KB Homes Wows With Results, But Is the Stock Too Dangerous?

Source: Thinkstock

Source: Thinkstock

KB Home (NYSE:KBH) is one of my favorite stocks for a housing recovery. But it is dangerous because if there is not a housing rebound or another large sector decline, it could get crushed. This is because the company is engaged in homebuilding activities in specialized markets in the United States. It constructs and sells various style homes, including attached and detached single-family residential homes, townhomes, and condominiums primarily for first-time, move-up, and active adult homebuyers. I highlight this because with our changing demographic in the United States, it is likely that these are the types of buyers that will drive the housing rebound when it kicks into full swing.

I should also point out that in addition to the homebuilding side of the company, it also provides property and casualty insurance, as well as earthquake, flood, and personal property insurance to its homebuyers, as well as provides title services. It has operations in Arizona, California, Colorado, Florida, Maryland, Nevada, New Mexico, North Carolina, Texas, and Virginia. The purpose of this article is to go over what I consider to be a blowout quarter from the company, but to also discuss the prospects for the stock. The stock is not cheap, trading at a premium multiple of 26 times earnings and only paying a 0.6 percent dividend yield. But does the stock deserve this? An analysis of the company’s performance and future potential is warranted.

No matter how you slice it, this quarter was fantastic. The company saw total revenues increase 8 percent to $565.0 million from $524.4 million in the prior-year quarter due to growth in the company’s housing revenues from higher average selling prices. One thing that surprised me was reduced volume. The company delivered 1,751 homes in its latest quarter, compared to 1,797 homes in the second-quarter of 2013.

However, the overall average selling price of $319,700 rose $29,300, or 10 percent, from the second-quarter of 2013, marking the seventh consecutive quarter of double-digit year-over-year percentage growth in the company’s average selling price. Average selling prices were higher across all of the company’s homebuilding regions with increases ranging from 9 percent in the Southeast region to 23 percent in the Southwest region. Further, homebuilding operating income increased to $34.3 million, up $25.6 million from $8.7 million in the year-earlier quarter. As a percentage of homebuilding revenues, operating income rose 440 basis points to 6.1 percent, compared to 1.7 percent for the 2013 second-quarter, and increased 210 basis points compared to 4.0 percent for the 2014 first-quarter.

What is nearly impossible to believe is the margin expansion. The housing gross profit margin increased 380 basis points to 18.9 percent from 15.1 percent for prior-year quarter, marking the company’s highest second-quarter housing gross profit margin since 2006. The current quarter housing gross profit margin also improved 120 basis points from the first-quarter of 2014. Selling, general, and administrative expenses as a percentage of housing revenues improved 60 basis points to 12.8 percent from 13.4 percent in the year-earlier quarter, primarily due to higher housing revenues in the current quarter and the company’s cost-containment initiatives. That is not all. The current quarter selling, general, and administrative expense ratio was the company’s lowest second-quarter ratio since 2006. What this all boils down to is that net income increased to a remarkable level year-over-year. It came in at $26.6 million, or $0.27 per diluted share, compared to the net loss of $3.0 million, or $0.04 per diluted share, in last year’s quarter. Jeffrey Mezger, president and chief executive officer, stated:

Reflecting the strong operational foundation we have established through the effective execution of our core strategies, we extended our trend of generating solid earnings improvement in the second-quarter, and remain focused on accelerating profitable growth. We have produced year-over-year revenue increases for eleven straight quarters and operating income improvement for ten consecutive quarters. The sustained progress in our results demonstrates the success of our targeted land and land development investments across our operating footprint, the appeal of our product designs and unique home buying experience, as well as our sound growth platform, which enables us to efficiently leverage costs as we expand.

With the momentum we have generated through the first half of the year and our robust backlog, we believe we are on track to meet our fiscal 2014 goals. Increasing the number of new home communities we have open for sales remains a top priority for us. We acquired several attractive large land positions and substantially advanced our land development in the second quarter to reinforce the upward trajectory of our business. We expect to measurably expand our community count into 2015 with the significant investments we are making in our land pipeline. We believe that with these and other strategic initiatives we have underway and the performance improvements we have delivered over the past several quarters, we are well positioned for accelerated revenue growth and profitability going forward.

Looking ahead, the company is in excellent financial position. The stock is expensive, trading at a premium valuation. However, I think that premium is justified. Potential future housing revenues in backlog at the end of the quarter surged 24 percent to $1.03 billion from $826.6 million at the end of last year’s quarter, reflecting an increase in the number of homes in backlog and a higher average selling price. The company’s quarter-end backlog value exceeded $1.00 billion for the first time since August 31, 2008. Total net order value increased 19 percent to $763.2 million for the 2014 second-quarter, up from $639.6 million for the year-earlier quarter. What about the balance sheet? It, too, is improving. The company’s cash, cash equivalents, and restricted cash increased quarter-over-quarter mainly due to the capital markets transactions completed in the current quarter, which generated total net proceeds of $531.6 million, partly offset by strategic investments in inventories to support future growth.

The company’s total liquidity at May 31, 2014 was $684.5 million, including its unrestricted cash balance and $200 million unsecured revolving credit facility, which had no borrowings outstanding. Stockholders equity rose to $709.7 million at May 31, 2014 from $536.1 million at November 30, 2013, mainly due to the company’s current-quarter public issuance of 7,986,111 shares of common stock for net cash proceeds of $137.0 million, and its net income year-to-date. In my opinion, this was a blowout quarter. But, you can only buy this stock if you think a housing rebound is coming. The status quo will not suffice. I believe this rebound is coming five years after the end of the Great Recession. Yes rising interest rates are a risk, but I think the risk is overblown. With more Americans working, families being started and our population growing, housing activity will pick up sooner rather than later.

Disclosure: Christopher F. Davis hold no position in K.B. Home and has no plans to initiate a position in the next 72 hours. He has a buy rating on the stock and a $35 price target.

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