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[This article first appeared on Minyanville.] After reading my recent comment on Toll Brothers (TOL), I received the following counterargument from a reader:

Toll builds to suit in most of its communities, thus putting itself in a position of carrying low amounts of inventory unlike virtually all other national builders. You don't have to give huge incentives to move a house that hasn't been built yet because you are giving the buyer choice!

This is an interesting observation. Let’s say the reader is right and Toll Brothers doesn’t build spec houses; all the houses are custom-built to order and it faces very few cancellations. Would this practice put the brakes on price declines? No. Toll Brothers competes against a small army of homebuilders that are facing cancellations of already built houses. A flood of new homes and a drop in demand caused by a cooling of the housing market have created significant pressure on house prices.

Toll Brothers' to-be-built houses will face competition from lower-priced, already built and/or to-be-built houses from struggling competitors. If other builders give incentives or lower prices to sell their houses, Toll Brothers will have to lower prices to be competitive -- unless its houses offer unique qualities like premium waterfront lots or much higher quality.

Toll Brothers may decide to abstain from selling houses at lower prices. It will then sell much fewer houses and its earnings will suffer. Unfortunately for Toll Brothers, industry structure is a function of the actions of all competitors, not just the stronger, wiser ones. Weaker, less disciplined competitors can destroy value for the whole industry. They’ve done it before and will do it again.

TOL 1-year chart:

Vitaliy N. Katsenelson may have a position in the securities mentioned in this article.

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Source: Custom-Building Won't Halt Price Declines for Toll