One thing you can surely say about KB Home (KBH) is that the company is not timid. It just unveiled four new financial initiatives that will strengthen its balance sheet and provide additional liquidity for its aggressive land purchases going forward. The shares lept 9% on the news.
What the perennial bears on this company - and the shorts who seem to bet against KBH after every rally (42% of the shares are short) - fail to realize is that the company they're bashing is long gone, and the new one is increasing in remarkable financial strength. KB has already doubled its cash position in a year and soon will pay-off or push-out its near-term maturities to 2017.
And there's been no lack of rear-view observers along the way, like the Fools at Motley, who have had their oh-so-knowledgeable exegesis of KB torn to ribbons by the stock's 192% rise since June. For example, see The Shorts Should Feel Right at Home from January 22, 2013, just three days ago. You can read this kind of drivel about KB Home weekly. At the slightest weakness, they come out of the woodwork and pummel the stock with doomsday predictions.
But the problem for the shorts is that investors who understand real estate can see where KB Home is heading, and continue to buy the turnaround story at every dip. So the mother of all short squeezes continues.
At the 2Q2012 conference call on June 29, 2012, CEO Jeffrey Mezger announced in his opening remarks that the company would soon be going on "offense". At the 3Q2012 conference call on September 21, 2012, he spelled it out.
"During our last call, I made the statement that KB Home is going on offense. I want to explain a little further what I meant by this because it is much more than just increased spending on land. Having positioned the company for profit, Going on Offense is my rally cry for growth. Now it is time to start moving forward again as a leaner, more efficient, better positioned company to take advantage of a market that is clearly recovering. It is a fresh mindset, and it is energizing for our team. Around the company, I am encouraging everyone to be bold and aggressive in pricing, gross margin enhancement, model opening timelines, land acquisition and compression of cycle times. As I said last quarter, going on offense is my personal #1 priority for this company."
This week, the company presented an ambitious series of four funding initiatives to fuel this offense.
1) A secondary offering of 5.5 ML shares - with an optional over-allotment to 6.325 ML shares for interested underwriters - at $18.25/share. If the full allotment is exercised, it would be an $118ML cash infusion for the company, and would raise its current cash position to $642ML.
This came on the heels of a rare mid-quarter pre-announcement that sales for the winter quarter were already 54% above the midpoint of 1Q2012. This secondary provides additional liquidity in KB shares for mutual funds eager to "buy into" a sector with a lot of alpha (out-performance) coming into 2013.
2) Concurrent with the secondary was a $200ML convertible senior debt offering at 1.375% due 2019 (or up to $230 million if the underwriters exercise their over-allotment option). This debt is convertible into shares at $27.37/share (8.4ML shares).
If the shares rise to the conversion price - and I am almost certain they will by 2014 - it is conceivable that KB home will add 14.7ML new shares to its float, or a 19% increase from yesterday's (77.2ML) outstanding shares, to a new total of 91.6ML shares - with a market cap of those shares (at $27.37) of $2.5BL. That would be a 73% increase in capitalization from today's $1.44BL.
3) The company has engaged Citigroup Global Markets to develop a new revolving credit facility of up to $300ML; and it has already received commitments from several financial institutions.
If you add up these three offerings (above), the cash infusion is between $500ML to $650ML in new money with only the credit facility costing a modest interest rate (to be announced).
In short, KB Home is using its shares and aggressive position in hot real estate markets to raise cash and fund the company's initiatives. It is an explosive path for near-term growth. The company has already said it will retire all pre-2017 LT debt maturities when they come due, leaving no LT debt payable for at least 4+ years.
4) KB Home is teaming up with Nationstar to offer homebuyers loans. It has been a long financial road for KB since the company first spun-off its in-house mortgage origination to Countrywide Financial in 2005. Three lenders later (and a high cancellation rate) the company is ready to re-embark on this very profitable business venture. It is especially important for KB Home because it makes more than 60% of its sales on high-end first-time buyers.
Buyers can now shop for a mortgage and a house at the same time. Because of KB's "built to order" model, it is possible for a customer to design a custom home in KB's design studio, include the extra options (wood floors, solar, data options, etc) rolled into a single mortgage, and then finance the entire package through the builder's mortgage wing. It's possible for a builder to capture 80% of its customers' mortgages through in-house financing. Barclays estimates that before the housing crisis, almost 8% of KB's pre-tax income was provided by its mortgage wing.
This is the 6th in a series of articles I began last summer on the housing recovery; highlighting KB Home in particular. The articles include the bullish trends in housing starts, inconsistencies in the book valuation of KB Home, deepening trends in inventory depletion combined with ramping asking-prices, and last week, a report on what lies ahead - an explosive growth spurt for the industry in Spring, 2013. KB Home has risen 100% since the first article.
I continue to think that KB Home will eventually receive a valuation comparable in share price and earnings to Lennar (LEN), Pulte (PHM), DR Horton (DHI), Ryland (RYL), Meritage (MTH), Standard Pacific (SPF) and the other builders.
Megan McGrath, of MKM Partners, expressed similar sentiments on Thursday in a note to investors, stating that KB Home is trading at 1.5 x its adjusted book value vs. 2.0 book for peers, and raised her target to $21/share. I also think the company's cash position will rise to $1BL within the next 5 quarters, while the cost of any new incremental debt remains minimal.
In some respects, KB's new communities for first-time buyers in upscale locales resemble Toll Brothers' (TOL) offerings. The company has several coastal CA communities where the average cost for a 4 bedroom home is $650K+.
KB employs economies of scale in the markets it enters. For example, in uber-expensive CA coastal markets like Silicon Valley or Marina Del Rey, it also offers luxury condos adjacent to central employment areas, parks, and public transportation. In neighborhoods where you couldn't touch a single family residence for less than $600K, it has 3 bedroom, 2 car garage offerings for $400K which a customer can then customize in KB's design studio. The company is opening these mini-communities all over CA, and it's one of the reasons the company's average selling prices have risen faster than any other builder.
I liken KB Home to my other favorite builder, Brookfield Properties (BRP), because of its aggressive land spend and its procurement of choice lots. Brookfield has over 100,000 developed and undeveloped lots in choice Canadian (Calgary, Alberta) and U.S. locations (Coastal CA, SF Bay Area, Denver, Washington DC).
Brookfield estimates the net value of its lots (after all development costs) at $4.5 BL over the next decade. For a 110ML share company, that's $45/share spread over 10 years. Brookfield recently (December, 2012) closed an oversubscribed secondary and debt offering similar to KB's and netted $800ML in new capital. It has also partnered with KB in its new joint venture in Marin Del Rey, CA
After Thursday's rise in the shares and the new funding, I'm raising my target for KB Home to the conversion rate of the senior convertible debt offering - $27.50/share. All previous rallies of the shares on high volume (January 23, 2013 - 17.7ML, September 21, 2012 - 33ML, June 29, 2012 - 27ML)) were followed by new highs in the weeks ahead. I would buy the shares on any pullback under $18. I also believe that demand for the January 24, 2012 secondary offering will be sufficient for KB Home to offer another secondary offering at a higher price by year's end, further strengthening its balance sheet.