Selling Toll Brothers on Good News

Yesterday the news came out that Toll Brothers (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 (KBH) and Ryland (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

Comments

[FLbuilder:]

Tom -

Good analysis.

Curious question for you though. How are you valuing KBH that makes it seem attractive to you? For example, when I value KBH just purely on its last quarter-end Book Value - it comes to about $9 per share ($683M in equity and 76M shares outstanding). KBH lost about $75M last quarter and that was with only $5M or so in impairments. I think you can assume that best case, they lose $50M a quarter for the balance of 2009 and end the year with about $580M in equity and a book value of $7.60. I doubt you would tell me that you would want to own KBH at $18 per share or 2.4x book value.

So I am curious how you value KBH and why you would own them.

Using your same scenario as you laid out for TOL - we could assume that KBH would have revenue of about $2B in 2010. You dont go into this much detail, but I can assure you that none of the homebuilders (besides NVR maybe) will make more than 15% gross margin on there sales for a very long time...until sales prices go up at least.

So KBH would generate $300M of Gross Margin (incredibly best case scenario). This past quarter they had about $75M of SG&A expense. So lets assume that at the very least, if they are growing there sales they will have a flat SG&A so annualize this past quarters run rate of $75M and you get $300M of SG&A expense.

Take the $300M of Gross Profit LESS the $300M of SG&A and you have 0 income. This is before any asset impairments or interest expense. In fact, I would tell you that I would expect KBH to lose around $100M in 2010 just from operations. Worse if they continue to impair land.

Just curious to see if I am missing something because I think KBH is the most over-valued homebuilder out there right now and you obviously feel differently.

Thanks

Aug 13 11:16 AM

[Tom Armistead:]

Very good questions. I am not entirely self-consistent in dealing with the homebuilders.

Doing the same recovery EPS estimate for KBH, I get estimated 2009 revenue at 1.655 billion, increase that by 33% for a recovery, allow net income as a percent of revenue of 4.4%, divide by 89.6 million shares and arrive at $1.08 X 15 = 16.20. That's done the same as how I did an estimate of TOL's recovery earnings.

I have been able to sell calls at 20 for amounts between 1.00 and 2.30 repetitiously over the past year, bought shares for as little as 9.73 on 3/12 so what I see is a rent to own operation, I own the shares, rent them out by selling the calls, and at 20 the lucky winner can claim his prize.

KBH has taken draconian writedowns. Over the years they have traded higher as a multiple of tangible book than TOL. I get an average multiple of 2 X tangible book for KBH over the course of the last 10 years. Tangible book when last I checked it 12/08 stood at 10.69, by now it is probably lower. But instead of using 1.5 X as a target here I have been using 2 X, based primarily on the historical multiples on this metric.

KBH is also "HTB."

Checking back I have sold KBH at prices from 13 up to 16.95 since June, so I am not as bullish on the stock as I may have sounded. Maybe if the stock goes back down to where I can get over $1 for selling 12.5 puts I will sell some, agree to buy the share back for less than I sold them.

The only explanation I can suggest for KBH's current price is that some market participants see "phantom" book value, large profits in the offing if KBH is able to sell houses built on land that has been marked down well below the cost of developing a new lot.




On Aug 13 11:16 AM FLbuilder wrote:

> Tom -
>
> Good analysis.
>
> Curious question for you though. How are you valuing KBH that makes
> it seem attractive to you? For example, when I value KBH just purely
> on its last quarter-end Book Value - it comes to about $9 per share
> ($683M in equity and 76M shares outstanding). KBH lost about $75M
> last quarter and that was with only $5M or so in impairments. I think
> you can assume that best case, they lose $50M a quarter for the balance
> of 2009 and end the year with about $580M in equity and a book value
> of $7.60. I doubt you would tell me that you would want to own KBH
> at $18 per share or 2.4x book value.
>
> So I am curious how you value KBH and why you would own them.
>
> Using your same scenario as you laid out for TOL - we could assume
> that KBH would have revenue of about $2B in 2010. You dont go into
> this much detail, but I can assure you that none of the homebuilders
> (besides NVR maybe) will make more than 15% gross margin on there
> sales for a very long time...until sales prices go up at least.<br/>
>
> So KBH would generate $300M of Gross Margin (incredibly best case
> scenario). This past quarter they had about $75M of SG&amp;A expense.
> So lets assume that at the very least, if they are growing there
> sales they will have a flat SG&amp;A so annualize this past quarters
> run rate of $75M and you get $300M of SG&amp;A expense.
>
> Take the $300M of Gross Profit LESS the $300M of SG&amp;A and you
> have 0 income. This is before any asset impairments or interest expense.
> In fact, I would tell you that I would expect KBH to lose around
> $100M in 2010 just from operations. Worse if they continue to impair
> land.
>
> Just curious to see if I am missing something because I think KBH
> is the most over-valued homebuilder out there right now and you obviously
> feel differently.
>
> Thanks

Aug 13 11:50 AM

[HOBBorg:]

With all of the allegations of KB Homes legal woes over defective construction, federal investigations, toxic loans, and illegal manipulation of home appraisals in KB developments; why would investors continue to gamble on their stock.

Aug 16 11:45 AM