It’s time to discuss KB Home (KBH). This Los Angeles, CA-based homebuilder just reported its second-quarter earnings after erasing all COVID-19 stock price losses in June. While I have been on the sidelines, as I distrusted the steep rally in homebuilding stocks, I am afraid that we are at a point where homebuilding sentiment needs to approve. While KB Home was able to report good earnings, its new orders were down big, with only a small improvement towards the end of the quarter. While I won’t be shorting anything, I am staying far away from homebuilders for the time being.
Source: KB Home
Here’s What Happened In Q2
First of all, let’s start by mentioning that the company’s second quarter started in March and ended at the end of June. In other words, this quarter included the full impact from the almost nationwide shelter-in-place orders.
That said, KB Home generated earnings worth $0.55 per share. That’s slightly above expectations and 8% up compared to the prior-year quarter. It marks the third consecutive quarterly improvement. Additionally, the company hasn’t reported earnings below expectations in years.
Unfortunately, total housing revenues totaled $910 million, compared to more than $1.0 billion in the prior-year quarter. This translates to a 10% decline, as overall deliveries were down 10%, with average selling prices declining roughly 1% to $364,100. Deliveries were down, as the COVID-19 pandemic caused severe economic and social disruptions and added uncertainty during the quarter. This caused cancellations to rise. While prices were down as well, the company believes the full-year average selling price to be in the $385K-398K range.
Fortunately, the company’s operating income margin, adjusted for inventory changes worth $4.4 million and severance charges of $6.7 million, came in at 6.9%. This is an improvement of 140 basis points. The housing gross profit margin improved 100 basis points to 18.2%, as the mix of homes delivered and lower amortization of capitalized interest, partly offset by lower housing sales, was able to provide a much-needed boost.
With that said, sales, margins, and earnings are backward-looking. What matters more is how new orders are doing. This will determine deliveries and sales going forward. Unfortunately, new orders absolutely imploded and were down 57% from the prior-year quarter. This is without a doubt a terrible number. What makes it worse is that nationwide building permits declined roughly 9% in the company’s second quarter.
The good news is that demand in markets like Houston improved as restrictions were eased, while overall new orders in June (third quarter) were mostly up compared to the prior-year quarter. To be precise, the improvement in June was 2%. While some might say it’s low, I believe it is too soon to call it a rebound.
We have entered a situation where data absolutely has to improve. Why? Simply because the stock has priced in higher growth. Right before the earnings call, the stock was almost flat for the year. Meanwhile, everything impacted by the virus is down more than double digits (airlines, retail etc.).
I don’t like the stock at prices above $20. Long term, it might be a buy, but the risk/reward is bad. If the economy is unable to end up in a V-shaped recovery (and I believe it won’t), this stock, and stocks in general, might be overpriced. The next two months are critical with regard to loan quality, delinquencies, and overall economic expectations. While I do have a number of dividend stocks, I am very conservatively managing my money right now.
Regardless, I keep KB Home on my radar, as the company has made great progress in enhancing margins and improving cash flow. Over the past 121 months, operating cash flow has risen to $586 million. This is more than double the value generated in 2019. Meanwhile, debt is only valued at 41.5% of capital, down from almost 55% in 2017. Adding to that, right now, the company holds $1.36 billion in liquidity through its available revolver capacity and unrestricted cash. The first debt maturity is in 2021, when $450 million in senior notes retire. After that, $350 million is due in 2022.
My point is that bankruptcy is not an issue. This company will be fine and show a tremendous recovery once the consumer is strengthening again. For now, the problem is that I don’t want to add shares that are as volatile as KB Home to my portfolio. My entry target of $20 might be a bit low, but that’s a risk I am willing to take. I am focusing on income-generating stocks right now and will buy cyclical stocks once the risk/reward improves.
If you disagree with my risk/reward assessment but believe the company’s long-term potential outweighs short-term risks, make sure to adjust your position for its volatile behavior.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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