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We maintained a Neutral recommendation on KB Home (KBH - Analyst Report) following appraisal of the third quarter 2012 results.

KB Home’s adjusted net loss per share of 10 cents in the third quarter was narrower than the prior-year quarter loss of 13 cents and the Zacks Consensus Estimate of a loss of 17 cents. Double-digit rise in revenues, reduced selling, general and administrative (SG&A) expense ratio, and improved gross margins led to the narrower loss in the quarter.

Total revenue increased 16% over the year-ago quarter to $424.5 million driven by higher housing revenues. Total revenue also beat the Zacks Consensus Estimate of $419 million. Housing revenue increased 15.7% over the prior-year quarter to $421.6 million driven by increase in homes delivered and average selling price as the overall housing market recovers. Adjusted homebuilding gross margin was 19.0% in the third quarter of 2012, up 180 basis points year over year driven by price increases.

KB Home is a well-known homebuilder in the United States. Its operational business model KBnxt offers consumers the flexibility to design their new homes. Apart from the obvious benefit of offering choice to consumers, the model also helps the company turn over its inventory more quickly than its peers, thereby supplying capital for reinvestment. Further, KB Home focuses on providing homes with energy-efficient features without materially increasing the price for the customer due to its single business model, thereby lowering the total cost of home ownership. This gives the company a competitive advantage.

Management believes that the housing market is slowly stabilizing with a gradual recovery in the overall economy, including the increase in employment rates and higher consumer confidence. Houses are more affordable now, as home prices stabilize, mortgage loans come with relatively low interest rates and home rents become more expensive. Thus, KB Home is witnessing increasing traffic levels due to heightened consumer demand. Inventory of foreclosed homes and short sale homes is declining, thus stabilizing prices of new homes. All these bode well for the company’s profitability.

In order to combat the significant downturn in the housing industry, KB Home significantly reduced its overhead, inventory and community count levels to better align its operations with diminished housing activity. Now, with the housing market stabilizing, the company has started rolling out communities in highly favorable submarkets, primarily in the Central and West Coast regions, which allows it to sell larger and higher-priced homes, thus driving the average selling price higher. The average selling price for KB home has increased for nine consecutive quarters in the third quarter. Further, it is activating communities in stabilizing markets, increasing revenues per community, and strengthening management teams with additional resources to improve its operating performance while carefully managing costs.

With the housing market recovery gaining momentum, KB Home believes its strategic initiatives including overhead reduction, margin expansion and land investments in higher priced, better located communities; coupled with the Nationstar deal; and increasing backlog will help it achieve profitability in the fourth quarter and beyond.

However, though the housing market is recovering, we believe that the process is erratic, uneven and not yet broad based. Overall, there remain many constraints including volatile macroeconomic conditions, tepid job growth, tight credit standards and reduced credit availability for residential consumer mortgage loans. A speedy housing recovery is unlikely and it will take several quarters for the markets to fully recover and return to a more historically typical operating environment. Moreover, the company’s net order growth rates are lower than that of its peers like Lennar Corporation (LEN - Analyst Report), Pulte Group, Inc. (PHM - Analyst Report) and D R Horton, Inc. (DHI - Analyst Report). We thus believe that the company may take time to achieve sustainable profitability.

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