Meritage Homes Corp (MTH) 2009 Q3 法說會逐字稿

Greetings and welcome to the Meritage Homes third quarter 2009 conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Mr. Brent Anderson, Vice President Investor Relations for Meritage Homes. Thank you. Mr. Anderson, you may begin.

Thank you, Diego. Good morning, everyone. I'd like to welcome you to the Meritage Homes third quarter 2009 earnings call and webcast. Our quarter ended on September 30th, and we issued a press release with our results for the quarter and first nine months of 2009 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 investors.meritagehomes.com, or by selecting the investors link at the top of our home page.

Please refer to slide 2 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 information regarding these risk factors please see our press release and our most recent filings with the Securities and Exchange Commission, specifically our 2008 annual report on Form 10-K and our most recent quarterly report on Form 10-Q.

Today's presentation also includes certain non-GAAP financial measures as defined by the SEC. To comply with SEC rules we have provided a reconciliation of these non-GAAP measures in our earnings press release.

Slide 3. With me today to discuss our results 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 A replay should be available on our website within an hour or so after we conclude the call.

I will now turn it over to Mr. Hilton to review our third quarter results.

Thank you, Brett. I'd like to welcome everyone to our call today. I will begin on slide 4. On our call last quarter we said we believed we were past the bottom of the housing cycle and were focused on returning to profitability in 2010. We have a plan to achieve that goal and our third quarter results demonstrate that we have made solid progress in executing our plan. We reduced our direct cost and overhead expenses, increased our sales and margins and reinvested in new lot positions that should move us closer to profitability.

Slide 5. We report a net loss for the third quarter of 2009 of $18 million or $0.56 per share compared to a net loss of $144 million or $4.69 per share in the third quarter of 2008. Our 2008 results also included our initial tax valuation charge. We incurred lower impairment charges of $13 million in 2009 compared to $55 million of impairments in the third quarter 2008, reflecting stabilizing prices in our communities and our strategy of exiting under-performing communities. We believe our risk of significant future impairments is small with stable to improving markets. Excluding impairments our pretax losses from operation decreased to $4 million in the third quarter of 2009 from $7 million in the third quarter of 2008. So we're approaching break even.

Slide 6. We've generated nearly $500 million in cash flow from operations over the last eight quarters and are reinvesting some of that cash by acquiring lower priced lots in locations where we've identified the best opportunities to sell our homes. We have redesigned our homes in communities to offer the quality and style that Meritage Homes are known for at very affordable and competitive prices. In doing so we have repositioned Meritage to appeal to entry level and first-time move-up buyers who we believe comprise about 75% of the current market. We have the second lowest supply of lots in the industry at just over three years in total, based on trailing 12-month closings. But we aren't saddled with heavy debt or long land positions as some builders are. We have been able to use our strong financial position to replenish inventory as low-priced finished lots become available in good locations where we believe we can earn normal or near normal margins.

We ended the quarter with about 13,200 lots under control, 235 more than we had at the end of the second quarter, 63% of those lots were owned and 37% were optioned and two-thirds of owned lots are finished. I believe our market research is a competitive advantage that helps us make good decisions quickly as we evaluate lot acquisitions, product offerings and pricing. The intelligence provided by our research gives us confidence that we are acquiring lots in the right locations at the right price to minimize our risk and leaving room for upside potential. In many cases we have acquired finished lots at deeply discounted prices, in some cases less than the cost of the development.

Slide 7. Executing our strategy we committed to a larger number of land purchases this quarter as we contracted for 11 new communities in five of our six states, representing approximately 2,500 additional lots. That includes about 1,300 lots in Province which we put on our contract during the quarter and closed in the quarter. You may have seen our press release announcing this purchase. Provence is an award-winning active adult community outside of Phoenix with a fully developed infrastructure including lakes, parks, greenbelts and a 35,000-square-foot recreational facility with a fitness center, indoor pool, auditorium and cyber cafe. It's an excellent addition to our existing portfolio of active adult communities in Arizona, and we'll leverage our existing operations here. It was a bank REO property from a bankrupt builder and we were fortunate to pick it up for the price that we paid. We plan to offer home designs that have been successful in our other active adult communities with starting prices in the mid 100's.

Slide 8. We've been acquiring lower priced lots in Phoenix through higher cost option lots that we canceled. We plan to open nine new communities in 2009 or early 2010 on lots we've recently acquired at lower prices. We believe we have a leading position in the entry level and first move-up market for new homes in Phoenix. We're marketing all-inclusive monthly payments including principal, interest, taxes, insurance and HOA fees to convert renters into homeowners. The payment is displayed on large banners hung across the garage doors of our model homes, as you can see on the slide, so that buyers can easily see which homes they can afford.

The photos in this slide are from the community called the Lakes at Rancho Eldorado, which is probably the best example of our strategy. It's a master planned community with enticing lakes and functional greenbelts and pocket parks not far outside of Phoenix in the town of Maricopa where we are selling two product types. We've sold 100 homes there since February of this year. Much higher than our average sales pace and with better margins. Our combination of lower lot prices and efficiently designed homes have allowed us to hit the sweet spot in the market with the right price and design criteria for today's buyers.

Slide 9. In Orlando we're opening five new communities in 2009 or early 2010 on lower priced lots that we've recently acquired. One of our new communities in Orlando sold 21 homes during the third quarter and we've been able to increase prices in some communities in Florida. We've totally redesigned our homes to make more efficient use of space which allows our new homes to compete well with a larger home that may be on the market due to a foreclosure. Since Florida was one of the first and most severely impacted states in the downturn, this example demonstrates that a good submarket still exists at the right location and price despite poor statistics for the broader market.

Slide 10. We've been able to take advantage of significant land price adjustments in California to rebuild our inventory as markets there recover after hitting bottom. We've opened or expect to open 10 new communities in 2009 or early 2010 on these lower priced lots. California achieved the highest sales per community in the Company this quarter and several communities there sold at or above one home per week which is considered normal in a healthy market. As you can see from the photos in these slides, our new series of homes are very attractive, retaining much of the Meritage Homes distinctive styling and features at much lower prices than before. In this way we're offering tremendous value to our customers allowing us to compete effectively with resales and foreclosures and capture more sales.

Slide 11. We report our first quarterly year-over-year increase in home sales since the beginning of the downturn in the housing market four years ago. Our net orders of 1,098 homes in the third quarter were 8% higher than the prior year driven by gains of 53% in California, 40% in Colorado, and 176% in Florida. However, those markets made up a little less than one quarter of our third quarter 2009 sales so the increases in those states are muted by slightly slower sales in our largest markets in Texas and Arizona. Texas markets have held up better than most and projections are that they will continue to be among the strongest in the future. We expect our sales in Arizona to improve over the next couple of quarters due to the number of new communities we have opened and plan to open in the next year. Our third quarter cancellation rate of 20% was the lowest we've experienced in more than four years and half of what it was last year after the financial crisis in September of 2008 drove our cancellation rate up to 40%. We believe normal seasonality accounts for second quarter sales means slightly higher in the third quarter.

Slide 12. Our average sales per community increased to 6.5 for the third quarter of 2009 from 4.8 in the third quarter of last year with 22% fewer communities at September 30th than we had open one year ago. Our newer communities are driving that increase as they are selling at a faster pace than most of our older communities. Again, seasonality accounts for the very slight decrease in sales pace from the second quarter. Our new communities make up approximately 12% of our active communities in the third quarter representing 17% of our units sold and 11% of our closing revenue. Since many of these are still in the start-up phase, we expect our sales per community to improve as well as our margins and profitability as these new communities scale up and as our markets stabilize and improve.

I will now turn it over to Larry Seay, Chief Financial Officer, and I'll end our prepared remarks with a few closing thoughts before Q and A. Larry?

Thank you, Steve. I'll pick up on slide 13. Our third quarter home closing revenue declined 38% year-over-year due to 29% fewer homes closed coupled with a 13% lower average closing price. Some of the decline in our average price was a result of general market declines but it also is due to a greater mix of sales in entry level and first move-up buyers, which represented about two-thirds of our third quarter 2009 sales. It was about half that amount a few years ago before the downturn in the housing market. With the increases in orders we've achieved, we've grown our backlog in each of the last four quarters. Given that, along with stabilizing prices and the success we're experiencing in our newer communities, we see opportunities for revenue growth over the next several quarters.

Slide 14. We've achieved the highest gross profit margin excluding impairment charges that we've reported in our last eight quarters. It climbed to 14.5% from 12.3% in the second quarter and 12.7% in the third quarter of 2008. We have driven down our average construction costs by 30% to 40% in many of our markets. This has helped improve our margins while at the same time allowing us to decrease our home prices. Because of those improvements and the results of thorough market research, our newer communities have achieved comparable margins that were several hundred basis points above our Company average and within 2% to 3% of our target margins. Given the preliminary results we've seen with our new communities, we believe we could achieve our 2010 targets under current market conditions without any significant appreciation in home prices.

Slide 15. We've been diligent in controlling our overhead costs as our sales and revenue have declined. We've kept our general and administrative expenses down to 6.2% of revenue in the third quarter of 2009, which is 31% lower than a year ago and in line with the last several quarters. Additionally, our commissions and other sales costs were 46% lower in 2009 than 2008 exceeding 38% decline in the home closings revenue. The decrease of approximately 110 basis points was due to the lower marketing and advertising costs we achieved by regionalizing those functions and lower model operating costs due to fewer models per community.

Slide 16. We reported a net loss of $110 million, or $3.52 per share for the first nine months of 2009, roughly half of the net loss of $213 million, or $7.37 per share for the first nine months of 2008. That was primarily due to lower impairments. $90 million this year to date compared to $154 million last year. And the prior year deferred tax asset valuation allowance of $106 million. Our adjusted EBITDA excluding impairments was a positive $33 million year to date in 2009 and $38 million in 2008. We've achieved a positive EBITDA excluding impairments in every quarter throughout this housing cycle.

Our cumulative deferred tax assets which are currently fully reserved totaled $169 million as of September 30th, 2009. After we returned to profitability that should offset federal income taxes on approximately $480 million of taxable income.

There were a couple of less significant items in our year-to-date results that impacted our year-over-year comparability which I will explain now. After voluntarily reducing our credit facility earlier this year we terminated it in September resulting in a write-off of $3 million of capitalized fees, $800,000 of which was in the third quarter. We didn't anticipate needing the credit facility before it was due to expire in 2011 and we'll save about $2 million in fees during that time. We also recorded a $9 million gain on the extinguishment of debt. We retired $24 million of our senior subordinated notes due in 2017 in exchange for 783,000 shares of Meritage Homes common stock. This will help us save approximately $2million of future interest costs per year. Our year-to-date results in 2008 included a $10 million benefit from a legal settlement in the second quarter which was included in G&A expense.

Slide 17. We increased our cash by nearly $250 million in the last 12 months and reduced our net debt-to-capital ratio to 35% from 46% a year ago. That also reflects a reduction in debt. We ended the quarter with $366 million in cash, including $19 million which was restricted to secure the outstanding letters of credit previously supported by our terminated credit facility. That $19 million shows up as cash used in investing activities on our cash flow statement this quarter. Our total cash, cash equivalents and restricted cash declined by about $20 million during the third quarter primarily due to lot purchases. We spent a little over $50 million in cash for lots this quarter. We are actively the pursuing new finished lot positions in most of our markets and expect to acquire additional communities throughout the balance of the year.

Based on our projections for the fourth quarter we expect to generate positive cash flow from operations for the full year after cash used for lot acquisitions during the year but before including the tax refunds of $108 million collected earlier this year. We've reduced our average cycle time from sale to close by approximately eight weeks since the beginning of 2008 and we're continuing to shorten it. As we bring it down, we should be able to deliver more homes without increasing our inventory balances, thereby improving inventory turnover and return on assets.

Slide 18. We have been starting more homes without a signed sales contract this year as part of our strategy to have homes available for quick move-ins by first-time homebuyers and renters. Despite that, our inventory of specs has continued to decline as our sales spec homes have outpaced our spec starts. Our spec inventory came down from 491 at June 30th, to 407 at September 30th. That's an average of 2.5 specs per community compared to 3.9 specs per community at September 30th, 2008.

I will now turn it back over to Steve.

Thank you, Larry. In summary, we made excellent progress towards achieving our goal of returning to profitability next year and believe we will be profitable for the full year anticipating no material impairments as our market stabilize and improve. We believe that's achievable without broad appreciation of home prices due to the improved margins and increased sales pace we've already seen in our newer communities. In addition to cutting our costs and controlling overhead as most other builders have done our strategy involves much more.

While not a complete list, our strategy includes these elements. We're using extensive market research to support our lot acquisitions, product selection and pricing which is enabling to us compete successfully with foreclosures and resale homes. We're actively in the market for finished lots and are acquiring lower priced lots in good locations. We've increased our focus on the entry level market and first-time homebuyers by offering lower priced homes and starting more spec homes. We're marketing all in inclusive monthly payment to appeal to renters who want to own their homes. We're designing our homes to make them more efficient while retaining the unique styling and quality that Meritage is known for. We're decreasing cycles times in order to deliver more homes without having to invest additional capital.

I believe this is one of the times in history that can be a game changer for many industries and an opportunity to find who the next leaders will be. Meritage is well positioned and our organization is poised to make the most of our opportunities and I'm excited about the prospects for our future.

Operator, we'll now turn it over for questions.

Thank you. We will now be conducting the question-and-answer session. (Operator Instructions). Our first question comes from Carl Reichardt with Wells Fargo Securities. Please state your questions.

Good morning, guys. I'm thinking the about that guidance, profitability guidance for next year, Steve. Let me ask two questions about that. One, what percentage of the lots that you expect to deliver next year do you currently have in your possession or an option on?

Go ahead, Steve.

What percentage of the lots that we are going deliver next year do we have in our possession?

You own outright or you have an option to buy.

Almost all of them, almost all of them.

Okay. So you've got a land cost that you're comfortable with.

Right.

In other words to get to your profit target. So now on your directs, your labor and material, how comfortable are you that either at current bid, since you're assuming no price increases what are you assuming your directs do?

We do not have to get additional savings in our directs to be profitable next year.

So you assume if labor and materials are effectively flat will you be profitable next year on that land base.

We're basing our assumption that we'll be profitable next year on current land costs that we already own or control, current construction costs that we believe are going to remain stable through next year, and pricing that we are experiencing on these new communities and our existing communities with new product that we've seen in the last few months.

All right, perfect. Then last question. Do you have your incentives as a percentage of your sales price, Larry?

It varies from market to market widely. I don't have that number off the top of my head but generally they're running in the 8% to 12% range.

Perfect, thanks much, guys.

Our next question comes from Joshua Pollard with Goldman Sachs. Please state your question.

Good morning and great job. I wanted to follow up on two questions. The first is with the 24 new communities you have outlined to open late this year and early next year, what percent of your deliveries in 2010 are you expecting from the newer communities, and what is that mix today? Additionally, could you tell us what the margin differential is there?

Larry, do we have that?

Sure. As we said on the script about 12% of deliveries today are from the new communities, and we expect that number to increase up into the 20s, mid-20s next year. It could even go higher. It just depends on how many additional communities we may acquire. As Steve said, we have really all the lots we need to do next year's plan, but we're still going to continue to buy new lots throughout next year as older communities wind down. So it could be a bit higher. And the second question was?

The margin spread between your newer communities and your older communities.

The premium we're seeing over the older communities is around 300 to 400 basis points now. Of course, the older communities have benefited, to some extent, by our construction cost decreases and redesigning some of the product on older lots. So that number has come up a bit, too. But today the number is somewhere between 300 to 400. As we've said, that's two to three percentage points away from our target margin.

I would also say that as we get more of these new communities on-line, I expect that differential between old and new to increase.

So if I run those numbers and I'm trying to run them as we speak, if only 12% of your deliveries today are your newer communities, and there's a 300 to 400 basis point spread, is it safe to say that your current margin on older communities is not that far from the 14% that you're reporting today?

Yes, it's a blend. The older communities are maybe in the 12% range or so. And the newer communities are up above the average. That's where you get that 300 to 400 basis point spread, and if you are looking at 17% gross margin, our target is 19% to 20% so that's where you get there within 200 to 300 basis points of being normal.

One very quick follow-up. Historically you've had up to 90% of your lots optioned. Do you feel now is a better time to own instead of option lots, and do you have a target there?

Yes, absolutely. We think it's a better time to own than to option, because if we want to take advantage of these distressed lot prices and purchase them from lenders or distressed situations, we're going to need to pay cash. And predominantly most of the purchases will be made in the west. We've gotten really decent buys, in some cases below replacement costs, you've got to pay cash. With that said we still believe we can option lots at compelling prices in Texas, and we're going to continue to use options there and in other places to the extent that they're available and we think the numbers work. But if you want to get the great prices, you are probably going to have to pay cash.

Very last question. Are you guys looking to expand the footprint at this point, most of your land transactions have been within your main MSAs. Are you guys looking to expand or are you comfortable with where you are today?

No, we're not looking to move into any new markets at this time. We believe we can increase our market share significantly in the 12 markets that we're in, and we want to leverage our capital in those markets to get bigger and we don't want to take away from that by going into any new markets.

Thanks, Steve, talk to you again soon. Our next question comes from [Michael Rihad] with JPMorgan.

Thanks. Good morning, everyone. Looking forward to seeing the Lakes community in Phoenix in a couple weeks. First question just goes back to what you were discussing before with the margin spread and the implication that the new communities are doing maybe like a 16%, 17%. I would think that the math would push it around there. That makes sense. But still below the 19%, 20% that you're targeting. Can you comment on that, and if that's more of a function of the fact that we are hearing that there is a decent level of competition in some of the rebounding markets, ie, the Phoenixes or So Cals, over-finished lots?

I don't think it's a function of lot price. I think it's just a function of us getting more of the new communities on-line. I really expect those margins to increase to get closer to that 19% or 20%.

It's more just a function of typical lifecycle of a community.

Some of those communities we bought earlier in the year, and maybe we didn't get as good a buy but the stuff that we're buying now, or the last quarter or two, I think we're getting better pricing, and I think we've got our game a little more fine-tuned, our product is better, our strategy is better. And I think we're going to show that we have better margins in these newer communities. It's too early to make that call on the difference between old and new.

I would add, I do think there are some start-up costs, as you're saying, up-front. You're absorbing some additional marking costs, et cetera. You haven't gotten your construction cycle completely fine tuned, so you will some improvement in overhead costs and leveraging of overhead costs as those communities come more on-line.

Okay. And I appreciate that Larry. Could you comment on the level of competition right now that you are seeing over the finished lots and given that I think some concerns that you have in some markets, still relatively high degree of consolidation among the larger publics, given that they're mostly the last man standing, any concerns about perhaps not finding enough lots at the target margins over the next year?

There certainly is a lot more competition. There are other public builders that are out competing to buy lots. But I am not concerned that we won't be able to find the lots that we want or lots that we need. I don't think there's as many quality lots available as people might believe, but I think there's enough to satisfy our business plan and that we will be successful in finding those.

Michael, I know there's this question about whether you can find lots, but I would much rather be in our position where we're able to go out and look for new lots at new low prices, and, sure, it will be competitive but the alternative is being stuck with a bunch of old legacy lots on your books that you bought at really high prices that you can't make money off of unless house prices go up significantly so I would much rather be in our position than that other position.

Right. One last quick point of clarification when you talked about cash flow expectations. Did you say positive for the full year or for the fourth quarter in and of itself? Because it would seem that you're already on a solid track to be positive for the full year given the first half.

It's for the full year, but we were pulling out the tax refund. But we were including lot purchases, so basically what we're saying is that our lot purchases, we will continue to buy, but we're not going to buy at such a pace that that would drive us to a negative position for the full year.

So 4Q should we expect still modestly negative if you continue to do the purchases?

Yes.

Thank you.

Our next question comes from David Goldberg with UBS. Please state your question.

Good morning, guys. First question is relatively straightforward. I was wondering if could you talk about conditions in Texas as we move through the quarter sequentially. Did you notice things slowing down through the quarter? And has that trend continued as we look past September?

Everywhere it's a little slower, September and October, certainly than it was in July and August and through the summer. But I don't see it really being much slower in Texas than it is in any of our other markets.

Second question is a little bit more theoretical but what I'm trying to understand is, given the cash position, given the liquidity, and given the cash conversion on the finished lots that you're buying, the cash conversion cycle, I'm trying to get an idea that if you look to ramp up the business, how quickly you can grow potentially adding new communities if you're finding opportunities. And I'm not sure how you think about it, but maybe could you give us an idea how liquidity position supports growth, if you guys find opportunities to grow from here.

I don't want to give you a specific number on what we believe we can grow on our existing capital base, but certainly we can't grow at 40%, 50% a year like we were in the boom years. But we think we can grow at a pretty healthy clip with the capital base that we have, without taking on significantly more debt or having to raise equity. But it will be dependent upon what opportunities are available. Based upon what we see right now in the market as far as lot opportunities, and potential acquisitions, we feel real comfortable with our capital strategy.

Do you have any idea what the conversion cycle looks like? I know it differs on each finished lot that you buy, but how long it takes to go from purchasing the finished lot to getting your cash back?

When we buy a lot we're trying to be up and operating within 90 days. That's our goal right now. We're reducing our cycle time. We would like to have more than half of our communities, we can deliver the home from the date of purchase to the date of closing in 99 days or less. So our goal is to really crunch the cycle time and turn our capital faster. I can't give you a precise time period, but as we buy smaller communities, less than 100 lots, we should be able to get in and out in two years. Any other questions, David?

I'm set. Thank you.

Our next question comes from James McCanless with FTN Equities

Good morning. The first question on the first time buyers' tax credit. There are two different things out there, an extension of the credit, then potentially a gradual tail-off of the credit. How does that factor into your profitability goal and what's your take on what passes at this point?

We're hearing that something could be coming up in the Senate the next day or two, maybe even as early as tonight. But we're not counting on that. It's not baked into our forecast. It's not baked into our assumption that we are going to be profitable next year. Certainly it's going to be helpful. Certainly the tax credit drove sales throughout the summer. And it will help us achieve our goals but we don't think it's an absolute requirement.

Also wanted to ask, what are the rental trends in terms of monthly rents look like in your different markets since I believe that's a focus that you are going at now, is trying to sell to that payment? What does that competition look like from apartments?

Certainly rents are going down because inventory is increasing, not really from new apartments but from people that are moving out of apartments and from people that are renting houses that are coming on the market that were foreclosures. So rents, there's pressure on rentals. At the same time, when you can buy a new home and get a mortgage, all inclusive mortgage payment of between $800 and $1,200 a month, in a fairly decent location, it's much more appealing than living in an apartment, and that's why we're having some success in several of our entry level communities around the metro Phoenix area and other markets where we're really geared to that first time buyer.

One quick follow-up. What do expect the community count to be by the end of 2010?

Probably around 175 communities, give or take a few in each direction.

Thank you.

Our next question comes from Nishu Sood with Deutsche Bank. Please state your question.

Thanks. First I wanted to follow up on a question that Dave was asking earlier about your liquidity position and your growth plans. One idea that's being kicked around as incentives is the NOL carryback. If that were passed, let's say, that might allow you to monetize the deferred tax assets sooner. So my question is, you folks obviously very lean operation, a lean land supply and mostly finished lots. So just thinking ahead here, if you were able to monetize your deferred tax asset, it would obviously boost your liquidity, would that change your outlook on growth? In other words, would it enable you to become a little bit more aggressive?

Larry?

First of all, if the tax credit, our tax carry-back is extended for a couple of years, we would probably get another $60 million or so in cash that we would harvest. That obviously is a substantial number but I'm not certain it would change our growth prospects that much. Sure, it would give us a little more dry powder to maybe be a little bit more aggressive in going out and reloading. Really, that's what it's all about is the ability to go out there and purchase new low-priced lots and replenish those lots we're selling out of in order to debt to that 170, 175 lot position. We could maybe do that a bit more aggressively, but that's really what we're talking about, is being able to be a bit more aggressive on acquisitions.

We don't think we're being held back by our capital position. There's not the buffet of deals out there to take advantage of that one might perceive there to be, so I don't think getting more dollars from a tax refund is going to have that substantive of an impact.

Very helpful. Second question, I also wanted to touch on what other folks are asking about this difference between the new communities and the old communities in terms of their gross margin. Just digging down to the community level and picturing it, I'm trying to understand whether the difference in the margins is an economic issue or an accounting issue. Specifically what I mean by that is take two communities, one new, one old, let's say, in a place like Phoenix. You are going to have the same subs work on them, the same materials. You have potentially redesigned the product in the older community to meet the needs, the sweet spot, as you describe it. So what is the difference? Let's say it's in a better location if it's new community, or is it accounting-wise simply that you are not able to mark the old assets down land price-wise to where the new communities are where you're buying them?

First of all, it's a combination of things. About half our communities are in Texas, so we haven't been able to -- the Texas market hasn't evolved like the other markets where prices have come down 50% or more. So we haven't gone into Texas and completely changed all of our product in those communities. But we've made some adjustments, and we're seeing some gains from that. In communities in our other markets, in some we've completely changed the products. In others we've tweaked them. And in some cases we've impaired our lots, but we can't impair them to a normal profit margin. We really have impaired them to more of a break-even.

So when we go out and buy brand-new community, we're underwriting it on a 19%, 20% gross margin or more, and contrasting that to an existing community where we've impaired it to a break or a small profit, there's a substantial difference, even though the product might be the same or similar. So it's really a function of new versus old, and the new community has the brand-new product that's designed to build for less money, and to appeal to that buyer that we're chasing, versus our older communities may be at higher price points, even though we've changed the product.

Got it. So it's more product rather than location, at least if you're thinking about it economically.

Yes, I'd say so.

It's product and lot price.

Got it. Great, that's very helpful, thanks a lot.

Our next question comes from Jim Wilson with JMP Securities. Please state your question.

Thanks, good morning, guys. Two questions, first, the land for the new communities in California, where is that geographically located?

Most of the communities we've bought are either in the East Bay, out in the Brentwood, Antioch, Oakley area, or towards Sacramento and Davis, Woodland, Sacramento, Placer County, Roseville, Rockland, Lincoln area.

All 10 new communities are in northern California?

No, a couple of them are down in southern California in the Inland Empire.

Got it. Larry, you referenced $50 million in lot spending. I wasn't clear is that both on existing lots and new purchases? And I wasn't totally clear on the time frame. Could you be a little more specific?

Sure. That was for both like lot option purchases for existing deals, particularly in Texas where almost all of our lot options are today, plus reloading with brand-new bulk purchases. So the total, that's about $50 million for the quarter for Q3.

Great, that's all I had.

Our next question comes from Bose George with KBW. Please state your questions.

I wanted to follow up on an earlier question about buying developed lots. There are some portfolios being shopped around by the FDIC. Have you guys looked at any of those and is that a potential source of lots?

We have looked at them but more likely than not it's not really a source for us because it's just a real collection of cats and dogs in there, and we're not in the business of sifting through portfolios like that and selling lots off to other parties. We're looking for lots that we can build houses on today and just don't think those portfolios really work for our business strategy.

The portfolios tend to have commercial property, industrial, raw land, and we're only interested in one segment, finished home sites.

But even the residential ones are just such a variety of stuff in there, small lots, big lots, condos, just broken down, half developed, partially developed, raw, all kinds of different things. That's not to say that we're not trying to align ourselves with people that are buying those portfolios where we can extract out of there lot positions that we like that make sense to us, and we're following those very closely, and staying in contact with the eventual buyers, and in some cases we may team up with somebody to take a portion of those lots, the ones that work for our business strategy.

Thanks very much.

Our next question comes from Dan Oppenheim with Credit Suisse. Please state your question.

Thanks very much. Was wondering if you can talk a little bit more in terms of the sequential trends during the quarter in terms of how those were on a month-to-month basis. And also as you think about 2010 what sort of absorption you're looking at in terms of thinking about the profitability, overall do you have an estimate in terms of what the absorption would be?

I'm sorry, I didn't catch the last part.

Just embedded in your thoughts in terms of profitability for 2010 what sort of absorption are you assuming in that.

I think -- Larry jump in here if you want -- but I think the absorption rate for next year is probably going to be in line with what we saw this last quarter. Certainly I think I mentioned earlier in the call that September and October were softer than July and August, but that is to be expected because of seasonality. Also, I think there was a little bit of pull-back because of the tax credit ending and people trying to either get a house ordered that we can deliver by November 30th or to buy a spec house that could be finished by November 30th. But I do believe the last two months have been substantively better than the same two months last year. So I'm very encouraged that we will have a positive comparison fourth quarter '09 to fourth quarter '08 but again, it was a bit softer.

Okay. Thanks very much.

Our next question comes from Alex Barron with Agency Trading Group. Please state your question.

Good morning, guys. I wanted to ask you, Larry, how does the interest allocation work between what goes inside cost of goods sold and what goes below the line?

As we have decreased our inventory, and particularly decreased land under development, because we have very little of that today, more and more of the interest breaks directly to interest expense in other income and expense. And the interest that has been capitalized has just been capitalized really to houses under construction. So I think you will continue to see a large number hitting interest expense each quarter and then as we gradually rebuild the balance sheet, you'll see a little of that going back up to cost of sales and less of it being expensed. But you are going to continue to see a substantial portion of interest hitting the income statement going forward for the next several quarters.

Okay. Thanks. And then as far as your impairment this quarter, both optioned lots and the other impairments, how did that break down by geography?

It was pretty evenly spread. We're really what I would call in the cleanup mode, where you're having a few impairments on individual houses, as maybe you have a spec or two that was built awhile back that has so many options, you have to discount it to sell. Then you have a few subdivisions where you still have a little bit of price erosion that you're having to take an impairment on. Then there have been, particularly in Texas, a handful of deals or so that we've locked, option deals where you have a modest deposit and some pre acquisition investment of a few hundred thousand dollars. And then we had one impairment for about $2.5 million on a JV in Texas. So those were the things that made up the impairments. But it was pretty evenly spread throughout all the states.

Okay, great, thank you.

Our next question comes from [Daniel Carraso]. Please state your question.

Hi, congratulations, great quarter, guys. The question is on California and Florida. Is the big jump in orders there, is that due to improvement in business trends in those states in general, or is that because of a company-specific community mix at Meritage with several new larger projects that could cause us to misinterpret the data and think that those states are actually rebounding?

I think it's predominantly because of new communities that we've opened in those states that have been positively received by the market. But with that said, California has improved. Certainly California had a $10,000 tax credit on top of the $8,000 tax credit that the federal government was giving, and that helped drive some traffic through the quarter and the previous quarter, but I think it's a combination of both. Markets are improving in California, Florida, but more so because of our new communities that we've opened that have been positively received.

Perfect, thanks very much.

Thank you. Our final question comes from Joel Locker with FBN Securities. Please state your question.

Most of my questions have been answered, but do you have a figure on customer deposits in dollars?

They're generally running around 2% to 3% of sales. So if you take an average sales price of $200,000, $230,000 dollars, you can do the math. Generally speaking, lower priced homes have a lower percentage, and higher priced homes have a little higher percentage.

So not much difference than the 2.8% of backlog at the end of the second quarter.

Correct.

What was your tax valuation allowance in the second quarter if you have it handy.

Basically, we reserve the benefit at the same time, and I couldn't tell what you those numbers were gross, because I'm not paying that much attention to what's triggered each quarter now. So I can't tell that you off the top of my head, I'm sorry.

Thanks a lot, guys.

Thank you for following Meritage, and we'll look forward to talking to you next quarter. Have a good day.

Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you, all. for your participation.