Fitch Affirms Lennar's IDR at 'BB+'; Outlook Remains Positive
KEY RATING DRIVERS
The ratings for Lennar are based on the company's strong track record over the past 36-plus years, geographic diversity, customer and product focus, generally conservative building practices and effective utilization of return on invested capital criteria as a key element of its operating model. Additionally, there has been continuity in Lennar's management during this housing cycle and Fitch considers this management team to be the deepest among the public builders within its coverage.
The Positive Outlook reflects Lennar's operating performance in 2014, 2015 and so far in 2016 as well as projected full-year 2016 and 2017 financial ratios (especially leverage and coverage), solid liquidity position and favorable prospects for the housing sector during 2016 and 2017. Fitch believes that the housing recovery is firmly in place (although the rate of recovery remains well below historical levels and the recovery will likely continue to occur in fits and starts).
The ratings and Outlook for Lennar also incorporate the company's successful execution of its operating model, resulting in a steady capital structure through the cycle, including net debt/capitalization levels consistently at or below 46% (this ratio was 40% as of Aug. 31, 2016). Given the company's strong cash flow generating ability during a cyclical downturn, the company's net debt/capitalization was lowest at the height of the housing downturn at around 30% during fiscal year end (FYE) 2007 and FYE2008 (after reporting inventory impairment charges of approximately $1.9 billion between FY2006-FY2008).
Management is also executing well on its soft-pivot strategy, wherein the company is looking to tie up land with a two-three-year average life and reducing its overall land supply. This is reflected in the company's total lots controlled, which declined 6.4% year-over-year (YOY) (with lots owned decreasing 2% YOY). Based on latest-12-month (LTM) closings, Lennar controlled 6.1 years of land and owned roughly 5.0 years of land, down from the 6.9-year supply (5.2 years owned) at FYE2015 and 7.8 year supply (6.3 years owned) at FYE2014.
The recently announced acquisition of WCI Communities, Inc., as currently contemplated, slightly increases the company's leverage levels but does not affect its ratings and Outlook. Fitch expects the company will fund the merger consideration, valuing WCI's common stock at $23.50 per share or a $643 million equity value (total enterprise value of $809 million), with 50% cash and 50% Lennar stock. (Lennar has the option of varying the portions of the $23.50 per share merger consideration that will be cash and stock, including paying the entire merger consideration in cash.) The company will also assume/repay WCI's existing $250 million 6.875% senior unsecured notes due 2021. On a pro forma basis, assuming 50/50 cash and stock consideration, Lennar's net debt/capitalization will increase slightly to 41% from 40% while debt/EBITDA will rise to 3.7x from 3.6x.
WCI ACQUISITION
On Sept. 22, 2016, Lennar announced that it had entered into a definitive agreement to acquire all of the outstanding shares of WCI Communities, Inc. in a cash and stock transaction valued at $23.50 per share, representing a 37% premium to WCI's closing stock price on Sept. 21, 2016. The transaction has been unanimously approved by WCI's board. There is a 35-day go-shop period wherein the company will actively solicit, evaluate, and potentially enter into negotiations with parties that offer alternative proposals. The transaction is expected to close in December 2016 or January 2017.
The transaction will combine two of the largest homebuilders in Florida. WCI Communities, Inc. has established a leading expertise in developing amenity-rich, lifestyle master planned communities catering to move-up, active adult and second-home buyers. In the LTM period ending June 30, 2016, WCI delivered 1,118 homes with an average sales price of approximately $444,000. The transaction will include a portfolio of owned and controlled land totalling approximately 14,200 homesites located in most of the highest growth and largest coastal Florida markets.
WCI's predecessor company was founded in 1998 and filed for bankruptcy in 2008 amidst the severe housing downturn. The company had heavy exposure to high-rise / high-end condos in vacation-home and resort communities in Florida. WCI emerged from bankruptcy in September 2009. Currently, WCI only has one high-rise project, a 75-unit high-rise tower unit in Bonita Springs, Florida.
IMPROVING FINANCIAL RESULTS AND CREDIT METRICS
Lennar's homebuilding revenues during the first nine months of FY2016 (ending Aug. 31, 2016) increased 16.3% to $6.7 billion as home deliveries improved 10.1% to 18,275 and the average selling price advanced 5.8% to $362,662. The company reported homebuilding operating income of $889.8 million (13.4% of homebuilding revenues) during the FY2016 YTD period, up from $785.8 million (13.6%) during the same period last year.
The company's net debt/capitalization declined from 44% at FYE2014 to 42% at FYE2015 and 40% as of Aug. 31, 2016. Debt/EBITDA has improved from 4.0x at FYE2014 to 3.7x at FYE2015 and 3.6x for the LTM period ending May 31, 2016. FFO adjusted leverage was 6.0x at FYE2015 and is currently 4.2x. Interest coverage rose from 4.3x at the end of FY2014 to 4.7x at FYE2015 and 5.2x for the May 31, 2016 LTM period. Fitch expects these credit metrics will improve further at FYE2016 and FY2017.
LAND STRATEGY
As of Aug. 31, 2016, the company controlled roughly 159,000 lots, of which 81% were owned and the remaining lots controlled through options and joint ventures (JVs). Based on LTM closings, Lennar controlled 6.1 years of land and owned roughly 5.0 years of land. While the company continues to evaluate land acquisition opportunities, it is reducing its land supply as part of its soft-pivot strategy. At this point of the cycle, management is looking to tie up land with a two-three-year average life. Total lots controlled fell 6.4% YOY, with lots owned declining 2% YOY.
Land and development spending totalled $2.5 billion in FY2015 and a similar amount was spent during FY2014 and FY2013. During FY2016, Fitch expects the company will spend a slightly higher amount for land and development activities. (It should be noted that land and development spending as a percentage of homebuilding revenues will be lower during FY2016.) Despite the higher real estate expenditures, Fitch expects Lennar will be solidly cash flow positive during FY2016.
Fitch is comfortable with this real estate strategy given the company's strong liquidity position and management's demonstrated ability to manage its spending. Fitch expects management will pull back on spending if the current recovery in housing stalls or dissipates.
LIQUIDITY AND CASH FLOW
As of Aug. 31, 2016, Lennar had unrestricted cash of $567.7 million and about $125 million of borrowings under its $1.482 billion revolving credit facility (which has an accordion feature of up to $1.8 billion) that matures in June 2020 ($160 million of the commitment matures in June 2018). The company has meaningful debt maturities in the next two years, including $400 million of 12.25% notes due June 2017, $400 million of 4.75% notes due December 2017, $250 million of 6.95% notes due June 2018, and $275 million of 4.125% notes due December 2018. Lennar regularly accesses the capital markets and Fitch expects the company will refinance a portion of these debt maturities.
The company generated positive cash flow from operations (CFFO) of $400 million for the May 31, 2016 LTM period after reporting negative CFFO of $420 million during FY2015 and negative $789 million during FY2014. Fitch expects the company will generate positive CFFO of $300 million - $500 million during FY2016 and perhaps a higher amount in FY2017.
AGGRESSIVE GROWTH STRATEGY
Lennar has grown substantially over its history, especially from the beginning of the 1990s until 2005. Although internal growth has been substantial, a meaningful portion of its growth has resulted from acquisitions - both large and small. In some cases the acquisitions were of homebuilders. In other instances large tracts of land were purchased. The smaller acquisitions were typically acquired with cash. The larger acquisitions were typically funded by debt and stock.
The acquisition is often motivated by Lennar's desire to enter new markets or enhance its position in existing markets. Management firmly believes that dominant size in major metropolitan markets as well as on a national basis offers key competitive advantage, especially in a consolidating industry. The proposed acquisition of WCI Communities appears to fit well with Lennar's growth plan, as WCI provides the company with a solid brand name as well as land holdings in attractive coastal Florida markets.
BROAD GEOGRAPHIC AND PRICE POINT DIVERSITY
Lennar was the second largest U. S. homebuilder in 2015 and has been for the past three years. More importantly, according to Builder Magazine, the company was the largest builder during 2015 in 7 of the 20 largest metro markets in the country and had the top 10 position in 31 of the 50 largest markets. It is one of the most geographically diverse builders, with operations in more than 40 markets across 17 states. Lennar has particular focus on markets in Florida, Texas and California. Lennar is the second largest builder in Houston with roughly 2,452 home deliveries (9.4% market share according to Builder Magazine) during 2015 (about 9%-10% of Lennar's deliveries). Fitch is concerned about the impact of continued low oil prices on the economy of this metro area.
In 2015, approximately 25% of sales were to the first-time homebuyer segment, half to first-time move-up customers and the balance was a mix of second time move-up, luxury and active adult (the acquisition of WCI further expands Lennar's position in this buyer segment).
MODERATE HOUSING RECOVERY CONTINUES
After four years of a moderate recovery and with land and labor constraints, it is unlikely that housing will accelerate into a V-shaped recovery. But a continuation of a multi-year growth is in the offing, and is supported by demographics, pent-up demand and attractive affordability as well as steady, albeit modest, easing in credit standards.
Though far from spectacular, the 2016 spring selling season was solid, which augurs well for the full year. Fitch is projecting single-family starts to expand 11.5% in 2016 and multifamily volume to gain about 4%. Total starts would be roughly 1.2 million (up 8.8%). New home sales should improve about 14.6%, while existing home sales rise 3%. Average and median home prices should rise 3.0%-3.5%, higher than earlier forecasts because of still tight inventories.
The year 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. Demand will continue to be affected by some narrowing of affordability, diminished but persistent and widespread negative equity, relatively challenging mortgage-qualification standards and lot shortages. A tight labor supply will also constrain production.
SOME EROSION IN AFFORDABILITY
The most recent Freddie Mac 30-year average mortgage rate (Sept. 29, 2016) was 3.42%, down 6 bps sequentially from the previous week and 11 bps higher than the all-time record low of 3.31%. Of course, current rates are still well 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 157.1 in July 2016.
Erosion in affordability is likely to continue as interest rates likely head higher later in 2016 (as the economy strengthens). Home price inflation should moderate a bit this year reflecting the mix of sales shifting more to first-time homebuyer product. However, average and median home prices should still rise within a range of 3.0%-3.5% this year, pressuring affordability.
DIVERSE REAL ESTATE RELATED ACTIVITIES
Lennar's primary business is traditional homebuilding. It also has a financial services operation that provides mortgage financing, title and other insurance and closing services. The company has also diversified its real estate activities beyond traditional residential single-family construction to include commercial real estate investment management and financing (Rialto), multifamily construction (Lennar Multifamily) and large scale master-planned communities (FivePoint Communities). During the 2016 YTD period, these segments generated roughly 12% of consolidated operating earnings (before corporate general and administrative expenses).
The diversification into these other real estate related activities during the housing downturn allowed the company to leverage the skills of its management team and take advantage of opportunities to supplement its homebuilding operations and grow the business. Over time, and as these ancillary businesses mature, Lennar intends to revert back to a pure-play homebuilder (with a financial services operation to support its homebuilding operations) and perhaps have these individual businesses operate independently. (Lennar had a similar commercial real estate investment management operation [LNR Property Corporation] in the 1980s that was spun off in 1997.)
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for Lennar include:
-- Industry single-family housing starts improve 11.5%, while new and existing home sales grow 14.6% and 3.0%, respectively, in 2016;
-- Lennar's homebuilding revenues increase 14%-16%, while homebuilding EBITDA margins decline 50 bps-100 bps during FY2016;
-- The company's net debt/capitalization is below 40% while debt/EBITDA approximates 3.0x and interest coverage reaches 5.8x by FYE2016;
-- Lennar generates CFFO of $300 million to $500 million during FY2016 and perhaps a higher amount in FY2017;
--The company completes the WCI acquisition during FY2017 with 50% cash and 50% stock consideration;
-- Lennar maintains an adequate liquidity position (well above $1 billion) with a combination of unrestricted cash and revolver availability.
RATING SENSITIVITIES
Fitch would consider upgrading Lennar's IDR to investment grade if it shows further steady improvement in credit metrics (such as net debt/capitalization consistently approaching or below 40%), while maintaining a healthy liquidity position (in excess of $1 billion in a combination of cash and revolver availability) and continues generating consistent positive cash flow from operations as it moderates its land and development spending. Fitch would also take into account the amount of the cash portion of the consideration to be paid for the WCI acquisition.
The Rating Outlook could be revised to Stable if there is sustained erosion of profits and cash flow, resulting in margin contraction and weakened credit metrics, including net debt/capitalization consistently between 45%-50%. The Outlook could also be revised to Stable if the company undertakes a more aggressive land and development strategy, debt-funded acquisition, or share buyback program that results in higher debt levels and weaker credit metrics, including net debt/capitalization sustained between 45%-50%.
Negative rating actions may be considered if there is sustained erosion of profits due to either weak housing activity, meaningful and continued loss of market share, and/or ongoing land, materials and labor cost pressures (resulting in margin contraction and weakened credit metrics, including net debt/capitalization sustained above 50%) and Lennar maintains an overly aggressive land and development spending program that leads to consistent negative CFFO, higher debt levels and diminished liquidity position. In particular, Fitch will be focused on assessing the company's ability to repay debt maturities with available liquidity and internally generated cash flow.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings for Lennar Corporation:
--Long-Term IDR at 'BB+';
--Senior unsecured debt at 'BB+/RR4';
--Unsecured revolving credit facility at 'BB+/RR4'.
The Rating Outlook is Positive.
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