S&P: Weekley Homes LLC Ratings Lowered To 'B+' From 'BB-'; Outlook Stable
We lowered the ratings because of the gradual decline in profitability and rise in total debt over the last two years, causing debt leverage to climb to 5.5x for the 12 months ended June 30, 2016. Along with leverage, many of the company's other key credit metrics have deteriorated to a level we consider consistent with a financial risk profile of aggressive. We previously assessed Weekley one level stronger at significant. Rising land and construction costs as well as higher overhead associated with the company's rapid community expansion, paired with increasing usage of the company's revolving debt facilities, have driven leverage higher. We expect this trend to moderate over the next 12 months and have seen positive closing growth in the first half of 2016.
Our assessment of Weekley's business-risk profile as fair reflects its participation in the cyclical U. S. homebuilding industry, which we view as having moderately high industry risk and very low country risk. We also assess the company's competitive position as fair based on the operational flexibility afforded by its asset-lite approach to land acquisition. The company delivered 3,355 homes in the 12 months ended June 30, 2016, ranking it smaller than many of its rated peers. Weekley is active in 22 markets, with a large concentration in Texas and Florida. Although the company participates in the entry-level and custom home markets, it is primarily focused on the move-up demographic. Through its asset-lite strategy, the company acquires a vast majority of its land inventory by entering lot option agreements, which allows the company to turn inventory faster and hold less land on its balance sheet relative to peers that buy raw land for development. Weekley's strategy allows it to scale down inventory more rapidly in a housing market downturn. Profitability metrics have slowly declined for most rated builders over the past few years, but the effects have been more pronounced for Weekley, as its expansion into new markets and fast community count growth have led to escalated overhead as a percentage of revenues. Overall, we still consider the company's profitability as average for a homebuilder.
Our assessment of Weekley Homes' financial risk profile as aggressive is driven by our forecast of gradually improving credit metrics over the next 18 months. Specifically, we project debt to EBITDA returning to 4x-5x, funds from operations (FFO) to debt of 12%-20%, and EBITDA interest coverage above 4x for fiscal 2017. Growth in selling communities has accelerated over the past 18 months to 178 from 136; however, delays in land development sparked a weak fourth quarter for closings in 2015. We expect continued sales growth driven by these newer communities gaining traction and improving absorption rates, along with higher backlog conversion relative to last year, to stimulate healthy volume growth for 2016 and 2017. In terms of adjusted homebuilding gross margins, our forecast contemplates flat to slightly higher margins relative to the first half of 2016. We believe Weekley will continue to rely on its revolving credit lines to help fund working capital and land spending, but that balances will come down over time as closings pick up and selling, general, and administrative (SG&A) leverage improves.
Our 'B+' corporate credit rating also takes into account the negative comparable rating analysis assessment, which we use for Weekley because of its smaller size and market share, and weaker EBITDA margin relative to industry peers at the 'BB-' rating, such as TRI Pointe Homes Inc., Meritage Homes Corp., and Taylor Morrison Home Corp. Weekley also has high debt leverage relative to these peers, and a higher geographic concentration to the Houston market that has hurt results over the past 18 months.
LiquidityWe view Weekley Homes' liquidity to be adequate because of our expectations for sources of cash to exceed uses over the next 12 months by at least a factor of 1.2x. The primary sources and uses considered in our assessment are detailed below and consider a 12-month horizon beginning after June 30, 2016.Unrestricted cash balance of $12.7 million. Approximately $225 million of undrawn available funds from revolving credit lines, all maturing beyond a 12-month horizon. Our forecast of $120 million EBTIDA over the next 12 months. Peak seasonal working capital deficit similar to prior years, which includes funds used for land acquisitions. We assume minimal capital expenditures, consistent with prior years. We assume the company will continue to make distributions to its owners.
Our stable outlook reflects our expectation that Weekley's leverage will improve to 4x-5x over the next 12 months with moderate community count growth and solid backlog conversion, and our forecast for homebuilding gross margins to be flat to slightly higher relative to the first half of fiscal 2016. Beginning in 2017, our forecast also expects the company's overhead leverage to improve as home sale volume increases.
We could take a negative rating action in the event that our forecast leverage improvement does not materialize and profitability continues to deteriorate such that we believe debt to EBITDA will remain above 5.0x. This may be a result of prolonged weakness in the Houston market and its impact on the company, or if gross margins come in weaker than our forecast.
Although we view it as unlikely within the 12-month horizon, we may consider a positive rating action if sales, closings, and gross margins prove materially stronger than our forecast, allowing the company to reduce total debt and push leverage down to below 4x debt to EBITDA.