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KBH Beats Q3 Earnings; Orders Fall

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Leading homebuilder, KB Home (KBH - Free Report) reported mixed third-quarter fiscal 2013 results, beating the Zacks Consensus Estimate for earnings but missing the same for revenues due to weak net orders; likely a result of recent interest rate spike.

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 (also included an income tax benefit). 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.

Including the income tax benefit, earnings stood at 30 cents per share, up significantly from a gain of 4 cents reported in the year-ago quarter.

Total revenue increased 29% from the year-ago quarter to $549.0 million in the third quarter of 2013. However, revenues missed the Zacks Consensus Estimate of $571 million by around 4% due to net order decline.

Revenues and Margins

Housing revenues increased 29.5% year over year to $545.8 million driven by increased pricing power which made for the moderating order growth.

The number of homes delivered increased 6% from the year-ago quarter to 1,825 homes.

Average selling prices (ASP) rose 22% year over year to $299,100, driven by gradually rising home prices. In addition, a shift in buyer mix to more experienced buyers who prefer larger/more upgraded homes and strategic community positioning to higher priced communities also pulled up ASPs. An intentional shift in deliveries in California region to higher-priced coastal areas added to the pricing gains.

Increased affordability, higher rentals and historically-low interest rates are boosting demand. Supply however, remains limited by low home inventories, both for new and existing homes. A shortage of land and labor is restricting production of homes, both single- and multi-family. Home prices are thus moving up sharply with the market demand gaining momentum and supply remaining limited.

The company’s backlog totaled 3,039 homes as of Aug 31, 2013, down 3% year over year, due to a net order decline. Potential housing revenues from backlog rose 9% to $808.5 million.

Net Orders Decline

Net orders declined 9% in the quarter to 1,736 homes. Net order growth was significantly below second quarter’s 6% and first quarter’s 40% growth. As a percentage of gross orders, the company’s cancellation rate was 33%, much higher than last quarter’s 27% as well as year-ago quarter’s 29%. The value of net orders grew 7% to $528.9 million, better than the decline seen in net order units due to higher selling prices.

We believe that the recent increase in interest/mortgage rates has slowed order pace and traffic. With the recent improvement in economic conditions and the housing market in general, mortgage rates are edging upwards to more normalized levels since May. High interest rates dilute the demand for new homes, as mortgage loans become expensive; thus lowering a buyer’s purchasing power. Accordingly, the sharp increase in interest rates shocked many customers and a few put off their purchase decision; thus increasing cancellation rates and lowering orders.

Moreover, in a scenario where home prices are continuously rising, management is emphasizing more on price and margin improvement to optimize returns from its land assets and slowing down its sales pace. The reduced focus on sales pace also led to the lower unit growth in the third quarter. We believe that though this price optimization initiative is encouraging and has boosted profits so far, KB Home needs to increase its volumes to boost long-term growth.

However, management stated that the moderating order pace caused by a spike in mortgage interest rates was a temporary effect and demand should go up once consumers adjust to both higher rates and pricing.

Margins Were Strong

Adjusted homebuilding gross margin improved 500 basis points (bps) in the quarter to 19.3%, driven by price increases, favorable community mix and improved operating efficiencies.

The selling, general & administrative (SG&A) expense ratio improved 250 bps year over year to 11.6% in the quarter due to the company’s cost reduction initiatives.

Operating margin improved 400 bps year over year to 6.6% driven by solid gross margin expansion and better operating efficiencies emanating from KB Home’s strategic actions. Higher income associated with outstanding cash-settled equity-based compensation awards also improved operating margin.

In addition to the strengthening housing market, KB Home’s strategic growth initiatives helped drive 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.

Outlook for Fiscal 2013

Despite the rising interest rates, KB Home expects further meaningful profits in the fourth quarter on the back of its strategic growth plans and strong housing fundamentals comprising steady demand and constrained supply.

Its strong land position, significant financial flexibility, increased community count, rising ASPs, solid backlog position and increasing margins and SG&A leverage are expected to help it to achieve its goals in the fourth quarter. The company expects to see enhanced profitability and accelerated growth in fiscal 2014 as well.

The company expects revenues to increase 40% in 2013. KB Home intends to open more than 120 communities in 2013 as the current land acquisition and development activities are converted into open communities. It expects to grow its community count by 15% in the fourth quarter of 2013 with many more scheduled for 2014. The company expects its land investment to exceed $1.2 billion for fiscal 2013 which will boost top-line growth.

Fourth Quarter Outlook

In the fourth quarter, KB Home expects gross margins to improve sequentially. Average closing price is expected to be greater than $300,000, while backlog conversion rate is expected to be approximately 70% in the fourth quarter.

Other Stocks to Consider

KB Home carries aZacks Rank #3 (Hold). None of the major homebuilding companies carry a positive Zacks Rank. Stocks in the building products sector that are performing well include PGT, Inc. (PGTI - Free Report) , Masco Corporation (MAS - Free Report) and CaesarStone Sdot-Yam Ltd. (CSTE - Free Report) . While PGTI and CSTE carry a Zacks Rank #1 (Strong Buy), MAS carries a Zacks Rank #2 (Buy).

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