Fitch Affirms KB Home's IDR at 'B '; Outlook Stable
A complete list of ratings actions is provided at the end of this release.
KEY RATING DRIVERS
The ratings for KBH are based on the company's geographic diversity, customer and product focus, conservative building practices and effective utilization of return on invested capital criteria as a key element of its operating model. The company did a good job in reducing its inventory exposure and generating positive operating cash flow during the severe industry downturn. Since its peak in the third quarter of 2006 (3Q06), homebuilding debt has been reduced from \\$7.89 billion to \\$2.82 billion.
Early in the recovery KBH was somewhat conservative in committing to incremental land purchases. It has accelerated its spending more recently but should not become stressed so long as it maintains its minimum return parameters for real estate that it purchases. If the economy and housing were to experience a downturn in 2015 or 2016, KBH has access to the liquidity to sustain itself, primarily using its current cash position and revolving credit facility (RCF).
The ratings and Outlook also reflect the following events: The housing recovery has continued into 2015 and should persist through the balance of this year and at least 2016; KBH is successfully mining the trade-up market and more affluent first-time buyers (note the 6.7% increase in average sales price so far in 2015); the South Edge legal issues and liabilities have been dealt with; operating comparisons so far in 2015 are improved (especially deliveries, ASP and unit dollar backlog); and perhaps most important the company has been successful in refinancing or paying off the \\$1 billion of debt that was scheduled to mature in 2014 and 2015.
Despite the slow start to 2015, financial results should gain considerable strength in the second half of the fiscal year leading to improvement in profitability and leverage for the full year. Nevertheless, the company does continue to lag its peers in certain operational and financial categories.
The ratings reflect KBH's business model and marketing prowess. The ratings also take into account its leadership role in constructing energy-efficient homes, its reemphasis of the value-engineered Open Series of home designs, its conservative building practices, its capital structure and the cyclicality of the U.S. housing market.
THE INDUSTRY
Housing metrics increased in 2014 due to more robust economic growth during the last three quarters of the year (prompted by improved household net worth, industrial production and consumer spending), and consequently acceleration in job growth (as unemployment rates decreased to 6.2% for 2014 from an average of 7.4% in 2013), despite modestly higher interest rates, as well as more measured home price inflation. A combination of tax increases and spending cuts in 2013 shaved about 1.5pp off annual economic growth, according to the Congressional Budget Office. Many forecasters estimate the fiscal drag in 2014 was only about 0.25%.
Single-family starts in 2014 improved 4.8% to 648,000 as multifamily volume grew 15.6% to 355,000. Thus, total starts in 2014 were 1.003 million. New home sales were up a modest 1.6% to 436,000, while existing home volume was off 2.9% to 4.940 million largely due to fewer distressed homes for sale and limited inventory.
New home price inflation moderated in 2014, at least partially because of higher interest rates and buyer resistance. Average new home prices, as measured by the Census Bureau, rose 6.4% in 2014, while median home prices advanced approximately 5.4%.
Housing activity is likely to ratchet up more sharply in 2015 with the support of a steadily growing economy throughout the balance of the year. Considerably lower oil prices should restrain inflation and leave American consumers with more money to spend. The unemployment rate should continue to move lower (average 5.3% in 2015). Credit standards should steadily, moderately ease throughout 2015.
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 12.5% to 729,000 in 2015 as multifamily volume expands 7.3% to 381,000. Total starts would be in excess of 1.1 million. New home sales are projected to increase 20% to 523,000. Existing home volume is expected to approximate 5.152 million, up 4.3%.
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 3.0%-3.5%.
Challenges remain, including the potential for higher interest rates and restrictive credit qualification standards.
SLOW START TO 2015
KBH's total revenues expanded 18.4% to \\$1.203 billion in 1H15. Homebuilding revenues increased 18.6% to \\$1.199 billion as home deliveries rose 5.8% to 3,380 and the average selling price increased 6.7% to \\$334,200. Homebuilding gross profit margins (excluding land option charges) dropped 312 basis points (bps) to 15.25% during 2015. The sharp year-over-year (YOY) decline in the housing gross profit margin was primarily due to higher land and construction costs, increased pricing pressure in certain markets, start-up field costs associated with new community openings, and an increase in the amortization of previously capitalized interest. SG&A expense as a percentage of homebuilding sales declined from 13.14% to 12.48% for the first six months of 2015.
The company reported homebuilding operating income, before real estate charges, of \\$33.2 million in 2015, which compares to a profit of \\$52.8 million for the first two quarters of 2014. Corporate pretax income (before charges) was \\$24.2 million for 1H15 vs. a profit of \\$38.5 million during the same period in 2014. Leverage (debt-to-LTM EBITDA) rose to 11.2x at May 31, 2015 from 10x at Nov. 30, 2014. Interest coverage at the end of 2Q15 was 1.4x, down from 1.5x at year-end 2014.
LIQUIDITY AND CAPITAL ISSUES
The company ended 2Q15 with \\$439.92 million in unrestricted cash and equivalents and \\$27.21 million in restricted cash.
As of May 31, 2015, the company had a \\$200 million senior unsecured RCF that was to mature on Mach 12, 2016. The credit facility contained an uncommitted accordion feature under which its aggregate principal amount could be increased up to \\$300 million under certain conditions and the availability of additional bank commitments, as well as a sublimit of \\$100 million for the issuance of letters of credit (LOC), which may be used in combination with or to replace KBH's LOC facilities. As of May 31, 2015, there were no cash borrowings. LOCs outstanding under the credit facility was \\$0.2 million. KBH had \\$199.8 million available for cash borrowings, and up to \\$100 million of that amount available for the issuance of LOCs.
On Aug. 7, 2015, KBH entered into an amended and restated revolving loan agreement that increased the commitment under the unsecured RCF from \\$200 million to \\$275 million and extended its maturity from March 2016 to August 7, 2019. The amended facility contains an accordion feature under which the aggregate principal amount of available loans may be increased to up to \\$450 million under certain circumstances, so long as additional lender commitments are obtained. The amended credit facility includes a \\$137.5 million sublimit for LOCs. At the closing, KBH had approximately \\$2.6 million in LOCs and no loans outstanding under the existing credit facility.
KBH maintains LOC facilities with various financial institutions to obtain LOCs in the ordinary course of operating KBH's business. As of May 31, 2015, the company had \\$26.8 million outstanding under the LOC facilities.
KBH had \\$2.82 billion of debt outstanding as of May 31, 2015. The company's debt maturities are well-laddered, with about 20% of its senior notes (as of May 31, 2015) maturing through 2018. Shareholders' equity totaled \\$1.62 billion at the end of 2Q15.
The company regularly accesses the capital markets and on Feb. 17, 2015 KBH completed a public issuance of \\$250 million in aggregate principal amount of 7.625% senior notes due 2023. The company used a portion of the net proceeds of approximately \\$247 million from this issuance to retire the remaining \\$199.9 million in aggregate principal amount of its 6.25% senior notes due 2015 at their maturity on June 15, 2015. KBH also did a public issuance of 7,986,111 shares of common stock for net cash proceeds of \\$137 million during the May 2014 quarter. Proceeds from these offerings were used for general corporate purposes, including land acquisition and land development.
HOMEBUILDING
KBH is primarily a single-family homebuilder, and ranked as the fifth largest homebuilder in the U.S. in 2008 through 2013, based on home closings. It ranked sixth in 2014. KBH operates in four regions comprising 10 states serving 40 major markets. The company delivered its first homes in California in 1963, Nevada in 1993, Colorado in 1994, Texas in 1996, Arizona in 1998, Florida in 2001, North Carolina in 2003, and greater Washington D.C. (Maryland/Virginia) in 2005. At present, the company is most heavily weighted to the California and Texas markets.
KBH has typically focused on entry-level homebuyers and, to a lesser extent, on first-step move-up buyers in the U.S. In 2014 and so far in 2015, trade-up buyers and more affluent first-time buyers dominated the sales mix; 56% of buyers were first time in 2Q15. The 1H15 average price was \\$334,200 for 3,380 homes delivered. The average price varies considerably by market, ranging from \\$237,900 in the Central region to \\$565,500 on the West Coast (California) during 1H15.
KBH employs what it calls its KBnxt operational business model. This strategy includes regular detailed product preference surveys, primarily acquiring partially or fully developed and entitled land in markets with high growth potential. Construction is generally begun only after a purchase contract has been signed, establishing an even flow of production, pricing homes to compete with existing homes and using design centers to customize homes to the preferences of homebuyers. KBH strives to be among the top five builders or, in very large markets, top 10 homebuilders, in order to have access to the best land and subcontractors.
REAL ESTATE
At the end of 2Q15, KBH controlled 49,905 lots, down 13% from the end of 2Q14 and a 74.7% drop from a peak of 197,000 lots at the end of 1Q06 (February 2006). Based on latest 12 month (LTM) closings, the company controlled 6.7 years of land (up from 5.1 years at the end of 2005); KBH has 5.6 years of owned land. The current options share of total lots controlled (17.5%) is down sharply from the peak of 53.7% (4Q05).
The company is expected to maintain substantial land spending this year. KBH spent \\$454.7 million on land and development for the first six months of the year, down from \\$859.6 million spent the year earlier. For the full year Fitch estimates that the company will expend approximately \\$1.1 billion - \\$1.2 billion on real estate and development activities. KBH invested \\$1.46 billion in land and development activities in 2014, \\$1.14 billion in 2013, and \\$564.9 million in 2012.
Unlike most other builders within its coverage, Fitch expects KBH could be cash flow positive in 2015. The company was negative CFFO by \\$48.9 million in the May 2015 quarter and on an LTM basis was CFFO negative by \\$212.1 million. In 2014, 2013, 2011 and 2010, the company was negative CFFO by \\$630.6 million, \\$443.4 million, \\$347.5 million and \\$134 million, respectively. KBH reported positive CFFO of \\$34.6 million in 2012. Fitch currently expects the company will be CFFO neutral to positive \\$50 million in 2015.
Although KBH will again spend heavily on land and development activities this year, expenditures could decline about \\$300 million vs. 2014 levels. In the years ahead, KBH may again step-up its spending as the up-cycle in housing persists.
KEY ASSUMPTIONS
Fitch's key assumptions within its rating case for the issuer include:
--Industry single-family housing starts improve 12.5%, while new and existing home sales grow 20% and 4.3%, respectively, in 2015;
--KB Home's homebuilding revenues increase in excess of 25%. Although homebuilding EBITDA margins erode 125 bps - 150 bps this year due to higher expenses (especially land costs) and lesser home price inflation, nevertheless EBITDA increases 10.5% - 12.0%;
--The company's debt/EBITDA approximates 9.2x and interest coverage reaches about 1.6x by year-end 2015;
--KBH spends approximately \\$1.1 billion-\\$1.2 billion on land acquisitions and development activities this year;
--The company maintains an adequate liquidity position (above \\$500 million) with a combination of unrestricted cash and revolver availability.
RATING SENSITIVITIES
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, free cash flow trends and uses, and the company's cash position.
KBH's ratings are constrained in the intermediate term because of relatively high leverage metrics. However, a positive rating action may be considered if the recovery in housing is meaningfully better than Fitch's current outlook, KBH shows continuous improvement in credit metrics, and maintains a healthy liquidity position (combination of cash and equivalents and availability on the credit facility). In particular, debt-to-EBITDA would need to approach 4x, debt-to-capitalization should approximate 55%, and interest coverage would need to exceed 4x in order to take a positive rating action.
Negative rating actions could be triggered if the industry recovery dissipates or if there is a meaningful shortfall in KBH's financials (revenues, profitability) and the company maintains an overly aggressive land and development spending program that meaningfully diminishes its liquidity position (i.e. to below \\$300 million).
FULL LIST OF RATINGS ACTIONS
Fitch has affirmed the following ratings for KB Home (NYSE: KBH):
--Long-term IDR at 'B+';
--Senior unsecured debt 'B+/RR4'.
The Rating Outlook is Stable.
RECOVERY RATING
The Recovery Rating (RR) of 'RR4' on KBH's senior unsecured notes indicates average recovery prospects for holders of these debt issues. KBH's exposure to claims made pursuant to performance bonds and joint venture debt and the possibility that part of these contingent liabilities would have a claim against the company's assets were considered in determining the recovery for the unsecured debtholders. Fitch applied a going concern valuation analysis for this RR.
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