KB Home Has Great Upside Potential

Sep.16.13 | About: KB Home (KBH)

The housing market has shown recovery over the past few months, as lower housing supply joined higher demand. KB Home (NYSE:KBH), California's largest home builder, reported improved quarterly results in the second quarter of 2013, enjoying the full benefit of housing's recovery.

Financial review

KB Home's revenue increased 73% to $524.4 million in the second quarter of 2013. The company was able to reduce its net loss by 88% over the prior year. However, it still posted a loss of $3 million at the end of the second quarter.

Growth in the company's top and bottom lines was driven by a rise in the number of homes delivered, lower selling and administrative costs, and massive home price increases. The amount of homes delivered in the second quarter increased 39% year over year, while average selling price increased 25% to $290,400.

KB Home expects profitability in the last two quarters of 2013 and also in 2014. For the current quarter, analysts estimate an average earnings per share of $0.21, and revenue of $569.30 million.

Improving gross margin

For homebuilders, gross margin represents the gross profit remaining after all construction costs -- homebuilders' biggest expense. In the second quarter of 2013, KB Home's housing gross profit margin was 15.1%, down from 15.8% a year earlier. Gross margin was depressed by a charge of $15.9 million linked with water intrusion-related repairs in central and southwest Florida, and land option contract abandonment charges of $0.3 million.

Excluding the above charges, the company's gross margin was 18.2%, compared to 12.1% in the year-earlier quarter. Improvement in gross profit is the first step for any company to increase net profit.

KB Home's gross margin ratio is lower than its industry peers. Lennar (NYSE:LEN) sports a gross margin ratio of 25%, while fellow homebuilder DR Horton's (NYSE:DHI) gross margin ratio is 20%. Both Lennar and DR Horton's operating margins are also higher than KB Home's.

Analysts at Credit Suisse expect the average selling price of homes to increase in the coming future. If so, KB Home's gross margin could improve further in coming quarters, which in turn would improve its bottom line.

First-time buyers

First time buyers are the key customers for KB Home, accounting for 60% of the company's business. According to the Council of Mortgage Lenders, 68,200 first-timers purchased property in the second quarter of 2013, the highest quarterly number since 2007.

The increased activity by first-time buyers suggests that the housing market is still on its way to recovery. As the job market improves, first-time buyers will become even more likely to take out loans. Since KB Home particularly targets this segment of homebuyers, it could profit handsomely as more of them take the plunge into home ownership.

Future developments

KB home is spending heavily on land acquisition and development, investing $230 million there in the second quarter. It acquired land to open two new home communities in east San Diego County. The company aims to open more than 120 communities in 2013.

KB Home will open its first community in Bastrop in East Austin, where it will build 26 homes in response to growing demand for new homes in this area.

KB Home has strong presence in the California market, generating more than 50% of its revenue from that state. The company plans to open four new communities in California's Inland Empire region. Recently, it acquired 40 acres of land in Eastvale, Calif., from Stratham Communities. and plans to build 207 homes at the site.

KB Home has the option to purchase 143 additional California home sites in the future. It breaks ground on the land this spring, and will offer homeowners three collections of homes. Home prices are also rising in California. The different collection of homes will attract home buyers and will thus boost the company's revenue which in turn will improve profitability in the future.

Bottom line

KB Home is adopting good strategies to benefit from the prevailing housing market recovery. The company is expected to benefit from improved gross margin, increased development activity and the rise in first-time home buyers, which is KB Home's prime target market. Also, the company will benefit from rising rents, which will ultimately make home buying cheaper. So, I believe KB Home has the potential to capitalize on the available opportunities, which is why I recommend the investors to buy the stock.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.