This is a look at KB Homes (KBH) and their respective larger markets and also our view on potential disruptors to the new home construction market. We are not in denial that the new home construction market has bottomed and has been logging in great gains year over year since 2009 when the economy began its recovery. We are however taking a realistic approach to the industry to see where it has been and what some likely outcomes are for the industry and in particular KB Homes. We think with KB Homes tangible book value of roughly $5 doesn't leave much upside for the stock even with the recent pullback in the stock over the last week. We think the stock could trade under $14 in the coming year and feel that street estimates for fiscal 2014 of roughly $1.00 are vulnerable to downward revisions. We do recognize that the company reports earnings on June 28th and feel that there could be extreme volatility over that time frame but would look to short the stock on any strength.
Our personal feeling on KB Homes is singled out for several reasons. We feel the company and its markets aren't the best markets to be in for new home construction. We also feel the stock is completely ahead of itself with respect to valuation on a number of different metrics but especially when it comes to price/book value of the company. Consistently high unemployment and migration out of California could weigh heavy on those homebuilders who look for gold in the California. We aren't of the belief that higher home prices will lead to increased activity in the new home construction market but do recognize that it may be good for a temporary boost to gross margins for the new homebuilders but feel that these higher margins are already being forecast in stock prices. Persistently high unemployment rates in California and Florida don't bode well for those new homebuilders that are focusing on those markets.
Now down to KB Homes, the company has been lacking profitability since the economy has been strengthening. During this stretch of strengthening economy the company has been increasing their debt relative to their total capital which could become even more burdensome for a company that has been struggling to return to profitable operations since 2009.
Cash flow has been negligible in the economic turnaround, which doesn't bode well for any future shock to the housing market. We will examine a few potential macroeconomic shocks later in this report.
The increasing leverage in KB Homes is further exemplified by their increasing assets to total equity. Looking at companies that increase their assets relative to total equity especially when those assets are tied up in long term inventory such as land can be a burden into the future and cause significant write-offs of their assets. In this case those assets may never be used and become completely unproductive.
Cash being tied up in inventory generally isn't considered a good thing in our mind. Of course homebuilders have to have inventory but one would expect with the recent increases in new homebuilding activity that this wouldn't increase at the rate that it has for KB Homes. This could lead to potential issues down the road if interest rates trend higher or the economy does slow due to premature QE cutting. The QE has been a big driver to overall homebuilding and buying of homes in general over the last several years. The remodeling market has been on a tear mostly due to lower interest rates.
The company segments their business in four categories. West Coast which consists only of California, Southwest which consists of Arizona, Nevada and New Mexico, Central consists of Colorado and Texas and the Southeast consists of Florida, Maryland, Virginia and North Carolina. We will start with the West Coast and look at California.
KB Homes gets the majority of their revenues and operating profit from the California market. In the quarter ended February the company had $206mm in sales which represented 51% of total sales for the company. They were able to achieve a 4.1% operating profit margin in the respective region for an operating profit of just under $10mm. California housing starts are a pittance relative to what they were prior to the boom time in the late 90's early 2000 time frame. We aren't expecting a pickup in California new housing construction to pick up any time in the near future. This feeling is mostly predicated on migration out of California and persistently high unemployment in California.
The next largest market is the Central market consisting of Texas and Colorado. In the latest quarter The Central market had $106mm in sales and $136k in operating profit. The Texas market has been more stable on an overall basis than most regions of the U.S. and that can be attributed to no state income tax and the state's ability to draw business to the state. According to the chart below it appears that Texas has run into a roadblock on new housing starts the last couple of months. It's hard for us to write off Texas mostly because I am a resident of the great state and there is prosperity in the state but with prosperity comes competition and there are plenty of homebuilders fighting for their share of sales in the state.
Florida which is in the Southeast region for KB Homes reported sales of $58mm as a total for the region and lost $8.3mm in the region. Florida had been a booming location for many homebuilders during the late 90s early 2000's but that market seems to have shifted for the worst. The Florida economy has been struggling with high employment and persistently high foreclosures for the last several years.
The recent uptick in rates could be a huge hindrance to the continued strength in new homebuilding and purchases of existing homes. We have looked at a scenario that would take out about 100k new home purchases if rates go persistently higher over the coming year. This would reduce new home sales to roughly 1.3mm in 2015 down from just over 1.4mm in most forecasts by professional economists. We also feel that any shock to the price of oil would take out new home starts by roughly the same amount. We put both of these scenarios as highly likely. We think oil could trend higher over the coming year due to continued conflict in the Arab countries, in particular Syria.
Higher delinquency rates and continued foreclosures could also put a damper on new home starts and we feel that investors haven't completely been cognizant of the potential effects of foreclosed homes coming back on the market either as rentals or outright sales. There is still a massive amount of homes that are owned by banks but some of that inventory is being scooped up by private equity firms and other buyers of blocks of homes.
We also think that the most important driver of the economy is getting people back to work. Clearly the labor force participation rate has changed dramatically in the last several years which could be attributed to retiring boomers and people who have exited the labor force for one reason or another. The U-6 unemployment is something that investors need to wake up to as the neighbor who was making $100k is now working part time and struggling to make ends meet.