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On Nov 11, we maintained a Neutral rating on the U.S. homebuilder, KB Home (KBH - Analyst Report), following mixed third-quarter results announced on Sep 24, 2013.

Why the Neutral Rating?

KB Home’s adjusted earnings (excluding income tax benefit) of 28 cents per share in the third quarter were a huge improvement over the year-ago adjusted loss of 10 cents per share. Earnings also beat the Zacks Consensus Estimate of 20 cents by 40% as price increases and margin improvements/cost discipline made up for the soft revenues and orders in the quarter.

In addition to the strengthening housing market, KB Home’s strategic growth initiatives helped drive pricing and profitability in the quarter. The company gained from its strategic shift to higher-priced and better-located communities and also improving and refining its products to meet consumer preferences. In addition, KB Home’s focus on pricing over sales pace also increased margins significantly.

Despite, the rising interest rates, KB Home expects further profitability in the fourth quarter as well as in fiscal 2014 on the back strong land position, significant financial flexibility, rising average selling prices (ASPs), solid backlog position and selling, general and administrative (SG&A) leverage.

Estimates were largely revised upwards after the company announced the earnings beat and an optimistic outlook for 2014. The Zacks Consensus Estimate for the fourth quarter rose a sharp 28.6% to 45 cents per share while that for 2014 increased by almost 4.5% to $1.17 over the last 60 days.

However, KB Home needs to increase its volumes to boost long-term growth.Net orders declined 9% in the quarter due to management’s reduced focus on sales pace in lieu of margin improvement. Though total revenue increased 29% year over year, it missed the Zacks Consensus Estimate due to net order decline.

Further, the recent increases in interest rates is concerning. The mortgage rates have started increasing from May 2013. High interest rates decrease demand for new homes as mortgage loans become expensive, thus lowering the buyers’ purchasing power. Any change in federal lending procedure could also add to the woes.

Rising input costs, due to increasing costs of raw material and labor, is also a concern. As housing starts accelerate, both labor and construction material costs continue to experience an upward pricing pressure, which could prove to be a major deterrent for margins in the future quarters.

Other Stocks to Consider

KB Home carries a Zacks Rank #2 (Buy). Other stocks in the homebuilding sector that are performing well and deserve a mention include M/I Homes, Inc. (MHO - Snapshot Report) and Meritage Homes (MTH - Snapshot Report). While M/I Homes carries a Zacks Rank #1 (Strong Buy), Meritage Homes has a Zacks Rank #2 (Buy). Among the building materials companies, Masco Corp. (MAS - Analyst Report) is worth mentioning; also carrying a Zacks Rank #2 (Buy).

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