MTH

Meritage Corporation 10-Q Summary: Quarter Ended March 31, 2002

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended March 31, 2002, for Meritage Corporation, a leading designer and builder of single-family homes in Texas, Arizona, and California. The company operates two primary segments: first-time/volume-priced homes and mid-to-luxury-priced homes. The reporting period reflects the impact of the May 2001 acquisition of Hancock Communities in Arizona and continued expansion in Northern California. Financial statements have been retroactively adjusted to reflect a 2-for-1 stock split effective April 26, 2002.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Home sales revenue increased 46% year-over-year, driven by a 47% increase in homes closed (758 vs. 516). This growth was fueled by the addition of Hancock Communities in Arizona and new communities in Northern California.
• Margin Compression: Home sales gross profit margin declined from 20.3% to 18.6%. Management attributes this to a shift in product mix toward volume-priced homes and the closing of homes ordered in late 2001 during slower economic conditions.
• Liquidity Position: Cash and cash equivalents decreased significantly from $3.4 million to $0.3 million. Net cash used in operating activities increased to $35.8 million due to higher real estate inventory purchases ($45.1 million increase) and lower accounts payable.
• Debt Levels: Total notes payable increased to $210.2 million from $177.6 million, reflecting increased borrowing to fund land acquisitions and construction.
• Backlog Expansion: Net sales backlog increased 34% in value and 36% in units, with significant contributions from Arizona (73% value increase) and California (20% value increase).

Guidance, Outlook, and Risks

Management Commentary: Management expects continued growth driven by the expansion of operations in Northern California and the integration of Hancock Communities. The company maintains 77 actively selling communities as of March 31, 2002, up from 57 in the prior year.

Accounting Changes: The company adopted SFAS No. 142 effective January 1, 2002, ceasing the amortization of goodwill. Goodwill is now subject to annual impairment testing. The first impairment test is scheduled for the second quarter of 2002; the impact on earnings is currently undetermined.

Liquidity and Capital Resources: The company has $175.0 million in short-term secured revolving construction and acquisition facilities, with approximately $84.8 million of unborrowed funds available. Additionally, $155 million in senior unsecured notes (9.75% interest) are outstanding. Management believes current borrowing capacity and cash flows are sufficient for foreseeable needs.

Risks: Forward-looking statements are subject to risks including interest rate fluctuations (variable rate debt), changes in housing demand, and the ability to secure financing. The company does not use derivative instruments to hedge interest rate risk.

Investor Verification Checklist

• Goodwill Impairment: Verify the results of the first goodwill impairment test scheduled for Q2 2002, as this could materially impact future earnings.
• Cash Burn Rate: Monitor the rapid depletion of cash reserves (down to $0.3 million) against the high level of operating cash outflows ($35.8 million).
• Margin Trends: Track whether the shift to volume-priced homes continues to compress gross margins or if pricing power improves in the luxury segment.
• Debt Covenants: Confirm continued compliance with financial covenants on the $155 million senior notes and revolving credit facilities, particularly regarding tangible net worth and leverage ratios.
• Backlog Conversion: Assess the conversion rate of the expanded backlog (2,004 homes) into revenue, noting the historical cancellation rate of approximately 25%.