3 Reasons to Sell This Homebuilder

Unlike its thriving peers, KB Home (NYSE: KBH  ) seems to have missed the memo that the housing market is recovering. While the company's CEO Jeffrey Mezger said that "the fundamentals of the current housing recovery are firmly in place," that alone may not generate huge returns for KB's shareholders.

This number could hurt future earnings
Sometimes it makes sense for a company to take on debt to take advantage of growth opportunities. For example, KB Home's competitor Lennar (NYSE: LEN  )  increased its long-term debt by 26% year over year. In part because of this debt increase, Lennar's debt-to-equity ratio sits at 1.3. However, Lennar also reported significant growth in the current quarter.

On the other side of the coin, PulteGroup (NYSE: PHM  ) actually cut its debt over the last year, and carries one of the industry's lowest debt-to-equity ratios at 0.5.

By contrast, KB Home increased its net long-term debt by 26%, and the company's debt-to-equity is much higher than its peers at 3.89.

So the first reason it might be time to sell KB Home is the company's use of long-term debt. While debt being used toward future growth is good, in two of the last four quarters, KB Home reported negative net earnings, in large part because of the company's interest expense. Just as an example, in May of this year, KB Home reported $10 million in operating earnings, yet had to pay $14 million in interest expense. With the company increasing its debt load, if KB Home doesn't report significant growth, future earnings could be challenged.

Higher debt for this?
One way to measure the future growth potential of a homebuilder is by looking at its backlog growth. If the company's contracts all are completed, this backlog becomes future earnings. Of the three companies we've looked at, Lennar reported significant growth while PulteGroup and KB Home reported much weaker results.

With increased demand across the housing industry, it has been pretty common for homebuilders to see increased prices. Since this is an industry tailwind, it makes more sense to look at unit growth. KB Home and the competitors we've looked at all compete in the same price range of around $300,000. Since their average prices are similar, unit growth should be a better measure of which company is showing real organic growth.

Thus, the second reason to sell KB Home is the company's weak-looking backlog growth. In the most recent quarter, Lennar reported annual unit growth in its backlog of 32%. But PulteGroup reported a 2% decline, and KB Home did even worse, with a 3% unit decline on a year-over-year basis.

If KB Home is showing a unit decline in its backlog, why take on more debt to produce these results?

KB Home's future in one number
The third reason investors need to look at selling KB Home is painfully obvious. In any business, a lot of cancelled orders are bad for business. While some cancellations in new home contracts are understandable, a high cancellation rate could indicate some problem with the company's way of doing business.

If there is one number that should worry KB Home investors, it's the company's 33% cancellation rate. To say that this level of cancellations is too high is a massive understatement. With negative unit growth of 3% and a 33% cancellation rate, KB Home needs to show investors that it can generate real growth and must cut the number of cancelled contracts.

PulteGroup and Lennar reported cancellation rates of 18%. With a cancellation rate that is 45% less than KB Home, investors would be right to consider looking to substitute either of these companies for this troubled homebuilder. When you consider that both of these companies also reported stronger backlog growth, it's tough to recommend keeping KB Home.

Delusional investing
To be blunt, KB Home shareholders seem to be operating under several delusions. The company is reporting sub-par backlog growth relative to its peers. Second, the company is losing more of these contracts because of its high cancellation rate.

Last but not least, KB Home is taking on more debt and risking the company's future earnings on more interest. It's one thing to believe that a company will do well in the future, it's something else to entirely ignore the facts. KB Home isn't doing well, and the company's results argue for more trouble in the future.


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