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 company currently has solid financial flexibility and meaningful cushion relative to Fitch's negative sensitivities to withstand a potential correction in the single-family market.

The rating affirmation and Stable Outlook are based on the assumptions of a mid-single digit decline in housing activity in 2023 and a further decrease in 2024 as affordability continues to constrain demand, further exacerbated by meaningful margin compression (see Key Assumptions).

While Fitch's Rating Case does not assume a severe contraction, the likelihood of one has increased and negative rating actions could result should market fundamentals track closer to the Downgrade Case than the Ratings Case.

Fitch envisions negative rating actions could result in a more pronounced downturn, including housing activity falling 30% over a multi-year period and meaningful home price declines and/or the management team employing aggressive capital allocation strategies that diminish liquidity. Such actions by management would be a departure from Fitch's expectation and the strategy employed by MDC during the last housing downturn and the beginning of the pandemic.

Key Rating Drivers

Meaningful Rating Headroom: MDC has meaningful rating headroom relative to the negative rating sensitivities for the 'BBB-' IDR, principally net debt to capitalization below 40%. Fitch expects the company will remain disciplined with its capital allocation strategy during these uncertain times, resulting in net debt to capitalization remaining below 20% and total debt to operating EBITDA situating at or below 2.5x during the next few years, compared with 27.9% at June 30, 2022 and 1.6x for the LTM period ending June 30, 2022, respectively.

Land Investment to Slow: Fitch expects MDC to be more measured in its approach to land acquisition and development activity in 2H22 and into 2023 as the company assesses the evolving housing environment. Fitch expects that the company will generate meaningful cash flow from operations (CFFO) in 2022 as it reduces land investment, as evidenced by the company spending about 48% less on land acquisition in 2Q22 compared with the prior year period. MDC spent close to $1.9 billion in land and development spending in 2021, which resulted in negative $208 million of CFFO.

Historically Conservative Land Policies: The company has generally employed more conservative land and development strategies than homebuilding peers covered by Fitch. As of June 30, 2022, MDC controlled 3.4 years of land and owned roughly 2.6 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 housing correction.

Weaker CFFO than IG Peers: High land and development spending activity in 2018-2021 due to its strong growth caused the company to generate negative to modestly positive CFFO in recent years. All of MDC's investment-grade homebuilding peers have generated consistently positive CFFO during the same time period due to these peers' higher EBITDA margins and, in some cases, more muted inventory investment compared with MDC. However, given the recent pullback on land spend and Fitch's expectation that the company will continue to invest at lower levels, Fitch expects MDC to generate $750 million-$800 million of CFFO in 2022.

Presale Strategy: The company's strategy has been to focus on the pre-sale of homes, with 91% of work-in-process unit inventory (excluding model homes) already sold as of June 30, 2022. Fitch views the company's to-be-built 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 to the detriment of 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, but Fitch expects the company to continue to offer predominantly to-be-built homes, in line with its stated strategy.

Geographic and Product Diversification: MDC benefits from geographic diversification, with operations across 15 states located in the West Coast, East Coast and Rocky Mountain region of the U.S. Some concentrations do exist within MDC's portfolio, as California and Colorado each represented approximately 23% of 2021 home deliveries. MDC's homebuilding footprint is less geographically diverse than larger, higher-rated homebuilders such as D.R. Horton, Inc. (BBB+/Stable), Lennar Corporation (BBB/Stable) and PulteGroup, Inc. (BBB/Stable).

Shift to First-Time and Move-Down Buyer: MDC addressed ongoing home affordability concerns by expanding its product offerings designed for first-time or move-down buyers. About 60% of 2021 net orders were from what the company considers affordably priced homes. Strong demand from millennial buyers, particularly since the spring of 2020, has contributed to MDC's robust home order growth in recent years. Fitch expects that the company will continue to invest in this product segment during the intermediate-term.

Rating Incorporates Housing Cyclicality: The company's rating incorporates the cyclicality of the housing market. Fitch assumes housing activity will fall mid-single digits in 2023 and low-single digits in 2024, leading to revenue contraction in the mid- to high-single digits in 2023 and low- to mid-single digits in 2024 and EBITDA margins contracting roughly 600 bps during the two-year period.

Prospects for Downgrade Case Increasing: Fitch's Ratings Case forecast does not assume a meaningful contraction similar to the last housing downturn. Should that be the case, there could be negative momentum on the ratings and/or Outlook, particularly if management employs an aggressive capital allocation strategy.

Derivation Summary

MDC's 'BBB-' IDR reflects its steady capital structure through the housing cycle, its relatively conservative land policy and build strategy, and its strong market position in core markets. Fitch views MDC's 'to-be-built' build 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. MDC's EBITDA margins trail many higher-rated investment-grade peers, due in part to its shorter land position.

The company is smaller, less geographically diversified, and generates more volatile CFFO (as it grows its community count) than higher-rated peers, including NVR, Inc. (BBB+/Stable), D.R. Horton, Inc. (BBB+/Stable), Lennar Corporation (BBB/Stable) and PulteGroup, Inc. (BBB/Stable). Some of these peers also procure land predominantly through option contracts, which may 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.

Key Assumptions

Homebuilding revenues increase 12.0%-12.5% in 2022 and fall 8% in 2023;

EBITDA margins of around 18.0% in 2022 and 14.0%-14.5% in 2023;

CFFO of $750 million-$800 million in 2022 and 7%-8% of homebuilding revenues in 2023;

Net debt to capitalization below 20% and total debt to operating EBITDA peaking at about 2.5x during the forecast period.

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 total debt to operating EBITDA will sustain above 3.0x;

The company maintains an aggressive land and development spending program that leads to consistently negative CFFO, 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 $1.15 billion available under committed revolving credit facilities and $475 million of homebuilding cash as of June 30, 2022. The company's next note maturity is not until January 2030, when a $300 million senior unsecured note comes due. 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.

Issuer Profile

MDC Holdings, Inc. has been building new homes under the name Richmond American Homes for over 40 years. The company is the 12th largest homebuilder in the United States based on 2021 closings and has a top 10 position in 15 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 excludes the EBITDA and debt of MDC's financial services operations as this subsidiary's only major debt, a mortgage repurchase facility, is non-recourse to MDC and the finance subsidiary generally sells the mortgage it originates and the related servicing rights to third-party purchases within 30 days.

Fitch's Corporate Criteria outlines adjusting consolidated profiles for group structures under which Fitch partially deconsolidates the mortgage origination operations from homebuilders' results as the agency believes there is weak linkage to the parent based on the debt being 364-day nonrecourse facilities, the assets securing it are typically held for short periods of time and limited strategic and operational links. When applying this adjustment, Fitch removes the associated debt and EBITDA from relevant ratios. Shareholders' equity is assumed to be unaffected. Fitch reviews historical cash flow from operations on a consolidated basis and also estimates CFFO excluding these 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

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This 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. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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