TMHC - KB Home Q3 2023 Earnings Preview: Additional Upside Exists From Here

2023-09-11 13:20:22 ET

Summary

• KB Home is expected to announce Q3 financial results, with analysts predicting a decline in revenue and profits.
• The housing market is showing signs of improvement, with an increase in new orders and rising home prices.
• Shares of KB Home are considered cheap compared to similar companies, making them an attractive investment opportunity.

After the market closes on September 20th, the management team at homebuilding company KB Home ( KBH ) is expected to announce financial results covering the third quarter of the company's 2023 fiscal year. In recent months, shares of the business have experienced a great deal of upside. Even though interest rates remain high, and we could see some weakening in the labor market before too long, a rather sizable shortage of homes and a consumer that has been, for the most part, quite robust, has caused a resurgence in the housing market. Given these developments and how cheap shares of KB Home are, I would make the case that additional upside for the company very likely does exist.

Keep an eye out

The very first thing that investors and market watchers tend to focus on after a company announces financial results are what I call the headline items. The first example of this is revenue. At present, analysts are forecasting sales of $1.46 billion for the third quarter of the 2023 fiscal year. Should this come to fruition, it would represent a rather large decline from the $1.84 billion the company reported in the third quarter of 2022.

For those who watch KB Home closely, such a large decline in revenue might seem inconceivable. After all, 2023 has already been bullish for the company from a revenue perspective. For the first half of the year, sales of $3.15 billion came in slightly higher than the $3.12 billion reported the same time last year. Even during the most recent quarter, the second quarter of the year, sales were higher than what the company reported in the second quarter of last year. Year over year, they rose from $1.72 billion to almost $1.77 billion.

This is not to say that analysts will be incorrect. In fact, I wouldn't be surprised if revenue does fall to some extent. To see what I mean, we need only look at certain data outside of sales as of the most recent quarter. During the second quarter of the year, total backlog for the company was 7,286 homes. That's down substantially from the 12,333 homes reported in the second quarter of 2022. This drop was aided by an increase in the cancellation rate of properties from 17% to 22%. During the second quarter, the company did see deliveries come in higher than they were the same time last year, with readings of 3,666 and 3,469, respectively. However, the average price of deliveries had also fallen, dropping from $494,300 to $479,500. This plunge in backlog and in pricing was all caused by inflationary pressures and high interest rates, both of which made home buying more difficult for most people.

On the bottom line, the picture is also expected to look weaker year over year. Analysts are currently forecasting earnings per share of $1.42. That would mark a substantial decline from the $2.86 per share that the company reported during the third quarter of 2022. If this comes to fruition and if the company did not repurchase any shares during the third quarter, this would mark a decline in profits from $255.3 million last year to $119.7 million this year. Once again, we can look at the most recent quarter to see if there might be some precedent for this. Sure enough, there is. During the second quarter of 2023, KB Home generated net profits of $164.4 million. This was down from the $210.7 million reported one year earlier. Higher costs aimed at attracting customers certainly played a role in this decline.

Even though analysts have not provided any estimates when it comes to other profitability metrics, there are a couple that investors should keep a close eye on. First and foremost would be operating cash flow. In the third quarter of last year, it totaled $90.8 million. But if we adjust for changes in working capital, we get a reading of $294.5 million. It is worth noting that the adjusted operating cash flow for the company for both the second quarter of this year and the first half of the year in its entirety came in lower than it did last year. Meanwhile, EBITDA for the business in the third quarter of last year was $344 million. As was the case with adjusted operating cash flow, EBITDA this year has so far been lower than it was last year. A continuation of this trend would not at all surprise me.

The market is strengthening

In some articles earlier this year, with the earliest dating back to January, I made the case that the housing market was due for a great deal of pain. Order numbers started coming in week last year. Cancellation rates were rising and backlog was evaporating. I figured the pain would be significant. But even with that pain, I recognized some firms that I believed were attractive enough for investors to consider. The optimism that I had regarding those particular companies centered around the idea that, while the housing market would probably experience a great deal of pain for some time, there was a catalyst that would not let that pain last forever.

You see, there already exists a rather substantial housing shortage, with some estimates pegging it at around 3.8 million units. Even though painful economic conditions can cause a slowdown in the homebuilding market, the combination of a continuously growing population and a large shortage of properties, made for a perfect recipe for a magnificent rebound. But I will be honest with you when I say that even I was surprised at how quickly the picture would start to improve. As I wrote about here and here , some players in the homebuilding space have already started seeing growth in their orders. It wouldn't be difficult to expect those improvements to apply to most or all of the players in this space. In fact, during the second quarter of this year, KB Home saw a modest improvement in new orders. Total net new orders for that quarter were 3,936 units. That was up from the 3,914 units ordered one year earlier.

Outside of the company specific data, we can also see some other data that shows that the turnaround in the housing market is already here. As of August of this year, for instance, median home prices are already up 4.8% year over year. At the bottom of the pricing decline, which would have been in April of this year, prices were down 3% year over year. In some markets, like Miami, Florida, prices are up a shocking 17.1% year over year. We are also seeing a decline, albeit a modest one, when it comes to mortgage rates, particularly for the 30-year mortgage. This data can be seen in the chart below. A decline in borrowing costs translates to additional borrowing because of the reduced expense the lower interest rate imposes upon home buyers. We don't yet know if we are at the peak of the current interest rate cycle. But when interest rates do eventually start to decline, which I believe will be around the middle of next year, that should prove even more bullish for investors, unless the decline is in response to a true economic downturn.

Shares are cheap

So long as the housing market does not cause new orders to fall year over year and so long as backlog does not continue to plummet, it's hard to imagine shares of KB Home not looking fundamentally attractive. By annualizing results experienced so far this year, I calculated that net profits on a forward basis should be $686.5 million. Adjusted operating cash flow should be around $858.3 million, while EBITDA should total $967.5 million. Using these figures, I then priced the company in the chart above. It shows how the company is priced on a forward basis for this year and using results for last year. The stock does look more expensive, but it's not outside of the range of what I consider to be cheap. Meanwhile, in the table below, you can see how shares are priced compared to five similar firms. On both a price to earnings basis and a price to operating cash flow basis, three of the five companies ended up being cheaper than KB Home. This number drops to two of the five if we use the EV to EBITDA approach instead.

Takeaway

Leading into the third quarter earnings release, I believe that investors in KB Home have reasons to be optimistic. I do expect revenue and profits to decline year over year. Having said that, the number of new orders will likely be a bright spot for the company. That, as well as the cancellation rate and overall backlog, would be incredibly important metrics to pay attention to. The average price for homes delivered will also be significant. I would also argue that all of these metrics would be more important than the revenue or profit figures that management reports. So it would be wise to keep an eye on these at this time. Add on top of this how cheap shares of the company are, and I remain optimistic. Since I last wrote about the business, in an article published in March of this year where I rated it a ‘buy’, shares are up 28% compared to the 10% experienced by the S&P 500. I see no reason why, given the totality of the picture, the stock cannot climb further from here.

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