MTH

Business Context and Reporting Period

Company: Meritage Homes Corporation
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2006
Business Overview: Meritage is a leading designer and builder of single-family attached and detached homes in the southern and western United States. Operations are divided into three regions: West (California, Nevada), Central (Arizona, Texas, Colorado), and East (Florida). As of December 31, 2006, the company was actively selling homes in 213 communities across six states.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth vs. Profit Decline: While revenue increased 15% to a record $3.46 billion and home closings rose 11%, net earnings decreased 12% to $225 million. This divergence was primarily driven by $78.3 million in non-cash charges related to inventory impairments ($23.7 million) and write-offs of option deposits and pre-acquisition costs ($54.6 million).
• Backlog Contraction: Backlog units decreased 42% and backlog value decreased 45% compared to 2005. This reflects deteriorating market conditions, lower sales volumes, and a cancellation rate of 35% in 2006 (up from 24% in 2005).
• Margin Compression: Companywide gross profit margin declined 290 basis points to 20.7% from 23.6% in 2005. Excluding impairment charges, margins were relatively comparable, but the West and East regions saw significant margin pressure due to pricing concessions and incentives.
• Order Volume: Net new orders dropped 26% to 7,778 units, with significant declines in the West and East regions due to market softening.

Guidance, Outlook, and Risks

Management Commentary: Management expects cancellation rates to trend toward historical averages (less than 25%) in 2007. The company anticipates delivering substantially all homes in the current backlog during 2007. To remain competitive in a weak market, the company is offering increased incentives and discounts.

Outlook: The company believes it is well-positioned for future growth with a four- to five-year land supply, 83% of which is under option or contract. However, the homebuilding industry remains cyclical and sensitive to interest rates and affordability.

Key Risks and Contingencies:

• Market Conditions: Continued deterioration in housing markets could lead to further inventory impairments and write-offs of land option deposits.
• Interest Rates: Increases in mortgage rates could adversely affect buyer affordability and demand.
• Joint Ventures: The company relies heavily on joint ventures for land acquisition. Risks include development delays, cost overruns, and potential guarantees on joint venture debt ($38.6 million in limited repayment guarantees and $82.3 million in "bad boy" guarantees).
• Legal and Environmental: Routine litigation regarding construction defects and environmental fines (e.g., dust control) are ongoing, though management does not expect material adverse effects.

Investor Verification Checklist

• Impairment Sustainability: Verify if the $78.3 million in 2006 impairments and write-offs are a one-time event or indicative of a continuing trend in land valuation.
• Backlog Quality: Assess the stability of the remaining $1.2 billion backlog given the 35% cancellation rate experienced in 2006.
• Liquidity Position: Review the $449 million borrowing availability under the credit facility and the company's ability to service $733 million in debt amidst negative operating cash flow.
• Regional Exposure: Evaluate the specific performance of the West and East regions, which faced the most significant margin compression and order declines.
• Stock Repurchase Program: Confirm the status of the $130.2 million remaining authorization for share repurchases and its impact on capital allocation.