KB Home: Outlook improving, but improvement comes at a price (NYSE:KBH)

investment thesis

KB Home (New York Stock Exchange: KBH) faces near-term headwinds due to the high interest rate environment, but some leading indicators, including improving new orders and stabilizing backlogs, indicate that we are nearing the bottom of the cycle and that sales will improve in FY24. Moreover, there is a possibility of a reversal The company’s focus on interest rate cycles and growing community numbers will contribute to the company’s revenue in the medium to long term. Long-term housing fundamentals are also attractive, with new home production lacking for more than a decade since the 2008 housing recession that limited resale home inventory.

The company’s margins are expected to benefit from healthy pricing levels for new orders, cost savings and improved productivity. The company’s made-to-order business model also typically offers higher margins.

I like the company’s prospects, but I can’t say the same about its valuation. that much The stock is already trading near its FY24 final book value one year from now, which we believe is appropriate in the current high interest rate environment. So while I like the company’s prospects, I prefer to wait for a better entry point before becoming more positive about the stock. We currently maintain a neutral opinion on KBH stock.

Revenue Analysis and Forecast

After experiencing strong growth in FY21 and FY22, the company’s revenue growth was negatively impacted by high mortgage rates in recent quarters, causing potential homebuyers to hold off on purchasing homes.

In the third quarter of 2023, the company’s revenue decreased 14% Y/Y to $1.587 billion. This follows a 14.1% Y/Y decline in core homebuilding revenue as the number of homes delivered by the company decreased Y/6%. 3375, with an average selling price of $466,300, down 8.3% Y/Y.

Although sales are expected to decline year-over-year in the fourth quarter and early 2024, there are signs that backlogs and order rates may be stabilizing, indicating a recovery in the second half of FY24.

KBH reported steady customer demand for new homes in the third quarter despite high interest rates, with 30-year mortgage rates exceeding 7%. Net orders in the third quarter increased 52% year over year to 3,097 units, reflecting improving demand for new homes and lower cancellation rates compared to the same period last year. Net new order value increased 54% Y/Y to $1.51 billion, and the company achieved an absorption rate (net orders per community per month) of 4.3. This is higher than the company’s historical average three-quarter pace before the volatility caused by the pandemic. Backlog decreased 34.8% Y/Y to 7,008 units and its value decreased 35.5% Y/Y to $3.4 billion, although backlog values ​​have stabilized over the past four quarters. Orders and backlogs provide good visibility into future revenue, so I think revenue will also bottom out to some extent, especially in the second half of FY24 (there is a lag of a few quarters between when a company receives an order and then ships the product to complete the sale) ) completed the house to the homebuyer)

Some investors are worried about the company’s on-demand model, saying customization could drive up home prices and reduce demand as buyers are now focused on affordability, but that doesn’t mean that’s really what’s happening in terms of the KBH sales we can make. no. Look at the strong net order growth. KBH is focused on providing homebuyers with affordable housing options, with approximately 70% of its communities offering plans under 1,600 square feet to fit the needs of budget-conscious homebuyers. Therefore, concerns about order intake trends are unwarranted, and the company should continue to maintain healthy order intake.

The company also plans to increase the number of communities by up to 15% from current levels by the end of FY24. The company has invested heavily in land acquisitions in recent quarters and has more than 57,000 lots in its possession or under contract, enabling it to support plans to open more than 150 new communities over the next five quarters. Increasing the number of communities means more orders, which will help the company grow in the long run.

Moreover, the high interest rate environment that is impacting the company’s sales is expected to reverse as there have been some positive indicators that inflation trends are heading in the right direction, which could lead to the Federal Reserve cutting interest rates next year. Analysts at Deutsche Bank recently noted that meaningful interest rate cuts will begin in June 2024. Once the Federal Reserve starts cutting interest rates, the industry will see a nice recovery. Severe Home Construction Shortage in the U.S. due to Shortage of New Homes from massive housing recession, This has created a tight supply and demand environment, which will support the recovery once the interest rate cycle reverses.

In summary, although there are short-term headwinds, we believe we are nearing the bottom and a recovery in sales is possible starting in the second half of 2024.

Margin Analysis and Forecast

In the third quarter of 2023, the company’s adjusted residential gross margin (excluding inventory-related costs) decreased due to price reductions and other homebuyer concessions for orders booked in prior periods, increased construction costs and a shift in mix away from the more expensive West Coast locations. SG&A as a percentage of housing revenue increased 130 bps year-over-year due to lower operating leverage due to lower housing revenue and higher sales commissions. Adjusted homebuilding operating margin (excluding inventory-related costs) fell 670 basis points year-over-year to 11.4%, driven by lower adjusted housing gross margins and higher SG&A expenses as a percentage of housing revenue.

Looking ahead, the company’s margins are near the bottom of the current downcycle and are expected to see some improvement in FY24. In the third quarter, healthy demand trends across the company’s end markets allowed the company to increase prices on new orders in ~65% of the community while reducing prices by only ~10%. The strength in new order prices the company is booking bodes well for the company’s margins going forward.

The company is also working to shorten the home building cycle to the historical four to five months. The company has performed well in this area so far, including 35 consecutive days of downsizing in the third quarter, and KB Home is currently building its first home in about six months. Reducing this number further will improve your company’s productivity.

Additionally, the company’s efforts to leverage a customer-centric, made-to-order business model also bodes well for margins. According to management, custom homes have 300 basis points higher margins than speculative homes (homes that are ready for immediate occupancy and are built before the homebuyer purchases them). Design studio and structure options.

Overall, the company’s margins will also bottom out around this level, with some improvement expected in the second half of FY24.

Evaluation and Conclusion

The company ended the third quarter with a book value per share of $48.29 and is currently trading at about $55.51, or about 1.15 times its last reported book value. In terms of future estimates, looking at the current consensus EPS estimates, the company is expected to post EPS of $1.68 in Q4 2023 and $7.31 in FY24. KBH’s annual dividend is $0.80 per share. Therefore, the company’s book value on a one-year forward basis, or at the end of FY24, should be closer to $56.48 (=$48.29+ $1.68+$7.31-$0.80). So the stock is trading close to its FY24 final book value after one year.

I don’t see much of a downside from these levels, given that the company’s revenue and margins are likely to bottom out, but I also don’t see much of an upside considering the stock is already trading near book value a year ahead. I’m not comfortable giving the stock a premium value over its book value one year forward, given where interest rates are. Therefore, I currently have a neutral opinion on the stock.