Meritage Homes Corp (MTH) 2007 Q2 法說會逐字稿

Good day ladies and gentlemen and welcome the second quarter 2007 Meritage Homes Corporation earnings conference call. My name is Latasha and I will be your coordinator for today. At this time all participants are on a listen-only mode. We will be facilitating a question and answer session towards the end of this conference. (OPERATOR INSTRUCTIONS)

I would now like to turn the call over to Mr. Brent Anderson, Director of Investor Relations for Meritage Homes. Please proceed.

Thank you Latasha. Good morning, everyone. I would like to welcome you to the Meritage Homes Second Quarter 2007 Earnings Call and Webcast. We completed our second quarter on June 30th and announced final results in an earnings release yesterday. If you don't have the release yet, it's available on our website at www.meritagehomes.com along with the slides that accompany this webcast. Please refer to slide two of our presentation.

Our statements during this call and the accompanying materials contain projections and forward-looking statements, which are the current opinions of management and subject to change. We undertake no obligation to update these projections or opinions. Additionally, our actual results may be materially different than our expectations due to various risk factors. For a discussion of these risk factors, please see our press release and most recent filings with the Securities and Exchange Commission, especially our most recent quarterly report on Form 10-Q and our annual report on Form 10-K. In our comments and slides as well as in our press release, we refer to certain non-GAAP financial measures such as EBITDA, adjusted EBITDA, and earnings excluding certain charges. We've provided descriptions and reconciliations of these items in our earnings release and in the supplemental information on slide 22, which is in the presentation and file on our website along with the press release.

Participating on the call today, Steve Hilton, Chairman and Chief Executive Officer of Meritage Homes and Larry Seay, our Chief Financial Officer. They will discuss our results for the second quarter and first half of 2007. At the end of their prepared remarks, we'll take questions from the listening audience. In the interest of other calls scheduled today, we'd like to keep this call to one hour. So we would ask you to please limit yourself during our Q&A period to one question and one follow-up. As a reminder, this call is being recorded and the replay will be available on our website within a couple of hours after we conclude the call. I'll now turn the call over to Steve Hilton and refer you to slide 3 of our presentation. Steve?

Thank you, Brent. I'd like to welcome all of you to our call this morning and thank you for your interest in Meritage Homes. I want to especially thank those investors who have remained involved in the home building sector and Meritage Homes while the market has been so difficult. Despite the negative atmosphere surrounding the sector, we are optimistic that the housing market will recover once the industry works through the excess inventories that exist today and buyers regain confidence that their homes will hold their value and appreciate. We believe that Meritage is well-positioned to what has historically been some of the best housing markets, including our strong franchise in Texas, which has recently outperformed most other large markets across the country.

We believe we have a sound strategy that manages our risk while enabling us to grow when there's an opportunity to do so. And we have an experienced and dedicated team that's leading us through the challenge of this cycle while our position -- while also positioning us for the future. Recall that Meritage is among the best performing home builders during the 5-year period ending 2006 with some of the highest growth rates and highest returns in the sector. As the market has slowed, our performance has been more in line with the industry, but we believe the very same option strategy that facilitated our growth has also protected our downside by limiting our losses. Though the strategy hasn't totally shielded us from the market downturn, it has allowed us greater flexibility than the traditional model of purchasing land with long-term debt. We firmly believe that by controlling land through options, we have been protected from losses, which could have been much more severe had we owned the property.

With that brief background, let's review the second quarter on slide four. Recent government housing statistics and reports from other builders clearly indicate that market conditions have been even more challenging in the last few months. Interest rates have increased, mortgage credit has tightened, and buyers continue to wait for signs that we're near in the bottom, especially in markets where affordability was a significant concern. After our first quarter, seemed to show some early signs of improvements, conditions deteriorated in April and have persisted since then. We can demand an increased price incentives resulting in lower margins, in additional inventory impairments. Based on slower sales and reduced selling prices, we adjusted our inventory valuations to current prices and abandoned certain lot purchase options. Where previously negotiated prices won't allow us to generate a reasonable return at today's lower home selling prices. This resulting impairment charges turn what would have been a modest net profit into a net loss for the quarter.

Slide 5. We reported a net loss for the second quarter 2007 of $57 million or $2.16 per share compared to net earnings of $77 million or $2.82 per diluted share in the second quarter of 2006. Net earnings were reduced by 70 million from the combination of real estate impairments and good will related impairments in Florida. We recorded real estate impairments in every state, but Texas, Including $45 million in California, $15 million in Florida, $12 million in Nevada, and $8 million in Arizona. Due to persistent and severe weaknesses in Southwest Florida, we determined that all good will and other intangible assets relating to our February 2005 acquisition in the Fort Myers/Naples market were impaired and we wrote off these assets. Excluding the good will related impairment in 2007 and severance cost from general administrative expenses reduced our G&A by 31% year-over-year, maintained it at 4% to 5% of our total revenue.

Slide 6. The total impairment charges amounted to 70 million after tax as I mentioned earlier. Excluding these charges we would have been profitable for the quarter, adjusted net earnings would have been 13 million for the second quarter 2007 compared to 82 million in 2006. This was a very difficult comparison considering the second quarter of 2006 produced the second highest quarterly earnings in Meritage's history.

Slide seven. Second quarter home closing revenue was $568 million in 2007 compared to a record $903 million in the second quarter of 2006. Again, a difficult comparison to record results last year. This 37% revenue decline reflects an 8% reduction in average selling price on a 32% fewer home closings. The largest year-over-year declines in closing revenue were experienced in Nevada, which was down 69%, followed by Arizona, down 58%, and California, which declined 52%. On the other hand, quarterly revenue from Texas home closings increased 8% year-over-year compared to the second quarter 2006.

Slide eight. Gross margins declined due to greater incentives reflecting increased competition for home sales. However the real estate related impairments make year-over-year comparisons less meaningful. So we've adjusted gross margins for better comparability. Excluding second quarter real estate related impairments of 79 million in 2007 and 7 million in 2006, gross margin was 15.6% in the second quarter this year compared to 24.9% last year.

Slide nine. Softer demand coupled with higher cancellation rates reduced net orders to 1734 homes with a total value of $501 million in 2007 compared to 2,116 orders valued at $694 million in 2006. This 18% decline in net home orders combined with a 12% lower ASP, average selling price, resulted in a 28% year-over-year reduction in total order value. The second quarter 2007 cancellation rate rose to 37% of gross orders, compared to 32% in the second quarter of 2006. The largest decline in sales were experienced in Arizona which was off 37%, and California off 35% from the previous year.

Slide ten. Briefly recapping our year-to-date results, we reported a net loss of 41 million or $1.58 a share for the first 6 months of this year compared to a net earnings of 157 million or $5.68 per diluted share for the first 6 months of last year. Excluding impairments, that reduced net earnings from home building operations by 81 million, adjusted net earnings were 40 million for the first half of 2007.

Slide eleven. Year-to-date home closing revenue for 2007 was $1.1 billion generated from 3,654 homes closed at an ASP of approximately 313,000. In the first half of 2006, home closing revenue was $1.7 billion, generated from 5,250 homes closed in an ASP of approximately 333,000.

Slide twelve. The largest declines in home closing revenue for our first 6 months of 2007 were in Nevada, which had a tremendous second quarter last year and was off 74% this year. In California, which was down 56% from the prior year, same period. Florida and Arizona closing revenues decreased 42% and 41% respectively. The Lone Star state was up while others were down. Texas represented 43% of our total closing revenue for the first half of this year and was up 5% over the first half of last year. Net orders for homes -- net orders for homes declined 19% in the first 6 months of this year and total order value declined 25% reflecting an 8% decline in prices for the same period a year ago.

Slide thirteen. Average sales per community were slightly less than 3 per month compared to 4 per month last year. This was a factor in our impairments since fewer sales per community resulted in negative leverage of project overhead such as construction management, marketing, and operating expenses of sales, offices, and models. Slower absorption rates are keeping communities open longer than expected. We also opened and started selling in a few communities that were in the development pipeline, resulting in a 9% increase in communities open for sale as of June 30th, 2007 compared to the same date in 2006.

Slide fourteen. Our order backlog at June 30th, 2007 stood at 3,838 homes, valued at 1.2 billion compared to 5,849 homes valued at 2 billion on June 30th last year. This reflects a 7% year-over-year decline in ASP combined with a 34% lower volume, which reduced backlog by 39% from a year ago. Arizona and Florida represented the largest declines in backlog from the previous year, declining 60% and 71% respectively. Texas backlog was 9% lower than a year ago. I'll now turn it over to Larry to review our balance sheet and related items and a few other details in this quarter's results.

Thanks, Steve. Moving to slide fifteen. Based on weaker demand today and our expectation that difficult selling conditions will persist for at least the remainder of the year, we reduced our lot supply by 7% this quarter, which translates to a 29% reduction from a September 2005 peak. We abandoned options to purchase another 2,000 lots, which would have cost an excess of 110 million has we exercised these options. Since the first quarter of 2006, we have (inaudible) options to purchase more than 9,000 lots. That represents about 20% of total lots we had under option at March 31st, 2006. By choosing not to exercise those options, we will avoid over 690 million of purchases.

Slide sixteen. Our total lot supply today stands at 38,925, which is roughly a 4.5 year supply of lots, based on trailing 12 month deliveries. Only about a year's supply of lots is owned and reflected on our balance sheet. In addition, we have roughly 3.5-year supply controlled under option contracts. We have a total of 175 million in deposits controlling 1.75 billion of land, which represents about 75% of our total supply. It's important to note that 42% of total options and total lot supply is in Texas. In line with a portion of revenues from the state. And where we've had no impairments or option abandonments. As we have done previously, we will continue to evaluate market conditions before deciding whether or not to exercise these option agreements.

Slide seventeen. Our inventories of unsold homes declined slightly in the quarter ending at 1,387 compared to 1,365 at the beginning of the year. We're aggressively working to reduce that number in the third and fourth quarters through various incentive programs.

Slide eighteen. Total real estate inventories at June 30th, 2007 were 1.6 billion compared to 1.5 billion at year-end 2006. This is due to the slight increase in standing inventory from cancellations and the fact that closings have slowed faster than our lot purchases so we've accumulated more lots on balance sheet. But still a small number compared to most other builders. We are working carefully to match lot take downs to our expected sales going forward and are actively renegotiating option contracts to accomplish this. As the market downturn has deepened and lengthened, our land bankers have become more willing to work with us in renegotiating terms of option contracts. They understand that demand for lots is significantly diminished and accordingly, the value they could sell the lots today for is lower than when the options were originally negotiated. Therefore, in many cases, we are able to extend option terms and reduce bought option pricing, making the option more economically viable to us. As we complete the remaining lot purchases under contract in communities that is are nearly built out, our lot option purchases will gradually wind down. Based on current demand levels, we anticipate that our option purchases will somewhat exceed our sales and starts during the last half of 2007, increasing our finished lot inventory modestly during that period. We expect that our own lot inventory will peak in early 2007 and then decline through the year beginning to generate free cash flow at that time. In addition, as we previously discussed, we expect to generate positive cash flow from the implementation of our (inaudible) reduction program.

Slide nineteen. Meritage's net debt to capital ratio increased to 47% as of June 30, 2007 compared to 42% at June 30, 2006, reflecting increases in inventory levels, but still within our target range of 40% to 50%. Total funds available under existing bank credit facilities stood at 516 million at June 30, 2007 after considering the facility's borrowing base availability and most restrictive covenants. We receive a lot of questions from analysts recently concerning covenant provisions on our debt, so I'll address that topic at this time. One important item to note that in addition to the normal addbacks to earnings in computing coverage ratio, such as income taxes, interest, depreciation, and amortization, our covenant definitions add back noncash charges such as real estate and good will related impairments which have reduced earnings. Given this and the fact that the ratio is calculated on a rolling four quarter basis, we still have considerable cushion under our interest coverage covenant, which is about 5 times. With a covenant requirement of just 2 times. Excluding impairment charges, we operated at a modest profit this quarter. Even at this level of ongoing operations, we could expect a small cushion under interest coverage covenant. We will continue to monitor this as we work to improve our operating results, reduce assets and related debt in order to stabilize and improve our covenant measures. But given current marketing conditions and the potential for further deterioration, we may also see covenet relief from a bank group at some point in the future as many builders have already done. I'll now turn it back over to Steve to wrap up our prepared comments.

Slide twenty. While most of the recent news about the housing sector has been negative, we believe there may be no better time to buy than now. This is a unique opportunity for buyers. Just as with stocks or other items shopping when they are out of favor in demand is low can be the best time to find good values. We are directing our efforts towards helping buyers become more comfortable with their purchase decisions by working directly with them and our sales offices and through channels such as the housing news network portal. Housingnewsnetwork.com provides buyers with information about the housing market, the immediate and long-term benefits of owning a home, and offers tools for selecting and purchasing a home. As more home buyers recognize the benefits of home ownership and the values available today, we believe that Meritage is well-positioned because of our emphasis on quality, value, and customer satisfaction.

Slide 21. We expect the remainder of 2007 will be difficult, but take confidence in our sound strategy, strong organization and solid franchise that includes some of the historically best home building markets in the country. We can't predict the future, we'll continue to focus on those things we can control, like protecting our balance sheet and providing our customers the quality and service they expect from Meritage Homes. We thank you for your attention, and we'll now open it up for questions.

Thank you. (OPERATOR INSTRUCTIONS) And your first question comes from the line of Stephen Kim from CitiGroup.

Hi, I'm sorry, I just wanted to clarify something that I thought I heard you say. You said you thought that the owned lot supply would peak in the beginning of -- did you say '07?

'08.

Okay. You meant '08. Okay, that's fine.

If I said '07, I apologize, I meant '08.

That what I figured you meant.. I was a little confused by that.

Sorry.

Okay. That's great. And in addition I was wondering if you could talk a little bit about what you're seeing in terms of the ability to renegotiate your contract? You touched on that in terms of your with your land bankers and so forth. My understanding has been that the land bankers naturally are more willing to negotiate on terms and on price. And that the nature of those term negotiations may result in situations where later on down the road you're going to have to wind up putting out more money or paying a higher price later on. Can you just sort of clear provide more clarity. Can you give us an example of a hypothetical example of sort of a typical land bank arrangement in terms of terms and kind of what would be a reasonable kind of renegotiation that you've been able to accomplish on that sort of -- in your hypothetical example? Just so we have some kind of idea.

Larry, let me take this one. I think there's sort of been three phases of negotiations with land bankers. I think phase one, which we were in about a year ago was that we would renegotiate deals, but we would pay for the extension. The price would increase because of the extra time it would take to get through the lots. Stage two was extending the term of the takedowns, but maybe at no cost. And stage three, which is I think where we are right now is just an outright reduction of the cost and an extension of the terms and the takedown times. So particularly over the last 90 days or so, land bankers have been much more flexible negotiable. We have had better sucess in slowing down our takedowns to match our sales rate today. We've accumulated lots on our balance sheet over the last several quarters because our takedowns exceeded our sales pace in option communities that we're still profitable. I think today at this point we're having a lot more success. Larry, you want to add on that?

I guess, Steven, to focus on your point about kind of gaining some kind of up side potential, I think the land bankers are somewhat reluctant to drop price today when things are tough without being able to participate in some of the appreciation that may happen if things turn around. So that is something that comes up in discussions. We actually have been resistant to that kind of thinking. And it kind of depends on the particular project, how many lots are left, et cetera. But if we can negotiate a better deal today to give us some up side tomorrow, that's something that we just have to assess the economics of. If you don't give up side tomorrow, then maybe you won't get quite the same reduction today. It's just something that we do on a case by case basis. Although we have not done much of that so far. We have not given much up side on the back end so far to most renegotiations.

Okay. Great. And as Steve was sort of indicating, it seems like certainly things have come far enough now that in many cases you're not even being required to give up any up side in the future for some concession today?

It's very rare for us to do that today.

Okay. Great. Thank you very much.

Thank you.

and your next question comes from the line of Nishu Sood with Deutsche Bank. Please proceed.

Thanks. Good morning, guys.

Morning.

Hi.

And first question -- I also wanted to ask about the trend that we've seen over the past few quarters that you were just mentioning. Since you're taking down option lots that are pace faster than your absorption. Your own lots are accumulating. My question was when you run the numbers on that decision, in other words to take down more lots than current absorptions would merit, what types of assumptions are you using in running the numbers? Pricing and future absorption wise? and I guess one way you could help us understand that is to maybe compare that to what types of assumption you're making in your impairments.

Larry?

Yes. We're generally to address your first question last, we're generally assuming current market conditions. I know that some of the builders out there have said that they're assuming worse market conditions. We are taking what we feel is a middle of the road approach, we aren't trying to be overly pessimistic nor overly optimistic. We believe the accounting rules would say you look at what your current expectations are and do your writedown impairment analysis based on that. When it comes to lots. The lot takedown -- the lot takedown provisions going forward have always been an just in time concept.

We've always tried to match the takedowns to what we think our sales pays are. If you make them overly consecutive, the price of the lot has traditionally gone up so we don't do that, but you don't want them to go overly optimistic so you don't build up lots. So in our renegotiation strategy, we are attempting to match to what we think current absorptions are. And sometimes we're wrong and we've gone back and renegotiated an option and brought it down even further. Particularly as the market has slowed. But one of the things to point out is that we are getting to the point we are getting through subdivisions. And we'll begin to start to close down subdivisions and the takedown requirements will go away.

To give you some idea, just in absolute numbers. Today based upon what we currently think we will renegotiate, we think we'll have a requirement, an option requirement, so we can always not take it. But in order to keep the option current for the rest of the year, we would need to buy about 4,000 lots. And the total purchase price of those lots would kind of be in the $240 million to $245 million range. Next year, we kind of start out at about an 1800 level for the first quarter and starting to decline down to about 15 or 1600 for the fourth quarter. And the total purchase price of those lots over that over the full year is about $475 million and that the total takedowns right at 6900 to 7000. So that's pretty close to what current demand is and current absorption rates are. So we feel pretty comfortable that things are peaking in the beginning of '08 and starting to come down. Obviously if things get worse, we'll have to renegotiate even further, but that's how that works

That's very helpful. And second question on the Fort Myers operation, obviously with the good will take down. I think it was in your commentary in your release you mentioned that you -- the operations have slowed there obviously a lot and you're not taking down anymore lots. Can you give me some more color there? Is that an indication that you're thinking about exiting this market? Or is this more of a temporary situation?

Well, we are -- we are suspending operations to pursue new projects. We don't see opportunities to buy new land there at the present time. And although we have -- we still have homes to sell there and homes to take care of from a warranty perspective. We've reduced our staff in that market significantly. And we will be reducing it farther. We have a plan in place with our personnel there to bring the account down to the balance of the year. And then into next year. Whether we pull out of the market as a decision we'll make down the road. But we're not any new communities there at this point.

Okay. And final quick question. Cash flow from operations, can you give us a sense of what that was in the quarter?

Yeah, we don't have the final numbers. But it was generally in the range of the first quarter. And generally the single largest use of cash was inventory buildup cause from increase in specs from the first quarter. And a little bit of increase in presold because we do have a little bit of seasonality. But the overall largest piece of it was buying lots and land on our books from minimum takedowns.

Okay. Thanks a lot.

thank you.

and your next question comes from the line of Andrew Bronsa with Bank of America Securities. Please proceed.

Hey, guys. I was curious, obviously given your sort of your unique (inaudible) option model and how it would affect your cash flow as you need to take down loss, can you give a sense for what sort of range you're expecting to have drawn on the revolving facility at year end?

We don't have a projection on that. I do think that it will go up in the first -- or in the third quarter. We may see a little bit of decrease in the fourth quarter because of our traditional stronger fourth quarter closings. But I think it will be higher than this quarter, although I think we're as I said as the lots start to peak, the usage of the line will start to peak and come down. I can't give you -- there's too many variables on giving you an absolute number today.

I could tell we're working really that hard as a management team to reduce our specs and to match our lot takedown to sales. And we're internally focussed to keeping our debt to cap below 50% at the end of the year. So that's what we're shooting towards.

Yeah, we are very, very focussed on balance sheet management and bringing inventory levels down more in line with current sales rates. That's our absolute number one priority.

Okay. And I guess obviously you guys do have more cushion than most under your current covenants. And you mentioned further down the line you might revisit with your banks. But have you talked to them at all recently? and have you gotten a sense that there's been any change in their position towards the industry or towards you guys? Or as flexibility and willingness to move forward with home building lending?

We have good relationships with our banks. We are continually having conversations with the significant, the larger players within our facility. And I think there's been several changes in interest coverage covenants, which is certainly the covenant that we're closest to. We don't really have much concern with the other ones. It's the interest coverage that it's critical to make sure it stays in line since it's the closest. I don't get the feeling like as long as you're doing a good job running your business working to control debt levels. Of course our debt level is significantly lower. Debt to capital level, than the other double-B rated builders. As long as we're doing a good job managing that, I think they will continue to work with us should we need to ask for a decrease in the interest coverage level going forward.

Okay. Great. Thanks.

As a friendly reeminder ladies and gentlemen, please lijmit your quesrtions to one question and one follow-up to give everyone oppotunity to ask a question. And your next question comes from the line of Joel Locker with FBN Securities. Please proceed.

Hi, guys, how you doing?

Fine, thanks.

Just I wanted to talk to you about SG&A. I guess if you exclude the good will impairment, as a percentage of revenues came up to around 13.5%, a little below. I was wondering just if you could talk about your plans to reduce head count and just what it looks like going forward if absorption stay at these levels.

Larry?

Sure. We've already taken steps and even at the end of the second quarter took further steps for head count reductions. And at the end of the quarter, we were at about 1550 people. That's a 38% reduction outside of Texas and a 25% overall reduction. So we are continuing to work on cost control with our regional division presidents. Our -- we're actually fairly pleased that we brought our SG&A down, excluding the one-time adjustments. Last year, for the quarter, it was about 4.3%. It's about 4.8%. So it's about a 50 basis point increase. But that's a pretty good control over overhead items considering the reduction in revenues we have seen. And obviously on a flip side, selling costs are up, mainly driven by increased commissions, increased advertising, and other marketing and model related costs.

Right. And just based on the reduction, you said 25% overall reduction, how much of that has come in the last month or so?

I think, Steve, you want to comment?

Well, we only probably took off 5% or 6% in the last month. We've done, I think we've done, depending upon which division 3 or 4 different reductions in force since the middle of last year. So 20% came in the first 11 months and another 5% or 6% in the last month or so.

Right.

Those percentages were from the middle of last year.

Right.

the 25 and 38.

We kind of peaked at our employment level in the second quarter last year and we've been bringing it down.

Right. All right. Thanks a lot.

and your next question comes from the line of Dan Oppenheim with Banc of America. Please proceed.

Hi, this is Mike Wood. Can you talk a bit about your pricing strategy and balancing prices and volume? It looks like your orders may have improved at the end of the quarter. And curious how others responded to maybe higher incentives towards the end of the quarter and whether or not you continued with those into July?

Well, incentives continue to increase throughout the quarter. Prices continue to fall in a lot of markets. And we're reacting to market conditions. Unfortunately, we need to be focussed on our balance sheet. And we need to move our inventory. As we said earlier, March was a pretty good month, we were pretty excited about our sales traction. April, it declined, substantially. We lowered prices again, we had a good month in May. And then sales slowed down again in June and we had to lower prices even more for July. So it's the dog days of summer right now. We're going to try to power through this month. And the rest of this month and next month and hopefully optimistically September comes along, we can see some price stabilization as some people come back from vacation and get back into the market.

Great. Any thoughts on stepping up efforts to sell land here to just reduce your owned inventory and generate more cash that way?

Yeah, to the degree that we can, we are attempting to sell land. But although it may be better for the balance sheet in the short-term, it's going to be a lot better for the income statement and the long-term if we can work through some of the land. We just don't have a very long-term land position in a lot of markets. So we don't have a lot of large positions that we can sell. But we have sold some assets. I think you'll see some hit the books in this quarter coming up, as we have some in escrow right now. And we're evaluating every community, every land holding we have, and every market on a regular basis. And those that make sense to dispose of were taken in action.

Great. Thank you.

and your next question comes from the line of Jim Wilson with JMP Securities. Please proceed.

Thanks. Good morning, guys. Just the two questions. One, in Texas, could you discuss, obviously, makes sense you haven't had to take any impairment. Can you discuss the level of profitability there a bit? and then my second question actually related to Phoenix and if you could color sort of what you think of your land positions and timing of purchase of what you have kind of the balance of it in Phoenix. Thanks.

Well, I'll start with Texas, Jim. Texas still remains a good market for us. We're still making overall throughout Texas 8% to 9% net profits. And Houston is very strong followed by Austin and Dallas, San Antonio is the weakest of the four markets that we're in, of course. We don't own a lot of land. A lot of the land we purchase there is seller carries. And so we don't foresee any impairments in that market really whatsoever. We don't have any unprofitable subdivisions in the entire Texas market. We have over 100 communities there. Phoenix, I wouldn't say it's stabilizing, but I'd say the decline the slowing. And a lot of our communities in Phoenix are very well-positioned. And we haven't had to take the impairments that some other builders have in this market. Larry, do you want to add on that?

Yeah, I guess I would add, first of all the 8% to 9%'s pretax. I think that's fairly obvious. I thought you might want to point it out. I'd just say California probably has been out toughest market from a profitability standpoint. I think the prices have ran up there more quickly and have fallen more quickly. And fortunately our lot inventory there is relatively short. So I think that's also helped us. And the absolute dollars are large there. So when you have an impairment, it's relatively it's a larger number.

Okay. Thanks.

And your next question comes from the line of Robert Jackowitz with RBS. Please proceed.

Yeah, hi, good morning.

Hi.

I was wondering first if you could update us on your expectations for community count. I know you had provided some expectations earlier in the year. Would you update those?

I think, Larry, you can correct me if I'm wrong, but I think it's going to be pretty flat going forward.

from the June quarter?

Yeah.

Yeah, we had said earlier that it was going to go up slightly. I think we maybe threw out the number around 220 or at 222. I think that's goign to be pretty close to the high water mark. You'll see it gradually come down consistent with the statements regarding (inaudible) lots.

Great. And you guys have sort of stood clear of the rating agency actions in terms of downgrades. Wondering, is that a function of you having not met with them recently? Or have you met with them recently and they just have decided not to act?

We, again, like our banks, we have ongoing conversations. But I think our balance sheet still in good shape. We're really focussed as Steve said of trying to keep the number of debt to capital under 50. I think as long as we do that and keep them informed of what our expectations are, what our lot position is and how we're managing through the option strategy. I would be hopeful that they continue at the current rating level.

Great. And then my last question is a little more forward-looking. And I understand your defensive position right now given the market conditions and your option model. But I suppose you may also be thinking about kind of are you go next and wondering if you're looking at any other markets out there that might make a good entry at the right time.

Not right now. We're too deep in the trenches to be thinking about new markets. I think as we've kind of pulled back, we'll have a bigger opportunity to grow in the markets that we're already in. Particularly like Orlando. We're relativeley a newcomer down there, I think we're going to be able to grow in that market. And some of the other western markets. So we're just down the trenches right now. And just been a pretty defensive position.

Fair enough. Maybe I'll ask that question early next year.

Ask next year, I'll have a better answer for you.

Thanks. Good luck.

Thanks.

Your next question comes from the line of Alex Barron with Agency Trading Group. Please proceed.

Yes, thanks. I wanted to ask you how many communities did you guys impair this quarter? and do you have a breakout by region? That's my first question.

I can't give it to you by region, but I can tell you we impaired 28 communities this quarter. Impaired or owned. And we terminated 8 options.

Okay.

If you want me to add on to that, I could tell you we've impaired about 53 communities total. And since the beginning and we've terminated 8 -- terminated 32 option or purchase contracts.

Got it. Thanks, Steve. My second question is going back to this issue of accumulating lots, can you tell me what markets, I guess you've been doing that and I guess, what kind of profitability would still give you the confidence to go ahead with that instead of using your option to cancel the option?

Well, I think there's a variety of factors to go into that the way we decide to terminate an option or not. I think number one, we're going to look at the margin that we're achieving, If we are achieving a positive margin. We're going to go forward. We're probably goign to go forward. We're looking at our investment. Is it early in the project, are we late in the project? What's our cash on cash return? What does the competition look like? What's the future hold? Is it going to get worse in this particular location or is it going to get better based on what the competition's doing? We're looking at all of those factors when we make a decision whether we're going to abandon or terminate an option. I don't think there's any one market that we're terminating more than others. It's kind of equal across the board outside of Texas.

Okay. I think our lot inventory isn't excessive -- our own lot inventory isn't necessarily excessive in any one state. And I would add on the going forward, when we decide to -- when we have a project that is a difficult project that's getting close to not making money, we reassess the project before we buy more lots based upon what kind of cash return we will achieve going forward considering the option deposit and other potential costs or costs.

And also depends on which land banker we're dealing. Some land bankers are a lot more flexible and they're working with us and we don't need to terminate those options and others maybe haven't quite got it yet and they're not in tune to the market and not as flexible and those options we have to terminate.

I guess I was just wondering if maybe a market like Texas that you felt more comfortable maintaining the option open where maybe a more difficult market like California made more sense to just walk away from them.

Well, as I said before, Alex, we're making money in Texas. And there's not one community in Texas out of over 100 that we're losing money. Why would we have to terminate an option there? In California, we've got a lot of communities where the price of the house has gone down 20% to 30%. It's going to be very hard to continue with an option on a community we purchased maybe in 2005 with that kind of decline in price. And those options probably going to be terminated or drastically renegotiated.

Too, Alex, in Texas a great majority of our options there are developer-seller carry, where the terms tend to be more liberal than say a land bank deal. So,if anything, that's another indication that we're comfortable with Texas even though it may be slowing slightly.

Thanks.

Because you have the ability to go back and renegotiate harder there than other places.

Got it. Thanks a lot, guys.

Thank you.

and your next question comes from the line with (inaudible) with Lehman Brothers. Please proceed.

Morning.

Morning.

Most of my questions have been answered. But just on talking about ASPs. I was just looking at the California and Arizona, the ASP on orders is down what roughly 20% to 22%? How much of that if you could comment is mix verses your taking a price discount?

I think some of it's mix, but I think most of it is lowering prices.

20% to 22%?

I'd say three quarters -- I'm talking off the cuff, I don't have any hard statistics to back that up, but I'd say three quarters of is due just to price declines.

and are you seeing is that enough to kind of move as much inventory as you'd like and do you think you might have to take further in those markets again?

It's hard to tell. We're lowering our prices and we haven't been able to get our absorption levels to the point we want them in a lot of communities. It's just on a case by case basis and we may have to lower the prices a little bit more. It depends on what the market conditions are over the next few months.

and are you -- and I suppose on top of this price increase, there are also some incentives? In terms of upgrades to the house or something else?

Oh, yeah, it's a combination of things that we do that eventually lower the price. It's lower in the base price, incentives through just reductions. It's options that we throw in, it's mortgage incentives, buying down the mortgage, making mortgage payments for 6 months. All those kind of things. It's a whole variety of arrows we have in our quiver to entice buyers to buy our product.

Of course. No. I think where I was getting to is are those incentives captured in the ASP? Or is there kind of --

Yes, I believe they are.

All the incentives wind up being reflective in the average sales price.

I see. And lastly, on the option verses [ indiscernable ] obviously as you've been walking away from options, your ratio of owned verses optioned has kind of been going up. Is there a golden number you kind of want to be at? Or is it end up?

Well, as we said today we're at 75%. We've also said that we probably will be a little bit more owned than optioned than we've been in the past. I would say going forward, 75%, 80% is probably a pretty good range. At this point, I think we would be working to not accumulate anymore lots than what we have. I said we probably will during the second half of the year, but we hope it peaks at that point and starts to come down then.

Thank you much.

Thank you.

Please stand by for your next question. And your next question comes from the line of (inaudible). Please proceed.

Hi, guys. Thanks for taking my question. I've been one of the shareholders that Steve talked about who's been involved with this thing from much higher levels. So we hope you guys do a good job again.

You and me both.

Yeah, of course. I just wanted to understand a little bit more about the lot issue. I know it's been asked a lot. But you said 4,000 lot options will be taken down on the back half of the year. Can you explain why those lot options will be taken down? Are those communities that are just profitable and so it makes sense for you to do that? and why that number goes down next year and what level you expect the lot count to peak at?

well, first of all, bear in mind that 4000 is a gross number. The great majority of those lots we're starting and building houses on. We're selling houses and building houses. So it's the net differential that builds up on our balance sheet. We have a takedown of 3 or 4 or whatever a month that's an option requirement in order to keep the option alive. If we're selling at 2 or 3 a month, there's a gap that builds up of 1 or 2 a month. That's the differential that we're renegotiating to get to. Part of it is making sure we keep our sales prices adjusted properly so we get our sales rates up to 4 a month, which is kind of the norm. And then if our -- If we can can or for some reason an option had a higher sales rate, renegotiate to bring it back down to essentially achieve a parity position. So as I said, it's a just in time strategy. Our goal is to buy 4,000 lots and sell and build 4,000 houses.

Yeah, that's what kind of if you look at our sales for the first half of the year, it's not quite 4,000, but we should be able to match that.

and the reason that that hasn't happened say in the last 6 to 9 months has just been the terms hadn't softened. You couldn't turn the ship around quickly enough to sort of do that match.

and the takedown requirements were higher. They're declining every quarter because these options are rolling off. And we're having more success renegotiating the number of lots that we have to buy. Certain communities we had originally forecasted a takedown of 8 lots a month, now we're able to renegotiate to 3 or 4 lots a month. 6 months ago we weren't able to get the land bankers to do that. Today we're able to do it.

At least we're much more successful getting it today than we were 9 months ago. It was happening 9 months ago too, but just not at these sucess rates.

If we could get absorptions back up to say better than 40 or 45 homes per community per year, at that point do margins and all these communities, not every single one, but on average over the your entire base, do the margins go back up to the kind of 10% level or 9% level that you guys had historically had?

It's just problematic because you can increase your absorptions, which will help you leverage your SG&A, which will help you make more money, which you've got to lower your price to increase your absorptions. You're really sacrificing your margin to get your absorption level up. You're sacrificing your margin more than you're leveraging your SG&A. It's a delicate balance. We could increase our sales right now if we wanted to lower our price.

Let me ask the question another way.

We want to maintain some level of profitability.

Let me ask the question another way. If you get some normalization of market conditions, are we back to that level in terms of the way the communities are currently underwritten?

Well, our underwriting standards haven't changed. We're still looking for a 20+% gross margin, 23% gross margin in new communities.. We're not looking to buy any new communities right now in a lot of markets because we don't need the lots. But I think on new communities going forward, this question you're asking are we going to be able to average down our margins with blending new communities with old communities?

No, I guess what I'm trying to get a sense of is for you guys is once we get a normal -- has the financial model changed at all once perhaps conditions out in the market normalized? That's all I'm trying to ask.

No, I don't think it has. Larry?

Yeah, our goal will be to operate under our long time standards. It will be a while for the market to recover. And remember, this is a kind of buyer perception-driven slowdown. And once buyer perceptions change and start to -- people start to buy more houses, that will allow us to gradually begin to raise sales prices back up. Both increase sales per community and raise sales prices and it will take a while. But we believe we will be able to get back to the normalized levels. It may take a year or two, who knows how long, but we'll gradually get back there as sales prices gradually improve as buyer perceptions and demand gradually improve.

Okay. I appreciate it. Thanks for taking my call.

Thanks.

Management, would you like to take one or two more questions before ending?

Let's take one more.

Okay. And your final question comes from the line of Bob Wetenhall with World Bank of Canada. Please proceed.

Hey, good