Homebuilders: A Report Card

S&P doesn't expect demand for new homes to bounce back quickly because of the glut of foreclosed homes in many markets

By James Fielding and George Skoufis From Standard & Poor's RatingsDirect

Despite more than three years of deteriorating housing market conditions, Standard & Poor's Ratings Services does not see evidence that the steady erosion of the creditworthiness of many U.S. homebuilders has abated. However, we do believe that several trends may emerge over the next 12 months that could signal an inflection point in the housing cycle.

We expect that housing starts will stabilize and that industry capacity will contract through attrition and consolidation. We also expect that the credit quality of better-positioned homebuilders may firm later this year if they are able to appropriately scale fixed costs relative to lower but potentially steadier consumer demand. However, we may see additional defaults in the interim.

The challenges facing U.S. homebuilders are, perhaps, unprecedented in the post-World War II era. New single-family home sales have fallen 76% from the July 2005, cyclical peak, dropping to an annual rate of 337,000 homes in February 2009. Single-family starts have tumbled 80% from the January 2006, cyclical peak, down to an annual rate of 357,000 in February 2009. Single-family starts may be bouncing along the bottom now. However, we don't expect that demand for the new homes sold by rated builders will bounce back quickly because of the glut of foreclosed homes in many markets.

We expect that deeply discounted foreclosed homes will continue to weigh on home prices. In fact, we believe that home prices—as measured by the S&P/Case-Shiller index—are likely to continue falling through next year, such that the peak-to-trough drop may be about 37%. For many rated builders, the bigger problem, in our opinion, is that prices fell sooner and may drop further in many of their most important markets in Nevada, Arizona, Florida, and California. Not coincidentally, in our opinion, these markets are seeing above-average foreclosure activity.

Most builders still have negative outlooks

The negative outlooks on 15 out of 18 rated industry participants reflect our view of the substantial stress that the sector is experiencing despite significant downgrade activity already. NVR (rated BBB-) is the only builder that maintains a stable outlook, which we attribute to its low leverage and its just-in-time land strategy that continues to support profitable homebuilding operations. Also, it is worth noting that our overall ratings dispersion for homebuilders, which is heavily weighted in the speculative-grade category. Besides NVR, the only other investment-grade rated homebuilding companies are MDC Holdings and Toll Brothers. Both of these companies are rated BBB- and have high cash balances,\ relative to their debt loads, and we believe that their near-term capital needs are manageable.

Notably, one-third of the rated homebuilders are in the CCC category, or lower. This acknowledges the potential for additional defaults in the near term. In our view, the most vulnerable rated homebuilders from a credit perspective include Beazer Homes USA and Stanley-Martin Communities (both rated CCC+); Hovnanian Enterprises, and Standard Pacific (both rated CCC); Champion Enterprises Inc. (CCC-); and William Lyon Homes (CC). In general, these companies have higher relative debt levels, and nearly all face greater liquidity constraints compared with more highly rated peers.

To date, fhe Rhodes Cos. (D) and five formerly rated homebuilders have defaulted on their financial obligations. Furthermore, it's our understanding that several dozen unrated public and private homebuilders have either filed for bankruptcy protection or have ceased to operate. We believe that while painful, a meaningful reduction in industry capacity would enable better-positioned competitors to eventually increase market share, which would be an important support to these companies' top lines given that we do not anticipate a sharp rebound in demand anytime soon.

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