KB Home Stock: Q4 Earnings Leave Shares With Limited Upside (NYSE:KBH)

Shares of KB Home (NYSE:KBH) have surged 76% over the past year as the housing market has proven to be resilient in the face of substantially higher rates, Since I rated shares a buy in September, the stock has the returned about 35%, bringing its return to 137% since my initial strong buy recommendation in 2022. As explained in those articles, I view the secular backdrop for housing as quite favorable, given the chronic undersupply in the market and growing millennial population. While those trends remain in place, shares now are more fully valued.

In the company’s fiscal fourth quarter, KB Home earned $1.85, which beat consensus by $0.15, even as revenue was down 14% from last year to $1.67 billion. While revenue was down from last year, it was flat to 2021 levels when interest rates were far lower, a testament to the resilience of demand. For the full year, earnings were $7.03, down from $9.25 in 2022, still the second strongest year on record, aided in part by the fact that company reduced its share count by 11%. In 2023, KBH generated $6.4 billion in housing revenue. Gross margins declined from 24.8% to 21.4%, a level management expects to hold in 2024.

In the quarter, it delivered 10% fewer homes, at 3,407 with the average selling price down about 4% to $487k. Considering mortgage rates rose as high as 8% during Q4, this was not a bad outcome, especially considering that KBH is arguably the most rate-sensitive homebuilder. In general, first-time homebuyers are more likely to “stretch” to get into a house than a luxury homebuyer who may have substantial financial assets. That means first-time buyer demand can be sensitive to rises in rates, which can make the monthly payment unaffordable. Half of KB’s buyers are first-time, and another quarter are making their second purchase. These are buyers most likely to step back during higher rates.

Now, for the full year, it delivered just 4% fewer homes at 13,236. One reason that KB has been able to weather higher rates is its backlog. A year ago, its backlog stood at $3.6 billion, providing a base of revenue even during periods when orders slowed amid higher rates. While that cushion has declined, it is still there in 2024.

As you can see below, its backlog is down to 5,500 homes from nearly 7,700 a year ago as KB delivered more homes in 2023 than it received orders for. In 2023, KB received 11,084 orders, which was actually up from 10,856 in 2022.

The company’s guidance (more below) implies at least as many deliveries in 2024 as in 2023. Now, management will not want to keep eroding its backlog as quickly, because it aims to have 70% of homes under construction at any time already sold. A backlog that is too low will make it difficult to have enough construction activity to maintain margins, which have held in quite well with a 10.9% operating margin in Q4.

Importantly, KB exited the year with solid order momentum. Net orders nearly tripled from last year to 1,909 as the cancellation rate dropped from 68% to 28%. Still, this cancellation rate was an uptick from 21% in Q3 and is something to monitor. The value of its orders was $933 million or $489k/order from $524k/order last year. Importantly, this momentum has carried forward into fiscal 2024. According to management, demand has improved “significantly” with order more than double last year’s pace through 5 weeks, though this is a seasonally quiet period. Management expects net orders to rise in 2024, and I believe guidance implies 12-13,000 orders from the 11,000 seen last year, which I view as reasonable.

Of course, a significant reason for this growth is that mortgage rates have fallen back down from their October highs. This decline is likely pulling buyers back in. After having seen rates move so high, prospective buyers who were priced out of the market may be seeking to lock in a home now, just in case rates go back up. Given the large pent-up demand and growing millennial population that KB serves, this should be supportive of prices. Management estimates the move in rates could be worth ~6% in price, which should support margins holding at least at Q4 2023 levels.

In addition to favorable pricing activity, supply chain issues have essentially resolved. As a result, build times are down to 5.5 months from 8.5 months a year ago. Shorter build times reduce costs and allows KB to respond more dynamically to shifts in demand to optimize its level of output.

Management has also acted very conservatively during the past year, given the risks higher rates posed to demand. Its inventories fell by 7% last year to $5.2 billion as it has slowed land investments. It has 56k lots owned or under contract, down by about 20% from a year ago. Aided by this working capital improvement, KB generated $1.1 billion in free cash flow during 2023. It is now carrying $727 million in cash, up $400 million from a year ago, even as it reduced debt by $148 million to $1.69 billion with no maturities until 2026. With that stellar balance sheet, it has been able to reduce its share count by 11% and push book value up to $50.22/share.

Alongside results, KB offered fiscal 2024 guidance. Next year, it expects to generate homebuilding sales of $6.4-6.8 billion at an 11% operating margin with an effective tax rate of 24%. Underpinning guidance, there are 7,000 homes in production, 70% of which are sold. Management expects its backlog to account for about 40% of sales.

This guidance implies about $6.85 in earnings from its homebuilding unit. Assuming a similar result in financial service, that implies $7.25 in earnings at the Q4 share count. When I wrote my buy recommendation in September, I argued KB had about $7 in earnings power over the ensuing 12 months, and so I view this guidance as in-line or a bit better than my expectations.

These are strong numbers, and the question is what the appropriate valuation is. I would note even with a similar level of EPS as last year, I expect free cash flow to decline because we are unlikely to see inventories fall further. Indeed, management said growth is the first priority, but KBH also intends to be “active” in repurchasing shares. As such, I expect about $500 million in free cash flow. On top of its 1.3% dividend, it can repurchase 8-10% of the floating, assuming it holds its cash balance broadly unchanged. Now a 10% free cash flow yield and an 8.5-9x multiple are not expensive. However with slow year over year growth and lower free cash flow, I am not sure these are results that can push shares significantly higher. Given the concerns around homebuilders’ cyclicality, I expect multiples to stay structurally constrained, unless we see interest rates continue to fall, which would likely help multiples expand.

At 9x earnings and 1.25x book value, I view shares at fair value and likely to perform in-line with the market, rather than continue to their strong outperformance. It is not overvalued, and I view the secular backdrop as constructive, so there is no rush to sell. I am moving shares to a “hold,” and investors with large gains may want to lock in some profits. I would not invest new capital into KBH today, and I would wait until the mid-$50’s, where shares were just over one month ago, to add. KB has proven itself resilient, and it now getting the respect it deserves. After such a run, shares have converged toward fair value and no longer are a buy.