OREANDA-NEWS. Fitch Ratings has revised Financiere Gaillon 8's (FG8) Outlook to Negative from Stable. Its Long-term Issuer Default Rating (IDR) is affirmed at 'B' and its EUR370m senior unsecured notes at 'B-' with a Recovery Rating of 'RR5'.

FG8 is a holding company with its sole asset an 88% stake in Kaufman and Broad (K&B), one of the largest house builders in France with a solid operating track record.

While K&B has been performing reasonably well despite the harsh French housing market, the Negative Outlook reflects an increase in leverage resulting from lower funds from operations (FFO), and uncertainty regarding the timing of deleveraging. In 2014 K&B was able to maintain its EBITDA as the French housing market dropped below 300,000 new homes (315,000 in 2013), but other items before FFO (taxes, interests and dividend to minorities) rose sharply. While Fitch was expecting those expenses to rise, the increase was either sharper or earlier than previously thought. As a result FG8's FFO gross leverage and interest cover rose above our rating guidelines.

For the rating outlook to be revised to stable, Fitch will await evidence of a FFO recovery as K&B's EBITDA rebounds following an expected improvement of the French housing market.

KEY RATING DRIVERS

Higher Leverage
FG8 managed to slightly reduce its net debt in 2014. However, FFO decreased substantially leading to FFO adjusted gross leverage rising above the 6.5x negative rating guideline. FFO was negatively impacted by taxes increasing earlier than initially forecast, exceptionally high cash interest expenses and higher dividend paid to minorities. While we expect interest expenses to decline, deleveraging will mostly hinge on K&B's ability to grow its EBITDA.

Lacklustre French Market Recovery
Through the cycle the French housing market has shown less volatility than other European markets in both volume and price. Following a recovery in 2010 and 2011, driven by favourable tax regimes and low mortgage rates, 2013 and subsequently 2014 marked a low point in volumes of new houses. A slow recovery is expected for 2015 onwards, helped by decreasing interest rates and favourable government policies.

Low Margin Volatility
K&B has below-average margins compared with other European house builders, although this is a function of a lower-risk house building business model. K&B's current policy is to maintain pre-sales rates above 60%, limiting downside price risk and improving working capital. Higher pre-sales ensure higher customer stage payments by the time large cash outflows are required for land acquisition. In France, house builders such as K&B use land options rather than outright acquisition of land bank. These options are typically only exercised if planning permission and a high pre-sales rate are obtained.

Fairly Low Working Capital
Land options limit development and volume risk, allowing K&B to cancel a project with minimal cash outflows. K&B has one of the lowest working capital requirements in the sector with a working capital/turnover ratio below 10% in 2014. However, during 2007 and 2008 this ratio reached 32%, primarily driven by a lower pre-sales rate of around 30%, meaning lower customer payments funding working capital requirements.

Maintaining Financial Discipline
K&B's management has a track record of maintaining high pre-sale rates. In a growth scenario with strong house price inflation the trade-off between profitability and pre-sales becomes more evident. Increased margins can be achieved in a rising price environment by lowering pre-sale rates, albeit at the increased risk of exposing more working capital to a potential downturn. Any reversal of K&B risk management's policies would be viewed as a rating-negative.

Modest Diversification
K&B is primarily focused on apartments across France, albeit skewed towards the Paris suburbs. Over the past decade it has remained a top five player with a stable market share of around 6%. The customer base is diversified across three broad groups, including institutional investors, individual investors (second home) and owner-occupiers (primary residence), limiting dependence on any one group. However, K&B remains a price taker and volumes are inherently linked to the French housing market, although structural under-supply provides long-term support.

KEY ASSUMPTIONS

Fitch's key assumptions within our rating case for the issuer include:
- Some recovery of the French housing market from 2015, supported by decreasing cost of borrowing and government initiatives
- K&B to maintain its market share and to grow its order book as the market recovers
- A stable gross margin and improving EBITDA margin
- K&B to pay a yearly dividend matching FG8's expenses

RATING SENSITIVITIES

Positive: Future developments that may, individually or collectively, lead to a revision of the Outlook to Stable include:
- FFO adjusted gross leverage falling to below 6.5x and FFO interest cover rising above 2.0x on a sustained basis
- Dividend cover (K&B FCF/dividend up-streamed to FG8) above 1.25x on a sustained basis
-Maintaining prudent development with pre-sale rates of at least 50% and working capital/turnover ratio below 20%
- Improving trend of the French housing market and K&B's positioning

Negative: Future developments that could lead to negative rating action include:
- FFO adjusted gross leverage rising above 6.5x and FFO interest cover below 2.0x on a sustained basis
- Evidence of weakening risk management policies with pre-sale rates falling and increasing working capital/turnover ratio to above 20%, impacting liquidity
- Dividend cover (K&B FCF/dividend up-streamed to FG8) below 1.25x on a sustained basis

LIQUIDITY AND DEBT STRUCTURE

Following last year's debt refinancing, both FG8 and K&B have no material debt maturities over the next four years. Liquidity is satisfactory with a high level of cash on balance sheet providing a buffer against seasonal working capital requirements that can be as high as EUR150m throughout the year.

FG8's sole financial debt is a EUR370m bond maturing in 2019 while the debt at the K&B level consists of a term loan with a 4.3 year average maturity (up from 2.1 years in 2013). A further working capital facility of EUR50m provides additional liquidity.