KB Home maintaining production in new home market, analyst explains

Despite topping its third-quarter earnings estimates, KB Home (KBH) reported a drop in homes delivered. The homebuilder is raising its full-year outlook in an attempt to push through new home market headwinds. Raymond James Analyst Buck Horne shares why he still has an "Outperform" rating on KB Home amid elevated mortgage rates and affordability concerns affecting U.S. housing starts.

"We find KB Home now trading through its tangible book value despite consistent profitability, a fantastic balance sheet, and looks like, you know, consistent growth and stable margins going into 2024," Horne says. "So, it's already through its historical cyclical lows at these valuation levels."

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Video Transcript

SEANA SMITH: Despite some of the concern that we're seeing, especially amongst investors here this morning, you still have an outperform rating on the stock, you're still pretty positive about what you're expecting to see from KB Home. Why?

BUCK HORNE: Yeah. No, it's a good question. And obviously, the concern right now is that higher mortgage rates are going to continue to crimp demand. And there's no question that higher rates for housing is generally not a good thing. But I think there's a couple of things going on in the new home market, which I think investors need to consider well.

And first and foremost, [INAUDIBLE] have to consider the valuation of the stock. We find KB Home now trading basically through its tangible book value despite consistent profitability, a fantastic balance sheet. And looks like consistent growth and stable margins going into 2024. So it's already through its historical cyclical lows at these valuation levels.

But what's going on in the new home market in particular is the inventory availability, that they're continuing to keep production going, they offer financial incentives for their buyers to get in at somewhat below market rate, mortgage rates. And also, they're adjusting price and they're adjusting floor plans to figure out how to make it more affordable for buyers.

And with that, what they're also attracting is a much higher income household into their new home communities. I think that's often overlooked is that as the existing home market in a lock-in effect effectively continues to take inventory out of the existing home market, those higher income buyers that, you know, where life happens and they need to get into a house fairly quickly, they're migrating into new home communities.

And KB's average household income is now up to $130,000, extraordinarily high FICO scores, average down payment 15%. And those buyers in the new home market in KB communities can afford a new home at 7 and 1.4% mortgage rates. The math actually still works for those buyers.

BRAD SMITH: And so, Buck, when we think about the home cancelation rates that we've seen, home purchase agreements that were canceled in August-- according to data from Redfin, 60,000 of them were canceled, so that represents about 1 in 7 pending sales for the month-- how does that overflow into what we're seeing, or how does that give you a better read through to some of the home builders, especially the KBs, the Lennars, the Toll Brothers out there?

BUCK HORNE: Yeah. I mean, anytime you have mortgage rate volatility and rates are rising, it's going to push some buyers to get either cold feet or it's going to create some qualification issues. And usually, those are temporary. But generally, as we've seen the year progress, buyers have been adjusting to these higher rates.

We haven't seen quite the level of volatility that we saw late last year. But we are seeing cancelation rates in the new home market are performing better. Can rates were down for KB Home both sequentially and year-over-year. So buyers that are still in the market, those that are in the new home market are committed. They need a house.

You know, life is going on, and they are financially capable of adjusting. And of course, you know the there's also an advantage in the new home market where if rates are volatile, the builder can step in and in some cases offer additional incentives, additional mortgage rate buy-down to make sure the deal closes.

But for the most part right now, we're seeing that they're not having to do that. In fact KB was able to raise prices in 65% of its communities just this past quarter and still seeing steady demand through the end of August. So that still gives us a good indication that, yeah, I mean, people are concerned about rates. But for the most part, they're able to adjust and afford these higher monthly payments.