The BMW Method
KBH - Due Diligence v1

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By Bakuvdanet
August 29, 2006

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Hello there.

Back with an initial take on KBH (KB Homes). Home builders have been knocked down a tad and I wanted to take a DD stab at one of them. For some reason, I'm drawn to KBH, it's beaten down, it's seems like a solid company and it's waiting for the housing market and interest rates to stabilize a bit. Nothing particularly wrong with the company itself.

Dan's post,, lists some nice macro points that I'm not sure how much weight to give (maybe more than a little, since he was in the biz). On the one hand, those forces are at work, on the other hand, isn't now the time to take a serious look at quality homebuilders (what is the saying, "be greedy when others are fearful, and fearful when others are greed"?). I could've sworn Dan mentioned KBH in another post way back in April or May, but I can't find it.

I'm trying to be realistic with the time frame here. I don't expect much to happen within a year, but over the next two or three, I see good potential. How to balance the fear of the unknown (potential lower share price in the near future) with the potential for great gains is a trick that isn't yet in my skill set. Has the housing market stabilized at all? I don't know. Is there worse to come? I don't know. Is it good times from here on out? I don't know. Which "I don't know" to give more weight to is the question. I think you just have to make a decision and go for it based on the facts at hand. But how much weight to give to each of the facts? Argghhh.

Much of the pros and cons I took from analyst reports, so take that for what it's worth. Having trouble with the valuation part, especially DCF, not really sure how applicable it is to a company like KBH.

A little long winded for an intro, sorry about that. Below is the DD. I'm sure something obvious is missing. As always, feel free to blast away with critique and comments.


KBH - KB Home

Date: August 28, 2006

Current Price: $41.70
3% rise from today: $42.95, 3% rise from recent low on July 20, 2006 of $38.82 is $39.98.
Dividend Yield: 2.40%

The Company
A top five homebuilder based on number of homes sold. Caters primarily to the first-time and first move-up buyers. Primarily serves the markets in AZ, CA, CO, FL, NV, NM, GA, NC, TX, SC and Chicago (the last two through acquisition). KB Home Design Studios are an industry standard to providing customers with a way to select from the vast array of options.

Focuses primarily on first-time and first move-up buyers. This is the largest segment of home buyers, providing a good opportunity for growth through market share gain. Reliant on purchasers who don't own a home or are moving, people for whom buying a home is more mandatory than discretionary (i.e. - more inclined to buy than someone who already has a home and doesn't need to move to another city). Industry leading marketing prowess. Design studio approach imparts value on home buying process. In other words, allowing customers to pick exactly the options they want in a home and leave out the unnecessary items that might drive the price higher. Important when trying to keep a monthly payment low in these times of higher (relatively) interest rates. This could lead to a lower per-home revenue, but will encourage more home sales than otherwise might have occurred.

Solid homebuilder, with management that has been through home building downturns and come through them. They know how to keep the company in good shape through this difficult period. Should be able to support the dividend and ride out the downturn. It's not like they're not selling any homes at all. Still building and selling homes, just at a slower pace and with less upward pressure on price. Strong fiscal management, does not de-value the land it owns by offering cut-prices just to sell houses. Believes the value of premium land will offer a better return later at better prices, and therefore won't sell it at a discount now.

Starting to expand its offerings to luxury, active-adult homes, high-density and mixed-use homes. Diversifying a bit. Constant assessment of consumer preferences and market opportunities. Focuses on efficient use of working capital.

Macroeconomic factors conspiring to make this a tough environment for homebuilders to grow at their previous pace. Factors influencing less than desirable market for homebuilders: large housing supply, higher interest rates making homes less affordable, slowdown of people buying homes as investments (fewer "Flippers"). KBH's backlog (previously ordered homes) could be at risk if competitors offer incentives, which mitigate the cost (loss of deposit) of canceling the order and buying from another builder.

Its primary target market is pretty sensitive to any factors that increase the cost of home ownership, higher interest rates come to mind first.

KBH owns up to half of its lot inventory at any one time, making it susceptible to write-downs if land prices decline. In newly entered markets, the land purchased by KBH will have a higher cost than land owned by competitors, limiting ability to compete based on price and, at the same time, maintaining a decent margin.

Reason for the Price Drop
The homebuilding industry is in a state of oversupply. As of the end of July, there was a 6 1/2 month supply of homes for sale nationwide. So if the homebuilders decided to stop putting up houses today, they could continue to sell their current stock for almost 7 months. Of course, they won't just stop, but should slow down, so supply should gradually decline a bit, though maybe not to the low levels seen in the past 8 years or so. An increase in interest rates helped to contribute to the oversupply due to the cost of owning a home increasing.

Upward Catalyst
Catalysts include demand catching up to supply, stability of interest rates, and a general return to normal in the housing market.

Financial Snapshot/Valuations
EPS CAGR is 26.57% from 1997 to estimated EPS of 7.70 for FY 2007. FY2007 EPS estimate is 7.70, a 30% decrease from FY2006 estimate. Current CAGR of stock price over past 10 years is 10.6%. KBH has a debt/equity ratio of 1.2. Dividends were steady at .60/year until 2003, since then they've increased to $1/share, 2.4% yield. Payout ratio is 10%.

Current price: $41.70
Ave CAGR Price: $70.02
P/E Valuation FY2007e Trading Range: $33.45 to $64.87
Dividend Valuation FY2007e Trading Range: $54.15 to $110.33
Graham Intrinsic Value (at 7.70 EPS for 2007): $183.22 (yeah, right)
Discount Cash Flow: $??? - current price represents a % discount
S&P Target Price: $57 - as of 6/19/2006 - today's price is an 25% discount to target.
AG Edwards Price Objective: $60 - as of 7/10/2006 - today's price is a 30% discount to objective.

BMW Metrics
Today / At time of purchase:
16-year chart
Ave CAGR = 13.3%
Current CAGR = 9.5%
RMS = -1.80, RF = 1.71

Potential Sell Prices at Ave CAGR of 13.3%, based on mklein charts:

             Ave CAGR Price   +1 RMS Price
August 2006      $ 70.02         $ 94.39
August 2007      $ 84.72         $114.21
August 2008      $102.52         $139.20
August 2009      $124.04         $167.22

I think this is a classic case of a good company that is near the bottom of a down cycle and will eventually come back up. Little chance of going bankrupt. It has enough cash to sustain the current dividend. It's survived down cycles before with current management, so they know how to pull through the current slowdown in good shape. The big question is, how much worse can the housing industry get? And the obvious follow-up is how far will KBH fall if the housing market stays in the doldrums? How much of the uncertainty is priced in already? Tough questions. And ones I can't really answer, obviously.

S&P Stock Report
AG Edwards Stock Report

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