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KB Home (KBH) is a one of the large homebuilding companies in the United States. The stock is about 15% off its highs having fallen a bit harder than the broader market. We've been pretty bullish all of 2023 on homebuilding stocks and our members/followers have made some profitable trades with us in the sector.  But while the stocks have been great performers, the situation is worsening a bit for homebuilders. The companies in the space are still in great shape, but the amazing tailwinds for the company, while largely in place, are diminishing. The pressure is now building on the sector. As such, one has to wonder if shares are correcting in anticipation of a meaningful slowdown, or if it is just a garden variety profit taking and healthy draw down. It is likely some of both options. We think shares are slowly becoming a buy, and the mid-$40s would be a solid entry point in our opinion. Why is this? Well, first, we do know that lumber and other building material prices have moderated significantly from their peaks, which is good news for homebuilders and their building margins. There is still a long-term shortage of homes for sale, as existing homeowners are hesitant to sell because they have low mortgage rates locked in. This has led to a surge in demand for new homes, even though interest rates are high. Existing homes simply are not going on the market like they used to. Mortgage demand is also slipping as well. While the existing home issue is bullish, a slowing of mortgage demand is bearish. We believe that demand for new homes will remain strong for the rest of 2023 and into 2024, although we expect overall demand to cool somewhat as mortgage rates rise further. So it is a mixed bag.

However, with this weak market, we are getting a nice sale on shares. We view shares as a buy for the next few quarters. When the Federal Reserve begins to cut interest rates, pressure may increase. Right now, we think that the Fed is going to cut rates in summer of 2024. When that happens, whether it is sooner or later than our expectation, you will start to see demand start to increase for more existing homes, because mortgage rates will start to recede. It will not be immediate, but the market will in turn anticipate the impact to homebuilders, and likely sell them off with the expectation they will be under pressure as rates come down. That is however, a mid, maybe late 2024 story, we believe. For now, we see the earnings as secure for the next year. This was evidenced by the just reported earnings. Let us discuss the just reported results.

From the overall headlines we see that the just reported earnings surpassed the consensus estimates handily on both the top and bottom line. Total revenues were down about 13.6% from last year however, suggesting that the market may has peaked for now. Revenues were down to $1.59 billion but did beat the consensus estimates by $130 million. EPS was impressive at $1.80, a strong $0.38 beat versus consensus. Despite the decline in revenues (which was expected) these are strong results overall. But what drove these results?

Home sales are the massive source of revenue, with a strong majority of the revenue being generated from building and delivering homes. Now that said, operating income was down for homebuilding massively to $179.2 million versus $325.1 million. Why the decline? Well, revenues were lower as there was a 8.3% decrease in average sales price of home deliveries. Of course the housing mix impacts this too. The average sales price of homes delivered was $466,300, down from $508,700 a year ago. That said, volumes also fell for deliveries. There was a 7% decrease in the number of home deliveries to 3,375 homes. However, we were impressed with the fact that net orders were up in the quarter versus a year ago.  Net orders for the third quarter grew 52% to 3,097, and net order value rose 54% to $1.51 billion. This suggests that the party is not over, and a reason we are bullish. Cancellation rates were lower this quarter too. The company also has an impressive backlog of $3.4 billion, though this backlog is down from $5.26 billion

We did see a decline in housing gross profit margin of 21.5% which was down 520 basis points from a year ago. If we make adjustments for inventory-related charges associated with housing operations of $0.6 million in the current quarter and $5.9 million in the year-earlier quarter, the housing gross profit margin was down from 27.0%. The main issue was lower sale prices of homes, slightly higher construction costs, as well as shift in the mix of home types and sizes that were delivered.

The Financial Services segment saw gains however as more mortgages were issued through their in house financial services versus mortgages from other financial institutions. In fact, KBH saw operating earnings more than double, coming in at $9.9 million compared to $4.6 million a year ago. In fact KBH originated 84% of the mortgage loans to its customers who ordered homes.  Ok, so we are definitely seeing some mixed performance, and there is evidence that while earnings are still strong, the tailwinds are slowing. Why buy? Because market conditions are still in the builders' favor and will be for the foreseeable future in our estimation.

While the multiple can easily expand here if performance declines markedly, right now the valuation of the stock is attractive at 7X FWD EPS. Further, you do get a small dividend yield of 1.7%, not impressive, but better than nothing.  That said, book value of the company was $48.29 per share, and now shares are trading below book value following the earnings. This presents a good risk-reward, as we see no immediate reason for book value to drop off tremendously.

The play (these are the types of trades presented at BAD BEAT Investing)

Target entry 1: $45.75-$46.50 (30% of position)

Target entry 2: $44.25-$44.50 (33% of position)

Target entry 3: $43.55-$43.60 (34% of position)

Stop loss: $40

Target exit: $51

As we look ahead, the balance sheet improvement is notable. There is a lot of cash and liquidity here. Cash and cash equivalents increased to $612.1 million, versus $328.5 million last year.  Further KBH had total liquidity of $1.70 billion, including cash and cash equivalents and $1.08 billion of available capacity under its unsecured revolving credit facility, with no cash borrowings outstanding. That is strong. Not only is the company paying a dividend, but it is also repurchasing shares.  In Q3, the company repurchased nearly 1.5 million shares of stock at a total cost of $82.5 million, bringing its total repurchases in 2023 to approximately 5.7 million shares at a total cost of $249.6 million. At the end of Q3 the company still had $325.4 million remaining under its current common stock repurchase authorization. 

For all of 2023, KBH should deliver another 3,500 homes and is looking to see gross margins of 21.3%. You can expect more share repurchases as well. Total housing revenue should eclipse $6.3 billion. In terms of earnings for the year, with these results, we are projecting $6.70 in EPS for 2023. With the stock at $47, this puts the stock at 7X FWD estimates. Our initial look for 2024 is is tempered by uncertainty for the first rate cut, but we are still projecting a cut in summer of 2024 of 50 basis points. This will not have an immediate impact, but assuming continued strong home pricing, ongoing pressure on existing home sales, and margins that should exceed 21%, we believe EPS will be between $6.90-$7.70.

While the situation is worsening for the sector overall, we believe the company is in great shape. The balance sheet and cash position is improving. As we have noted, the repurchases will benefit EPS. Home prices are declining some, but are not likely to drop dramatically. You get a small dividend here, and shares are below book value. We rate shares of KBH a buy.

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