Fitch Affirms M.D.C. Holdings' IDR at 'BBB-'; Outlook Stable
KEY RATING DRIVERS
The low investment grade rating is supported by the company's focus on a short land supply (keeping limited exposure to this key asset whose valuation is vulnerable in a housing contraction), above average liquidity relative to its size, distant debt maturities, and steady, moderate improvement in its credit metrics.
MDC's ratings are also based on the company's execution of its business model in the current moderately recovering housing environment, and overall cautious land policies. During the past cycle, the company noticeably improved its capital structure, pursued conservative capitalization policies and positioned itself to withstand the past, sharp, long-lasting housing correction. Significant insider ownership of 26% aligns management's interests with the long-term financial health of MDC.
Excluding non-cash inventory impairments, the company only lost money on an EBITDA basis in 2008 ($7.3 million) and was modestly profitable during the other years of the pronounced housing contraction. The company generated $61.1 million in pretax profits in 2012, $129.8 million in 2013 and $100.5 million in 2014. During the housing downturn, MDC's cash and marketable securities consistently exceeded its debt.
During the past few years, MDC has been re-building its land position, supported by its strong liquidity. MDC spent approximately $227 million on land and development in 2009. The company purchased about $380 million of land and expended $40 million on land development in 2010 and then spent $280 million on land and development in 2011. MDC expended $370 million on land and development activities in 2012 and spent $630 million on land and $140 million on development activities in 2013. The company spent $605 million on real estate in 2014. MDC is likely to invest about $800 million in land and development in 2015, mostly for land purchases. The company's community count at the end of 2015 should be 5% to 10% higher year-over-year (YOY).
Risk factors include the cyclical nature of the homebuilding industry and MDC's more recent sporadic underperformance relative to its peers in certain operational and financial categories.
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, relatively robust 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 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.
COMPANY PROFILE
MDC Holdings, Inc. and its subsidiaries have been building new homes under the name Richmond American Homes for over 40 years. The company currently has 156 active communities in nine states. MDC was the 13th largest homebuilder based on 2014 closings and revenues and has been consistently among the top 15 (and often among the top 10) largest homebuilders. The company has particularly heavy exposure in Colorado, Arizona and California. MDC designs, builds and sells single-family homes, especially for the first-time and first-time move-up buyers (the deepest part of the market). The company also builds a limited number of homes for the second-time move-up and luxury homebuyers. The average price for its homes during 2014 was $377,324. MDC also has design centers (Home Galleries and Design Centers) in most of its homebuilding markets. Through the design centers, homebuyers are able to customize certain features of their homes by selecting from a variety of options and upgrades.
MDC has rarely used acquisitions of companies to grow. Occasionally, the company has purchased assets (i.e. real estate lots) of a company to establish itself in a new market or supplement its position in an existing market. More often MDC has started greenfield operations, hiring a manager with experience in the new market. This is generally the least risky way of geographic expansion. The company does not participate in joint ventures.
MDC FIRST-HALF 2015 FINANCIAL RESULTS
MDC's corporate revenues grew 11.8% to $861.6 million during the first six months of 2015. Home sales revenues expanded 11.9% to $838.7 million as home deliveries edged up 0.2% to 2,035 and the average selling price increased 11.7% to $412,146. Deliveries improved in the West (+9.3%) but fell in the East (-13.3%) and Mountain regions (-4.0%). Softer demand in certain markets and a conscious metering of sales to maximize price were reflected in the 2015 delivery statistics.
The homebuilding gross profit margin fell 176 basis points (bps) to 16.06% for the first two quarters of 2015. The decline in the gross margin was due to lower margins from speculative home deliveries as a result of higher incentives utilized in MDC's efforts to reduce the company's aged spec inventory. To a lesser extent margins were adversely impacted by higher land and construction costs and a decline in positive warranty adjustments.
SG&A expenses rose 7.3% year-to-date (YTD) in 2015. SG&A expenses as a percentage of homebuilding revenues declined from 13.09% in the first half of 2014 to 12.54% in 2015. The improvement in the expense ratio was driven primarily by a decrease in compensation related expenses but was partially offset by an increase in net legal expenses.
Homebuilding EBITDA totaled $61.3 million for the first half of 2015, down from $68.1 million in the same period of 2014. Excluding an early extinguishment of debt charge of $9.4 million in 2014, 2015 YTD homebuilding pretax profits dropped 37.4% to $31.6 million.
YTD financial services revenues increased 6.3% to $22.0 million, while segment pretax income expanded 17.0% to $13.6 million. The primary driver of the higher financial services pretax income was a $1.5 million adjustment recorded in the 2015 second quarter in MDC's other financial services segment to reduce insurance reserves as the result of a decline in insurance claim payment severity and frequency relative to prior period estimates. The decrease in pretax income for MDC's mortgage operations segment was primarily due to the 2014 second quarter including a $0.8 million gain on the sale of mortgage servicing rights, while the same quarter in the current year did not have such a transaction.
Corporate pretax income, before the debt extinguishment charge, fell 27.2% to $45.2 million in the first half 2015.
Net income was $28.4 million during the first two quarters of 2015. Reported net income was $33 million for the same period in 2014.
Net unit orders and the value of orders expanded 15.8% and 28.6%, respectively, for the first six months of 2015. Also, second quarter 2015 unit orders and value of orders improved 4.4% and 15.6%, respectively. As of June 30, 2015, unit backlog is up 35.6%, while value of backlog ($1.1293 billion) is 48.3% higher. The average sales price in backlog was $441,492, up 9.3%.
Debt-to-LTM EBITDA was 6.0x at the end of the second quarter 2015, down from 7.3x as of June 30, 2014. Funds from operations (FFO adjusted leverage was 6.2x up from 5.1x a year earlier. Interest coverage was 2.5x at the end of June 2015 and 2.3x a year earlier.
MDC's average community count for the first half of 2015 was 164, up 6.5% YOY. The actual community count at June 30, 2015 was 156, off 1.9% as compared to a year ago.
LIQUIDITY
The company ended the second quarter of 2015 with $148.2 million in homebuilding unrestricted cash and equivalents, $123.1 million in marketable securities and $4.9 million in restricted cash compared to homebuilding debt of $861.8 million. The company's debt maturities are well-laddered, with $250 million maturing in February 2020.
The company has a $550 million senior unsecured revolving credit facility with an uncommitted accordion feature that could increase the size of the facility to $1.0 billion, subject to certain conditions and availability of additional bank commitments. The facility also provides for the issuance of letters of credit. Letters of credit issued under the facility reduce available borrowing capacity. The maturity date of the facility is Dec. 13, 2019. At June 30, 2015, there were $15 million of borrowings outstanding and $12.0 million of letters of credit issued under the revolving credit facility.
Like most other builders in the agency's coverage, Fitch expects MDC will have negative cash flow from operations (CFFO) in 2015. The company was CFFO positive $29.1 million for the quarter ended June 2015 and on an LTM basis was CFFO negative by $22.9 million. In 2014, 2013 and 2012, the company had negative CFFO of $163.6 million, $269.5 million and $108.8 million, respectively. MDC had negative $80.3 million CFFO in 2011. Fitch currently expects the company will be CFFO negative in 2015, but considerably less negative than in 2014. MDC will again spend substantially on land and development activities this year. As the cycle matures, real estate spending will level-out or trend down (perhaps in 2017), profits will continue to rise and cash flow could turn positive as early as 2016.
DEBT AND CREDIT METRICS
MDC had $861.8 million of debt outstanding, net of applicable discounts, as of June 30, 2015. Debt-to-LTM EBITDA at the end of the second quarter was 6.0x compared with 5.7x at the end of 2014 and 7.6x at the conclusion of 2013. Net debt-to-LTM EBITDA was 4.1x at June 30, 2015. FFO adjusted leverage was 6.2x at the end of the 2015 second quarter which compares to 5.1x and 4.8x at the conclusion of 2013 and 2014, respectively. Debt-to-capitalization was 41.1% and debt (net of cash and equivalents and marketable securities)-to-net capitalization was 32.3% as of the end of the second quarter 2015. EBITDA-to-interest coverage was 2.5x for the LTM period ending June 30, 2015 compared with 2.4x and 2.3x at year end 2013 and 2014, respectively. Fitch expects these credit metrics will improve by year end 2015, with leverage declining to less than 5.5x and interest coverage approaching 3.5x. These credit metrics should be meaningfully better in 2016.
MDC had $249.96 million of 5.375% senior notes, net, which matured July 2015 and were paid off. The next debt maturity is not until February 2020 ($246.16 million, net).
LAND STRATEGY
The company employs conservative land and construction strategies. MDC's priority is to acquire finished lots using rolling options, finished lots in phases for cash or, if the potential returns justify the risk, land for development. The long-term goal is to maintain a -two to three year supply of land, where possible increase land under option, and reduce land owned.
At the end of the June 2015 quarter, MDC controlled 14,670 lots, a 12.2% decrease from the year-ago period. 84.5% of lots are owned. Based on LTM closings, the company controlled 3.4 years of land and had 2.8 years of owned land. The community count was 156 at second quarter end 2015 as compared to 159 at second quarter end 2014.
MDC chooses to be relatively short on land as many of its peers control six to eight years of lots (much of that owned). That strategy can be a disadvantage when land prices are rapidly rising (not currently). On the other hand, being short on land is clearly advantageous following a market peak when excess land compromises the balance sheet and margins.
Similar to the other builders Fitch follows, the company is expected to purchase sizable land this year to replenish and expand its supply. MDC may spend about $800 million on real estate acquisitions with perhaps two-thirds of that targeted for land spend and the balance for land development. Fitch anticipates as much as $1 billion in real estate spend in 2016.
Fitch is comfortable with MDC's growth strategy given its liquidity position, existing land supply, and proven access to the capital markets. Fitch expects management to pull back on its land spending if market conditions deteriorate from current levels.
KEY ASSUMPTIONS
Fitch's key assumptions within the rating case for MDC include:
--Industry single-family housing starts improve 12.5%, while new and existing home sales grow 20% and 4.3%, respectively, in 2015;
--MDC's homebuilding revenues increase at a mid-teens pace. Although homebuilding EBITDA margins erode almost 70 bps this year due to higher expenses (especially land costs) and lower margins from speculative home deliveries and higher incentives to reduce aged spec inventory, nevertheless EBITDA increases by mid- to high-single-digits.
--The company's debt/EBITDA approximates 5.4x and interest coverage reaches about 3.3x by year-end 2015;
--MDC spends approximately $800 million on land acquisitions and development activities this year;
--The company maintains an adequate liquidity position (above $600 million) with a combination of unrestricted cash and revolver availability.
RATING SENSITIVITIES
MDC's ratings are constrained in the intermediate term because of relatively high leverage metrics. However, positive rating action may be considered if the recovery in housing is significantly stronger than the agency's current outlook, if the company's operating and credit metrics are well above Fitch's expectations for 2015 and 2016, and liquidity is expanded. In particular, debt leverage would need to approach 2x and FFO interest coverage would need to exceed 7x in order to take positive rating actions.
A negative rating action could be triggered if the industry recovery dissipates; MDC's 2015/2016 revenues drop sharply while pretax income approaches break-even levels; and MDC's 2015/2016 liquidity position (cash, investments and availability from the revolving credit facility) falls markedly, perhaps below $500 million. Negative rating actions could also occur if the company's credit metrics do not improve much from current levels in a sustained housing recovery, including debt/EBITDA consistently remaining above 5x during the next 12 months.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings for M.D.C Holdings, Inc.:
--Long-term IDR at 'BBB-';
--Senior unsecured debt at 'BBB-'.
The Rating Outlook is Stable.
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