Meritage 10-Q 2006
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
For the quarterly period ended March 31, 2006
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
Commission File Number 1-9977
MERITAGE HOMES CORPORATION
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large Accelerated Filer x Accelerated Filer o Non-Accelerated Filer o
Indicate by a checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes o No x
Common shares outstanding as of October 30, 2006: 26,121,016.
MERITAGE HOMES CORPORATION
This quarterly report on Form 10-Q/A is filed for the purpose of restating Note 12 in the Notes to Condensed Consolidated Financial Statements for the quarters ended March 31, 2006 and 2005, which includes expanded reportable segment footnote disclosure related to our homebuilding operations. The restatement has no impact on our consolidated balance sheets as of March 31, 2006 and December 31, 2005, or our consolidated statements of earnings and related earnings per share amounts, consolidated statements of cash flows or consolidated statements of stockholders equity for the quarters ended March 31, 2006 and 2005. Conforming changes have been made to Managements Discussion and Analysis of Financial Condition and Results of Operations in Part I, Item 2 and our Controls and Procedures discussion in Part I, Item 4 of this Form 10-Q/A. See Note 12 in the Notes of Condensed Consolidated Financial Statements for further information relating to the restatement. This Form 10-Q/A has not been updated for events or information subsequent to the date of filing of the original Form 10-Q, except in connection with the foregoing.
TABLE OF CONTENTS
HOMES CORPORATION AND SUBSIDIARIES
See accompanying notes to condensed consolidated financial statements
HOMES CORPORATION AND SUBSIDIARIES
See accompanying notes to condensed consolidated financial statements
HOMES CORPORATION AND SUBSIDIARIES
See supplemental disclosures of cash flow information at Note 10.
See accompanying notes to condensed consolidated financial statements
NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION
Organization. We are a leading designer and builder of single-family attached and detached homes in the rapidly growing southern and western United States, based on the number of home closings. We offer a variety of homes that are designed to appeal to a wide range of homebuyers, including first-time, move-up, luxury and active adult buyers. We have operations in three regions: West, Central and East, which are comprised of 14 metropolitan areas in Arizona, Texas, California, Nevada, Colorado and Florida. Meritage Homes Corporation was incorporated in 1988 as a real estate investment trust in the State of Maryland. In 1996 and 1997, through a merger and acquisition, we acquired the homebuilding operations of our predecessor companies having operations in Arizona and Texas. We currently focus exclusively on homebuilding and related activities and no longer operate as a real estate investment trust.
We operate in Texas as Meritage Homes, Legacy Homes and Monterey Homes; in Arizona as Meritage Homes and Monterey Homes; in Florida as Meritage Homes and Greater Homes and in California, Nevada and Colorado as Meritage Homes. At March 31, 2006, we were actively selling homes in 185 communities, with base prices ranging from $107,000 to $1,147,000.
Basis of Presentation. The accompanying consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles and include the accounts of Meritage Homes Corporation and those of our consolidated subsidiaries, partnerships and other entities in which we have a controlling financial interest, and of variable interest entities (see Note 3) in which we are deemed the primary beneficiary (collectively, the Company). Intercompany balances and transactions have been eliminated in consolidation and certain prior year amounts have been reclassified to conform to our current year financial statement presentation. In our condensed consolidated statement of cash flows for the three months ended March 31, 2005, we changed the classification of distribution of earnings from unconsolidated entities to present such changes as an operating activity. We previously presented such changes as an investing activity. In the accompanying condensed consolidated statement of cash flows for the three months ended March 31, 2005, this reclassification resulted in a $3.0 million increase to operating cash flows and a corresponding decrease to investing cash flows from the amounts previously reported. In our condensed consolidated statements of earnings for the three months ended March 31, 2005, we reclassified $2.0 million in expenses from other income, net to general and administrative expenses to conform to the current year presentation. These financial statements should be read in conjunction with our audited consolidated financial statements included in our annual report on Form 10-K/A for the year ended December 31, 2005.
The Company designs, constructs and sells a wide range of homes designed to meet the specific needs of each of its markets. Because each of our homebuilding regions has similar economic characteristics, housing products and class of prospective buyers, the homebuilding regions have been aggregated into a single homebuilding segment.
Common Stock Repurchase. In August 2004, the Board of Directors approved a stock repurchase program authorizing the expenditure of up to $50 million to repurchase shares of our common stock. This program was completed in February 2006, with the repurchase of 601,000 shares at an average price of $59.21.
In February 2006, the Board of Directors approved a new stock repurchase program, authorizing the expenditure of up to $100 million to repurchase shares of our common stock. There is no stated expiration date for this program but we will purchase shares subject to applicable securities law and at times and in amounts as management deems appropriate. In March 2006, we repurchased 255,000 shares at an average price of $53.77 under this program.
Off-Balance Sheet Arrangements. We often acquire finished building lots at market prices at the date the contract is executed from various development entities under option and purchase agreements. This lot acquisition strategy reduces the financial requirements and risks associated with direct land ownership and land development. Under these option and purchase agreements, we are usually required to make deposits in the form of cash or a letter of credit, which may be forfeited if we fail to perform under the agreement. As of March 31, 2006, we had entered into option and purchase agreements with an aggregate purchase price of approximately $2.8 billion and had made deposits of approximately $163.6 million in the form of cash and approximately $86.4 million in letters of credit.
We also enter into land acquisition and development joint ventures. Our participation in such joint ventures provides us a means of accessing larger parcels and lot positions and helps us expand our market opportunities and manage our risk profile. Our participation in joint ventures is an increasingly important part of our business model and we expect it to continue to increase in the future. We and/or our joint venture partners occasionally provide limited repayment guarantees on a pro rata basis on debt of certain unconsolidated land acquisition and development joint ventures. At March 31, 2006, our share of these limited pro rata repayment guarantees was $31.7 million.
In addition, we and/or our joint venture partners occasionally provide guarantees that are only applicable if and when the joint venture directly, or indirectly through agreement with its joint venture partners or other third parties, causes the joint venture to voluntarily file a bankruptcy or similar liquidation or reorganization action (commonly referred to as bad boy guarantees). These types of guarantees typically are on a pro rata basis and are designed to protect the secured lender from the joint venture filing voluntary bankruptcy to impede the lenders remedies with respect to its mortgage or other secured lien on the joint ventures underlying property. To date, no such guarantees have been invoked and we believe it is unlikely that such a guarantee would be invoked in the future as it would require us to voluntarily take actions that would generally be disadvantageous to the joint venture and to us. At March 31, 2006, we had outstanding guarantees of this type totaling approximately $62.2 million. By definition, these guarantees, unless invoked as described above, are not considered guarantees or indebtedness under our revolving credit facility or senior note indentures.
We and our joint venture partners are also typically obligated to the project lenders to complete land development improvements if the joint venture does not perform the required development. Provided we and the other joint venture partners are in compliance with these completion obligations, the project lenders are generally obligated to fund these improvements through any financing commitments available under the applicable joint venture development and construction loans. In addition, we and our joint venture partners have from time to time provided unsecured environmental indemnities to joint venture project lenders. In some instances, these indemnities are subject to caps. These indemnities generally obligate us to reimburse the project lenders only for claims related to environmental matters for which such lenders are held responsible. As part of our project acquisition due diligence process to determine potential environmental risks, we, or the joint venture entity, generally obtain an independent environmental review from outside consultants.
Additionally, we and our joint venture partners sometimes agree to indemnify third party surety providers with respect to performance bonds issued on behalf of certain of our joint ventures. If a joint venture does not perform its obligations, the surety bond could be called. If these surety bonds are called and the joint venture fails to reimburse the surety, we and our joint venture partners would be obligated to indemnify the surety. These surety indemnity arrangements are generally joint and several obligations with our other joint venture partners. As of March 31, 2006, we had approximately $29.2 million of surety bonds outstanding subject to these indemnity arrangements. None of these bonds have been called to date and we believe it is unlikely that any of these bonds will be called.
We also obtain letters of credit and performance, maintenance and other bonds in support of our related obligations with respect to the development of our projects. The amount of these obligations outstanding at any time varies depending on the stage and level of our development activities. In the event the letters of credit or bonds are drawn upon, we would be obligated to reimburse the issuer of the letter of credit or bond. At March 31, 2006, we had approximately $28.0 million in outstanding letters of credit and $235.4 million in performance bonds for such purposes. We believe it is unlikely that any of these letters of credit or bonds will be drawn upon.
Intangibles, net. Intangible assets consist primarily of non-compete agreements, tradenames and floor plan designs acquired in connection with our February 2005 acquisition of Colonial Homes and our September 2005 acquisition of Greater Homes. These intangible assets were valued at the acquisition dates utilizing accepted valuation procedures. The non-compete agreements, tradenames and floorplan designs are being amortized over their estimated useful lives. The cost and accumulated amortization of our intangible assets was $11.5 million and $2.7 million, respectively, at March 31, 2006. For the quarter ended March 31, 2006, amortization expense was $0.8 million. Amortization expense is expected to be approximately $2.1 million in the remaining nine months of 2006 and $2.8, $2.3, $1.1 and $0.5 million per year in 2007, 2008, 2009 and 2010, respectively.
Additionally, we have capitalized software costs at March 31, 2006, in accordance with SOP 98-1 Accounting for Costs of Computer Software Development or Obtained for Internal Use of $4.8 million, net of accumulated amortization of $3.1 million. In the first quarter of 2006, amortization expense was approximately $0.7 million related to the capitalized
software costs and is expected to be approximately $2.3 million for the remaining nine months of 2006 and $1.4, $0.4, $0.4 and $0.3 million in 2007, 2008, 2009 and 2010, respectively.
Accrued Liabilities. Accrued liabilities consists of the following (in thousands):
Warranty Reserves. As is customary in the homebuilding industry, we have obligations related to post-construction warranties and defect claims for homes closed. We have established reserves for these obligations based on historical data and trends with respect to similar product types and geographic areas. Warranty reserves are included in accrued liabilities on the accompanying condensed consolidated balance sheets. Additions to warranty reserves are included in cost of sales within the accompanying condensed consolidated statement of earnings. We periodically review the adequacy of our warranty reserves, and believe they are sufficient to cover potential costs for materials and labor related to post-construction warranties and defects. A summary of changes in our warranty reserves follows (in thousands):
Recently Issued Accounting Pronouncements. In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 153, Exchanges of Nonmonetary Assets, an Amendment of APB No. 29. SFAS No. 153 amends APB Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A monetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This statement is effective on January 1, 2006. The adoption of SFAS No. 153 did not have a material effect on our consolidated financial statements.
In December 2004, the FASB issued Staff Position 109-1 Application of FASB Statement No. 109 (FASB No. 109), Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 (FSP 109-1). FSP 109-1 clarifies guidance that applies to the new deduction for qualified domestic production activities. When fully phased in, the deduction will be up to 9% of the lesser of qualified production activities income or taxable income. FSP 109-1 clarifies that the deduction should be accounted for as a special deduction under FASB No. 109 and will reduce tax expense in the periods that the amounts are deductible on the tax return. We began applying the provisions of FSP 109-1 January 1, 2005, and expect that the impact of this deduction will increase as the deduction is phased in under the statute.
Reference is made to Note 9 regarding our adoption of SFAS No. 123R, Share-based Payment.
NOTE 2 - REAL ESTATE AND CAPITALIZED INTEREST
Real estate consists of the following (in thousands):
Subject to sufficient qualifying assets, we capitalize all development period interest costs incurred in connection with the development and construction of real estate. Capitalized interest is allocated to real estate when incurred and charged to cost of home closings when the related property is delivered. Certain information regarding capitalized interest follows (in thousands):
NOTE 3 - VARIABLE INTEREST ENTITIES AND CONSOLIDATED REAL ESTATE NOT OWNED
FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (FIN 46R) requires the consolidation of entities in which an enterprise absorbs a majority of the entitys expected losses, receives a majority of the entitys expected residual returns, or both, as a result of ownership, contractual or other financial interests in the entity. Prior to the issuance of FIN 46R, entities were generally consolidated by an enterprise when it had a controlling financial interest through ownership of a majority voting interest in the entity.
Under FIN 46R, a variable interest entity, or VIE, is created when (i) the equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties or (ii) equity holders either (a) lack direct or indirect ability to make decisions about the entity, (b) are not obligated to absorb expected losses of the entity, or (c) do not have the right to receive expected residual returns of the entity or (iii) the equity of investors as a group are considered to lack the direct or indirect ability to make decisions about the entity if (x) the voting rights of some investors are not proportional to their obligations to absorb the expected losses of the entity, their rights to receive the expected residual returns of the entity, or both, and (y) substantially all of the entitys activities either involve or are conducted on behalf of an investor that has disproportionately fewer voting rights.
Based on the provisions of FIN 46R, we have concluded that when we enter into an option or purchase agreement to acquire land or lots from an entity and pay a non-refundable deposit, a VIE is created because we are deemed to have provided subordinated financial support, which refers to variable interests that will absorb some or all of an entitys expected losses if they occur. For each VIE created, we compute expected losses and residual returns based on the probability of future cash flows as outlined in FIN46R. If we are deemed to be the primary beneficiary of the VIE, because we are obligated to absorb the majority of the expected losses, receive the majority of the residual returns, or both, we will consolidate the VIE in our consolidated financial statements. Not all of our purchase and option agreements are determined to be VIEs.
We have applied FIN 46R by developing a methodology to determine whether or not we are the primary beneficiary of the VIE. Part of this methodology requires the use of estimates in assigning probabilities to various future cash flow possibilities relative to changes in the fair value and changes in the development costs associated with the property. Although we believe that our accounting policy properly identifies our primary beneficiary status with these VIEs, changes in the probability estimates could produce different conclusions regarding our primary beneficiary status.
We generally do not have any ownership interest in the VIEs that hold the lots and land under option or contract, and accordingly, we generally do not have legal or other access to the VIEs books or records. Therefore, it is not possible for us to compel the VIEs to provide financial or other data to us in performing our primary beneficiary evaluation. Accordingly, this lack of information from the VIEs may result in our evaluation being conducted primarily based on managements judgments and estimates.
In most cases, creditors, if any, of the entities with which we have option agreements have no recourse against us and the maximum exposure to loss in our option agreements is limited to our option deposit. Often, we are at risk for items over budget related to land development on property we have under option. In these cases, we have contracted to complete development at a fixed cost on behalf of the land owner. Some of our option deposits may be refundable if certain contractual conditions are not performed by the party selling the lots.
The table below presents a summary of our lots under option or contract at March 31, 2006 (dollars in thousands):
(1) Deposits are non-refundable except if certain contractual conditions are not performed by the selling party.
(2) Deposits are refundable at our sole discretion. Includes 6,924 lots under control for which we have not completed our acquisition evaluation process and we have not internally committed to purchase.
Notes: At March 31, 2006, we had no specific performance options, as none of our option agreements require us to purchase lots.
Our options to purchase lots remains effective so long as we purchase a pre-established minimum number of lots each month or quarter, as determined by the applicable agreement. The pre-established number of lots typically is structured to approximate our expected rate of home orders.
NOTE 4 - INVESTMENTS IN UNCONSOLIDATED ENTITIES
We participate in homebuilding and land development joint ventures from time to time as a means of accessing larger parcels of land and lot positions, expanding our market opportunities, managing our risk profile and leveraging our capital base. We had equity investments of 50% or less and did not have controlling financial interests in these unconsolidated entities at March 31, 2006. Our joint venture partners generally are other homebuilders, land sellers or other real estate investors. We also enter into mortgage and title business joint ventures from time to time. These unconsolidated entities follow accounting principles generally accepted in the United States of America and we generally share in their profits and losses in accordance with our ownership interests.
For land development joint ventures, we and, in some cases our joint venture partners, usually receive an option or other similar arrangement to purchase portions of the land held by the unconsolidated joint ventures. Option prices are generally negotiated prices that approximate market value when we enter into the option contract. For homebuilding and land development joint ventures, our share of the joint venture earnings relating to lots we purchase from the joint ventures is deferred until homes are delivered by us and title passes to a homebuyer. At such time, we allocate our joint venture earnings to the land acquired by us as a reduction in the basis of the property.
Summarized condensed financial information related to unconsolidated joint ventures that are accounted for using the equity method was as follows (in thousands):
* Our share of net earnings is recorded in Earnings from unconsolidated entities, net on our consolidated statements of earnings. Our share of net earnings excludes joint venture earnings related to lots we purchased from the joint ventures. Those earnings are deferred until homes are delivered by us and title passes to a homebuyer.
At March 31, 2006 and December 31, 2005, our investments in unconsolidated entities includes $1.1 million and $1.5 million, respectively, related to the difference between the amounts at which our investments are carried and the amount of underlying equity in net assets. These amounts are amortized to equity of earnings of unconsolidated entities over the life of the respective joint ventures, which offsets their related earnings. We amortized approximately $0.7 million and $1.1 million to our equity of the joint venture earnings in the first quarter of 2006 and 2005, respectively.
In addition to joint ventures accounted for under the equity method summarized in the above table, at March 31, 2006, and December 31, 2005, our investments in unconsolidated entities included joint ventures recorded under the cost method. These joint ventures were formed to acquire large parcels of land, to perform off-site development work and to sell lots to the joint venture members and other third parties. As of March 31, 2006, and December 31, 2005, our investments in unconsolidated entities recorded under the cost method were $15.5 and $14.9 million, respectively. As of March 31, 2006, we have not recorded any income or distributions from these joint ventures.
As of March 31, 2006, our total investment in unconsolidated joint ventures of $79.0 million was primarily comprised of $27.3 million in our West Region, $50.9 million in our Central Region and $0.1 million in our East Region. As of December 31, 2005, our total investment in unconsolidated joint ventures of $88.7 million was primarily comprised of $28.5 million in our West Region and $59.4 million in our Central Region.
NOTE 5 - LOANS PAYABLE AND OTHER BORROWINGS
Loans payable consists of the following (in thousands):
We have determined that the construction costs and related debt associated with certain model homes which are owned and leased to us by others and that we use to market our communities are required to be included on our balance sheet. We do not legally own the model homes, but we are reimbursed by the owner for our construction costs and we have the right, but not the obligation, to purchase these homes. Although we have no legal obligation to repay any amounts received from the third-party owner, such amounts are recorded as debt and are typically deemed repaid when we simultaneously exercise our option to purchase the model home and sell such model home to a third-party home buyer. Should we elect not to exercise our rights to purchase these model homes, the model home costs and related debt under the model lease program will be eliminated upon the termination of the lease, which is generally between one and three years from the origination of the lease.
On December 20, 2005, we amended our $600 million senior unsecured revolving credit facility to add an accordion feature that will allow Meritage to request from time to time an aggregate increase of up to $200 million in the maximum borrowing commitment. Each member of the lending group may elect to participate or not participate in any request we make. In addition, any increase in the borrowing capacity pursuant to this accordion feature is subject to certain terms and conditions, including the absence of an event of default.
NOTE 6 - SENIOR NOTES
Senior notes consist of the following (in thousands):
In March 2005, we used a portion of the proceeds from the $350 million sale of our 6.25% senior notes to repurchase pursuant to a tender offer and consent solicitation approximately $276.8 million of our outstanding 9.75% senior notes due 2011. In connection with this tender offer and repurchase, we reported a one-time pre-tax charge of approximately $31.3 million for premiums, commissions and expenses associated with the tender offer and the write-off of existing offering costs associated with the 9.75% senior notes, net of the accretion of existing note premiums on the 9.75% senior notes. Later
during 2005, we repurchased an additional $2 million of our 9.75% senior notes. We have provided notice to the holders of the remaining outstanding 9.75% senior notes that we will be redeeming such notes on June 1, 2006, at a price of 104.875%.
The bank facility and indentures for the 7% senior notes due 2014 and the 6.25% senior notes due 2015 contain covenants which require maintenance of certain levels of tangible net worth and compliance with certain minimum financial ratios, place limitations on the payment of dividends and redemptions of equity, and limit the incurrence of additional indebtedness, asset dispositions, mergers, certain investments and creations of liens, among other items. As of and for the quarter ended March 31, 2006, we were in compliance with these covenants. After considering our most restrictive bank covenants, our borrowing availability under the bank credit facility was approximately $354.8 million at March 31, 2006 as determined by borrowing base limitations defined by our agreement with the lending banks. The revolving credit facility and senior notes restrict our ability to pay dividends, and at March 31, 2006, our maximum permitted amount available to pay dividends was $155.6 million, which is equal to 50% of our consolidated net income for the most recent four quarters.
Obligations to pay principal and interest on the bank credit facility and senior notes are guaranteed by all of our subsidiaries (collectively, the Guarantor Subsidiaries), each of which is directly or indirectly 100% owned by Meritage Homes Corporation. Such guarantees are full and unconditional, and joint and several. Separate financial statements of the Guarantor Subsidiaries are not provided because Meritage (the parent company) has no independent assets or operations, the guarantees are full and unconditional and joint and several, and there are no non-guarantor subsidiaries. There are no significant restrictions on the ability of the parent company or any guarantor to obtain funds from its subsidiaries by dividend or loan.
NOTE 7 - ACQUISITIONS AND GOODWILL
Greater Homes Acquisition. In September 2005 we purchased all of the outstanding stock of Greater Homes, Inc. (Greater Homes), a builder of single-family homes in Orlando, Florida. The purchase price was approximately $86.2 million in cash, including the repayment of existing debt of approximately $27.7 million. The results of Greater Homes operations have been included in our financial statements since September 1, 2005, the effective date of the acquisition. Assets and liabilities were recorded at their estimated fair market value at the date of acquisition, and are subject to change when we finalize our analysis.
Colonial Homes Acquisition. In February 2005 we purchased the homebuilding and related assets of Colonial Homes of Florida (Colonial Homes), which operates primarily in the Ft. Myers/Naples area. The purchase price was approximately $66.2 million in cash. The results of Colonial Homes operations have been included in our consolidated financial statements as of the effective date of acquisition, February 1, 2005.
Goodwill. Goodwill represents the excess of the purchase price of our acquisitions over the fair value of the assets acquired. The acquisitions of Colonial Homes and Greater Homes were recorded using the purchase method of accounting. The purchase price for each was allocated based on estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition. The excess purchase price over the fair value of the net assets acquired of $27.9 and $10.1 million for Colonial Homes and Greater Homes, respectively, was recorded as goodwill.
The changes in the carrying amount of goodwill for the three months ended March 31, 2006, follow (in thousands):
Under the guidelines contained in SFAS No. 142, Goodwill and Other Intangible Assets, in the first quarter of 2006 management performed its annual assessment of goodwill and determined that no impairment existed.
See Note 11 for a summary of the allocation of the purchase price to acquired assets and liabilities.
NOTE 8 - EARNINGS PER SHARE
Basic and diluted earnings per common share are presented in conformity with SFAS No. 128, Earnings Per Share. The following table presents the calculation of basic and diluted earnings per common share (in thousands, except per share amounts):
NOTE 9 - STOCK-BASED COMPENSATION
In the first quarter of 2006, we adopted SFAS 123R, Share-Based Payment (SFAS 123R), which revises SFAS 123, Accounting for Stock-Based Compensation. Prior to 2006, we accounted for stock awards granted to employees under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and Related Interpretations. As a result, in periods prior to fiscal year 2006, no compensation expense was recognized for stock options granted to employees because we did not grant stock options with exercise prices below the market price of the underlying stock on the date of the grant.
SFAS 123R applies to new awards and to awards modified, repurchased or cancelled after the required effective date, as well as to the unvested portion of awards outstanding as of the required effective date. We use the Black-Scholes model to value new stock option grants under SFAS 123R. We have applied the modified prospective method for existing grants, which requires us to value stock options prior to our adoption of SFAS 123R under the fair value method and expense the unvested portion over the remaining vesting period. SFAS 123R also requires us to estimate forfeitures in calculating the expense related to stock-based compensation and to reflect the benefits of tax deductions in excess of recognized compensation expense as both a financing inflow and an operating cash outflow upon adoption.
Our Board of Directors administers our current stock option plan (the Plan), which was adopted in 1997 and is stockholder-approved. The Plan authorizes grants of incentive and non-qualified stock options to officers, key employees, non-employee directors and consultants for up to 5,900,000 shares of common stock, of which 492,550 shares remain available for grant at March 31, 2006. We believe that such awards provide a means of performance-based compensation to attract and retain qualified employees and better align the interests of our employees with those of our stockholders. Generally, option awards are granted with an exercise price equal to the market price of Meritage stock at the date of grant, a five-year ratable vesting period and a seven-year contractual term.
The following table illustrates the effect on net income and earnings per share for the three months ended March 31, 2005, as if our stock-based compensation had been determined based on the fair value at the grant dates for awards made prior to 2006, under the Plan and consistent with SFAS 123R (in thousands, except per share amounts):
* Total stock-based compensation expense determined using the fair value method for awards, net of related tax effects
The pro forma results above are not intended to be indicative of, or a projection of, future results.
The fair values of option awards are estimated using a Black-Scholes option pricing model that uses the assumptions noted in the following table. Beginning January 1, 2006, expected volatilities are based on a combination of implied volatilities from traded options on our stock and historical volatility of our stock. Expected term, which represents the period of time that options granted are expected to be outstanding, is estimated using historical data. Groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve.
A summary of option activity under the Plan as of March 31, 2006, and changes during the three months then ended is presented below:
The total intrinsic value of options exercised during the quarters ended March 31, 2006 and 2005, was $15.0 million and $12.6 million, respectively. The intrinsic value of a stock option is the amount by which the market value of the underlying stock exceeds the exercise price of the stock option.
As of March 31, 2006, we had $27.9 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the Plan that will be recognized on a straight-line basis over the remaining
vesting periods. That cost is expected to be recognized over a weighted-average period of 3.25 years. For the three months ended March 31, 2006, our total stock-based compensation expense was $2.7 million ($2.0 million after tax or $0.08 per basic share and $0.07 per diluted share).
Cash received from option exercises under the Plan for the quarters ended March 31, 2006 and 2005, was $2.5 million and $1.5 million, respectively. The actual tax benefit realized for the tax deductions from option exercises totaled $5.0 million and $2.6 million for the quarters ended March 31, 2006 and 2005, respectively.
NOTE 10 - INCOME TAXES
Components of the provision for income taxes are (in thousands):
NOTE 11 - SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
The February 2005 acquisition of Colonial Homes (East Region) resulted in the following changes in assets and liabilities (in thousands):
NOTE 12 - OPERATING AND REPORTING SEGMENTS
Subsequent to the issuance of our unaudited condensed consolidated financial statements for the quarter ended March 31, 2006, management determined that the notes to the consolidated financial statements for the quarters ending March 31, 2006 and 2005 should be restated to contain revised and expanded reportable segments disclosures in accordance with SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. Historically, we have reported our six operating segments (the six states in which we are currently actively selling homes) as a single homebuilding segment, but have revised and restated our segment disclosure by aggregating our operating segments into three reportable segments: the West, Central and East regions, as further described below. Revenues in these segments are primarily derived from the sale of homes that we construct. This restatement has no impact on our condensed consolidated financial statements, related earnings per share amounts or cash flows.
As required by SFAS No. 131, the operating segments aggregating into each reporting segment have been determined to have similar economic characteristics such as: historical and projected future operating results, employment trends, land acquisition and land constraints, municipality behavior as well as meeting the other qualitative aggregation criteria. The reportable homebuilding segments are aggregated as follows:
West: California and Nevada
Central: Texas, Arizona and Colorado
Managements evaluation of segment performance is based on segment operating income, which we define as homebuilding and land revenues less cost of home construction, commissions and other sales costs, land development and other land sales costs and other costs incurred by or allocated to each segment. Each reportable segment follows the same accounting policies described in Note 1, Organization and Basis of Presentation, to the consolidated financial statements in our 2005 Annual Report on Form 10-K/A. Operating results for each segment may not be indicative of the results for such segment had it been an independent, stand-alone entity for the periods presented. The following segment information is in thousands:
(a) Revenue includes the following land closing revenue, by segment (in thousands): 2006 - $897 in Central Region; 2005 - $221 in Central Region.
(b) Balance consists primarily of corporate costs and numerous shared service functions such as finance, legal and treasury that are not allocated to the operating segments.
(c) Balance consists primarily of goodwill and intangibles and other corporate assets not allocated to the segments.
See additional segment discussions in Notes 4, 7 and 11.
The following discussion gives effect to the restatement discussed in Note 12 to the condensed consolidated financial statements.
We are a leading designer and builder of single-family homes in the rapidly growing western and southern United States based on the number of home closings. We focus on providing a broad range of first-time, move-up, active adult and luxury homes to our targeted customer base. We believe that population, job and income growth, as well as the favorable migration characteristics of our markets, continue to provide long-term growth opportunities for us. At March 31, 2006, we were actively selling homes in 185 communities, with base prices ranging from $107,000 to $1,147,000. We operate in the following geographic regions, which are presented as our reportable business segments:
West: California and Nevada
Central: Arizona, Texas and Colorado
Total home closing revenue was $846.4 million for the three months ended March 31, 2006, increasing 54% from $550.9 million for the same period last year. Net earnings for the first quarter of 2006 increased 230% to $79.7 million from $24.2 million in the same period last year. Net earnings for the three months ended March 31, 2005, included a one-time bond refinancing charge related to a series of refinancing transactions that resulted in a charge of $31.3 million, which reduced after-tax net earnings by $19.5 million. Excluding this one-time charge, net earnings for the three months ended March 31, 2006, increased 82% compared to the same period last year.
Our strong first quarter 2006 revenue and net income are the result of closing orders taken during the robust housing markets in 2005. As a result of favorable housing markets in 2005, we benefited from pricing power, which resulted in our gross margin for the first quarter of 2006 increasing to 25.3% from 21.7% in the same period last year. During the fourth quarter of 2005 and first quarter of 2006, our housing markets in northern California, Arizona and Florida began to soften. These markets experienced robust sales activity in 2004 and 2005 and now appear to be returning to more historic levels. This softening has resulted in a decline in sales, which we expect will result in a decrease in our reported margins in the latter part of 2006 and continuing into 2007. Although we reported significant increases in sales during the first quarter of 2006 in Texas, these markets have historically experienced lower margins than our other markets. As a result of these trends, we do not believe the gross and net margins we reported in the first quarter of 2006 are sustainable and we expect our margins to trend lower toward more historic levels.
At March 31, 2006, our backlog of approximately $2.2 billion was consistent with our backlog at December 31, 2005, and an increase of 22% compared to the same period last year. This backlog typically gives us visibility into our anticipated results over the next couple of quarters.
Our sales value of homes ordered declined slightly compared to the record breaking period from a year ago. Overall, our sales orders in the first three months of fiscal 2006 have been strong in Texas, helping to offset moderating sales in some of our other markets. Average sales prices on homes ordered have continued to climb in the Central Region while decreasing in the West and East Regions. We believe these results demonstrate the benefits of our diversification strategy that has taken us from operations in seven markets in three states four years ago to 14 markets in six states at March 31, 2006. This strategy has extended our reach with a 26% increase in the number of communities in which we actively sell homes to 185 from the same period last year. It is our expectation that price appreciation in our markets that experienced robust sales activity in 2005 will moderate and we expect the home order rate to return to more normal levels in 2006 and beyond. In the first quarter of 2006, our cancellation rate on sales orders has increased to approximately 28% from 20% in the same period a year ago, which has resulted in a modest increase in the percentage of unsold homes recorded on our balance sheet. Consequently, we may use various incentive and discount offerings to reduce the amount of unsold homes. We believe our experiences in these markets are consistent with the overall trends in the homebuilding industry. Looking beyond 2006, based on current market conditions, we do not believe we will sustain the revenue growth rates that we achieved during the last several years and expect our revenue in 2007 to be flat or up 5-10% compared to anticipated 2006 results. If these trends continue or worsen, it could adversely impact our results or projections.
Critical Accounting Policies
We have established various accounting policies that govern the application of accounting principles generally accepted in the United States of America in the preparation and presentation of our consolidated financial statements. Our significant policies are described in Note 1 of the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2005. Certain of these policies involve significant judgments, assumptions and estimates by management that may have a material impact on the carrying value of certain assets and liabilities, and revenue and costs. We are subject to uncertainties such as the impact of future events, economic, environmental and political factors and changes in our business environment; therefore, actual results could differ from these estimates. Accordingly, the accounting estimates used in the preparation of our financial statements will change as new events occur, as more experience is acquired, as additional information is obtained and as our operating environment changes. Changes in estimates are made when circumstances warrant. Such changes in estimates and refinements in estimation methodologies are reflected in our reported results of operations and, if material, the effects of changes in estimates are disclosed in the notes to the consolidated financial statements. The judgments, assumptions and estimates we use and believe to be critical to our business are based on historical experience, knowledge of the accounts and other factors, which we believe to be reasonable under the circumstances. Because of the nature of the judgments and assumptions we have made, actual results may differ from these judgments and estimates, which could have a material impact on the carrying values of assets and liabilities and the results of our operations.
The accounting policies that we deem most critical to us, and that involve the most difficult, subjective or complex judgments, include:
Real estate is stated at cost, which includes direct construction costs for homes, development period interest and certain common costs that benefit the entire community. We assess these assets for recoverability whenever events or circumstances change indicating that the carrying amount of an asset may not be recoverable. Recoverability of assets is measured by comparing the carrying amount of an asset to fair value less cost to sell.
We review the carrying value of goodwill annually or whenever events or circumstances change that indicate that the carrying amount is not recoverable. In evaluating impairment, we base our estimates of fair value on an analysis of selected business acquisitions in the homebuilding industry provided to us by an independent third party. Such evaluations for impairment are significantly impacted by the amount a buyer is willing to pay in the current market for a like business. Our reporting units are determined in accordance with SFAS 142, Goodwill and Other Intangible Assets, which defines a reporting unit as an operating segment or one level below an operating segment.
Warranty reserves are included in other liabilities in the consolidated balance sheets. We record reserves covering our anticipated warranty costs for each home closed. We review the adequacy of warranty reserves based on historical experience and our estimate of the costs to remediate the claims, and adjust these provisions accordingly. Factors that affect our warranty liability include the number of homes sold, historical and anticipated rates of warranty claims, and cost per claim.
Off-Balance Sheet Arrangements
We invest in entities that acquire and develop land for sale to us in connection with our homebuilding operations or for sale to third parties. Our partners generally are unrelated homebuilders, land sellers and financial or other strategic partners.
Most of the unconsolidated entities through which we acquire and develop land are accounted for by the equity method of accounting because such arrangements do not meet the criteria for consolidation set forth in FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities (FIN 46R). We record our investments in these entities in our consolidated balance sheets as Investments in unconsolidated entities and our pro rata share of the entities earnings or losses in our consolidated statements of earnings as Earnings from unconsolidated entities, net. See Note 4 in the accompanying financial statements for additional information related to our investments in unconsolidated entities.
We also enter into option or purchase agreements to acquire land or lots from entities, for which we generally pay non-refundable deposits. We analyze these agreements under FIN 46R to determine whether we are the primary beneficiary of the VIE created as result of these agreements using a model developed by management. If we are deemed to be the primary beneficiary of the VIE because we are obligated to absorb the majority of the expected losses, receive the majority of the residual returns, or both, we will consolidate the VIE in our consolidated financial statements. See Note 3 in the accompanying financial statements for additional information related to our off-balance sheet arrangements.
Results of Operations Segment Analysis
The following discussion and analysis of financial condition and results of operations is based on our consolidated unaudited financial statements at and for the three months ended March 31, 2006 and 2005. All balances and transactions between us and our subsidiaries have been eliminated. In managements opinion, the data reflects all adjustments, consisting of only normal recurring adjustments, necessary to fairly present our financial position and results of operations for the periods presented. The results of operations for any interim period are not necessarily indicative of results expected for a full fiscal year.
The data provided below presents operating and financial data regarding our homebuilding activities (dollars in thousands):
Home Closing Revenue
* Results for Florida for the quarter ended March 31, 2005, do not include Greater Homes, acquired in September 2005, and only include Colonial Homes since acquisition in February 2005.
Companywide. Home closing revenue increased 54% to $846.4 million in the first quarter of 2006 from $550.9 million in the same period last year. Average selling prices on homes closed rose 9% to $334,800 for the quarter ended March 31, 2006 compared to $308,300 a year ago coupled with a 41% increase in the number of homes closed to 2,528 from 1,787 in the prior year. The primary factors leading to these increases were the strong order activity experienced in 2005 and a greater portion of closings coming from markets with higher average selling prices, particularly those in our West and East Regions.
West. The West Region experienced a 179 unit, or 41%, increase in homes closed for the quarter ended March 31, 2006 as compared to March 31, 2005, which was the primary factor for the $95.4 million increase in home closing revenue to $321.0 million. Despite some softening demand in California, which resulted in increased cancellations, home closing revenue increased 27% to $246.9 million in the first quarter of 2006 on 423 homes closed, an increase of 23% compared to a year ago. In Nevada, home closing revenue increased to $74.2 million on 189 homes closed, increases of 138% and 115%, respectively, due in large part to communities that opened for sales in late 2004 which are now delivering homes.
Central. Home closings increased $141.1 million to $451.0 million for the three months ended March 31, 2006 when compared to the prior year, due to the 29% increase in homes closed and 12% increase in average sales price. With a 44% increase in active communities, Arizona generated $225.9 million in home closing revenue on 736 homes closed with an average selling price of $306,900, increases of 47%, 23% and 19%, respectively, compared to the same period last year. In the Texas market, we believe a sound underlying economy and a 11% increase in active communities contributed to our strong performance in that market for the quarter ended March 31, 2006 with 952 homes closed compared to 717 for the same period in 2005, resulting in $219.1 million in home closing revenue, an increase of 40%.
East. The East Region accounted for approximately 20% of our overall increase in home closing revenue in the first quarter of 2006, reflecting a full quarter of closings in 2006 from our 2005 acquisitions of Colonial Homes and Greater Homes in Florida and our start-up operation in Orlando. These items contributed to a year-over-year increase in our community count in the East Region from 6 to 15 at March 31, 2006.
Based on the trends previously discussed, we expect that during the remainder of 2006 and continuing into 2007, we will experience a shift in the mix in home closings that will result in lower average sales prices resulting from a greater percentage of closings in Texas, which is a lower-priced market, and a lower percentage of closings in higher-price markets, such as Arizona, California and Florida.
* Results for Florida for the quarter ended March 31, 2005, do not include Greater Homes, acquired in September 2005, and only include Colonial Homes since acquisition in February 2005.
Companywide. Home orders for any period represent the aggregate sales price of all homes ordered by customers, net of cancellations. We do not include orders contingent upon the sale of a customers existing home as a sales contract until the contingency is removed. In the first quarter of 2006, we took home orders for 2,590 homes valued at $832.6 million, decreases of 2% and 6%, respectively, from the companys record breaking level of order activity achieved in the first quarter of 2005.
West. The value of homes ordered for the quarter ended March 31, 2006 decreased $148.3 million, primarily as a result of the 39% decline in units of homes closed. In California, we took orders for 237 homes valued at $137.4 million, significant decreases of 50% and 52%, respectively, compared to the first quarter of 2005. The average sales price of homes
ordered decreased moderately in California year-over-year by 5% to $579,600. In Nevada, we took orders for the same number of units with a 5% increase in average sales prices.
Central. For the three months ended March 31, 2006, the Central Region took orders for 2,087 homes, a 10% increase from the comparable quarter of the prior year. This increase led to the $106.5 million increase in the value of homes ordered. In Arizona, a decrease in the number of homes ordered of 21% was partially offset by a 20% increase in average selling prices, yielding a 5% decline in sales order value. In Texas, we believe favorable economic conditions contributed to orders for 1,312 homes valued at $315.1 million for the quarter ended March 31, 2006, increases of 35% and 48%, respectively, compared to the same time period last year. An additional factor in our order increase in Texas is our product line expansion into entry-level and semi-custom luxury markets.
East. During the first quarter of 2006, we experienced moderating sales in our East Region with increased cancellation rates and a decline in average selling price of 11%. We have an additional nine communities in our East Region at March 31, 2006 compared to the same period last year, primarily due to our 2005 acquisitions of Colonial Homes and Greater Homes, which partially offset softening market conditions.
We believe speculation contributed to high appreciation in California, Arizona and Florida in recent periods, which is now contributing to higher than normal cancellation rates in those markets. Our overall cancellation rates increased to 28% for the quarter ended March 31, 2006 from 20% for the same time period last year. We expect home orders for the balance of 2006 to return to more normal levels as compared to the rapid pace experienced in 2005. Although home cancellation rates in our California, Arizona and Florida markets were significantly higher than in prior periods, we believe that cancellation rates are stabilizing from the recent spikes we experienced as homebuyers adjust to current market conditions. Based on the trends previously discussed, we expect that during the remainder of 2006 and continuing into 2007, we will experience a shift in the mix in home sales that will result in a greater percentage of sales in Texas, which is a lower-priced market, and a lower percentage of closings in higher-price markets, such as Arizona, California and Florida.