Fitch Affirms Meritage Homes' IDR at 'BB-'; Outlook Revised to Positive
Fitch Ratings has affirmed the ratings for Meritage Homes Corporation (NYSE: MTH), including the company's Issuer Default Rating (IDR) at 'BB-'. The Rating Outlook has been revised to Positive from Stable. A complete list of rating actions follows at the end of this release.
KEY RATING DRIVERS
The 'BB-' rating for MTH is influenced by the company's execution of its business model, conservative land policies, geographic diversity and healthy liquidity position. The ratings and Outlook also take into account Fitch's expectation of further moderate improvement in the housing market in 2016 and 2017 and share gains by MTH and hence volume outperformance relative to industry trends even as the market, to a degree, re-focuses on entry level/first time buyer housing (MTH's new emphasis).
The Outlook revision is prompted by Fitch's expectation that MTH will approach the 3.5x leverage trigger for an upgrade by year-end 2016 and then sustain below that level in 2017 and 2018. Coverage ratios should steadily improve over the next three years as well. Another trigger, liquidity, is projected to be well above Fitch's $350 million minimum targets during the next three years. The company's new thrust into the entry level plus customer segment should benefit from a steady upsurge in demographics and customer demand. Finally, Fitch is becoming more confident that this housing up-cycle is likely to last more than another two years.
MTH's sales are reasonably dispersed among its 21 metropolitan markets within nine states. During 2015, the company ranked among the top 10 builders in such markets as Houston, San Antonio and Austin, TX; Orlando, FL; Phoenix, AZ; Denver, CO; San Francisco/Oakland/Fremont and Sacramento, CA; and Nashville, TN. The company also builds in the Central Valley, Inland Empire, and Riverside/San Bernardino CA; Tucson, AZ; Tampa, FL; Greenville, SC and Raleigh-Durham and Charlotte, NC. MTH entered the Nashville, Tennessee market with its August 2013 acquisition of Phillips Builders and entered Atlanta, GA and Greenville-Spartanburg, SC with the acquisition of Legendary Communities in 2014.
Fitch estimates that currently about 20% of MTH's sales are to entry level buyers; two-thirds of the total are generated from first and second time trade-up customers; and the balance divided among active adult buyers and luxury home buyers.
The entry level/first time home buyer has typically represented about 40% of total industry housing sales (new and existing). During the housing recovery that segment has remained at approximately 30% of the total. Fitch expects this customer segment will be more vibrant during the remainder of the upcycle and help spur growth for MTH. The company has been buying land over the past year and a half and starting to design and offer town homes and smaller detached dwellings to serve the more affluent entry level/first time buyer. The company's high energy efficient standards will be helpful in marketing to this customer segment.
IMPROVING HOUSING MARKET
Housing activity ratcheted up more sharply in 2015 as compared with 2014 with the support of a generally robust economy throughout the year. Considerably lower oil prices restrained inflation and left American consumers with more money to spend. The unemployment rate moved lower (5% in 2015). Credit standards steadily, moderately eased throughout 2015. Demographics were somewhat more of a positive catalyst. Single-family starts rose 10.3% to 715,000 as multifamily volume grew 11.8% to 397,000. Total starts were just in excess of 1.1 million. New home sales increased 14.6% to 501,000. Existing home volume approximated 5.250 million, up 6.3%.
New home price inflation slimmed with higher interest rates and the mix of sales shifting slightly more to first time homebuyer product. Average new home prices increased 3.7%, while median prices rose 4.7%.
Sparked by a similarly growing economy the housing recovery is expected to continue in 2016. Although interest rates are likely to be higher, a robust economy, healthy job creation, demographics, pent-up demand, steep rent increases, and further moderation in lending standards should stimulate housing activity. More of those younger adults who have been living at home should find jobs and these 25- to 35-year-olds should provide some incremental elevation to the rental and starter home markets. First time buyers should be able to take advantage of less expensive mortgage insurance and lenders offering low downpayment programs. Housing starts should approximate 1.21 million with single-family volume of 0.797 million and multifamily starts of 0.413 million. New home sales should reach 574,000, up 14.6%. Existing home volume growth should be low-single digit (+3%).
Average and median home prices should rise 3%-3.5%, higher than earlier forecasts because of still tight inventories.
2017 could prove to be almost a mirror image of 2016. Real economic growth should be similar to this year, although overall inflation should be more pronounced. Interest rates will rise further but demographics and employment growth should be at least as positive in 2017. First time buyers will continue to gradually represent a higher portion of housing purchases as qualification standards loosen further. Land and labor costs will inflate more rapidly than materials costs. Housing starts should total 1.311 million. Single-family volume should expand 10% to 877,000, while multi-family starts grow 5% to 434,000. New home sales should reach 640,000, up 11.5%. Existing home sales should gain 4% to 5.625 million.
Average and median home prices should expand 2.0-2.5% in 2017.
SOME EROSION IN HOME AFFORDABILITY
The most recent Freddie Mac 30 year average mortgage rate (June 9, 2016) was 3.6%, down 6 bps sequentially from the previous week and 19 bps higher than the average rate during the month of January 2013 (3.41%), a low point for mortgage rates. Current rates are still below historical averages and help moderate the effect of much higher home prices during the past few years. Income growth has been (and may continue to be) relatively modest.
Nevertheless, there has been some lessening of affordability as the upcycle in housing has matured. The Realtor Association's composite affordability index peaked at 207.3 in the first quarter of 2012, averaged 176.9 in 2013, 165.8 in 2014, 163.9 in 2015, and was 162.4 in April 2016.
Erosion in affordability is likely to continue as interest rates likely head higher in 2016 (as the economy strengthens). Fitch projects that mortgage rates will average up to 20 bps higher in 2016. Home price inflation should moderate a bit this year reflecting the higher interest rates and the mix of sales shifting more to first time homebuyer product. However, average and median home prices should still rise within a range of 3%-3.5% this year, higher than earlier forecasts because of still tight inventories, but still pressuring affordability.
TEXAS AND OIL
The much lower oil prices and oil industry lay-offs are of concern. Texas, MTH's largest state market, represented 37.9% of home closings and 31.9% of home sales revenues in calendar 2014. The share of closings and home sales revenues in 2015 were 31% and 27.9%, respectively. Texas home closings fell 8.9% yoy in 2015, and much of that occurred in Houston. However, Texas home closings rose 5.7% in 1Q16, and state home sales revenues improved 4.8%. As of March 31, 2016, Texas unit backlog was up 9.5%, and the value of backlog was 18.9% ahead of a year ago.
At present MTH's strongest markets in Texas are Dallas and San Antonio, followed by Austin and Houston. The Houston market is most vulnerable to oil and gas, but employment in that sector is concentrated in certain submarkets. Other industries, notably health, continue to generate jobs in Houston. The Houston and Texas economies are considerably more diversified than during past energy downturns. Only 3%-6% of MTH's Texas home buyers were employed in oil and gas.
MTH employs conservative land and construction strategies. The company typically options or purchases land only after necessary entitlements have been obtained so that development or construction may begin as market conditions dictate.
Under normal circumstances MTH has used lot options, and that is expected to be the future strategy in markets where it is able to do so. Use of non-specific performance rolling options gives the company the ability to renegotiate price/terms or void the option, which limits downside risk in market downturns and provides the opportunity to hold land with minimal investment.
However, as of March 31, 2016, only 31.8% of MTH's lots were controlled through options. This is a lower than typical percentage as there are currently fewer opportunities to option lots and, in certain cases, the returns for purchasing lots outright are far better than optioning lots from third parties.
Total lots controlled, including those optioned, were 28,429 at March 31, 2016. This represents a 4.3-year supply of total lots controlled based on trailing 12-months deliveries. On the same basis, MTH's owned lots represent a supply of 2.9 years.
MTH began to increase its overall land position during the middle of 2010 following four years of declining lot supply. The company spent roughly $236 million on land purchases during 2010, compared with $182 million during 2009. In 2011, MTH invested $193 million in land and $54 million in development. The company spent $480 million on land and development in 2012. In 2013 MTH expended $594 million on real estate including $228 million on development activities. In 2014, the company committed $705 million to land and development. During 2015, MTH spent $490 million on land and $220 million on development activities. This year the company may invest approximately $900 million in real estate activities, excluding about $200 million in potential land banking.
MTH successfully managed its balance sheet during the severe housing downturn, allowing the company to accumulate cash and pay down its debt as it pared down inventory. The company had unrestricted cash and equivalents of $172.2 million at March 31, 2016. The company's debt totaled $1,119.4 million at the end of the first quarter 2016.
MTH's debt maturities are well-laddered, with the next debt maturity in March 2018, when its 4.50% $175 million senior notes become due.
MTH has been willing to occasionally issue equity. It issued about $90 million of common equity during the 3Q 2012. More recently, in January 2014 the company issued approximately 2.53 million shares of common stock for net proceeds of approximately $110 million to use for working capital, potential expansion into new markets and/or expansion of existing markets, including the possible acquisition of other homebuilders or assets, and general corporate purposes.
In July 2012, MTH entered into an unsecured revolving $125 million credit facility. The company has occasionally increased the credit facility and extended its maturity date. Most recently, in the first quarter of 2015, MTH increased the capacity to $500 million. In July 2015, the maturity date of the credit facility was extended to July 9, 2019, and the accordion feature was amended to permit the size of the facility to be increased by $100 million up to a maximum of $600 million.
Leverage improved during 2013 and 2014 but lost ground in 2015. The ratio edged down to 4.0x at the end of the first quarter of 2016 from 4.1x at 4Q end 2015. Leverage was 7.9x in 2012, 3.9x in 2013 and 3.5x in 2014. Interest coverage, which was 1.7x at Dec. 31, 2011, improved in 2012 to 4.3x and to 4.7x in 2013 and then decreased in 2014 (4.5x) and 2015 (4.1x) - reaching 4.0x at March 31, 2016. Fitch expects leverage of 3.6x and coverage of 4.7x at the end of 2016. These metrics should show consistent improvement in 2017 and 2018 as well.
Like most other builders in the agency's coverage, Fitch expects MTH will be cash flow negative in 2016. The company was CFFO negative $81.8 million in the March 2016 quarter and on an LTM basis was CFFO negative by $48 million. In 2015, 2014, 2013, 2012 and 2011, the company was negative CFFO by $3.3 million, $211.2 million, $86.3 million, $220.5 million and $74.1 million, respectively.
Fitch currently expects MTH will be CFFO negative about $75 million in 2016. The company is expected to increase its land and development spending in 2016 influencing cash flow. But as the cycle matures, real estate spending is likely to level out or decline in 2017/2018 as profits continue to rise and consequently cash flow likely will turn positive.
Fitch is comfortable with this real estate strategy given the company's liquidity position and debt maturity schedule. Fitch expects MTH over the next few years will maintain liquidity (consisting of cash and investments and the revolving credit facility) of at least $350 million, a level that Fitch believes is appropriate given the challenges/risks still facing the industry.
Fitch's key assumptions within its rating case for the issuer include:
--Industry single-family housing starts improve 11.5%, while new and existing home sales grow 14.6% and 3%, respectively, in 2016;
--MTH's revenues increase high teens and homebuilding EBITDA margins decrease about 30 bps this year, largely due to increased land and labor costs;
--The company's debt/EBITDA approximates 3.6x and interest coverage is about 4.7x by year-end 2016;
--MTH spends approximately $900 million on land acquisitions and development activities this year and will also contract with land bankers $200 million or more for access to additional developed land;
--The company maintains a healthy liquidity position (roughly $625 million with a combination of unrestricted cash and revolver availability).
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.
Positive rating actions may be considered if the recovery in housing is better than Fitch's current outlook and shows durability; MTH shows sustained improvement in credit metrics (such as homebuilding debt to EBITDA consistently below 3.5x). The company would be expected to maintain a healthy total liquidity position consisting of cash, short term investments and credit facility availability (at or above $350 million) through the cycle.
A negative rating action could be triggered if the industry recovery dissipates; 2015 and 2016 revenues drop significantly, while pretax profitability approaches 2012/2011 levels; and MTH's liquidity position falls sharply, perhaps below $250 million as the company maintains an overly aggressive land and development spending program.
FULL LIST OF RATINGS
Fitch has affirmed the following ratings:
Meritage Homes Corporation
--Long-term IDR at 'BB-';
--Senior unsecured debt at 'BB-/RR4'.
The Rating Outlook is revised to Positive from Stable.
The Recovery Rating of '4' for Meritage Homes' unsecured debt supports a rating of 'BB-', and reflects average recovery prospects in a distressed scenario.
Additional information is available on www.fitchratings.com
Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:
--Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation and interest expense included in cost of sales and also excludes impairment charges and land option abandonment costs.
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
Dodd-Frank Rating Information Disclosure Form
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