Meritage Homes Corp (MTH) 2009 Q1 法說會逐字稿

Good morning. My name is Sarah and I will be your conference operator today. At this time, I would like to welcome everyone to the Meritage Homes First Quarter 2009 Analyst Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

I would now like to turn the call over to Mr. Brent Anderson, Vice President, Investor Relations. Mr. Anderson, you may begin your conference.

Thank you, Sarah. Good morning. I'd like to welcome you to the Meritage Homes First Quarter 2009 Earnings Call and Webcast. Our quarter ended on March 31st and we issued a press release with our results for the quarter after the market closed yesterday. If you need a copy of the release or the slides that accompany our webcast today, you can find them on our website at www.investors.meritagehomes.com or by selecting the Investors link at the top of our homepage.

Refer to slide 2 in the 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 obligations to update these projections or opinions.

Additionally, our actual results may be materially different than our expectations due to various risk factors. For information regarding our risk factors, please see our press release and most recent filings with the Securities and Exchange Commission, specifically our 2008 annual report on Form 10-K and our first quarter 2009 report on Form 10-Q after it's filed. Today's presentation also includes certain non-GAAP financial measures as defined by the SEC. To comply with their rules, we have published -- provided a reconciliation of the non-GAAP measures in our earnings press release.

With me today to discuss the quarter are Steve Hilton, Chairman and CEO of Meritage Homes, and Larry Seay, our Executive Vice President and CFO. We expect our call to run about an hour this morning so that we end before noon Eastern time.

I'll now turn the call over to Mr. Hilton to review our first quarter results. Steve?

Thank you, Brent. I'd like to welcome everyone to our call today. I'll begin with slide 4 if you're following along on the webcast. The continued weakening of the housing market over the last year was reflected in our revenue decline and net loss in the first quarter 2009. However, despite harsh conditions, many of our results were positive this quarter.

We ended the quarter with $344 million in cash, an increase of $138 million from our year-end 2008. We reduced our net debt to capital ratio to 35% at quarter end. We lowered our general and administrative expenses by 35% year-over-year and we generated $10 million of first quarter adjusted EBITDA. We nearly doubled our net orders over the fourth quarter of 2008 and we are positioned to take advantage of opportunities to acquire lots at lower prices, will help us to return to profitability more quickly.

Slide five. We generated positive cash flow of $139 million from operations during the first quarter. This is our sixth consecutive quarter of positive cash flow. We ended the quarter with $344 million of cash, the largest cash balance we've ever carried, with no bank debt outstanding as we paid it off early last year. Our cash balance includes the collection of $108 million of tax refunds in March, which was obtained by carrying back tax losses from 2008 to reclaim taxes paid in 2006.

The increase in cash generated on our balance sheet improved our liquidity and reduced our leverage. Our net debt to capital ratio decreased to 35% on March 31st, 2009 from 45% at the end of 2008 and 47% at March 31st, 2008. Considering that we are in compliance with all of our covenants and have no bond maturities until 2014, that increased liquidity represents additional capital available, selective future acquisitions of new lots at lower prices.

Slide seven. Our first quarter home closing revenue declined 38% year-over-year due to 30% fewer homes closed and 11% reduction in average closing price. We also had 21% fewer actively selling communities at the end of the first quarter than we had a year ago, which contributed to our decreases in both closings and sales. Our closing per community were down just 12% year-over-year. We closed 932 homes at an average price of about $248,000 in the first quarter compared with 1,328 homes closed at an average price of about $280,000 the first quarter of last year.

Slide eight. Our impairments this quarter were lower than they've been since the downturn began. Our charters for real estate-related valuation adjustments were $10 million in the first quarter of 2009, 83% lower than the $60 million in charters we incurred in the first quarter of 2008. The lower impairments were the result of our greatly reduced lots under option contracts and our minimal remaining investment in joint ventures. Together, these accounted for approximately $30 million of impairments that occurred in the first quarter of 2008 and our much lower inventory of lots and homes compared to last year.

Nearly all of our impairments in the first quarter of this year related to specific homes or lots rather than impairing entire communities as we did in 2008. With the possible exception of one large option contract in Arizona, we have little remaining option deposits that could be written off. Our option deposit balance at March 31st, 2009 was approximately $50 million with $19 million of that related to options in Texas. Because Texas has been less impacted during the downturn, we believe that these have less risks for future impairment.

In addition, approximately $28 million of the $50 million in option deposits relates to one 1,200 lot project in north Phoenix coupled with approximately $20 million of pre-acquisition costs. This is the largest investment we have in a single project, about two times the size of the next largest. We are continuing to evaluate possible development scenarios for this project to determine the best course of action that will maximize our long-term returns.

Slide nine. Our first quarter 2009 adjusted gross margins were level with the first quarter of 2008 at about 12% in both years, excluding charges for impairments. Considering that prices declined 11% over the same one-year period, you might expect margins to have been compressed for the current quarter. While they are still far below historical average gross margins of approximately 19% to 20%, we've been able to resist further deterioration in our gross margins by further reducing our building costs as our home prices have come down.

Slide 10. We have brought our average selling price down more than 30% from the peak in 2006 by as much as 50% in some markets. Part of this was due to our redesign of new series of homes that are smaller and more efficient to build. We've designed these homes at prices that compete more effectively with resales and foreclosed homes and nearly all are within FHA limits.

In order to protect our margins, we've also reduced our construction costs by 30% or more in many divisions by renegotiating vendor contracts and by realizing many construction efficiencies in our redesign product. We further reduced our overhead cost structure by reducing overhead costs. Our strategy has been to recalibrate the size of our organization as our revenues declined through the consolidation of several divisions and the elimination of a couple combined with related personnel reductions and aggressive control of other overhead expenses.

As a result, we have taken general and administrative expenses down by 35% over the last year to just one third of the total G&A expenses incurred in the first quarter of 2006. That one-year reduction is in line with our 38% decline in revenue over that same period.

Our total SG&A expenses of $33 million for the first quarter of 2009 were 40% lower than the $55 million total in the first quarter of 2008 with a 43% reduction in commissions and other sales costs in addition to savings in G&A. We believe all of these factors position Meritage to weather the current recession and to return to profitability as conditions improve.

I'll now turn it over to Larry. Larry?

Thanks, Steve. Moving to slide 12. We reported a smaller loss before taxes of $18 million in the first quarter of 2009 compared to a loss of $71 million in the first quarter of 2008. After backing out the charges for impairments in both years, our pre-tax loss in the first quarter of 2009 was $8 million compared to an $11 million loss in 2008.

One consequence of our reduced inventories is that less of the fixed interest charges we incur in our debt is eligible for capitalization and must be instead expensed through our income statement in the current period. The interest income earned on our cash is very nominal. For this reason, there was a significantly greater drag on income in the first quarter due to interest charged directly to operations, approximately $8 million of the total $12 million interest incurred.

Without this expense, and excluding our non-cash impairments taken during the quarter, we would have operated at about break even for the first quarter. We generated approximately $10 million in adjusted EBITDA, excluding impairments. That is a 28% improvement year-over-year in adjusted EBITDA evidencing our progress toward returning to profitability.

Slide 13. Our net sales were 40% lower this quarter than in the first quarter of 2008, reflecting the continued difficult housing market conditions. Our year-over-year comps are more difficult than other builders due to the fact that our sales held up better last year. We had the smallest decline in sales from 2007 to 2008 among all the major public builders, so our year-over-year comps will continue to be challenging for the next couple of quarters.

However, our sales rebounded from a dismal fourth quarter last year, increasing by 97% sequentially and they have continued at our first quarter pace into April. This increase was due to an overall improvement in demand, some seasonality, repositioning of our product, and a much lower cancellation rate of 26% in 2009, less than half of the 56% cancellation rate we experienced in our fourth quarter of 2008 and more consistent with a 27% rate one year ago. Our normal historic cancellation rate is in the low to mid 20s.

Our central region, which includes Texas, Arizona and Colorado, experienced the smallest declines in orders during the first quarter of 2009. The relative strength of Texas market has greatly benefited us during this downturn and has accounted for approximately 60% to 65% of our active communities and orders this quarter.

Some key advantages of the Texas home-building markets through this cycle have included lower levels of foreclosures, less price volatility, lower unemployment rates than the national average. We believe these conditions will likely continue, benefiting Texas as a whole and in turn, Meritage. We are a leading builder in Texas and have been growing our market shares over the last couple of years. Many of our competitors are having difficulty obtaining construction and development financing, which we believe will allow us to continue to gain market share.

Slide 14. As anticipated with our asset-life strategy, we have reduced our real estate inventory during the slowdown and harvested millions of dollars in cash originally invested in that inventory. Our total real estate inventory came down by $391 million at the end of the first quarter of 2008 to less than half of what it was in March of 2007. This decrease resulted from a combination of factors, including the reduction of unsold, pre-sold, and model homes in inventory, strictly limiting lot purchases while billing through existing bottom inventory, and impairments due to valuation adjustments.

Slide 15. We reduced our spec inventory to 550 homes or 3.2 homes per community as of March 31st, 2009 from 768 spec homes at the end of 2008. That's lower than we believe is necessary today in order to maximize our sales opportunities to renters or existing home owners who have sold their homes.

They often want completed or nearly completed homes ready for them to move into and may not be willing to order and then wait for a home to be built unlike in past years. Therefore, we remain a build-to-order builder, but we are making an allowance to adjust our strategy to current market conditions. We may increase our level of spec inventory to get closer to a target of four to five homes per community.

Slide 16. Our own lot supply remains one of the lowest in the industry in terms of trailing 12-months closings. We had a total of 15,069 lots owned or controlled at March 31st, 2009, representing a 0.9 year supply of lots based on trailing 12-months closings. That includes 8,340 owned lots. By comparison, our total lot supply was 24,591 lots or 3.4 years supply at March 31st, 2008 with 9,920 of those owned. Traditionally, we have targeted a much higher option-to-own ratio. However, in the current economy, we own a higher percentage of lots due to our termination of a vast majority of our options over the last couple of years.

As was previously noted, our lot supply in many states is now quite low. We have about one to 1.5 year supply of lots in California, Colorado, and Florida. In addition, while lot supplies look healthy or even heavy, almost half of those lots are in active adult communities, which can actually require more lots over which to spread a larger up-front infrastructure cost and one large option of undeveloped lots in a prime location in north Phoenix which we discussed earlier.

Slide 17. Our strategy while seeking new lot positions is to contract for small parcels of well-located finished lots that we believe we can sell and build out within a year or two of opening. With our financial strength, liquidity, and relatively light lot supply, we are in a position to replace some older, lower margin communities with deeply discounted lots in certain markets where we see immediate opportunity and have begun to make some selective lot acquisitions to take advantage of these.

For example, we recently purchased a note from a bank that covered about 80 lots in Arizona. The original cost was approximately $190,000 per lot and we purchased a note from a bank for what amounts to approximately $35,000 per lot. These lots are completely finished in a gated community. We anticipate completing the foreclosure process within the next week and expect to sell homes priced in the low $200,000s on these lots, which is below the prices of foreclosures in that market. That is a typical deal we're looking for in today's market and where we have relatively short supply of billable lots.

Slide 18. During the quarter, we retired $6.6 million principal amount of our senior subordinated notes by issuing approximately 250,000 shares of common stock in exchange for those notes, with an implied discount of 45% to the face value of the notes retired. The [$2.8 million] gain on the early extinguishment of debt is reflected as a component of other income in the first quarter. We may transact additional exchanges in the future depending upon terms and market conditions, but our bank debt covenants prohibit us from repurchasing bonds for cash.

We also adopted an amendment to our Articles of Incorporation that is designed to preserve the tax treatment of our net operating loss. These tax assets total approximately $134 million at March 31st, 2009 and were fully reserved for accounting purchases, but are available to offset approximately $380 million of future taxable income at current tax rates.

There has been a fair amount of press regarding some problems with Chinese drywall use in homes. It appears that such is used for Meritage are only in the Fort Myers area of Florida for homes that were closed in the late 2006 through 2008. Structured -- excuse me.

We believe our exposure is limited as we closed only approximately 150 homes in Fort Myers during that time period and we're currently aware of only a small number of those homes that had any issues alleged due to the drywall. We are working with affected homeowners, contractors, and insurance companies to inspect and remedy any issues. We do not expect to have any significant adverse impact on our financial position.

I will now turn it back over to Steve.

Thank you, Larry. Housing affordability today is the best it's been in almost four decades, for the biggest improvements in those markets have experienced the greatest appreciation in home prices during the first half of this decade. According to a recent study by John Burns, a national real estate consultant, the monthly cost of homeownership has fallen 43% from its peak in this cycle due to declines in pricing and mortgage rates as well as increases in income over the past few years.

Since entry-level buyers compare the cost of ownership to the cost of renting, Mr. Burns projects that buying activity will increase substantially as more renters recognize the attractiveness of home ownership. We agree and emphasize that buyers have a unique opportunity today to acquire a new home at historically low prices and low mortgage rates, further enhanced by Federal and some State tax incentives.

Slide 20. Our primary objectives in managing through this downturn have been to strengthen our balance sheet and return to profitability by reducing our inventories and debt, generating cash, build liquidity, and reducing our cost structure in line with lower revenue. I'm pleased with the progress we've made towards these objectives to date, as demonstrated in our results. There's less competition today as many other builders who were overloaded with land, inventory, and debt or do not have adequate access to capital have disappeared in this recession.

Meanwhile, we have increased Meritage's market share and are now the tenth largest builder in the US, according to the most recent Big Builder rankings. We believe Meritage is uniquely positioned with the right products in the right markets, a strong balance sheet, and a relatively low lot supply, giving us the ability to take advantage of opportunities as they become available. As we continue to roll out our lower-priced, more affordable homes on new lower-cost, well-located finished lots, we expect our margins to gradually improve, returning us to more normal levels of profitability.

Thank you for your attention and we'll now open up for questions. The operator will remind you of the instructions for Q&A. Operator?

Thank you. (Operator Instructions).

And your first question comes from the line of David Goldberg from UBS. Your line is now open.

Good morning, guys, and great quarter.

Thank you, David.

I was very impressed given the environment. First question was about geographic footprint and if you -- do you think it makes sense to be in all the markets that you're in given that the order numbers have come down so dramatically in some of your markets?

We're very bullish about the markets we're in. We think we're in the best markets in the country. The markets are going to rebound. Someone could argue why are we in Las Vegas? I mean, we're in Las Vegas today because we have assets up there that we need to work through and we're not going to be able to do that overnight. So, we continue to evaluate every market every quarter, but I do believe over the long-term, we like very much all of the markets that we're in and we're going to continue to have a substantive presence in those markets.

Okay. And a follow-up question was really about land and the liquidation of land from banks and I know you kind of gave -- Steve kind of -- Larry kind of gave an example earlier about an exempt where you found a bank liquidating a portfolio of land and you guys were able to acquire it.

And I guess what I'm trying to understand is first -- I guess the first part is what gives you guys the confidence that there's going to be enough of that land coming from distressed sellers that you can acquire at the right price to reload the balance sheet as you look forward, especially if there are market share gains that you look forward to grow the business again? And I guess the second part of the question is, when you look at that deal and when you guys went out and bought some land, what kind of gross margins and operating profits were implied by the prices that you paid for the lots?

Well, first of all, we wouldn't buy any new lots unless we could earn a normal gross margin, and that's 20% or more. So, we're underwriting the purchase of assets -- new assets, new lots, to today's housing prices and to what we deem as normal and acceptable gross margins and IRRs. I think there's going to be a lot more opportunities. I think the opportunities are accelerating. I think there's a lot of private builds that are assets, they're getting disposed through banks and I think they're going to accelerate through the later part of this year and we're going to have some good choices out there to make.

If I could sneak one more in, you mentioned that [inventory turns] have come down 31 days, which I think is great. Can you kind of put some color on where that leaves you and where you think you can get to in terms of the cycle times and turnover?

Well, we'd like to be able to turn our assets upwards of three times a year, which we were able to do, or not quite do that well at the peak of the market. But as we get some of these legacy assets off the books and work through them and work our way towards lower-priced housing so we can build quicker, we think our inventory turns are going to increase substantially. And that allows us to build more with less capital and requires us to carry less debt, so that's the objective.

And for the frame of reference, 31 days lower, where does that leave you now?

I think we're -- I don't know the exact number, but Larry, I mean -- we're about 120 days, 125 days --?

It varies from market to market and product type, but when we talked about cycle times, we're talking about from point of sale to closing, not just construction time. So, we've leased not only construction times, but also time from sale to start and time from finish to close and that total time kind of runs from 120 to 150, and in some cases, it's lower than that because we've made strides. But bear in mind, that's the full time and not just the construction time.

I'd say this is a major Company issue for us and we see an opportunity to drive it even lower than we're at right now and that's something that I think we're going to have considerable progress on over the next several quarters.

Great. Thank you guys so much.

Your next question comes from the line of Nishu Sood from Deutsche Bank. Your line is now open.

Thanks. Hello, everyone.

Hi.

Good morning.

And thanks for the detailed disclosures, as always. I wanted to ask about this shift to the lower price-point product that you're offering. In order just to get a sense of how that's going because I was just scanning across some of the products you're offering in a place like Houston, I didn't see anything you're offering that's below let's say $130,000, $140,000 base price for the lowest level floor plans and that's kind of median in that market. So, is this something that's going -- that you expect to take -- how long is it going to take to kind of transition --?

Well, I think -- the shift to lower price-point products has been done primarily outside of Texas. We haven't changed our product that much in our Texas markets, but I can tell you, for example, in the Phoenix area where we have approximately 14 communities, we've changed the product in every one of our communities and brought the price down substantially.

In Orlando, Florida we've changed our product in almost all of our communities and brought the price down significantly by building smaller and less amenitized homes. In Texas, it's not our goal to get down below 100s to compete with the shrimp volume, more [intense] builders, but we are a dominant builder in the Houston market, for example, you mentioned where we have 40 plus communities.

And -- but in a hole, particularly outside of Texas, we are changing our product and bringing the pricing down substantially and it is working well. We've had several communities in the Phoenix market where we've had very strong sales over the last couple of months because our prices are down low to mid 100s.

Got it. So, this is really a strategy for the foreclosure-saturated markets where you need to compete more effectively?

Exactly. Exactly.

Got it, okay. And a related question, reloading of the lots at distressed prices. In these markets where you're going to be picking up these distressed lots, I mean a lot of these lots are going to have been entitled and developed with a larger floor plan in mind, a larger footprints of a home. How does it affect the kind of dynamics of the building just in terms of the entitlement? How does it affect everything that you're going to be putting up a much smaller product on these lots?

Generally, it doesn't have too much of an impact. I mean, there's not many communities that I'm aware of where they require you to build a large home or certain square footage. I mean, some communities may have some architectural requirements for the front elevation and the setbacks and the garage door exposure, but beyond that, I mean there's no law that says you can't build a 1,500 square foot home versus a 3,000 square foot home.

So, we're finding -- we're very sensitive to making sure that our homes fit in with the existing community, but at the same token, we want to deliver exceptional value to our buyers and we can do that by bringing the right product to the market.

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

Thank you.

Your next question comes from the line of Dan Oppenheim from Credit Suisse. Your line is now open.

Good morning. This is Russell on for Dan. I was hoping just to get a quick follow-up, actually, to one of Nishu's questions. If you could just specifically -- I appreciate the commentary about the low-priced homes you're rolling out, but if you could just kind of specifically talk about the California market. We saw a significant drop in orders there, but noticed that prices were up on a year-over-year basis, so basically wondering what drove that and what you're doing going forward there?

Larry, you want to take that?

That -- one, you have to recognize that we really only have about four or so actively-selling communities in southern and northern, so a total of about eight or so. And mix issues, then, have significant impacts when you only have that small of scale.

The point is is we have dramatically dropped prices in California and we have instituted redesigned product and we are actively looking to replace these lots that we've either terminated, because a lot of our options -- our lots were controlled through options in California, by buying these low-priced, deeply-discounted lots. So, that's really how we're going to turn California around and the only thing you're seeing there is just a slight mix issue from quarter to quarter because the sample size is so small.

Yes. And also, we had three communities in California that were -- in southern California that were very high-priced infill communities that were two or more at $1 million and one of them was in the $600,000 price range and we have not changed the product there. And when Larry talks about the mix issues, that's had a substantial impact on the mix and we moved several homes in those communities in the last quarter and that's had that mix impact.

Well, that's very helpful. Thank you so much. And just one quick follow-on. Just as we look through the cycle, you've talked a lot about land opportunity and especially we appreciate the detail on Phoenix, but as we look through the cycle, where would you like to expand your presence in terms of what you think is a healthy geographic balance for your Company and are there any new markets that you'd like to be in?

I don't think our emphasis is going to be on any new markets; we're really focused on the markets that we're in. I think we want to be more balanced, with Texas being one of the 35% to 40% of our total deliveries, which means we need to rebuild California, think long-term. California is a market that we want to have a bigger footprint in.

Certainly Denver, Phoenix, Tucson, Orlando are all markets where we have an opportunity to increase our market share and rebuild our community count and I think -- then maintain our market share and continue to expand our market share in the Texas market. So, I think the focus is going to be on organic in-market growth, markets we're currently building in.

Thanks so much, guys.

Thank you.

Your next question comes from the line of Carl Reichardt from Wachovia. Your line is now open.

Larry or Steve, I'm curious. You talked about kind of a 20% minimum gross margin as the base for looking at new lots that you might take down from banks or others. What kind of absorption basis would you expect to get in a minimum basis on lots like that?

Three to four sales a month.

So, just kind of back to a normal, traditional pace. Okay.

Correct.

And then, just quickly and then I have one other. Active adult is what percentage of your business now and is that going to alter in the next 12 to 18 months or so if trends continue?

Larry?

Yes. Active adult hasn't changed a whole lot; it's still down in the kind of 5%, a little bit high 5% to 7% range. And we have three or four, depending on how you slice it, communities in Arizona. And at this point, we're continuing to build through those and we have plenty of lots to continue to build there, so we have a several year supply. And we are looking for opportunities of lots even in active adult, so we hope that we find some very attractively-priced active adult lots.

And I must add to your brass question. I think that we are pro forming lots, our absorption, at a bit lower than that three to four, although we certainly -- today, but we certainly can make money and make good margins at that maybe two to three absorption rate. I don't want to imply that we are being overly optimistic in our underwriting today.

But we wouldn't buy a new deal unless we could convince our self we could do at least three a month.

Correct.

Right.

Okay. And then, I'm sorry, just one other question. You guys in your past have been a utilizer of what's termed the land banking industry and I'm just kind of interested, Steve, in your comments on the structure of that business and what you're seeing out there among the partners you've traditionally worked with in that frame and whether or not their continued involvement in the business or their lack of involvement is going to impact you in your strategy going forward.

Well, certainly there's no land banking available today from what we consider to be third-party land bankers that we brought in to purchase land for us and sell it back to us on a rolling option. But there are many lots available, particularly in Texas, from developers that we can buy lots from on a rolling option terms or seller carry terms.

In the market today, though, most of the great opportunities that we're seeing are lots that are being sold by lenders, by banks, or land bankers in conjunction with our lenders, short sales for lots, and the terms on those are cash. And I think that's the way it's going to be for a while.

One of my concerns is, though, particularly when I was driving around Texas over the last couple of weeks, is I noticed that there's a lot of private developers that aren't able to access the credit to finish the next phase of lots to build out their lot positions and that's going to affect our ability to some degree to buy lots on rolling options because I think a lot of private developers are going to be very, very credit constrained.

So, I think in the short-term, it's going to be cash and carry, but over the long-term I think some of the hedge funds or some of the investors that have bought lots to get the returns they want are going to have to sell them on a rolling option or just-in-time basis.

Okay. I appreciate the color. Thanks much.

Sure.

Your next question comes from the line of Joshua Pollard from Goldman Sachs. Your line is now open.

Hi. My question is on the pricing front. You've got a mix of different data between Case-Shiller and what's coming out on a couple of different other indices. Can you guys talk about any areas of the country or any products or price points where you're seeing prices actually stabilize? Along that same question, when you look at those Arizona purchases that you've made, how much further of a price decline did you guys bake into your models for those purchases?

I think we're seeing prices stabilize in select submarkets in Orlando, in Denver, in Phoenix, in California. It's really a localized analysis you have to do. You have to look at the competition, the lot supply in the area from other builders; you have to look at what the foreclosures are in that submarket.

In a market like Phoenix, for example, there may be eight to 10 different submarkets and you can't just paint the entire market with a broad brush. Some areas, certainly, like Las Vegas, there are still substantive price declines coming. But we wouldn't buy a new community or a new lot position in an area where we saw there was a substantial risk of further price declines.

So, we're not baking into our pro formas additional price declines. We're really underwriting these communities to the current market and making sure we get a healthy enough margin that if there is a slight price decline that we can absorb that.

Okay. Great. My follow-up is just on cash flow. Is there any reason that Meritage should be cash flow negative in any quarter in 2009?

The only reason why we would be is we noted that we think our spec level is a little bit low. And to the extent we do increase our spec count a little bit, that would obviously be a use of cash, but we would hope that our continued liquidation of lot inventory would offset that and not have a negative cash flow quarter. But because there's an interplay between a positive and a negative, I can't guarantee you that if we had a moderate increase in specs next quarter that that might not drive us to be slightly negative.

And one last, quick follow-up. Thanks, guys, for the time, is you mentioned 200 to 225 as a target for ASP. How quickly do you guys plan to get there?

I -- also, we can give you an exact timeframe, but it's our goal over the next year to try to get in that range.

Thank you very much.

Your next question comes from the line of Timothy Jones from Wasserman & Associates. Your line is open.

Good morning.

Good morning.

Yes. The first question is the system -- you were talking about this 1,200]lot, deal that you have in Phoenix. Is that the deal that you had with the state?

Correct.

Why would you think with getting out of that deal given the fact that you have a lot of flexibility way over the normal option with the state?

Well, we're still evaluating it. It's not our intention to get out of it. We're negotiating with the state to get some further flexibility from them and we're continuing to evaluate the market conditions in that submarket. It's probably one of the best locations you could find in the Phoenix metropolitan area. It's right on the Scottsdale-Phoenix line and it's a very desirable place where people want to live.

So, we have a substantial investment there, of course, but we have not made the decision yet to start development or start moving dirt and get houses going, but we're going to continue to evaluate over the next few quarters and make a decision, hopefully by year end.

Is the state getting less flexible or is it just market conditions?

I wouldn't say they're getting less flexible, but I think they're somewhat constrained by state statutes on what they can do for us, and having to work through those issues.

Second question is, you talked in your release about taking steps to protect your NOLs and that you have done it. Since a couple -- a number of builders have actually lost their NOLs, can you be more specific on what you did and why didn't some of the other builders do the same thing?

Larry?

We -- well, I think several builders have changed their bylaws and they've had special elections to get approval from their shareholders to change their bylaws and articles to prohibit somebody from owning 4.9% -- from more than 4.9% of their shares. And we did that in a special meeting earlier in the quarter and as we disclosed, it's -- I forget the exact numbers, around $340 million, $350 million of future profits that is protected by that move.

So, it's a pretty big savings, a tax asset and $132 million range. So, it's very important for us to do that. I think several other builders have done that. Unfortunately, a few other builders, because of their financial issues, weren't able to take those kinds of steps.

Okay. Thank you.

Operator, any more questions?

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

All right. Thanks. Good morning, guys.

Hi.

Good morning.

So, just wondering, Larry, given the comment on what margins look like in backlog, a little perspective just with the recent sales and what those look like?

Yes. They're in the 12% to 13% range and we get asked this kind of margin question routinely and I think the point here is that we can't tell precisely what margins are going to be in next quarter's closings. And I've continued to kind of give that 12% to 13% answer. As you can see historically, we've kind of settled into that point and I've also said going forward as we reload we would expect to see that increase, but I can't predict that next quarter, we're going to see a big increase. I think you'll see a gradual improvement.

Also, if you look at the margin chart that we've provided, you'll see a little seasonality to it, so we tend to gradually have improving margins through the year because some of the construction costs that are in cost of sales are fixed costs. So, I would think that you'll gradually see a bit of improvement through the year and as we can reload lots, you'll gradually see our margins return over a period of couple of three years to our normal level.

All right. Makes sense. And then, my other question was just on this note repurchase deal and you talked about where you're re-pricing the product. Could you kind of give a little idea on new products, what size of homes these are, and in the neighborhood what kind of hard costs you anticipate or you're seeing in building these smaller units out?

These are going to be homes in this particular community that we mentioned probably between 1,800 and 2,500 feet and maybe some a little bit bigger available, but I think the average buyer is going to be around 2,000, 2,200 feet. Our hard costs are going to probably be under $40.00 a foot and this is a neighborhood where the homes are -- we're selling $450,000 to $550,000 and they were probably averaging 3,000 square feet.

Yes. Great. And the $40.00 number for a lot of the new, smaller product could bring out, is that the reasonable rule of thumb?

Yes. I mean, I think some of our houses that we're building are as low as $35.00 a foot on some of the larger square footage, but I think we're trying to push all of our hard cost down to that $40.00 average or lower.

Okay, all right. Great, sounds good. All right. Thanks a lot.

At this time, I'd like to remind everyone that there are several questions in queue. Please limit yourself to one question and one follow-up in order to get through to our allotted time.

Your next question comes from Joel Locker from FBN Securities. Your line is now open.

Just wanted to ask you about the -- your backlog conversion rate was -- I think it's the highest in the last decade, around 73%, and a lot of that was selling the finished specs. But wondering if you could keep that up just in the second quarter or third quarter seeing that your finished spec count is still somewhat high?

Well, probably not, because our finished specs are much lower than they've been for the last year-and-a-half down to 550 or so, so I don't think we're going to be able to keep it that high. On the other hand, by building homes quicker and reducing our cycle times, it'll help us keep that number higher, but I don't expect a repeat of that number in the second quarter.

Second quarter, right. And just on the California orders, obviously they were down 73% year-over-year as was mentioned and a lot of that was community count, but did you see any uptick in the March month based on the tax credit?

We did have a little uptick in sales in March and a little bit in April. But again, we're talking about really small numbers in California and a lot of that -- I don't know if we're a good barometer for the market. And also, considering a few of our communities are at that higher price point, again we're not the best barometer for what's happening in the state of California.

Right. And so -- but that March and April, that might have just been a seasonal uptick from what you see?

I don't know if it's a seasonal. I mean, we adjusted prices and just got more competitive and got to the end of some communities, so we had more closeouts. And I don't know if we could put our finger on any one particular factor in California.

All right. Thanks a lot, guys.

Okay.

Thank you.

Your last question comes from the line of Bose George from KBW. Your line is now open.

Good morning. First question, do you have a way to gauge the percentage of your buyers that will be able to benefit from the national tax credit, and how big of a driver do you think that is for your buyers?

I think it's a pretty big driver for between a third and half of our buyers right now. I just spent last week touring around Texas and talking to our people on the ground there and they said that's had a pretty big impact on their business. And I know in Phoenix we have some lower-priced communities that have had pretty strong sales success over the last couple of months and I think one of the reasons is the tax credit that expires at the end of November.

So, we're certainly trying to put ourselves in a position to take advantage of that as much as we can and maybe the Congress and Administration will think about extending that credit. But I do think it's having some impact and I only wish it was larger and wider, because unfortunately it's limited only to first-time homebuyers.

Great. Thanks. And just switching to financing, can you just discuss how most of your buyers are financing themselves? Does FHA continue to be the main source of funding?

I think, Larry, you have some stats on that, right?

Yes. Certainly, there's a large portion today that's using FHA lending, kind of in the 40% to 50%, although there's still a large group using conventional, too, although most of the conventional kind of meets the FHA/VA -- at least the FHA requirements from a down payment perspective. You kind of have two groups -- one down at kind of that 3% or so range, which is the government; and then if you're in conventional, there's another range that's in the 20% range. So, you have two kind of distributions and the average down payment is kind of running around 11% or so.

Can I just add on to what Larry -- 98% of our buyers are using some type of government-sponsored program. So, it's either FHA, VA, Fannie Mae or Freddie Mac would be 98% of our buyers; there's very few non-conforming loans.

Great. Thanks very much.

Thank you.

Okay, I think that wraps up our questions. We thank you very much for your support and look forward to talking to you again next quarter. Have a good day.

This concludes today's conference call. You may now disconnect.