Are More of KB Home's Challenges Operational or External?
When it comes to public home builder earnings seasons, KB Home goes first. Question is, after Friday's KB release and conference call with analysts, what exactly was that?
As the company spin would have it, a perfect storm conspired to set KB Home's orders initiatives back on their heels--a spike in can rates; an opportunistic strategic re-focus on higher-priced built-to-order homes vs. discounted spec inventory; and the rotation of legacy lots into better-producing ones in its geographical footprint.
What's more, KB Home noted in its first-quarter earnings release that metrics for financials and operations improved, except in the area of new orders. Indeed, for the period compared with a year earlier, revenue was up by 29% to $254 million, deliveries were up; prices were up; and losses for the quarter narrowed from $47.9 million in 2011 to $31.1 million in Q1 2012.
So, what's wrong with the picture? Haven't we been hearing that, since December anyway, home builders anecdotally have been suppressing urges to get really excited about what they've been seeing happen in their stores. So, is what will become known in 2012 as KB Home's big miss an anomaly or a signal of the darkening of a briefly lit near-term horizon for housing?
As one of the industry's bellwether companies, based on its coming first in line in each new earnings season, KB Home tends to set a tone around expectations for the other builders. So, when KB announced that its orders for the period caved, a frisson of anxiety shot through a Wall Street network of analysts and experts already on edge from a series of less than steller housing data prints. Was KB Home's difficulty the exception, or would it be the rule?
The equity analysts questions for KB Home ranged from a focus on the company's own narrative--i.e. the altogether brutal mortgage finance environment and KB's travails as it transitioned from MetLife to Nationstar Mortgage as its go-to lending partner; its switch to emphasize holding or raising its prices vs. discounting to drive volume; and evolving its community count and locations to higher-profitability stores--to ones that reflected challenges to KB Home management's assumptions.
For instance, Ivy Lynne Zelman of Zelman & Associates, fired this salvo during Friday's conference call:
One of my questions would be, with the compression in margin is there possible changes in the business model that might be opportunistic with respect to the design centers, studios, knowing that those are higher-cost structures and might be adding to the compression in margins? Because even with the improvement you are looking forward to experience, that would still be very much lower than your peer group, recognizing gross margins aren't always apples-to-apples. But the design studio, I guess, is a high-cost business. I am wondering if in your strategy going forward, if there's any potential change that can reduce that compression in margin.
KB Home ceo Jeff Mezger, of course, asserted that the design studios and the company's built-to-order focus go hand in hand, and that home buyers couldn't get the choices they get without the design centers, which are not set up as profit centers but as, he puts it, "typically net out to our targeted normalized house margin."
KB Home's story, and it's sticking to it, is that it's going to control its variable costs by being very careful with land acquisitions for the time being and it's going to continue to hammer at its overheads by reducing fixed costs--laying off more people, among other initiatives.
We're intrigued with a strategy that seems to pin itself around an assumption that KB Home's "rotation" will be from tracts where its first-time buyer pays a lower price to ones where first-time buyers are higher income and will pay a higher price. Here's how Mezger phrases it in his remarks in Friday's call:
As we open these new communities that we keep sharing, pick California or the nicer suburbs of our Texas cities, you're rotating to a higher price point, yet you're still very affordable in that submarket. So it's part of our strategy, but it's not like we're going to second and third up product. We're just moving to higher price range locations. In our other markets, or other communities, where we're Built to Order and we have a broad footage range, we are seeing the customers select larger homes than they were even a year ago. So our footage is moving up in those cases because of what the buyer wants. And I think it's a reflection of the first-time buyer, and our mix didn't change, so about 65% of our deliveries were to first-time buyers. It's a higher-income first-time buyer because of the activity being in markets that are a little better off economically. And they're buying a higher-priced home than they were a year ago.
Counting on redemption from the very segment that is most beleaguered by a hostile credit environment seems to suggest even greater risk. The tough part for KB Home is that it's got to do this major re-tooling this year, when it might well have taken its medicine in both its real estate strategy and its operational, fix-cost infrastructure more than a year ago.
Here's a scenario from ISI Group's Stephen East, put together following Friday's earnings conference call:
Let's look first at cash and the balance sheet. Unrestricted cash is now at $304M as total cash dropped another $111M this quarter. As we mentioned in our "First Look" report, we believed KBH would be fine if they limited investment and generated cash from a stronger backlog. Both arguments are not as persuasive as a quarter or two ago. The California market requires a cash commitment bigger than other markets they play in. We believe they are now on the growth treadmill, requiring volume improvement to achieve profitability. Also, with the backlog conversion dropping, the cash coming in the door gets squeezed. Throw in peak working capital demands and the cash could become very tight, with the caveat that land spend has some discretion. Finally, we believe the company should suspend the dividend. From a balance sheet perspective, net debt to total equity is now 76% and likely going higher. While management is comfortable that they will not need to tap the markets, we are more circumspect and doubt standing still in the capital markets is a viable alternative for KBH. Further, we believe KBH's cost of capital is climbing with each passing day.
Let's work through the other issues, starting with Orders. Management spent significant time explaining the miss. At the top of that explanation was the mortgage lending snafu that led to significant cancellations as outside lenders could not or would not deliver a loan. This somewhat self-inflicted problem not only affected Orders, it smacked Closings hard as well. The second issue on the Orders front was a push for higher gross margins, i.e., higher selling prices. While we agree with that strategy given the dreadful gross margin, this explanation does not fully sync up with the numbers. We understand the peculiarities with calculating KBH's Orders ASP's, but all regions were down sequentially, ranging from a 4% to 14% drop. Given the price movements, we expect this will go up in subsequent quarters. (Closings ASP's declined in 3 of 4 markets.) Finally, KBH has left some markets, but it also acquired communities late last year, so we look at those movements as nearly a push.
Profitability improvement will primarily be a function of growing revenues. This dynamic is one reason we worry about cash, as management believes the operating margin improvement YoY is a function of revenue growth. We believe it will be difficult attaining the 500 basis point operating profit improvement versus 2011, particularly with backlog conversion rates in the 50's. Even if achieved, when we fully load interest costs in, the operating margin will remain negative. To us, the real challenge is driving margins higher regardless of volume, in other words, gross margin gains coming through price/cost improvements and SG&A through further streamlining of costs.
East is suggesting that if KB succeeds in doing what its management says it wants to do, it's going to escalate liquidity pressure as growth pushes its capital needs higher.
What we believe is that KB Home has a "year of living dangerously" ahead of itself, with little to no margin for error.
More broadly, we see the baker's dozen or so public home builders split roughly into two groups, one of which is the set of peers who geared up for a relatively robust recovery beginning this year (wrong), and those who operated, disciplined, and took the medicine necessary to position themselves to run profitably in a protracted adverse environment.
Which do you think we've got?