Toll Brothers became the latest builder to have its debt downgraded last week, when Moody’s Investors Service reduced its credit rating on Toll’s senior debt to below-investment, or “junk,” grade. The rating, to Ba1 from Baa3, addresses Toll’s senior notes, which at the conclusion of the quarter ended April 30 totaled $1.143 billion. Moody’s says its rating affects just less than $1.5 billion of Toll’s debt.
The New York-based Moody’s has been the most bearish and pessimistic among the credit raters — which include Standard & Poor’s and Fitch Ratings— in its view of current housing market conditions. (It lowered the ratings of six publicly traded builders’ debt last month alone.) And the Horsham, Pa.-based Toll, which remains one of only a few builders that are generating positive earnings before impairment charges, has wobbled financially recently, with a net loss of nearly $190 million for the six months ended April 30.
Fred Cooper, Toll’s senior vice president of investor relations, declined to comment on the record about Moody’s rating and what his company would need to do to restore that debt’s investment-grade status.
Whether the lower debt rating will put a crimp in Toll’s operations or in any future recapitalization efforts remains an open question, considering the company had a $1.89 billion credit facility in place at the conclusion of the first half of its fiscal year.
Moody’s downgrade of Toll’s notes is based on two factors: the general malaise of public builders that continue to leak red ink; and the prospect that Toll’s fortunes are sliding downhill.
The timing of the downgrade corresponds with the completion of a review of the builder’s debt that Moody’s initiated on March 27, says Joseph Snider, a senior credit officer with the rating service. “Both economic and home building industry trends have become more negative since the ratings were first put on review,” he states.
When asked why Moody’s downgraded Toll’s senior notes but left its ratings on Toll’s $350 million in subordinated notes unchanged, Snider tells BUILDER that his company now uses a “loss given default model” to rate debt based on several criteria, including the position and proportion of that debt within a company’s capital structure. It also accounts for broader economic factors.
That model narrowed the difference in the rating between Toll’s subordinated and senior debt, even though Toll’s senior debt is supported by a guaranteed upstream of capital from the builder’s operating subsidiaries.
Snider concedes that Toll’s debt-to-equity ratio, which is at or near its lowest level ever, remains one of its strengths. However, he also notes that “ratings have to be forward-looking; otherwise you’d always be racing to catch up with events.” Consequently, Moody’s downgraded Toll’s senior debt based on its anticipation that some strengths could become weaknesses in short order.
Moody’s is particularly concerned about the impact that the flood of unsold condominiums on the market will have on future sales in Toll’s high-rise business in the Northeast, which has been one of the builder’s best sectors. (According to Toll’s latest filing with the Securities and Exchange Commission, the Northeast, which accounted for 28 percent of the builder’s home building revenue during the six months ended April 30, was the only geographic area where Toll reported positive earnings in that period.)
Moody’s also worries that a tighter credit market will limit home buyers from obtaining mortgages to buy Toll’s luxury and semi-custom homes.
In his report, Snider writes that Moody’s expects the luxury builder to continue amassing cash and exercising fiscal discipline. But Moody’s also wants to see Toll make “significant” reductions in unsold inventory. “Toll lags behind other builders in this regard,” Snider says. And the service might lower its rating of Toll’s debt further if the builder’s cash flow dipped into the negative column, if the builder sustained “significant” pre-impairment quarterly losses; if it repurchased a significant amount of its outstanding stock, or if its debt-to-capitalization rises above 50 percent.
John Caulfield is a senior editor at BUILDER magazine.