KB Home (KBH) short thesis

Homebuilder shares have been rallying strongly and there may be a short squeeze happening in KBH.  53.70% of the float is sold short according to Yahoo Finance.  It may be possible to make a small profit by shorting into the squeeze.

KBH is GAAP unprofitable and has negative cash flow from operations.  Either way you look at it, it is unprofitable.  It seems clearly overpriced as it has a price/book ratio of 2.85.

Why is it trading so high?

I’m not sure.  I don’t believe that KB Home has hidden assets on its balance sheet.  Land (and capitalized interest costs) are more likely to be overstated than understated as land prices have been declining over the past several years.  Joint venture assets are likely to be overstated for similar reasons.  The KB Home ‘franchise’ is worth something if you anticipate a very strong housing recovery.  However, KB Home is a second-tier homebuilder at best.  Most of its publicly-traded competitors are GAAP profitable whereas KB Home is not.  (The best managed homebuilders would be NVR, TOL, LEN.)

Financial management at KB Home is poor in my opinion.  Considering its overvaluation, it should sell its overpriced stock.  Also, it should cut its dividend considering its debt level as the will eventually be very dangerous.  As of May 31 2012, Google Finance shows that the company has $1,582.79M in long-term debt versus $369.53M in equity.  KB Home has recently issued 7.5% senior notes due 2022.  It will not be easy for KB Home to outearn its cost of capital.

I believe that the shorts are betting on KB Home on continuing to lose money (it has negative cash flow from operations) and eventually dying in a fireball of debt.  This could take a while.  Housing peaked around 2005.  7 years later KB Home is still alive.  The company doesn’t have long-term debt due until 2014 and 2015 (roughly $250M and $300M respectively).

Housing outlook

There used to be reasons to be bearish on housing.  One major factor was that many people were squatting in “their” own homes as the banks did not foreclose on them right away (partly because they were swamped with unpaid mortgages, partly to defer taking impairments on their loan book).  I am guessing that this shadow inventory should be (more or less) cleared out by now.  Another factor is the resets on adjustable-rate mortgages.  Many mortgages reset in the past few years (see Whitney Tilson’s presentations on the topic).  Shorting US homebuilders has been somewhat disappointing over the last few years as very few of them have gone bankrupt if they weren’t in the low single digits already.  The reasons to be bearish in the past don’t apply anymore.

Maybe the rebound in housing will finally materialize.  Mortgage rates continue to be artificially low thanks to quantitative easing.  Americans only need a 3.5% downpayment to buy a house thanks to the FHA, compared to 10% minimum for Canadians and 40/50% for Chinese.  In the past, homebuyers could have a 0% downpayment as they could loan against their homebuyer’s credit and use loaned money for the downpayment.  As far as I know, the 0% downpayment is over (unless you are a veteran that qualifies for VA loans).  In the future, it is possible that financing becomes more difficult.  In theory, the US government should stop its irresponsible lending to homebuyers (via the FHA) and other housing subsidies (e.g. artificially low long-term interest rates).  It is theoretically possible that the US housing market continues to move sideways as financing gets more difficult for buyers, reducing demand.  Otherwise, the long-awaited rebound in US housing could finally materialize.

Closing remarks

Unless there is in an incredible bull market in housing, I see KB Home trading in the low/mid single digits in a few (two) years.  The fact that they are losing money in a reasonable market for homebuilders suggests that KB Home is very poorly managed.  Its cash position will hit a critically low level and investors will start to question whether KB Home will go bankrupt.  I don’t think bankruptcy is guaranteed as KB Home uses long-term debt and may be saved by a housing rebound.  I would cover at lower prices instead of trying to ride this company to 0.

The short interest in this stock is extreme so I would recommend using a very small position size.  The interest on the borrow is around 2% currently.

*Disclosure:  Short KBH.

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One thought on “KB Home (KBH) short thesis

  1. Pingback: Homebuilders revisited | Glenn Chan's Random Notes on Investing

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