Toll Brothers Remains Surprisingly Unscathed

The housing crisis is where the financial meltdown started and some analysts speculate housing is where the recovery must begin. Implosion of the subprime and “Alt A” mortgage markets (loans made to lower-quality borrowers) began the painful decline in property values that continues as many regions of the country have a gross oversupply of housing inventory. Until this imbalance in the supply and demand equation is brought down to more reasonable levels, expect continued downward pressure on residential real estate values and continued pain for the overall economy.

The crisis that started in housing has rippled out into nearly every facet of our economy—and that of the world as a global recession appears underway. It should come as a surprise that while the S&P 500 is down 38% for the year and the Dow Jones Industrial Average has lost a third of its value, the stock of luxury homebuilder Toll Brothers (TOL) is down only 9% during the same time period. Seriously, just 9%! TOL has swung wildly over the last year but somehow has largely remained relatively unscathed. It’s not that business has been booming, far from it: Toll Brothers reported earnings Tuesday that show just how bad things are. Revenue dropped 41% from last year and the company declined to give any sort of earnings guidance going forward. With housing starts at multi-year lows, the company reported that its backlog of business fell 54% to $1.33 billion from $2.85 billion. Total contracts also fell 27% since last year. While everyone would like to see a bottom in the housing market, judging from TOL’s latest quarter, we are not going to see one anytime soon.

In a blog posted June 4th, we wrote about the CEO of Toll Brothers calling for government action to stem the misery in the residential real estate market. He is still waiting for a “bailout” and conditions continue to deteriorate. Tuesday, Robert Toll called again for a government lifeline (take a number!!!), saying, “We believe the government’s attention should be focused on shoring up the housing market, which is the root of the current financial crisis.” We said it then and we will repeat it now, it is doubtful that the government is going to bail out home-builders. The origins of this crisis are many but builders like Mr. Toll must take some of the blame as overbuilding created the overhand of inventory which is so problematic now. Thus, builders should have to endure some tough quarters and not encourage government action which will only delay the inevitable reckoning in the marketplace.

Frankly, it is a surprise to us that Toll Brothers' stock has not been hit harder, considering its abysmal results and no guidance going forward. The stock didn’t even react negatively to Tuesday’s results and is actually up slightly versus the broader indices, which are negative. To be fair, the stock did take a nosedive from mid 2005 through the middle of 2006, but its performance has been virtually flat since then. Is it possible that the market accurately priced in a meltdown in the housing market almost two years ago? We think not, which is one of the factors which led us to downgrade TOL to an Overvalued rating in this week’s report.

We believe that the fundamentals simply do not justify this price, especially in this bear market. It is certainly uncommon in this market for a stock to be trading at levels that are above its historical valuation metrics. For example, over the last 10 years, TOL has normally traded between .61-1.17 times revenue, but its current price-to-sales number is slightly higher at 1.18x. This overvalued condition is more pronounced when looking at price-to-cash flow. Historically speaking, Toll Brothers has traded in the range of 13.47x to 25.7x for price-to-cash flow but the current level is 28.6x.

Generally, we are contrarian investors and believe that the market has overreacted negatively to many of the stocks we follow. However, we believe that in the case of Toll Brothers and other overvalued homebuilders [Pulte (PHM), Lennar (LEN), DR Horton (DHI)], the market has not dealt with them harshly enough for their severely crippled businesses with little near term hope of recovery.

Comments

[DussaultCap...:]

I mostly agree with this article except for the comment about homebuilders being responsible for overbuilding. A credit bubble of easy money and artificial speculative demand are the cause of our current oversupply. The homebuilders were just supplying the product that their customers wanted. Of course they made tons of mistakes along the way like getting caught at the top of the bubble with lots of land and spec homes, but you can hardly fault them from building homes when there were people with money (loans) who wished to buy them. That's their job!

2008 Nov 12 09:37 AM

[RPK:]

The stock probably has not declined that much since the company's debt level is relatively low, still has a positive cash flow, and has approximately $1.5B in cash.

2008 Nov 12 12:26 PM

[nyka:]

I, too, have observed Toll's stock price over the last several months, and wondered aloud why it remains virtually untouched by the bloodbath affecting virtually every other stock. Would I buy this stock seeing that it's apparently immune from the slaughter? No thanks.

2008 Nov 12 05:54 PM

[Did U Think...:]

Good call.

2008 Nov 13 02:59 PM

[bobbobwhite:]

Yes, all stocks will eventually be hit hard. Toll is one of the last standing, but will fall as Wall Street continues to seek out those still high enough to be shorted for big profits. Nothing is immune nor sacred in the obscene pursuit of the dollar.

Wall Street will then decide when to change directions and go long thus making more obscene profits from the retails. So it always goes, and retails continue to buy in to the game that looks so good on the surface but eventually takes their money, like now.

2008 Nov 14 09:49 AM

[a believer:]

Housing (which drove our domestic economy - houses are made of many things not easily shipped in from China) is in a multi-year, maybe decades-long decline.

In our area and I suspect across the country, the McMansions are being-reoccupied by the baby boomers' children, who could never afford a new house at today's service economy wages. I suspect that many, just like their parents, have poor money management skills. After all, most are still betting on the 10-20% returns they had been promised (by the financial services industry, of course) 'buying-and-holding' stocks.

2008 Nov 16 05:55 PM