UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

or

o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 1-9977

MERITAGE HOMES CORPORATION

(Exact Name of Registrant as Specified in Its Charter)

(480) 609-3330

(Registrant’s Telephone Number, Including Area Code)

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 November 2, 2006: 26,121,016.

 

MERITAGE HOMES CORPORATION

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2006

TABLE OF CONTENTS

PART I.	FINANCIAL INFORMATION
	Item 1.		Financial Statements
			Condensed Consolidated Balance Sheets as of September 30, 2006 (unaudited) and December 31, 2005
			Unaudited Condensed Consolidated Statements of Earnings for the Three and Nine Months Ended September 30, 2006 and 2005
			Unaudited Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2006 and 2005
			Notes to Unaudited Condensed Consolidated Financial Statements
	Item 2.		Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.		Quantitative and Qualitative Disclosures About Market Risk
	Item 4.		Controls and Procedures
PART II.	OTHER INFORMATION
	Item 1.		Legal Proceedings
	Item 1A.		Risk Factors
	Item 2.		Unregistered Sales of Equity Securities and Use of Proceeds
	Item 3.		Not Applicable
	Item 4.		Not Applicable
	Item 5.		Not Applicable
	Item 6.		Exhibits
SIGNATURES
INDEX OF EXHIBITS

 

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PART I - FINANCIAL INFORMATION

Item 1.  Financial Statements

MERITAGE HOMES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share amounts)

		September 30,			December 31,
		2006			2005
		(unaudited)
Assets:
Real estate		$	1,577,169		$	1,392,267
Cash and cash equivalents		75,436			65,812
Deposits on real estate under option or contract		194,644			167,040
Receivables		74,104			60,745
Goodwill		129,800			130,222
Intangibles, net		13,055			14,029
Property and equipment, net		40,416			36,239
Prepaid expenses and other assets		31,004			16,289
Investments in unconsolidated entities		108,149			88,714
Total assets		$	2,243,777		$	1,971,357
Liabilities:
Accounts payable		$	119,488		$	140,789
Accrued liabilities		265,242			290,275
Home sale deposits		57,281			76,299
Deferred tax liability, net		18,875			20,865
Loans payable and other borrowings		309,416			112,398
Senior notes		478,594			479,726
Total liabilities		1,248,896			1,120,352
Stockholders’ Equity:
Common stock, par value $0.01. Authorized 125,000,000 shares at September 30, 2006, and 50,000,000 shares at December 31, 2005; issued and outstanding 34,009,184 and 33,112,358 shares at September 30, 2006 and December 31, 2005, respectively		340			331
Additional paid-in capital		329,725			296,804
Retained earnings		853,578			637,248
Treasury stock at cost, 7,891,068 and 5,935,068 shares at September 30, 2006 and December 31, 2005, respectively		(188,762		)	(83,378		)
Total stockholders’ equity		994,881			851,005
Total liabilities and stockholders’ equity		$	2,243,777		$	1,971,357

See accompanying notes to condensed consolidated financial statements

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF EARNINGS

(in thousands, except per share amounts)

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Home closing revenue		$	875,743		$	753,505		$	2,624,968		$	1,956,235
Land closing revenue		2,453			1,945			15,159			3,954
Total closing revenue		878,196			755,450			2,640,127			1,960,189
Cost of home closings		(697,956		)	(575,494		)	(2,013,651		)	(1,506,196		)
Cost of land closings		(2,232		)	(1,888		)	(13,809		)	(3,426		)
Total cost of closings		(700,188		)	(577,382		)	(2,027,460		)	(1,509,622		)
Home closing gross profit		177,787			178,011			611,317			450,039
Land closing gross profit		221			57			1,350			528
Total closing gross profit		178,008			178,068			612,667			450,567
Commissions and other sales costs		(55,934		)	(39,635		)	(156,810		)	(106,975		)
General and administrative expenses		(34,347		)	(31,894		)	(128,413		)	(82,529		)
Earnings from unconsolidated entities, net		4,238			3,594			15,077			10,108
Other income, net		2,482			2,369			7,867			6,325
Loss on extinguishment of debt		—			—			—			(31,477		)
Earnings before provision for income taxes		94,447			112,502			350,388			246,019
Provision for income taxes		(34,908		)	(42,249		)	(134,058		)	(92,331		)
Net earnings		$	59,539		$	70,253		$	216,330		$	153,688
Earnings per common share:
Basic		$	2.28		$	2.57		$	8.15		$	5.72
Diluted		$	2.25		$	2.40		$	7.94		$	5.35
Weighted average number of shares:
Basic		26,087			27,311			26,554			26,880
Diluted		26,490			29,217			27,259			28,748

See accompanying notes to condensed consolidated financial statements

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

		Nine Months Ended September 30,
		2006			2005
Cash flows from operating activities:
Net earnings		$	216,330		$	153,688
Adjustments to reconcile net earnings to net cash used in operating activities:
Depreciation and amortization		15,272			12,752
Write-off of senior note issuance cost		—			4,977
Write-off of deposits and land acquisition costs		16,233			—
Increase in deferred tax liability		—			1,385
Stock-based compensation		9,397			—
Excess tax benefit from stock-based compensation		(11,190		)	—
Tax benefit from stock option exercises		—			9,811
Equity in earnings from unconsolidated entities		(15,077		)	(10,108		)
Distributions of earnings from unconsolidated entities		13,958			10,008
Changes in assets and liabilities, net of effect of acquisitions:
Increase in real estate		(192,132		)	(372,474		)
Increase in deposits on real estate under option or contract		(35,410		)	(41,510		)
(Increase) decrease in receivables and prepaid expenses and other assets		(26,844		)	1,561
(Decrease) increase in accounts payable and accrued liabilities		(39,158		)	127,793
(Decrease) increase in home sale deposits		(19,018		)	25,539
Net cash used in operating activities		(67,639		)	(76,578		)
Cash flows from investing activities:
Investments in unconsolidated entities		(43,057		)	(48,081		)
Distributions of capital from unconsolidated entities		15,563			12,496
Cash paid for acquisitions		—			(152,425		)
Purchases of property and equipment		(21,328		)	(15,480		)
Proceeds from sales of property and equipment		1,006			488
Net cash used in investing activities		(47,816		)	(203,002		)
Cash flows from financing activities:
Net borrowings under line of credit agreement		206,400			150,800
Proceeds from loans payable and other borrowings, net		1,214			—
Repayments of loans payable and other borrowings, net		—			(13,123		)
Proceeds from issuance of senior notes, net		—			343,836
Payments of senior notes		(1,254		)	(285,472		)
Purchases of treasury stock		(105,384		)	—
Proceeds from sale of common stock, net		—			69,699
Excess tax benefit from stock-based compensation		11,190			—
Proceeds from stock option exercises		12,913			6,149
Net cash provided by financing activities		125,079			271,889
Net increase (decrease) in cash and cash equivalents		9,624			(7,691		)
Cash and cash equivalents at beginning of period		65,812			47,876
Cash and cash equivalents at end of period		$	75,436		$	40,185

See supplemental disclosures of cash flow information at Note 11.

See accompanying notes to condensed consolidated financial statements

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NOTE 1 - ORGANIZATION AND BASIS OF PRESENTATION

Organization.  We are a leading designer and builder of single-family homes in the growth regions of the 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. At September 30, 2006, we were actively selling homes in 213 communities, with base prices ranging from $107,000 to $1,176,000.

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”). In management’s 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. Intercompany balances and transactions have been eliminated in consolidation.  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.

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.  In August 2006, the Board of Directors authorized an additional $100 million under this repurchase program.  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 the first quarter of 2006, we repurchased 255,000 shares at an average price of $53.77 under this program.  In the second quarter of 2006, we repurchased 1,000,000 shares from John R. Landon, our former Co-CEO and Co-Chairman, for $52.19 a share (see Note 13 - Other Events).  In August 2006, we repurchased 100,000 shares at an average price of $38.96 per share.  At September 30, 2006, we had approximately $130.2 million available under this program to repurchase additional shares.

Off-Balance Sheet Arrangements.  We often acquire finished building lots from various development entities pursuant to option and purchase agreements.  The purchase price typically approximates the market price at the date the contract is executed.  We believe 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 letters of credit, which may be forfeited if we fail to perform under the applicable agreements.  As of September 30, 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 $194.6 million in the form of cash and approximately $68.2 million in letters of credit.

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.  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 September 30, 2006, our share of these limited pro rata repayment guarantees was $43.6 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 or take other actions that are fraudulent or improper (commonly referred to as “bad boy guarantees”).  These types of guarantees typically are on a pro rata

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basis and are designed to protect the respective secured lender’s remedies with respect to its mortgage or other secured lien on the joint venture’s 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 September 30, 2006, we had outstanding guarantees of this type totaling approximately $80.5 million.  We believe that these guarantees, as defined, 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, our exposure under these indemnities is limited.  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 generally obtain, or the joint venture entity generally obtains, 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 September 30, 2006, we had approximately $40.1 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 September 30, 2006, we had approximately $36.9 million in outstanding letters of credit and $269.6 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 home 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 home plan designs are being amortized over their estimated useful lives.  The cost and accumulated amortization of our intangible assets was $11.5 million and $4.0 million, respectively, at September 30, 2006.  In the first nine months of 2006, amortization expense was $2.2 million.  Amortization expense is expected to be approximately $0.7 million in the remaining three months of 2006 and $2.8, $2.3, $1.2 and $0.5 million per year in 2007, 2008, 2009 and 2010, respectively.

Additionally, in accordance with Statement of Position 98-1, “Accounting for Costs of Computer Software Developed or Obtained for Internal Use,” we have capitalized software costs at September 30, 2006 of $5.6 million, which is net of accumulated amortization of $4.6 million.  In the first nine months of 2006, amortization expense was approximately $2.1 million related to the capitalized software costs and is expected to be approximately $0.8 million for the remaining three months of 2006 and $1.9, $0.8, $0.8, $0.8 and $0.5 million in 2007, 2008, 2009, 2010 and 2011, respectively.

Accrued Liabilities.  Accrued liabilities consists of the following (in thousands):

		At September 30, 2006			At December 31, 2005
Accruals related to real estate development and construction activities		$	140,381		$	135,953
Payroll and other benefits		56,517			51,382
Accrued taxes		—-			48,941
Warranty reserves		27,141			25,168
Other accruals		41,203			28,831
Total		$	265,242		$	290,275

 

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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 statements 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 September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R) (“SFAS No. 158”). This pronouncement requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan (other than a multiemployer plan) as an asset or liability on its statement of financial position. SFAS No. 158 also requires an employer to recognize changes in that funded status in the year in which the changes occur through comprehensive income. In addition, this statement requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position, with limited exceptions. SFAS No. 158 is effective for fiscal years ending after December 15, 2006. The adoption of SFAS No. 158 is not expected to have an impact on our financial position, results of operations or cash flows.

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108 (“SAB No. 108”). Due to diversity in practice among registrants, SAB No. 108 expresses SEC staff views regarding the process by which misstatements in financial statements are evaluated for purposes of determining whether financial statement restatement is necessary. SAB No. 108 is effective for fiscal years ending after November 15, 2006.  The adoption of SAB No. 108 is not expected to have a material impact on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS No. 157”).  SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements.  SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.  We are currently reviewing the effect of SFAS No. 157, if any, on our consolidated financial statements.

In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS No. 109 (“FIN 48”).  FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes.  FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition.  FIN 48 is effective for fiscal years beginning after December 15, 2006.  Earlier application of the provisions of FIN 48 is encouraged if the enterprise has not yet issued financial statements, including interim financial statements, in the period this interpretation is adopted.  We are currently evaluating the impact of the adoption of FIN 48 on our results of operations and statement of financial position.

Reference is made to Note 9 regarding our adoption of SFAS No. 123R, “Share-based Payment.”

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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 entity’s expected losses, receives a majority of the entity’s 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, (ii) equity holders (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 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 entity’s 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 entity’s 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 FIN 46R.  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.

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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 VIE’s 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 management’s judgments and estimates.

In most cases, creditors 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 to us.  At September 30, 2006, we had no specific performance options, as none of our option agreements require us to purchase lots.

The table below presents a summary of our lots under option or contract at September 30, 2006 (dollars in thousands):

										Option/Earnest Money Deposits
		Number of Lots		Fair Value			Purchase Price			Cash			Letters of  Credit
Options recorded on balance sheet as real estate not owned (Note 2) (1), (3)		210		$	5,212		$	5,270		$	832		$	—
Option contracts not recorded on balance sheet – non-refundable deposits (1)		34,996		n/a			$	2,142,256		$	157,264		$	67,701
Purchase contracts not recorded on balance sheet – non-refundable deposits (1)		10,070		n/a			405,570			35,574			484
Purchase contracts not recorded on balance sheet – refundable deposits (2)		5,501		n/a			236,694			1,806			—
Total options not recorded on balance sheet		50,567		n/a			2,784,520			194,644			68,185
Total lots under option		50,777		$	5,212		$	2,789,790		$	195,476		$	68,185

 

Notes:           Our option 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 agreement.  The pre-established number typically is structured to approximate our expected rate of home orders.

(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 5,305 lots under control for which we have not completed our acquisition evaluation process and we have not internally committed to purchase.

(3)                                  The purpose and nature of these consolidated lot option contracts (VIEs) is to provide the Company the option to purchase these lots in anticipation of building homes on these lots in the future.

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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.  Based on the structure of these joint ventures, they may or may not be consolidated into our results.  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 joint venture.  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.

We and/or our joint venture partners occasionally provide limited repayment guarantees on a pro rata basis on the debt of certain unconsolidated land acquisition and development joint ventures.  At September 30, 2006, our share of these limited pro rata repayment guarantees was approximately $43.6 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 or take other actions that are fraudulent or improper (commonly referred to as “bad boy guarantees”).  These types of guarantees typically are on a pro rata basis and are designed to protect the respective secured lender’s remedies with respect to its mortgage or other secured lien on the joint venture’s 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 September 30, 2006, we had outstanding guarantees of this type totaling approximately $80.5 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.

Summarized condensed financial information related to unconsolidated joint ventures that are accounted for using the equity method follows (in thousands):

 

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(1)         Our share of pre-tax earnings is recorded in “Earnings from unconsolidated entities, net” on our consolidated statements of earnings.  Our share of pre-tax 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 September 30, 2006 and December 31, 2005, our investments in unconsolidated entities includes $2.0 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 in a manner consistent with the activities of the joint venture, which offsets their related earnings.  We amortized approximately $0.1 million to our equity of the joint venture earnings in the third quarter of 2006 and approximately $0.8 million and $1.1 million in the first nine months of 2006 and 2005, respectively.  We had no such amortization in the third quarter of 2005.

In addition to joint ventures accounted for under the equity method summarized in the above table, at September 30, 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 September 30, 2006, and December 31, 2005, our investments in unconsolidated entities recorded under the cost method were $17.0 and $14.9 million, respectively. As of September 30, 2006, we have not recorded any income or distributions from these joint ventures.

As of September 30, 2006, our total investment in unconsolidated joint ventures of $108.1 million was primarily comprised of $36.1 million in our West Region, $67.5 million in our Central Region and $3.1 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):

		September 30,			December 31,
		2006			2005
$850 million unsecured revolving credit facility maturing May 2010 with extension provisions, and interest payable monthly at LIBOR (5.32% at September 30, 2006) plus 1.25% or Prime (8.25% at September 30, 2006)		$	279,000		$	72,600
Model home lease program, with interest in the form of lease payments payable monthly approximating 7.83% at September 30, 2006		28,740			39,336
Other borrowings, acquisition and development financing		1,676			462
Total loans payable and other borrowings		$	309,416		$	112,398

We have determined that the construction costs and related debt associated with certain model homes that 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 these 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 it to a third-party home buyer.  Should we elect not to exercise our rights to

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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 generally has a maturity date of one to three years.

On May 16, 2006, we amended and restated our senior unsecured revolving credit facility.  Under the First Amended and Restated Credit Agreement with Guaranty Bank, as administrative agent, and a number of other financial institutions (the “New Credit Agreement”), our credit facility was increased from $600 million to $800 million, and the term was extended from May 2009 to May 2010.  The maximum borrowings under the New Credit Agreement are based on the amount of qualifying borrowing base assets (generally real estate assets), limited to the facility size.  In addition, the New Credit Agreement includes an accordion feature that will allow the Company to request from time to time an increase of up to $250 million in the maximum borrowing commitment.  Each member of the lending group may elect to participate or not participate in any request we make to increase the maximum borrowing commitment.  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.  On June 30, 2006, we exercised a portion of the accordion feature under the New Credit Agreement to increase our borrowing capacity by $50 million to $850 million and amended the New Credit Agreement to make certain other minor changes.

NOTE 6 - SENIOR NOTES

Senior notes consist of the following (in thousands):

		September 30, 2006			December 31, 2005
6.25% senior notes due 2015. At September 30, 2006, and December 31, 2005, there was approximately $1.5 and $1.6 million, respectively, in unamortized discount		$	348,527		$	348,396
7.0% senior notes due 2014. At both September 30, 2006, and December 31, 2005, there was approximately $0.1 million in unamortized premium		130,067			130,074
9.75% senior notes due 2011		—			1,256
		$	478,594		$	479,726

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 $31.5 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.  During the second quarter of 2006, we repurchased the remaining $1.2 million of our outstanding 9.75% senior notes.

The New Credit Agreement and indentures for the 7% senior notes due 2014 and the 6.25% senior notes due 2015 contain covenants that 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 September 30, 2006, we were in compliance with these covenants. After considering our most restrictive bank covenants, we have additional borrowing availability under the New Credit Agreement of approximately $468 million at September 30, 2006 as determined by borrowing base limitations defined by our agreement with the lending banks. The New Credit Agreement and indentures relating to our senior notes restrict our ability to pay dividends, and at September 30, 2006, our maximum permitted amount available to pay dividends was $340.0 million.

Obligations to pay principal and interest on the New Credit Agreement 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.  We do not provide separate financial statements of the Guarantor Subsidiaries 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 Company or any Guarantor Subsidiary to obtain funds from their respective subsidiaries, as applicable, by dividend or loan.

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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 nine months ended September 30, 2006, follow (in thousands):

		Corporate			West			Central			East			Total
Balance at December 31, 2005		$	1,323		$	37,395		$	54,043		$	37,461		$	130,222
Tax benefit of amortization of excess tax basis		—			(55		)	(88		)	(279		)	(422		)
Balance at September 30, 2006		$	1,323		$	37,340		$	53,955		$	37,182		$	129,800

 

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):

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Basic weighted average number of shares outstanding		26,087			27,311			26,554			26,880
Effect of dilutive securities:
Stock options and restricted stock		403			1,906			705			1,868
Diluted weighted average shares outstanding		26,490			29,217			27,259			28,748
Net earnings		$	59,539		$	70,253		$	216,330		$	153,688
Basic earnings per share		$	2.28		$	2.57		$	8.15		$	5.72
Diluted earnings per share		$	2.25		$	2.40		$	7.94		$	5.35
Antidilutive stock options not included in the calculation of diluted earnings per share		965			—			645			36

 

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NOTE 9 - STOCK-BASED COMPENSATION

In the first quarter of 2006, we adopted Statement SFAS No. 123R, Share-Based Payment (“SFAS No. 123R”), which revises SFAS No. 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 No. 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 No. 123R.  We have applied the “modified prospective method” for existing grants, which requires us to value stock options prior to our adoption of SFAS No. 123R under the fair value method and expense the unvested portion over the remaining vesting period.  SFAS No. 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.

We have two stock compensation plans, the Meritage Stock Option Plan, which was adopted in 1997 and has been amended from time to time (the “1997 Plan”), and the 2006 Stock Incentive Plan (the “2006 Plan” and together with the 1997 Plan, the “Plans”).  The Plans, which were approved by our stockholders, are administered by our Board of Directors.  The provisions of the Plans are generally consistent with the exception that the 2006 Plan allows for the grant of stock appreciation rights, restricted stock awards, performance share awards and performance-based awards in addition to the non-qualified and incentive stock options allowed under the 1997 Plan.  The Plans authorize awards to officers, key employees, non-employee directors and consultants for up to 6,600,000 shares of common stock, of which 979,101 shares remain available for grant at September 30, 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 and nine months ended September 30, 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 Plans and consistent with SFAS No. 123R (in thousands, except per share amounts):

 

(1)           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

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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 Plans as of September 30, 2006, and changes during the nine months then ended is presented below:

Options		Shares		Weighted Average Exercise Price			Weighted Average  Remaining Contractual Term		Aggregate Intrinsic Value
							(years)		(in thousands)
Outstanding at January 1, 2006		2,799,282		$	27.90
Granted		633,000		$	53.03
Exercised		(896,826	)	$	14.40
Forfeited or expired		(488,402	)	$	39.28
Outstanding at September 30, 2006		2,047,054		$	38.87		4.83		$	79,561
Exercisable at September 30, 2006		693,054		$	24.69		3.38		$	17,113

A summary of the status of the Company’s restricted stock as of September 30, 2006 is presented below:

Restricted Stock		Shares		Weighted-Average Grant- Date Fair Value
Nonvested at January 1, 2006		—		—-
Granted		68,886		$	49.02
Vested		—
Forfeited		(20,443	)	$	54.87
Nonvested at September 30, 2006		48,443		$	46.55

The total intrinsic value of options exercised during the three and nine months ended September 30, 2006 was $3.3 million and $34.6 million, respectively, and $5.2 million and $33.7 million during the three and nine months ended September 30, 2005, 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 September 30, 2006, we had $33.9 million of total unrecognized compensation cost related to non-vested stock-based compensation arrangements granted under the Plans 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 3.42 years.  For the three and nine months ended September 30, 2006, our total stock-based compensation expense was $2.0 million ($1.5 million net of tax) and $9.3 million ($6.8 million net of tax), respectively.  Stock compensation expense net of tax for the three months ended September 30, 2006 was $0.06 per basic and diluted share.  Stock compensation expense for the nine months ended September 30, 2006 was $0.26 per basic share and $0.25 per diluted share.

Cash received from option exercises under the Plans for the three and nine months ended September 30, 2006, was $2.5 million and $12.9 million, respectively, and $1.3 million and $6.1 million for the three and nine months ended September 30, 2005, respectively.  The actual tax benefit realized for the tax deductions from option exercises totaled $1.1 million and $11.2 million for the three and nine months ended September 30, 2006, respectively, and $1.6 million and $9.8 million for the three and nine months ended September 30, 2005, respectively.

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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 and the September 2005 acquisition of Greater Homes (both in our East Region) resulted in the following changes in assets and liabilities (in thousands):

The following presents certain supplemental cash flow information (in thousands):

NOTE 12 — OPERATING AND REPORTING SEGMENTS

As defined in SFAS No. 131, “Disclosures About Segments of an Enterprise and Related Information,” we have six operating segments (the six states in which we operate).  We have historically reported our six operating segments as a single, national homebuilding segment, but have since restated our segment disclosure to aggregate these operating segments into three reportable segments. The operating segments aggregating into our three reporting segments 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.  Our reportable homebuilding segments are as follows:

West:       California and Nevada
Central: Texas, Arizona and Colorado
East:       Florida

Management’s 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

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segment had it been an independent, stand-alone entity for the periods presented.  The following segment information is in thousands:

		Three Months Ended September 30,						Nine Months Ended September 30,
		2006			2005			2006			2005
Revenue (a):
West		$	281,223		$	297,683		$	890,954		$	777,264
Central		549,890			413,846			1,558,302			1,104,102
East		47,083			43,921			190,871			78,823
Consolidated total		878,196			755,450			2,640,127			1,960,189
Operating income:
West		27,812			63,163			133,332			165,168
Central		71,542			53,102			231,180			121,491
East		(1,380		)	5,033			17,506			9,573
Segment operating income		97,974			121,298			382,018			296,232
Corporate and unallocated (b)		(10,247		)	(14,759		)	(54,574		)	(35,169		)
Earnings from unconsolidated entities, net		4,238			3,594			15,077			10,108
Other income, net		2,482			2,369			7,867			6,325
Loss on extinguishment of debt		—			—-			—			(31,477		)
Earnings before provision for income tax		$	94,447		$	112,502		$	350,388		$	246,019

 

		At September 30, 2006			At December 31, 2005
Assets
West		$	622,285		$	587,236
Central		1,232,064			1,003,839
East		190,910			207,692
Corporate and unallocated (c)		198,518			172,590
Consolidated total		$	2,243,777		$	1,971,357

 

(a) Revenue includes the following land closing revenue, by segment (in thousands): three months ended September 30, 2006 - $2,453 in Central Region; three months ended September 30, 2005 - $1,945 in Central Region; nine months ended September 30, 2006 - $11,475 in West Region and $3,684 in Central Region; nine months ended September 30, 2005 - $3,954 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.

NOTE 13 — OTHER EVENTS

On May 17, 2006, John R. Landon, the Company’s Co-CEO, resigned.  In connection with Mr. Landon’s departure, both his employment and change of control agreement terminated (other than certain provisions in the Employment Agreement that survive termination).  Under the terms of the Employment Agreement, subject to his compliance with certain restrictive covenants and other requirements therein, Mr. Landon is entitled to a payment of $10,000,000, payable in equal monthly installments over the course of 24 months, and acceleration of all outstanding stock options that were granted to him after the effective date of the employment agreement, which was July 1, 2003.  During the quarter ended June 30, 2006, the Company expensed approximately $10.0 million related to the obligations owed to Mr. Landon pursuant to the terms of his employment agreement and also recorded stock-based compensation expense of approximately $2.3 million related to the accelerated vesting of certain of his outstanding stock options.  On June 12, 2006, the Company entered into a Stock Purchase Agreement with Mr. Landon, pursuant to which the Company acquired 1,000,000 shares of the Company’s common stock from Mr. Landon at a price of $52.19 per share, or an aggregate purchase price of $52.2 million.

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