KB Home price weakness is a signal to buy this cash machine

Key points

• KB Home's share prices decreased after reporting a solid quarter that points to ongoing capital returns.

• The "higher for longer" Fed stance tilts the market toward home builders. 

• Results are weak compared to last year but reveal normalization within the homebuilding market. 

• 5 stocks we like better than KB Home.

KB Home (NYSE: KBH) is selling off on a narrowing margin and FOMC hawkishness, but don't be fooled. The sell-off has shares down 16% from their highs, and they may go lower, but this is good news for investors. Despite the Fed's stance of "higher for longer," or perhaps because of it, the market is tilted strongly in favor of homebuilders. High interest rates keep existing owners out of the market, and supply is tight, meaning pent-up demand has nowhere to go but the home builders. 

Regarding KB Home and its sell-off, the deepening sell-off is opening up a significant value in a cash flow machine. The stock trades at a meager 6.6x earnings and below its book value, which is rising. Book value is rising on the combination of results and share repurchases, which have been robust over the past year. Cash flow is so strong that KB Home has been able to pay its ultra-safe dividend, buy back shares, invest in the business, and build its cash position. This has it set up for leverage when the FOMC reduces interest rates and frees up the market. 

There is some concern about rising cancellations, but the takeaway from that data is cancellations are high but normalized for the conditions. Recent data from Redfin Redfin (NASDAQ:RDFN) shows cancellations rising in August to the highest level in 10 months and up compared to last year. However new orders, as reported by Lennar (NYSE:LEN) and KB Home, are more than enough to offset it.

KB Home reported a 21% cancellation rate for Q3, down significantly from the prior year and marginally compared to the prior quarter. The rise of interest rates may increase the pace but not enough to impact capital returns. 

KB Home business is stabilizing above 2019 levels 

KB Home's revenue fell 13.6% compared to last year on the combination of lower volume and prices, but it beat the Marketbeat.com consensus by nearly 900 basis points, and there was margin strength. Margins contracted at the gross level and were offset by cost reductions to deliver $1.80 in GAAP EPS. This is down YOY, but compared to record-setting, bubble-induced levels and $0.38 or 2600 bps better than expected and strength is expected to continue. 

The company's backlog is down 35%, a concern mitigated by new orders. The net new orders increased 52% compared to last year, with value rising 54%. The company expects the average selling price to decline sequentially, but the 200 bps of strength in the new order value suggests a bottom for prices is at hand. Zillow expects average home prices to rise by 6.5% over the next 12 months, a forecast echoed by Case-Shiller data. 

The guidance is favorable to income investors. The company expects the margin to narrow compared to last year but hold steady sequentially. This is on top of an upward revision to revenue that put the mid-point above the pre-release consensus. Sufficient to sustain share repurchases and dividends, a primary focus of management. Share repurchases totaled 1.5 million in the quarter, bringing the count down by 6.9% compared to last year. 

Analysts buy Into KB Home's cash return strategy 

The analysts' sentiment has firmed in KB Home, with the consensus rating moving to a solid Moderate Buy from Hold over the summer. The price target is steady but assumes a 12.5% upside for the market. A move up to the consensus would put the market near an all-time high with a possibility of setting new highs. 

The post-release analyst activity is interesting because it includes 3 revisions (picked up by Marketbeat) with one boosted target, one reiterated target, and one lowered target with an average price of $58.33. That's another 12% above the broad consensus and puts the market well into new all-time high territory. 

The technical action has KBH pulling back sharply, forming a gap and potentially in capitulation. In this scenario, the market should continue to build support at or near the $46 level before moving higher. If not, the market could correct to $44 or lower, where it would present an even deeper value. The indicators are weakening and suggest a deeper downturn is possible, but they are also consistent with significant entry points in 2022 and early 2023.