Fitch: More Challenges Await U.S. Homebuilders as Housing Downturn Enters Year 4
With
the U.S. economy in a severe recession and housing likely to
deteriorate more sharply in 2009, U.S. homebuilders are facing even
more operational and financial pressures, according to Fitch Ratings,
which took rating actions on its public U.S. homebuilder universe of 14
companies late last week, resulting in nine downgrades and five
affirmations.
Housing had stood out as one of the weakest sectors of (what was thought to be) a reasonably stable
economy
during the first three quarters of 2008. Affordability, wavering buyer
confidence and significantly tighter mortgage standards, as well as
still-considerable inventories of new and existing homes for sale
(boosted by foreclosures) had severely restrained housing. But in the
fall credit markets in the U.S. and in many other parts of the world
froze, a condition that has barely eased. Already weak consumer
confidence has plummeted. Job losses have surged. The economy is
clearly now in a sharp recession. As weak as housing has been, it can
deteriorate further, in particular, influenced by job losses, fear of
job loss, poor consumer confidence and lack of income growth or
possibly income contraction. Fitch is projecting that the recession,
which technically began in December of 2007 (according to the Business
Cycle Dating Committee of the National Bureau of Economic Research)
will extend well into 2009. Some recently announced programs or
programs under consideration by the Treasury Department and Fed
designed to boost housing demand may soften the impact of the
recession, but it appears very likely that key housing metrics (starts,
new home sales, existing home sales) will be meaningfully weaker in
2009 than was reflected in Fitch's earlier forecast. A trough in new
home sales is not likely until the second half of 2009, if not later.
Starts should bottom three-to-six months after new home sales.
Ratings Rationale:
Fitch
concludes that operational and financial pressures will persist and,
probably, intensify for the public homebuilders during 2009.
Profitability and cash flow will be somewhat weaker than anticipated
earlier. Operational and financial ratios will suffer further stress.
The consequence of the change in macro perspective resulted in Fitch's
most recent rating actions for the homebuilders. The Rating Outlook for
the sector is Negative.
The new ratings for the homebuilders
reflect the most likely macro perspective for the balance of 2008 and
2009 as well as company-specific performance to this point in the
cyclical downturn. As Fitch has noted in the past, a homebuilder's
approach to land and development spending, inventory management, free
cash flow generation and management and debt reduction are considered
in its ratings in the midst of a housing downturn as are other factors
such as credit metrics, ability to satisfy covenants, liquidity, size,
geographic and product diversification, margins, and frequency of real
estate write downs and option write-offs, etc.
Homebuilders have
to successfully operate within this challenging environment or wither
away. Companies have to continue to downsize to the point where they
can remain or become profitable (excluding non-recurring real estate
charges). That means further cuts in staffing and other overhead, as
well as other cost reductions.
The public homebuilders cannot
significantly influence profitability, but they can manage their
balance sheets and their liquidity. Fitch Ratings believes that,
overall, the U.S. homebuilding sector has good liquidity, although
there are some weaker companies that face greater risk. Many companies
in this sector have generated meaningful free cash flows over the past
12 months, while terming out borrowings and maintaining access to
committed bank facilities which together provide room to handle
maturities and fund working capital needs. As compared to the last
major housing downturn in the latter 1980's into the early 1990's,
leverage was lower during the later part of this upcycle, at the peak
and currently (for some of the builders). For the majority of public
homebuilders, debt composition 15-20 years ago was mostly, or all,
short-term construction loans and possibly a secured credit line, while
today the debt is often weighted most heavily to well laddered public
debt (a more appropriate balance with longer-lived real estate assets),
and, to a lesser degree, to an unsecured revolving credit facility.
(All of the public homebuilders in Fitch's coverage have unsecured
revolving credit facilities except for Beazer Homes USA, Hovnanian
Enterprises, Inc. and Standard Pacific Corp., which have secured
revolving credit facilities.)
Fourth-Quarter 2008 and Calendar 2009:
The
world economy is entering a severe recession. Output is falling in the
US, Japan, Germany, France and the UK, and prospects are for this
contraction in activity to intensify over the next 12 months. For the
major advanced economies (the US, Euro area, UK and Japan) in
aggregate, Fitch Ratings is forecasting the steepest decline in GDP
since the Second World War at -0.8%, in part reflecting the unusually
synchronized downturn expected next year.
Although the latest
GDP figures for the third quarter of 2008 showed only a small fall,
this disguised a clear trend of accelerated declines in consumer
expenditure. Growth in the third quarter of 2008 was supported by an
inventory accumulation and net exports. While imports will continue to
decline, the recent pace of export growth seems unlikely to be
sustained. Fitch projects fourth quarter GDP will decline at least
0.7%. GDP is expected to shrink by just over 1% next year. Unemployment
is expected to rise in the 2008 fourth quarter and continue to increase
reaching to 8.3%, some 3.5pp above its structural rate.
Fitch's
forecast for the housing sector became more bearish as 2008 evolved.
This is principally due to the influence of even tighter credit
standards for homebuyers and the effect of disruptions in the credit
markets.
Of course, most potential homebuyers, absent any real
urgency to buy, are deferring the purchase decision, concerned that
selling their existing home at a fair price may be challenging, and
fearing that real home prices might further decline as builders
increase the level of incentives being offered to the advantage of
those who wait to buy.
The disruption in broad credit markets
and media focus on accelerating job losses took a further toll on
homebuyer confidence since September. Consequently, housing metrics are
likely to be weaker in the fourth quarter of 2008 as compared to the
preceding quarter.
Total housing starts are forecast to be
910,000 in 2008, 33.1% lower than in 2007. Single family starts are
expected to be 0.62 million, down 41.0% as compared to a year ago.
Multi-family starts should decrease 6.5% to 290,000. New single family
home sales should fall 37.2% to 487,000, while existing home sales ease
13.6% to 4.88 million.
For the full year of 2008, production, as
represented by housing starts (especially single family), is expected
to fall slightly faster than sales (new orders), but unfortunately the
supply of homes is expected to still be excessive entering 2009.
The
average single family new home price is expected to drop 6.5% in 2008,
while the median new home price decreases 5.5%. The 'real' price
reductions are larger than shown by the government's published
transaction prices (and our forecasts) as, for example, sales
incentives are not included. However, in 2008 a greater portion of the
"real" price reduction was due to overt sales price decreases than was
the case in 2007. Unfortunately, home prices have still not yet reached
market-clearing levels in most places. Home prices (especially existing
home prices) definitely had been 'sticky' on the downside, but came
down more sharply in 2008, at least partially prompted by aggressive
pricing of foreclosures and distressed homes.
Fitch is forecasting a contracting
economy
during the first half of 2009. Real GDP is forecast to decrease 1.2%
for all of 2009. Investment is expected to plunge 6.9% as consumer
spending and imports decline 0.6% and 3.2%, respectively. Government
spending (+2.3%) and exports (+2.2%) will be economic positives next
year. Inflation is expected to slow to 1.5% from 2.7% in 2008. Interest
rates are expected to slightly recede.
The economy in the midst
of a moderate to severe recession is another blow to housing. In
particular, a deteriorating economy further erodes consumer confidence
and accelerates job losses and consequentially foreclosures. One
source, RealtyTrac, is currently predicting 1 million foreclosures in
2009. Undoubtedly, another stimulus program will emanate from Congress
early in 2009 and there may be national legislation to specifically and
more effectively target the foreclosure problem, as well as accelerate
housing demand. However, these actions are unlikely to stabilize and
then boost housing demand until the second half of 2009 or later.
In
2009, total housing starts are projected to fall 22.0% to 710,000 with
single family volume declining 22.6% to 480,000. New home sales are
forecast to decrease 16.0% to 409,000, while existing home sales slip
3.0% to 4.735 million.
Average and median single family new home
prices are projected to fall 2% and 1%, respectively, in 2009. The
combination of overt price decreases and sales incentives should
represent a less significant percentage of the base home price next
year than was the case in 2008.
Implications for the Companies and the Ratings:
Through
the three quarters of calendar 2008 builder revenues are down about
39%, home deliveries are off 33%, and EBITDA margins (before
non-recurring, non-cash real estate charges) are about 570 basis points
lower than year earlier levels. Third quarter net new unit orders are
down 34%, on average, and unit backlog at the conclusion of the third
quarter, on average, is 46% beneath year earlier levels.
These
companies have been contracting staffing as demand has evaporated with
personnel typically down 50-65% as compared to peak staffing in early
2006. Just as important, builders have been reducing inventories in
2008, down 53% on average as of the end of the 2008 third quarter (or
equivalent) as compared to the peak quarter end in 2006. (Admittedly,
this is partially as a consequence of write downs). The companies have
lowered debt - on average 28.5% since the peak, typically in 2006. Free
cash flow comparisons have generally improved.
Credit metrics
(LTM EBITDA/interest incurred, debt to LTM EBITDA, and FFO interest
coverage) are considerably lesser than at this time last year.
Debt/capitalization ratios have deteriorated moderately to sharply for
the majority of builders when compared to one or two years ago, largely
as a result of erosion in shareholders' equity from sizeable real
estate charges.
Given Fitch's adjusted macro forecasts for the
balance of 2008 and 2009, it appears likely that builders' financial
pressures will continue unabated. For the full year of 2008
homebuilders' revenues could drop 40%, on average, while pretax losses,
before real estate charges, will be reported for 12 of the 14
homebuilders Fitch tracks.
Price competition will likely persist
at current levels well into 2009. Consequently, margins will remain
under pressure and more land value write downs are a distinct
possibility, although likely to be of lesser magnitude than in 2008.
However, fewer option write-offs are likely.
Deterioration in
credit metrics will continue during the fourth quarter of 2008 and next
year, particularly for profit related metrics (EBITDA, interest
coverage; debt to EBITDA). Tangible net worth covenants will again be
challenged.
Most of the public builders that Fitch tracks have
negotiated new revolving credit agreements or amendments to existing
agreements that should prevent the companies from violating interest
coverage covenants in the fourth quarter of 2008 and into 2009 as well
as covenants applicable to speculative inventories and tangible net
worth. Some builders may have to revisit their bank syndicates and
request further covenant adjustments in 2009.
If Fitch's
year-end forecast for 2008 is correct, then 2009 will start off with
still considerable inventory over-hang. New home sales comparisons
(year-over-year) would likely bottom late in 2009 with housing starts
bottoming three-to-six months later.
There is a high probability
that many public builders' revenues and profitability will fall further
in 2009. Excluding tax refunds, cash flow from operations is likely to
be lower in 2009 relative to 2008.
Credit pressures will
continue. It will be imperative that builders continue to contract
their balance sheets, further reducing land and development spending.
Possibly more aggressive pricing may be necessary to lower inventories,
especially specs. Positive free cash flow comparisons should result.
Fitch
expects homebuilders to reduce debt where possible and to exercise
restraint as to share repurchase, dividends and acquisitions in these
uncertain times.
Although some builders have been more proactive
than others in reducing inventories and lowering debt levels, most, in
retrospect, started relatively late during this cyclical downturn.
Fitch
rates the builders within the context of a typical cycle. In the midst
of a non-typical upcycle, as took place in the 1992-2005 period, a
number of builders realized higher credit ratings. Conversely, in this
sharper than expected contraction, which it appears will last longer,
and as builders' operating and credit metrics will be even more
stressed, ratings again have to be adjusted.
Following last
week's rating actions, Fitch's Rating Outlook is Negative for the
majority of the homebuilders. Recent and projected credit metrics and
other key metrics, such as inventory and debt contraction and cash flow
generation, were taken into account relative to the new ratings.
The following is a list of Fitch rated issuers and their current Issuer Default ratings (IDRs) in the U.S. homebuilding sector:
--Beazer Homes USA ('B-'; Outlook Negative);
--Centex Corp. ('BB'; Outlook Negative);
--D.R. Horton, Inc. ('BB'; Outlook Negative);
--Hovnanian Enterprises, Inc. ('B-'; Outlook Negative);
--KB Home ('BB-'; Outlook Negative);
--Lennar Corp. ('BB+'; Outlook Negative;
--M.D.C. Holdings, Inc. ('BBB-'; Outlook Stable);
--Meritage Homes Corp. ('B+'; Outlook Negative);
--M/I Homes, Inc. ('B'; Outlook Negative);
--NVR, Inc. ('BBB'; Outlook Stable);
--Pulte Homes ('BB+'; Outlook Negative);
--Ryland Group ('BB'; Outlook Negative);
--Standard Pacific Corp. ('B-'; Outlook Stable);
--Toll Brothers, Inc. ('BBB-'; Outlook Stable).
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