Fitch Upgrades D. R. Horton's IDR to 'BBB-'; Outlook Revised to Stable
KEY RATING DRIVERS
The upgrade of DHI's ratings to investment grade reflects the company's successful execution of its business model, resulting in a steady capital structure through the cycle, including net debt to capitalization levels consistently below 45% (net debt to capitalization ratio was 23% as of June 30, 2016). DHI's strong interest coverage ratio (9.2x for the latest 12 months [LTM] ending June 30, 2016) and solid liquidity position also support an investment grade rating.
The upgrade further reflects Fitch's expectation that the company will maintain discipline in its financial strategy (refraining from undertaking debt-financed shareholder-friendly activities) as well as its growth strategy and will pull back on land and development spending when market conditions deteriorate, allowing the company to generate meaningful cash flow and accumulate cash and/or pay down debt. The company's low leverage level at this point of the housing cycle should allow the company to absorb a meaningful deterioration in housing activity and maintain its leverage below 45% through the cycle.
The ratings for DHI also reflect its geographic and price point diversity, as well as the company's execution of its strategy of increasing its lots under option as a percentage of its total lots under control. The company was an active consolidator in the homebuilding industry in the past, but has been much less acquisitive over the past 12 years. (DHI completed several small acquisitions during the past few years.)
The ratings also reflect the company's relatively heavy speculative building activity (at times averaging 50%-60% of total homes in production and 45% at June 30, 2016). DHI successfully executed this strategy in the past, including during the severe housing downturn. Nevertheless, Fitch is somewhat more comfortable with more moderate spec targets of roughly 35%-40% of homes under construction.
The rating and the Stable Outlook takes into account further moderate improvement in the housing market in 2016 and 2017 and potentially segment share gains by DHI, but also the company's above average performance from credit and operating perspectives during much of the past housing downturn and so far in the recovery. DHI was one of the few public builders profitable in 2010 and 2011. The company reported solid profits in 2012, 2013, 2014 and 2015 and should report stronger pretax and net income this fiscal year (FY). The company was the second builder to reverse its substantial federal deferred tax asset allowance (during FY12).
IS THIS A CYCLICAL UPGRADE?
DHI's financial results and credit metrics have benefited from the moderate recovery in housing. Unlike previous housing recoveries, which tended to be V-shaped, this recovery has been more subdued and will perhaps extend longer than the typical three to five year upturn. Entering the fifth year of the recovery, Fitch's projected total housing starts of 1.2 million for 2016 remains below the 1.5 million average housing starts reported between 1959 and 2000. The company has achieved its strong credit metrics on lower revenues and home closings compared with peak levels. (DHI reported $11.3 billion of revenues on 38,638 home deliveries for the LTM period ending June 30, 2016 compared with revenues of $14.8 billion on 53,099 home closings during FY06).
The company's management team has also demonstrated that it can execute on its business model and generate meaningful cash flow during a housing downturn, allowing DHI to accumulate cash and pay down debt, while maintaining low leverage (measured on a net debt to cap basis).
At the end of FY06 and going into the previous housing downturn, DHI had $4.9 billion of debt and a net debt to capitalization ratio of 41%. Between FY07 and FY11, DHI generated roughly $5.1 billion of cash flow from operations (including about $1.1 billion of tax refunds), allowing the company to reduce debt by $3.3 billion to $1.59 billion at fiscal year-end 2011 (FYE11). DHI's net debt to capitalization ratio peaked at 43% (debt to cap at 56%) at FYE08 and steadily declined to 18% (debt to cap of 38%) at FYE11. As of June 30, 2016, DHI had total debt of $2.8 billion and net debt to capitalization ratio of 23% (debt to cap of 30%). Net debt to capitalization ratio is expected to remain in the 20%-25% range during the next few years.
So far during this housing recovery, the company has maintained a conservative capital structure while investing in growth opportunities. Land and development spending totalled $2.24 billion in FY15, $2.3 billion in FY14, and $2.6 billion during FY13. Through the first nine months of FY16, the company spent about $2 billion on land and development activities. Fitch expects the company will spend about $3 billion on land and development activities during FY16. (By comparison, during the peak of the housing cycle, DHI spent about $5 billion annually on land and development.) Fitch expects the company will generate cash flow from operations of $300 million-$500 million this year and perhaps a similar amount next year.
IMPROVING FINANCIAL RESULTS AND CREDIT METRICS
DHI's homebuilding revenues during the first nine months of FY16 increased 10% to $8.2 billion as home deliveries grew 7.6% to 28,062 and the average selling price advanced 2% to $290,272. Homebuilding gross profit margin (excluding inventory and land option charges) expanded 25 basis points (bps) during the 2016 year-to-date (YTD) period to 20%. SG& A as a percentage of homebuilding revenues declined 40 bps to 9.5% for the first nine months of FY16. The company reported homebuilding pretax income, before real estate charges, of $877.3 million (10.7% of homebuilding revenues) during the FY16 YTD period, up from $750.8 million (10.1%) during the same period last year.
Net debt to capitalization declined from 34% at FYE14 to 25% at FYE15 and 23% as of June 30, 2016. Debt-to-EBITDA has improved from 3.3x at FYE14 to 2.5x at FYE15 and 1.9x for the LTM ending June 30, 2016. Funds from operations (FFO) adjusted leverage was 3.8x at FYE15 and is currently 2.4x. Interest coverage rose from 5.4x at the end of FY14 to 7.9x at FYE15 and 9.2x for the June 30, 2016 LTM period. Fitch expects these credit metrics will improve slightly during FY16 and FY17.
As of June 30, 2016, the company controlled 202,000 lots, of which 55.5% were owned and the remaining lots controlled through options. Based on LTM closings, DHI controlled 5.2 years of land and owned roughly 2.9 years of land. As is the case with other public homebuilders, the company is trying to opportunistically acquire land at attractive prices. Total lots controlled increased 16.4% year-over-year (YOY), with lots under option growing 68% while owned lots declined 6.7% YOY. DHI has been successful in increasing its lots under options, growing from 20.1% of total lots controlled at FYE08 to 44.5% currently.
Land and development spending totalled $2.24 billion in FY15, $2.3 billion in FY14, and $2.6 billion during FY13. Through the first nine months of FY16, the company spent about $2 billion on land and development activities. (During the peak of the housing cycle, DHI spent about $5 billion annually on land and development.) Fitch expects the company will spend about $3 billion on land and development activities this year. Despite the higher real estate expenditures, Fitch expects DHI will be solidly cash flow positive during FY16.
Fitch is comfortable with this land strategy given the company's strong liquidity position, well-laddered debt maturity schedule and management's demonstrated ability to manage its spending. Management reiterated that land and development spending will remain a priority, but the company will adhere to its strict underwriting guidelines and continue to maintain adequate liquidity. Additionally, we expect management will pull back on spending if the current recovery in housing stalls or dissipates.
SOLID LIQUIDITY POSITION
As of June 30, 2016, DHI had unrestricted cash of $862.9 million and $881.8 million of availability under its $975 million revolving credit facility that matures in September 2020. DHI has well laddered debt maturities, with $349.3 million of senior notes maturing in 2017 and $398.7 million coming due in 2018. DHI repaid the $170.2 million and $372.7 million of senior notes at maturity in January and April 2016, respectively.
DHI generated positive cash flow from operations (CFFO) of $700 million during FY15 after spending $2.24 billion on land and development activities last year. For the LTM period ending June 30, 2016, the company generated about $600 million of CFFO. Fitch expects the company will generate CFFO of about $300 million to $500 million this year and perhaps a similar amount next year.
Fitch expects the company will maintain liquidity (combination of unrestricted cash and revolver availability) of at least $1 billion over the next few years.
MODERATE HOUSING RECOVERY CONTINUES
After four years of a moderate recovery and with land and labor constraints, it is unlikely that housing will accelerate into a V-shaped recovery. But a continuation of a multi-year growth is in the offing, and is supported by demographics, pent-up demand and attractive affordability as well as steady, albeit modest, easing in credit standards.
Though far from spectacular, the 2016 spring selling season was solid, which augurs well for the full year. Fitch is projecting single-family starts to expand 11.5% in 2016 and multifamily volume to gain about 4%. Total starts would be roughly 1.2 million (up 8.8%). New home sales should improve about 14.6%, while existing home sales rise 3%. Average and median home prices should rise 3.0%-3.5%, higher than earlier forecasts because of still tight inventories.
2017 could prove to be almost a mirror image of 2016. Real economic growth should be similar to this year, although overall inflation should be more pronounced. Interest rates will rise further but demographics and employment growth should be at least as positive in 2017. First-time buyers will continue to gradually represent a higher portion of housing purchases as qualification standards loosen further. Land and labor costs will inflate more rapidly than materials costs. Housing starts should total 1.311 million. Single-family volume should expand 10% to 877,000, while multi-family starts grow 5% to 434,000. New home sales should reach 640,000, up 11.5%. Existing home sales should gain 4% to 5.625 million. Average and median home prices should expand 2.0%-2.5% in 2017. Demand will continue to be affected by some narrowing of affordability, diminished but persistent and widespread negative equity, relatively challenging mortgage-qualification standards and lot shortages. A tight labor supply will also constrain production.
SOME EROSION IN AFFORDABILITY
The most recent Freddie Mac 30-year average mortgage rate (Sept. 22, 2016) was 3.48%, down 6 bps sequentially from the previous week and 17 bps higher than the all-time record low of 3.31%. Of course, current rates are still well below historical averages and help moderate the effect of much higher home prices during the past few years. Income growth has been (and may continue to be) relatively modest. Nevertheless, there has been some lessening of affordability as the upcycle in housing has matured. The Realtor Association's composite affordability index peaked at 207.3 in the first quarter of 2012, averaged 176.9 in 2013, 165.8 in 2014, 163.9 in 2015 and was 157.1 in July 2016.
Erosion in affordability is likely to continue as interest rates likely head higher later in 2016 (as the economy strengthens). Home price inflation should moderate a bit this year reflecting the mix of sales shifting more to first time homebuyer product. However, average and median home prices should still rise within a range of 3.0%-3.5% this year, pressuring affordability.
Several builders, including DHI, have introduced new product offerings over the past few years to address the erosion in home affordability. In FY14, DHI introduced the Express Homes brand targeted at the true entry level buyer who is focused first and foremost on affordability. Express is now offered in 51 markets, with the significant majority of sales and closings to date coming from Texas, the Carolinas and Florida. Express accounted for 28% of DHI's home deliveries in 3Q16 and 20% of home sales revenue. The average closing price of Express Homes in the June 2016 quarter was $205,000.
The company was an active consolidator in the homebuilding industry in the past, but has been much less acquisitive over the past 12 years. Since 2012, DHI has completed five acquisitions totaling about $512 million, including the acquisition of Wilson Parker Homes in September 2016 for $90 million. It appears that the company will continue to be principally focused on harvesting the opportunities within its current and adjacent markets.
DHI was the largest U. S. homebuilder in 2015 and has been for the past 14 years. More importantly, according to Builder Magazine, the company was the largest builder during 2015 in five of the 10 largest metro markets in the country and had the top 10 position in 35 of the 50 largest markets. It is the most geographically diverse builder with operations across 78 markets in 26 states. DHI has particularly heavy exposure to South Central, Southeast and Western states.
The company has historically focused on the broadest segments of the market-entry level and first step trade-up. DHI introduced two new brands in the past few years, targeting low entry level and luxury customer segments. Most recently, DHI introduced a new product offering targeting the active adult segment.
Fitch's key assumptions within our rating case for the issuer include:
--Industry single-family housing starts improve 11.5%, while new and existing home sales grow 14.6% and 3.0%, respectively, in 2016;
--DHI's homebuilding revenues increase about 10%-12%, while homebuilding EBITDA margins improve 10-30 bps during FY16;
--The company's net debt to capitalization ratio remains below 25% while debt/EBITDA approximates 1.8x and interest coverage reaches about 10x by FYE16;
--DHI spends approximately $3 billion on land acquisitions and development activities this year and generates cash flow from operations of $300 million to $500 million;
--The company maintains an adequate liquidity position (well above $1 billion) with a combination of unrestricted cash and revolver availability;
--DHI maintains a disciplined financial and growth strategy over the long-term that results in a steady capital structure.
Positive rating actions are unlikely in the near to intermediate term absent a change in the company's operating model wherein land is primarily controlled through options, which results in consistent cash flow generation through the cycle and significantly reduces the risk of downside volatility.
Negative rating actions may be considered if there is sustained erosion of profits due to either weak housing activity, meaningful and continued loss of market share, and/or ongoing land, materials and labor cost pressures (resulting in margin contraction and weakened credit metrics, including net debt to capitalization ratio consistently above 45%) and DHI maintains an overly aggressive land and development spending program that leads to consistent negative cash flow from operations and diminished liquidity position. In particular, Fitch will be focused on assessing the company's ability to repay debt maturities with available liquidity and internally generated cash flow.
Negative rating actions may also occur if the company meaningfully changes its financial and growth strategy, including debt-funded acquisitions and shareholder friendly activities and that could result in significantly weaker credit metrics at this point of the housing cycle.
FULL LIST OF RATING ACTIONS
Fitch has upgraded the following ratings for D. R. Horton, Inc.:
--Long-Term IDR to 'BBB-' from 'BB+';
--Senior unsecured debt to 'BBB-' from 'BB+/RR4'.
The Rating Outlook has been revised to Stable from Positive.