KB Home is priced to sell

By Robert Walberg

Home builders are using the same formula with Wall Street these days: report dismal earnings while giving investors some sign of hope that a recovery in housing has begun.

KB Home (KBH, news, msgs) followed the script beautifully this morning, when the company posted a quarterly loss of 64 cents due to a $343.3 million one-time land-related charge. The nation's fifth-largest home builder went on to say that net orders had plummeted 38% and that gross margins had fallen to 18.8% (excluding noncash charges) from 27.1% a year ago.

But before you place that sell order, here's the ray of hope the company offered: The cancellation rate of 48% was down from the prior quarter's abysmal rate of 53%. That's right folks, we are supposed to get excited by the fact that cancellations, while up from 31% last year, are slowing down ever so slightly. Strike up the band: "Happy days are here again!" On cue, the stock rose 2.6% in early trading today.

Happy days?

There were a few other nuggets for bulls. Revenue of $3.55 billion exceeded the Street estimate of $2.73 billion, and the overall average selling price rose by 4% to $272,400. However, when you think about it more closely, the fact that earnings were so bad despite better-than-expected revenue and average selling prices doesn't really point to better days ahead.

Like all home builders, KB Home is trying to make the best of a bad situation, and that's to be expected. We just need to be more-critical readers. A slight improvement in the cancellation rate off a horrible number is not good news. The numbers stink, and conditions aren't showing any signs of material improvement even though interest rates have moderated from last summer's peaks.

You don't need the company CEO or a Wall Street analyst to tell you about the conditions of the housing market. Just look around. Listen to your friends and neighbors share their stories of trying to move. Housing demand remains extremely sluggish, sellers are having to discount prices and still aren't getting buyers, and houses are sitting on the market forever -- especially high-end homes.

Obviously, the housing market is different from place to place. There are areas of the country that the experts can point to and say that demand is picking up. But it's not happening in the big markets and isn't widespread.

The overall picture remains bleak and there's just no way to sugarcoat the fact that earnings within the sector are falling hard and will continue to do so for at least another year. KB Home's earnings are expected to drop by 46% in fiscal 2007, and my guess is that number remains too optimistic.

Wildly overpriced

If KB Home's shares were trading at a new 52-week low heading into today's announcement, you might understand the bullish reaction to the earnings report. But that isn't the case -- KB Home entered the session up more than 37% from its midsummer low.

Why the home-building stocks continue to climb in the face of bad news and generally gloomy forecasts is beyond me. It's reminiscent of the tech bubble, when investors continued to buy dips all the way down on the hope that the stocks that lead the last rally would quickly regain their leadership status. They never did, and the stubborn sector bulls ended up compounding their losses.

Don't let this happen to you with the housing sector. Don't chase the recovery until there is compelling evidence of a real bottom. And a slowing in the cancellation rate isn't what we call a compelling sign of a bottom, especially not when its 55% above year-ago levels. Sell into today's earnings pop on KB Home. Look for the stock to settle initially at $47, with a break of this floor setting the stage for an extended decline in the $42-to-$43 area.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.