A Builder That Still Hasn't Bottomed

10/20/2008 11:00 am EST

Focus: OPTIONS

Michael Shulman

Editor, Short-Side Trader

Michael Shulman, editor of ChangeWave Shorts, says a homebuilder is still vulnerable as the market remains weak.

The homebuilders have tortured us for almost six months, but now we have a host of very profitable positions-and I want to add one more, KB Home (NYSE: KBH). Here's why:

1. KBH's third-quarter results were truly miserable. Revenues were $682 million compared with more than $1.5 billion in Q3 2007. It lost $478 million from continuing operations-that is a lot of money.

2. It ended the quarter with a lot of cash-roughly $950 million-but twice that in debt. And its debt-to-capital ratio zoomed from 44% in the third quarter of 2007 to 62% in this year's third quarter.

3. It continues to dump homes-$30,000 less per home sold in [the third quarter] compared to 2007-and it's writing down properties to the tune of more than $600 million.

4. Its order backlog is just under 4,800 homes and net orders were an awful 1,300 units and change. [In the third quarter], the company sold or "recognized revenues" on less than 3,000 homes. When does it end? These order rates mean annualized revenue could fall to less than $2 billion or less than half a billion a quarter.

5. KBH still has to write off a lot of properties, and this reduces what analysts call "tangible" book value. I expect write downs going forward will be more than Street expectations.

6. Given this mess, KBH is bound to cut its buck-a-share dividend-[nearly 7% at recent prices]. That dividend can't be sustained if the company wants to convince someone to give them some dough.

It's a perfect storm-reduced sales and more losses from operations, more losses from writing down tangible book value, and an unsustainable dividend.

One reason, however, the stock held up until everything blew up last week was its strong cash position. But how long can that last for a company hemorrhaging money at the rate of $100 million a quarter?

And did I mention its existing credit line was cut from $1.3 billion to $800 million? It also has a provision that if its tangible book value falls to a certain level-below $800 million-then its credit line also gets cut to $650 million. And this line matures in two years (November 2010), long before the housing market will turn around.

Get on the short side of this dog. Buy the KBH January 2010 $5 Puts (YABMA) under $1.25. (The stock closed above $14 Friday, while these puts changed hands at $1.35. Short selling is only for very risk-tolerant investors who can afford to lose the money they're putting into the trade-Editor.)

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