February 11, 2015 KB Home (KBH-NYSE) Current Recommendation Prior Recommendation Neutral Date of Last Change 02/11/2015 Current Price (02/10/15) $13.61 Target Price $12.00 UNDERPERFORM SUMMARY We are downgrading our recommendation on KB Home from Neutral to Underperform as the homebuilding company reported disappointing fourth quarter 2014 results and provided a bleak outlook for 2015. KB Home s fourth quarter 2014 earnings of $0.27 per share lagged the Zacks Consensus Estimate by 48% and declined 12.9% year over year. Fewer-than-expected home deliveries, higher construction cost, increased incentives and weaker margin resulted in weak earnings in the quarter. Though total revenue increased year over year, homebuilding gross margin in the fourth quarter missed the company s guidance. Also, gross margin outlook for 2015 is disappointing as the company expects these headwinds to continue into 2015, thereby hurting margins. SUMMARY DATA 52-Week High $20.67 52-Week Low $11.87 One-Year Return (%) N/A Beta 2.33 Average Daily Volume (sh) 6,290,766 Shares Outstanding (mil) 92 Market Capitalization ($mil) $1,252 Short Interest Ratio (days) 2.93 Institutional Ownership (%) 88 Insider Ownership (%) 12 Annual Cash Dividend $0.10 Dividend Yield (%) 0.73 5-Yr. Historical Growth Rates Sales (%) 8.7 Earnings Per Share (%) N/A Dividend (%) N/A using TTM EPS 15.0 using 2015 Estimate 14.8 using 2016 Estimate 11.0 Zacks Rank *: Short Term 1 3 months outlook 5 - Strong Sell * Definition / Disclosure on last page Risk Level * Above Average Type of Stock Mid-Value Industry Bldg-Rsdnt/Comr Zacks Industry Rank * 232 out of 267 ZACKS CONSENSUS ESTIMATES Revenue Estimates (In millions of $) Q1 Q2 Q3 Q4 Year (Feb) (May) (Aug) (Nov) (Nov) 2013 405 A 524 A 549 A 619 A 2,097 A 2014 451 A 565 A 589 A 796 A 2,401 A 2015 471 E 670 E 731 E 913 E 2,785 E 2016 3,097 E Earnings Per Share Estimates (EPS is operating earnings before non-recurring items, but including employee stock options expenses) Q1 Q2 Q3 Q4 Year (Feb) (May) (Aug) (Nov) (Nov) 2013 -$0.16 A -$0.04 A $0.29 A $0.31 A $0.44 A 2014 $0.09 A $0.27 A $0.28 A $0.27 A $0.93 A 2015 $0.01 E $0.19 E $0.25 E $0.47 E $0.92 E 2016 $1.24 E Projected EPS Growth - Next 5 Years % 5 2015 Zacks Investment Research, All Rights reserved. www.zacks.com 10 S. Riverside Plaza, Chicago IL 60606
OVERVIEW Based in Los Angeles, CA, KB Home (KBH) is a well-known homebuilder in the United States and one of the largest in the state. The company s revenues are generated from its Homebuilding and Financial Services operations. The company s Homebuilding operations (99.5% of total revenue in fiscal 2014) include building and designing homes that cater to first time, move-up and active adult homebuyers on acquired or developed lands. KB Home also builds attached and detached single-family homes, town homes and condominiums. KB Home caters to 40 housing markets across 10 states. There are four main reportable segments based on geographical presence: West Coast (comprising California), Southwest (comprising Arizona and Nevada), Central (constituting Colorado, New Mexico and Texas) and Southeast (including Florida, Maryland, North Carolina and Virginia). KB Home s Financial Services operations (0.5%) offer mortgage banking, title and insurance services to homebuyers. In Jan 2013, KB Home formed a joint venture called Home Community Mortgage, with its current preferred mortgage lender, National Mortgage. National Mortgage is a subsidiary of Nationstar Mortgage Holdings Inc., one of the largest non-bank mortgage providers in the U.S. Home Community Mortgage started mortgage banking operations from Jul 21, 2014 until which National Mortgage was managing KB Home s mortgage banking applications. REASONS TO SELL Weak Fourth Quarter 2014 Results: KB Home s fourth-quarter fiscal 2014 results are disappointing. The company s adjusted earnings of $0.27 per share in the fourth quarter of 2014 missed the Zacks Consensus Estimate of $0.52 by a significant 48% and declined 12.9% year over year. Earnings were weak as fewer-than-expected home deliveries hurt gross margin during the quarter. Despite a 9% year-over-year increase, the number of homes delivered stood at 2,229 homes and was near the lower end of the company s expected range of 2,200 to 2,400 homes. As a result, the company lost some operating leverage related to increasing indirect construction cost, which consequently hurt margins. Adjusted homebuilding gross margin (excluding land option contract abandonment charges and warranty related charges) declined 110 basis points (bps) year over year to 18.7%. Management was expecting homebuilding gross margin to improve sequentially over the third quarter of 2014. Instead, gross margin declined 30 bps sequentially owing to softer demand in response to pricing pressure and higher construction, labor and material costs. Margins were also affected by higher incentives in the quarter. Disappointing Guidance; Estimates Lowered: KB Home s outlook for 2015 was even more concerning. The company expects headwinds such as higher construction, labor and material costs, higher incentives, moderation in pricing power to continue into 2015. Given the weak margins in the Equity Research KBH Page 2
fourth quarter of 2014, KB Home expects gross margin to decline year over year in the upcoming quarters of 2015. The company warned that gross margin would be lower than its long term target of 20% in 2015. Estimates largely moved downward after management s disappointing guidance for 2015, compelling us to downgrade the company from Neutral to Underperform. Higher Competitive Pressure: KB Home increased sales incentives in the last few quarters, owing to an increasingly competitive environment where, according to management, many peers were offering large incentives to drive volumes. Higher incentives and cost inflation are lowering the company s pricing power thereby denting its margins Supply Constraints: A shortage of buildable lots, skilled labor and available capital for smaller builders are limiting home production, thereby lowering the inventory of homes, both new and existing. As a result, demand cannot be fully met which is pushing up home prices. Rising Labor, Land and Material Costs: Rising building materials and labor costs are an increasing margin headwind. Both labor and construction material costs are rising proportionally with increasing housing starts and there could be significant inflation in the future. This could eat into the margins of the homebuilders, going ahead.. Slow Economic Recovery: Despite moderate improvement in economic growth, consumers are spending only modestly, as a surge in job growth this year is yet to translate into significantly higher wages. The lending environment is still overly restricted for first-time buyers. High down payments and strict underwriting standards are restricting access to the mortgage markets. Until there is a more robust economic recovery, new home sales would continue to lag historical levels Federal Government Actions: The federal government s actions related to economic stimulus, taxation, borrowing limits could affect consumer confidence and spending levels which, in turn, could hurt the economy and the housing market. Currently, there is a high probability of a rise in short-term interest rates in mid-2015 considering the fact that the Fed has ended its six-year long quantitative easing program in Oct 2014. A short-term fund rate hike would push mortgage interest rates up. High mortgage rates dilute the demand for new homes, as mortgage loans become expensive. This lowers buyers purchasing power and hurts volumes, revenues and profits of homebuilders. Concentration in a Few Markets: KB Home depends heavily on the housing market in Central U.S. (Colorado and Texas) and the West Coast (California). A lack of geographic diversity signifies that the company is heavily exposed to fluctuations in a few markets. RISKS A Positive Housing Market Outlook for 2015: Economic growth, improving job scenario, growing consumer confidence, moderating home prices and low interest rates aided housing market growth in the second half of 2014, though at a slow pace. The general market sentiment indicates that homebuilding activity will pick up in 2015 backed by improving job numbers and an upbeat economy. Moreover, moderating home prices, affordable Equity Research KBH Page 3
interest rates, higher rentals and limited supply of inventory are expected increase home demand this year. Housing price gains slowed dramatically in 2014 which is expected to continue in 2015. Moreover, analysts are predicting that with the rising home prices, it will become difficult for the millennial generation to pay for a down payment which has increased. So instead of buying, they will rent, in turn, increasing the rents. In case the mortgage rates do rise in the latter half of this year, these should still be reasonable. Further, lower fuel prices, as well as record employment levels, have greatly increased the purchasing power of U.S. consumers. A reduction in fuel costs has given a boost to consumer confidence, which in turn is expected to boost home buying. If improving housing trends perk up KB Home s results in the upcoming quarter, we may reconsider our recommendation. Aggressive Land Acquisition Strategy: The company invests aggressively in land acquisition and land development mainly in high-end locations, which is critical for community count expansion and top-line growth. From the second half of 2012, the company has almost doubled its investments in land and land development. The company spent around $1.5 billion in fiscal 2014 and $1.14 billion in fiscal 2013 on land and land development, significantly more than $564.9 million spent in 2012. As a result, the company expects its community count to increase year over year in fiscal 2015. Improving community count is resulting in KB Home s improving order trends in the last few quarters. If KB Home s order trends improve significantly in the upcoming quarters, we may consider the recommendation. RECENT NEWS KB Home Misses Fourth Quarter Earnings, 2015 View Bleak Jan 14, 2015 KB Home s adjusted earnings of $0.27 per share in the fourth quarter of fiscal 2014 lagged the Zacks Consensus Estimate of $0.52 by 48% and declined 12.9% from the year-ago earnings of $0.31 per share. Earnings were hurt by weak margin. The company s reported earnings per share of $8.36 include an income tax benefit of $824.2 million, which is reflected as $825.2 million of deferred tax asset valuation allowance reversal. Total revenue of $796 million in the fourth quarter surpassed the Zacks Consensus Estimate of $779 million by 2.2%. In addition, revenues increased 28.7% from the year-ago quarter. Quarter Details In the fourth quarter of fiscal 2014, homebuilding revenues increased 29% year over year to $792.8 million, driven by higher average selling prices. Equity Research KBH Page 4
The number of homes delivered increased 9% from the year-ago quarter to 2,229 homes. The number of homes delivered was however near the lower end of the company s expected range of 2,200 and 2,400 homes, possibly due to softer demand in response to pricing pressure. Average selling price (ASP) rose 17% year over year to $351,500, driven by a strategic shift in product mix. With more communities in lucrative markets of northern California, KB Home shifted its product mix toward higher priced larger homes. This way the company could cater to high income consumers. Regionally, average selling prices increased 1% in the Southwest to 17% in the West Coast region. The company s backlog totaled 2,909 homes as of Nov 30, 2014, up 14% year over year. Potential housing revenues from backlog rose 34% to $914.0 million owing to higher number of homes in backlog and increased pricing. At the end of the quarter, the company had 227 communities, up 19% from the prior-year quarter. Net orders rose 10% in the quarter to 1,706 homes driven by the company s higher average community count. The value of net orders increased 22% to $587.4 million. KB Homes order trends started improving since early 2014 on the back of aggressive land investments made by the company in the past quarters. KB Home s adjusted homebuilding gross margin declined 110 basis points year over year and also missed the company s expectation of sequential improvement over the third quarter of 2014. In fact, adjusted homebuilding gross margin declined 30 bps sequentially. Higher construction, labor and material costs and higher incentives mainly hurt gross margins. Moreover, moderation in pricing power pulled down gross margins. Fewer-than-expected home deliveries also impacted gross margin during the quarter as the company lost some operating leverage related to increasing indirect construction cost. Fiscal 2014 KB Home s adjusted earnings of $0.94 per share in fiscal 2014 lagged the Zacks Consensus Estimate of $1.23 by 23.6% but increased 104.4% from the year-ago earnings of $0.46 per share. The company s reported earnings per share were $9.25, which includes an income tax benefit reflected as deferred tax asset valuation allowance reversal. Total revenue of $2.40 billion was in line with the Zacks Consensus Estimate. In addition, revenues increased 14% from the year-ago quarter, owing to an increase in number of homes delivered and average selling price. Outlook Given the weak margins in fourth quarter 2014, KB Home expects gross margin to lag year over year in the upcoming quarters of 2015. Gross margin is expected to hit a bottom in the first quarter of 2015, with sequential improvement throughout the rest of the three quarters of 2015. KB Home expects gross margin to be lower than 20% in 2015. The company expects community count to increase year over year in 2015. Equity Research KBH Page 5
VALUATION KB Home s current trailing 12-month earnings multiple is 15.0x, a 0.7% premium to the industry average of 14.9x. Based on 2015 earnings estimate of $0.92, the stock is trading at 14.8x, a 6.5% premium to the industry average of 13.9x. At the end of the fourth quarter of fiscal 2014, the P/B multiple of the stock was approximately 0.9x, a discount of 40.0% to the industry average of 1.5x. Overall, the stock is expensive given a trailing 12- month ROE of 10.1%, lower than 10.6% average return for the industry. Our target price of $12.00 is based on approximately 13.0x our 2015 earnings estimate. On a P/B basis, the price target is based on a P/B multiple of approximately 0.8x. Key Indicators F1 F2 Est. 5-Yr EPS Gr% P/CF 5-Yr High 5-Yr Low KB HOME (KBH) 14.8 11.0 5.0 12.3 15.0 N/A 13.7 Industry Average 13.9 10.6 8.2 16.6 14.9 N/A 13.5 S&P 500 16.3 15.2 10.7 15.1 18.8 19.4 12.0 Standard Pacific Corp. (SPF) 13.3 11.3 10.1 10.2 15.5 N/A 13.2 Ryland Group Inc. (RYL) 12.3 10.6 N/A 9.4 14.0 N/A 9.9 Meritage Homes Corporation (MTH) 10.8 10.0 8.7 10.1 11.5 N/A 10.3 Hovnanian Enterprises Inc. (HOV) 25.3 9.4 5.0 13.3 36.7 85.8 33.4 TTM is trailing 12 months; F1 is 2015 and F2 is 2016, CF is operating cash flow P/B Last Qtr. P/B 5-Yr High P/B 5-Yr Low ROE D/E Last Qtr. Div Yield Last Qtr. EV/EBITDA KB HOME (KBH) 0.9 4.0 0.7 10.1 1.6 0.7 24.8 Industry Average 1.5 1.5 1.5 10.6 0.7 0.7 29.8 S&P 500 5.3 9.8 3.2 25.5 2.1 Equity Research KBH Page 6
Earnings Surprise and Estimate Revision History Equity Research KBH Page 7
DISCLOSURES & DEFINITIONS The analysts contributing to this report do not hold any shares of KBH. The EPS and revenue forecasts are the Zacks Consensus estimates. Additionally, the analysts contributing to this report certify that the views expressed herein accurately reflect the analysts personal views as to the subject securities and issuers. Zacks certifies that no part of the analysts compensation was, is, or will be, directly or indirectly, related to the specific recommendation or views expressed by the analyst in the report. Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe to be reliable, but is not guaranteed as to accuracy and does not purport to be complete. Because of individual objectives, the report should not be construed as advice designed to meet the particular investment needs of any investor. Any opinions expressed herein are subject to change. This report is not to be construed as an offer or the solicitation of an offer to buy or sell the securities herein mentioned. Zacks or its officers, employees or customers may have a position long or short in the securities mentioned and buy or sell the securities from time to time. Zacks uses the following rating system for the securities it covers. Outperform- Zacks expects that the subject company will outperform the broader U.S. equity market over the next six to twelve months. Neutral- Zacks expects that the company will perform in line with the broader U.S. equity market over the next six to twelve months. Underperform- Zacks expects the company will under perform the broader U.S. Equity market over the next six to twelve months. The current distribution of Zacks Ratings is as follows on the 1121 companies covered: Outperform - 15.3%, Neutral - 76.8%, Underperform 7.1%. Data is as of midnight on the business day immediately prior to this publication. Our recommendation for each stock is closely linked to the Zacks Rank, which results from a proprietary quantitative model using trends in earnings estimate revisions. This model is proven most effective for judging the timeliness of a stock over the next 1 to 3 months. The model assigns each stock a rank from 1 through 5. Zacks Rank 1 = Strong Buy. Zacks Rank 2 = Buy. Zacks Rank 3 = Hold. Zacks Rank 4 = Sell. Zacks Rank 5 = Strong Sell. We also provide a Zacks Industry Rank for each company which provides an idea of the near-term attractiveness of a company s industry group. We have 264 industry groups in total. Thus, the Zacks Industry Rank is a number between 1 and 264. In terms of investment attractiveness, the higher the rank the better. Historically, the top half of the industries has outperformed the general market. In determining Risk Level, we rely on a proprietary quantitative model that divides the entire universe of stocks into five groups, based on each stock s historical price volatility. The first group has stocks with the lowest values and are deemed Low Risk, while the 5 th group has the highest values and are designated High Risk. Designations of Below-Average Risk, Average Risk, and Above-Average Risk correspond to the second, third, and fourth groups of stocks, respectively. Analyst Last Updated by Copy Editor Content Editor Lead Analyst QCA Reason for Update Sarmistha Roy Chowdhury Sarmistha Roy Chowdhury Debasmita Banerjea Kinjel Shah Kinjel Shah Kinjel Shah 4Q14 Equity Research KBH Page 8