Fitch Upgrades M/I Homes' IDR to 'B '; Outlook Stable
KEY RATING DRIVERS
MHO's ratings and Outlook reflect the company's execution of its business model in the current housing environment, management's demonstrated ability to manage land and development spending, healthy liquidity position, improving credit metrics and Fitch's expectation of further improvement in the housing market in 2015.
The ratings upgrade reflects MHO's improving financial and credit metrics and Fitch's expectation of further progress in financial results during the next 12-18 months. Credit metrics have improved significantly over the past three years. Leverage as measured by debt to EBITDA declined from 12.1x at the end of 2011 to 6.6x at the conclusion of 2012, 4.9x at year-end 2013 and 4.2x at the conclusion of 2014. Similarly, interest coverage increased from 0.8x in 2011 to 1.7x during 2012, 2.6x during 2013 and 3.5x at year-end 2014. Fitch expects further improvement in these credit metrics this year, with debt to EBITDA projected to be below 4x and interest coverage remaining above 3x.
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 4.9% to 647,400 and multifamily volume grew 16% to 355,600. Thus, total starts in 2014 were 1.003 million. New home sales were up 1.9% to 437,000, while existing home volume was off 3% 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 rose 5.7% in 2014, while median home prices advanced approximately 5.5%.
Housing activity is likely to ratchet up more sharply in 2015 with the support of a steadily growing, relatively robust economy throughout 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 (averaging 5.8% 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 17.5% to 760,000 as multifamily volume expands 7% to 381,000. Total starts would be in excess of 1.1 million. New home sales are projected to increase about 18% to 515,000. 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.
HOUSING AFFORDABILITY
The most recent Freddie Mac 30 year average mortgage rate (Feb. 26, 2015) was 3.80%, up 4 basis points (bps) sequentially from the previous week and 39 bps higher than the average rate during the month of January 2013 (3.41%), a low point for mortgage rates. Current rates are about 37 bps below the average in 2014 and still 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, 164.4 in 2014 and was 167.8 in December 2014.
Erosion in affordability is likely to continue as interest rates likely head higher in 2015 (as the economy strengthens). Fitch projects that mortgage rates will average 30-40 bps higher in 2015. Home price inflation should moderate this year reflecting the higher interest rates and the mix of sales shifting more to first time homebuyer product. However, average and median home prices should still rise within a range of 2.2%-2.7% this year, pressuring affordability.
HEALTHY LIQUIDITY POSITION
MHO ended 2014 with \$15.5 million of unrestricted cash and \$243 million of borrowing availability under its \$300 million revolving credit facility. In October 2014, MHO amended its revolver and increased the facility by \$100 million to \$300 million, extended the maturity to 2018 and reduced its Eurodollar and Alternative base rate margins. The facility has an accordion feature that allows the revolver to be increased up to \$400 million, subject to additional commitments. The company has no major debt maturities until 2017, when \$57.5 million of convertible senior subordinated notes mature.
LAND STRATEGY
Following the significant reduction of its land supply during the 2006-2009 periods, MHO began to focus on growing its business in late 2009 by investing in new communities and entering new markets. In 2010, the company increased its total lot position by 9.2% and expanded into the Houston, Texas market. During 2011, the company entered the San Antonio, Texas market and also grew its total lot position by 1.8%. MHO extended its geographic footprint by expanding further into Texas, entering the Austin market in 2012 and the Dallas/Fort Worth market in 2013. Total lots controlled increased 37.2% in 2012, 39.6% in 2013, and 4.5% in 2014.
MHO maintains an approximately 5.6-year supply of total lots controlled, based on trailing 12 months deliveries, and 3.1 years of owned land. Total lots controlled were 20,725 at Dec. 31, 2014. About 54.8% of the lots are owned and the balance is controlled through options.
Historically, MHO developed about 80% of its communities from which it sells product, resulting in inventory turns that were moderately below average as compared to its public peers. During the recent downturn, MHO had been less focused on land development as most land purchases were developed lots. In 2011, only 5% of land purchases were raw lots. During the past three years, MHO has been purchasing more raw land due to the decline in the availability of developed lots. Management estimates that raw land purchases accounted for about 60% of total land purchases during 2012 and 50% of total land purchases during 2014 and 2013. The percentage of lots internally developed by the company was 79% during both 2014 and 2013.
LAND AND DEVELOPMENT SPENDING AND CASH FLOW
MHO spent roughly \$382 million on land and development during 2014 (\$237.7 million for land and \$144.3 million for development) compared with \$323.6 million expended during 2013 (\$216.8 million for land and \$106.8 million for development) and \$195.1 million in total spending during 2012. The company expects total land and development spending will be between \$400 million and \$450 million during 2015.
MHO has reported negative cash flow from operations (CFFO) for the past five years, as the company rebuilds its land position. In 2014, MHO reported negative CFFO of \$132.7 million. This compares to negative CFFO of \$74 million in 2013, \$47 million in 2012, \$34 million in 2011 and \$37.3 million in 2010. Fitch expects MHO will be cash flow neutral during 2015 as the company only slightly expands inventory.
Fitch is comfortable with this strategy given the company's healthy liquidity position and management's demonstrated ability to manage its spending.
KEY ASSUMPTIONS
Fitch's key assumptions within its rating case for the issuer include:
--Total industry housing starts improve 13.8%, while new and existing home sales grow 18% and 4.3%, respectively, in 2015;
--MHO's revenues grow low double-digits and operating profit margins remain stable in 2015;
--MHO's debt/EBITDA falls below 4.0x and interest coverage exceeds 3.0x during 2015;
--The company spends between \$400 million and \$450 million on land acquisitions and development activities during 2015;
--The company maintains a healthy liquidity position (above \$150 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 and especially free cash flow trends and uses, and the company's cash position.
Further positive rating actions may be considered if the recovery in housing is maintained, MHO's credit metrics improve further (particularly debt-to-EBITDA sustaining at 3.5x and interest coverage exceeding 4x), and the company preserves a healthy liquidity position (above \$150 million with a combination of unrestricted cash and revolver availability).
A negative rating action could be triggered if the industry recovery dissipates; EBITDA margins decline 200-300 bps; leverage exceeds 6x and MHO's liquidity position falls sharply, perhaps below \$100 million.
Fitch has upgraded M/I Homes' ratings as follows:
--Long-term IDR to 'B+' from 'B';
--Senior unsecured notes to 'BB-/RR3'from 'B+/RR3';
--Convertible senior subordinated notes to 'B-/RR6'from 'CCC+/RR6';
--Series A non-cumulative perpetual preferred stock to 'CCC+/RR6' from 'CCC/RR6'.
The Rating Outlook is Stable.
The Recovery Rating (RR) of 'RR3' on MHO's senior unsecured notes indicates good recovery prospects for holders of this debt issue. MHO's exposure to claims made pursuant to performance bonds 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 debt holders. The 'RR6' on MHO's convertible senior subordinated notes and preferred stock indicates poor recovery prospects in a default scenario. Fitch applied a liquidation valuation analysis for these recovery ratings.
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