Nothing To Write Home About

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

With homebuilder KB Home (NYSE: KBH) reporting earnings and the subsequent reaction in the stock, you would think this company blew all of their competition out of the water. I sincerely hope that investors thoroughly read the company's earnings release, because if they do they'll realize this quarter was nothing to write home about.

I'll say up front, I've been bullish on homebuilders as a group for a while now. I've written multiple articles about Toll Brothers (NYSE: TOL) and Lennar (NYSE: LEN) in particular, singling them out as good investment candidates for people who want exposure to this group. I've also made calls on Motley Fool's CAPS on both companies saying that I expected them to outperform the market. My Toll Brothers call has been outperforming since August of last year, and Lennar has been outperforming since February of this year. I expect this outperformance to continue, as both companies are reporting significant increases in their earnings and backlogs. Looking across the industry, anyone who believes the housing market is not recovering is burying their head in the sand and ignoring the numbers. Take a look at the backlog increases reported by five major homebuilders and I think you'll see my point:

<table> <tbody> <tr> <td> <p><strong>Name</strong></p> </td> <td> <p><strong>Backlog Dollars Increase</strong></p> </td> <td> <p><strong>Backlog Units Increase</strong></p> </td> <td> <p><strong>Cancellation Rate</strong></p> </td> </tr> <tr> <td> <p>Toll Brothers</p> </td> <td> <p><a href="/mhenage/2012/08/30/bell-tolls-thee/10603/">59.00%</a></p> </td> <td> <p><a href="/mhenage/2012/08/30/bell-tolls-thee/10603/">44.00%</a></p> </td> <td> <p><a href="/mhenage/2012/08/30/bell-tolls-thee/10603/">4.60%</a></p> </td> </tr> <tr> <td> <p>Lennar</p> </td> <td> <p>67.50%</p> </td> <td> <p>61.00%</p> </td> <td> <p>16.00%</p> </td> </tr> <tr> <td> <p>KBHome</p> </td> <td> <p>33.00%</p> </td> <td> <p>18.00%</p> </td> <td> <p>29.00%</p> </td> </tr> <tr> <td> <p><strong>DR Horton</strong> <span class="ticker" data-id="203305">(NYSE: <a href="">DHI</a>)</span></p> </td> <td> <p>40.00%</p> </td> <td> <p>31.00%</p> </td> <td> <p>23.00%</p> </td> </tr> <tr> <td> <p><strong>PulteGroup</strong> <span class="ticker" data-id="204985">(NYSE: <a href="">PHM</a>)</span></p> </td> <td> <p>36.82%</p> </td> <td> <p>30.86%</p> </td> <td> <p>14.00%</p> </td> </tr> </tbody> </table>

You can clearly see that new houses are being ordered in large numbers. You might also notice though that the cancellation rate is tremendously different depending on which homebuilder. I will come back to that later, but for now let's look at KB Home's recent earnings to see how the company performed.

In KB Home's most recent quarter, revenues increased 16% and reported earnings-per-share came in at $0.04. This actually brings me to the first huge problem I noticed with the company's earnings release. While it was explained in the release, many investors might not notice that the company actually lost money without a one time item. KB Home recorded a $10.7 million federal income tax benefit as a result of a tax audit, without this benefit, net income of $3.3 million would have become a loss of $7.4 million. While this shows an improvement over the company's loss of $9.6 million last year, it is certainly not the profit that many people might see at first. Digging into the rest of the numbers shows positive results, but also some red flags for investors to be aware of.

KB Home reported delivered units up 7% and the average selling price increased 8%. While a 7% increase in units sounds good, this was nowhere near as good as some of their competition. By point of comparison, Toll Brothers showed units rising 39%, and Lennar showed an increase in units of 20%. While Toll Brothers competes in a different market with an average selling price more than double KB Home, Lennar is a direct competitor with almost the exact same average selling price. This should be a major concern for KB Home shareholders, because if the housing market is improving the company is not keeping up with their competition.

Coming back to the cancellation rate issue for a minute, the problem at KB Home cannot be understated. Considering the fact that KB Home's backlog grew at a rate less than half of their direct competitor Lennar, that already places the company at a disadvantage. This disadvantage becomes even larger when you consider that in the same quarter KB Home's cancellation rate was nearly double their direct competitor. Even other companies such as DR Horton and PulteGroup showed a lower cancellation rate and better backlog growth. While investors were probably encouraged by the companies reported $14.1 million in positive net cash flow, this also has to be adjusted for the one time $10.7 million tax benefit. The bottom line is, while KB Home is moving in the right direction, they represent probably the least attractive homebuilding stock that I've seen.

Unfortunately for KB Home investors, I believe the gains the stock is seeing today will be short-lived. Once analysts pull apart the earnings report, and realize how unfavorably the company compares to their competition, the stock will likely give back some of the short squeeze that is happening. The numbers just don't lie, investors looking for the best play on a rebound and housing should consider Toll Brothers first and Lennar second. With Toll Brothers dominating high-end housing, and Lennar showing strength in the average priced housing market, there really is no place for KB Home. Until KB Home can get its cancellation rate under control, and show real net income, I would suggest investors continue to avoid the shares.

MHenage has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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