vk.com/id446425943

Goldman Sachs

Credit Outlook

Homebuilders: Kwaku Abrokwah

Sector View:

We have a Cautious coverage view on Homebuilders, as noted in our December 3, 2018 initiation, that reflects our stance that there are significant downside risks to FactSet consensus home prices entering FY2019 brought on by the nearly 100bp increase in mortgage rates over the past year (as of October 2018, based on the Freddie Mac 30yr mortgage). Our view is that the rate move merely reveals a housing sector that is overpriced from an affordability standpoint, with a nine-year price CAGR of 5.6% (based on median single family home prices) from March 2009 to March 2018 compared to CPI-U excluding shelter that has been running closer to 1.6% CAGR. We believe that the highly favorable environment of ever-rising home prices that allowed builders to recover margins is ending and that the next stage of the housing market revolves around price and pace rationalization.

As the market dynamics evolve, we prefer builders with geographic scale, lower leverage and greater exposure to the luxury/high end of the market. We highlight two trade ideas, (1) swapping out of LEN 4.75s of ‘21 and into KBH 7s of ‘21 and (2) swapping out of LEN 4.75s of ‘27s and into TOL 2028s.

The homebuilding sector is one of the most cyclical parts of the economy given its direct link to interest rates (specifically, mortgage rates). We view the current housing slowdown as reflecting more than just buyer concerns about affordability in a rising rate environment and exposing structural constraints that curtail the supply of affordable homes – the high cost of land near urban areas where people want to live as well as the costs of entitling land, labor and materials that have led builders to build higher-priced move-up homes during much of the current housing recovery.

The current market turbulence, seen mostly in the equity markets, reflects more than a “pause” in buyer traffic and represents downside risks for credits going into FY2019. The homebuilding sub-index year to date is the second-worst performing sector (down 3.6% YTD) in the Yieldbook high yield benchmark (roughly flat YTD), behind oil services (down 5.5% YTD), and had been the worst performing for much of the year. When examining measures of homebuilding health, aggregate net leverage (3.6x) is markedly higher today then at the peak of the prior cycle (1.3x). Asset coverage (2.0x) is also lower than at the peak of the prior cycle (2.8x).

We view future catalysts as the upcoming 4QF18 earnings reporting season and

management guidance into FY2019. Specifically, we are watching for details on absorption pace, incentive growth, cancellation rates and the level of spec inventory – industry-wide months of supply at 7.4 are the highest since 2011. Recent 4QF18 results and previews by BZH and KBH, respectively, suggest that the slowdown in absorption pace has continued and may be broadening into the end of the year. Additionally, we view the 2019 spring selling season as providing a window into how aggressive builders have to be with incentives and/or price cuts if the slowdown continues or deepens.

4 December 2018

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Goldman Sachs

Credit Outlook

Given the natural interplay of pace and price, we are concerned that price may become the offset to maintain volume if the slowdown in pace accelerates into 2019.

While we acknowledge the long-term bullish case for homebuilders – the largest Millennial cohort wave (now 27 years old) is still several years away from the home-buying age – our analysis shows that such conclusions are not deterministic but rely on assumptions about the capacity of Millennials to become home buyers. Given that a large percentage of Millennials live at home with their parents, are financially burdened with student loans and are delaying major life decisions that lead to household formation, we temper our view of the idea that a large wave of potential home buyers is just about to knock on the door to rescue the housing market.

The broadest risk to our view, which would also make us more positive on the sector, is if rates moderate and begin to fall in a manner not corresponding with recessionary expectations.

Exhibit 72: S&P Case-Shiller 20-City Pricestier (%y/y)
30%
20%
10%
0%
-10%	Recession
-20%	Low
	Mid
-30%	High
-40%
Jun-91	Dec-95	Jun-00	Dec-04	Jun-09	Dec-13	Jun-18

Source: S&P Case-Shiller, Bloomberg, Goldman Sachs Global Investment Research

Exhibit 73: Trends in affordability of median homes

Price in 000s

$400		Pct above or below median					30%
$350		Implied Median - adj for Sqft					25%
		SF Median Price
$300		Average pct diff					20%
$250							15%
							10%
$200
							5%
$150
							0%
$100							-5%
$50							-10%
$0							-15%
Oct-90	Oct-94	Oct-98	Oct-02	Oct-06	Oct-10	Oct-14	Oct-18

Source: Census Bureau, US Bureau of Labor Statistics, Bloomberg, Goldman Sachs Global Investment Research

Exhibit 74: Aggregated components of gross and operating margin

30%		28			SG&A		EBITDA margins				Gross margins
	25		25							25	26	25
25%							23	23					24	24
		10		21		21		22
					20
20%	11		11								10	10
										12			10	10
15%							16		14
				15				18
					16	18
10%
		18
	15										15	15
5%			14						10	13			14	14
				6			7
					4	3		4
0%
	'04	'05	'06	'07	'08	'09	'10	'11	'12	'13	'14	'15	'16	'17

Source: Company data, Goldman Sachs Global Investment Research

Exhibit 75: Aggregate closings (000s) and ASP ($000)

120	000's					Homes-lhs			ASP-rhs					500
														450
100														400
80														350
														300
60														250
														200
40														150
20														100
														50
0														0
	'04	'05	'06	'07	'08	'09	'10	'11	'12	'13	'14	'15	'16	'17

Sum of homes closed for BZH, KBH, LEN and TOL. Unit weighted average of ASP

Source: Company data, Goldman Sachs Global Investment Research

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Goldman Sachs

Credit Outlook

Best ideas

Trade Idea #1: Buy KBH 7.0% due 2021 vs. Sell LEN 4.75% due 2021

Ticker	Coupon	Maturity	Issue Size ($mn)	Rating	$ Price	YTW	OAS (bp)	OAD
KBH	7.000	12/15/2021	450	B1 / BB-	104.00	5.4	260	2.4
LEN	4.750	4/1/2021	500	Ba1 / BB+	101.50	4.0	119	2.0

Source: Bloomberg, Goldman Sachs Global Investment Research

At comparable maturity and slightly favorable forward leverage, we recommend swapping out of the LEN 4.75s of 2022 and into the KBH 7.5s of 2022. This swap pays 2.5pt and moves out 0.4yr in duration (OAD) to pick up ~140bp of spread and yield in a less levered credit. While we appreciate Lennar’s scale, we view KB Home’s lower leverage profile (FY2019 net leverage of 2.0x vs 2.5x) and commitment to further delever (targeting net debt to capital between 35-45% versus prior guide of 40-50%) as an offset. To be clear, we still prefer Lennar’s greater scale and exposure to diverse product categories along the different price points versus KBH’s more concentrated exposure to California and Texas, but believe that valuation already reflects this fact and creates opportunities in the KBH structure.

Risks to our view: KBH concentrated exposure to California (price correction) and Texas (oil correction), TCJA SALT effect is unknown for coastal markets, more benign housing market that is truly in a pause.

Exhibit 76: KBH vs LEN price ($)

Exhibit 77: KBH vs LEN OAS (bp)

114	Diff (rhs)		KBH 7 12/15/21		LEN 4 3/4 04/01/21	9	350	Diff (rhs)		KBH 7 12/15/21		LEN 4 3/4 04/01/21	140
112						8	300						120
110
						7
108
						6	250						100
106
104						5	200						80
102						4	150						60
100						3
							100						40
98						2
96
							50						20
94						1
92						0	0						0
Nov-17	Jan-18	Mar-18	May-18	Jul-18	Sep-18	Nov-18	Nov-17	Jan-18	Mar-18	May-18	Jul-18	Sep-18	Nov-18

Source: Bloomberg, Goldman Sachs Global Investment Research

Source: Bloomberg, Goldman Sachs Global Investment Research

4 December 2018

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Goldman Sachs

Credit Outlook

Trade Idea #2: Buy TOL 4.35% due 2028 vs. Sell LEN 4.75% due 2027

Ticker	Coupon	Maturity	Issue Size ($mn)	Rating	$ Price	YTW	OAS (bp)	OAD
TOL	4.350	2/15/2028	400	Ba1 / BB+	88.00	6.1	308	7.2
LEN	4.750	11/29/2027	900	Ba1 / BB+	93.38	5.7	271	7.1

Source: Bloomberg, Goldman Sachs Global Investment Research

We believe that concerns over the high-end slowing have created opportunities to long TOL versus short LEN across the curve, especially at the long end. We recommend buying TOL 4.875s of 2027 and selling out of the LEN 5.0s of 2027. This swap is of even duration, takes out ~5.4pt of dollar and picks 37bp of spread and yield. The weakness in both absorption and prices first seen at the luxury end of the market has migrated to the affordable segments as mortgage rates have risen ~100bp over the past year. Given that the lower end of the market is more sensitive to rate moves, we see further weakness ahead and prefer the relatively lower volatility of the high end.

Risks to our view: A severe slowdown in the luxury segment, the TCJA SALT effect is unknown for coastal markets, the lowering of Fannie and Freddie conforming loan threshold, a benign housing market that is truly in a pause.

Exhibit 78: TOL vs LEN price ($)

105	TOL '28 minus LEN '27 (rhs)				0
	LEN 4 3/4 11/29/27
	TOL 4.35 02/15/28				-1
100
					-2
95
					-3
90
					-4
85					-5
80					-6
Jan-18	Mar-18	May-18	Jul-18	Sep-18	Nov-18

Exhibit 79: TOL vs LEN OAS (bp)

350	TOL '28 minus LEN '27 (rhs)				40
	LEN 4 3/4 11/29/27
	TOL 4.35 02/15/28				35
300					30
250					25
					20
200					15
150					10
					5
100					0
Jan-18	Mar-18	May-18	Jul-18	Sep-18	Nov-18

Source: Bloomberg, Goldman Sachs Global Investment Research

Source: Bloomberg, Goldman Sachs Global Investment Research

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