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It's Not Too Late To Buy On This Housing Leader's Pullback

Friday, November 1, 2013 - 1:00pm

Buying a house is a terrible way to profit from the recovery in the housing market.

Houses are illiquid assets. They carry high transaction costs. And they are loaded with expenses such as insurance, maintenance and taxes.

When you think about it, a house looks a lot like an "anti-dividend": Investors pay a lot of money to own them.

There's a better way to cash in on the recovery in housing. This leading homebuilder provides incredible leverage against the ongoing recovery in housing without the burdens of buying a house. And with shares recently dipping 28% while earnings estimates continue to surge, this is a rare chance to buy on a pullback. Take a look at the recent pullback in the chart below.

With a market cap of $1.5 billion, KB Homes (NYSE: KBH) is one of the largest homebuilders in the United States. Shares had been rallying big on the recovery in housing before this spring's spike in interest rates triggered a wave of profit-taking that sent KB falling 28% from its recent all-time high.

That's creating an opportunity to buy one of the best housing stocks at a relative discount. And KB has plenty of room to keep growing.

The biggest catalyst for KB will be the ongoing recovery in the housing market. After a big spike this spring, interest rates are once again trending lower. That reversal is being driven by the Federal Reserve, aggressively reassuring the market it intends to keep interest rates low for years to come. That will continue to support homeownership rates and homebuilder volumes.

KB will also be cashing in on the strength of its business model. The company focuses on the high end of the housing market, making its customers less sensitive to economic volatility, employment rates and consumer sentiment. Many of its customers are "move-up" buyers upgrading to bigger homes. Access to equity from a current home, higher credit scores and personal wealth support higher home values and average sale prices.

KB protects itself from bloated inventories by beginning work on a new project or home only after a contract has been signed. That enables KB to hedge its project investments from a lack of back-side demand.

KB will also continue to benefit from its aggressive land acquisition strategy. The number of lots it owned increased 11% in 2012. In the first half of 2013, it invested $575 million in land and land developments, three times its spending in the previous year. Looking forward, land and land development investments are expected to total $1.2 billion in 2013, providing more leverage against the bullish trend in housing.

KB is focused on key markets that are seeing the biggest gains in home prices and sales volumes. Its biggest markets in the western U.S. are California, Arizona, Nevada, and New Mexico. These warmer states continue to gain popularity as destinations for retirees fleeing the cold winters of the Midwest and Northeast. KB strong presence in high-growth West Coast markets showed up in average sale prices, coming in at $480,000 on the West Coast compared with the $299,000 national average. However, KB also has a strong presence in several high-growth East Coast markets.

The good news has already been driving KB's results. The company's recent third-quarter results saw national closings rise 6%, West Coast closings climb 25%, and average sale prices jump 22%. Margins were also on the upswing, with adjusted gross margin climbing 110 basis points to 19.3%. That performance lifted KB back to profitability, reporting earnings of $0.28 a share, a dramatic turnaround from a per-share loss of $0.10 last year.

Looking forward, that strong earnings growth is expected to continue. The consensus estimate is calling for earnings growth of 169% in 2013 and another 86% in 2014.

Risks to Consider: Focusing on high-growth areas can be a double-edged sword if prices and demand decline. "Shadow" housing inventories controlled by the banks are also a potential threat to the relatively low levels of housing supply right now.

Action to Take --> KB Home's recent 28% pullback is a rare chance to buy a leading homebuilder on a big dip. That also went a long way to sweeten the valuation. With a forward price-to-earnings (P/E) ratio of 18 times in line with its peers, KB rates a buy anywhere below $20.

Michael Vodicka does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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