MTH

Business Context and Reporting Period

Company: Meritage Homes Corporation
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2007
Business Overview: Meritage is a leading designer and builder of single-family homes in the southern and western United States, operating in three regions: West (California, Nevada), Central (Texas, Arizona, Colorado), and East (Florida). The company operates 220 actively selling communities with home prices ranging from approximately $100,000 to $1,060,000.

Key Financial Metrics

Material Changes vs. Prior Period

• Significant Impairments: The 2007 net loss was primarily driven by $398.3 million in pre-tax real estate-related impairments and $130.5 million in goodwill-related impairments. In contrast, 2006 recorded $78.3 million in real estate impairments and no goodwill impairments.
• Revenue Decline: Revenue dropped 32.2% due to a 26.7% decrease in homes closed (7,687 vs. 10,487) and an 8% decrease in average sales price ($303,600 vs. $328,400).
• Margin Compression: Gross margins collapsed to 1.1% from 20.7% in 2006. Excluding impairments, the adjusted gross margin was 15.1% in 2007 compared to 22.9% in 2006.
• Backlog Reduction: Backlog value decreased 44.2% to $670 million, driven by lower sales volumes, price concessions, and a high cancellation rate of 37% (up from 35% in 2006).
• Regional Performance: The West Region recorded a gross loss of $162.1 million due to severe market corrections in California and Nevada. The Central Region remained profitable but saw margins decline. The East Region recorded a gross loss of $32.7 million, partly due to winding down operations in Ft. Myers, Florida.

Guidance, Outlook, and Risks

Management Commentary & Outlook: Management expects the homebuilding downturn to persist. They anticipate cancellation rates will stabilize as excess inventory is absorbed and prices normalize. The company is focusing on reducing unsold inventory, limiting speculative construction, renegotiating land options, and reducing debt levels. They believe they are positioned to weather the downturn due to their inventory of entitled land and strong balance sheet, though they may need to raise equity or amend debt facilities if conditions worsen.

Key Risks & Contingencies:

• Market Downturn: Continued weakness in housing demand, high inventory levels (9.6 months supply), and reduced mortgage availability threaten future sales and margins.
• Asset Impairments: Further write-downs of real estate inventory and land options are likely if market conditions do not improve.
• Liquidity & Debt Covenants: The company amended its Credit Facility in September 2007 to reduce capacity to $800 million and relax interest coverage covenants. Failure to meet covenants could trigger defaults.
• Joint Venture Exposure: The company has significant exposure to unconsolidated joint ventures, including $88.2 million in "bad boy" guarantees and $34.2 million in limited repayment guarantees.
• Legal Proceedings: Routine litigation regarding construction defects is ongoing, with $2.9 million reserved for probable losses.

Investor Verification Checklist

• Impairment Methodology: Verify the assumptions used in fair value calculations for the $398.3 million in real estate impairments and the $130.5 million goodwill write-off.
• Debt Covenant Compliance: Monitor the company's ability to maintain the amended interest coverage and leverage ratios under the Credit Facility.
• Backlog Quality: Assess the risk of further cancellations given the 37% cancellation rate and the high percentage of unsold inventory (20.6% under construction, 19.9% completed without contracts).
• Joint Venture Defaults: Review the status of the joint ventures with defaulted debt and the potential for "bad boy" guarantees to be triggered.
• Liquidity Position: Confirm the availability of the $375.4 million remaining borrowing capacity under the Credit Facility and the company's ability to generate positive operating cash flow in 2008.