A lot has transpired since my previous commentary on (KBH) at the end of July, 2012. Although the shares have risen 50% over the long summer and are ramping again, I continue to think we are only halfway there, and that a dramatic Q4 lies ahead for KB Home.
A large part of this rise is coming from investors' reassessment of KB's actual book value. Builders are considered richly valued at 2 to 2.5 x book. But what of 1.5x book? Then there is room to grow, and KB Home is growing into this higher valuation.
KB's CFO, Jeff Kaminski, made a couple of important statements on the September 21st conference call. He stated the company has $1.8 billion in housing inventory and ended the quarter with $467ML in cash.
Bob Wetenhall (of RBC Capital) also offered some interesting comments earlier in the quarter on August 3, 2012:
"After accounting for tax benefits that it accrued during the housing downturn, the company's price/book ratio is 1, about 30% below that of other home builders …" (KB's opening share price on August 3 was $9.56)
So let's calculate a back-of-the-envelope value for KB Home, using the Investopedia definition of book value: "The net asset value of a company, calculated by total assets minus intangible assets (patents, goodwill) and liabilities."
$1.8BL (inventory) + $0.467BL (CASH) + $0.25BL (tax-benefit on profits, 2012-14) = $2.517 BL
LT Debt (long term debt maturities) = $1.78BL
$2.517BL minus $1.78BL = $0.737BL (assets after liabilities deducted)
KB has 77.13 ML shares outstanding
$0.737BL in equity divided by 77.13ML shares = $9.56/share is book value
At $16/share, KB is trading at 1.67 x Book value (BV).
Taking the tax benefit into account and applying 2.05 x book as a reasonable valuation, $20 is a fair price for KBH.
Now it's true, if you eliminate the tax-credit on profits in the calculation, the book value is much lower; and as long as a company is unprofitable, the tax loss carry forward is of no effect. But all that changes when a company turns profitable, and this just happened for KB Home. Going forward - as long as the company generates net operating profits - the tax credit moves directly to its bottom line. The new valuation becomes real.
Q4 has traditionally been KB's ATM quarter. They add to cash on the books in preparation for the upcoming year. The CFO indicated this year will be no exception, saying he believes, "We'll add to our cash during the quarter and enhance our position even more."
Their backlog rose 33% versus the prior year. As its inventory rises in value, the book value will also rise. More cash plus a higher value of inventory equals an increase of book value.
By my pencil, the share price could continue to rise towards $20 without the ratio of BV to share price increasing much; remaining steady somewhere between 1.8 to 2.0.
This clearly sets KB Homes apart from the other members of the home builder index (XHB): Lennar (LEN) at 2.23 x bv, Pulte (PHM) at 3.21 x bv, Toll Brothers (TOL) at 2.16 x bv, MDC Holdings (MDC) at 2.21 x bv, and Meritage (MTH) at 2.68 x bv - builders which have already risen dramatically in price.
Finally, towards the end of the conference call, there was a unique question and answer session between KB management and Ivy Zelman, analyst. Jeffrey Mezger CEO admitted that ALL of the company's land for planned developments in 2013 - and half of 2014 - was already locked up.
Land and land development are the single biggest costs for a builder. If those costs are now "fixed" (except for minor margin adjustments for supply costs and labor) then the road map to increased profitability for the upcoming 7 quarters is clearer (Q4'2012, all of 2013, 1H'2014).
The company's goal is to invest in "choice locations within highly desirable and more affluent submarkets, building larger floor plans and more structural options" (Mezger). This translates to higher average selling prices for higher square footage houses in choice geographic areas (CA, TX, NV). Excluding distressed sales, Core-Logic's Home Price Index is poised to rise 6.9% in September, 2012. In many areas of coastal CA and the "Inland Empire," median asking prices have already risen 15% year over year. This is KB Home's traditional stronghold. They are the largest builder by volume in CA.
Because it's primary market is the very expensive CA coastal area, where it takes years to get permits before finally breaking ground, and CA is often the last state to leave a recession (current unemployment hovers around 10%) - the CA housing market - and KB Home with it - are in the early stages of recovery.
So what could go wrong?
KB Home was recently downgraded to sell by Citigroup in a note to clients on Tuesday. The analyst cited excessive leverage vs peers (77% vs 40% peer mean) and KB's need to over invest in developed lots to keep up with peer builders during the mid-cycle of the recovery, while still paying their annual interest payments ($125ML).
KB has increased the company's developed lots in three highly-desirable areas in 2011-12 by 20%: coastal CA, Las Vegas NV, and TX; so that part has been answered. But it has done nothing long term to address the gargantuan debt. This is its biggest weakness.
Through some careful restructuring of long-term debt earlier this year, the company has moved its maturities forward to 2015, 2017 and 2020. It has only $76ML due in 2014, a number the CFO said it could easily handle. Its current level of cash to short-term maturities (pre-2015) minus the $76ML is 1.01:1.
But what of the longer term? No word there, yet. And on the most recent conference call, Jeffrey Mezger CEO made it clear that land purchase would remain a priority over cash preservation. The company is aggressive. There's no denying that, and with an approach like this comes risk, clearly evidenced by the 53% short position. The company is stubbornly sticking to leverage as the best policy at the early phase of the real estate cycle. It wants to keep its options open, and as the CEO says, "Going on Offense."
To bring its debt more into line with both equity and cash, the company would need to add $105ML per quarter in free cash flow, and be solidly profitable going forward ($34ML/Q for interest payments; $71ML/Q towards debt retirement). In three years time it could bring the debt down under a billion dollars.
Can KB Home do it? Until the company becomes solidly profitable, a plan for de-levering is probably not feasible. (You can't talk about such a plan until you have the means to do it). But a plan would go a long way towards relieving analysts' concerns and put a floor under the shares. Pulte did a de-levering in early 2011 and it did wonders for its shares later on.
Jeffrey Saut, chief investment strategist from Raymond James, recently mentioned a dynamic facing underperforming mutual funds in Q4.
" The nearly four-month old rally of about 16% has left 90% of portfolio managers (PMs) under-performing the SPX. As year-end approaches, this under-invested crowd is now staring at not only performance risk, but bonus risk, and ultimately job risk. Indeed, just pull up a chart of the SPX and think about all of the under-invested participants that are NOT keeping up with the "Dow Jones" as they approach year-end performance report cards. Manifestly, it seems like everybody is unhappy."
To use the quote I referenced a few weeks ago from Merrill Lynch's legendary strategist Bob Ferrell:
"Money managers are unhappy because 70% of them are lagging the S&P 500 and see the end of another quarter approaching. Economists are unhappy because they do not know what to believe: this month's forecast of a strong economy, or last month's forecast of a weak economy. Technicians are unhappy because the market refuses to correct, and gets more and more extended. Foreigners are unhappy because due to their underinvested status in the U.S., they have missed the biggest double play (a big currency move plus a big stock market move) in decades. The public is unhappy because they just plain missed out on the party after being scared into cash after the crash. It almost seems ungrateful for so many to be unhappy about a market that has done so well. ... Unhappy people would prefer the market to correct to allow them to buy and feel happy, which is just the reason for a further rise. Frustrating the majority is the market's primary goal." (Bob Ferrell)
This sounds eerily like the homebuilder rally of 2012.
I think KBH can offer these underinvested funds a chance to participate as it rises to full valuation inQ4'2012.