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We have upgraded our rating of KB Home (KBH) from Sell to Hold after an increase in our expectations for the company through 2016. We increased our operating income outlook from $100M to $150M, based on the company's latest results, as well as upped our expectations for the rest of the year, as new home sales are outperforming our original expectations for the year. Depreciation numbers were better than expected and free cash flow has drastically improved this year. KB Home, typically, appeals to first-time homebuyers, so it has struggled compared to other home-builders, but the latest round of earnings saw backlog up 22% and selling price up 9%. At the same time, this company is still losing money, and we believe that until profitability becomes consistent, the stock is still a Hold.

Ticker: KB Home (KBH)

Rating: Upgrade from Sell to Hold

Price Target

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Value is hard to determine on losing companies, but it looks pretty fair with a lot of growth priced in over the next five years. One thing that is helping the company is getting lending. The company made Nationstar Mortgage (NSM) its main lender in March, and that lending seems to be going very well. This news came after Metlife (MET) closed its operations. As that relationship grows, it will only help the company.

Outlook

The company seems to believe that things are improving for them. Comments from the company's CEO seem to suggest recovery is on the way:

"The overall housing market appears to have largely stabilized and is moving into a period of recovery. Dynamics have improved significantly over the past 90 days, as compared to late last year, or early this year, with declining inventory levels and heightened consumer demand."

Profitability

Margins remain obviously low for KB Home due to its losses, but we are seeing improvements in gross margin and ROE for the company this year. Operating margins have declined slightly, but they have improved in the TTM. We should see higher profitability in the second half of the year. The company scored a 31 on Profitability out of 100, which was ranked 9th out of the home-builders. At this time, profitability still remains quite weak for the company.

Value

Value appears pretty fair, but with income negative right now, value indicators do not really show very much for the company. The company is pricing in around $175M in growth in operating income through the next five years, which is very obtainable.

Growth

KB Home ranked 9th out of 12 in our Growth indicator with a score of 22. The company, while starting to show some growth, has not shown any consistent income. The housing recovery, additionally, cannot improve drastically without jobs increasing.

Financial Health

KB Home's financial health is the worst in the residential construction industry due to its high levels of debt that are not decreasing with negative free cash flow. The company has posted an FCF increase, as well as improved its current ratio. The company's debt-to-equity ratio though has increased this year thus far. The company could do a lot for its equity value by decreasing its debt. Even a 25% reduction in debt would increase our model's price target 50%. Most other residential construction companies did a much better job at reducing debt than KB Home.

Source: KB Home Upgraded To Hold, Profitability Phase Beginning For Company