KB Home: Compelling Opportunity Despite Slowing House Market

One doesn’t have to look too far to find negative news about the housing market. Mortgage rates have surged to about 7%, higher than any time since the 2008 financial crisis. This dramatic rise in rates since the depths of the COVID pandemic has severely worsened home price affordability, forcing many Americans who’d like to buy to rent instead while also capping home prices. Indeed, it was just reported by Case-Shiller than home prices fell 0.6% in July, though they remain up double-digits from a year ago.

Against this backdrop, it may be tempting for investors to say “I’m going to avoid housing-related stocks.” I understand that impulse, but periods of stress can often create attractive opportunities for longer-term investors. That is just the case with KB Home (NYSE:KBH), whose shares have lost a third of their value over the past year, leaving it with a very compelling valuation.

Now, the company is not immune to challenges in the housing market. When it reported Q3 earnings, revenue of $1.84 billion trailed estimates by about $60 million. However, profits of $2.86 a share were above consensus, and profits are ultimately what investors should be focusing on.

Management also provided guidance for its fourth quarter. Average selling prices will fall by about 1% sequentially to $503k, reflecting the slowing in the housing market, but revenue will rise to $1.95-$2.05 billion, which should translate to about $330 million of operating income. That should equate to about $3 of EPS given a 24% tax rate and 88.9 million shares outstanding.

That fourth quarter performance means the company will generate about $9.50-$9.75 of earnings during 2021, giving the stock a 3x price to earnings ratio, which is extremely low. When multiples are that low, I usually think either earnings are way too high or the company has a problematic debt load or some other problem. Now, I suspect 2021 will be a peak year for earnings just as it is the peak for the housing market. But at this multiple, even if earnings were halved to $5, the P/E would still only be 5x. Earnings would have to fall by 70% for the stock to have a 10x P/E-by no means expensive.

In reality, I think earnings, while likely to fall next year, will prove to be somewhat resilient. This is because KB Home still has a significant backlog of houses-contracts signed with buyers for homes it still has to deliver. This backlog finished Q3 at $5.26 billion and 10,000 homes. That backlog provides about 8 months of future sales and $1 billion in net income at its current production pace and margins, even without a single net new order. That alone provides over $10 of value per share that will be coming in the door.

In practice, the company will still receive additional orders, though these are slowing alongside the market. Last quarter, the company generated 2,040 net new orders from 4,000 a year ago. The company delivered 3,600 homes in the quarter, so it is gradually eating into its backlog. This is what backlogs are for, to stabilize revenue as the market slows. Even if orders slowed another 20% from here, the company could continue to deliver 3,600 homes a quarter for the next five quarters. In practice, I am expecting deliveries to moderate towards the 3,000 pace, which it could sustain for two years at that backlog and order rate. That pace would be consistent with run-rate earnings of $6 per share or a 4.5x P/E multiple.

Now, if you believe the housing market is going to implode even further than another 20% drop in orders, you may not be convinced. However, I think this is a reasonable and conservative scenario. The US housing market remains under-supplied. In the 10 years after the financial crisis, we built 9 million new homes vs a long-term average of 15 million. With millennials increasingly turning 30+ years old, there is demand for housing and a general shortage of housing units. Under-supplied markets are good secular bets even as they go through cyclical downturns-that is how I view the housing market. Additionally, at a $500k selling price, KBH sells a bit below the national average of $521k. Higher mortgage rates could push homebuyers into somewhat cheaper homes, providing more demand for KBH’s production. Additionally, we are seeing commodity prices like lumber fall, which should alleviate some cost pressure and protect margins even if end-prices fall somewhat.

Even more compelling, KBH offers a very strong balance sheet. Shareholder’s equity is $3.49 billion with debt to capital of 36.8%. That is below the 39.6% of a year ago, meaning the company has used the strong housing market to reduce financial leverage. Back in 2007, debt to capital was 53.9%. KBH used much more debt during the housing boom, which is why the drop in prices was so painful.

KB Home learnt its lesson and is not relying on borrowed money to fund speculative land purchases. This low leverage means the company can much more easily manage through a prolonged downturn. The company’s shareholder’s equity comes to $39.20 a share, or a 50% premium from its current share price.

Importantly, with the company generating strong profits, its book value is rising. A year ago book value $32.25. Rather than a melting ice cube where book value erodes, KBH is earning profits and growing book value. Because its balance sheet has a very manageable debt load, it can use those profits to buy back shares. Its share count fell by about 5% from a year ago. Repurchasing stock below book value is very accretive and helps to further increase book value per share.

KB Home’s conservative management has enabled the company to withstand a housing downturn we may be starting to experience. Its backlog provides future cash flow and should keep earnings floored $6 per share the next two years, and it can use this cash flow to repurchase shares at a discount, on top of a 2.3% dividend yield.

Yes the housing market faces strains, but KB Home is well positioned and has been sold down to very low levels in investors’ rush to exit the sector. I am looking for shares to trade to $36 or 6x my run-rate earnings and .9x book value, as I suspect the market will conservatively price KBH below book value to reflect the risk of further housing market deterioration. Even at $36, I think KBH represents attractive value, but it is important to have reasonable price targets, recognizing sentiment, which is why I am keeping it below book value. Nonetheless, that offers nearly 40% upside from current levels. KBH is a great example of how value can be found in beaten-up sectors.