The reaction to the Q1 2022 earnings report from KB Home (KBH) symbolizes the skepticism that enshrouds housing-related stocks when the economic cycle turns against them. KBH management was almost as bullish as can be during the earnings conference call. Yet, sellers took KBH down the next day by 4.6%. Last week, KBH tested its 2021 lows from January. With a little more pressure, KBH could eat further into its gains from 2020. The lower KBH goes, the deeper the stock will sink into its recession valuation.
Management was as clear as can be in its press release about the strength (and resilience) of the business.
- Management stuck to the long-standing narrative that has supported home builders for years now: “Market conditions are healthy, driven by a low supply of available inventory and favorable demographics, along with steady employment and wage growth.”
- They are confident in guidance for 2022: “With a backlog value of $5.7 billion and over 10,400 homes in production, a 46% increase relative to the comparable number of homes in production in the prior-year quarter, we are solidly positioned to achieve our financial targets for this year.”
- Accordingly, KBH reaffirmed its guidance for the year: “…with 30% growth to $7.4 billion, and modestly increasing both our operating margin and return on equity expectations to over 16% and 27%, respectively.”
KB Home provided more color during the earnings conference call (transcript from Seeking Alpha). Management also tried to provide a multitude of reassurances to a skeptical analyst crowd. I group the information into themes.
Demand
- Largest backlog in value terms in 15 years. As a result, KBH has already sold nearly all the homes they need to make 2022 revenue guidance. “Our biggest challenge today is completing homes, not selling them, as demand continues to be robust.”
- Communities are selling out at a “rapid pace.”
- No evidence of borrowing stress among buyers. They are not shifting in types of homes although KB Homes is prepared to respond if needed. “I don’t think we’re anywhere near a stress point because of rates going up the way a lot of the media is hammer it right now.”
- Having said that, KB Homes has apparently proactively moved to smaller lot sizes and townhomes to price homes to the median income in a market.
- In California, KB Home’s largest market, demand still far exceeds supply (for more details see the California section of my last Housing Market Review). Management is not “letting communities run hot” and pricing accordingly.
- On-going land purchase activity confirms management’s confidence. From the press release: “Investments in land acquisition and development for the quarter ended February 28, 2022 increased 27% to $704.7 million, compared to $556.0 million for the year-earlier period.” KB Home now has land worth 3.8 years of supply.
Pricing and Costs
- Order rates appear to validate current pricing levels.
- “The majority of our backlog is locked down on the cost side.”
Supply and deliveries
- I think analysts are concerned that KB Homes could see its backlog evaporate given the expense of financing. Management is not concerned about that prospect. Still, with 46% more homes in production year-over-year, I can understand analysts’ fears.
- The Omicron variant of COVID-19 caused unexpected expenses and delays. For example, KBH lost 2 weeks of construction cycle time in the last 6 weeks of Q1.
- Material shortages are rampant: flexible duct work for heating and air conditioning, appliances like double ovens, garage doors, windows, cabinets, HVAC equipment, and siding. KBH expects these to persist for the rest of the year. One more point to cause concern among analysts.
Guidance
KB Homes was incredibly detailed in its reaffirmation of guidance. Once again, this posture suggests a high degree of confidence in the coming year despite the headwinds in the housing market. From the press release:
- Housing revenues: $7.20B to $7.60B (+30% year-over-year for the midpoint)
- Average selling price: $490K to $500K
- Homebuilding operating income as a percentage of revenues: 16.0% to 16.6% – the midpoint is a 450 basis points year-over-year improvement and “a slight increase from…prior guidance” (from the transcript)
- Housing gross profit margin: 25.5% to 26.3% – “mainly driven by price increases that have outpaced cost pressures in our established communities, strong selling margins in recently opened communities and an expected reduction in amortization of previously capitalized interest” (from the transcript)
- Ending community count of ~255
- Return on equity over 27% (up from 19.9% in 2021)
Recession Valuation: The Trade
An analyst’s question neatly summarized the trade on KBH: “the market is valuing your shares is probably demonstrating the biggest gap versus your perception or your perspective than we’ve almost ever seen.” KBH’s CEO responded as any CEO would – he cannot explain the “dislocation.” He even admitted that “it’s discouraging at times to see it.”
KBH is now trading at a recession valuation: 0.95 price/book, 5.3 trailing P/E, 3.3 forward P/E, and 0.53 price/sales. Short interest is even low on KBH at a mere 4.7% share of float. If I had not declared the end of the seasonality trade on home builders, I would already have shares of KBH on-hand. Instead, I am keeping KBH high on my shopping list. The further KBH falls from here, the harder it will be to resist accumulating shares ahead of the next up cycle in the housing market.
Stay tuned and be careful out there!
Full disclosure: long KBH {April 6, 2022 correction: Since I already have a small position, I am actually considering ADDING to it. I had a brain blank and forgot that I did not sell the position when I declared the end of the seasonal trade.}