KB Home (KBH) recently reported its second-quarter results. While the company’s top-line declined ~10% y-o-y, it was able to post ~8% y-o-y growth in its diluted EPS due to excellent gross margin and operating margin performance. The company’s gross margin for the second quarter was 18.2%, up 100 bps y-o-y. It was helped by a favorable impact from the mix of homes delivered and lower amortization of capitalized interest. The company’s SG&A expense as a percentage of sales was up 50 bps versus the last year. However, if we exclude the current quarter severance charge of $6.7 mn, the SG&A expense ratio improved 30 bps versus the last year.
I consider the company’s margin performance very impressive given the kind of volume decline it witnessed due to coronavirus. However, most of the investors are focused on net orders to get a sense of future trends. The company’s 57% y-o-y net orders decline for the quarter was worse than most of its peers were reporting. The company’s stock, as well as other home building stocks, saw some pressure post the company’s results. I don’t think it is justified as these order trends aren’t reflective of the company’s or industry’s near or medium-term potential. If we look a couple of quarters ahead, orders will return to their normalized levels and we will likely see a significant improvement over the last quarter trends.
The main reason behind KB Home’s poor performance was the company’s more conservative approach versus other builders during the lockdown. The company was quick to close its communities in mid-March which is among its busiest period and reopened more slowly as compared to other builders. Even after it opened its communities when the restrictions were eased in the second half of April, it followed an appointment-only approach with only one customer group permitted in its sales centers, model homes, and design studios at any one time. So, the company’s sales were impacted more than other builders.
With the economy opening up and the company accepting walk-in traffic, new orders showed significant improvement in the month of June. For the first three weeks of June, new orders were up 4% y-o-y. While 4% doesn’t sound like a big number, one should remember that the company faced a really tough comparison in the third quarter of this year. The company’s net order growth in the third quarter of last year was 24% y-o-y versus 15% y-o-y in the second quarter of 2019. So, the comparisons are tougher by 900 bps. If the company is able to post growth in new orders despite this, I believe the underlying trends have improved significantly.
Another thing to note is that the company increased prices in 60% of its communities in May. So, clearly, management doesn’t think the slowdown in new orders is anything more than a short-term disruption.
While coronavirus has caused short-term disruption in the industry over the past four months, there have also been a couple of positive developments for the housing industry from a medium-to-long-term perspective. First, the Federal Reserve has lowered the interest rates to zero percent, and mortgage rates are now near all-time lows. This should help drive demand as consumers now have to pay reduced monthly installments. Second, there is a heightened desire among consumers to relocate away from densely populated areas. This has resulted in a shift away from renting multifamily homes in metros to buying single-family homes in suburban areas which should help KB Home and most of the publicly-listed homebuilders.
Usually, net orders take a couple of quarters to convert into revenues. So, we will see these orders converting into revenues from 1QFY21. Since the company’s net orders are now trending up versus FY2019, I believe its revenues for FY21 will likely be higher than FY2019 levels if we do not see another leg down in the housing market.
This coupled with cost-cutting measures KB Home has undertaken will result in it posting a good EPS growth in FY21 versus FY19. Management has implemented workforce reduction and other cost-saving programs which are expected to result in ~$40 mn on annualized savings.
I believe the company can easily surpass its FY19 EPS of $2.85 in FY21. The stock was trading at a 52-week high of ~$40 in February before coronavirus related shutdowns hit its sales. I believe the stock can again reach these highs over the next 12 to 18 months. The stock is also cheap on P/BV basis with its book value of ~$27 as of the last quarter-end. I believe medium-term investors should consider buying the stock after its recent correction.
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.