A Rising Tide Boosts Profits, And Homebuilders Fortify Their Footings

The credit outlook for homebuilders benefits from good long-term demand, stronger pricing amid tight supply and record-low mortgage rates, good cost management, and judicious capital allocation. Many homebuilders have used this windfall to strengthen their balance sheets for an unpredictable, but inevitable downturn. Even if the boom in homebuilder profits moderates in 2021 or 2022 with higher costs and less determined buying, we expect that robust profitability and low debt levels will sustain solid credit measures for most. The industry's profitability in 2021 relies on disciplined pricing and better returns from stronger market positions at 1.3 million to 1.4 million housing starts than the euphoric volume growth in the mid-2000s. Nevertheless, higher interest rates could yet sap the important price growth that has sustained margins amid higher costs and an industrywide shift to lower price points. Or, higher unemployment could yet drag volumes down for economically sensitive and discretionary items like new homes.

We have positive outlooks on 28% of credits early in 2021. The positive credit momentum of U.S. homebuilders only took a short breather when the pandemic slowed customer traffic in the spring of 2020. U.S. homebuilders were building significant buffer to withstand a sharp slowdown heading into the pandemic, and industry conditions resumed their multiyear strength after a pause in March and April 2020. Debt leverage from lower earnings is higher in a few cases, but most homebuilders generated good cash flows bolstered by more conservative policies even before the pandemic started. Moreover, U.S. homebuilder balance sheets are well fortified to withstand a slowdown, given improving asset coverage from lower debt over the past few years.

Over the past six months S&P Global Ratings has taken favorable rating actions on four of the five builders rated in the 'BB+' category, our highest speculative-grade rating. In October 2020, we assigned positive outlooks on three of these builders, namely Lennar Corp., PulteGroup Inc., and MDC Holdings Inc. Of the remaining two, we upgraded Meritage Homes Corp. to 'BB+' in mid-February, and thus equalized its rating to the other four homebuilders in this rating category including Toll Brothers Inc., which we've rated at this level since 2011.

Performance under individual issuer stress tests for credit buffer will guide upgrades. Our varying (and some long) outlook horizons take into account potentially volatile earnings in this cyclical industry, as well as each companies' track record of debt-funded growth or shareholder remuneration. We typically aim for a one-year outlook horizon for speculative-grade credits and up to two years to confirm transition among investment-grade ratings. Some of these companies have improved debt leverage only in the last 24 months, so that persistence and cushion are most important, especially in the transition to investment-grade. As such, each will be subject to profit, capital, and policy scenarios that test key rating thresholds so we can be reasonably assured of defensible credit ratios in difficult conditions.

Potential upgrades to investment grade ('BBB-') for the five builders discussed below are case-by-case, based on each company's growing financial cushion, underpinned by indications of sustainably improved competitive positioning in the last decade. Our rating decisions should stand up to comparisons against industry peers as well as investment-grade companies in other sectors. This article breaks down each company's credit strengths and weakness and unique characteristics amid an uncertain, dynamic industry backdrop.

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It's Not Just How Good You Look Now…

It's one thing to achieve ratios consistent with an investment-grade rating amid a decade-long industry upswing. Keeping an investment grade rating when the cycle turns, however, necessitates stress tests now to determine the downside cushion for a reasonable downturn.

Real estate development and homebuilding is a highly cyclical industry. Homebuilders (mostly U.S.) experienced an average peak-to-trough (PTT) decline in revenues of about 20% during recessionary periods since 1968. In three of the recessionary periods, revenue declines significantly exceeded 20%, with the steepest decline (a 45% drop in revenues) occurring during the most recent downturn in 2007-2009. Since 1959, EBITDA margins typically fell by about one-quarter during recessionary periods.

We've applied these declines in revenues and profits to the 2020 results of these five 'BB+' builders, in a scenario where 2020 is the peak of the cycle. The 'BB+' rated homebuilders with positive outlooks appear likely to sustain our key debt to EBITDA threshold in this hypothetical stress scenario, thanks to their growing cushion below our key 3x level. Under the simulated stress conditions, the only builder whose credit profile breaches its downside triggers would be Toll Brothers, whose leverage could rise to 5.6x in a quick downturn from 3.3x in 2020.

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Admittedly, these are simple assumptions, with only two variables (debt and EBITDA), to facilitate comparison. Note that this stressed exercise makes no allowance for countercyclical characteristics inherent to what's a very cyclical industry. The most important countercyclical characteristic, or lever, to pull in a downturn is for a builder to reduce the replenishment of (land) inventories in a downturn. During the housing crisis of 2006-2010, for example, every builder in this group (and most of the industry) generated significant free operating cash flows by pulling back on land acquisition and development in response to sharp declines in revenues and EBITDA.

Upside scenarios

Our thresholds for an upgrade are largely tied to the sustainability of some key credit metrics, with debt to EBITDA viewed as the most important. Our upgrade triggers are closely tied to maintaining existing leverage metrics through a cycle without significant deterioration that would warrant a rating change. For the smaller-scale builders, namely MDC, Toll Brothers, and Meritage, in addition to maintaining leverage metrics below 3x, we also assess either their size or profitability and in the case of Meritage, both, relative to their ratings peers.

Table 1

Pricing Power Is Offsetting Higher Input Costs

We forecast PulteGroup's profit margins of 18%-19% through 2022, exceeding those of its 'BB+' rated peers. However, we've observed sharply improving profit trends at MDC and Meritage as well, despite their much smaller scale--or perhaps because they are smaller, and nimbler than Lennar, PulteGroup, and even Toll Brothers.

Meritage and MDC each operate in about 20 markets, compared to more than twice that for these larger ratings peers yet with EBITDA doubling (Meritage), and nearly tripling (MDC), from 2017 through 2021 estimated, their EBITDA margins now approach PulteGroup's.

Moreover, the industry has become increasingly focused on returns, a comprehensive measure whose calculation also reflects capital (deployed), where improved activity levels, or asset turns, compound the benefit from higher margins. Based solely on five-year returns on capital, MDC and Meritage's profitability now easily exceed PulteGroup and these other, larger peers, thanks largely to their faster inventory turns.

Toll Brothers typically generates the industry's highest EBITDA margin on the industry's highest average selling price (ASP), which provides it with leading margin dollars per unit. In 2020, however, Toll Brothers' EBITDA margin of less than 13% was the lowest of all the 'BB+' rated homebuilders because of deeper and more protracted downturns in its geographical and product segments early in the pandemic. Toll Brothers' robust cash margin requires, by far, the highest working capital intensity, converting high margins into the lowest return on capital among its peers; the company only generates inventory turns that are about two-thirds those of its direct peers.

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The lack of geographic diversification can be a short-term strength but a hindrance over an entire housing cycle

MDC improved its EBITDA margin to 15% from 10% in just the past three years, helping to drive an even wider improvement in returns (on capital) from 2017 through 2020. But, even though its revenues have grown apace, or by about 50% in this span, we think that's in part due to being in the right states--where nearly 80% of revenues, and likely an even greater portion of profits, arise from its "big 4" western states (Colorado, California, Arizona, and Nevada). Similarly, in 2020, some 73% of all Meritage's revenue was generated from just four states (Texas, California, Arizona, and Florida).

Efficient builders capitalize on scale and other competitive advantages

Size and diversification are usually associated with market breadth, which can lead to economies of scale. On the revenue side, product diversification allows a builder to offer homes to multiple distinct buyer-types (first move-up, active adult, luxury)--often within a single neighborhood (i.e., community) and across any market. A broad business mix allows the builder to capture a wider base of buyers. In terms of cost benefits from scale, efficiencies gained here translate to lower overhead costs and other expenses. Though homebuilding has relatively few fixed costs, corporate overhead is the largest fixed, leverage-able expense. The chart below illustrates the relationship between scale (based on 2020 home closings) and selling, general, and administrative (SG&A) costs.

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Based on its low SG&A expenses of about 8% (of revenues), Lennar is the most efficiently managed homebuilder in the 'BB+' rated category. Not coincidentally, Lennar is the largest builder of the group. PulteGroup, the next largest, has the second-lowest SG&A, at just under 10%. All others have SG&A of about 10% of revenues, except Toll Brothers, whose sales and overhead costs combine for 12.5% of revenues.

Management of inventories (i.e., land and homes) is another key differentiator

The primary risk in the developer and homebuilding industry is in the land and (unsold) homes carried on the balance sheet as inventory, when the industry is going through a downturn. Thus, the considerable amount of risk inherent to these costly inventories warrants their active management. Indeed, S&P Global's Recovery Analysis--a simulated default scenario--basically assesses the recoverable value of inventories in relation to the builder's borrowings, further underscores the importance of what's typically a builder's largest single asset.

Lessons from crises past

Most builders continue trending toward a "land-light" business model, to offset these land-related risks when demand is weak, and to enhance returns amid strong demand, as is currently the case. This approach helps minimize capital needs and allows builders to "take-down" or purchase homesites closer to delivery of the home on that lot. This strategy should also help avoid the very large land related write downs taken by most builders in the previous downturn.

Table 2

Revenue growth exceeding asset growth is an important industry trend

Most builders now prioritize returns over profits alone, another nod to NVR's highly successful approach. When combined with higher margins, faster inventory turnover results in higher returns and swelling discretionary cash flows. Compared to the last upcycle ended in 2005-2006, builders now increasingly rely on volumes rather than price. These resulting lower capital needs will provide additional cushion--against inventory-based risks--when housing demand declines.

Financial Risk

Most of these five builders already operate close to the financial metrics of the two long-standing investment-grade builders (i.e., NVR Inc., D.R. Horton). With the housing cycle now in its 10th and most profitable year, for the builders, net debt levels have declined for the majority. Combined with EBITDA trending upward, most of these five builders have made sharp improvements on key leverage metrics.

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Toll Brothers and Meritage provide studies in contrasts

Average home prices remain on a downward trend. That largely reflects an industry-wide shift in mix to more affordable homes and despite home price inflation (when adjusted for size, location, etc.). Of this group of five 'BB+' rated builders only Toll Brothers and Meritage have stable outlooks, with Lennar, PulteGroup, and MDC with positive outlooks since October 2020. And while Meritage is a newcomer to this highest speculative-grade rating, our issuer credit rating on Toll Brothers has been at 'BB+' since mid-2011.

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Pennsylvania-based Toll Brothers' has focused on the luxury home market since it began more than 50 years ago. Its ASP is more than double that for Meritage. It's only been in the past five or six years that Arizona-based Meritage began to sharply shift its focus to favor the entry-level and first move-up segments.

Meritage's successful shift in product mix--to the largest and currently most robust home-buying segment--is a key driver of the company's significantly improved credit profile. By contrast, Toll Brothers' absence from these profitable buyer segments has been a drag its results and, in consequence, our credit rating on the company. Indeed, Meritage's debt to EBITDA dropped to 0.5x in 2020 from 3.4x in 2017, by reducing debt and growing EBITDA each by close to 70%. Yet over this same three-year span, Toll Brothers' leverage increased to 3.3x in 2020, from 2.7x, due to a modestly higher debt balance and moderately lower EBITDA.