KB Home: Initiating Coverage

Investment Summary

We believe investors and sell-side analysts are significantly underestimating KB Home’s gross margin expansion potential in FY2022. The company is getting orders which have an average selling price ~11% higher than the home sales ASP which it is currently realising in its income statement. As revenues from new orders starts flowing through P&L, we will see significant margin expansion in the coming quarters. We expect the company’s results as well as management guidance will serve as a major catalyst for the stock as FY2022 progresses.

Business Basics

KB Home (NYSE: KBH) is a mid-sized homebuilder based in the U.S. that primarily serves first-time and first move-up homebuyers, and also has some exposure to second move-up and active adult homebuyers. The company is currently operational in four regions in the US: Westcoast, southwest, central, and southeast. 

The company follows a build-to-order approach and starts building a home only after receiving an order from a prospective home buyer. This is in contrast with the speculative inventory approach where a home builder starts building a home first in anticipation of getting a homebuyer for it in the future.

One thing which differentiates KB Home from other home builders is its focus on designing and building customized homes. KBH’s design studios allow homebuyers to select their desired location, elevation, floorplan, structural option in the community and personalize their design. This customized approach has resulted in higher average orders per community versus its peers.

Understanding the Key Drivers

KB Home’s primary business is homebuilding where it buys or options land, develops it in communities, gets orders from customers for homes in these communities, build homes, and completes the sales to the homebuyers. So, the key drivers in this business are the number of communities where KB Home is currently selling homes (also called active communities), the average monthly net orders per community it is getting (also called monthly absorption), the average selling price of homes, and the kind of margins it is making on those sales.

Active communities

KB Home’s active communities decreased from 250 at the end of Q1 2020 to 200 at the end of Q2 2021 as lockdown related restrictions and a tight labour market delayed new community opening while existing communities got sold out at an accelerated pace due to demand surge post-Covid. However, it has started increasing again from Q3 2021 with easing restrictions and labour market conditions moving back to normal. KB Home has invested a huge sum of money (~$779 million) in land acquisition and development in the third quarter and management expects a sequential increase in community count will continue in the coming quarters. The company now has enough lots (~16000) to reach a total community count of around 260 by the end of next year. This will help the company’s revenue growth going forward.

Absorption

KB Home’s orders were impacted in the initial phases of lockdown and its monthly absorption (new orders/community/month) declined by ~50% from Q1 2020 to Q2 2020. However, thanks to the fiscal and monetary stimulus by the U.S. Government and Federal Reserve, housing demand saw a significant jump post covid. As restrictions eased KB Home’s absorption saw a good increase which surged above the pre-pandemic levels and peaked at ~7 in Q2 2021. Of late, the industry is facing some disruption in the supply chain and raw material shortages. So, management has decided to restrict booking new orders and this has resulted in absorption declining slightly from Q2 2021 to Q3 2021. However, this won’t impact its top-line growth as the company already has enough orders in its backlog. 

Average Selling Price

Due to a surge in demand for entry-level homes post-Covid, coupled with lack of supply, homebuilders have seen a good pricing power and the real estate prices have gone up significantly. This increase is reflected in KB Home’s average selling price (ASP) which has increased from ~$390 thousand in Q1 2020 to ~$427 thousand in Q3 2020. Note that this ASP is of the homes for which sales is completed (or closed) and the possession is handed over to customers in the quarter. Since the company books the order first and it usually takes five to six months for it to build and close home sales after taking orders, the kind of pricing it is getting on the new order is a good indicator of where home closing ASP is headed in the coming quarters. If we look at the ASP which KB Home is getting on its new orders, it paints a really good picture for price increases over the coming quarters. The company’s ASP for new orders was ~$474 thousand in Q3 2021. So, I believe the company’s ASP for home closings will move towards this level in the coming months.

Chart: KB Home’s Average Selling Price for New orders and Homes Closed (in USD thousands)

Gross Margin and S,G&A

The significant increase in home prices post covid has helped homebuilders more than offset rising raw material prices and increasing labour costs. As a result, the company’s gross margin has increased from 17.38% in Q1 2020 to 21.50% in Q3 2021. As discussed in the previous section, we expect home closing ASP to continue increasing in the coming quarters. Hence gross margin is expected to continue its upward trajectory. Selling, general and administrative expenses as a % of sales are also trending in the right direction and have decreased as the company is seeing higher operating leverage due to increased sales. Increasing gross margins and decreasing S,G&A as a percentage of sales bodes well for the company’s operating profit margins in the near future.

The Story So far..

In the initial phases of the Covid-19 pandemic, when the design studios were forced to remain shut and homebuyers were not comfortable with face-to-face interactions with designers, KB Home’s new orders took a bigger hit compared to its competitors that didn’t offer much customization (and hence don’t require many faces to face interaction during the sales process.) However, KB Homes was quick to adapt and shifted towards electronic sales, virtual appointments, and tours to minimize some of the adverse impacts. As Covid-19 related lockdown and other restrictions started lifting the company’s order rate started to catch up with its peers and it started seeing benefits from the overall recovery in the housing market. 

Low interest and mortgage rates; higher savings particularly among white-collar workers thanks to government stimulus and fewer avenues to spend outside due to covid related restriction; and multi-decade low supply of entry-level homes resulted in a very attractive setup for homebuilders who saw a significant surge in demand post-Covid. KB Homes, along with other home builders, is currently seeing healthy order growth, good pricing power and improved profitability as a result.

Of late, there have been some concerns due to supply chain disruptions and raw material scarcity in the industry. In the last quarter, KB Home and other builders restricted their order pace as a result. However, we believe this will likely be a short term issue and supply chain conditions and raw material availability will improve as we move further in 2022. We may prove wrong if the Omicron variant causes further shutdown across the globe and disrupt production. However, for now, we believe there will be only limited shutdowns.

Forecast

Looking forward, management has given a target of ~260 communities by the end of next year and I believe there is a good chance that the company will achieve this target given the significant land purchases it has made in the recent quarter. The company’s home closing ASP was ~$427 thousand last quarter and it will also increase to ~$474 thousand over the coming quarter as the company starts delivering homes booked in the recent quarter. This will also cause the company’s home closing gross margins to improve substantially as most of this pricing increase will flow to the bottomline. If we look at the current sell-side consensus estimates they are modelling in the company’s gross margins to be in the low 20% range. However, we believe the company can easily post home closing margins in mid to high 20 percentages in the next two years. We have assumed ~25% gross margin in FY2022 and FY2023.

The biggest uncertainty in the market right now is about the upcoming quantitative tightening by Federal Reserve and how it will impact the company’s new orders pace. Given the significant increase in inflation we have seen in the recent months, Federal Reserve has turned hawkish and will be raising interest rates and decreasing the size of its balance sheet in the back half of this year and 2023. This will lead to a rise in mortgage rates making home buying less affordable.

While we don’t think the company’s absorption will continue to be in mid six or 7 levels which we have seen in the recent quarters, we believe it will still be higher than pre-Covid levels. Just before the company’s results were impacted by Covid related shutdown, it posted an absorption of ~4.7 in Q1 2020. (The company’s Q1 runs from December to February and Covid related shutdown began impacting the U.S. companies in March 2020.)

We are of the opinion that even after the interest rate increase, KB Homes can still see absorption around mid 5 levels. There are two reasons for this.

First, after Covid-19, consumers have started spending a lot of time indoors and their home also doubles up as their office, a place for entertainment, their children’s school etc. This has led to an increased requirement for customization. KB Home’s design studio which gives home buyers an ability to customise their homes will help the company gain market share versus its peers some of which offers only standardized homes.

Second, Covid has unleashed a pent up demand among homebuyers. If we look at the historical housing starts they have averaged at ~1.5 million new homes from 1959 to 2007. However, between 2008 and 2019, the average was ~1.1 million. In other words between 2008 and 2019, four hundred thousand less homes were built every year compared to historical averages as home buyers deferred their home buying decision. There were several reasons behind it like the psychological impact of the great recession of 2008 which was caused by housing market crash, millennials marrying late compared to the previous generation and hence delaying household formation, etc. The demand was not lost as the population is still increasing, only delayed. Some of this demand is now coming back post-Covid and we expect we will continue to see healthy demand levels in the coming years as we offset some of the “underbuild” we have seen from 2008 to 2019.

Using the assumptions we get the following forecast for KB Home.

Table: KB Home’s Income Statement Forecast

While our revenue estimates are only slightly higher than the current sell-side consensus estimates, our EPS estimates are meaningfully higher. We believe the market is significantly underestimating the upcoming improvement in the company’s gross margin. As FY2022 progress and the company posts better than expected results, we believe sell-side estimates for margins and EPS will see a significant upward revision which will bode well for the company’s share price.

Valuations

KB Home ended Q3 2021 with a tangible book value (TBV) of ~$30 per share. If we add our Q4 2021e, FY2022e and FY2023e EPS to Q3 2021 ending TBV, we get FY2023 year end tangible book value of ~$53 per share. Over the last five years, KB Home has traded at an average Price/Tangible Book Value per share multiple of ~1.2x. If we assume it gets a similar multiple by FY 2023 end, we get a price target of $63.6 over the next two years. This indicates ~57.7% potential upside over the next two years. Hence, we believe the stock offers an attractive risk-reward at the current level.

Risks

The biggest risk we see to our thesis is a more than anticipated impact of interest rate increases on absorption. Should the interest rate hike substantially decreases demand, our estimates for revenues may prove optimistic. The second major risk factor we see to our thesis is the company’s Price to Tangible book value per share multiple compressing below five-year average levels along with the broader Homebuilding industry as interest rates rise. However, we still see a limited downside as the improved performance in terms of gross margin will likely help the company deliver better than expected earnings which we think can more than offset the impact of these factors.

[Analyst: Lavina Shahu, Sanket Bendre Email: Info [at] MarjanInvest.com Disclaimer: This is not financial advice customized for your needs. Please consult your financial advisor before making any investment decision. While a reasonable effort has been made to ensure accuracy of the content, no guarantee is given nor responsibility taken by us for errors or omissions and we do not accept responsibility in respect of any information or advice given in relation to or as a consequent of anything contained herein. Please do your own due diligence before investing.]