Meritage Homes Corp (MTH) 2010 Q2 法說會逐字稿

Greetings and welcome to the Meritage Homes second quarter 2010 conference call. (Operator Instructions)

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

Thank you. Good morning. I'd like to welcome you to the Meritage Homes second quarter 2010 earnings call and web cast. Our quarter ended on June 30th and we issued results for the quarter after the market closed yesterday. If you need a copy of the press release or the slides that company our web cast 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 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 information regarding these risk factors please see our press release and most recent filings with the Securities and Exchange Commission, specifically our 2009 annual report on 10-K and subsequent quarterly reports on form10-Q. Today's presentation also includes certain non-GAAP financial measures as defined by the SEC. To comply with the SEC's rules we have provided a reconciliation of these non-GAAP measures in our earnings press release.

With me today to discuss our results are Steve Hilton, Chairman and CEO of Meritage Homes and Larry Seay, our Executive VP and CFO. We expect our call to run about an hour this morning and replay of the call should be available on our website within an hour or so after we conclude the call. It will remain active for 30 days.

I'll now turn it over to Mr. Hilton to review our second quarter results. Steve?

Thank you, Brent. I'd like to welcome everyone to our call today. I'll begin with an overview of our second quarter 2010 operating results as shown on slide four. When we reported our final results for 2009, we stated that our number one goal for 2010 was to return to profitability as soon as possible and to be profitable for the entire year. We achieved the first part of that goal last quarter as we were one of the first publicly traded home builders to report a profit for the first quarter of 2010. We just reported our second profitable quarter and our successfully executing our strategy to achieve our goal of profitability for the entire year.

We generated net income of $4 million against a prior year net loss of $74 million, which included $67 million of real estate impairments in 2009, compared to only about $300,000 of impairments in the second quarter of this year. Our net income in 2010 was reduced by $3.5 million loss on the early extinguishment of debt associated with the refinancing of approximately $200 million of our senior notes in the second quarter. Our second quarter 2009 net loss benefited from a $6.5 million gain on the early extinguishment of debt associated with our stock for debt exchange last year. If we exclude the effects of the impairments and our gains or losses associated with the financing transactions our adjusted pre-tax income for the second quarter of 2010 was approximately $8 million. Reversing a pre-tax loss of $12 million for the same period last year.

The increase in our second quarter net income was largely driven by improved margins or an increased number of closings. We closed 36% more homes resulting in the 32% increase in home closing revenue, as average prices on closings were 3% lower than 2009. We believe the increase in closing was partially due to an acceleration of closings to meet the initial June 30th deadline for the home buyer tax credit as well as stronger sales in our first quarter. Florida closed 88% more homes year over year, California closings were up 66%, with Arizona coming in third with a 40% year over year increase. We're nearly doubled our gross profit on that greater number of home closings generating $53 million in gross profit for the second quarter of 2010, compared to $27 million gross profit before impairments in last year's second quarter. Included in the effect of the impairments in the prior year's second quarter 2009 we reported a gross loss of $39 million which translates to $92 million improvement in gross margins year over year.

Please turn to slide five. Our strategy to improve profitability centers around increasing our gross margins by reducing our costs and opening new communities on lower priced lots. We increased our home closing gross margin by approximately 600 basis points over the second quarter of 2009, bringing it to 18.3% from 12.3% excluding impairments and cost of sales. Next to 19.2% gross margin reported last year, this was the second highest adjusted gross margin we achieved in the last three years. And close to our target of approximately 20%.

We offered less in sales concessions during the first quarter when demand was stronger, where as we increased the concessions offered in a few of our new higher margin communities in the later half of the second quarter to increase absorptions and off set some of the impact of the expiration of the tax credit. Additionally, we had more closings from some lower margin communities during the second quarter which explain the sequential decline in our average margin.

Our margin improvement compared to this prior year second quarter was the result of savings in our construction cost and additional closings in communities built on lower price lots we have acquired since the start of 2009. Our newer communities are driving the margin improvements we've been achieving over the last five quarters. Approximately 20% of the second quarter 2010 net closings and revenue came from our newer communities. Our margins on those homes were approximately 600 basis points higher than the margins we earned on our older communities, demonstrating our continued success of our strategy to improve profitability.

We opened eight new communities in the second quarter, replacing nine of our older communities that had below average margins. One of our newly opened communities, a very special project named Lion's Gate in Gilbert, Arizona. I'll come back to that in a couple of minutes. We have another 20 to 30 communities in the pipeline that have targeted opening dates of the last half of 2010 or early 2011. Our currently projecting approximately 35% to 40% of our sales and 30% to 35% of our closings will be coming from our new communities by the end of this year.

Our net new orders in the second quarter of 2010 were 22% lower than the prior year partially due to a 15% decline in our average active communities. In addition to a generally softer market after the April 30th tax credit contract signing deadline. The decline in sales following the expiration of the home buyer tax credit was more significant than we expected and surprising because we didn't experience a significant increase in spring sales until the last few weeks of April. However, we were hopeful for a relatively short hangover effect, similar to what the auto industry experienced with the Cash for Clunkers program.

Based on our second quarter sales, we anticipate lower third quarter closings and looking for improving sales in the later part of the year. Despite external factors we are continuing to execute our by opening new communities in good locations to replace older and lower performing communities, differentiating Meritage as an industry leader in home efficient construction, ensuring that our plant selections and model presentations are inviting and appropriately matched to our target buyers preferences and training equipment our sales people to be the best in the business. Although we can't predict when the market will improve, we are confident that it will improve and we are positioning Meritage Homes to be one of the best in the business both now and in the future.

We had 25% fewer communities than Texas than our average in the second quarter in 2009. This was by choice, not by chance. Since part of our plan to improve margins and profitability includes closing out communities with lower margins and redeploying assets into new communities where we are achieving higher margins and sales. We sold out of more communities in Texas in the second quarter than anywhere else as we reported previously, many of these best opportunities we found over the last couple years have been in California, Florida and Arizona, which has resulted in some rebalancing of our active communities from Texas to these other markets. Primarily due to the 25% lower average community count in Texas our home sales there were 30% lower than in the second quarter of 2009. Accordingly, Texas comprised 51% of the company's total homes sold compared to 57% a year earlier, while California and Florida represented a larger percentage of our total homes sold during the quarter.

Due to slowing sales in the quarter as previously discussed, our average sales per community for the second quarter of 2010 was 6.1 which was slightly lower than 6.6 sales per community in the second quarter of 2009 and 7.0 in the first quarter this year. California, Florida achieved the higher absorption rates. Nearly all of our communities have been open in the last couple of years on new lock positions with new product lines offering proves points of the success of our strategy. Partially off setting the 22% decline in total homes sold, our average sales prices were up 11% over the prior year of the second quarter, resulting in a total order value decreasing by leaser 13% year over year.

Our average sales price for the second quarter of 2010 was approximately $254,000 compared to $229,700 in 2009. This reflects an increased share of sales for many of our newer closer end communities which command higher prices and some of our older communities, as well as growth in our higher average market places like California and Florida. Our second quarter cancellation rate was 20% in 2010, compared to 23% in 2009, slightly below our historical average in the low to mid 20s, 20%.

Turning to slide seven, just last month we opened a new community at Lion's Gate in Gilbert, Arizona, one of the best markets in the Phoenix metro area. This community is a prototype for future high energy efficiency communities. To the extent that it is successful, as we expect it will be, we plan to open additional communities based on this model. While we are already at 100% energy star qualified in all of our communities our homes in Lion's Gate go far beyond that. Incorporating the latest energy efficient technology in every home and no additional charge to the buyer with prices starting at under $180,000. The homes are designed to save homeowners up to 80% on their home utility bills compared to a typical existing home as published by the U.S. Department of Energy. Not only is that great for the homeowner, the community, and the utility company, but it's also great for our country. It's a great selling point for Meritage.

Buyers can save a considerable amount of money with our new homes compared to used homes or other new homes that don't have these energy saving features. All of our homes in Lion's Gate include a full set of state of the art materials and equipment that are designed to compliment each other for the greatest energy efficiency and energy use and cost. Those features include an advanced solar, electric and thermal system, a high performance wall system, spray foam insulation, electronic home management system, weather sensing irrigation and water management systems. These are demonstrated in our learning center and sales office at the community. You can also read more about them on our website.

A key differentiator for Meritage is that they are included as a standard feature in every home, not options that you have to select separately and pay extra for, which many builders are offering today. We believe this is a competitive advantage for Meritage that will help us to sell more homes. I'll now turn it over to Larry Seay, CFO, and I'll return with prepared marks and a few closing thoughts before Q&A.

Thanks, Steve. Moving to slide eight, as Steve stated, we accelerated the deliveries in the second quarter to meet the June 30 closing deadline for the home buyer tack credit, we converted 89% of our beginning back log into second quarter closings in 2010 with approximately 40% of those closings from specs and ended the quarter with approximately 580 total specs, or 3.9 per community. 52% of those were finished. We were careful not to overbuild specs in anticipation of increased demand due to the tax credits, so we're comfort able the level of specs we're currently carrying in our communities.

Our ending backlog at June 30, 2010 totalled 1,044 homes valued at $293 million, which was 23% less than our total backlog value at the end of the second quarter of 2009, partially due to the accelerating closings into the second quarter. Because of cycle times have come down and we've implemented a 99 day delivery guarantee in many of our communities to compete with resells and attract renters our back log convergence rates have been trending higher. We would expect it to remain above ours historical levels as a result executing our strategy to shorten cycle times. Although will likely be less than 89% in future quarters.

Slide nine. We've been very diligent in controlling our overhead as a percentage of revenue during this downturn and have one of the lowest SG&A percentages in the industry. Our absolute level of G&A expenses increased by approximately $3 million year over year in the second quarter but declined approximately 500 basis points as a percent of revenue to 5.7% in the second quarter of 2010 compared to 6.2% in the same period last year. Much of the variance from last year's second quarter was due to various items in 2010 which are not operational in nature such as legal expenses and extension of subleases with negative spreads, as well as some compensation increases in certain areas. Assuming total ongoing G&A expenses remain in the vicinity of $15 million to $16 million for the next quarter or so, we may see temporary increases in G&A as a percent of revenue based on the second quarter sales and ending back log. However, we will continue to be diligent in managing overhead expenses and reducing them wherever possible. As we said, we're primarily focused on growing revenues to bring our G&A percentage down.

Slide ten. For the first half of 2010, our total home closings were 11% higher with 9% higher closing revenue than 2009. We achieved gains in every state except Nevada despite 15% fewer average communities in total year to date. Steve addressed the reasons for these trends earlier in his comments.

We reported net income of $7 million, or $0.21 per share for the first half of 2010, compared to a net loss of $92 million or negative $2.97 per share in the first half of 2009. We incurred less than $1 million of pre-tax real estate related impairment charges to date in 2010 compared to $77 million of impairments in the first six months of 2009. However we recorded a $3.5 million loss on early extinguishment of debt in 2010 versus a $9.4 million gain on early extinguishment of debt in 2009.

Excluding the effects of the impairment and gains and losses resulting from our financing transactions, our adjusted pre-tax income was approximately $11 million for the first half of 2010 reversing a pre-tax loss of $22 million in the first half of 2009. Our deferred tax assets totalled approximately $89 million as of June 30th, 2010. These tax assets are reserved and therefore not on our balance sheet, are available to offset federal and state income tax liabilities on an estimated $234 million of future taxable income. That estimate may change going forward due to the various state and federal limitations on use of NLL carry forwards.

Slide 11. We continue to generate more cash from closings than we reinvested during the quarter. We generate $15 million of cash flow from operations even after using $55 million to purchase approximately 1100 lots during the quarter. We ended the quarter with $442 million in total cash and cash equivalents, restricted cash, and short-term investments.

Which reduced our net debt to capital ratio to 24.8% at June 30, 2010, from 32.6% at June 30, 2009. Last year we exchanged some stocks for a portion of our debt in the first half of the year. Additionally in the second quarter of this year, we refinanced another portion of our debt and effectively pushed out our maturities by five to six years.

In April 2010, we issued $200 million of senior notes due in 2020 with a coupon of 7.15% priced to yield 7.5% to maturity. We used the proceeds to retire our entire $130 million senior notes due in 2014 plus an additional $65 million of our notes due in 2015. The transaction resulted in a $3.5 million loss on early extinguishment of debt as noted in the operating statements. We believe we have one of the best balance sheets in the industry, with the highest balance of cash and the lowest net debt to capital ratio in the company's history. No debt maturities until 2015 and one of the lowest supplies of high older high priced lots within the public home builder group.

Slide 12. Since we have a relatively light lot supply we must continually replenish our pipeline as we sell and close out communities. Approximately 45% of our lots as of June 30 have been acquired in the last 18 months at historically low prices which are helping us to achieve higher margins while at the same time lowering our risk of impairments and maintaining flexibility to respond to changing market conditions. We believe this differentiates Meritage from other home builders who are carrying larger supplies of lots at higher legacy prices which may constrain their margins and ability to grow profits while reducing their returns on assets.

We are continuing to find and acquire new communities and helping the markets using our leading market research and experienced land managers which we believe is a strategic advantage to Meritage. While increased competition has driven up lot prices from the low levels we were able to take advantage of last year, we are still finding an adequate supply of available lots in good locations and are acquiring lots at places we believe will allow us to earn near normal margins and attractive returns without assuming any inflation in home prices. Replenishing our pipeline this quarter with lots that meet our normal underwriting criteria we have contracted for approximately 2400 lots in 28 communities, 22 of which are in new communities and 6 additions to existing communities during the quarter.

58% of those were in our Texas markets where we haven't tied up as much in the way of new lot positions in the last year or two since land prices hadn't contracted as much there as they had in our other markets. As lot prices have become more attractive and we have succeeded in closing out a number of older communities in Texas, we have been acquiring some lots that were available in better locations as indicated by our market research. We all added a significant number of lots in Orlando, northern and southern California, Phoenix and Denver.

Since the beginning of 2009, we have contracted for more than 8800 new lots as of June 30th, 2010 controlled approximately 14,460 lots, equivalent to 3.4 years supply based on our 12 months closings. We own approximately 71% of those lots with a remaining 29% under option contracts of one type of another. About 80% of our option lots are in Texas where options are still available at reasonable prices. Now I'll turn it back over to Steve

Thank you, Larry. We've been executing a very deliberate set of strategies designed to get us back to profitability and position the company best for the long term. We believe that these strategies provide sustainable competitive advantages and have already seen positive results from our strategic initiatives. We were one of the first home builders to return to profitability in 2010.

We have constructed a strong balance sheet with a relatively light supply of land and no near term debt maturities, providing us the flexibility to reload with lower priced lots as opportunities are down sized to our market research. We have introduced a new series of simple, smart homes designed to compete better with resales. They are more efficient to build, so we price them lower and reduce our direct cost allowing us to earn near normal margins on those homes. And we've reduced our incentives while maintaining prices, thereby expanding our margins while our sales philosophy increased with our newer communities and a 99 day guaranteed delivery system in many of those communities.

We just wrapped up our 2010 Meritage Homes Leadership Institute where more than 100 leaders gathered to assess our progress, set new goals, share best practices, and ensure alignment throughout our organization. Based on what I saw and heard, I'm confidence that we have some of the best talent in the industry at Meritage Homes. I'm very excited about the successes we will achieve in the future.

I appreciate your is support and attention today. We'll now open it up for your questions. The operator will remind you of the instructions. Operator?

Thank you. (Operator Instructions). Our first question is coming from the line of Nishu Sood with Deutche Bank.

Thanks. Good morning everyone. I wanted to get some clarity on your kind of current thinking on 2010 profitability. You mentioned that you're still comfortable with the idea of bringing out the return to profitability in 2010. I know this is a question on everyone's mind. Does that mean then that you think that profitability will persist in the second half of the year?

I do, but I certainly believe it's going to be modest. Sales have been weak throughout the summer, and it will be harder to be profitable in the second half of the year than we thought certainly a few months ago. I still believe that we convert our backlog and be profitable in the third and fourth quarter

Okay, great. That's good Secondly, you have historically been one of the most return on capital focused builders out there. Which is great and obviously shareholders appreciate that.

I wanted to understand the shift that may have happened in your gross margin targeting since you have become more land owner rather than land options. And so in other words, internally are you targeting higher gross margins? Obviously you need a higher gross margin to off set the higher capital carry. And as we should, on the outside, should we investors be looking at your gross margins and saying they should have higher gross margins than they have had historically because of the market being forced to carry a little bit more land?

Well, we are targeting higher gross margins than we were when we were doing predominantly rolling options. We're reputing the internal charge when we carry land as if we had, you know, had a land banker carry it for us. We're just taking that cost and impugning it on our own income statements. The answer is yes. We're trying to achieve a higher gross margin since we're carrying more land. Because land banking is just not available today

So that the 20 that you mentioned that you're roughly targeting right now, that was a 17 or 18 a couple years ago during the boom?

I'd say around 18

Okay great. Thanks a lot

Thank you.

Our next question is coming from the line of Josh Levin, Citigroup. Please proceed with your question.

Good morning, everybody. If demand stays at the current levels, do you think it will affect your plans for rolling out new communities?

No. I think it's more important than ever for us to get into new communities because we're seeing even in the slower times over the last couple months, the newer communities are performing dramatically better than our older communities. It's still important for us to get into new lots at lower price points with more finally tuned products so we can compete with the resale housing market. I think we're going to be prudent and careful not to overpay for lots and not to get caught up in any lot buying fever. But, still it is very important for us to replace older lots with newer lower priced lots.

Okay. And last question. Can you share any information about traffic and trends in July relative to June?

I'd say July was pretty much on par with June, disappointingly. We haven't seen significant improvement in our July sales rate.

Okay. But it hasn't been worse than June?

No.

Thank you very much.

Okay.

Our next question is coming from the line of Stephen East at Ticonderoga.

If we can talk just following on Josh's question a little bit about community growth. Sort of clumping a few questions around it. What you expect the rest of this year. And when you look at those new communities, in addition to the gross margin bump , do you have a different SG&A profile, I'm thinking really selling expense there? And when you talk about your normal margins, are you talking about from a gross margin perspective or the OP margin

Steve, our strategy is really more quality over quantity. What we want to do is replace older communities that are having, experiencing very low absorption rates with newer communities where we can get much higher absorption rates. So we can increase our volumes just by replacing these older communities, not necessarily adding in a lot of communities. So with that said, you know, I think our community count will start to, you know, trend north, but very modestly because we still have a lot of older low margin weak performing communities to get through and replace. And you know, we're targeting certainly the higher margins we talked about. Larry, do you want to add on to that?

Sure. I'd add two things on the gross margin side of things. One of the reasons why our gross margins in our newer communities are outperforming the older communities are not only on the lot price we're getting, which is much larger, but it is because of that additional capital charge that we are factoring into cover having that asset on balance sheet. On the overhead side of the subdivision sense, we're getting better absorptions from the newer subdivision certainty as a percent of revenue. We would see the overhead covered better on new subdivisions, too, so that would result in a better operating margin, too, from covering the G&A better.

When you talk about near normal margins, is that from the gross perspective or the OP margin perspective?

It's more from the gross perspective, obviously. We still have to, as we said earlier in our comments, we need to focus on drawing revenue to better cover true G&A at the division and corporate level. Also cover interest expense better at the company wide level. So we still need to grow revenue to cover those items better.

Okay. And then Steve, you had mentioned that postings at the end of the quarter were similar to June. Are you seeing the need to accelerate concessions on pricing? And then what did, you know -- how much lower was June versus -- as you went through the quarter, say versus April?

I'd say May, June and July were kind of all very close to each other. We haven't seen a significant increase or decrease since we experienced the significant drop in activity in May. So it's been pretty flat for the last three months. We are selectively incentivizing certain communities, you know, to help us maintain certain volume level so we can, you know, at least leverage some of our overhead. But we're being very careful not to dramatically cut prices across the board.

Okay, thanks.

Thank you.

Next question is from the line of Bose George with Keefe, Bruyette, & Woods.

Can you provide any color on your tax segment, including sub markets, as well as any possible impact from the oil spill?

We're not seeing a direct impact in Houston from the oil spill. I would say all the markets in Texas right now are performing similarly. I wouldn't say there's one market that's doing dramatically better than the others. Again, certainly some of our newer, closer end locations we were able to buy lots at deep discounts and are doing better. But I'd say just Texas is pretty consistent market to market.

Okay. And is it possible to quantify the impact of community close outs on the gross margin? And if you expect this trend to continue in the second half of the year?

Larry, why don't you take that one?

Sure. We do think that adding the new subdivisions and selling out of the old subdivisions will trend our margins up. On the other hand, with the sales being slow, that may off set the impact of that somewhat, so we're not as positive as seeing a continuing trend. Things may be more stable for awhile, but over the long run, with the new communities replacing the old ones, we would definitely expect to see a trend upwards in gross margins.

Thank you.

Next question coming from Karl Reichardt.

In terms of the sequential declining gross margin which is a function of fixed and lower margin, was that purposeful knowing that the tax credit was going to expire? You had a chance to build out, sell through some of the older communities and accelerate the turnover, or was that something you weren't expecting?

No. I think that was by design. We didn't expect the gross margin to come down that much, but we do want to get out of these older stores and be able to concentrate our overhead into these newer communities. And move forward with that. That's always been our strategy. And we probably build some more specs, selling into the tax credit. But yearning as we said earlier, we're comfortable of the level of specs that we have today. When you're competing heavily against the resell market, it's important to have those. So yeah, that's definitely part of our strategy.

Thanks. Then just on the 2400 or so lots you added during the quarter. What percentage of those are finished now or will be by the time you take them down versus requiring you to invest development dollars? Just as you're looking out at the land market, it seems to have altered a bit in the last quarter or so. Are you seeing more finished lot deals or still a good size proportion that are going to require some capital?

It's actually the opposite. We're starting to see less finished lot deals than we're pursuing more development opportunities because we think that's where the better buys are going forward. With that said, I don't know. We've got a lot of undeveloped lots in the quarter. Larry, I don't know if you have that number.

I don't have a number. But the great majority were finished lots.

Okay.

I can tell you all the lots that we own or control, only 11% of them require development.

Okay.

Is that right, Larry?

Correct. That's an overall number of the 14,000 we control.

Terrific. Thanks so much, guys.

Okay.

The next question is from the line of Joshua Pollard with Goldman Sachs.

Good morning, guys. Steve, what do you think is a break even number of deliveries in a quarter to get you to bottom line profitability, given your overhead profile?

You know, it depends on our pricing and our margin. In the first quarter of this year, we believe we delivered 808 homes and we were slightly above break even. I'd say it's in the 800 to 850 range. If we can deliver somewhere in there, depending on what the mix is and what happens with prices we should be able to break even there.

When you think about that mix, is there anything in that mix that is regional? I mean, just looking at your community count, sort of down 25 in Texas, up 18 in Florida. I recognize that that's a function of where you guys are opening new. But are there material differences in your margins across the regions right now?

Only to the extent that in certain states we have more new than old. Okay? So California's almost all new. So to the extent we can deliver homes in California, margins will be higher. And then goes from there. In those markets we've gotten rid of older legacy lotsmargins are going to be higher.

Where are the largest majority of your older communities? I'm assuming Texas, but not sure --

Yeah, Texas. Larry, I mean --

Well, Texas, Nevada and Arizona.

Okay. And then the last follow-up is, when you think about closing out of communities, are the closeout communities a level of gross margins greater than that 500 to 600 discount you said with respect to old communities versus new? And if you can also give us a sense of how many communities you plan to close out of in the back half of this year. You gave the sort of 20 to 25 number for the number you want to open.

Larry, why don't you take that?

I'll take the first question, or the last question first. We'll be closing out about equivalent number of communities that we're adding, so we don't expect our community count to go up by much. Maybe it will be stable or go up a little bit. As far as the margins, in some cases we do have a closeout community where we decide to go ahead and build up the last few lots and maybe accept a lower margin. That's not completely true. But in certain instances it is. But as a whole, I'm not certain if those last closeout communities definitely get lower margins than the other older communities, probably happens in some cases, but it's not a given.

Okay. Can I just sneak one last one in?

Sure.

If we are at this pace for the next call it two or three months, do you start to re-enter the potential write-down cycle for some of your older communities? I know prices is a bigger determinant. But if you want to come in well below what you guys were thinking when you did your last round of write downs, which I'll call it fourth quarter of 2009, can pace alone drive you to a smaller write-down cycle?

I don't think so. I think it would have to be longer than two or three months before we would see impairments again.

The pace has an impact but not a significant impact. Price is more of the factor. And we've also, in our newer communities, we're buying these at normal kind of underwriting standards.

So there's a huge cushion, our entire margin, before we would start to have any impairments on those. Then even in our older communities where we've been able to put new product on and improve the community, we've built up a cushion on the margin there, even though it's not as strong as the new communities. So there would have to be pretty significant price erosion before we'd see material impairments again.

Okay. Thank you very much.

Could I clarify one thing? On the 11% of lots that are not finished, that's actually 11% of the communities we own. The lot percentage is somewhat higher because of the active adult communities that have longer term phases that are undeveloped. So 11% relates to the number of communities we own that are undeveloped.

Thank you.

Our next question is coming from Alan Radner of Zellner and Associates.

Thanks for taking my question. If you assume your guidance of getting to about 35% of sales or closings by fourth quarter come from new communities, that should give you about 100 basis point mix benefit on the gross margin. Thinking about the next two quarters. Would you expect obviously this sequential decline is a bit surprising to us. Would you expect that margin, you know, based on what you know on price and the cuts you've had to make in June and July to support some volume. Would you expect that 100 basis point mix shift is enough to keep margins relatively flat or higher from here, or have the price cuts been enough on a corporate scale that you might see some deterioration?

We opened it would be enough. One of the things that we're finding, particularly over the last several weeks, is our new communities are performing dramatically better than our older communities. And the mix of new communities is higher, so I think we're thinking our July sales about 50% of our sales are coming, you know, from new communities, even though new communities only represent about a 30% of our total communities. So hopefully, the volume is coming from the new communities, you know, will offset the potential decline, you know, in some prices. Larry, do you want to add to that?

That's what we certainly are expecting and hoping for, although in this environment is very difficult to say what sales trends will be over the next few months and how that may impact margin. What I said earlier, we would hope we would be at least stable, and as we continue to add these new communities, that it would again start to drive up our margins overall.

Okay. So in terms of the price concessions you've had to make so far, that has not been enough to kind of offset that expected benefit you see. So any decline would have to come from incremental price cuts that you make in the back half of the year?

That's a fair statement. We have not made that much concessions to date. They've been relatively minor.

Okay. Appreciate it.

Our next question is from David Goldberg with UBS.

I was hoping we could spend a little bit of time talking about the Lion's Gate community and getting a better idea how you evaluate the success of that community. Is it just sales rate? Is it a pricing benefit that you get? And with that, I'm kind of hoping we can also talk about, Steve, you said in the prepared remarks, you see this competitive advantage, as you guys offer it standard in the community and a lot of people offer it as an upgrade. Certainly, a lot of the public builders are starting to think about the environmental and the green movement and integrating that into their offerings more. I guess the first part of the question is how are you evaluating the success of that community relative? And the second part of that first question is really about, how sustainable you think that competitive advantage is relative to your peers?

Well, let me take it from a high level. We, like other builders, are thinking every day about how we can compete with resale. 92% of the homes sold in this country today are resale or I like to call them used homes. We got to figure out how to take some of that market share back. And one of the ways I believe that we can do that is by offering a product that has lower operating costs. Higher energy efficiency, lower utility bills, you know, etc.

So if we can build green or high energy efficiency communities that get us above average absorption rates at margins that are comparable or within our underwriting standards and with our expectations, then I think it's a success. So, you know, at Lion's Gate, sales pace and absorption rate is going to be a critical thing that we'll be looking at. It's a good market there in Gilbert. But it's very competitive. We have other national builders within the same community, within close proximity, and if we can capture more market share, then I think it will be deemed to be successful and we will pilot it in other places and continue to explore pushing that strategy

Just to summarize, make sure I understand, is it fair to say that you feel like you're taking market share maybe from other builders but more importantly from the existing home market as you sell the total payment to the buyer?

Yeah, absolutely. It's hard to quantify where you're getting the buyer from, but certainly can see we're selling seven or eight houses a month and brand X is next door and they're selling two houses a month, there's got to be a difference, and the difference may be the energy efficiency component. And so that's a positive. On the other hand, if we don't have a lot of new home competition around us, somewhere where we're piloting it, and getting above average absorption rates, clearly we're taking resale home buyers, turning them into new home buyers.

Got it. Just a quick follow-up. I know we kind of talked about this. You talked about it in your opening remarks and in the Q&A session. I want to put a fine line on the concept of protecting profitability and not offering more incentives and maybe sacrificing some sales volumes. Are there metrics that you look at where if you fall below these level of sales or this kind of activity, then we need to start matching incentives? It seems like the way this goes, it's like one builder starts offering incentives, the other builders lose some sales so everyone has to follow. I'm just trying to get an idea how long you can kind of stay out of playing that game against everybody else. And how you evaluate that from your perspective

I don't know that everybody is out there wholesale discounting their homes.

Not yet.

Not yet. And maybe not at all. But we'll see. I think the metric that we're looking at is break even. You know? We want to stay in the black and to the extent that we can discount and stay in the black, you know, that's what we'll have to do. But beyond that, we can't do is keep our losses to a minimum. We're just managing the profitability and covering our overhead. And pretty simple way of looking at it, I think.

David, at some point, too, we'll start looking at the overhead and starting to make adjustments there. To bring down our break even point.

We already are. You know, like we said earlier, we didn't expect the dropoff to be as big as it's been. And so we have to adjust our strategy to that.

Thank you.

Next question is from Dan Oppenheim with Credit Suisse.

I wonder if you can talk about the absorption. You mentioned the communities are about 30% of the communities but close to 50% of the current orders. That would seem then that the absorption is basically more than twice as high for those now that the older ones are very low in terms of the absorption right now, thinking about where you are in terms of the May, June, July pace of sales. What do you think about in terms of just needing -- what sort of pace per community do you need in terms of the older communities before you start to move through those more quickly?

Well, we need to keep them at a pace that we're selling houses and not creating impairments. So if we can sell one to two houses a month in older communities and get through them and be possibly profitable, I think we'd take that.

Okay. And secondly, in terms of land, when you're looking at new land purchases right now, are you able to get the numbers to work using the current sort of June, July pace of order trend or do you have to use something more normalized?

We're underwriting new land purchases based upon the performance of our new communities in June, July, and into August. We still have communities that we purchase that are achieving acceptable absorption rates. We're very focused on studying very current data on the resale housing market, looking at the trends and what's happening the last six, seven, eight weeks many the resale housing market with prices. Underwriting our new acquisition to those numbers.

Great. Thank you very much.

Dan, if anything, the out performance of the new subdivisions is what's giving us more confidence that our market research and our analysis is correct. Because they haven't been as impacted by the sales slowdown as the older communities have. It just reinforces our, you know, sellout of old and get to new as soon as possible.

Great. Thank you.

The next question is coming from Jim Wilson with JMP Securities. Please proceed with your question, sir.

Thanks. Good morning, guys. I was wondering, you gave a good breakdown Q2 lots acquired and where they were. Larry, do you have handy the P&D required in the last 18 months, roughly what that geographic breakdown has been?

I don't have that off the top of my head, but it's been -- it's been lower in California, Arizona, Colorado and Florida, and none in Vegas and some in Texas.

Okay. All right.

We'll try to get you more detail on that certainly next quarter for sure.

Okay, great. And just wondering, of any of your sub markets whether the sales pace is any better or worse. And I guess secondly, how much I guess on the margin going forward geographic mix of communities might change further. Sounds like Q2 you did start to pick up more in Texas. So if we look to the end of the year, would the geographic mix of community locations be fairly stable?

The only thing I can really say to that, again, the newer communities and the closer end locations where the difference between today's housing prices and the previous peak prices is greater are doing better. But there's no one market or two markets that we're in that are doing significantly better, you know, than others for any other reason other than we may have more communities than those markets, more newer communities than those markets.

I'd add, too, that longer term you will see more market more of our sales and closing shift out of Texas so Texas will become a smaller portion of our business as other markets recover more. So that's a long-term trend you should see.

It's really important that we convey the message that we're very focused on maintaining our market share in Texas. Even though we're diversifying into our other markets, we still want to maintain our share in those markets, particularly our dominant share as the number two or three builder in Dallas and Houston. That's important to us. We don't tend to give that up.

It isn't as if Texas is falling. It's the other ones are growing back faster in.

Right.

All right. Good. Thanks.

Thank you.

Next question today is from the line of Al Faren of Housing Research Center.

Just wondering if you're seeing more competition from the bigger guys there in terms of them being more aggressive, cutting prices, or raising broker commissions, that kind of thing.

I wouldn't say it's any different than it was in the first quarter. You know, there certainly are those that from time to time become more aggressive on the pricing strategy. But I haven't seen any kind of real shift in the market today versus what it was in the end of the year.

When you talk about profitability for the back half of the year, is that just at the operating level or the EPS level also.

At the EPS level.

Okay. All right. Thanks.

Okay.

Our next question is from Jay McCanell from Guggenheim Partners.

Couple housekeeping questions then a strategic question. First what was the spec count at the end of Q2?

I believe it was 540. Excuse me, 580 total specs.

Okay. And then on the incentives, can you give me the average dollar value or what percentage of the sales price was given as incentives for 2Q.

I don't know that off the top of my head. It varies from subdivision to subdivision.

Okay. Okay. The strategic question is, assuming the pain that the public builders are feeling from the slow sales pace right now is translating down to the private level. Is the deal flow for potentially buying some private builders and accessing some lots in a quicker fashion, are you seeing more of that? Are you seeing, getting more calls from people willing to sell out right now?

No. Frankly, there just isn't a lot of private builders to buy, that have anything a lot of people would be interested in. I just don't see going forward volume of public buy and privates to be significant. I think, you know, most of the privates, the publics that are interesting are going out of business. We're getting their lots in other ways from the lenders.

Okay

I just don't think that. And also think that even though things have slowed down the last two or three months, we're not seeing wholesale price cuts on lots from lot sellers. Whether they be land developers or lenders. People are holding off.

Is that ultimately you think going to force you guys to look at some of these FDIC deals or do more from the banks that you're already doing?

Probably not. Those FDIC deals include commercial properties and home loans and broken down development deals and, you know, they include a lot of things that generally we're not interested in. We'd like to get pieces of some of those deals, but it's probably not our strategy to form, at this time, to form an entity to pursue those deals.

Okay. Thanks.

Our next question is from the line of Michael Kim with CRT Capital Group.

During the second quarter you purchased roughly 1100 lots at an average price of $50,000 per lot. Can you talk about pricing on a per lot basis by region? I know you mentioned Orlando, northern California, Denver, and Phoenix and also any color on pricing trends year to date would also be helpful.

I don't want to get that specific on exactly what we paid in each individual region. I mean, that's pretty granular. But as I said on the previous question, you know, opportunities are presenting themselves this quarter that we didn't see last quarter because of the slowdown. We're not seeing significantly lower prices. Prices are kind of holding up.

Okay.

But we certainly see, you know, some of our peers pulling back and fewer deals being done.

The average price is up from last quarter, simply because we bought a few more lots proportionately in California, which generally are more expensive. We bought more lots last quarter in Arizona and markets where it's less expensive. So that's why that increase is happening. I wouldn't read anything into that particularly about overall lot pricing.

Right. Okay. Great. Steve, you mentioned you're seeing better value in unfinished, undeveloped lots. Do you have any interest in join venture activity for these land parcels. Do you see the JV structure coming back at all?

We pursued selective joint ventures with land developers or other builders. But I think we certainly would learn some lessons with respect to joint ventures from the past and we're going to be careful motto make the same mistakes again. Structured correctly, we would be interested.

Okay. Great. Thank you.

Yep. We're taking two more questions, operator.

Thank you. Our next question is from the line of Joel Locker with FBN Securities.

Just got your total spec count. Do you have a finished spec count?

52% of those are finished.

Okay.

Just one more quick item on the customer deposits. Do you have that, what it was at the end of the quarter versus backlog?

I probably have it around here someplace. It's -- about $8 million off the top of my head. But I'd have to check that. It's in the $7 million to $8 million range.

Just one theoretical question on the California tax credit. Should expire around the Septemberperiod. That'll be the first time in 18 months that they haven't had any credit. Are you doing anything internal to prepare for that or if that was even on the radar?

Yeah. I'm open to suggestions what we could do.

Such as maybe buying less land or maybe preparing in any way?

We're doing some things on the marketing side promotion wise to try to compensate for it. We're being very careful what we buy, in California. Some of the recent buys made last quarter were variable because they were very well located in sites that we think are going to have very well received when they come to market.

All right. Thanks a lot, guys

Okay. Deposit number is $8.7 million

48.7 million. Thanks.

Thank you. Gentlemen, there are no further questions in the queue at this time. I'd like to hand it back to management for closing comments.

Thank you very much we appreciate your questions and for following Meritage. We'll look forward to talking to you next quarter.

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation.