The Shorts Should Feel Right at Home

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

I don't short stocks. I never have and I don't see a reason that I ever would. That being said, there are certain companies that make me want to change my mind. One such example is KB Home (NYSE: KBH). The company first came to my attention in March of last year when it popped up as the seventh most shorted stock based on percentage of shares sold short at over 36%. I examined the stock then and concluded that KB Home did in fact deserve this designation, and unfortunately for investors, the situation today isn't drastically different. Apparently the shorts agree as the percentage of shares sold short has climbed above 41% as of the end of 2012.

If KB Home operated as a virtual monopoly I could see owning the stock. With the economy slowly improving homebuilders should be a group that does well over the next few years. However, KB Home isn't a monopoly, and almost no matter what company you compare them to, they fall short (pun intended).

Some of the numbers from KB Home's last quarter were encouraging. The company saw revenue increase 20%, homes delivered increased 6%, and net orders were up 4%. In something that's happening across the country, the average selling price of new homes increased. In KB Home's case, the price increased 14% year-over-year. In addition, the company's backlog increased by 35% in dollars and 20% in units. If this sounds like great news to you I would only say, not so fast.

KB Home has two problems that separate the company from its competition. The first is the company's gross margin. In the company's most recent quarter, they reported a gross margin of just 3.22%. While homebuilding is a tough business, none of their peers suffers with this poor of a gross margin. Toll Brothers (NYSE: TOL) admittedly operates in the higher-end housing market and has an industry leading gross margin of 24.6%. PulteGroup (NYSE: PHM) and Lennar (NYSE: LEN) are much closer competitors to KB Home however, and these companies managed 18.21% and 23.5% gross margins at last report. When a company's gross margin is small enough to be worse than some of their competitor's net margins, you know they operate at a disadvantage.

The second issue facing KB Home is their cancellation rate is borderline absurd. KB Home already lagged its peers by a significant amount last quarter with a 29% cancellation rate compared to rates of 4.6% at Toll, 14% at PulteGroup, and 16% at Lennar. This quarter, the company's results were even worse. The current quarter showed a cancellation rate of 35%. This number more than anything is a huge reason to choose another company instead of KB Home.

When you consider that KB Home's backlog growth lags most of their competition, this already puts the company at a disadvantage. If you combine slower backlog growth and a huge cancellation rate, you get future growth numbers that are highly unreliable. The company's cancellation rate is more than double their peers, and this number has been consistently higher than most other homebuilders. Another factor that is working against KB Home is their relatively weak balance sheet.

The company did manage to generate positive free cash flow in the most recent quarter. However, their cash and cash equivalents balance is $567.1 million versus over $1.72 billion in long-term debt. While cash did increase faster than long-term debt on a year-over-year basis, I have to wonder why the company is taking on more long-term debt if they are free cash flow positive? Given that this company was burning through cash until recently, it would seem reasonable to shore up their balance sheet until positive cash flow becomes a consistent pattern. No matter what KB Home does with their balance sheet, one thing investors can't ignore is the difference in valuation between the company and other homebuilders.

If you consider that KB Home has a lower gross margin, lower backlog growth, and higher cancellation rate compared to their peers, you would expect the shares to sell at a discount. However, KB Home shares trade for nearly 160 times 2013 estimates, yet the company is only expected to grow EPS by 4% in the next few years. Though PulteGroup is only expected to grow by 5%, their stock is much more reasonably priced at 16.8 times estimates. Lennar appears to represent an even better value, as the company is expected to grow earnings by 6%, yet has been crushing estimates by over 300% on average in the last year. Lennar also has seen consistent backlog growth, and their cancellation rate was less than half of KB Home's last quarter.

The best value in the industry might be Toll Brothers. Toll does sell for 38 times projected earnings, but with a nearly 25% expected growth rate, the company is in a different class relative to their competition. In addition, Toll has been beating estimates by over 240% on average, and they have the lowest cancellation rate of the group. If you had to choose one homebuilder, I would start with Toll.

Sorry KB Home investors, but your company is underperforming most of its peers badly. With so many better options available, short sellers should feel right at home betting against this stock.

MHenage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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