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KB Home

(KBH) - Get KB Home Report

announces earnings later Thursday, the key issue won't be the widely expected profit decline, but instead the future uses of the company's growing pile of cash.

So far this year, the homebuilder's buyback activity has been brisk, and many shareholders are looking for the company to keep up the pace. But a very hard landing in housing could require KB Home, as well as other builders, to shift much of its cash flow to paying down debt, which might not provide as much juice to the stock.

Most investors realize that earnings are falling in the sector as the housing market continues its rapid slowdown. Two weeks ago, KB Home preannounced third-quarter earnings of $1.85 to $1.95 a share, down from the $2.55 it earned a year earlier. The company also cut its full-year guidance by 20%.

But not every investor realizes that by early next year, KB Home and other homebuilders should have a lot of cash on hand as long as they slow down their land purchases, which the companies have said they will do.

As home contracts turn into closings, KB Home's free cash flow will begin to pile up, particularly in January and February. That's a big difference from previous years in which nearly all builders saw negative cash flow from operations because they purchased so much land. KB Home has given a conservative estimate of producing $1 billion of free cash flow through the end of 2007.

Currently, as often happens with companies, there are dueling demands between KB Home's bondholders and certain equity investors about what to do with that cash. Many of the bondholders are worried about the company's liquidity and would like to see cash simply pile up.

Fitch Ratings analyst Robert Curran says the prudent thing for KB to do is to "husband" its money and pull back land purchases, as well as be "cautious" on share repurchases.

"Management's share repurchase strategy has been aggressive at times, but so far has not impaired KB Home's financial flexibility," Curran wrote in a recent note, in which he cut the company's outlook to stable from positive and confirmed its BB+ rating.

Certain shareholders, particularly hedge funds, would like to see very large buybacks instead.

As one hedge fund manager with a position in KB Home points out, builders currently are under a lot of pressure to keep their credit ratings intact. This manager, who has been investing in the sector for several years, is hoping for large buybacks from KB Home to the tune of 10% to 20% of its shares outstanding. However, the company's management will hold back in fear of the ratings agencies, he says.

KB Home has had large buybacks in the past. From 1999 to 2000, the company bought back 20% of its shares in one year.

In the first half of this year, KB Home already has repurchased 2.02 million shares at a cost of $299.9 million. As of the end of the second quarter, 6 million shares remained under the current buyback authorization. The company has about 91 million shares outstanding.

Last year, the company bought just $134.7 million of stock, at higher prices.

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KB Home will likely use much of its cash to either call or buy back some of its near-term bonds that hold higher interest coupons.

There already is evidence that other builders' management teams are turning to paying debt, rather than buying back shares.

At a recent Bank of America investor conference, builders

Standard Pacific



D.R. Horton

(DHI) - Get D.R. Horton Inc. Report

both stressed that they are focused on paying debt.

Standard Pacific Chief Financial Officer Andy Parnes said that the company's current focus is to deleverage the balance sheet, given what appears to be a much hard landing than initially expected, according to a research note from Bank of America analyst Dan Oppenheim.

"As such, we do not expect cash flow to be used to add to land inventory or share repurchase," Oppenheim wrote. According to the report, Parnes said the company "put its stock buybacks on hold" and has not repurchased any stock since the second quarter, when the board approved a new $50 million repurchase authorization.

Oppenheim also said that D.R. Horton's presentation at the conference left him with the sense that the builder "will utilize free cash for de-leveraging the balance sheet and preserving liquidity in order to conserve capital should opportunities arise 6 to12 months from now," he wrote. "We do not expect significant share repurchase activity or acquisitions in the near-term."

But for evidence of how a huge buyback announcement can propel the homebuilders, look at


(NVR) - Get NVR Inc. Report


In late June, the builder announced a new authorization to buy back about 10% of its stock. The company's stock eventually tanked with the rest of the sector over the ensuing weeks, and hit a low of $386.55 in mid-July, compared with $507.50 prior to the announcement.

The stock now trades around $553, up 43% from its July low, beating all other builder stocks since then. That outperformance comes despite the fact that NVR's key housing market -- Washington, D.C., and Northern Virginia -- is one of the worst in the country. The large buyback, at a time when nearly 14% of the company's share float was held short, clearly helped propel the stock.

The hedge fund manager hopes that KB's buybacks resume in 2007 once the debt paydown is completed. By the end of next year, if the housing market has improved and builders ramp up buybacks and continue to avoid buying new land, investors could find themselves holding stock certificates that are worth a lot more than today.