebuilder, in some markets conditions are now requiring that we build specs where we have none or very few today, catering to buyers who have already sold their home and wish to move immediately.

Slide 22. Higher cancellations increase the inventory of unsold homes relative to the Company's strategic targets and long-term averages. Meritage had 545 unsold completed homes and another 820 unsold homes under construction at year-end 2006, together representing 32% of total inventory compared to a 14% spec inventory level at the year-end 2005.

Slide 23. We were successful in reducing total lot supply to 44,075 lots at December 31, 2006, a 19% decrease from 54,109 lots at December 31, 2005. Based on 2006 deliveries our year-end 2006 total represents a 4.2 year supply of lots. The percentage of lots controlled under purchase agreements, joint ventures and option contracts declined from 83% -- to 83% from 91% a year earlier reflecting the cancellation of approximately 7,200 lots controlled under option during the year and the increase in owned lots due to minimum takedowns requirements of existing option contracts. Based on our expectations for fewer deliveries this year, we are adhering to our target of managing to a four to five-year lot supply and have limited our new investment in lot positions. I will now turn it back over to Steve to wrap up.

Thank you, Larry. In summary 2006 was a year of both record results and weakening trends for Meritage and homebuilders as a group. Based on these trends 2007 looks to be a challenging year. Meritage has a strong balance sheet and we have taken steps to protect it by reducing our cost structure and deferring new capital investments. I am confident in our strategy and our ability to adapt to dynamic market conditions. We are adjusting our tactics while continuing to evaluate opportunities to strengthen our competitive position and continue to produce superior results for our stockholders. As market conditions improve, I believe that Meritage will be in a position to compete successfully and grow as our markets improve. We will open up for questions at this time.

Operator?

[OPERATOR INSTRUCTIONS].

Mind if I jump in here for just a minute? This is Brent Anderson. We have got a little technical difficulty here with the slides online. We will try to get that resolved, but go ahead with the q-and-a. Thanks.

Your first question comes from Margaret Whelan with UBS. Please proceed.

Hi. It's actually Dave Goldberg on for Margaret. I was hoping you guys could talk about where land prices are now. Where, if they're not moving at this point, what you think is going to have to happen to make them move and what kind of expectations you have in terms of timing for that?

Well, we haven't been real active in the land acquisition game for the last many months. But I would say our market intelligence tells us that land prices really haven't began to move to the degree that we had hoped or anticipated they would, particularly in the better locations. I would say there's -- we are starting to see some movement in the outlying locations that are more in the lower-priced housing markets -- lower-priced segment of the different markets that we are in outside of Texas. But the bottom line is we haven't seen prices move that much, and I think it's going to be a while before they do.

If I could ask some follow-up questions. I guess the next one will really be about, if land prices aren't going to be moving, what are your priorities for free cash flow, what kind of timing do you expect to be generating free cash flow, and sort of the amounts that could be generating? And what are you guys going to do with it?

Well, I think we're going to continue to pay down our debt and keep our balance sheet strong, and be available to opportunities as they arise whether it will be lower land prices or acquisitions that, maybe, make some sense down the road or buy back our stock. We are going to continue to be active on all those fronts, but I don't know at this point if we can commit to any one specific strategy.

Have you started to see some distress among, maybe some private builders or some more capital constraints coming in and again are markets getting a little bit better?

No.

No, we haven't seen much of that.

Yes, but David we are seeing in some cases a few land bankers have taken back a few positions in our remarketing and they are accepting a little bit lower prices. There is a few builders we have seen who are builders who may be selling lots at the prices they paid for those lots a couple of years ago, so they have kind of taken the peak out and re-priced them back to a couple of years ago; but there's not enough activity out there to say that that's a wide market trend. It's isolated -- isolated events.

I would like to just get one more question for you guys. I was hoping you could give us some more color on the Phoenix market and what is happening there and your kind of expectations?

Well, there is a lot of houses for sale down here, but there is also a lot of demand in the market. The economy is very healthy here and tremendous amount of job growth. I think the A locations are going to do better, of course, in 2007; and some of the outlined locations on the far East Valley and the far West Valley are going to have to adjust pricewise before they are going to see some life. I'm confident about this market, but I think 2007 is going to be a tough year here.

Great, thank you very much.

Your next question comes from Alex Barron with JMP Securities. Please proceed.

Great. Thanks, guys. Good job on the relative out-performance this year. I wanted to ask you about your impairments. I think you guys just kind of lump them together, and I was hoping you could break them up between option write-offs and land evaluation adjustments.

We do have them on -- once the slides become available, there is a Slide 10 that does break the impairments out by quarter and then breaks them up by real estate write-downs and option terminations. And for the total year, the optioned -- the real estate owned write-down was about $24 million and the option write-down was about $54 million for a total of about $78 million.

Okay. Can you give us some color as far as the regions where you guys are -- or how these breakout?

Alright, but we are not giving that out, [inaudible] get into specific regions, but I would say Florida, Reno and California, where we had the most write-downs and write-offs.

I might add to that, in Florida, this shows the difference between Orlando and Fort Myers. We had almost no write-downs in Orlando and almost all of our write-downs in Florida were in the Fort Myers area. So dramatically different market performance.

Got it. Can you also tell me like how many communities we are talking about that you guys have written-down, maybe this quarter and to date?

Total numbers, there is some overlap because some communities do have a certain amount of real estate owned versus option, but you're talking kind of in the 30,40 range depending upon how you count it.

Okay, got it. And I guess, how would you -- what was the pre-impairment value, I guess before you guys took these write-downs and the options.

I am not certain how to answer that question; I'm not certain what you're asking for.

So in other words, if you had a community where you took let's say 20 -- where you wrote it down by $20 million, what was it worth before that?

He wants to know the percentage difference between what the value -- what the community books for and what it was written down?

That is really hard to tell, because you're writing down houses in some cases, sometimes you are writing down land, sometimes you are just writing off an option deposit where it's really hard to make that distinction--.

But some of it was pre-acquisition costs. We had some communities that we had on purchase contract that we didn't proceed with the contract and we wrote off our investment. It's a lot of different -- a lot of different things that went into that, those two numbers, the $24 million and $54 million.

But in the 24 bracket then, any sense what percentage we are talking about?

Not really.

Okay. Another thing, hoping we could get into Texas, just seems like you guys had a sharp drop off in orders there relative to last quarter. Just kind of hoping you can give us a little bit more color of what's happening in the Texas markets.

Well, the fourth quarter was a bit challenging in Texas particularly in San Antonio and in Dallas. The Houston market and our Austin markets continue to be very strong, but we did start to see some weakness in those two markets. I think those two markets were proliferated a little bit more by investors, and we scrubbed some of those investors out of our backlog and that resulted in lower net orders in the quarter in Texas.

Was that due to just kind of less gross sales coming in or more increased cans or both?

I think it was probably both.

Okay. And then lastly, you guys didn't seem to give an outlook for '07 just kind of wondering if you had some sense for units, margins, EPS?

No , we're not giving any guidance in any of those areas. The markets remain pretty turbulent and I think it's going to be challenging, at least at this point in time, to give guidance. Possibly at the next quarter call, after we get a little deeper into the spring selling season then we will be able to give some more specific guidance.

Okay, thanks Steve. I will get back in the queue.

Thanks.

And your next question comes from Dan Oppenheim with Banc of America. Please proceed.

Thanks very much. I was wondering if you can provide a little more color in terms of your expectations on land as we go into -- through '07. You mentioned that the lot supply is really what you're looking for right now. Should we assume that you will just close on the options throughout '07 to expect a few walk-aways beyond what we have seen so far?

Hopefully not. If the spring selling season is -- meets our expectations then we won't have to make any more write-downs or write-offs or walk-aways. But if the markets underperform from where we think they're going to be, where our assumptions are then there will be some more. But I would say, as I add on to that, we hope to -- continue to reduce our lot count. We are not in the market right now to buy lots. We have reduced our lot count from 54,000 to about 44,000. I hope that by the end of the year we can get that under 40,000 and not by walking away from lots but by just burning through our inventory and not replacing it.

Thanks that sounds like a good strategy there. Wondering, you mentioned that if the spring is in-line with your expectations, what is it that you are currently expecting in terms of the spring so just put some color on that.

While we're not giving any specific guidance on what our expectations are for sales for this spring. I would tell you though the first few weeks of the year seem to be off to a good start, but it's too early to make a trend out of it. And we're going to have to get a little deeper into it to get comfortable with -- that the market is heading in the right direction.

Thanks very much.

Your next question comes from the Greg Gieber with A.G. Edwards. Please proceed.

Good morning, gentlemen. I wonder, in terms of the -- you could give us some color into what you have been able to renegotiate on option contracts? Are you able to renegotiate lower prices or just extending the length of the option? And if you're extending the length, I know that some land developers are asking for increased money. Is that the case, are you having -- are you paying any of that?

Well, every situation is different and it depends on a great deal to where you stand on that option agreement. Whether you entered in the early stages and just getting started in that community or whether you are more than halfway through in the late stages.

Generally, communities that we are -- have been involved with for quite some time and we will be building houses and we are well underway, but you know halfway in or greater those are not communities we are walking away from because we have equity in our land and we have forward momentum. In those communities we're getting some of our take-downs delayed potentially, we are getting in certain cases some option fees reduced. The deals that we are walking away from are more early-stage deals where maybe we haven't started the models yet, we haven't done a lot of development work, maybe just horizontal development no vertical development and we bought these communities in late '05, at the peak of the market and there has been a serious erosion in the price of homes in those areas and the profit really has gone. So that makes up the bulk of our write-offs and every land banker has been different. Some have been very difficult and challenging and we haven't got many concessions, and some have been -- have come right to the table and worked with us in a very productive and efficient manner and have been willing to share the pain.

I would add two more points and it really depends on the specific community and how much to the market that specific market area has deteriorated and obviously the more deterioration the more leverage we have with renegotiating price. The other thing as far as deposits go in increasing our investment, we have always been a low deposit option -- optioner -- optionee and we have focused on maintaining that so our mantra has been no additional deposits, no additional investments, no current pay, so I think that is one of the reasons why our options strategy is working well for us is that we have kept our investments low so it gives us more negotiating room.

Okay. Could you just tell me this, how many lots that you have coming up that you expect per contract you were supposed pull down on option contracts?

I do not have that specific number by month or by quarter for '07 although we are monitoring that. And obviously, as we said on our prepared remarks, that our finished inventory has increased and we do see that increasing somewhat during the year, but then by the time you get through the end of the year, we have worked through a large portion of the lot inventory so we're kind of in the middle of the year sometime cresting and then starting to improve from the existing inventory we have. Now there may be new investments and new deals if the market starts to stabilize and improve but based on our existing deals, we would continue to take down and put some on our books and we would see that number go up for the next couple of quarters and then we would hope sometime towards the later part of the year that would start to crest and start to come back down. So we are monitoring that and watching that very, very carefully.

That's helpful, if I could ask a question now in just pricing you said in some areas you have seen fairly dramatic price cuts such that you're walking away from land, I assume these are some on the outlying areas like around Phoenix. Can you just give us an example of just how large those price cuts have come and I guess the further out places like Casa Grande or Queens Creek?

I think that some of the far out locations are not only in Phoenix but also in California and Florida house prices have gone down 20%, 25% and that has a larger impact on lot prices. Because you've got to remember when you are preparing the financial analysis the construction costs are relatively fixed. If you still want to achieve a gross margin of at least 20% the residual number is the land price. So, 20%, 25% decline in house prices is going to have an exponentially greater impact on the land prices.

Okay, that is helpful. Thank you very much.

Your next question comes from Carl Reichardt with Wachovia Securities. Please proceed.

Morning guys, how are you?

Morning, thanks.

What -- Larry, what discount rate did you use on the impairments and were there any in the JVs?

We did not have impairments in JVs and because we use options and those options are very short term and there's very -- often times, most times a very little investment on our books, a discounting concept is not quite as relevant as with somebody who has a very long term project that goes up for many many years on balance sheet. For those projects where we do have on balance sheet where they were longer term and discounting was utilized as required by GAAP our discount rate was kind of in the mid -- the mid-teens and, I don't want to give a specific number but it is in the mid-teen range.

Okay, great. And you mentioned that community count is not likely to rise appreciably in '07. Is the mix in terms of either geography or in terms of the price points you are attempting to hit going to change substantially? What I am really looking for is, is your mix going to shift more entry level or higher-end as you look at net adds and subtractions in '07?

I don't think so. I think, if anything it is going to continue to be heavily oriented towards Texas but as far as -- which would drive down our ASP little bit but I don't see a big shift in product mix. Larry?

No, I agree. If anything we have said that we are driving -- trying to drive prices down by building a little different product so you will see some lower priced product come onto books a little more tax product but the great great majority of our products still going to be single family detached and I think what you see as far as community counts you will see a gradual increase as the last few communities we have tied up come online and start actively selling but then towards the end of the year, given no additions to lots under control you will gradually see that start to crest and start to fall back down. Now, whether that really happens depends on what the market does. If the market gets tougher we'll probably be less likely to tie up new projects. If the market starts to improve, well than you will see that -- maybe not crest but continue to gradually increase. But based on our current tied ups subdivision you kind see that crest during the year sometime and then start to gradually come back down.

Okay, that's helpful, and my last question is, on the goodwill, am not sure how to ask this, but what will need to happen I guess from a profitability or cash flow perspective that would create a goodwill impairment for you especially in Florida on the recent deals but just in general? Can you kind of outline that for me?

Sure, you know the impairment on goodwill is definitely a long term impairment, a permanent impairment and we are committed to Florida. We battened down the hatches in Fort Myers but we are cutting our costs and we are hanging in there and we have every intention of growing that market back again and actually continuing to expand within the state as the market comes back. So based upon that strategy and the assumption that things will improve in the next few quarters sometime, we don't have a permanent impairment and we can create cash flow assumptions that are very -- of growth and probability over the next few years, which are very reasonable assumptions which provide us with plenty of cushion on impairment. Now if we changed our strategy and said we were going to pull out of Fort Myers or pull out of Florida which isn't our intention then that -- those things would change whether we have a write-down or if we had this very long term that Florida was going to be down and out for many years then those kinds of things would trigger permanent impairments.

Terrific that is very helpful. Thanks so much guys.

Thank you.

Your next question comes from Stephen East with SIG. Please proceed.

Hi, good morning guys. I guess if I could start with incentives, where are you all now as a percentage of sales and how is that compared to a year ago?

Well, again, it varies by market and varies by product and varies by community but a year ago incentives were nominal. Today they can range anywhere from 5% to 20%.

Okay.

We don't have one number, we don't have an average for across the board and across the company and the incentives take different shapes and forms. They could be mortgage buy downs, they could be options, free options, they could be just discounts off the price.

Okay. Is it fair to say though if I look at your gross margin compression year-over-year, the majority of that is due to either incentives or tighter pricing in the same markets?

No doubt, I mean a lot of that was due to us having to go into the backlog and provide some incentives for buyers to close on their contracts.

Okay.

On average and I think quarter-over-quarter on margin compression we were a little below 25% in gross margin last year's fourth quarter and we are just a little below 20%. Yes, certainly that margin erosion has been caused by incentives and discounting.

Okay, and if you look at your gross margin that is sitting in your backlog now how that's shape up versus the quarter just ended?

I think gross margin as we go deeper into 2007 is going to be down.

We certainly we're still benefiting from having a few houses closed from a stronger period so I do think you'll see further gross margin decreases. How much that is, it just depends on where the market goes.

Okay, alright, and Larry, I think it was Dave that was asking about the cash flow and uses and all that, what do you think just generally speaking where do you think your free cash flow will be in '07?

We don't have a projection on that but I would say we are in a little bit different position than some builders that traditionally have very large land positions whereas as they burn off those land positions that does create free cash flow. Since we are a traditionally option builder, all we do is just not buy a -- a lot and not build a house. So we are in a little different position about -- of generating free cash flow. We will not, because of our past record, because we've never had the money invested there's not as much money to harvest back. And in fact, as I said earlier, we are bringing some lots on balance sheet to keep existing option contracts that we have not been able to push back the take-downs or bring them on balance sheet because they are still good projects with good margins. So you will see over -- in the next two or three quarters, lot finished inventory can hinder growth so that is actually use of cash but that will eventually peak and reverse itself.

Okay, all right. And then the last question, Steve, you talked a little bit about -- you've got expectations for spring selling season, I guess what -- without using this as a guidance type thing, what would you consider successful in the spring selling season? Is that a flat type of order rate? Is it down 20% type thing?

Well, I think if we can get back to one house sold per week per community on average, then we are back to more of what I call normal market.

Okay. I appreciate it, thanks.

And your next question comes from Stephen Kim with Citigroup. Please proceed.

Thanks guys. I was wondering if you could provide a little bit more color on your commentary about scrubbing the backlog. I don't know if that was the expression you used but that is the expression others have used. Can you be a little more specific? I think you mentioned that, you know, if a buyer is not performing, I think is the phrase you used, that then you would sort of take steps to sort of accelerate the cancellation. Can you be a little more specific? Give us an example of what kind of a situation might have resulted in a cancellation that heretofore might not have.

Let's say we had a house to sell and they're anticipating they were going to have their house sold by the time the house that we are building for them is complete and they haven't sold it and they can't perform on our contract and, you know, in some cases they will be given another month or two to try and to get their house sold; but I think we wanted to make sure we entered 2007 with as few cancellations going forward as necessary and we wanted to make sure that any buyers that we didn't think could perform or were going to perform we extracted them from the backlog.

Stephen, to quantify on that, we don't report a home to sell contingency as a sale, a lot of people in the past were signing off on that contingency even though they hadn't sold their home so we are aware they still had to sell their home, but they were willing to take the risk and we could keep their option money—

...earnest money

Yes, their earnist money. And what we are doing is if people aren't being realistic about their sale, their home sales price and they aren't making progress or they are getting cold feet and they aren't coming in and picking up their options and upgrades and we're sending them a letter they need to come in and do that or they aren't getting the final qualification on their mortgage done. Those are all indications that people are getting cold feet and aren't going to close. So instead of waiting until people show up at the closing -- don't show up at the closing table, we are more proactively contacting and pushing them to perform; and if they don't, we are more proactively canceling them.

So I guess -- but just so I'm clear on this. When you record something as a cancellation for this -- purposes, so that people like me track this information, these are actually situations where both parties have agreed that there's a cancellation there?

Right

This is not a situation where the buyer is still out there ostensibly thinking that they are going to move into a house but you have just for recording purposes for the street have said, let's be a little bit more cautious and let's record this as a cancellation even though it's not actually a cancellation yet?

I think it's some of both. I mean we have buyers who came in and said we're canceling and we want our money back and we're not proceeding with this contract, and we have other situations where buyers are not performing under the terms of their contract and we've cancelled them.

But you've actually told them you're canceling them?

Yes.

Okay, got it. Okay that is what I wanted to clarify. Okay, great. Secondly you -- I guess an answer to I think Stephen East's question about what would constitute a good selling season or reasonably -- you'd be reasonably satisfied with that kind of a spring selling season, I think your remarks about like one sale per community per week, which is putting you with your current community count somewhere in the neighborhood of 11,000 orders or something for the following year, which is not terribly off from where we are at. And I guess my question is, what -- is that the level of overhead that you are trying to gear your company to have as you enter 2007 or is that, are you carrying an overhead level, expense level somewhat above that?

I said that's what I thought would be the normal market if we can get to one sale, per community, per week. We have not built our projections on that and I don't expect that to happen.

Okay, so you're somewhat lower than that in other words?

We are lower than that number. I don't expect that to happen, but when we get to that point I will believe that the market has fully recovered and that we are back to more of a stabilized normal market. I don't expect us to be there in 2007, and we have not designed our overhead structure this company at that level. We think it's going to be, without giving guidance, it's going to be below that number.

Okay.

And as far as overhead goes, Steven, we have already done a couple of rounds of layoffs from the peak numbers excluding Texas since Texas really hasn't had layoffs because it's a good market. We have had 28% of our workforce laid off from the peak of our employment. And we are focused on meeting our budgeted sales forecast; and if people miss those, we will continue to cut overhead. And I think that's where the company has been successful in keeping our G&A number relatively in line.

That is a pretty significant number, 28% outside of Texas.

Yes, no, I agree how things go, and I think that it's an appropriate response to what's happened. Can I ask some more questions or should I get back in the queue?

Go ahead.

Okay. Your steps to sort of cleanse the backlog so to speak. I was curious as to whether you anticipated that that would result in a cancellation rate as a percentage of beginning backlog declining as we go forward here. Irrespective of whatever your gross orders are going to be, I understand it's really hard to predict that one. But if -- aside from whatever you get walking in the door in terms of how much of your backlog is going to cancel it would seem that your remarks would suggest that one should be anticipating that cancellation as a percentage of backlog should begin to diminish. Is there anything that you see as you head into '07 that would make that not happen?

I think the short answer is no. I think most of the buyers now that are in the backlog are buyers that have purchased more recently that have gotten the lower purchase prices and they've gotten incentives. And a lot of buyers that are coming in today and buying our houses have already sold their home. They're not taking the chances as they did in the past if they'd have their home sold by the time our house is done. And a larger percentage of the homes that we are selling today are spec homes, which keeps them in the backlog a shorter period of time, which has an impact on that. So we are very optimistic that our cancellation rate is going to come down to that 20, 25% range, this has kind of been historically the normal average.

Yes, that's a percent of sales.

I understand.

And it is not going to get there all in one quarter, but we certainly believe that the fourth quarter cancellation rates were at the high watermark and we should start to see improvement and there'd have to be another downturn in the market for that not to happen.

Right, right. Exactly. Last question. You talked about maybe looking for opportunities at some point, maybe not right away, but somewhere a little bit down the road here. Would your emphasis be on maybe diversifying your portfolio of markets that you are in? I mean is this a good time for a company like Meritage to be seeking the next -- going over the next tail there and seeing what's going on in other markets? Or is your perception that this figure, you like the markets you're in, and you'd like to strengthen your position in those markets, and that's going to take precedence?

I think it's some above. I think we are definitely interested in pursuing more markets in the Southeast later this year whether that be through a Greenfield startup or an acquisition. Our eyes are definitely opened to opportunities in the Southeast. But then again, we also have opportunities to grow subsequently in almost all the markets we're already in.

Okay.

That's why, that's why we are working hard to protect our balance sheet and make sure we keep our leverage low, keep our liquidity high so we have dry powder to take advantage of opportunities as the market returns.

Okay, great. Thanks very much guys.

Thank you.

Your next question comes from Timothy Jones with Wasserman. Please proceed.

Good morning. First of all, I am surprised that your goal is to keep a four to five year land supply. I mean, most said that, most of the builders said that they want that down to two or three years. Can you comment on that?

I just think what they want, the time it takes to bring lots to the market and get them improved, and get them entitled and get them ready. It's hard to operate for a much, with a much less supply than that. Particularly in the western markets that we're in they take even longer. Certainly in some markets in the Midwest and the East and Texas you can bring lots to market quicker and you don't need to have a longer supply but where we do business we think that's necessary.

Okay. I was very surprised when you named the three markets where you had the most write-offs. We know Florida and California, but you did not mention Arizona given the size of that market to you.

Well I think in Arizona we have a very strong and seasoned land position. We didn't buy a lot of land in Arizona in 2005 and the early parts of 2006. The land that we did buy was a very long term position that we thought we bought at very attractive prices. So, we just haven't had the write-offs or write-downs in Arizona. I think maybe we had two communities here, two or three maybe, but we didn't have the buildup of lots here in the last 18 months or so that maybe some other guys did.

Okay. In that very good supplemental information that Greg provides, I was very surprised to see the average price in Florida go from down 30% for the year but be up 60% for the quarter, and the same with Nevada being up 12% for the year but being up 47% for the quarter. Could you comment on that please?

The Florida percentage is biased by the very weak performance in Fort Myers where you had actual negative sells being generated because of Fort Myers, so that at average, it's not an average you should pay any attention to. It's just a mathematical number that's pretty meaningless.

I can -- that's my point. I thought that was the case. How about Nevada?

Nevada did -- we mentioned that Nevada sold out at a couple of key communities, or those -- or those committees were intended to be lower-priced communities. So you shouldn't think that Nevada sales prices are going to maintain at that much elevated level that has newer communities come on in '07 that we have planned and you will see that average price come back down.

Did you -- did you say that the new communities in Nevada were closing out this year or that you were bringing a couple on next year?

We are bringing -- we closed some out in '06 and we are bringing some on in '07.

There's the differ -- difference in the price range of the ones closed and the ones coming on?

Right, or the one that's closed out versus the ones that continued and then as the new ones come on then price will come back down.

Is that -- could you give me roughly what the number of units in those?

No, I don't have that specific data off the top of my head. I'm sorry.

The last question, real quick one is, you said you are increased in specs in some markets, would that mainly be Texas where you do have a high level of specs?

I would say we are increasing our specs in Texas, I would say more of it is going to be in the western markets in Florida due to cancellations.

[inaudible] to have said that. And I think some builders are going to run out of their product if they get too cute. All right, thank you.

Thank you.

Your next question comes from Silvan Berlina with Bear Stearns. Please proceed.

Thanks I just had a question, I guess, on your debt levels and going into next year assuming your target of debt to EBITDA of 2 times or lower and clearly that is going to be an issue going into 2007. If you could address that and also what you are planning to do with your outstandings on your bankline?

We are -- first of all as far as our targets, we will see some increase on our leverage, a moderate increase going into the year; we always have a seasonal increase. We wound up about 2 percentage points higher from the prior year. We think, considering the environment that only being up 2% and staying around the 40% level was very, very good performance. But you will see that continue to go up a bit. We have plenty of room under all of our covenants be it interest coverage or debt to tangible net worth. So those things shouldn't be an issue and -- did that answer all your questions or did you have one more in there?

Well, I guess that debt to EBITDA you typically have a target ratio of 2 times or lower?

And we should be able to stay pretty close to that level. At the end of the year we were at 1. -- or for the year we were at 1.7. So, over the last several years we have kept it under 2, I would think we would still be able to keep it at the 2, 2 or lower.

Okay, so is that assuming some reduction in debt in 2007 towards the end of the year?

No. Well, yes I don't think that where we are today we are going to go above 2.

Okay and then--

And based upon our expectations for our balance sheet performance during the year I don't think we would go above 2.

Do you have expectations to issue in the unsecured debt market assuming your balance and your bankline?

Yes, we could go out there and issue some more debt to pay down our bankline. We haven't made any final decisions on what we would do if anything but it's possible that we could go out and pay down our banklines a bit in order to just free up some more liquidity to make sure that we are well positioned for '07 and '08.

Great, thanks so much.

Your next question comes from the line of Sharmu Fotokynes with Lewis Partners. Please proceed.

Hi, guys. I wanted to sort of understand a little bit about the option contracts you are now choosing to perform on. So you guys talk about sort of the target ranges for gross margin of 19% to 20% and you know, targets, sort of, return on assets 10% to 15% and return on equity 25% to 35%. The contracts that you are now -- the option contracts that you are now choosing to perform on, do you believe that, sort of, over the long term you can achieve those targets if -- on the contracts that you are now choosing to actually exercise?

Well, not on all of them. I mean some contracts we are willing to continue to perform on them but take a much lower margin as prices have fallen back. As long as we are in a positive territory where we are making a positive margin after paying our overhead, you know, we continue with the contract. But I am not really sure what your question is, I mean if you are looking for guidance on our -- where gross margins are going to be or if you're asking us for how we look at each deal.

I'm just trying to figure out sort of during the re-negotiation process what are the key things you are looking for to determine whether to go ahead and walk away from the option versus going ahead and sort of deciding to perform?

We generally, again it varies depending upon whether we are three quarters away through the project or not but let's say it's a project that's fairly new where we don't have a lot of investment models, we don't have customer contracts where -- you know for homes that were sold and in closing. We would typically try to look at it as a new project and consider all of our prior investments, say an option deposit that's kind of sunk cost and say, gee going forward given the cash flow coming -- going into the project and coming out of the project what kind of yield would we getting kind of generally underwritten as a new project. Now as we get further into it we will take a little bit less of a return, less than a -- less on IRR and less of a margin, because we're already into it. We have more sunk cost, and we are -- even though it's a sunk cost we are recovering costs, but certainly when we get down to a low single digit margin, we are thinking really long and hard that those things don't make any sense both on a margin side and IRR side.

So for the projects that you're actually not into we are talking about a certain return [rate] that's sort of hurdle that you typically target or is that the sort of where you generally look at these things?

Yes, we would typically look at a net a gross margin hurdle, like net contribution margin hurdle, a return on asset/IRR hurdle and a new project would meet those hurdles. And the hurdles might be different and different states depending upon perceived risk or depending on the length of the project and the perceived risk of the project itself.

Let's say sales -- if sales prices are down 10% or more on a new project, that's a project that we're going to look at long and hard of either walking on the option contract or significantly restructuring it.

And are the options again that you're performing -- decided to perform on right now, are those projects -- within those assumptions that you are making, are you assuming sort of current absorption pace/current price, further deterioration of absorption price/further deterioration in price or sort of some improvement back to the normalized level of both absorption pace and price?

I don't think we factor into -- we factor in real market conditions; we don't factor into more deterioration or factor in market improvement.

I hear you.

We do a pro forma every quarter on every project based on what today's market conditions are.

Okay. So really it's not that you think you underwrite a current deal with the expectation that you're going to get back to the one community per week --

No.

Okay, one home per week per community, okay.

We do it at what the current absorption rate is for the last quarter.

Okay. The second thing I wanted to ask is, in Las Vegas and Arizona are you seeing the inventory levels of new and used, new and existing homes in those areas, are you seeing those stable now or do you expect that to sort of further increase as you get into the spring selling season?

They've actually leveled off and are starting to decline, albeit very slowly. I believe both those markets, both these states are going to -- inventory of re-sale homes is going to begin to decline.

I see. And so you don't think that there's a pent up sort of supply of people who would pull their homes off the market, say at the end of the year last year that would come back into those markets once the spring selling season gets going?

No, you know we don't have those weather kind of issues here, where people are waiting for the weather to get better to put their house, you know spring kind of, it's always springtime here. So I don't see that being the case.

Okay, wonderful. Thank you. I appreciate it.

Thank you.

Due to the current time constraints, would management like to accept more questions?

We will accept two more.

Your next question comes from Alex Barron with JMP Securities. Please proceed.

Yes, thanks guys. I guess I was just hoping to get a little bit more color on Florida where you guys have seen -- or not just you guys, but a lot of builders have seen negative orders. I mean what's really going on there? Have you guys dropped your prices and people are still not buying or what do you think is happening?

You know -- Alex we are in two principal markets of Florida, we are in Orlando and then we're in the Fort Myers/Naples area--

I'm on a call, can you call me back in about 20 minutes?

Hello, Alex are you there?

Yes I'm here.

Okay, someone got in there. So you know Fort Myers/Naples, is a very seasonal buyer, and a buyer there is very selective decision, a lot of second homes retirees coming down there. We are going to be able to give you better color in the next few months after we see what happens here in the spring selling season. Up until this point though, there hasn't been a lot of buyers, a lot of interest. There's been a handful of bottom fishers down there, but it's been very, very discouraging and disappointing in that market. Orlando is a totally different situation. The buyers in Orlando -- there's real employment, there's real job growth down there. It's a much more market, like Phoenix is a market. We are seeing some good activity in our sales office; we are seeing some traffic. Too early to call the market; it's too early to predict a trend but the first few weeks in Orlando for 2007 look promising.

Okay. And I was also wondering about your other comment that you guys said you felt you needed to start increasing specs in a few markets. I'm kind of wondering which markets and why if you're not concerned that there's too much inventory already out there?

Don't misinterpret that. What we are saying is that in very rare instances we may wind up building a couple of more specs in markets where we burned off our specs in order to be able to sell to homebuyers who want to close immediately. What we are seeing is that homebuyers are being more cautious now and not buying a home until they've sold their own home so they have a more of a need to move into a new home more quickly because they've already moved out of their old home. So when we burn off specs you may see us build a couple of more specs than it would have on historic terms because of that condition. We hope it goes back to -- completely back to historic conditions and we want to continue to be a pre-sold builder.

Got it. Okay, thanks a lot.

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

Hi guys, just wanted to get your take on just your deposit that you're taking on the -- on a home that's not built yet. Did that change any in the last year and if that differs between the regions?

Well, it's gone down because we had to lower it because of the competition. In the past we've been pretty successful at requiring our buyers to give us a larger deposit --

Previously was it around 5% of purchase price, or--?

Yes, I think 3% to 5% depending on the product, I mean, more expensive luxury product we're getting 10% but some of the lower priced entry -- more entry level products we're getting smaller deposits. But across the board, we've had pretty good success in years past and getting larger deposits but it's been more difficult to achieve that here as of late--.

Has it been in all the regions where competition has been lowering their demand purchase or option purchase for the --?

I would say everywhere outside of Texas, I mean Texas things haven't changed that much but I would say everywhere else. Unfortunately there are some builders out there that we compete with that do not require much of a deposit.

So what percentage of the purchase price say in Phoenix and California are you typically getting now?

Well here is the average for the whole company. We have about $42 million in home sell deposits, and we have $1.2 billion in backlogs so you got about 3.5% companywide. In some places like California it is legally limited to 3%. Now you cannot get more but it is refundable so it is a little bit of a waste of time to get more. So in Texas we have a little lower priced homes so we kind of get a little less in Texas. Arizona and Nevada little higher priced homes so we get a little more plus you can keep it legally.

Right.

So that kind of gives you a little bit more color.

And a year ago what was it, percent deposit versus the backlog?

It was a little closer to 4% instead of 3.5%.

So it is more to 4%, so it is not down that much it's about 0.5% or so?

Yes.

Right. And this -- the goodwill on the balance sheet at the end of the December quarter, do you know what it was?

It is about $130 million; I do not have the specific number off the top of my head.

Alright, we will just go with the $130 million. Already, thanks a lot.

Thank you.

At this time there are no further questions in the queue, I would now like to turn the call over to Mr. Steve Hilton for closing remarks.

Thank you for joining us for our fourth quarter 2006 earnings call, and we look forward to speaking with you next quarter. Thank you very much.

Thank you for your participation in today's conference, this concludes the presentation. You may now disconnect and have a great day.