I’ve written for over a year about the improvement in the housing market. Toll Brothers Inc (NYSE:TOL) and Lennar Corporation (NYSE:LEN) have been two of my best performing calls on Motley Fool CAPS. These companies have huge potential and seem to be in an excellent position to post gains for investors for years to come. As the economy continues to recover, there is good reason to expect continued growth in the housing industry. Peter Lynch once said that he picked stocks based on their fundamental merits and not because of the industry they operate in. The idea that a rising tide lifts all boats may not apply in the case of KB Home (NYSE:KBH).
Lackluster Is The Only Word That Describes This Performance
One of the reasons investors should worry about KB Home (NYSE:KBH)’s is, analysts are calling for terrible earnings growth over the next few years. In fact, among their peers, KB Home is expected to grow earnings by just 4% over the next few years. The only company that is expected to grow slower is Lennar Corporation (NYSE:LEN) at 3.18%. By comparison, both PulteGroup, Inc. (NYSE:PHM) and Toll Brothers Inc (NYSE:TOL) are expected to grow much faster at 42.77% and over 62% respectively.
What’s really amazing is, based on the backlog growth at each of these companies, KB Home (NYSE:KBH) could actually do even worse than analysts expect. The second, and maybe most significant challenge facing KB Home is, the company’s lackluster backlog growth. If you look at each company’s potential future growth, the contrast is obvious.
| Name | Revenue Growth | Unit Growth |
|---|---|---|
| KB Home | 19% | 6% |
| Lennar | 76% | 55% |
| PulteGroup | 52% | 35% |
| Toll Brothers | 69% | 52% |
When your peers are growing potential sold units by 35% to 55%, and you are growing this same measure by 6%, something is dreadfully wrong.
Paying Too Much In Two Different Ways
It’s never a good thing to pay too much, and with KB Home (NYSE:KBH), both the company and investors are paying too much. On the one hand, the company has put itself in a terrible position when it comes to debt and interest expense. This is the third reason investors need to be very careful betting on KB Home.
One way to determine if a company could be in financial trouble is by looking at their interest expense as a percentage of operating income. In the current quarter, KB Home paid 215% of their operating income in interest expense. When a company pays $2 in interest for every $1 of income, you know that something is terribly wrong. By contrast, Lennar pays the second most in interest at just 14.53% of income. When you consider that PulteGroup pays less than 1% of operating income, and Toll Brothers pays just 4.5% in interest, you can see just how much trouble KB Home appears to be in.
While it should worry investors that KB Home is paying too much in interest expense, there is no logical reason investors should pay too much for the stock. This is the fourth problem with KB Home; the stock is almost comically overvalued. When a company is struggling and is expected to grow earnings by just 4%, why in the world would investors pay over 50 times projected earnings for the stock?
The simple fact is, based on P/E ratio, KB Home is the most expensive stock of its peer group. The second most expensive stock based on P/E is Toll Brothers at about 39 times earnings. The huge difference between Toll Brothers and KB Home is one (KB Home) is expected to grow by 4%, Toll Brothers is expected to grow by more than 62%. Looking at PulteGroup’s forward P/E of about 14, and Lennar’s P/E of about 19, these stocks seem very cheap compared to KB Home’s seemingly crazy valuation.
Nothing Good Comes Of This
When you look at KB Home’s performance, you can see investors have good reason to worry. What is the one thing that investors in an over-leveraged company should worry more about? One final problem with KB Home is, the company is forming a mortgage banking company with its preferred mortgage company Nationstar Mortgage.
I’m not sure what KB Home’s management is thinking. Why would a company that is struggling with its core business decide to enter a volatile business like mortgage banking? An overvalued stock, poor growth, high interest costs, and a challenging new venture would seem to spell trouble for investors. Given that all of KB Home’s competition offer better values, and more stable businesses, I have one suggestion for KB Home shareholders. You need to pack this stock up and send it home. This house doesn’t stand a chance of standing.
Chad Henage has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned.
The article 5 Reasons To Send This Stock Home originally appeared on Fool.com and is written by Chad Henage.
Chad is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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