Selling Toll Brothers on Good News

 |  Includes: KBH, RYL, TOL
by: Tom Armistead

Yesterday the news came out that Toll Brothers (NYSE:TOL) is getting increased sales orders for the first time in 16 quarters and that cancelations are now down to levels last seen before the housing meltdown. Shares rallied, predictably, about 15%.

I have been playing homebuilders on a price to book theory, buying them at a price to book of less than 1 and looking to sell at a ratio of 1.5 or better.

Massive writedowns have made this strategy problematic, although I have acceptable results based on selling a lot of covered strangles over the past year averaging in at the market low points. My other homebuilder holdings are KB Homes (NYSE:KBH) and Ryland (NYSE:RYL), and I recently sold covered calls over my entire holdings of those two.

Toll has taken a lot less writedowns than the others, and perhaps for that reason is trading lower to its tangible book value per share, 20.18 at the end of 2008. I have now come around to the belief that any homebuilder's physical assets should be valued based on their abiltiy to generate income going forward.

For TOL I take projected 2009 sales of 1.5 billion, increase them 33%, and then apply 8% net income as a percentage of revenue, divide by 161 million shares, and arrive at a recovery EPS target of $1. 1 X 15 (generous for a homebuilder) is 15 and the stock is trading above 23 per share as of yesterday's close. So if these assets don't generate enough EPS to support the current share price in a recovery situation then I would question whether the assets have the value claimed.

I sold calls at 23 on a good part of my position and then started selling off the remainder, maybe today if it goes up I will sell the last of the shares that don't have calls written over them.

Also TOL is classified by my broker as "HTB" (hard to borrow), which means it is so popular to borrow and sell short that the supply of shares available for those purposes is limited. Good for creating a short squeeze but not exactly a vote of confidence from some of your smarter players. My overall results on HTB type stocks have been deplorable.

See TOL's Q3 outlook call transcript here.

Disclosure: long TOL, KBH and RYL, short calls on all, reducing TOL