Seeking Alpha
Special situations, long/short equity, ETF investing
Profile| Send Message|
( followers)  

There has been a lot of bearish commentary on KB Home (NYSE:KBH) recently, especially from the Motley Fool, and I'd like to present a different view of KB as a turnaround play.

2011 will surely go down as one of the worst years ever for the residential construction industry. During that year, KB had two preferred mortgage brokers leave them. First it was Bank of America (NYSE:BAC) at the beginning of 3Q 2011, and then Met Life (NYSE:MET) in 1Q2012. This change in plans had nothing to do with KB Home and everything to do with the new Dodd-Frank requirements for those banks. But the two unexpected moves cost KB a lot of sales - which created some awful comps - and a horrendous drop in share prices.

Also in 2011, a judge sided against KB home and a consortium of builders in a legal dispute concerning a large 2,000-acre housing project just south of the Las Vegas Strip. This settlement cost KB an unexpected $240M in cash.

Although large in scope, these two losses were one-off events and not likely to be repeated. If you delete their effect from KB's balance sheet, it would have a cash to long-term debt ratio (0.40) similar to Lennar's (NYSE:LEN).

Another knock on the company is they "burned through" nearly a billion in cash in 2011. Yet I haven't read a single critic ask the question, "On what?"

And this is where the story gets better. In 2011, KB decided to realign itself towards more profitable geographic locations in communities which were experiencing strong demand. KB is a Los Angeles-based builder and has always specialized in the California real estate market.

So they bought land at rock bottom prices all over coastal California, and re-focused the company into higher margin markets in land-constrained A locations. Yes - at the bottom - even despite the preferred mortgage lender setbacks and the $250M settlement that went against them - they leveraged their business model to the hilt to fully prepare for the recovery they saw coming in CA real estate.

In Housing is the Business Cycle, by Edward E. Learner (Federal Reserve bank of Kansas City, 2007, pps. 181-182) the author writes about the relationship of land to price in high-demand areas:

It really is a volume cycle, not a price cycle...(which) gives a hint about housing markets. It's not the structure that has a volatile price; it's the land. Where there is plenty of buildable land, the response to an increase in demand for homes is mostly to build more, not to increase prices. Where there is little buildable land, the response to an increase in demand for homes is mostly a price increase...

Not a week goes by where I do not receive an announcement of another new KB community opening in a high-demand CA location. This is KB's new strategy: higher margins, rising ASPS, and "A" locations in land-constrained communities.

Volumes are rising now. In the last 18 months, national housing starts have increased 48% (chart) from a low of 520k in February, 2011 to 767k in June, 2012. That's a 28% compound annual growth rate, precisely what Goldman Sachs alluded to in its upgrade of KB home this morning from neutral to buy. The HMI (homebuilder sentiment index) has expanded 50% in the West from 29 to 44 in two months.

The nascent recovery is also why KB has been moving their maturities forward 5 to 10 years - so they can concentrate on homebuilding at the beginning of this cycle rather than finance issues. The CEO said it himself in the last conference call. They have plenty of cash to operate their business. This differentiates them from Hovnanian (NYSE:HOV) and Beazer (NYSE:BZH) who had to announce dilutive secondary offerings in the last week in order to raise cash for future building.

Another criticism of the company is the high cancellation rate in 1H2012, comparing them unfavorably to Toll Brothers or Lennar. A flip side to this high cancellation rate, however, means they were spreading as wide a net as possible to first time and unfamiliar buyers in a credit-constrained market. Most of the cancellation rate could be attributed to the loss of their two preferred lenders in 2011, not to KB's business prospects. The banks that left the partnership had no incentive to capture or retain the new mortgage business for KB.

As the CEO mentioned in his Q2 comments, these cancellations yielded a silver lining. The homes that didn't sell in Q1 sold for more in Q2 as median asking prices rose.

The bears also forgot to tell their readers that KB Home was the largest builder (by completions) in CA in 2011; or that in the highly desirable coastal areas where KB is now opening new communities, inventory has dipped to a very low two to four months of inventory. To illustrate how crazy the CA home buyer's market has gotten this summer, consider this: since January 1st, median asking prices have risen 38% in San Francisco and 24% in San Jose. They've risen 10% in Los Angeles, Riverside, Orange and Marin counties; and 14% in 4 months in San Diego.

You don't think KB home can make profits in a seller's market like that?

They have 14 communities in the San Francisco Bay Area; 20 in Riverside; 6 in Los Angeles, 5 in Orange County, 3 in San Diego, and 8 in Sacramento. They have 5 communities in Phoenix, 2 in Tucson; and 8 in Las Vegas.

Further, the newly passed anti-foreclosure laws in CA and NV have had the effect of freezing distressed inventory in those states. A lack of non-distressed, traditional housing in Phoenix has caused prices to rise 25% in a year. The truth is, underwater homeowners with jobs either will not - or cannot - sell their homes at a loss.

Frustrated buyers can't find traditional, non-distressed inventory in CA, NV and AZ this selling season. The stories of bidding wars and all-cash offers in Phoenix, Las Vegas, the SF Bay Area and LA from spring 2012 are well-documented. The large public builders - new construction - are now filling the gap for traditional home buyers. The inflection point has been reached.

Banks have watched the recent rise in median asking prices and wisely feel no rush to liquidate their REOs. Not a week goes by where the affordability index for home buying does not hit some 40 year low. Meanwhile, incentivizing interest rates on 30 year fixed loans approach 3.5% and rents are in a sky-high bubble.

BlackRock upped their stake in KB to a full 10.8% of all shares last quarter. Since June 1st, trading in KB has outperformed all builders except for Hovnanian.

KB Home could come roaring back in 2H2012. The 27 million shares that traded on June 29th were a shot across the bow. Since January, 2012 there have been two massive rallies in the stock. The first peaked in mid-March following a 100% rise in the shares. After the disappointment of the Q1 earnings report, the stock dropped 50%, giving back all the gains of the previous 10 weeks. Now it's on a tear again, up 54% in a month, but still below its recent highs.

I've listed 56 of KB's 62 communities in CA, plus another 7 in AZ and 8 in Las Vegas. KB will have thousands of new homes for sale in those markets in the coming year. Median asking prices are rising and inventory in those areas has fallen dramatically. The odds look good that KB Home may soon be like the proverbial cat with a mouse on a square mile of linoleum.

They have re-opened Inspirada in NV and the company is intent on monetizing its $240ML settlement there. They have written off or liquidated every low-performing community they owned, and now there are interested buyers looking for those B and C lots in outer metro areas for affordable housing. KB can either sell the mothballed lots for cash or build on them. Their ASPs, backlog, and completions are rising. In the recent Q2 conference call, KB said that every one of their 32 sub-markets was doing well.

Lastly, they have a distinguishable product with higher margins. KB custom-builds homes with open floor plans per buyer specifications, and their green approach to homebuilding is very popular among young buyers. Along with Meritage, they produce Net Zero homes - home construction that's a combination of high-tech insulation and building materials, low VOC paints, solar energy, high-efficiency HVAC systems and water-saving devices. Imagine owning a home in Las Vegas with a zero air-conditioning bill in the summer? That's the idea. These are the homes of the future.

KB home also carries the highest energy star rating in all classes for its homes. The only builder to do so. KB Home was named the #1 Green Homebuilder in a 2010 study by Calvert Investments and the #1 Homebuilder on FORTUNE magazine's 2011 World's Most Admired Companies list.

If you take a trip down memory land, you'll discover that this once proud company built 32,000 homes in 2006. I think the shorts have overlooked a lot on their merry way to a BK for KB. It's here to stay, not go away, and it's just getting started.

Source: KB Home As A Turnaround Play