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KB Home Stock Wins 4 Upgrades in 2 Days

Rich Smith, The Motley Fool

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

KB Home (NYSE: KBH) may be only America's fifth-largest homebuilder, but this week, it's second to none in momentum.

Since reporting better-than-expected earnings Wednesday evening, KB Home has already won no fewer than four separate upgrades on Wall Street -- and two hikes to price target besides. Yesterday, KeyBanc and Buckingham Research upgraded KB stock (to overweight and buy, respectively). This morning, it's CFRA and Raymond James taking their turns at the upgrades wheel.

Let's look at what the analysts are saying about the No. 5 player in the housing industry.

Workers read a blueprint at a home construction site

Image source: Getty Images.

"But first, a few words from our sponsor..."

Actually, before we do that, though, let's see what KB Home itself had to say in Wednesday's announcement.

KB reported it earned $0.51 per share in its fiscal second quarter 2019 on sales of just over $1 billion. Granted, these sales were down 7% in comparison to last year's Q2, and profits were below the $0.57 per share earned last year. But Wall Street had been forecasting much steeper declines: only $0.40 in earnings on sales of $936 million.

The fact that KB Home didn't do nearly as bad as analysts had predicted is what sparked a 7.9% rally in the stock Thursday. And now, finally, a few words on what's helping to send KB Home up again on Friday.

Analysts chime in

Wall Street had nothing but kind words for KB Home yesterday after its earnings beat, as detailed in a series of analyst summaries provided by TheFly.com. Praising the strong Q2 results, Buckingham Research predicted that gross margin will improve at the homebuilder based on what it's seeing in the company's geographic mix of homebuilding locations, its improving sales volume, and the better prices it's selling homes for. Buckingham especially liked the fact that while sales declined, orders received in the quarter grew 15% -- foreshadowing stronger sales performance in the months ahead.

KeyBanc, meanwhile, keyed in on KB's rising community count and improved outlook for H2 2019 and 2020. With 255 communities under construction at the end of Q2 (up 21% from the prior-year period), the company forecast 15% to 18% growth in its community count year over year in Q3. On top of that, management predicted improved gross margin (up 0.7 to 1.3 percentage points sequentially) in Q3 -- followed by even more improvement in Q4.

Today's upgrades were a bit less enthusiastic. But even so, independent research firm CFRA removed its sell rating from KB stock after earnings, while investment banker Raymond James noted that "healthy" order growth is reducing downside risk. Both analysts now give KB Home shares the equivalent of a neutral rating.

What it means for investors

Overall, Wall Street is taking an optimistic tone after KB's earnings beat, with some analysts predicting the shares will go as high as $30 within 12 months -- and maybe they're right. After all, just a few months ago KB rival Pulte said that it, too, saw an "improving demand environment" in homebuying, supported by a "strong economic backdrop" in the U.S. -- and that was coming from a company whose net new orders were down 6% last quarter, not up like KB's orders were.

With KB shares selling for less than nine times earnings today, and management forecasting double-digit growth rates in the near term, the odds of this stock outperforming could be good.

That being said, two things still concern me. First, as Pulte management pointed out in its April report, seasonal upswings in home-selling activity in the spring and summer are "typical" -- and therefore not necessarily indicative of any longer-term trend in the market. I'm also more than a little bit worried by the fact that in KB's report, it didn't divulge a free cash flow number (and hasn't filed a 10-Q with the SEC containing that information yet, either).

Last we heard, S&P Global Market Intelligence was still showing KB's trailing-12-month free cash flow of $150 million in the February quarter -- less than half the $272 million it was reporting under generally accepted accounting principles (GAAP) as net income. If that hasn't improved in Q2 (and the declining sales and earnings kind of suggest it might not have), then KB Home stock could in fact already be selling for a much higher price-to-free-cash-flow ratio than its P/E ratio. (And that, of course, would imply that the stock is not as cheap as it looks.)

At a valuation of 15 times its last-reported free cash flow and a projected earnings growth rate of only 11%, I'm still more inclined to side with the analysts rating KB Home stock a hold than with those insisting that it's a buy.

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Rich Smith has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.