NEW DELHI & SYDNEY & SINGAPORE--(BUSINESS WIRE)--Fitch Ratings has upgraded the Issuer Default Rating (IDR) of Meritage Homes Corporation (NYSE: MTH) to 'BB-' from 'B+'. The Rating Outlook is revised to Stable from Positive. A complete list of rating actions follows at the end of this release.
KEY RATING DRIVERS
The ratings and Outlook for MTH are influenced by the company's execution of its business model, conservative land policies, geographic diversity and healthy liquidity position. The ratings and Outlook also take into account Fitch's expectation of further moderate improvement in the housing market in 2014 and 2015, share gains by MTH and hence volume outperformance relative to industry trends as the market continues its focus on trade-up housing (MTH's strength) and MTH's better profitability and sharply improved credit metrics.
MTH's sales are reasonably dispersed among its 15 metropolitan markets within eight states. During 2012, the company ranked among the top 10 builders in such markets as Dallas/Fort Worth, San Antonio and Austin, TX; Orlando, FL; Phoenix, AZ; Riverside/San Bernardino, CA; Denver, CO; and San Francisco/Oakland/Fremont and Sacramento, CA. The company also builds in the Central Valley, CA; Houston, TX; Inland Empire, CA; Tucson, AZ; Tampa, FL; and Raleigh-Durham and Charlotte, NC. MTH entered the Nashville, Tennessee market with its August 2013 acquisition of Phillips Builders.
Fitch estimates that currently less than 20% of MTH's sales are to entry level buyers; less than 5% are to active adults (retirees); less than 5% are to luxury customers; and the balance of the total are generated from first and second time trade-up customers.
GENERALLY IMPROVING HOUSING MARKET
Comparisons are challenging through first-half 2014, and so far this year most housing metrics seem to have been short of expectations and fallen somewhat from a year ago. Though the severe winter throughout much of North America restrained some housing activity, nonetheless, there is an absence of underlying consumer momentum so far this spring, perhaps due to buyer sensitivity to higher home prices and finance rates and the slowing of job growth at year end.
Housing metrics should improve for all of 2014 due to faster economic growth, and some acceleration in job growth, despite somewhat higher interest rates, as well as more measured home price inflation. Single-family starts are projected to improve 15% to 710,000 as multifamily volume grows about 9% to 335,000. Thus, total starts this year should top 1 million. New home sales are forecast to advance about 16% to 500,000, while existing home volume is flat at 5.10 million, largely due to fewer distressed homes for sale.
As Fitch noted in the past, the housing recovery will likely occur in fits and starts.
SOME EROSION IN HOME AFFORDABILITY
The most recent Freddie Mac 30 year average mortgage rate was 4.21%, down 8 bps sequentially from the previous week and about 80 bps higher than the average rate during the month of January 2013, a recent low point for mortgage rates. While the current rates are still well below historical averages, the sharp increase in rates and considerably higher home prices in 2013/2014 have moderated affordability.
Fitch projects that mortgage rates will average 60-80 bps higher in 2014 (relative to 2013) as the Fed continues to taper and the economy strengthens. New home price inflation should moderate in 2014, at least partially because of higher interest rates. Average and median new home prices should increase about 3.5% in 2014. However, Fitch's expectations of a more dynamic economic expansion this year with stronger job growth will more than offset this lessening in affordability. This will be particularly the case for the move-up and active adult markets.
MTH employs conservative land and construction strategies. The company typically options or purchases land only after necessary entitlements have been obtained so that development or construction may begin as market conditions dictate.
Under normal circumstances MTH extensively uses lot options, and that is expected to be the future strategy in markets where it is able to do so. The use of non-specific performance rolling options gives the company the ability to renegotiate price/terms or void the option, which limits downside risk in market downturns and provides the opportunity to hold land with minimal investment.
However, as of March 31, 2014, only 26.8% of MTH's lots were controlled through options - a lower than typical percentage as there are currently fewer opportunities to option lots and, in certain cases, the returns for purchasing lots outright are far better than optioning lots from third parties.
Total lots controlled, including those optioned, were 25,807 at March 31, 2014. This represents a 4.8-year supply of total lots controlled based on trailing 12-months deliveries. On the same basis, MTH's owned lots represent a supply of 3.6 years.
MTH began to increase its overall land position during the middle of 2010 following four years of declining lot supply. The company spent roughly $236 million on land purchases during 2010, compared with $182 million during 2009. In 2011, MTH invested $200 million in land and $50 million in development. The company spent $480 million on land and development in 2012. In 2013 MTH expended $565 million on real estate including $165-175 million on development activities. This year the company may invest $700-750 million in real estate activities, including a couple of hundred million in land development. Land banking may play a moderately more significant role in MTH's land strategy in 2014.
MTH successfully managed its balance sheet during the severe housing downturn, allowing the company to accumulate cash and pay down its debt as it pared down inventory. The company had unrestricted cash of $261 million and investments and securities of $77.7 million at March 31, 2014. The company's debt totaled $904.9 million at the end of the first quarter 2014.
MTH's debt maturities are well-laddered, with the next debt maturity in March 2018, when its 4.50% $175 million senior notes become due.
MTH has been willing to occasionally issue equity. It issued $90 million of common equity during the 3Q 2012. More recently, in January 2014 the company issued approximately 2.53 million shares of common stock for net proceeds of approximately $110 million to use for working capital, potential expansion into new markets and/or expansion of existing markets, including the possible acquisition of other homebuilders or assets, and general corporate purposes.
In July 2012, the company entered into a new $125 million unsecured revolving credit facility maturing in 2015. The facility was amended during the second quarter of 2013, which increased the commitment to $135 million and extended the maturity to 2016. The size of the facility was subsequently raised further to $200 million. There were no outstandings under the revolver as of March 31, 2014. Current availability is $164.4 million.
Leverage has been steadily improving in recent years, in particular during 2013 and into 2014. The ratio decreased to 3.5x at the end of the first quarter of 2014 from 7.9x at 4Q end 2012 and 12.0x at the conclusion of 2011. Interest coverage, which was 2.0x at Dec. 31, 2012, has also been consistently improving - reaching 5.0x at March 31, 2014. Fitch expects these credit metrics will be enhanced during the balance of 2014 with leverage decreasing to slightly less than 3.5x and interest coverage expanding in excess of 5x.
As is the case with most builders in our coverage, Fitch expects MTH will be cash flow negative in 2014. The company was cash flow from operations (CFFO) negative $131.7 million in the March 2014 quarter and on an LTM basis was CFFO negative by $217.9 million. In 2013, 2012 and 2011, the company was negative CFFO by $86.3 million, $220.5 million and $74.1 million, respectively. Fitch currently expects MTH will be CFFO negative by almost $100 million in 2014. The company is expected to meaningfully increase its land and development spending in 2014 influencing cash flow. But as the cycle matures, real estate spending is likely to level out in 2015 as profits continue to rise and consequently cash flow likely will turn positive.
Fitch is comfortable with this real estate strategy given the company's liquidity position and debt maturity schedule. Fitch expects MTH over the next few years will maintain liquidity (consisting of cash and investments and the revolving credit facility) of at least $350 million - $400 million, a level which Fitch believes is appropriate given the challenges/risks still facing the industry.
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 better than Fitch's current outlook and shows durability; MTH shows sustained improvement in credit metrics (such as homebuilding debt to EBITDA consistently at or below 3.5x); and the company continues to maintain a healthy total liquidity position consisting of cash, short term investments and credit facility availability (above $350 million).
A negative rating action could be triggered if the industry recovery dissipates; 2014 and 2015 revenues each drop in excess of 20% while pretax profitability approaches 2011 levels; and MTH's liquidity position falls sharply, perhaps below $300 million as the company maintains an overly aggressive land and development spending program.
Fitch has taken the following rating actions on MTH:
--IDR upgraded to 'BB-' from 'B+';
--Senior unsecured debt affirmed at 'BB-'.
With the upgrade of MTH's IDR to 'BB-' from 'B+', recovery ratings are no longer assigned to individual debt instruments. MTH's senior unsecured notes are rated at the same level as the company's IDR.
The Rating Outlook is revised to Stable from Positive.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Corporate Rating Methodology' (Aug. 5, 2013);
--'Liquidity Considerations For Corporate Issuers (June 12, 2007).
Applicable Criteria and Related Research:
Corporate Rating Methodology: Including Short-Term Ratings and Parent and Subsidiary Linkage
Liquidity Considerations for Corporate Issuers