Despite Wall Street expectations to the contrary, KB Home's fiscal second quarter performance was mostly positive. Many analysts predicted that after what some would consider an applause-worthy first quarter, given the depressed state of the housing market, results for the company's fiscal second quarter, ended May 31, would lack the same luster. Earnings did miss analysts' estimates at a loss $78.4 million, or -$1.03 per diluted share; however, the company's sequential increases in both new orders and backlog, lower cancellation rate, improved housing gross margin, and reduced SG&A levels, both in terms of dollars and percent of revenue, offset some of the red ink.
The company's noteworthy performance, from an operational standpoint, was directly linked to the continued rollout of the company's new Open Series product line. With an average selling price of roughly $216,200, the product not only aggressively competes with resale and foreclosure inventory but also meets many of the demands of the entry-level market. In fact, according to calculations from Dan Oppenheim, an analyst with Credit Suisse, the company sold 22 homes per community during its fiscal 2Q2009, up 13% year over year.
Raymond James analysts Buck Horne and Paul Puryear provided some additional detail on the product line in a recent research note. They wrote:
"After recently touring several 'Open Series' models in Florida, we can personally attest that KB Home appears to have a product that is very hard for competitors to match on a base-price-per-foot basis. This pricing hook, which stands in sharp contrast to other new homes and is very competitive with resale prices, does appear to be working in the field and gives KB Home an opportunity to leverage faster cycle times and its design center upgrades to rebuild what is likely an otherwise thin margin on the 'sticks and bricks.'"
During the company fiscal second quarter earnings call on Friday, June 26, CEO Jeff Mezger offered some additional fast facts on the product line's performance:
* First-time buyer focus. The product line is gaining good traction with the entry-level market, as anticipated. Mezger said first-time buyers made up 72% of fiscal 2Q2009 deliveries and 79% of backlog. * Sales starter. Sales rates on the new product are back to running at what Mezger called "historical norms"; Wachovia analyst Carl Reichardt estimated that rate was roughly four to five sales per community per month, although he noted he believed some Open Series tracts were selling at twice that rate. In addition, Mezger said he anticipated sales rates would gain momentum in the back half of 2009 as the company rolled out more Open Series communities. Pricing power. Mezger said the Open Series value-oriented pricing strategy has generated a lot of demand, so much in fact, that the company has been able to raise prices on the product line in a number of markets. * Short cycle time. The product line's cycle from contract to close is a selling advantage, Mezger said. In Las Vegas, for example, the cycle is roughly four months, which Mezger said was less time than it would take, on average, to complete a bank-owned transaction. * Revamp opportunities. The success of the Open Series has allowed the company to reopen previously troubled communities. As an example, Mezger said the company had rolled out the new product in a community in Texas, where sales had been suspended. With the new product, home prices are $60,000 below what they were and average cost to build was down $80,000, meaning the community was able to re-establish sales volume while increasing gross margin.
Despite the buzz around the new product rollout and heightened performance expectations--by year-end, 50% of the company's deliveries should be Open Series--the company admittedly still had some work to do to get back into the black. As Mezger explained, "While I am pleased with our steady progress, we are still short of our ultimate goal of restoring profitability."
Despite management's assurances that gross margins would continue to improve as the Open Series made up a larger portion of its product mix, some analysts remained skeptical. "It still remains unclear, in our view, if KB Home can deliver materially stronger profitability on these downsized entry-level homes," wrote Raymond James analysts Horne and Puryear.
Moreover, management seemed to indicate that SG&A, which came in at an elevated 19.1% of revenues, wouldn't drastically change going forward, even as SG&A total dollars declined. As senior vice president and chief accounting officer Bill Hollinger noted, "Reduction of overhead costs remains a high priority and we continue to evaluate all opportunities for further savings. We are mindful, however, of the need to maintain a strong talent base and infrastructure platform so we can respond quickly to the prospects that will arise as housing markets stabilize."
But management remained confident that profitability would be restored sooner rather than later as the company saw opportunity to refill its lot pipeline with lower-cost lots. In fact, Mezger noted that the company entered into five optioned-lot deals during the quarter, giving the company access to roughly 600 total lots spread across various regions. Mezger said he expected financial performance on these new communities, which will uniquely offer the Open Series product, to be robust. Using as an example a new project that management had contracted on in Florida, Mezger said:
"Part of the reason that we are going out on these soft options and moving quickly is we can raise our returns and our margins and if this community hits pro forma and the initial sales rate suggest it's well on its way, the margins will be north of 20% and the IRR is north of 30%, so it will help to lift margins over time."
