NEW YORK--(BUSINESS WIRE)--Fitch Ratings has affirmed the ratings of KB Home (NYSE: KBH), including the company's Long-Term Issuer Default Rating (IDR) at 'B+'. The Rating Outlook is Stable. A complete list of rating actions follows at the end of this release.
KEY RATING DRIVERS
The ratings for KBH are based on the company's geographic diversity, customer and product focus, conservative building practices and effective utilization of return on invested capital criteria as a key element of its operating model. The company's largely presale strategy also reduces the risk of excess inventory.
Early in the recovery KBH was somewhat conservative in committing to incremental land purchases. It has accelerated its spending during the past few years but should not become stressed so long as it maintains its minimum return parameters for real estate that it purchases. The company has also generated positive cash flow from operations (CFFO) during FY15 and Fitch expects the company will continue to generate positive CFFO during FY16 and FY17.
The Stable Outlook takes into account further moderate growth in the housing market in 2016 and 2017, KBH's solid liquidity position and improvement in the company's operating and financial results. The company has also shown the ability to manage land and development spending and generate meaningful cash flows during periods of distress.
IMPROVING FINANCIAL RESULTS
KBH's homebuilding revenues during the first nine months of FY16 (ending Aug. 31, 2016) increased almost 24% to $2.39 billion as home deliveries improved 20.5% to 6,769 homes and the average selling price (ASP) advanced 2.8% to $353,100. Land sales totaled $4.2 million during the 2016 YTD period compared with $110.5 million during the same period last year.
Homebuilding gross profit margin (excluding inventory and land option charges) increased about 35 bps during the 2016 YTD period to 16.4% due to increased home deliveries, offset in part by higher land and construction costs (primarily labor costs). SG&A as a percentage of homebuilding revenues declined 100 bps to 11.7% for the first nine months of FY16.
The company reported solid net order growth despite lower average community count and ended third-quarter 2016 with 5,226 homes in backlog with a value of $1.85 billion.
CREDIT METRICS IMPROVING BUT REMAIN WEAK
The company's credit metrics have shown improvement in recent years but remain generally weak. KBH's net debt to capitalization ratio declined from 75% at fiscal year-end (FYE) 2013 (ending Nov. 30, 2013) to 58% at FYE2014 and 55% at FYE2015. This ratio was 58% as of Aug. 31, 2016. Total debt to capitalization declined from 80% at FYE2013 to 62% at FYE2014, 61% at FYE2015 and 61% at Aug. 31, 2016. Fitch expects KBH's net debt/capitalization will remain below 60% at FYE16 and approach 55% at FYE2017. The company has a target (mid-term) net debt to capitalization ratio of 40% - 50%.
Debt-to-EBITDA has improved from 10.0x at FYE2014 to 8.4x at FYE2015 and 7.4x for the latest-12-months (LTM) ending May 31, 2016 (third-quarter 2016 financial statements are not yet available). FFO adjusted leverage was 7.5x at FYE2015 and is currently 6.8x. Interest coverage rose from 1.5x at the end of FY2014 to 1.7x at FYE2015 and 1.9x for the May 31, 2016 LTM period. Fitch expects these credit metrics will improve further during FYE2016 and FY2017.
LIQUIDITY AND CASH FLOW
As of Aug. 31, 2016, KBH had unrestricted cash of $334.7 million and $242.5 million of borrowing availability under its $275 million revolving credit facility that matures in August 2019. The company has meaningful debt maturities during the next three years, including $265 million of senior notes in 2017, $300 million of senior notes in 2018 and $630 million of senior notes in 2019 (including $230 million of convertible notes). The company has shown the ability to access the capital markets in the past and Fitch expects KBH will refinance a portion of these debt maturities as their due dates approaches.
KBH generated positive cash flow from operations (CFFO) of $149.5 million for the Aug. 31, 2016 LTM period after reporting positive CFFO of $181.2 million during FY15 and negative CFFO of $630.6 million during FY14. Fitch expects the company will generate CFFO of $50 million - $100 million during FY16 and perhaps a similar amount in FY17.
In January 2016, KBH's board authorized the company to repurchase a total of up to 10 million shares of its outstanding common stock, which incorporated four million shares that remained under a prior board-approved share repurchase program. During first quarter 2016, the company repurchased 8,373,000 of its common stock for $85.9 million. Management indicated that the share repurchase was opportunistic and a compelling use of its capital at that time. Management is focused on delevering the balance sheet and Fitch does not anticipate additional meaningful share repurchases.
OPERATING AND LAND STRATEGY
KBH employs what it calls its KBnxt operational business model. This strategy includes regular detailed product preference surveys, primarily acquiring partially or fully developed and entitled land in markets with high growth potential. Construction is generally begun only after a purchase contract has been signed, establishing an even flow of production, pricing homes to compete with existing homes and using design centers to customize homes to the preferences of homebuyers. KBH strives to be among the top five builders or, in very large markets, top 10 homebuilders, in order to have access to the best land and subcontractors.
The company generally does less speculative building of homes than almost all of its peers. This is a low risk approach to homebuilding. KBH is one of a handful of public builders aggressively marketing energy efficient homes as a way of differentiating its homes from other builders' product and existing homes for sale.
As of Aug. 31, 2016, KBH controlled 46,636 lots, of which 81% were owned and the remaining lots controlled through options. Total lots controlled declined 1.5% YOY as its owned land position fell about 3% while lots controlled through options grew approximately 6% YOY.
Based on LTM closings, KBH controlled 5 years of land and owned roughly 4.0 years of land. The company's land supply (number of years) has been falling due to increased deliveries as well as declining lots controlled since the second half of FY14. Total land supply fell from 8.6 years at FYE13 to five years currently while the company's owned land supply decreased from 5.4 years at FYE14 to 4.0 years as of Aug. 31, 2016.
Land and development spending totalled $967 million in FY15 compared with $1.47 billion during FY14, $1.14 billion in FY13 and $564.9 million during FY12. For the first nine months of FY16, the company spent $1.06 billion on land and development activities. During FY16, the company expects to spend about $1.3 billion. Despite the higher real estate expenditures, Fitch expects KBH will generate CFFO of $50 million to $100 million during FY16.
Fitch is comfortable with this real estate strategy given the company's strong liquidity position and management's demonstrated ability to manage its spending. Fitch expects management will pull back on spending if the current recovery in housing stalls or dissipates.
KBH has also been reactivating previously mothballed communities. During first-quarter 2012, the company had about $737 million of land held for future development, accounting for about 43% of its total inventory. As of third-quarter 2016, land held for future development has declined to approximately $421 million or about 12% of total inventory. Management indicated that during third-quarter 2016, about 15% of its deliveries were from communities that have been reactivated and about 16% of its average community count was previously mothballed communities. At the end of the quarter, the company had 227 active communities, of which 38 communities were previously mothballed.
The gross margins from home deliveries from reactivated communities average about 10% compared with the YTD gross margin of about 16.4%. During 3Q'16, management estimates that deliveries from reactivated communities reduced overall gross margins by about 80 bps. While this has negatively impacted the company's gross margins, the reactivation of previously mothballed communities allows the company to monetize these assets and use the cash flow to invest in assets that could generate higher returns. Management indicated that KBH has 60 mothballed communities remaining, which can be reactivated if market conditions improve.
REASONABLE GEOGRAPHIC AND CUSTOMER DIVERSITY
KBH was the 6th largest homebuilder in 2015 and 2014 and had been consistently among the top five builders between 2004 and 2013. The company operates in 36 markets across seven states. According to Builder Magazine, KBH has a presence in 13 of the top 20 housing markets and has a top ten position in 13 of the 50 largest metro markets in the country. During the second quarter of FY16, the company began a transition out of the Washington D.C. market that is expected to be completed over the next 12 months. KBH's operation in this geography, which consisted of communities in Maryland and Virginia, represented 2% of the company's homebuilding revenues for the nine months ended Aug. 31, 2016.
Management estimates that about 52% of its homes were directed to the first-time homebuyer, 22% to first move-up, 12% to second move-up and 14% to the active adult segment.
KBH is headquartered in California and has had significant exposure to that state for most of its history. For the first nine months of FY2016, 26.6% of home deliveries and 43% of revenues were generated from that state. About 39% of the company's homebuilding assets are located in California. It is important to note that the state is made up of a number of regions and markets which do not perform uniformly and react to different stimuli. Within California and through the cycle, the company tries to overweight those markets which have the best demand, pricing and return characteristics. (Currently, strong price appreciation in coastal markets is pushing demand higher in inland markets.) Overall the state's cyclicality generally mirrors that of the nation as a whole and often begins a downturn before most states and begins recovery earlier.
KBH also has meaningful exposure in Houston and was the 7th largest homebuilder in that metro area with 1,025 deliveries (3.9% market share according to Builder Magazine) during 2015. (The Houston market represented about 12% - 13% of KBH's deliveries). Fitch is concerned about the impact of continued low oil prices on the economy of this metro area. The company pulled back on its investments in Houston in early 2015, resulting in lower community count. According to management, it is seeing the market stabilize with solid demand at price points below $250,000. KBH's average ASP in Houston is about $230,000. The company reported YOY net order growth during third-quarter 2016 despite fewer open communities.
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%.
The year 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. 29, 2016) was 3.42%, down 6 bps sequentially from the previous week and 11 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.
Similar to other homebuilders, the company has taken steps to address the erosion in affordability. KBH has repositioned some of its communities wherein it may offer a smaller home in terms of square footage and price the product lower. The company does extensive market research in order to ensure that its products are aligned with the consumers and the household incomes in their communities.
Fitch's key assumptions within the rating case for KBH include:
--Industry single-family housing starts improve 11.5%, while new and existing home sales grow 14.6% and 3.0%, respectively, in 2016;
--The company's homebuilding revenues increase 15% - 17%, while homebuilding EBITDA margins improve 25-75 bps during FY16;
--KBH's net debt to capitalization ratio remains below 60% while debt/EBITDA approximates 7x and interest coverage reaches 2x by FYE16;
--The company spends about $1.3 billion on land and development activities during FY16;
--KBH generates cash flow from operations of $50 million to $100 million during FY16 and perhaps a similar amount in FY17;
--The company maintains an adequate liquidity position (above $500 million) with a combination of unrestricted cash and revolver availability.
KBH's ratings are constrained in the intermediate term due to relatively high leverage levels. However, positive rating actions may be considered if KBH shows further steady improvement in credit metrics (such as net debt to capitalization ratio consistently at or below 50%), while maintaining a healthy liquidity position (in excess of $500 million in a combination of cash and revolver availability) and continues generating consistent positive cash flow from operations as it improves its profitability and/or moderates its land and development spending.
Conversely, 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 sustained above 55%) and KBH maintains an overly aggressive land and development spending program that leads to consistent negative cash flow from operations, higher debt levels 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 be considered if the company's credit metrics do not improve from current levels in a moderately improving housing environment.
FULL LIST OF RATING ACTIONS
Fitch has affirmed the following ratings for KB Home:
--Long-Term IDR at 'B+';
--Senior unsecured debt at 'B+/RR4'.
The Rating Outlook is Stable.
The Recovery Rating (RR) of 'RR4' on KBH's senior unsecured notes indicates average recovery prospects for holders of these debt issues. KBH's exposure to claims made pursuant to performance bonds and joint venture debt (recourse) 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 debtholders. Fitch applied a liquidation valuation analysis for this RR.
Additional information is available on www.fitchratings.com.
Summary of Financial Statement Adjustments - Financial statement adjustments that depart materially from those contained in the published financial statements of the relevant rated entity or obligor are disclosed below:
--Historical and projected EBITDA is adjusted to add back non-cash stock-based compensation and interest expense included in cost of sales and also excludes impairment charges and land option abandonment costs.
Criteria for Rating Non-Financial Corporates (pub. 27 Sep 2016)
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