Wednesday, 31 October 2012

KBH - From the doghouse to the penthouse (October 30 - $11.00 target)

KBH The Company:
KBH is a low-cost no frills US home builder operating in four geographic regions: West, Southwest, Central, and Southeast. The company focuses on first-time home buyers and their average home price as of Q3 12 is $245,000. KBH is not the lowest cost producers for the first-time buyer segment, the largest US home builders, DR Horton, wins that battle.

Over the last five years KBH, like many other US home builders has been scaling back its operations in order to return to a more efficient and sustainable level of business. Company revenues are down from 11billion in 2006 to it's current pace of 1.45billion in 2012. Number of communities have decreased from 42 to around 30 currently. The company has been in losses every year since 2007 however much of that has been due to inventory write-downs.

KBH's current strategy amidst a gruelingly slow housing recovery has been to 1) accumulate land, 2) strengthen its balance sheet, and 3) achieving profitability at the low pace of new housing

The Market:
US home building has undergone the worst slow down in decades. The level of the housing starts and duration of slowdown are unprecedented historically. Even the 35% increase in September over last year only brings the number to 872,000, which is still miles below historical levels.

The Bull Case Scenario for Housing

Homebuilding has been one of the best performing sectors over the last 12 months. Stocks have been boosted by future expectations. Strong growth rates in starts from exceptionally low levels, optimism over the broad US recovery, house prices bottoming, high home affordability, and attractive valuations at the end of 2011 have all contributed to the rise. 

In order to understand KBH's earning potential in a robust housing market; I've created a bullish housing market recovery scenario. Highlights of the scenario include:
  • Demographic need for housing of around 1.5 million
  • An increase in ownership rates creating a strong demand for housing over the next few years and completions running at 1.4m in 2013, 2.1m in 2014, and 1.9m in 2015, before stablizing at 1.5m.
  • An increase of 36% in home prices over the next 4 years. 
Graph below charts housing supply, demand, and vacancy. As seen from the graph, vacant housing has been rising considerable since 2006. According to the 2010 Census, vacancy rates stood at 11.4% in 2010 compared to 9.0% in 2000. A recovery in home prices will require absorption of the excess inventory built up.

I've tried to break-down the demand for housing into 1) actual demographic demand for housing 2) depletion of old stock 3) changes in home ownership rates. After peaking in 2004 at 69%, home ownership rates have been the biggest drag on housing demand. My steady-state home ownership rate assumption is 67.8% yielding a demographic+depletion need of around 1.5m homes, with a 1.05% growth rate.

Housing Assumptions Applied to KBH:
I've continued on with the bullish scenario and laid out further optimistic assumptions about the operations of KBH along with our optimistic home building scenario. Highlights of the KBH operations include:
  • KBH's market share increases from the present 0.86% of the US market, to 1.40% by 2016. Combined with the increase in home building; KBH's deliveries increase by 236% over the next 4 years.
  • Gross margin increases to 20% before stabilizing at 18% in 2016; currently at 16%.
  • Inventory to sales ratio decreases from 1.20 to 0.50.

Even with the bullish assumptions, we end up with a steady-state P/E ratio of 7.8x in 2016.

Valuation: $11.00 Target
Using the bullish US housing scenario combined with the bullish KBH scenario I arrive at a DCF value of $17.43, representing an 8% upside from the current price. This includes $2.84/share in deferred tax assets. I believe this is an extremely bullish scenario and even the biggest optimists on the U.S. housing market would probably have lower housing market estimates. In order to realize this value, we would need to assume       a) housing will definitely recover to a 1.5mil starts rate; b) KBH is able to turn around its shrinking market share which currently stands at around 0.9% - KBH's performance in new orders has been extremely sluggish and that was the main reason it was trading close to it's inventory value not 6 months ago. Not much has changed and new orders came in at +3.5% y/y last quarter, this is much lower than it's competitors and the rate of growth in housing starts.

KBH's current market share even with a fully recovered housing market yields a price of $10.89. Given that KBH has been decreasing its number of communities, currently around 30 down from 42 at it's peak, and has been struggling to increase new orders, currently growing at 3.5% vs. 25% growth rate of US housing starts; I believe this is a more realistic valuation.

Another method for valuation is looking at current inventories. Given that KBH has a 15% gross margin, a 15% premium to inventories could be treated a bottom price for the stock, which would yield $6.00 bottom price where you are paying nothing for the business. A more generous premium to inventories of 40% given the positive long-term outlook for the industry yields a price of $11.11.

  • Short-term housing boom such as one that occurred in the early 2000's. A surge in home building above 1.5million would make KBH seem extremely cheap and investors may overlook the fact that such levels are not sustainable in the long-run.
  • Strong US housing starts continue to push investor sentiment higher about US home builders. Even though our bullish scenario incorporates high housing starts growth, investors sentiment can always push valuations beyond their fundamentals.
  • KBH regains market share and US housing growth continues to surge. Although if only one of these events take place, target price of $11.00 still makes sense; however if both occur simultaneously the bull-case price target of $17.43 would be more realistic.