KB Home (KBH) was the sixth largest builder in the U.S. in 2016, according to Builder Magazine. The company operates in four regions, nine states and 39 metropolitan markets. It generates most of its sales in California, with operations in 16 local markets, including Los Angeles, San Francisco, San Diego and the Inland Empire. Outside of California, it has a significant presence in Phoenix, Tucson, Las Vegas, Denver, five cities in Texas and ten metro markets in Florida. It offers houses in all price points, but it has traditionally focused on first-time and first-move-up buyers.
KBH struggled more than most builders coming out of the recession. Impairment charges and stranded land positions delayed its return to profitability and its debt levels have remained high.
When it finally returned to sustained profitability in fiscal 2014 (ended Nov. 30), KBH reversed its $825.2 million deferred tax valuation allowance, which resulted in a non-cash gain of $8.30 per share. Accounting rules do not permit recognition of deferred tax assets (DTAs) that arise from net operating loss carryforwards (NOLs) until a company can demonstrate sustained profitability. At the end of the fiscal 2016 third quarter, KBH had $757 million in NOLs remaining, which could offset up to $2 billion of future taxable income.
KBH’s operating and financial performance has improved steadily since fiscal 2013. Over the past two years (from fiscal 2014 to fiscal 2016), the company’s homebuilding pre-tax income increased at an average annual rate of nearly 30%. Revenues from the sale of homes have risen at a 22% annual clip over the same period. Ditto for the dollar value of net orders. In fact, net orders have increased year-over-year for 19 consecutive quarters.
Yet, KBH’s net income over the past four fiscal years has been choppy, due mostly to the accounting changes associated with the reversal of the DTA allowance. Prior to the reversal, KBH booked no income tax against earnings; but after the reversal, accounting rules require it to recognize income tax at normal rates, even though its profits are sheltered by NOLs.
Fiscal 2016 fourth quarter results. The company reported a decline in fiscal 2016 fourth quarter net income and earnings per share, due mostly to an increase in impairment charges taken on land positions and mothballed communities that are being readied for sale. Earnings were $37.5 million and $0.40 per diluted share, down from $44.0 million and $0.43 in the prior year period.
Fourth quarter housing revenues increased 21% to $1.19 billion, due to an 18.6% increase in homes delivered to 3,060 units combined with a 2.0% increase in average selling price to $387,400. All regions posted gains in unit deliveries, led by a 35% surge in the West Coast. Management attributed some of the improvement in West Coast deliveries to an increase in mortgage processing efficiency under its new mortgage origination partner, Stearns Lending. Thus, it may have pulled some deliveries forward from the 2017 first quarter.
Housing gross profit margin slipped 70 basis points (bp) to 16.5% due to labor cost pressures and increased sales of older, previously mothballed communities. Management said that construction costs have risen 8% this year or roughly $5,000 per house, but this has been partially offset by increases in average selling prices.
The company has also lowered prices at some older communities to get the inventory off the books. Deliveries from these older communities accounted for 15% of the company’s total in fiscal 2016, up from about 10% in 2015. Continued sales from these communities will represent a headwind for KBH’s gross margin in 2017, but the sales will raise cash which can be used to re-invest in the business or reduce debt.
During the quarter, the company recorded $30.6 million of impairment charges on anticipated future land sales. The charges were taken to reduce the carrying value of the properties to their estimated fair values. As a result of the charges, KBH recorded a loss on land sales of $30.4 million in the quarter.
The decline in housing gross margin and loss on land sales was partially offset by an 80 bp year-over-year decline in KBH’s SG&A expense ratio to 9.2%. With these changes, KBH’s housing operating margin declined by 240 basis points to 4.7% in the quarter. Excluding the $36.1 million of inventory-related charges (which consists of $5.5 million of impairments from housing operations and the $30.6 million of charges against land held for sale), operating margin was 7.7%, which was roughly flat with the prior year.
Projections for 2016 and beyond. Although fourth quarter GAAP earnings declined, KBH continues to make progress on its efforts to improve future earnings, deleverage its balance sheet and invest in its business. The company begins the year with a backlog that is up 11.4% in units and 18.5% in dollar value. Management’s fiscal 2017 guidance of $4.0 billion in housing revenues (at the mid-point of the range) implies growth of roughly 12%, which breaks down, according to my estimates, to a 10% increase in deliveries and 2% increase in average selling prices. Assuming no inventory impairment charges and a modest improvement in profitability (driven mostly by another decline in the SG&A expense ratio), the company could deliver a GAAP operating margin of 6.0%, up from 4.2% in 2016. This would result in diluted EPS of $1.57, according to my estimates, up from $1.12 in 2016.
Longer-term, KBH’s fiscal 2019 targets include $5 billion in revenues (which represents compounded annual growth of more than 12%); homebuilding operating margin of 8%-9%, up from 4.2% in fiscal 2016; return on equity in the low– to mid-teens; and net debt-to-capital of between 40% and 50%, compared with 54.6% currently.
Management’s efforts to reduce leverage will be aided by utilizing NOLs and building out or selling projects that were mothballed during the housing bust. (It will therefore be paying virtually no taxes and converting these older land positions into cash, at least part of which will be used to pay down debt.)
By my estimates, KBH’s fiscal 2019 targets translate into projected earnings of $3.14 per share and a potential share price of $38, assuming a 12X valuation multiple. Obviously, this target price assumes the sustainability of the recoveries in both the economy and housing market over the next four years.
Potential Impact of Tax Reform. Given its NOLs, which are reflected as a DTA on its balance sheet, the potential reduction in corporate tax rates will have a mixed impact on KBH’s financial statements. If the maximum corporate tax rate is reduced from the current 35% to say 20%, then KBH’s DTA will probably be less valuable. The NOL will not change, but KBH may not be able to utilize them fully before they expire in 2035. Accordingly, the company may have to increase its valuation allowance on its DTA, which will reduce the size of the DTA on its balance sheet.
Once the increase in valuation allowance is recorded, KBH’s income tax expense will fall from about 35% currently to the 20% given in my example. Earnings would increase by a corresponding amount. Investors may possibly bid up the stock as a result of the increase in earnings, but the company’s cash flow will be unaffected by the corporate income tax rate reduction because tax expense does not require a cash expenditure as long as NOLs are available to shelter income.
Recent Stock Performance. In 2016, KBH was the second best performer among the twelve homebuilders included in the Lark Research Homebuilder Stock Price Index. For the year, it advanced 28.2% in price, better than the Index’s 6.1% gain and also better than the gains of 9.5% on the S&P 500 and 19.5% on the Russell 2000.
Virtually all of KBH’s gains came from January to July. Since the end of July, the stock has essentially traded sideways. However, the stock did reach a new 52-week high of $17.38 in December, before pulling back a bit. From a technical point of view, the stock can now be described as range-bound.
Despite the strong relative performance in 2016, KBH merely caught up to the average to the 3-year average performance of its peer group. The performance of it and its peers has lagged the broader market averages over that time. If the housing recovery continues at the accelerated pace that we witnessed over the last half of 2016, the homebuilders should narrow that performance gap in 2017.
Valuation. At the current price of $16.28, KBH’s stock is trading at just 10.4 times projected fiscal 2017 EPS of $1.57, which is roughly in line with the peer group average. Earnings are expected to grow 37.5%, slightly above the peer group average, giving the company a PEG ratio of 0.3, which is relatively cheap. KBH’s low forward P/E multiple and PEG ratio, which are consistent with peer averages, reflect both the cyclicality of the industry and skepticism about its ability to achieve its earnings targets. Yet, as already noted, momentum in the housing market picked up in the second half of the year and looks poised to continue into 2017. If growth continues at the current pace, it is reasonable to think that KBH’s stock could deliver a return at least equal to its projected earnings growth rate, assuming no change in its forward P/E multiple.
With operating momentum on its side, I think that KBH is still a good bet in the current market environment.
January 23, 2017
Stephen P. Percoco
Lark Research, Inc.
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246
incomebuilder@larkresearch.com
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