MTH-2012.9.30-10Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 ____________________________________________________________
FORM 10-Q
 ____________________________________________________________
(Mark one)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2012
Or 
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from              to             
Commission File Number 1-9977
 ____________________________________________________________
MERITAGE HOMES CORPORATION
(Exact Name of Registrant as Specified in Its Charter)
 ____________________________________________________________
Maryland
 
86-0611231
(State or Other Jurisdiction of
 
(I.R.S. Employer
Incorporation or Organization)
 
Identification No.)
 
 
 
17851 North 85th Street, Suite 300
 
 
Scottsdale, Arizona
 
85255
(Address of Principal Executive Offices)
 
(Zip Code)
(480) 515-8100
(Registrant’s Telephone Number, Including Area Code)
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)
 ____________________________________________________________
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 a checkmark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer
o
Accelerated filer
x
Non-accelerated filer
o  (Do not check if a smaller reporting company)
Smaller reporting company
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, 2012: 35,590,401


Table of Contents

MERITAGE HOMES CORPORATION
FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2012
TABLE OF CONTENTS
 
 
 
 
Items 3-5. Not Applicable
 

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PART I — FINANCIAL INFORMATION
 
Item 1.
Financial Statements
MERITAGE HOMES CORPORATION AND SUBSIDIARIES
UNAUDITED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
 
 
September 30,
2012
 
December 31,
2011
Assets:
 
 
 
Cash and cash equivalents
$
305,049

 
$
173,612

Investments and securities
66,549

 
147,429

Restricted cash
15,254

 
12,146

Other receivables
16,681

 
14,932

Real estate
1,004,825

 
815,425

Deposits on real estate under option or contract
12,983

 
15,208

Investments in unconsolidated entities
12,008

 
11,088

Property and equipment, net
14,112

 
13,491

Deferred tax asset
7,709

 

Prepaid expenses and other assets
26,032

 
18,047

Total assets
$
1,481,202

 
$
1,221,378

Liabilities:
 
 
 
Accounts payable
$
52,069

 
$
37,735

Accrued liabilities
96,364

 
79,464

Home sale deposits
14,027

 
8,858

Senior, senior subordinated, convertible senior notes and other borrowings
722,675

 
606,409

Total liabilities
885,135

 
732,466

Stockholders’ Equity:
 
 
 
Preferred stock, par value $0.01. Authorized 10,000,000 shares; none issued and outstanding at September 30, 2012 and December 31, 2011

 

Common stock, par value $0.01. Authorized 125,000,000 shares; issued 35,590,401 and 40,377,021 shares at September 30, 2012 and December 31, 2011, respectively
356

 
404

Additional paid-in capital
387,234

 
478,839

Retained earnings
208,477

 
198,442

Treasury stock at cost, none and 7,891,250 shares at September 30, 2012 and December 31, 2011, respectively

 
(188,773
)
Total stockholders’ equity
596,067

 
488,912

Total liabilities and stockholders’ equity
$
1,481,202

 
$
1,221,378

See accompanying notes to unaudited consolidated financial statements

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Home closing revenue
$
334,880

 
$
217,534

 
$
820,242

 
$
615,154

Land closing revenue
7,763

 

 
8,846

 
100

Total closing revenue
342,643

 
217,534

 
829,088

 
615,254

Cost of home closings
(272,309
)
 
(178,544
)
 
(670,125
)
 
(504,943
)
Cost of land closings
(7,493
)
 

 
(8,164
)
 
(91
)
Real estate impairments
(417
)
 
(920
)
 
(904
)
 
(2,174
)
Land impairments

 
(127
)
 
(669
)
 
(127
)
Total cost of closings and impairments
(280,219
)
 
(179,591
)
 
(679,862
)
 
(507,335
)
Home closing gross profit
62,154

 
38,070

 
149,213

 
108,037

Land closing gross profit/(loss)
270

 
(127
)
 
13

 
(118
)
Total closing gross profit
62,424

 
37,943

 
149,226

 
107,919

Commissions and other sales costs
(25,855
)
 
(19,708
)
 
(67,950
)
 
(53,876
)
General and administrative expenses
(19,209
)
 
(16,466
)
 
(50,446
)
 
(46,582
)
Earnings from unconsolidated entities, net
2,975

 
1,797

 
6,626

 
3,931

Interest expense
(5,009
)
 
(7,517
)
 
(18,718
)
 
(23,036
)
Other (expense)/income, net
(8,340
)
 
876

 
(7,712
)
 
2,872

Loss on extinguishment of debt

 

 
(5,772
)
 

Income/(loss) before income taxes
6,986

 
(3,075
)
 
5,254

 
(8,772
)
(Provision for)/benefit from income taxes
(202
)
 
(160
)
 
4,781

 
(560
)
Net income/(loss)
$
6,784

 
$
(3,235
)
 
$
10,035

 
$
(9,332
)
Income/(loss) per common share:
 
 
 
 
 
 
 
Basic
$
0.19

 
$
(0.10
)
 
$
0.30

 
$
(0.29
)
Diluted
$
0.19

 
$
(0.10
)
 
$
0.30

 
$
(0.29
)
Weighted average number of shares:
 
 
 
 
 
 
 
Basic
35,216

 
32,417

 
33,541

 
32,358

Diluted
35,761

 
32,417

 
34,010

 
32,358

See accompanying notes to unaudited consolidated financial statements

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
 
Nine Months Ended
 
September 30,
 
2012
 
2011
Cash flows from operating activities:
 
 
 
Net income/(loss)
$
10,035

 
$
(9,332
)
Adjustments to reconcile net income/(loss) to net cash used in operating activities:
 
 
 
Depreciation and amortization
5,913

 
5,267

Real-estate-related impairments
1,573

 
2,301

Stock-based compensation
6,095

 
5,215

Loss on early extinguishment of debt
5,772

 

Equity in earnings from unconsolidated entities
(6,626
)
 
(3,931
)
Deferred tax asset valuation benefit
(7,709
)
 

Distributions of earnings from unconsolidated entities
6,118

 
4,609

Other operating expenses
403

 
371

Changes in assets and liabilities:
 
 
 
Increase in real estate
(190,509
)
 
(60,785
)
Decrease/(increase) in deposits on real estate under option or contract
2,192

 
(3,061
)
Increase in receivables and prepaid expenses and other assets
(1,882
)
 
(1,797
)
Increase in accounts payable and accrued liabilities
31,204

 
6,794

Increase in home sale deposits
5,169

 
3,136

Net cash used in operating activities
(132,252
)
 
(51,213
)
Cash flows from investing activities:
 
 
 
Investments in unconsolidated entities
(406
)
 
(427
)
Distributions of capital from unconsolidated entities
24

 
10

Purchases of property and equipment
(7,139
)
 
(5,429
)
Proceeds from sales of property and equipment
470

 
40

Maturities of investments and securities
190,701

 
324,000

Payments to purchase investments and securities
(109,798
)
 
(213,896
)
Increase in restricted cash
(3,108
)
 
(1,765
)
Net cash provided by investing activities
70,744

 
102,533

Cash flows from financing activities:
 
 
 
Repayments of senior notes
(315,080
)
 

Proceeds from issuance of senior and senior convertible notes
426,500

 

Debt issuance costs
(9,500
)
 

Proceeds from issuance of common stock, net
87,125

 

Proceeds from stock option exercises
3,900

 
1,831

Net cash provided by financing activities
192,945

 
1,831

Net increase in cash and cash equivalents
131,437

 
53,151

Cash and cash equivalents at beginning of period
173,612

 
103,953

Cash and cash equivalents at end of period
$
305,049

 
$
157,104

See supplemental disclosures of cash flow information at Note 11.
See accompanying notes to unaudited consolidated financial statements

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MERITAGE HOMES CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 — ORGANIZATION AND BASIS OF PRESENTATION
Organization. Meritage Homes is a leading designer and builder of single-family detached homes based on the number of home closings. We primarily build in the historically high-growth regions of the western and southern United States and offer a variety of homes that are designed to appeal to a wide range of homebuyers, including first-time, move-up, active adult and luxury. We have operations in three regions: West, Central and East, which are comprised of seven states: Arizona, Texas, California, Nevada, Colorado, Florida and North Carolina. Through our predecessors, we commenced our homebuilding operations in 1985. Meritage Homes Corporation was incorporated in 1988 as a real estate investment trust in the State of Maryland. On December 31, 1996, through a merger, we acquired the homebuilding operations of our predecessor company. Since January 1997, we have focused exclusively on homebuilding and related activities and no longer operate as a real estate investment trust. Meritage Homes Corporation operates as a holding company, has no independent assets or operations, and its homebuilding construction, development and sales activities are conducted through its subsidiaries.
Our homebuilding and marketing activities are conducted under the name of Meritage Homes in each of our markets, although we also operate as Monterey Homes in Arizona and Texas. At September 30, 2012, we were actively selling homes in 153 communities, with base prices ranging from approximately $106,000 to $708,000.
Basis of Presentation. The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. These financial statements should be read in conjunction with the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2011. The consolidated financial statements 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, “us”, “we”, “our” and “the Company”). Intercompany balances and transactions have been eliminated in consolidation. In the opinion of management, the accompanying financial statements include all adjustments (consisting only of normal recurring entries), necessary for the fair presentation of our results for the interim periods presented. Results for interim periods are not necessarily indicative of results to be expected for the full year.
Cash and Cash Equivalents. Liquid investments with an initial maturity of three months or less are classified as cash equivalents. Amounts in transit from title companies for home closings of approximately $43.2 million and $13.1 million are included in cash and cash equivalents at September 30, 2012 and December 31, 2011, respectively. Included in our cash and cash equivalents balance as of September 30, 2012 are $77.8 million of money market funds that are invested in short term (three months or less) U.S. government securities.
Restricted Cash. Restricted cash consists of amounts held in restricted accounts as collateral for our letter of credit arrangements. The aggregate capacity of these secured letter of credit arrangements was $40.0 million at September 30, 2012. Our restricted cash accounts invest in money market accounts and U.S. government securities and totaled $15.3 million and $12.1 million at September 30, 2012 and December 31, 2011, respectively.
Investments and Securities. Our investments and securities are comprised of both treasury securities and deposits with money center banks that are FDIC-insured and secured by U.S. government treasury-backed investments, and therefore we believe bear a limited risk of loss. All of our investments are classified as held-to-maturity and are recorded at amortized cost as we have both the ability and intent to hold them until their respective maturities. The contractual lives of these investments are greater than three months but not exceeding 18 months. Due to their short duration and low contractual interest rates, the amortized cost of the investments approximates fair value with no unrecognized gains and losses or other-than-temporary impairments.
Real Estate. Real estate is stated at cost unless the asset is determined to be impaired, at which point the inventory is written down to fair value as required by Accounting Standards Codification (“ASC”) Subtopic 360-10, Property, Plant and Equipment (“ASC 360-10”). Inventory includes the costs of land acquisition, land development, home construction, capitalized interest, real estate taxes, capitalized direct overhead costs incurred during development and home construction that benefit the entire community, less impairments, if any. Land and development costs are typically allocated and transferred to homes under construction when construction begins. Home construction costs are accumulated on a per-home basis, while selling costs are expensed as incurred. Cost of home closings includes the specific construction costs of the home and all related allocated land acquisition, land development and other common costs (both incurred and estimated to be incurred) that are allocated based upon the total number of homes expected to be closed in each community or phase. Any changes to the estimated total

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development costs of a community or phase are allocated to the remaining homes in the community or phase. When a home closes, we may have incurred costs for goods and services that have not yet been paid. Therefore, an accrued liability to capture such obligations is recorded in connection with the home closing and charged directly to cost of sales.
We rely on certain estimates to determine our construction and land development costs. Construction and land costs are comprised of direct and allocated costs, including estimated future costs. In determining these costs, we compile project budgets that are based on a variety of assumptions, including future construction schedules and costs to be incurred. It is possible that actual results could differ from budgeted amounts for various reasons, including construction delays, labor or material shortages, increases in costs that have not yet been committed, changes in governmental requirements, or other unanticipated issues encountered during construction and development and other factors beyond our control. To address uncertainty in these budgets, we assess, update and revise project budgets on a regular basis, utilizing the most current information available to estimate construction and land costs.
Typically, a community’s life cycle ranges from three to five years, commencing with the acquisition of the land, continuing through the land development phase, if applicable, and concluding with the sale, construction and closing of the homes. Actual community lives will vary based on the size of the community, the sales absorption rate and whether the land purchased was raw, partially-developed or in finished status. Master-planned communities encompassing several phases and super-block land parcels may have significantly longer lives and projects involving smaller finished lot purchases may be shorter.
All of our land inventory and related real estate assets are reviewed for recoverability quarterly, as our inventory is considered “long-lived” in accordance with GAAP. Impairment charges are recorded to write down an asset to its estimated fair value if the undiscounted cash flows expected to be generated by the asset are lower than its carrying amount. Our determination of fair value is based on projections and estimates. Changes in these expectations may lead to a change in the outcome of our impairment analysis, and actual results may also differ from our assumptions. Our analysis is completed on a quarterly basis with each community or land parcel evaluated individually. For those assets deemed to be impaired, the impairment recognized is measured as the amount by which the assets’ carrying amount exceeds their fair value. The impairment of a community is allocated to each lot on a straight-line basis.
Existing and continuing communities. When projections for the remaining income expected to be earned from existing communities are no longer positive, the underlying real estate assets are not deemed fully recoverable, and further analysis is performed to determine the required impairment. The fair value of the community’s assets is determined using either a discounted cash flow model for projects we intend to build out or a market-based approach for projects to be sold. Impairments are charged to cost of home closings in the period during which it is determined that the fair value is less than the assets’ carrying amount. If a market-based approach is used, we determine fair value based on recent comparable purchase and sale activity in the local market, adjusted for variances as determined by our knowledge of the region and general real estate expertise. If a discounted cash flow approach is used, we compute our fair value based on a proprietary model. Our key estimates in deriving fair value under our cash flow model are (i) home selling prices in the community adjusted for current and expected sales discounts and incentives, (ii) costs related to the community — both land development and home construction — including costs spent to date and budgeted remaining costs to spend, (iii) projected sales absorption rates, reflecting any product mix change strategies implemented to stimulate the orders pace and expected cancellation rates, (iv) alternative land uses including disposition of all or a portion of the land owned and (v) our discount rate, which is currently 14-16% and varies based on the perceived risk inherent in the community’s other cash flow assumptions. These assumptions vary widely across different communities and geographies and are largely dependent on local market conditions. Community-level factors that may impact our key estimates include:
The presence and significance of local competitors, including their offered product type, comparable lot size, and competitive actions;
Economic and related demographic conditions for the population of the surrounding community;
Desirability of the particular community, including unique amenities or other favorable or unfavorable attributes; and
Existing home inventory supplies, including foreclosures and short sales.
These local circumstances may significantly impact our assumptions and the resulting computation of fair value and are, therefore, closely evaluated by our division personnel in their generation of the discounted cash flow models. The models are also evaluated by regional and corporate personnel for consistency and integration, as decisions that affect pricing or absorption at one community may have resulting consequences for neighboring communities. We typically do not project market improvements in our discounted cash flow models, but may do so in limited circumstances in the latter years of a long-lived community.

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Mothball communities. In certain cases, we may elect to stop development of an existing community (mothball) if we believe the economic performance of the community would be maximized by deferring development for a period of time to allow market conditions to improve. The decision may be based on financial and/or operational metrics. If we decide to mothball a community, we will impair it to its fair value as discussed above and then cease future development activity until such a time when management believes that market conditions have improved and economic performance will be maximized. No costs are capitalized to communities that are designated as mothballed. Quarterly, we review all communities, including mothballed communities, for potential impairments.
When a community is initially placed into mothball status, it is management’s belief that the community is affected by local market conditions that are expected to improve within the next 1-5 years. Therefore, a temporary postponement of construction and development work is expected to yield better overall returns.
In addition to our quarterly impairment analysis, which is conducted to determine if any current impairments exist, we also conduct a thorough quarterly review of our underperforming and mothballed communities to determine if they are at risk of future impairment. The financial and operational status and expectations of these communities are analyzed as well as any unique attributes that could be viewed as indicators for future impairments. Adjustments are made accordingly and incremental impairments, if any, are recorded at each re-evaluation. Based on the facts and circumstances available as of September 30, 2012, we do not believe that any of our underperforming or mothballed communities will incur material impairments in the future. Changes in market and/or economic conditions could materially impact the conclusions of this analysis, and there can be no assurances that future impairments will not occur.
Inventory assessments on inactive assets. For our mothballed communities as well as our land held for future development, our inventory assessments typically include highly subjective estimates for future performance, including the timing of development, the product to be offered, sales rates and selling prices of the product when the community is anticipated to open for sales, and the projected costs to develop and construct the community. We evaluate various factors to develop our forecasts, including the availability of and demand for homes and finished lots within the marketplace, historical, current and future sales trends, and third-party data, if available. Based on these factors, we reach conclusions for future performance based on our judgment.
Option deposits and pre-acquisition costs. We also evaluate assets associated with future communities for impairments on a quarterly basis. Using similar techniques described in the Existing and continuing communities section above, we determine if the income to be generated by our future communities is acceptable to us. If the projections indicate that a community is still meeting our internal investment guidelines and is generating a profit, those assets are determined to be fully recoverable and no impairments are required. In cases where we decide to abandon a project, we will fully impair all assets related to such project and will expense and accrue any additional costs that we are contractually obligated to incur. In certain circumstances, we may elect to continue with a project because it is expected to generate positive cash flows, even though it may not be generating an accounting profit. In such cases, we will impair our pre-acquisition costs and deposits, as necessary, and record an impairment to bring the carrying value to fair value. Refer to Note 2 of these consolidated financial statements for further information regarding our impairments.
Deposits. Deposits paid related to purchase contracts and land options are recorded and classified as Deposits on real estate under contract or option until the related land is purchased. Deposits are reclassified as a component of real estate inventory at the time the deposit is used to offset the acquisition price of the lots based on the terms of the underlying agreements. To the extent they are non-refundable, deposits are charged to expense if the land acquisition is terminated or no longer considered probable. Since the acquisition contracts typically do not require specific performance, we do not consider such contracts to be contractual obligations to purchase the land and our total exposure under such contracts is limited to the loss of the non-refundable deposits. The review of the likelihood of the acquisition of contracted lots is completed quarterly in conjunction with the real estate impairment analysis noted above and therefore, if impaired, the deposits are recorded at the lower of cost or fair value. Our deposits were $13.0 million and $15.2 million as of September 30, 2012 and December 31, 2011, respectively.
Off-Balance Sheet Arrangements Joint Ventures. Historically, we have participated in land development joint ventures 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; however, in recent years, such ventures have not been a significant avenue for us to access lots. See Note 4 for additional discussion of our investments in unconsolidated entities.
In connection with our land development joint ventures, we may also provide certain types of guarantees to associated lenders. These guarantees can be classified into two categories: (i) Repayment Guarantees and (ii) Completion Guarantees, described in more detail below. Additionally, we have classified a guarantee related to our minority ownership in the South Edge joint venture separately, as there is pending litigation with the venture’s lender group regarding that guarantee.
 

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(In thousands)
At September 30, 2012
 
At December 31, 2011
Repayment guarantees
$
249

 
$
346

Completion guarantees (1)

 

South Edge guarantee (2)
13,243

 
13,243

Total guarantees
$
13,492

 
$
13,589

 
(1)
As our completion guarantees are typically backed by funding from a third party, we believe these guarantees do not represent a potential cash obligation for us, as they require only non-financial performance.
(2)
As discussed in Note 13, we dispute the enforceability of this guarantee, and ultimate resolution of this matter will be addressed through litigation and/or settlements.
Repayment Guarantees. We and/or our land development joint venture partners occasionally provide limited repayment guarantees on a pro rata basis on the debt of land development joint ventures. If such a guarantee were ever to be called or triggered, the maximum exposure to Meritage would generally be only our pro-rata share of the amount of debt outstanding that was in excess of the fair value of the underlying land securing the debt. Our share of these limited pro rata repayment guarantees as of September 30, 2012 and December 31, 2011 is presented in the table above (excluding any potential recoveries from the joint venture’s land assets).
Completion Guarantees. If there is development work to be completed, we and our joint venture partners are also typically obligated to the project lender(s) to complete construction of the 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 indemnities to joint venture project lenders. These indemnities generally obligate us to reimburse the project lenders only for claims and losses related to matters for which such lenders are held responsible and our exposure under these indemnities is limited to specific matters such as environmental claims. A part of our project acquisition due diligence process is to determine potential environmental risks and generally we or the joint venture entity obtain an independent environmental review. Per the guidance of ASC460-10, Guarantees, we believe these guarantees are either not applicable or not material to our financial results.
Surety Bonds. We and our joint venture partners also 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 make such payments. These surety indemnity arrangements are generally joint and several obligations with our joint venture partners. Although a majority of the required work may have been performed, these bonds are typically not released until all development specifications under the bond have been met. None of these bonds have been called to date and we believe it is unlikely that any of these bonds will be called or if called, that any such amounts would be material to us. See the table below for detail of our surety bonds.
The joint venture obligations, guarantees and indemnities discussed above are generally provided by us or one or more of our subsidiaries. In joint ventures involving other homebuilders or developers, support for these obligations is generally provided by the parent companies of the joint venture partners. In connection with our periodic real estate impairment reviews, we may accrue for any such commitments where we believe our obligation to pay is probable and can be reasonably estimated. In such situations, our accrual represents the portion of the total joint venture obligation related to our relative ownership percentage. In the limited cases where our venture partners, some of whom are homebuilders or developers who may be experiencing financial difficulties as a result of current market conditions, may be unable to fulfill their pro rata share of a joint venture obligation, we may be fully responsible for these commitments if such commitments are joint and several. We continue to monitor these matters and reserve for these obligations if and when they become probable and can be reasonably estimated. Except as noted below and in Note 13 to these unaudited consolidated financial statements, as of September 30, 2012 and December 31, 2011, we did not have any such reserves.
See Note 13 regarding outstanding litigation related to a joint venture project known as “South Edge” or "Inspirada" and the corresponding reserves and charges we have recorded relating thereto.
Off-Balance Sheet Arrangements Other. From time to time, we may acquire lots from various development entities pursuant to option and purchase agreements. The purchase price generally approximates the market price at the date the contract is executed (with possible future escalators). See Note 3 for further discussion.
We provide letters of credit in support of our obligations relating to the development of our projects and other

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corporate purposes. Surety bonds to guarantee our performance of certain development and construction activities are generally posted in lieu of letters of credit or cash deposits. The amount of these obligations outstanding at any time varies depending on the stage and level of our development activities, as bonds are generally not released until all development activities under the bond are complete. In the event a bond or letter of credit is drawn upon, we would be obligated to reimburse the issuer. We believe it is unlikely that any significant amounts of these bonds or letters of credit will be drawn upon. The table below outlines our surety bond and letter of credit obligations (in thousands):
 
 
September 30, 2012
 
December 31, 2011
 
Outstanding
 
Estimated work
remaining to
complete
 
Outstanding
 
Estimated work
remaining to
complete
Sureties:
 
 
 
 
 
 
 
Sureties related to joint ventures
$
1,950

 
$
1,950

 
$
1,594

 
$
32

Sureties related to owned projects and lots under contract
81,406

 
49,246

 
65,921

 
37,252

Total sureties
$
83,356

 
$
51,196

 
$
67,515

 
$
37,284

Letters of Credit (“LOCs”):
 
 
 
 
 
 
 
LOCs for land development
$
9,749

 


 
$
6,451

 
N/A

LOCs for general corporate operations
4,991

 


 
4,960

 
N/A

Total LOCs
$
14,740

 


 
$
11,411

 
N/A

Accrued Liabilities. Accrued liabilities consist of the following (in thousands):
 
At September 30, 2012
 
At December 31, 2011
Accruals related to real-estate development and construction activities
$
16,204

 
$
11,048

Payroll and other benefits
17,621

 
13,535

Accrued taxes
5,652

 
3,075

Warranty reserves
22,973

 
23,136

Legal reserves
16,177

 
10,157

Other accruals
17,737

 
18,513

Total
$
96,364

 
$
79,464

Warranty Reserves. We provide home purchasers with limited warranties against certain building defects and have certain obligations related to those post-construction warranties for closed homes. The specific terms and conditions of these limited warranties vary by state, but overall the nature of the warranties include a complete workmanship and materials warranty typically during the first year after the close of the home and a structural warranty that typically extends up to 10 years subsequent to the close of the home. With the assistance of an actuary for the structural-related warranty, we have estimated these reserves based on the number of home closings and historical data and trends for our communities. We also use industry averages with respect to similar product types and geographic areas in markets where our experience is not robust enough to facilitate a meaningful conclusion. We regularly review our warranty reserves and adjust them, as necessary, to reflect changes in trends as information becomes available. A summary of changes in our warranty reserves follows (in thousands):
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Balance, beginning of period
$
21,243

 
$
25,929

 
$
23,136

 
$
29,265

Additions to reserve from new home deliveries
2,166

 
1,825

 
5,771

 
4,673

Warranty claims
(436
)
 
(2,474
)
 
(5,934
)
 
(8,269
)
Adjustments to pre-existing reserves

 
795

 

 
406

Balance, end of period
$
22,973

 
$
26,075

 
$
22,973

 
$
26,075

Warranty reserves are included in accrued liabilities on the accompanying consolidated balance sheets, and additions and adjustments to the reserves are included in cost of home closings within the accompanying consolidated statements of operations. These reserves are intended to cover costs associated with our contractual and statutory warranty

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obligations, which include, among other items, claims involving defective workmanship and materials. We believe that our total reserves, coupled with our contractual relationships and rights with our trades, are sufficient to cover our general warranty obligations. However, as unanticipated changes in legal, weather, environmental or other conditions could have an impact on our actual warranty costs, future costs could differ significantly from our estimates.
Recently Issued Accounting Pronouncements. In May 2011, the Financial Accounting Standards Board (“FASB”) issued ASU 2011-04, which amended ASC 820, Fair Value Measurements (“ASC 820”), providing a consistent definition and measurement of fair value, as well as similar disclosure requirements between U.S. GAAP and International Financial Reporting Standards. ASU 2011-04 changes certain fair value measurement principles, clarifies the application of existing fair value measurement and expands the disclosure requirements. ASU 2011-04 became effective for us beginning January 1, 2012. The adoption of ASU 2011-04 did not have any effect on our consolidated financial statements or disclosures.
In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”). ASU 2011-05 requires the presentation of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. ASU 2011-05 became effective for us beginning January 1, 2012. The adoption of ASU 2011-05 did not have any effect on our consolidated financial statements or disclosures because our net income equals our comprehensive income.
NOTE 2 — REAL ESTATE AND CAPITALIZED INTEREST
Real estate consists of the following (in thousands):
 
 
At September 30, 2012
 
At December 31, 2011
Homes under contract under construction (1)
$
205,616

 
$
101,445

Unsold homes, completed and under construction (1)
98,354

 
97,246

Model homes (1)
55,853

 
49,892

Finished home sites and home sites under development
524,842

 
441,242

Land held for development (2)
54,981

 
55,143

Land held for sale
24,619

 
29,908

Communities in mothball status (3)
40,560

 
40,549

 
$
1,004,825

 
$
815,425

 
(1)
Includes the allocated land and land development costs associated with each lot for these homes.
(2)
Land held for development primarily reflects land and land development costs related to land where development activity is not currently underway but is expected to begin in the future. In these cases, we may have chosen not to currently develop certain land holdings as they typically represent a portion of a large land parcel that we plan to build out over several years.
(3)
Represents communities where we have decided to cease operations (mothball) as we have determined that their economic performance would be maximized by deferring development. In the future, some of these communities may be re-opened while others may be sold to third parties. If we deem our carrying value to not be fully recoverable, we adjust our carrying value for these assets to fair value at the time they are placed into mothball status. As of September 30, 2012, we had three mothballed communities with a carrying value of $11.2 million in our West Region and eight mothballed communities with a carrying value of $29.4 million in our Central Region. During the nine months ended September 30, 2012, we did not place any additional communities into mothball status. We do not capitalize interest for such mothballed assets, and all ongoing costs of land ownership (i.e. property taxes, homeowner association dues, etc.) are also expensed as incurred.
As previously noted, in accordance with ASC 360-10, each of our land inventory and related real estate assets is reviewed for recoverability when impairment indicators are present as our inventory is considered “long-lived” in accordance with GAAP. Due to the current economic environment, we evaluate all of our real estate assets for impairment on a quarterly basis. ASC 360-10 requires impairment charges to be recorded if the asset is not deemed fully recoverable and the fair value of such assets is less than their carrying amounts. Our determination of fair value is based on projections and estimates. We also evaluate alternative product offerings in communities where impairment indicators are present and other strategies for the land exist, such as selling the land or holding the land for sale in the future. Based on these reviews of all our communities, we recorded the following contract termination and real-estate impairment charges during the three and nine months ended September 30, 2012 and 2011 (in thousands):
 

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Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Terminated option/purchase contracts and related pre-acquisition costs:
 
 
 
 
 
 
 
West
$

 
$

 
$

 
$

Central
263

 
98

 
346

 
100

East

 

 

 

Total
$
263

 
$
98

 
$
346

 
$
100

Real estate inventory impairments (1):
 
 
 
 
 
 
 
West
$
42

 
$
295

 
$
284

 
$
552

Central
54

 
468

 
197

 
1,235

East
58

 
59

 
77

 
287

Total
$
154

 
$
822

 
$
558

 
$
2,074

Impairments of land held for sale:
 
 
 
 
 
 
 
West
$

 
$

 
$
669

 
$

Central

 
127

 

 
127

East

 

 

 

Total
$

 
$
127

 
$
669

 
$
127

Total impairments:
 
 
 
 
 
 
 
West
$
42

 
$
295

 
$
953

 
$
552

Central
317

 
693

 
543

 
1,462

East
58

 
59

 
77

 
287

Total
$
417

 
$
1,047

 
$
1,573

 
$
2,301

 
(1)
Included in the real estate inventory impairments are impairments of individual homes in a community where the underlying community was not also impaired, as follows (in thousands):

 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Individual home impairments:
 
 
 
 
 
 
 
West
$
42

 
$
166

 
$
284

 
$
423

Central
54

 
239

 
197

 
695

East
58

 
59

 
77

 
287

Total
$
154

 
$
464

 
$
558

 
$
1,405

The table below reflects the number of communities with real estate inventory impairments for the three- and nine-month periods ended September 30, 2011, excluding home-specific impairments (as noted above) and the fair value of these communities as of September 30, 2011 (dollars in thousands). There were no such impairments recorded for the three and nine month periods ended September 30, 2012.
 
 
Three Months Ended September 30, 2011
 
Number of
Communities
Impaired
 
Impairment Charges
 
Fair Value of Communities Impaired
(Carrying Value less Impairments)
West
1

 
$
129

 
2,501

Central
4

 
229

 
6,894

East

 

 
N/A

Total
5

 
$
358

 
$
9,395


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Nine Months Ended September 30, 2011
 
Number of
Communities
Impaired
 
Impairment Charges
 
Fair Value of Communities Impaired
(Carrying Value less Impairments)
West
1

 
$
129

 
2,501

Central
6

 
540

 
13,721

East

 

 
N/A

Total
7

 
$
669

 
$
16,222


In the latter part of 2011, we announced our intent to wind-down operations in the Las Vegas, Nevada market. As of September 30, 2012, we had 33 lots remaining to sell and close in our two remaining actively selling Nevada communities. The value of those lots and any associated homes inventory was $5.9 million as of September 30, 2012. Based on our current orders pace, we expect to complete our construction operations within 12 to 18 months. The remaining $18.5 million of our Nevada assets relate to properties that we are not currently developing and which we are either actively marketing for sale or which we have mothballed. In the second quarter of 2012, we entered into a sales contract for $6.5 million that relates to a parcel of land, of which approximately $3.3 million was received in July 2012, and the remaining payment due to us January 2013. In addition, in the third quarter of 2012, we sold a second parcel of land to a third party for $1.1 million, all of which was received as of September 30, 2012.
Subject to sufficient qualifying assets, we capitalize interest incurred in connection with the development and construction of real estate. Completed homes and land not actively under development do not qualify for interest capitalization. Capitalized interest is allocated to real estate when incurred and charged to cost of closings when the related property is delivered. To the extent our debt exceeds our qualified assets base, we expense a proportionate share of the interest incurred. A summary of our capitalized interest is as follows (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Capitalized interest, beginning of period
$
17,836

 
$
13,205

 
$
14,810

 
$
11,679

Interest incurred
11,654

 
10,848

 
33,819

 
32,545

Interest expensed
(5,009
)
 
(7,517
)
 
(18,718
)
 
(23,036
)
Interest amortized to cost of home, land closings and impairments
(4,296
)
 
(2,421
)
 
(9,726
)
 
(7,073
)
Capitalized interest, end of period (1)
$
20,185

 
$
14,115

 
$
20,185

 
$
14,115

 
(1)
Approximately $750,000 of the capitalized interest is related to our joint venture investments and is a component of “Investments in unconsolidated entities” on our consolidated balance sheets as of September 30, 2012 and December 31, 2011.
NOTE 3 — VARIABLE INTEREST ENTITIES AND CONSOLIDATED REAL ESTATE NOT OWNED
We enter into purchase and option agreements for land or lots as part of our normal course of business. These purchase and option agreements enable us to acquire properties at one or multiple future dates at pre-determined prices. We believe these acquisition structures reduce our financial risk associated with land acquisitions and holdings and allow us to better maximize our liquidity.
Based on the provisions of the relevant accounting guidance, we have concluded that when we enter into purchase or option agreements to acquire land or lots from an entity, a variable interest entity, or “VIE”, may be created. We evaluate all purchase and option agreements for land to determine whether they are a VIE. ASC 810, Consolidations, requires that for each VIE, we assess whether we are the primary beneficiary and, if we are, we consolidate the VIE in our financial statements and reflect such assets and liabilities as “Real estate not owned.” The liabilities related to consolidated VIEs are excluded from our debt covenant calculations.
In order to determine if we are the primary beneficiary, we must first assess whether we have the ability to control the activities of the VIE that most significantly impact its economic performance. Such activities include, but are not limited to,

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the ability to determine the budget and scope of land development work, if any; the ability to control financing decisions for the VIE; the ability to acquire additional land into the VIE or dispose of land in the VIE not under contract with Meritage; and the ability to change or amend the existing option contract with the VIE. If we are not determined to control such activities, we are not considered the primary beneficiary of the VIE. If we do have the ability to control such activities, we will continue our analysis by determining if we are also expected to absorb a potentially significant amount of the VIE’s losses or, if no party absorbs the majority of such losses, if we will benefit from a potentially significant amount of the VIE’s expected gains.
In substantially all cases, creditors of the entities with which we have option agreements have no recourse against us and the maximum exposure to loss under our option agreements is limited to non-refundable option deposits and any capitalized pre-acquisition costs. If we are the land developer, we are also at risk for costs over budget related to land development on property we have under option. In these cases, we have typically contracted to complete development at a fixed market cost on behalf of the land owner and any budget savings or shortfalls are borne by us. Some of our option deposits may be refundable to us 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 September 30, 2012 (dollars in thousands):
 
 
Number of
Lots
 
Purchase
Price
 
Option/Earnest
Money Deposits
Cash
 
Purchase and option contracts recorded on balance sheet as Real estate not owned

 
$

 
$

  
Purchase and option contracts not recorded on balance sheet — non-refundable deposits, committed (1)
2,415

 
122,914

 
11,748

  
Purchase and option contracts not recorded on balance sheet — refundable deposits, committed
227

 
5,116

 
185

  
Total committed (on and off balance sheet)
2,642

 
128,030

 
11,933

  
Total purchase and option contracts not recorded on balance sheet — refundable deposits, uncommitted (2)
1,439

 
42,910

 
1,050

  
Total lots under contract or option
$
4,081

 
$
170,940

 
$
12,983

  
Total option contracts not recorded on balance sheet
$
4,081

 
$
170,940

 
$
12,983

(3)
 
(1)
Deposits are generally non-refundable except if certain contractual conditions fail or certain contractual obligations are not performed by the selling party.
(2)
Deposits are refundable at our sole discretion. We have not completed our acquisition evaluation process and we have not internally committed to purchase these lots.
(3)
Amount is reflected in our consolidated balance sheet in the line item “Deposits on real estate under option or contract” as of September 30, 2012.
Generally, our options to purchase lots remain effective as long as we purchase a pre-established minimum number of lots periodically, as determined by the terms of the respective agreement. In nearly all of our option contracts, we have the right not to exercise our option to purchase the lots and forfeit our deposit without further consequences. Accordingly, we do not consider the payment of the lot purchase price to be a firm contractual obligation. The pre-established number of lot purchases is typically structured to approximate our expected rate of home construction starts.
NOTE 4 — INVESTMENTS IN UNCONSOLIDATED ENTITIES
In the past, we have entered into land development joint ventures 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. Due to the current homebuilding environment, although we view our involvement with land joint ventures to be beneficial, we do not view such involvement as critical to the success of our homebuilding operations. 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 generally do not have a controlling interest in these ventures, which means our joint venture partners could cause the venture to take actions we disagree with, or fail to take actions we believe should be undertaken, including the sale of the underlying property to repay debt or recoup all or part of the partners’ investments. As of September 30, 2012, we had two active equity-method land ventures.
We also participate in five mortgage and title business joint ventures. The mortgage joint ventures are engaged in mortgage activities and they provide services to both our clients and other homebuyers. Although some of these ventures

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originate mortgage loans, we have limited recourse related to any mortgages originated by these ventures. Our investments in mortgage and title joint ventures as of September 30, 2012 and December 31, 2011 were $2.0 million and $1.2 million, respectively.
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 these ventures, our share of the joint venture profit relating to lots we purchase from the joint ventures is deferred until homes are delivered by us and title passes to a homebuyer. Therefore, we allocate the portion of such joint venture profit 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):
 
 
At September 30, 2012
 
At December 31, 2011
Assets:
 
 
 
Cash
$
3,802

 
$
4,530

Real estate
45,804

 
44,764

Other assets
3,622

 
3,946

Total assets
$
53,228

 
$
53,240

Liabilities and equity:
 
 
 
Accounts payable and other liabilities
$
4,529

 
$
4,534

Notes and mortgages payable
20,658

 
20,923

Equity of:
 
 
 
Meritage (1)
9,303

 
9,351

Other
18,738

 
18,432

Total liabilities and equity
$
53,228

 
$
53,240

 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Revenue
$
10,268

 
$
6,116

 
$
18,733

 
$
13,764

Costs and expenses
(3,711
)
 
(3,164
)
 
(8,250
)
 
(8,399
)
Net earnings of unconsolidated entities
$
6,557

 
$
2,952

 
$
10,483

 
$
5,365

Meritage’s share of pre-tax earnings (1)(2)(3)
$
2,975

 
$
1,797

 
$
6,626

 
$
3,931

 
(1)
Balance represents Meritage’s interest, as reflected in the financial records of the respective joint ventures. This balance may differ from the balance reflected in our condensed consolidated balance sheets due to the following reconciling items: (i) timing differences for revenue and distributions recognition, (ii) step-up basis and corresponding amortization, (iii) income deferrals as discussed in Note (3) below and (iv) the cessation of allocation of losses from joint ventures in which we have previously impaired our investment balance to zero and where we have no commitment to fund additional losses.
(2)
The joint venture financial statements above represent the most recent information available to us.
(3)
Our share of pre-tax earnings is recorded in “Earnings from unconsolidated entities, net” on our consolidated statements of operations and excludes joint venture profit related to lots we purchased from the joint ventures. Such profit is deferred until homes are delivered by us and title passes to a homebuyer.
Our investments in unconsolidated entities include $1.0 million at September 30, 2012 and December 31, 2011, related to the difference between the amounts at which our investments are carried and the amount of our portion of the venture’s equity. These amounts are amortized as the assets of the respective joint ventures are sold. No amortization was recorded for these assets in the first nine months of 2012 or 2011.
The joint venture assets and liabilities noted in the table above primarily represent two active land ventures, five mortgage and title ventures and various inactive ventures in which we have a total investment of $12.0 million. As of

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September 30, 2012, we believe these ventures are in compliance with their respective debt agreements, if applicable, and except for $249,000 of our limited repayment guarantees as discussed in Note 1 to these unaudited consolidated financial statements, the joint venture debt reflected above is non-recourse to us.
NOTE 5 — SENIOR, SENIOR SUBORDINATED, CONVERTIBLE SENIOR NOTES AND OTHER BORROWINGS
Senior, senior subordinated, convertible senior notes and other borrowings consist of the following (in thousands):
 
 
At September 30, 2012
 
At December 31, 2011
6.25% senior notes due 2015. At December 31, 2011, there was approximately $451 in unamortized discount
$

 
$
284,549

7.731% senior subordinated notes due 2017
99,825

 
125,875

7.15% senior notes due 2020. At September 30, 2012 and December 31, 2011, there was approximately $3,650 and $4,015 in unamortized discount, respectively
196,350

 
195,985

7.00% senior notes due 2022
300,000

 

1.875% convertible senior notes due 2032
126,500

 

$125 million unsecured revolving credit facility

 

 
$
722,675

 
$
606,409

The indentures for our 7.731% senior subordinated notes contain covenants that require maintenance of certain minimum financial ratios, place limitations on investments we can make and 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 September 30, 2012, we believe we were in compliance with our covenants. The indentures for our 7.15% and 7.00% senior notes contain covenants including, among others, limitations on the amount of secured debt we may incur, and limitations on sale and leaseback transactions and mergers. The covenants contained in the 7.15% and 7.00% senior notes are generally no more restrictive, and in many cases less restrictive, than the covenants contained in the indenture for the 7.731% senior subordinated notes. Our convertible senior notes do not have any financial covenants.
Obligations to pay principal and interest on the senior, convertible senior and senior subordinated notes are guaranteed by all of our wholly-owned subsidiaries (each a “Guarantor” and, 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. In the event of a sale or other disposition of all of the assets of any Guarantor, by way of merger, consolidation or otherwise, or a sale or other disposition of all of the equity interests of any Guarantor then held by Meritage and its subsidiaries, then that Guarantor will be released and relieved of any obligations under its note guarantee. There are no significant restrictions on our ability or the ability of any Guarantor to obtain funds from their respective subsidiaries, as applicable, by dividend or loan. We do not provide separate financial statements of the Guarantor Subsidiaries because Meritage (the parent company) has no independent assets or operations and the guarantees are full and unconditional and joint and several. Subsidiaries of Meritage Homes Corporation that are nonguarantor subsidiaries, if any, are, individually and in the aggregate, inconsequential.
In April 2012, we completed an offering of $300.0 million aggregate principal amount of 7.00% Senior Notes due 2022 (“2022 Notes”). Concurrent with this offering, we repurchased all $285.0 million of our 6.25% Senior Notes due 2015. We also repurchased an aggregate principal amount of approximately $26.1 million of our 7.731% Senior Notes due 2017. The debt redemption transactions resulted in $5.8 million of expense in the second quarter of 2012 reflected as Loss on extinguishment of debt in our consolidated statements of operations.

In July 2012, we entered into an unsecured revolving credit facility ("Credit Facility") of up to $125.0 million, of which $50.0 million will be available for letters of credit. The Credit Facility matures in July 2015. Borrowings under the Credit Facility are unsecured but availability is subject to, among other things, a borrowing base. The Credit Facility also contains certain financial covenants, including (a) a minimum tangible net worth requirement of $360.0 million (which amount is subject to increase over time based on subsequent earnings and proceeds from equity offerings), and (b) a maximum leverage covenant that prohibits the leverage ratio (as defined therein) from exceeding 60%. In addition, we are required to maintain either (i) an interest coverage ratio (EBITDA to interest expense, as defined therein) of at least 1.00 to 1.00 (increasing to 1.50 to 1.00 on January 1, 2013 and thereafter) or (ii) liquidity (as defined therein) of an amount not less than our consolidated interest incurred during the trailing 12 months. There were no outstanding advances or letters of credit under the Credit Facility as of September 30, 2012.


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In September 2012, we issued $126.5 million aggregate principal amount of 1.875% Convertible Senior Notes due 2032 (the “Convertible Notes”). The Convertible Notes will initially be convertible into shares of our common stock at a conversion rate of 17.1985 shares of our common stock per $1,000 principal amount of Convertible Notes. This corresponds to an initial conversion price of $58.14 per share and represents a 47.5% conversion premium based on the closing price of our common stock on September 12, 2012. The conversion rate is subject to adjustments upon the occurrence of specific events. The Convertible Notes may be redeemed by the note-holders on the fifth, tenth and fifteenth anniversary dates of the Convertible Notes. We may call the Convertible Notes at any time after the fifth anniversary. Interest is due on the Convertible Notes on March 15 and September 15 of each year, commencing March 15, 2013, maturing on September 15, 2032.
NOTE 6 — FAIR VALUE DISCLOSURES
We account for the non-recurring fair value measurements of our non-financial assets and liabilities in accordance with ASC 820-10, Fair Value Measurement and Disclosure. This guidance defines fair value, establishes a framework for measuring fair value and addresses required disclosures about fair value measurements. This standard establishes a three-level hierarchy for fair value measurements based upon the significant inputs used to determine fair value. Observable inputs are those which are obtained from market participants external to the company while unobservable inputs are generally developed internally, utilizing management’s estimates, assumptions and specific knowledge of the assets/liabilities and related markets. The three levels are defined as follows:
Level 1 — Valuation is based on quoted prices in active markets for identical assets and liabilities.
Level 2 — Valuation is determined from quoted prices for similar assets or liabilities in active markets, quoted prices for identical or similar instruments in markets that are not active, or by model-based techniques in which all significant inputs are observable in the market.
Level 3 — Valuation is derived from model-based techniques in which at least one significant input is unobservable and based on the company’s own estimates about the assumptions that market participants would use to value the asset or liability.
If the only observable inputs are from inactive markets or for transactions which the company evaluates as “distressed”, the use of Level 1 inputs should be modified by the company to properly address these factors, or the reliance of such inputs may be limited, with a greater weight attributed to Level 3 inputs. Refer to Notes 1 and 2 for additional information regarding the valuation of our non-financial assets.
A summary of our long-lived real-estate assets re-measured at fair value as of and during the three and nine months ended September 30, 2012 and 2011 is as follows (in thousands):
 
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
September 30,
 
September 30,
  
Hierarchy
2012
 
2011 (2)
 
2012
 
2011 (2)
Description:
 
 
 
 
 
 
 
 
 
Adjusted Basis of Long-Lived Real Estate Assets (1)
Level 3
 
$
5,510

 
$
19,559

 
$
10,491

 
$
28,149

Impairments
 
 
417

 
1,047

 
1,573

 
2,301

Initial Basis of Long-Lived Real Estate Assets
 
 
$
5,927

 
$
20,606

 
$
12,064

 
$
30,450

 
(1)
The fair values in the table above represent only those real estate assets whose carrying values were adjusted in the respective period.
(2)
The carrying values for these real-estate assets may have subsequently increased or decreased from the fair value reported due to activities that have occurred since the measurement date.


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Financial Instruments. The fair value of our fixed-rate debt is derived from quoted market prices by independent
dealers and is as follows (in thousands):
 
 
 
 
September 30, 2012
 
December 31, 2011
 
Hierarchy
Aggregate
Principal
 
Estimated
Fair Value
 
Aggregate
Principal
 
Estimated
Fair Value
6.25% senior notes
Level 2
 
N/A

 
N/A

 
$
285,000

 
$
278,588

7.731% senior subordinated notes
Level 2
 
$
99,825

 
$
102,820

 
$
125,875

 
$
110,770

7.15% senior notes
Level 2
 
$
200,000

 
$
215,760

 
$
200,000

 
$
190,000

7.00% senior notes
Level 2
 
$
300,000

 
$
321,000

 
N/A

 
N/A

1.875% convertible senior notes
Level 2
 
$
126,500

 
$
124,919

 
N/A

 
N/A

Due to the short-term nature of other financial assets and liabilities, we consider the carrying amounts of our other short-term financial instruments to approximate fair value.
NOTE 7 — EARNINGS/(LOSS) PER SHARE
Basic and diluted earnings/(loss) per common share were calculated as follows (in thousands, except per share amounts):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Basic weighted average number of shares outstanding
35,216

 
32,417

 
33,541

 
32,358

Effect of dilutive securities:
 
 
 
 
 
 
 
Convertible debt (1)

 

 

 

Stock options and non-vested shares (2)
545

 

 
469

 

Diluted weighted average shares outstanding
35,761

 
32,417

 
34,010

 
32,358

Net income/(loss)
$
6,784

 
$
(3,235
)
 
$
10,035

 
$
(9,332
)
Basic income/(loss) per share
$
0.19

 
$
(0.10
)
 
$
0.30

 
$
(0.29
)
Diluted income/(loss) per share (1) (2)
$
0.19

 
$
(0.10
)
 
$
0.30

 
$
(0.29
)
Antidilutive stock options not included in the calculation of diluted income per share
530

 
1,665

 
348

 
1,769

 
(1)
During the quarter ended September 30, 2012, we issued $126.5 million of 1.875% convertible senior notes convertible into shares of our common stock at a rate of 17.1985 shares per $1,000 principle amount. In accordance with ASC Subtopic 260-10, Earnings Per Share, ("ASC 260-10") we calculate the dilutive effect of convertible securities using the "if-converted" method. The effect of the convertible debt was not included in the diluted earnings per share calculations for the three and nine months ended September 30, 2012 as it would have been anti-dilutive.
(2)
For periods with a net loss, no options or non-vested shares are included in the dilution calculation as all options and non-vested shares outstanding are considered anti-dilutive.


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NOTE 8 — STOCKHOLDERS’ EQUITY
A Summary of changes in shareholders’ equity is presented below:
 
 
Nine Months Ended September 30, 2012
 
(In thousands)
 
Number of
Shares
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Total
Balance at December 31, 2011
40,377

 
$
404

 
$
478,839

 
$
198,442

 
$
(188,773
)
 
$
488,912

Net income

 

 

 
10,035

 

 
10,035

Exercise of stock options
259

 
3

 
3,897

 

 

 
3,900

Equity award compensation expense

 

 
6,095

 

 

 
6,095

Issuance of restricted stock
200

 
2

 
(2
)
 

 

 

Issuance of stock (1)
2,645

 
26

 
87,099

 

 

 
87,125

Cancellation of treasury shares (2)
(7,891
)
 
(79
)
 
(188,694
)
 

 
188,773

 

Balance at September 30, 2012
35,590

 
$
356

 
$
387,234

 
$
208,477

 
$

 
$
596,067

 
(1)    In July 2012, we issued a public offering of 2,645,000 shares of common stock, par value $0.01 per share, at a price to the public of $34.75 per share.

(2)    During the third quarter of 2012, we canceled and retired all of our treasury shares. These shares remain as authorized and unissued shares.

 
Nine Months Ended September 30, 2011
 
(In thousands)
 
Number of
Shares
 
Common
Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Treasury
Stock
 
Total
Balance at December 31, 2010
40,030

 
$
400

 
$
468,820

 
$
219,548

 
$
(188,773
)
 
$
499,995

Net loss

 

 

 
(9,332
)
 

 
(9,332
)
Exercise of stock options
119

 
1

 
1,830

 

 

 
1,831

Equity award compensation expense

 

 
5,215

 

 

 
5,215

Issuance of restricted stock
167

 
2

 
(2
)
 

 

 

Balance at September 30, 2011
40,316

 
$
403

 
$
475,863

 
$
210,216

 
$
(188,773
)
 
$
497,709


NOTE 9 — STOCK-BASED COMPENSATION
We have a stock compensation plan, the 2006 Stock Option Plan (the “Plan”), that was adopted in 2006, and superceded a prior stock compensation plan that has been amended from time to time. The Plan was approved by our stockholders and is administered by our Board of Directors. The provisions of the Plan allow for the grant of stock appreciation rights, restricted stock awards, performance share awards and performance-based awards in addition to non-qualified and incentive stock options. Our Board of Directors and stockholders approved an amendment to the Plan to increase the number of available shares by 1,200,000 at our 2012 annual meeting of stockholders on May 25, 2012. The Plan authorizes awards to officers, key employees, non-employee directors and consultants for up to 8,950,000 shares of common stock, of which 1,410,014 shares remain available for grant at September 30, 2012. 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. Non-vested stock awards and stock options granted in previous years are usually granted with either a three-year or five-year ratable vesting period or with a three-year cliff vesting for performance-based awards.
Compensation cost related to time-based restricted stock awards are measured as of the closing price on the date of grant and are expensed on a straight-line basis over the vesting period of the award. Compensation cost related to performance-based restricted stock awards are also measured as of the closing price on the date of grant but are expensed in accordance with ASC 718-10-25-20, Compensation – Stock Compensation, which requires an assessment of probability of attainment of the performance target. As our performance targets are annual in nature, once we determine that the performance

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target outcome is probable, the year-to-date expense is recorded and the remaining expense is recorded on a straight-line basis through the end of the award’s vesting period.
Below is a summary of compensation expense and stock award activity (dollars in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Stock-based compensation expense
$
2,822

 
$
2,114

 
$
6,095

 
$
5,215

Non-vested shares granted
16,750

 
0

 
386,500

 
357,000

Performance-based non-vested shares granted
0

 
0

 
56,250

 
56,250

Stock options exercised
179,832

 
3,000

 
259,132

 
119,600

Restricted stock awards vested (includes performance-based awards)
3,300

 
12,634

 
200,316

 
166,751

We did not grant any stock option awards during the nine months ended September 30, 2012 or September 30, 2011. The following table includes additional information regarding the Plan (dollars in thousands):
 
 
As of
 
September 30, 2012
 
December 31, 2011
Unrecognized stock-based compensation cost
$
13,468

 
$
9,058

Weighted average years remaining vesting period
2.33

 
2.05

Total equity awards outstanding (1)
1,650,135

 
1,738,533

 
(1)
Includes vested and unvested options outstanding and unvested restricted stock awards
NOTE 10INCOME TAXES
Components of the income tax (provision)/benefit are as follows (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Federal
$

 
$

 
$

 
$

State
(202
)
 
(160
)
 
4,781

 
(560
)
Total
$
(202
)
 
$
(160
)
 
$
4,781

 
$
(560
)
Due to the effects of the deferred tax asset valuation allowance and federal and state tax net operating losses (“NOLs”), the effective tax rates in 2012 and 2011 are not meaningful as there is no correlation between effective tax rates and the amount of pre-tax income or losses for those periods.
At September 30, 2012 and December 31, 2011, we have no unrecognized tax benefits due to the lapse of the statute of limitations and completion of audits for prior years. We believe that our current income tax filing positions and deductions will be sustained on audit and do not anticipate any adjustments that will result in a material change. Our policy is to accrue interest and penalties on unrecognized tax benefits and include them in federal income tax expense.
In accordance with ASC 740-10, Income Taxes, we determine our net deferred tax assets by taxing jurisdiction. We evaluate our net deferred tax assets, including the benefit from NOLs, by jurisdiction to determine if a valuation allowance is required. Companies must assess whether a valuation allowance should be established based on the consideration of all available evidence using a “more likely than not” standard with significant weight being given to evidence that can be objectively verified. This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the length of statutory carryforward periods, our experience with operating losses and our experience of utilizing tax credit carryforwards and tax planning alternatives.
We recorded a full valuation allowance against all of our net deferred tax assets during 2008. We continue to

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maintain a full non-cash valuation allowance against net deferred tax assets in most of our jurisdictions because the weight of the negative evidence in most jurisdictions exceeds that of the positive evidence. However, during the second quarter of 2012 after a careful review of all the available evidence, we determined that the positive evidence exceeded the negative evidence in the tax jurisdiction of Florida. Only our Florida subsidiaries are taxable in Florida and they have experienced several sequential quarters of sustained profit. There is also no current nor foreseeable cumulative loss from Florida operations, and Florida has a 20 year NOL carryforward utilization period. We therefore concluded that it is more likely than not that most of the deferred tax assets and NOL carryforwards for the Florida jurisdiction will be able to be realized. In accordance with ASC 740, approximately $1.0 million of the remaining valuation allowance on Florida deferred tax assets is expected to be reversed in future periods as sufficient positive evidence is evaluated.
Based on the above, during the quarter ended June 30, 2012, we reviewed our net deferred tax assets and recorded a $5.2 million net tax benefit primarily attributable to the partial reversal of the valuation allowance against our Florida deferred tax assets as adjusted for federal tax benefit. In future periods, the remaining valuation allowance for Florida and other tax jurisdictions, including the federal tax jurisdiction, will be evaluated in a similar manner to determine if sufficient positive evidence indicates that it is more likely than not that an additional portion of our net deferred tax assets should be able to be realized. At September 30, 2012, we have deferred tax assets of $96.3 million and deferred tax liabilities of $3.4 million for a net asset of $92.9 million, before application of the valuation allowance.
At September 30, 2012 and December 31, 2011, we had a valuation allowance against deferred tax assets as follows (in thousands):
 
September 30, 2012
 
December 31, 2011
Federal
$
70,109

 
$
70,228

State
18,526

 
23,897

Total Valuation Allowance
$
88,635

 
$
94,125

Our future NOL and deferred tax asset realization depends on sufficient taxable income in the carryforward periods under existing tax laws. Federal NOL carryforwards may be used to offset future taxable income for 20 years and begin to expire in 2030. State NOL carryforwards may be used to offset future taxable income for a period of time ranging from 5 to 20 years, depending on the state, and begin to expire in 2012. Deferred tax assets include both tax-effected federal and state NOL carryforwards. On an ongoing basis, we will continue to review all available evidence for sufficient taxable income in future periods to determine when we expect to realize our NOL carryovers and other net deferred tax assets.
At September 30, 2012, we have income taxes payable of $0.6 million, which primarily consists of current state tax accruals as well as tax and interest amounts that we expect to pay within one year for having amended a prior-year federal tax return. This amount is recorded in accrued liabilities in the accompanying balance sheet at September 30, 2012.
We conduct business and are subject to tax in the U.S. and several states. With few exceptions, we are no longer subject to U.S. federal, state, or local income tax examinations by taxing authorities for years prior to 2007. We are not subject to any federal or state income tax examination at this time.
The tax benefits from our NOLs, built-in losses, and tax credits would be materially reduced or potentially eliminated if we experience an “ownership change” as defined under Internal Revenue Code (“IRC”) §382. Based on our analysis performed as of September 30, 2012, we do not believe that we have experienced an ownership change. As a protective measure, our stockholders held a Special Meeting of Stockholders on February 16, 2009 and approved an amendment to our Articles of Incorporation that restricts certain transfers of our common stock. The amendment is intended to help us avoid an unintended ownership change and thereby preserve the value of our tax benefits for future utilization.


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NOTE 11 — SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
The following presents certain supplemental cash flow information (in thousands):
 
 
Nine Months Ended September 30,
 
2012
 
2011
Cash paid during the period for:
 
 
 
Interest, net of interest capitalized
$
19,615

 
$
22,774

Income taxes
$
909

 
$
862

Non-cash operating activities:
 
 
 
Real estate not owned
$

 
$
532

NOTE 12 — OPERATING AND REPORTING SEGMENTS
As defined in ASC 280-10, Segment Reporting, we have seven operating segments (the seven states in which we operate). These segments are engaged in the business of acquiring and developing land, constructing homes, marketing and selling those homes, and providing warranty and customer service. We aggregate our operating segments into reporting segments based on similar long-term economic characteristics and geographical proximity. Our reporting segments are as follows:
West: California and Nevada
Central: Texas, Arizona and Colorado
East: Florida and North Carolina
Management’s evaluation of segment performance is based on segment operating income/(loss), which we define as homebuilding and land revenue 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, including impairments. Each reportable segment follows the same accounting policies described in Note 1, “Organization and Basis of Presentation,” to the consolidated financial statements in our 2011 Annual Report on Form 10-K. Operating results for each segment may not be indicative of the results for such segment had it been an independent, stand-alone entity. The following is our segment information (in thousands):
 
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
 
2012
 
2011
 
2012
 
2011
Revenue (1):
 
 
 
 
 
 
 
West
$
97,249

 
$
32,930

 
$
184,365

 
$
88,290

Central
193,784

 
156,935

 
510,110

 
458,623

East
51,610

 
27,669

 
134,613

 
68,341

Consolidated total
342,643

 
217,534

 
829,088

 
615,254

Operating income/(loss) (2):
 
 
 
 
 
 
 
West
8,665

 
363

 
10,621

 
(84
)
Central
12,327

 
5,128

 
27,674

 
17,203

East
3,691

 
1,721

 
9,768

 
5,962

Segment operating income
24,683

 
7,212

 
48,063

 
23,081

Corporate and unallocated (3)
(7,323
)
 
(5,443
)
 
(17,233
)
 
(15,620
)
Earnings from unconsolidated entities, net
2,975

 
1,797

 
6,626

 
3,931

Interest expense
(5,009
)
 
(7,517
)
 
(18,718
)
 
(23,036
)
Other (expense)/income, net
(8,340
)
 
876

 
(7,712
)
 
2,872

Loss on extinguishment of debt

 

 
(5,772
)
 

Income/(loss) before income taxes
$
6,986

 
$
(3,075
)
 
$
5,254

 
$
(8,772
)
 

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(1)
Revenue includes the following land closing revenue, by segment: three months ended September 30, 2012$4.4 million in the West Region, $2.6 million in the Central Region, $0.8 million in the East Region; nine months ended September 30, 2012$4.4 million in the West Region, $3.6 million in the Central Region, $0.8 million in the East Region; nine months ended September 30, 2011$100,000 in the Central Region.
(2)
See Note 2 of this Quarterly Report on Form 10-Q for a breakout of real estate-related impairments by region.
(3)
Balance consists primarily of corporate costs and numerous shared service functions such as finance and treasury that are not allocated to the reporting segments.
 
At September 30, 2012
 
West
 
Central
 
East
 
Corporate and
Unallocated (1)
 
Total
Deposits on real estate under option or contract
$
3,516

 
$
8,367

 
$
1,100

 
$

 
$
12,983

Real estate
204,737

 
672,037

 
128,051

 

 
1,004,825

Investments in unconsolidated entities
177

 
10,983

 
13

 
835

 
12,008

Other assets
18,417

 
145,271

 
21,264

 
266,434

 
451,386

Total assets
$
226,847

 
$
836,658

 
$
150,428

 
$
267,269

 
$
1,481,202

 
 
At December 31, 2011
 
West
 
Central
 
East
 
Corporate and
Unallocated (1)
 
Total
Deposits on real estate under option or contract
$
3,216

 
$
11,158

 
$
834

 
$

 
$
15,208

Real estate
207,656

 
529,885

 
77,884

 

 
815,425

Investments in unconsolidated entities
176

 
10,245

 
14

 
653

 
11,088

Other assets
8,911

 
90,532

 
8,842

 
271,372

 
379,657

Total assets
$
219,959

 
$
641,820

 
$
87,574

 
$
272,025

 
$
1,221,378

 
(1)
Balance consists primarily of cash and other corporate assets not allocated to the reporting segments.
NOTE 13COMMITMENTS AND CONTINGENCIES
We are involved in various routine legal proceedings incidental to our business, some of which are covered by insurance. With respect to most pending litigation matters, our ultimate legal and financial responsibility, if any, cannot be estimated with certainty and our actual future expenditure to resolve those matters could prove to be different from the amount that we accrued or reserved. On a quarterly basis, our senior management and legal team conduct an in-depth review of all active legal claims and litigation matters and we record a legal or warranty accrual representing the estimated total expense required to resolve each such matter. We have reserved approximately $16.2 million related to non-warranty related litigation and asserted claims (which includes the additional $8.7 million reserve recorded in the third quarter of 2012 related to the Joint Venture Litigation discussed below). In addition, our $23.0 million warranty reserve includes accruals for all construction defect claims that are similarly recorded in an amount we believe will be necessary to resolve those construction defect claims. Except as may be specifically disclosed herein, we currently believe that any reasonably possible additional losses from existing claims and litigation in excess of our existing reserves and accruals would be immaterial, individually and in the aggregate, to our financial results.
Joint Venture Litigation
We are a defendant in a lawsuit filed by the lenders related to a project known as “South Edge” or “Inspirada”. We are also a party to a demand for arbitration made by an entity controlled by co-venturers, which demand was made by that entity as Estate Representative of bankrupt South Edge, LLC. The project involves a large master-planned community located in Henderson, Nevada, which was acquired by an unconsolidated joint venture with capital supplied by the co-venturers, and a syndicated loan on the project. In connection with the loan obtained by the venture, we provided a narrowly crafted repayment guarantee that could only be triggered upon a “bankruptcy event”. That guarantee covers our 3.53% pro rata share of the project financing.
On December 9, 2010, three of the lenders filed a petition seeking to place the venture into an involuntary bankruptcy. On June 6, 2011, we received a demand letter from the lenders, requesting full payment of $13.2 million the lenders claimed to be owed under the springing repayment guarantee, including past-due interest and penalties. The lenders claim that the involuntary bankruptcy filed by three of the lenders triggered the “springing” repayment guarantee. We do not

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believe the lenders have an enforceable position associated with their $13.2 million claim and do not believe we should be required to pay such amount because, among other reasons, the lenders breached their contract with us by refusing to accept the April 2008 tender of our performance and by refusing to release their lien in connection with our second and final takedown in this project and we do not believe the repayment guarantee was triggered by the lenders’ filing of the involuntary bankruptcy. As a result, on August 19, 2011, we filed a lawsuit against JP Morgan Chase Bank, NA (“JP Morgan”) in the Court of Common Pleas in Franklin County, Ohio (Case No. 11CVH0810353) regarding the repayment guarantee. In reaction to that lawsuit, on August 25, 2011, JP Morgan filed a lawsuit against us in the US District Court of Nevada regarding the same issues addressed in the Ohio litigation. The Ohio action and the Nevada action have been consolidated. On October 26, 2011, the Bankruptcy Court approved a Plan that, among other things, provided for the project to be conveyed to Inspirada Builders, LLC, which is an entity owned by four of the co-venturers in the South Edge entity (KB Home, Toll Brothers, Pardee Homes and Beazer Homes) and pursuant to which the lenders’ repayment guarantee claim is being pursued by those four builders and, as a result, it is anticipated that the consolidated lawsuit regarding the repayment guarantee claim will be litigated between those four builders, JP Morgan, and us.
On September 4, 2012, the Court ruled on a motion for summary judgment that JP Morgan has standing to pursue its repayment guarantee claims against Meritage, and that Meritage was liable thereunder to JP Morgan and that the parties should be permitted to conduct discovery with respect to the amount of damages to which JP Morgan is entitled under the repayment guarantee. We disagree with many of the conclusions and findings contained in the Court's order, and have challenged and will continue to challenge the ruling. In addition, we believe that the four above-named builders are liable to Meritage for any amounts that Meritage may ultimately be required to pay under the repayment guarantee, and we have filed claims against those builders to, among other things, recover from them any amounts Meritage is required to pay under the repayment guarantee.
In March 2012, Inspirada Builders, LLC, as Estate Representative of South Edge, LLC (the original joint venture) filed demand for arbitration in the United States Bankruptcy Court in the District of Nevada against Meritage Homes of Nevada, Inc. seeking: (1) $13.5 million, relating to alleged breaches of the Operating Agreement of South Edge, LLC, for an alleged failure to pay the amounts Meritage Homes of Nevada fully tendered but South Edge rejected in April 2008; and (2) $9.8 million relating to our supposed pro rata share of alleged future infrastructure improvement costs to be incurred by Inspirada Builders, LLC (the new owner of the project and which is owned by the four builders identified above). The $13.5 million component of this claim represents the same alleged obligation and amount that is the subject of the above described pending $13.2 million repayment guarantee litigation between us and JP Morgan. Meritage has filed a response to Inspirada Builders' arbitration claims denying liability, together with cross-claims against the four above-named co-venture builders for breach of contract, breach of the implied covenant of good faith and fair dealing, and indemnity. These claims are currently pending, and the arbitration hearing will likely be concluded sometime in mid-2013. In connection with the on-going legal proceedings, we have established reserves for amounts that we believe are appropriate for these matters. Our 3.53% investment in the venture has been previously fully impaired. We do not believe that the ultimate disposition of these matters will have a material adverse affect on our financial condition.

Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Overview and Outlook
During the first nine months of 2012, the overall housing market appears to have stabilized and began to improve largely driven by increasing consumer confidence levels related to the homebuilding industry, continued excellent housing affordability based on historical metrics, decreasing inventory home levels in many markets, and higher consumer confidence in the overall economy. Individual markets continue to experience varying results as local economic and employment situations strongly influence the local market demand and homebuying abilities; however, most of the markets in which we operate have shown positive indications of a sustainable recovery, particularly those markets most affected by the downturn, including California, Arizona and Florida. We continue to focus on successfully differentiating ourselves from our competition, largely comprised of resale homes, through our extreme energy efficient offerings, innovative technology, ability to personalize our homes and by providing a home warranty. Overall, our positive results in the third quarter have strengthened our financial position, with solid improvements in nearly all of our key operating metrics, including increases in closings, averages sales prices, orders, backlog, gross margin and net earnings.
Summary Company Results
In addition to overall increased customer demand, we also attribute our improving trends to investments in new communities in desirable submarkets and our Meritage Green energy efficiency initiatives. As our results demonstrate and as buyer demand strengthens, we continue to initiate price increases in a majority of our communities, which we expect will more

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than offset construction cost increases and improve our bottom-line results in upcoming quarters. We continue to focus on growing our land positions and increasing our active community count to meet additional demand in most of our markets.
In the third quarter of 2012 our positive momentum continued as we recorded 1,204 orders and 1,197 closings, increases of 32.9% and 42.5%, respectively over the third quarter of 2011. The sustained positive trends in volume are coupled with an increase in our orders per average active community up 27.4% versus the same period in 2011 to 7.9 orders per average active community. Our improved beginning backlog and the increase in orders over the last several months both contributed to an ending backlog of 1,618 units valued at $489.5 million which we believe is indicative of increased demand and consumer confidence, and which should translate into higher revenues and profitability moving into the last fiscal quarter of 2012. While we believe our current operating results indicate a recovering and stronger housing market, we recognize that we are still operating in a volatile economic environment but are cautiously optimistic about our future operational outlook. We believe the housing market will continue to strengthen given a modestly improving overall economy.
Total home closing revenue was $334.9 million and $820.2 million for the three and nine months ended September 30, 2012, increasing 53.9% and 33.3%, respectively, from the same periods last year. The quarterly increase is mainly driven by the 357 additional closing units for the quarter ended September 30, 2012 as compared to the same period last year and was further aided by an 8.0% increase in average sales prices of $20,800, increasing total revenue by $117.3 million over prior year. For the nine months ended September 30, 2012, increased closings of 624 units were boosted by a 5.6% increase in average sales price of $14,500 as compared to the nine months ended September 30, 2011. The increased sales prices were driven primarily by a shift in order mix to higher priced states and larger homes. We reported net income of $6.8 million and $10.0 million for the three and nine months ended September 30, 2012, as compared to net loss of $3.2 million and $9.3 million for the same periods in 2011, respectively. Our quarterly and year-to-date income in 2012 included a one-time charge related to a litigation accrual of $8.7 million. Additionally, our year-to-date 2012 results include a $5.8 million loss from early extinguishment of debt and a $5.2 million tax benefit primarily due to the reversal of most of the company’s deferred state tax asset in Florida. There were no similar charges in 2011. We expect improving bottom-line results for the remainder of 2012, as indicated by our higher ending backlog, improved sales pace and average sales prices.
At September 30, 2012, our backlog of $489.5 million reflects an increase of 69.7% or $201.0 million when compared to backlog at September 30, 2011. The improvement reflects a 32.9% and 39.3% increase in unit orders in the first three and nine months of 2012, respectively, as well as higher average sales prices on home orders of 12.5% and 8.5% for the three and nine months ended September 30, 2012, respectively, as compared to the same periods a year ago. In the third quarter of 2012, we were also able to maintain a relatively low cancellation rate on home orders at 13% of gross orders as compared to 17% in the same period a year ago.
Land Closing Revenue and Gross Profit
From time to time, we may sell certain land parcels to other homebuilders, developers or investors if we believe the sale will provide a greater economic benefit to us than continuing home construction or where we are looking to diversify our land positions in the specific geography. As a result of such sales, we recognized land closing revenue of $7.8 million, and $8.8 million for the three and nine months ending September 30, 2012, respectively as compared to $100,000 for the nine months ending September 30, 2011. The majority of the land sales are related to the divestiture of assets in Nevada associated with the wind-down of our operations in the market. We also recognized impairments related to land sales in the amount of $669,000 for the nine months ending September 30, 2012, compared to $127,000 of such impairments in the prior comparable period. All of our 2012 land sale impairments related to a land sale in connection with the wind-down of our Nevada operations.
Company Actions and Positioning
As the homebuilding market stabilizes and recovers, we are focused on our main goals of re-growing our orders and revenue, generating profit and maintaining a strong balance sheet. To help meet these goals we continue to execute on the following initiatives:
Strengthening our balance sheet; recently we completed a new senior note issuance and debt tender, extending our earliest debt maturities until 2017 and completed a convertible debt transaction at an attractive 1.875% interest rate;
Generating additional working capital and improving liquidity; recently we completed an equity offering and established a revolving credit facility;
Continue to actively acquire and develop lots in markets we deem key to our success in order to maintain and grow our lot supply and active community count;
Utilizing our enhanced market research to capitalize on the knowledge of our buyers’ demands in

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each community, tailoring our pricing, product and amenities offered;
Continuing to innovate and promote the Meritage Green extreme energy efficiency program, where every new home we construct, at a minimum, meets ENERGY STAR® standards, including the recent construction of the only triple-certified homes in the country, certified by the U.S. Environmental Protection Agency, for indoor air quality, water conservation and overall energy efficiency;
Adapting sales and marketing efforts to generate additional traffic and compete with resale homes;
Focusing our purchasing efforts to manage cost increases as the economy recovers and demand rises;
Growing our inventory balance while ensuring sufficient liquidity through exercising tight control over cash flows;
Striving for excellence in construction; and monitoring our customers’ satisfaction as measured by survey scores and working toward improving them based on the results of the surveys.
We previously consolidated overhead functions in all of our divisions and at our corporate offices to hold down general and administrative cost burden and we continue to monitor such expenditures.
Additionally, we are continually evaluating opportunities for expansion into new markets that were less impacted by the homebuilding downturn over the past several years or that appear to be recovering more quickly than other markets. We are looking to redeploy our capital into projects both within our geographic footprint and through entry into new markets. In connection with these efforts, in 2011 we announced our entry into the Raleigh-Durham, North Carolina and Tampa, Florida markets and our intention to wind down operations in the hard-hit Las Vegas, Nevada market. We also recently announced entry into the Charlotte, North Carolina market with operations anticipated to commence in the last quarter of 2012.
In the third quarter of 2012, we opened 23 new communities while closing out 21 older communities, ending the quarter with 153 active communities. The relatively flat actively-selling community count is to a large extent the result of our improved sales pace in 2012, which has resulted in closing out communities at a faster pace than we anticipated. In addition, as we are acquiring more undeveloped land, a longer lead time is required to allow for development activities before our new communities are able to open for sales.
In the second and third quarters of 2012, we also took steps to strengthen our balance sheet and extend debt maturities through several debt and equity transactions. In April 2012, we concurrently issued $300.0 million of 7.00% senior notes due 2022 and redeemed all of our $285.0 million senior notes due 2015 and approximately $26.1 million of our $125.9 million of senior subordinated notes due 2017, extending our earliest debt maturities to 2017. During the third quarter of 2012, we completed an equity offering of 2,645,000 shares, generating approximately $87.1 million in net proceeds as well as established an unsecured revolving credit facility with a capacity of $125.0 million. We also issued $126.5 million in convertible senior notes due 2032 in the third quarter, generating approximately $122.3 million of net proceeds. (See Notes 5 and 8 to the accompanying unaudited consolidated financial statements for further discussion.)
We believe such initiatives help support our goals and, coupled with the improving economy and homebuilding market, allow us to be well positioned to take advantage of a full recovery as it occurs.
Critical Accounting Policies
The accounting policies we deem most critical to us and that involve the most difficult, subjective or complex judgments include revenue recognition, valuation of real estate, warranty reserves, off-balance sheet arrangements, valuation of deferred tax assets and share-based payments. There have been no significant changes to our critical accounting policies during the nine months ended September 30, 2012 compared to those disclosed in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in our 2011 Annual Report on Form 10-K.


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The composition of our closings, home orders and backlog is constantly changing and is based on a dissimilar mix of communities between periods as new projects open and existing projects wind down. Further, individual homes within a community can range significantly in price due to differing square footage, option selections, lot sizes and quality of lots (e.g. cul-de-sac, view lots, greenbelt lots). These variations result in a lack of meaningful comparability between our home orders, closings and backlog due to the changing mix between periods. The tables below present operating and financial data that we consider most critical to managing our operations (dollars in thousands):
Home Closing Revenue
 
Three Months Ended
 
Quarter over
 
September 30
 
Quarter
 
2012
 
2011
 
Chg $
 
Chg %
Total
 
 
 
 
 
 
 
Dollars
$
334,880

 
$
217,534

 
$
117,346

 
53.9
 %
Homes closed
1,197

 
840

 
357

 
42.5
 %
Avg sales price
$
279.8

 
$
259.0

 
$
20.8

 
8.0
 %
West Region
 
 
 
 
 
 
 
California
 
 
 
 
 
 
 
Dollars
$
88,748

 
$
28,708

 
$
60,040

 
209.1
 %
Homes closed
244

 
83

 
161

 
194.0
 %
Avg sales price
$
363.7

 
$
345.9

 
$
17.8

 
5.1
 %
Nevada
 
 
 
 
 
 
 
Dollars
$
4,113

 
$
4,222

 
$
(109
)
 
(2.6
)%
Homes closed
22

 
19

 
3

 
15.8
 %
Avg sales price
$
187.0

 
$
222.2

 
$
(35.2
)
 
(15.8
)%
West Region Totals
 
 
 
 
 
 
 
Dollars
$
92,861

 
$
32,930

 
$
59,931

 
182.0
 %
Homes closed
266

 
102

 
164

 
160.8
 %
Avg sales price
$
349.1

 
$
322.8

 
$
26.3

 
8.1
 %
Central Region
 
 
 
 
 
 
 
Arizona
 
 
 
 
 
 
 
Dollars
$
59,519

 
$
33,314

 
$
26,205

 
78.7
 %
Homes closed
243

 
137

 
106

 
77.4
 %
Avg sales price
$
244.9

 
$
243.2

 
$
1.7

 
0.7
 %
Texas
 
 
 
 
 
 
 
Dollars
$
104,041

 
$
102,121

 
$
1,920

 
1.9
 %
Homes closed
434

 
440

 
(6
)
 
(1.4
)%
Avg sales price
$
239.7

 
$
232.1

 
$
7.6

 
3.3
 %
Colorado
 
 
 
 
 
 
 
Dollars
$
27,639

 
$
21,500

 
$
6,139

 
28.6
 %
Homes closed
83

 
68

 
15

 
22.1
 %
Avg sales price
$
333.0

 
$
316.2

 
$
16.8

 
5.3
 %
Central Region Totals
 
 
 
 
 
 
 
Dollars
$
191,199

 
$
156,935

 
$
34,264

 
21.8
 %
Homes closed
760

 
645

 
115

 
17.8
 %
Avg sales price
$
251.6

 
$
243.3

 
$
8.3

 
3.4
 %
East Region
 
 
 
 
 
 
 
North Carolina
 
 
 
 
 
 
 
Dollars
$
14,459