Fitch Ratings has affirmed the ratings of M.D.C. Holdings, Inc., including the company's Long-Term Issuer Default Rating (IDR) and unsecured debt ratings at 'BBB-'.

The Rating Outlook is Stable.

MDC's 'BBB-' IDR reflects its steady capital structure through the housing cycle, relatively conservative land policy, build-to-order strategy, and strong market position in core markets. Risks include the company's less consistent cash flow generation and lower geographic diversification relative to higher-rated homebuilding peers.

The rating affirmation and Stable Outlook reflect MDC's substantial cushion relative to Fitch's net debt to capitalization negative rating sensitivity, enabling the company to withstand the meaningful slowdown in housing activity. Fitch's rating case assumptions include single-family housing starts falling 15%-20% in 2023 and improving slightly in 2024. The ratings could be pressured if Fitch expects the company to have difficulty returning to $500 million in EBITDA, which would result in EBITDA leverage persisting above 3.0x at the company's current debt level.

Key Rating Drivers

Significant Decline in Revenue and EBITDA: Fitch projects MDC's revenues to decline 23%-24% in 2023 and flatten in 2024 as affordability issues, a softening economic environment and low consumer confidence continue to weigh on demand. U.S. homebuyer sentiment is likely to remain subdued as consumer expectations of higher home prices persist and mortgage rates stabilize at relatively elevated levels. EBITDA margins are forecast to contract 700-750bps this year and be flat to slightly higher in 2024 as homebuilders adjust home prices and offer more incentives to drive demand, while input costs remain elevated.

Fitch expects MDC's operating results to fare worse than other public builders in Fitch's coverage as the company saw outsized yoy net order declines during 2H22. Higher speculative building activity is likely to weigh on margins as home prices have declined from peaks in many markets and MDC prioritizes pace over price.

Strong Balance Sheet Provides Cushion: MDC has meaningful rating headroom relative to Fitch's net debt to capitalization negative rating sensitivity for the 'BBB-' IDR, supported by meaningful cash on hand. This ratio was -0.7% (after considering $75 million of cash as not readily available for working capital) as of June 30, 2023. Fitch expects MDC will remain disciplined with its capital allocation strategy as demand remains volatile, resulting in net debt to capitalization remaining below 20%. However, given the significant drop in revenues and contraction in margins, Fitch expects EBITDA leverage to increase meaningfully from its low of 1.5x at YE2022 to approach 3.5x at YE2023 before declining toward 3.0x by 2025.

The ratings could be pressured if Fitch expects EBITDA leverage to sustain above 3.0x, which would infer an inability to return to $500 million in EBITDA at current debt levels. The absence of a clear path back to $500 million in EBITDA may imply impairment of the business profile, which would not be consistent with an investment-grade rating. Fitch will evaluate MDC's EBITDA leverage in conjunction with its cash flow and liquidity profile, which remain very strong.

Robust Financial Flexibility: MDC has a very strong liquidity position with $1.61 billion of homebuilding cash and marketable securities and $1.14 billion available under its revolving credit facility as of June 30, 2023. This level of liquidity, combined with its long-dated maturity schedule, affords MDC flexibility to continue to invest in the business. Fitch expects MDC to generate meaningful cash flow from operations (CFO) in 2023 as it reduces land acquisition. CFO is projected to decline but remain positive in 2024 and beyond at about 1.0%-2.0% of homebuilding revenues as the company increases land acquisition to support community count growth.

MDC significantly reduced land and development spending in 2022 (46% below 2021), resulting in the generation of $906 million of CFO.

Increased Spec Building: MDC's strategy has historically been to focus on the pre-sale of homes, but has pivoted to a more speculative building strategy given higher demand for quick move-in homes and increased cancelations. Spec homes increased to 2,155 at June 30, 2023 from 653 last year. While elevated in the near term, spec building is expected to represent a relatively modest portion of homes delivered going forward. This shift in strategy adds risk to the credit profile, although Fitch views the current modest level of speculative activity as appropriate in the present environment given the demand for quick move-in homes, low existing inventory and still-elongated, although improving, cycle times.

Fitch views the build-to-order strategy as a more conservative approach to homebuilding as builders could be burdened with excess inventory in a housing downturn under a speculative building strategy, pressuring gross margins. There have been instances in the past when the company was more aggressive with its speculative building activity, such as in 2014 and 2015.

Historically Conservative Land Policies: MDC has generally employed more conservative land and development strategies than homebuilding peers covered by Fitch. As of June 30, 2023, MDC controlled 2.5 years of land and owned just 2.1 years of land based on LTM closings. The company's relatively lower amount of owned land on the balance sheet compared with some Fitch-rated peers should help to lessen impairment charges as a percentage of total assets during a more-pronounced housing correction.

Geographic Diversification: MDC benefits from geographic diversification, with operations across 16 states located in the West Coast, East Coast and Rocky Mountain region of the U.S. There are some concentrations within MDC's portfolio, as California and Colorado represented 22% and 21% of 2022 home deliveries, respectively. MDC's homebuilding footprint is less geographically diverse than larger, higher-rated homebuilders.

Significant Exposure to Entry-Level: MDC addressed ongoing home affordability concerns by expanding its product offerings designed for first-time or move-down buyers. About 63% of 2022 deliveries were from what the company considers affordably priced homes. Fitch expects demographic trends to continue to support long-term housing demand for entry-level homes. However, Fitch believes demand at the lower price points can be more cyclical and volatile as first-time buyers are more sensitive to higher mortgage rates and home prices and deteriorating economic conditions.

Derivation Summary

Fitch views MDC's 'to-be-built' strategy as more conservative than peers such as Meritage Homes Corporation (BB+/Stable), as Meritage sells a majority of its homes speculatively, which could lead to more volatile through-the-cycle margins. However, the company significantly underperformed similarly- and higher-rated peers in the recent downturn as net orders declined precipitously and cancelations spiked, resulting in the realization of widespread impairment charges. Consequently, the company announced a pivot to a more speculative build strategy. While expected to remain below the level of some peers, Fitch views this change as a credit negative, particularly given the company's lack of requisite experience managing a speculative strategy.

The company is smaller, less geographically diversified, and generates more volatile CFO than higher-rated peers, including NVR, Inc. (BBB+/Stable), D.R. Horton, Inc. (BBB+/Stable), Lennar Corporation (BBB/Positive) and PulteGroup, Inc. (BBB/Positive). Some of these peers also procure land predominantly through option contracts, which should result in more consistent cash flow generation and stable credit metrics through housing cycles. MDC's short owned-land position relative to similarly-rated peers such as Toll Brothers (BBB-/Positive) mitigates some of the risk associated with land ownership in a contracting housing market. The company has also maintained a very conservative posture through housing cycles and currently has financial flexibility comparable with higher-rated peers.

Key Assumptions

Single-family housing starts to decline 15%-20% in 2023 and improve slightly in 2024;

Homebuilding revenues drop 23%-24% in 2023 and are relatively flat in 2024;

EBITDA margins of 10%-11% in 2023 and 8.5%-9.5% in 2024;

CFO of $550 million-$600 million in 2023 and flattens in 2024 as the company resumes meaningful investment in inventory;

Net debt to capitalization ratio below 10% in 2023 and 2024;

EBITDA leverage of around 3.0x-3.5x in 2023 and 2024.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Fitch's expectation that net debt-to-capitalization will sustain below 30%;

The company increases its size and further enhances its geographic diversification and local market leadership positions;

EBITDA margins sustain in the mid-teens.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

Fitch's expectation that net debt-to-capitalization will sustain above 40%;

Fitch's expectation that EBITDA leverage will sustain above 3.0x;

The company maintains an aggressive land and development spending program that leads to consistently negative CFO, higher debt levels and a diminished liquidity position.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Strong Liquidity: MDC's homebuilding operation has strong liquidity with $1.14 billion available under committed revolving credit facilities ($10 million outstanding and $46.7 million of LCs) and $1.61 billion of homebuilding cash and marketable securities as of June 30, 2023. A portion of the company's revolving credit facility ($75 million) is set to expire in December 2023, with the remaining $1.125 billion maturing in December 2025.

Long-Dated Maturity Schedule: The company has no near-term note maturities as its next maturity is not until January 2030, when its $300 million senior unsecured notes come due.

Issuer Profile

MDC Holdings, Inc. has been building new homes under the name Richmond American Homes for over 40 years. The company is the 11th largest homebuilder in the United States based on 2022 closings and has a top 10 position in 13 of the 50 largest housing markets in the country and is the largest builder in the Denver metro area.

Summary of Financial Adjustments

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.

Fitch also excludes the EBITDA and debt of MDC's financial services (FS) operations as this subsidiary's only debt, a mortgage repurchase facility, is non-recourse to MDC and the FS subsidiary generally sells the mortgage it originates and the related servicing rights to third-party purchases within 30-45 days. However, as part of its captive finance adjustment, Fitch assumes a capital structure for the FS operations that is sufficiently robust for that entity to support its debt without reliance on the corporate entity.

Fitch applies a hypothetical capital injection from the corporate entity to achieve a target capital structure (2.0x debt/equity) that is indicative of a self-sustaining credit profile for MDC's FS operations. The debt to equity ratio of MDC's FS operation was below this target level, so Fitch did not make any adjustments related to the FS operations. Shareholders' equity is assumed to be unaffected. Fitch reviews historical CFO on a consolidated basis and also estimates CFO excluding the FS operations.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

The highest level of ESG credit relevance is a score of '3', unless otherwise disclosed in this section. A score of '3' means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch's ESG Relevance Scores are not inputs in the rating process; they are an observation on the relevance and materiality of ESG factors in the rating decision. For more information on Fitch's ESG Relevance Scores, visit https://www.fitchratings.com/topics/esg/products#esg-relevance-scores.

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