Even though KB Home (currently trading at $60.50 per share) has gained 12.6% over the last six months, it has lagged the S&P 500’s 19.5% return during that period. This was partly driven by its softer quarterly results and may have investors wondering how to approach the situation.

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Why Do We Think KB Home Will Underperform?

We don't have much confidence in KB Home. Here are three reasons we avoid KBH and a stock we'd rather own.

1. Backlog Declines as Orders Drop

We can better understand Home Builders companies by analyzing their backlog. This metric shows the value of outstanding orders that have not yet been executed or delivered, giving visibility into KB Home’s future revenue streams.

KB Home’s backlog came in at $1.99 billion in the latest quarter, and it averaged 20.4% year-on-year declines over the last two years. This performance was underwhelming and shows the company is not winning new orders. It also suggests there may be increasing competition or market saturation.

2. New Investments Fail to Bear Fruit as ROIC Declines

ROIC, or return on invested capital, is a metric showing how much operating profit a company generates relative to the money it has raised (debt and equity).

We like to invest in businesses with high returns, but the trend in a company’s ROIC is what often surprises the market and moves the stock price. Over the last few years, KB Home’s ROIC has unfortunately decreased. We like what management has done in the past, but its declining returns are perhaps a symptom of fewer profitable growth opportunities.

3. High Debt Levels Increase Risk

Debt is a tool that can boost company returns but presents risks if used irresponsibly. As long-term investors, we aim to avoid companies taking excessive advantage of this instrument because it could lead to insolvency.

KB Home’s $3.89 billion of debt exceeds the $330.6 million of cash on its balance sheet. Furthermore, its 5× net-debt-to-EBITDA ratio (based on its EBITDA of $671.8 million over the last 12 months) shows the company is overleveraged.

At this level of debt, incremental borrowing becomes increasingly expensive and credit agencies could downgrade the company’s rating if profitability falls. KB Home could also be backed into a corner if the market turns unexpectedly – a situation we seek to avoid as investors in high-quality companies.

We hope KB Home can improve its balance sheet and remain cautious until it increases its profitability or pays down its debt.

Final Judgment

KB Home falls short of our quality standards. With its shares trailing the market in recent months, the stock trades at 10.4× forward P/E (or $60.50 per share). This valuation multiple is fair, but we don’t have much confidence in the company. There are better investments elsewhere. Let us point you toward an all-weather company that owns household favorite Taco Bell.

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