Fitch Affirms Toll Brothers' IDR at 'BBB-'; Outlook Stable

NEW YORK--(BUSINESS WIRE)--

Fitch Ratings has affirmed its ratings for Toll Brothers, Inc. TOL, including the company's Issuer Default Rating (IDR) at 'BBB-'. The Rating Outlook is Stable.

A complete list of rating actions follows at the end of this release.

KEY RATING DRIVERS

Toll's ratings and Outlook reflect the company's well-entrenched market position as the pre-eminent public builder of luxury homes, the successful execution of its operating model which has produced one of the better margins within the industry over a cycle, and relatively stable debt-protection measures despite significant erosion in profitability during the extended downside of this cycle. The acquisition of Shapell's substantial, unique land position is likely to be very rewarding over the next few years and will noticeably bolster Toll's market share within California. The company's liquidity position provides a buffer and supports the current ratings.

Risk factors include the cyclical nature of the homebuilding industry; the volatility in the value of Toll's extensive land holdings (some of which will be developed over an extended period of time); and the company's primary focus on the luxury housing segment of the market which, although diversified geographically and by product type across many niches within the urban and suburban up-scale market, is not as broad as the first-time and first-step trade-up segments.

Industry challenges (although somewhat muted) remain, including restrictive credit qualification standards and limited availability of 'A' location lots in certain markets.

Future ratings and Outlooks will be influenced by broad housing market trends as well as company-specific activity, such as trends in land and development spending, general inventory levels, speculative inventory activity (including the impact of high cancellation rates on such activity), gross and net new-order activity, debt levels and especially free cash flow trends and uses, and the company's cash position.

THE INDUSTRY

Housing metrics all showed improvement in 2013. However, what began as an untypically moderate housing recovery has decelerated further since late 2013. For the first nine months of 2014, existing home sales fell 4.9%, while new home sales grew 1.7%. Single-family housing starts increased 3.8% during the January-September year-to-date (YTD) period.

Single-family starts in 2014 are now projected to improve 2.9% to 636,000 as multifamily volume grows 17.5% to 361,000. Thus, total starts this year should approximate 1 million. New home sales are forecast to edge up almost 1.5% to 436,000, while existing home volume is likely to decline 6% to 4.785 million due to fewer distressed homes for sale and limited inventory.

New home price inflation should moderate in 2014, at least partially because of higher interest rates. Average and median new home prices should rise about 3.5% in 2014.

Housing activity is likely to ratchet up more sharply in 2015 with the support of a steadily growing economy throughout the year. The unemployment rate should continue to move lower (averages 5.8% in 2015). Credit standards should steadily, moderately ease throughout next year.

Demographics should be more of a positive catalyst. More of those younger adults who have been living at home should find jobs and these 25-35 year olds should provide some incremental elevation to the rental and starter home markets. Single-family starts are forecast to rise about 18% to 750,000 as multifamily volume expands about 7% to 386,000. Total starts would be in excess of 1.1 million. New home sales are projected to increase 18% to 515,000. Existing home volume is expected to approximate 5.025 million, up 5%.

New home price inflation should further taper off with higher interest rates and the mix of sales shifting more to first time homebuyer product. Average and median home prices should increase 2.2%-2.7%.

As Fitch noted in the past, the housing recovery will likely occur in fits and starts.

THE SHAPELL ACQUISITION

On Feb. 4, 2014, Toll completed its acquisition of Shapell Industries, Inc. Pursuant to the purchase agreement, Toll acquired, for cash, all of the equity interests in Shapell from Shapell Investment Properties, Inc. (SIPI) for an aggregate purchase price of $1.60 billion. Toll acquired the single-family residential real property development business of Shapell, including a portfolio of approximately 4,950 home sites in California, some of which Toll has sold and may continue to sell to other builders. This acquisition provides Toll with a premier California land portfolio including 11 active selling communities, as of the acquisition date, in affluent, high-growth markets: the San Francisco Bay area, metro Los Angeles, Orange County, and the Carlsbad market.

Toll did not acquire apartment and commercial rental properties owned and operated by Shapell or Shapell's mortgage lending activities relating to their home building operations.

Toll financed the acquisition with a combination of $370 million of borrowings under its $1.035 billion revolving credit facility, $485 million from a term loan facility, as well as with $815.7 million in net proceeds from debt and equity financings completed in November 2013. At July 31, 2014, Toll had repaid the $370 million of borrowings under its unsecured revolving credit facility.

Toll has been successfully operating in California since 1994 and knows the state's housing markets. California has historically represented approximately 9% of Toll's consolidated annual closings with the company's California average delivered prices 50% above Toll's corporate average price. The acquisition of Shapell is basically a land buy. The addition of Shapell added scale in top locations in both northern and southern California. And the industry-wide supply of quality California lots is scarce. Toll's inventory balance in California had been steadily declining until a few quarters before the Shapell acquisition.

OPERATING ENVIRONMENT

Toll Nine Months 2014 Financial and Operating Results

--Home sales revenue for the first nine months of 2014 increased 57.1% to $2,560.9 million as home deliveries expanded 33% to 3,590 and the average sales price improved 18.1% to $713,346.

--Gross profit margins, excluding the effect of inventory impairment charges, grew 186 basis points (bps) to 21.54% during the first nine months of 2014. Also, excluding interest expense the gross margin reached 25.12% in 2014, up from 24.09% in 2013. The 2014 year-to-date gross profit margin was influenced by a change in product mix/areas to higher margin areas, lower interest and increased prices of homes delivered in the fiscal 2014 period, as compared to the fiscal 2013 period, offset, in part, by an increase in cost of sales of approximately 1.2% due to the application of purchase accounting for the homes sold from the Shapell acquisition and 0.3% due to higher inventory impairment charges and write offs taken in the fiscal 2014 period, as compared to the fiscal 2013 period.

--S,G&A expense increased 26.6% to $312.2 million. S,G&A expense as a percentage of home sales decreased to 12.19% from 15.12%.

--Toll reported corporate pretax profits of $316 million for the first three quarters of 2014 versus $117.5 million for the same period in 2013. Included in these losses are impairment charges totaling $9.9 million and $2 million for the first nine months of 2014 and 2013, respectively. Year-to-date net income was $208.5 million in 2014 and $75.7 million in 2013.

--Third quarter 2014 net orders of 1,324 were down 5.8%, and were below peer results for the calendar third quarter. Net orders for the nine months of 2014 were 3,989, down 3.4%. Note: it takes Toll nine months, on average, to deliver a home from the time a buyer signs a contract. The third quarter cancellation rate was 6.6% compared to 4.6% in fiscal year (FY) 2013's third quarter.

--Toll ended the third quarter with 4,204 homes in backlog at an average sales price of $737,298 and a total value of $3,099.6 million. This compares to 4,001 homes in backlog with an average sales price of $708,572 and a total value of $2,835 million.

--As of July 31, 2014, Toll's debt to capitalization was 46.4%. Net debt to capitalization was 43.3%. Debt-to-latest 12 months (LTM) EBITDA was 5.3x at the end of the third quarter 2014. Interest coverage as of July 31, 2014 was 3.9x.

LAND STRATEGY

During the past five years, Toll added to its land position, supported by its strong liquidity. During the third quarter (ended July 31, 2014), the company's lot count increased by 1,856 lots year-over-year. At the end of the third quarter, Toll controlled 49,037 lots, 78.1% of which are owned with the remaining 21.9% controlled through options. This represents a 9.7-year supply of total lots controlled and a 7.6-year supply of owned land based on trailing 12-month deliveries. Because of current lower absolute volumes, the company's lot position is higher than the eight to nine year land supply (four to six years of owned lots) that the company had during the 1996-2008 period.

The company spent $560 million on land and development in fiscal 2010, $472 million in 2011 and $500 million on land and $245 million on development in 2012. And Toll expended about $1 billion for land and $350 million on development activities in 2013. Fitch forecasts that Toll will spend $600 million on land and $500 million on development activities in 2014. (This does not include the $1.6 billion spent on the Shapell acquisition.) Fitch is tentatively projecting about $1.1 billion for land and development spending in 2015.

Despite its long land position, the company continues to look for opportunities to tie-up land at attractive prices. Fitch is comfortable with this strategy given the company's 47-year track record, cash and liquidity position, debt maturity schedule, proven access to the capital markets, and management's demonstrated discipline in pulling back on its land and development activities and improving liquidity as the economy and housing contract. The company exhibited that discipline during the last housing downturn and during the severe housing contractions in the late 1980s and early 1990s.

LIQUIDITY AND CREDIT METRICS

Toll successfully managed its balance sheet during the severe housing downturn, allowing the company to accumulate cash as it pared down its inventory. At July 31, 2014, Toll had unrestricted cash and equivalents of $374.6 million and marketable securities totaling $12 million.

Negative cash flow is typical in the early stages of a housing recovery for most of the large public builders. Toll reported negative cash flow from operations in fiscal 2013 ($569 million), as the company continued its land acquisition activities. For the first nine months of fiscal 2014, cash flow was positive $38.6 million.

For fiscal 2014, Fitch expects the company to be cash flow positive (in excess of $200 million). However, cash flow is projected to again be negative in fiscal 2015.

In addition to its strong cash position, Toll has access to a $1.035 billion revolving credit facility that matures in August 2018. Up to 75% of the aggregate credit commitment is available for letters of credit. The credit facility has an accordion feature which could increase the credit facility up to a maximum aggregate amount of $2 billion. At July 31, 2014, Toll had no outstanding borrowings under the credit facility and had outstanding letters of credit of about $94.7 million. As part of the Shapell acquisition, Toll borrowed $370 million under the credit facility on Feb. 3, 2014, all of which was repaid as of July 31, 2014. At the end of the third quarter, the company had sufficient room under the facility's financial covenants.

Toll had $3.29 billion of debt as of July 31, 2014. Toll's debt maturities are well laddered, with the most current maturities $300 million maturing in May 2015 and $400 million due in October 2017.

Leverage has typically been 46% or lower as of fiscal year end over the past 10 years. At the end of the third quarter, leverage as measured by homebuilding debt-to-total capitalization was 46.4%. Taking into account its unrestricted cash position and marketable securities, net debt-to-capitalization was 43.3%. These leverage ratios are appropriate for the rating category, taking into account Toll's cash flow generation and operating risk profile.

The company's inventory-to-net-debt ratio, at present 2.3x, has consistently remained in excess of 2x, providing a healthy buffer following the recent housing downturn.

OTHER INCOME STREAMS

Outside of its traditional homebuilding activities, Toll has cultivated other real estate activities, particularly during the past six years. The proceeds of these activities generated $86.6 million of other and joint venture (JV) income through the first nine months of fiscal 2014 and have averaged more than $50 million for the last six years. The JV activities consist of land sales and development, a portion of City Living (condos for sale) and Apartment Living (rental). Other income includes land sales and development, Apartment Living, and ancillary businesses such as Gibralter Capital, TBI Mortgage, Golf Course Development Management, Toll Landscaping, Security and Title.

RATING SENSITIVITIES

The ratings could be downgraded if:

--Toll does not realize the anticipated cash generation in 2014/2015 from Shapell asset and backlog sales with resulting debt reduction and/or the recovery in housing dissipates;

--Toll's 2015 revenues drop sharply while pretax profits approach break-even levels;

--Toll maintains an overly aggressive land and development spending program that leads to consistent and significant negative quarterly cash flow from operations and meaningfully diminished liquidity position (perhaps below $500 million).

Toll's ratings are constrained in the intermediate term because of relatively high leverage metrics. However, a Positive Outlook may be considered if the recovery in housing is significantly better than Fitch's outlook and the company shows meaningful improvement in credit metrics (such as homebuilding debt-to-LTM EBITDA levels approaching 2.0x) while maintaining a healthy liquidity position (above $1 billion with a combination of cash and revolver availability). Of course, the debt associated with the Shapell acquisition would need to be largely repaid.

Fitch has affirmed the following ratings for Toll with a Stable Outlook:

--IDR at 'BBB-';

--Senior unsecured debt at 'BBB-'.

Additional information is available at 'www.fitchratings.com'.

Applicable Criteria and Related Research:

--'Corporate Rating Methodology' (May 28, 2014);

--'Liquidity Considerations for Corporate Issuers' (June 12, 2007).

Applicable Criteria and Related Research:

Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=749393

Liquidity Considerations for Corporate Issuers

http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=328666

Additional Disclosure

Solicitation Status

http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=918255

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