Byron Douglass, senior research analyst at Credit Derivatives Research, looks at a capital structure arbitrage trade on KB Home

KB Home reported weaker than expected earnings at the end of September and the follow-on action in the equity, bond and CDS markets sparked our interest. While the company's sales remain anaemic, its margins finally turned positive; however, this sent its stock down and CDS spread wider.

Interestingly, after jumping 90bp post-announcement, KB's CDS continued to be bid up and now trades almost a full 100bp wider, while its stock was range-bound at around US$15/share. Given KB Home's strong liquidity and balance sheet (no substantial debt is due until 2014), downside risk is heavily tilted towards the equity portion of the capital structure, making long credit/short equity a solid trade.

Price action of KB Home securities in the month following its 25 September earnings announcement created an interesting trading opportunity. Its equity initially led the charge (pre- and post-earnings), trading down 25%, while during the same time period its CDS shot up by 80bp. Both took a breather, trading in ranges, until mid-October when its CDS resumed its ascent (see Exhibit 1).

After the second leg wider, KB's CDS trades an additional 100bp wider at 370bp, while its equity remains roughly flat. Also, the z-spread of its 6 ¼ of June 2015 bond widened by 50bp post-announcement; however, it did not participate in the late October sell-off of the CDS (actually tightening by 20bp). We find this to be indicative of a technically-driven underperformance of its CDS.

Relative to other homebuilders, KB's CDS is the biggest underperformer over the past three months (see Exhibit 2). Its CDS spread is wider by 140bp since early August, while a duration-weighted index of builders (ex-wide spread credits) is only up by 38bp.

Fundamentally, we find the risk of underperformance to be weighted towards the equity of the company rather than the debt. Even though KB's operating margins finally tipped into positive territory and are now well above the average of the last four quarters, sales remain absolutely abysmal, putting a huge strain on future earnings (see Exhibit 3).

That being said, the company maintains a decent balance sheet, with little risk of immediate trouble. KB holds US$950m in cash, plus inventory of US$1.9bn. While the company now generates positive cashflow from operations, it will also capitalise a percentage of its interest payments (60% in 2009), reducing the constraint on its cash.

The greatest demand on funds will come from the US$185m outstanding balance on its 2010 revolver and a US$100m note maturing in 2011. Beyond these two maturities, no debt comes due until 2014. Though KB Homes is far from solid profitability, the risk of a drop in the value of the company's stock price is much greater than that of further spread widening.

Position
Sell 10,000 shares KB Home at US$15.60.

Sell US$1m notional KB Home 5Y CDS at 355bp.

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Note: This article is intended for general information and use, and does not constitute trading advice from Structured Credit Investor (see also terms and conditions, below, section 12).