WHILE PUBLIC BUILDERS may lament how analysts rate their stocks, big builders should be able to sustain their investment grade credit ratings through the next industry downturn, predict analysts from the three major credit rating agencies. Stellar balance sheets and several qualitative factors will combine to make the next slowdown different than previous cyclical turns in which builder ratings plunged.
“The 20 companies we rate are well-positioned,” says Jim Fielding, associate director of the Real Estate Cos. Group at Standard & Poor's. “The vast majority of our rated companies will maintain their ratings in the next downturn,” he says. S&P routinely constructs a worst-case scenario in its credit analysis. Even if new home sales drop 20 percent, ratings should not be affected, S&P's worst-case numbers show.
Bob Curran, senior director at Fitch Ratings, is a little less sanguine, saying that builder ratings will hold up if the next slowdown is not quite as severe as previous cycles. “Better business practices have left builders better positioned to handle cyclicality,” he says. More homes are pre-sold. Optioning has taken some of the risk of owning land off of balance sheets. Information technology has made builders more responsive to competitor moves, local job growth, and business conditions. Capital structures have improved with debt obligations staggered so that major cash calls are not concentrated in any one year. Builders have diversified their product lines and now play in more segments of the market.
All three analysts are favorably impressed with the way companies have become geographically diversified. “National companies can shift capital to faster-growing regions,” S&P's Fielding says. Geographic diversification reduces risk and helps companies survive what Fitch's Curran terms “rolling recessions,” where different areas of the country such as the rust belt or the oil patch come under pressure at different times. Moody's Snider says he is satisfied with geographic diversification at the 15 companies he rates, but he also says that high concentration of profits in California has led to lower credit ratings than would otherwise be justified by quantitative measures alone at three other home building firms: Standard-Pacific, McMillian, and William Lyon Homes.
Potential Pitfalls Ratings sustainability is not in the bag, however. S&P analysts are concerned about re-emerging vertical integration in the industry where builders begin to act as their own subcontractors or manufacture their own components. While it may boost profitability in the short run, vertical integration clearly increases fixed costs. “You have to consider what happens to those factories or framers if home purchases slow materially,” Fielding says.
Then there is the fact that home buyers are more highly leveraged today. The “extraordinary liquidity” of the mortgage market and the recent rise of credit scoring, with its emphasis on payment records instead of debt levels, has put weaker buyers into homes, Fielding's colleague and managing director at S&P, Lisa Sarajian, says. “If those buyers come under stress, repossessed homes will compete with new construction and home builders could suffer even though they didn't create the problem.” S&P's own studies show no material difference in buyer default rates under credit scoring so far, but the results of longer-term studies are still a long way off, she points out.
Moody's Snider says he is worried about a different scenario. Builders will be generating substantial cash flow in the first year of a downturn and will have little use for it—bank debt is low and the industry's bonds are generally not callable or are trading well above par. Snider says he sees builder stock prices falling at the same time, leading builders into temptation to buy back shares. “If they materially decapitalize their balance sheets, their credit ratings could be in jeopardy,” says Snider. “Long-term debt as a percent of capitalization would skyrocket.” The quantitative would overwhelm the qualitative at that point, so managers should resist shareholder pleas to prop up share prices, he says. “They have other constituencies to satisfy, including credit rating agencies,” he adds.