Will KB Homes Restructure Its Debt?

KB Homes is not out of the homebuilders' wilderness just yet. Chief executive Jeffrey Mezger admitted on the third-quarter earnings call that economic conditions continue to work against KB Homes, and the profit outlook for the builder remains negative going forward into 2010. In addition, although management has worked hard to better its capital structure during this housing downturn, a review of the earnings quarterly filed with the SEC suggests an increased probability of default on its family of $1.8 billion in debt.

KB Homes, the fifth largest U.S. homebuilder, has focused on entry-level and first-step trade-up housing. First-time buyers now account for 80 percent of sales, up from 40 percent back in 2006. Not withstanding improvements in housing orders and cancellation rates in its third quarter, the company delivered 20 percent fewer properties in the quarter, or 2,240 homes. Net orders, however, increased 60 percent, reflecting consumers' embrace of KB Homes affordable Open Series of home designs (priced to compete with resales and foreclosures). The cancellation rate as a percentage of gross orders also improved to 27 percent compared with 51 percent canceling in the year ago quarter.

Despite a net debt to total capital ratio of 55.2 percent, KB Homes stood on solid financial footing as of Aug. 31, supported by unrestricted cash of $953.5 million, no debt maturing until 2011, homes and lots under production totaling $1.44 billion, and access to $464.9 million under its $650 million credit facility (net of $185.1 million of letters of credit). As all of us know, however, cash always seems to disappear quickly from our wallets. Going forward, cash flow generation at KB Homes will depend largely on a return to profitability, which seems unlikely to occur in a continued environment of declining prices and other incentives (such as paying for closing costs): the overall average selling price of its homes decreased 15 percent year-on-year to $202,800 in the quarter.

In the nine months ended August 31, KB Homes recognized pretax, non-cash inventory impairment charges on its 136 communities (and other land parcels) of $52.9 million, down from $373.4 million in the prior year. As the company still faces challenging economic conditions - and an uncertain housing recovery - expect additional asset impairments to follow, which will likely erode net worth, increase debt leverage to equity values, and increase the risk of violating certain key financial ratio metrics required under existing loan covenants:

At August 31, KB Home had an excess of $328.8 million under its reset TNW covenant of $278.2 million. In addition to the strong possibility of further inventory charge-offs, in my opinion, the TNW cushion could rapidly deflate in coming quarters from other write-downs, too, including:

• KB Homes recognizes the need to strengthen its balance sheet as a buffer against the financial impact of rapidly deteriorating housing markets. Ergo, the company still believes it is imperative to reduce its housing inventory - which could result in millions more in asset write-offs.
• The company is holding land parcels being developed with an assigned total value of $48.5 million. The problem is that the fair value of these assets is unknown - a big guess - for there are no observable comps or active markets by which to assign accurate prices to these holdings.
• Through a variety of arrangements, from recourse guaranties to deeds in lieu of foreclosure, KB Homes is also active in unconsolidated joint ventures that finance certain land and inventory investments. The company's potential responsibility under its "off-the-books" deals, if triggered, is approximately $194 million.
• Order backlog at August 31 consisted of 3,722 net orders, representing projected future housing revenues of approximately $734.1 million. Even assuming an improvement in cancellation rates to 23 percent, land contract abandonment charges could still lower TNW by several million dollars in the fourth quarter.
• At the end of the third quarter, KB Homes had deferred tax assets (such as "carry forward" operating loss) totaling $946 million -which equated to more than $12 of book value per share. While the deferred tax asset valuation allowance is a non-cash item, it does impact the balance sheet and book value. Consequently, if it becomes clear that the company does not expect to make expected profits in future years, the value of the tax asset has been impaired and needs be reversed - resulting in a write-down to TNW.