- Relative to earnings and revenue growth, the stock looks cheap;
- Stock has been locked in trading range for 2- 3 years.
- QE3 was targeted at mortgage market - Taper could be having impact.
- New single-family home data has been gradually slowing.
Toll Brothers (NYSE:TOL), the high-end homebuilder reports their fiscal Q3 '14 earnings before the bell on Wednesday morning, September 3rd, 2014 with a conference call to follow early Wednesday afternoon.
Per Thomson Reuters, analyst consensus is expecting $0.45 in earnings per share (NYSEARCA:EPS) on $987 million in revenue for expected year-over-year (y/y) growth of 73% and 43% respectively.
The consensus analyst estimates for the 3rd quarter have come down since May '14's last report, when expectations for the third quarter, were $0.47 in EPS and $1.033 billion in revenue.
And therein lies the conundrum: our / my internal valuation model puts an estimated intrinsic value on TOL of $54 per share as of the May '14 results, which means - at least according to Trinity's model - TOL is trading at a 34% discount to estimated intrinsic value, while Morningstar's intrinsic value estimate as of the May '14 report was or is $27 per share.
Some readers have been critical of Morningstar's discounted-cash-flow (DCF) valuation model, which I think isn't a correct or accurate assessment of either Morningstar's methodology or their intrinsic valuation estimates. In fact I think the Morningstar model is quite good, but Trinity's model is different in that I try and put a premium on earnings growth and forward earnings estimates, while a true DCF model attempts to look through a growth cycle for longer periods of time.
We can argue the merits of that approach forever, but it is why we use both valuation estimate models for clients, since it gives me two different perspectives not to mention the other valuation metrics used such as p.e ratio's, book value estimates, cash-flow valuations and such.
I'm talking out loud a little but here, but the point of this discussion is that if you (as an investor) put a premium on earnings and revenue growth, TOL, like a lot of housing stocks, looks cheap at its current price. If you the reader (as an investor) put a premium on life-cycle or "absolute value" investing (and expect interest rates to normalize at some point) then TOL looks overvalued. TOL and the rest of the homebuilders are typically valued as a percentage of tangible book value, where TOL today is trading about 1.7(x) book value, with no material goodwill on the balance sheet that I see, thus the stock looks overvalued by 30%.
And the fact is, this can be an issue with all uber-cyclical stocks and sectors.
Here is the last 5 quarter's y/y revenue and EPS growth for TOL:
Toll Brothers y/y Revenue and EPS growth
* Source: internal spreadsheet from earnings reports
Selling all of our homebuilder and housing exposure in May '13 as these articles detail here and here, has been a good call so far, for other reasons, besides just valuation. Technically TOL has been stuck in a trading range since late 2012's, early 2013 high of $38.36, and the early October '13 low of $29.64.
Some housing related metrics like order growth and y/y change in average price of homes delivered, have started to slow from lofty levels, but investors are still looking at high-single-digit order growth and decent new home price appreciation.
The July New Single-Family Home Sales report released on 8/25 noted that new home sales fell 2.5% in July on the back of an upwardly-revised June '14 number. The median and average price of new homes sold rose between 2.5% - 3%.
Part of the reason for the partial slowdown in some of the metrics, is that as QE3 is "tapered", the Fed, according to former Chairman Ben Bernanke's own speeches around the time QE3 was initiated, noted that the stimulus was targeted to the mortgage market, and in particular mortgage spreads.
The point being that the fact that housing metrics are softening a little one year into the taper of QE3, shouldn't be a big surprise.
To conclude, the PEG metrics of the homebuilders like TOL and the other homebuilders are appealing, but we haven't repurchased the sector at all, since selling last year. The earnings and revenue growth are robust and the multiples on the stocks look cheap:
Toll Brothers consensus forward revenue and EPS expectations
|Rev est||y/y gro||EPS est||y/y gro|
* Source: Thomson Reuters current consensus expectations
At $36 per share, TOL is trading at 21(x), 16(x) and 13(x) the above forward EPS estimates - quite a discount to current growth.
I do suspect the current multiple and the current stock price action is probably predicting slowing housing activity over the next few years. Mortgage standards are still very tough from what I've read, and that probably won't change.
TOL has the best balance sheet in a sector where very few if any companies are rated investment-grade credits. TOL has the chance to refi a lot of debt and lengthen maturities in this interest rate environment.
We are going to stay out of the sector until I can either pick up TOL for clients in the high $20's or there is a clear, higher volume breakout above the high end of the range.