Description

NOTE:  After the close, Keefe, Bruyette and Woods upgraded KBH from “Underperform” to “Neutral”.  Last month, BofA and Ned Davis both downgraded to “Sell” as it appears business for KBH is starting to finally pick up.  Moreover, BofA has a $21 price target.  FBR and Deutsche Bank are also “Neutral” both with a $21 PT.  With only 6 Buy ratings, and 18 Holds/Sells, the sell-side provides added conviction for shunning stocks near the bottom, and embracing them near tops.  Street Sentiment – 6 – Buy, 11 – Hold, 7- Sells – with price targets typically 10-15% above where the stock is trading.  

ANALYSIS and INVESTMENT THESIS

KBH – One of the last truly cheap cyclicals within the USA market.  There are about 91mm shares outstanding, but only about 72.5mm float.  Short interest came down about 5mm shares from mid-March to end of March, from 20.7mm to 15.7mm, but still nearly 22% of the float. 

This is clearly a contrarian play, as sentiment is abysmal from sell-side and buy-side both. 

CONVICTION LEVEL:  VERY HIGH.  9 out of 10

The top down view on the homebuilders - The group in general has significant upside, and the stocks tend to trade together, but KBH within the group is the most attractive stock, and has the best risk/reward and investment dynamics at this point.

• The investment thesis factors in the examination of long-term demographic data, and historic household formations over time vs. current household formations, and how many homes are being built.
• In prior cycles, after long period of times when housing formations are depressed during the downturn, in the ensuing 5 to 6 years, we typically see a significant catchup period in which formations actually go above trend as all of the pent up demand created during the downturn comes back.
• Normalized households formations (given the demographics in the USA) should be just under 1.4mm with about 300k houses demolished on average annually within the US housing stock.  (The US housing stock today is abnormally old, so there is probably a bias to the upside.)  So on a normalized basis (not factoring in any kind of catch-up) 1.4mm roughly + 300k in demolition = about 1.7mm normalized housing starts.  We are running just below one million today.  Thus, the upside from here is likely significant. 
• I am aware of the credit constraints and various dynamics that have made the housing recovery different than other housing recoveries, but given where things stand today, it would appear we are in early stages of a housing recovery.

While we are in early stages, and this group largely trades in tandem and it would appear to me that investors can make money in this group by owning a basket in general, KBH is the most compelling individual stock within the group for a number of reasons. 

Valuation:  Investors have an opportunity to buy KBH today at ~1x Tangible Book Value (TBV).  The group trades at around ~1.6-1.7x tangible book.  While on the surface, it appears that KBH is the most expensive, it is in fact the cheapest.  By simply pulling the numbers off of Bloomberg (or whatever financials database investors use, or Quants use, e.g. MarketWatch lists Price/Book Ratio for KBH at 3.08), KBH appears to trade around ~2.5x TBV.  In reality, it is trading at 1x TBV.  The deferred tax asset (DTA) that they accumulated as losses accumulated on the balance sheet has not been reversed.  To reverse that accrual and to return this value to the balance sheet, the company (due to accounting standards) needs to demonstrate  3-4 quarters of positive earnings to reverse that accrual and to return the asset back onto the balance sheet.  So, though it appears KBH is trading at ~2.5xTBV, it is really trading at 1.0xTBV upon making the adjustment.  Thus, optically, the company will go from appearing to be the most expensive to cheapest by quite a margin when the accounting adjustment is made.   

Most Attractive Markets and with 8 years of land on the books:  KBH is basically a California homebuilding play with significant Texas-exposure as well as a few select other attractive markets. 

• About ½ their business is in California, which is significantly land-constrained.
• About ½ in Texas (which also has strong secular dynamics), Florida, Phoenix, and a little bit of exposure in Nevada and Denver, CO. 

As fundamentals bottomed this time around and we have seen subsequent improvement, prices have recovered in many markets to above their prior peaks as a consequence to there being so much fear of excess supply coming out of the downturn.  Consequently, construction has been very limited and constrained as a result of these concerns.  Thus, as demand has started to increase, pricing has gone up very quickly.

Insufficient Supply and Affordability:  The bearish sentiment for the space and especially KBH is somewhat illogical.  I have heard bears on the space argue that the dearth of supply (lack of new construction), suggests that things must be bad.  In every other business I can recall, when there is insufficient supply at current pricing points to satisfy your customers, this is typically viewed as a good thing, provided one can expand supply.  If one looks at pricing and where it can go in the future, there is ample room for upside from here, and still remain well within historic norms.  In general, investors are nervous about higher interest rates, and concerns that people will not be able to afford their homes.  Relative to affordability, housing prices can go up 7-9% per year for the next three years, and interest rates can go up another 150bps before we reach average long-term affordability.

Pricing and Volumes:  For KBH, I think pricing is likely to be steady or expand slowly from here.  But, looking at volumes, compare KBH volumes to a normalized basis.  To arrive at a normalized level, I think it makes sense to look at 2003-2004 as a proxy for where the market should be on a normalized basis (prior to the 2005-2006 when the market was really hot into the bubble).  And the volumes are about 25% of where they were on a normalized basis.  Moreover, there has obviously been significant population growth since 2003, so arguably that normalized number should be a little bit higher.  From an investment perspective, we can buy this asset, KBH at 1xTBV, that is currently generating 25% of what normalized volumes should be, and we have embedded earnings growth for the next couple of years, since after multiple years of contraction, they are finally starting to again grow their community account. 

Downside Protection:  Unless the economy goes into a massive contraction, we should have valuation support around TBV, and that TBV should grow with earnings for the next couple of years.  And once this DTA gets reversed and the cycle gains some momentum,  it should trade at least to the average of the group, even though the structural dynamics for KBH are better.

Investor Negativity and Sentiment:  As mentioned above, sentiment is clearly awful.  The consensus view is a negative stance on home-building overall, largely because of potential rate increases.

Investors and analysts typically believe higher rates will crush any potential recovery.  This has actually never been the case on a historic basis.  Prior recoveries in home-building have occurred simultaneously with interest rates rising.  The consensus view mistakenly believes that housing cannot recover if interest rates are rising.  Where rates are today, and where they have been on a normalized basis, there is a wide gap.

Strategic Assets:  The market has seen some of the other homebuilders make recent acquisitions in California, as the land has become increasingly strategic and in short supply.  Obviously, KBH has a very significant land bank in California.  It is likely there is also potential strategic interest for the assets they own by others.  It is highly unlikely that valuations will continue to go up for the underlying land, while KBH continues to trade where it currently does.  As a data point, there was a very large builder who recently acquired another builder in California.  It is not a perfect comparable, but by ascribing a similar valuation to the California land, one can get to a ~$40 valuation for KBH pretty easily. 

Catalyst

CATALYST:   After the interest rate shock in May of 2013, the fundamentals of the industry and especially for KBH are beginning to improve.  As we get closer to second half 2014, investors will begin to focus on the improving fundamentals of this group.  Order patterns will get much better in late Q2, and then continue to improve into Q3 and Q4.  Lastly, as investors look for sectors that have lagged, and concerns set in that the bull is tired, PMs will look to deploy capital in new sectors with improving fundamentals and reasonable valuation.  As the shorts cover, and investors try to buy into this sector, names like KBH will have an aggressive move to the upside.