KB Home: Positive Outlook, But Lack Margin Of Safety (NYSE:KBH)

Synopsis

KB Home (NYSE:KBH) is a leading US homebuilding company that specialises in constructing a variety of residential homes. These homes include single-family homes, townhomes, and condominiums. It primarily caters to first-time and move-up homebuyers.

KBH’s Built-to-Order model gives it competitive advantages by offering homebuyers customisation, which appeals to selective buyers. However, its historical financial performance has been volatile, with declining revenue and contracting margins in 2023 due to macroeconomic challenges such as rising mortgage rates and inflation.

Although the long-term housing demand trend is positive and its investment in land and inventory management is expected to position it well for future growth, KBH underperformed compared to its peers in growth outlook and profitability margins. On that note, and due to a lack of margin of safety in its share price, I am recommending a hold rating for KBH.

Historical Financial Analysis

Over the last three years, KBH’s growth has been volatile. In 2022, its revenue increased to approximately $6.9 billion from 2021’s $5.7 billion. However, in 2023, its revenue experienced a decrease compared to 2022 and fell to $6.4 billion. For context, KBH’s total revenue has two segments, which are homebuilding and financial services, and homebuilding has always formed the largest part of KBH’s total revenue.

In 2023, its homebuilding revenues decreased 7%, and this was driven by a 4% decrease in the number of homes delivered to 13,236 homes as well as a decrease in the average selling price of those homes. The average selling price fell to $481,300.

As a result of increasing mortgage rates, high inflation, and other macroeconomic factors, it resulted in a decrease in housing demand during the second half of 2022, which ultimately rolled into the first quarter of 2023. Although demand recovered in the later part of 2023 as total net orders increased 2% year-over-year, the overall revenues were still lower. Pricing adjustments and concessions KBH provided to homebuyers resulted in a reduction in average selling price and housing gross profit margins.

Moving on to margins, both its adjusted housing gross profit margin and homebuilding operating income margin also contracted in 2023. In 2023, its adjusted housing gross profit margin contracted to 21.40%. This decline was driven mainly by the pricing adjustments and mortgage concessions KBH provided to homebuyers to drive up demand. Although these strategies helped improve demand, they also applied pressure on profitability.

KBH’s homebuilding operating income margin contracted to 11.30%. The drivers behind the decline were due to the gross profit margin contraction as discussed as well as an increase in selling, general, and administrative expenses (SG&A). The increase in KBH’s SG&A compressed its homebuilding operating income margin even further.

Second Quarter 2024 Earnings Analysis

For 2Q24, KBH’s total revenue decreased by 3% year-over-year to $1.71 billion. KBH’s total revenue is made up of two segments, which are homebuilding and financial services. Homebuilding forms the largest share of its total revenue. For the quarter, it accounts for 99.5% of its total revenue.

For 2Q24, homebuilding revenues fell 3% year-over-year. This decline was driven by a 4% reduction in the number of homes delivered. For the quarter, 3,523 homes were delivered compared to the previous period’s 3,666. However, overall average selling price slightly increased, driven by changes in product and geographic mix and a reduction in homebuyer concession. The average selling price increased from $479,500 to $483,000.

Financial services 2Q24 revenue increased 11% year-over-year from $7.47 million to $8.301 million. This growth was driven by an increase in insurance commissions, but partially offset by a decrease in title services revenues.

KBH’s 2Q24 net orders grew 2% year-over-year to 3,997, while net order value increased 7% to approximately $2.03 billion. The increase in net order value was driven by increasing net orders and average selling price. One notable point is that the cancellation rate improved from 22% to 13%.

For the quarter, KBH reported that ending backlog homes decreased 14% while backlog value fell 10%. However, the year-over-year decline has been narrowing for the fourth consecutive quarter. In terms of average community count, it fell 4% year-over-year, but ending community count was flat at 247. On a sequential basis, ending community count actually grew by 4%.

Moving on to margins, both performed relatively well for the quarter, but I do notice a slight contraction. Its adjusted housing gross profit margin contracted 0.2% to 21.2%. For the quarter, housing gross profit decreased 3% year-over-year, driven by lower housing revenues. On an unadjusted basis, gross margin was flat year-over-year, as higher construction and land costs and a shift in product and geographic mix offset the benefits from reduced inventory-related charges and homebuyer concessions. On an adjusted basis that excludes inventory-related charges, margins declined a modest 0.2%.

For operating income, it decreased 7% year-over-year as a result of lower gross profit and increasing selling, general, and administrative expenses (SG&A). In terms of adjusted operating income margin, it decreased 0.6% to 11.1%, primarily driven by higher SG&A expenses.

Built to Order Model’s Competitive Advantages

The BTO model, or Built-to-Order, is one of the competitive advantages that KBH possesses. Its BTO model provides homebuyers with not just flexibility but also choices. This model allows homebuyers to choose their preferred floor plan, lot, square footage, and personalised finishes through the KBH’s design studios. As a result of the customisation, it ensures that each home that buyers choose is tailored to their budget and preferences, and this customization appeals to today’s selective homebuyers. Currently, approximately 65%–75% of KBH’s business is made up of BTO.

One important complement to KBH’s BTO model is the availability of quick move-in homes. This allows KBH to cater to homebuyers who prioritise a faster move-in timeline. In addition, this model also gives homebuyers the ability to determine their sales price, and the sales price will be based on their selection of lot types and finishes. Currently, more than 70% of KBH’s communities offer plans that are under 1,600 square feet. Although these houses are smaller, they maintain the liveability aspect while being offered at lower starting prices. One major takeaway is that although houses are smaller and prices are lower, KBH stated that there is no compromise to its gross margins.

As a result, KBH’s model creates a clear differentiating factor between it and resale homes. Resale homes are KBH’s biggest competitor so far. As discussed, the BTO model emphasises greatly on affordability as well as choice. As a result, this has allowed KBH to achieve consistently higher monthly absorption rates as compared to its peer group. Looking at the monthly absorption rates chart over the past few years, it clearly shows that KBH has consistently outperformed its peer group average. This result clearly demonstrates the effectiveness of its BTO strategy in driving demand and capturing market share.

Land Investments and Inventory Management

For its most recent quarter, KBH reported a significant increase in its land investment. Its lot position grew 17% year-over-year. As a result, it ended the quarter with more than 65,500 owned or controlled lots. Diving deeper, 39,900 out of 65,500 were owned, and within these owned lots, more than 16,000 were in finished condition.

Another key takeaway is with regard to KBH’s excellent inventory management. Although it has increased its land investment, the company places great emphasis on capital efficiency, and it only develops lots when needed and in small phases. This approach allows KBH to manage its inventory of finished lots effectively. Currently, KBH is confident that its own or controlled lots are sufficient to meet its delivery targets through 2026. Looking ahead, KBH has positioned itself well to support its future growth.

Positive Long-Term Housing Demand Trend

Currently, the housing demand trend for the long term remains positive. This favourable outlook is mainly driven by favourable demographic trends, increasing household formation, and the chronic undersupply of homes.

According to realtor’s data, 1.7 million new households formed in 2023. However, housing starts lagged new household formation, and this resulted in a cumulative gap of approximately 2.5 million units between 2012 and 2023. On the other hand, the single-family deficit increased to approximately 7.2 million units.

Although the mortgage rate was volatile and created uncertainty, challenging housing affordability, KBH employed sales strategies such as mortgage concessions to lower cancellations and, at the same time, drive up order activity.

For 2Q24, net orders grew 2% year-over-year, with the monthly net order pace per community increasing to 5.5. This 5.5 figure is one of the highest 2Q levels. In addition, net order value increased 7% year-over-year to $2.03 billion. This is driven by the increase in net orders and by a higher average selling price.

Relative Valuation Model

According to Seeking Alpha, KBH operates in the homebuilding industry. In my relative valuation model, I will compare KBH’s performance against its peers in terms of growth outlook and profitability margin trailing twelve months (TTM). For growth outlook, I will be comparing their forward revenue growth rate, which is considered to be forward-looking. For net income margin TTM, I will be comparing their EBITDA margin TTM and net income margin TTM.

Starting with growth outlook, KBH underperformed its peers’ median. KBH has a forward revenue growth rate of 1.30%, which is lower than peers’ median of 3.85%. This represents 0.34x over the median, or 2.55% lower. For profit margins, KBH also underperformed its peers in both EBITDA margin and net income margin TTM. For EBITDA margin TTM, KBH reported 12.34%, which is 7.87% lower than peers’ median of 20.21%. For net income margin TTM, KBH reported 9.43%, again lower than peers’ median of 14.63%.

Currently, KBH’s forward non-GAAP P/E ratio is 9.63x while peers’ median is 12.38x. Given KBH’s underperformance in both growth outlook and profitability margins, I argue that it is fair that KBH’s P/E trades at a discount. However, I do acknowledge that KBH’s current P/E of 9.63x reflects some market optimism. Therefore, I have chosen a more balanced and prudent approach of using the midpoint between this and its 5-year average of 7.81x as my 2025 target P/E for KBH. By doing so, it allows my valuation to be conservative.

For 2024, the market revenue estimate for KBH is approximately $6.83 billion, while EPS is $8.40. For 2025, the market revenue estimate is approximately $7.18 billion, while EPS is $8.99. Given my forward-looking analysis as discussed, it supports the market’s estimate. Therefore, by applying my 2025 target P/E to KBH’s 2025 EPS estimate, my 2025 target share price is $78.

Risk and Conclusion

The upside risk associated with my rating on KBH is in regard to the potential improvement in the housing market condition and the overall economy. Recently, the Fed indicated its intentions to cut interest rates. Therefore, any reduction to mortgage rates might potentially alleviate some of the pressures that have been dampening housing demand and affecting KBH. In addition to that, a favourable macroeconomic environment will also stabilise consumer confidence and reduce contract cancellations. Therefore, KBH could experience higher revenue as well as margins.

In 2023, KBH’s revenue fell due to increasing mortgage rates and high inflation affecting housing demand. To boost demand, KBH offered concessions and made pricing adjustments, but this resulted in a reduction in the average selling price and housing gross profit margins. As a result, margins contracted in 2023. Looking ahead, KBH’s investment in land, emphasis on inventory management, and the positive long-term housing demand trend are expected to support its growth outlook. However, compared to its peers, KBH underperformed in both growth outlook and profitability margins. Given the lack of margin of safety in its share price, I am recommending a hold rating.