Homebuilder Toll Brothers: Attractive At Current Levels? (TOL)

Feb.23.06 | About: Toll Brothers (TOL)
Toll Brothers (NYSE:TOL) makes McMansions, they make lots of them, and they make them on land that they buy pretty cheap -- usually through options rather than direct purchase. That means their land purchases are low risk (they have the right, but not the obligation, to purchase and/or develop the land).

The big picture here is the overall housing market in the US. Many think it is about to tank. Many of those same pundits have thought that the housing market was on the verge of tanking for each of the last 8 years. The housing boom has been stimulated by demographics, interest rates, and wealth conversion (stock market profits going into real estate):

● Demographics - The American Dream is to own a home in the suburbs, once you are old enough to have kids. Has that changed with the current generation? No. Are there more Americans today? Yes. Look around. Are any serious population centers that you know of dying? I'm betting on the continued need for new homes.
● Interest Rates - They were very low, and have now come back up, but mortgage rates over that span only shifted about 2%, since the long bond has held steady. Mortgage risk is not like it used to be, due to mortgage backed securities and various risk derivatives based on them. That means lenders are not as scared of you, don't demand to be paid richly for their alleviated fears, and hence keep their rates down. Greenspan was trying to kill off the housing market, but he's gone. Could high interest rates kill the sector? You bet. Will they? They are just about topping right now, and there has been no serious signs of a mortgage default wave. Borrowers are still servicing their debt, so the market seems to be saying that the current levels are sustainable. Historically, too, the current mortgage rates are perfectly reasonable. This is not the 1970's with 17% inflation.
● Wealth Conversion - If the stock market tanks, real estate is a refuge. If the market soars, people pull money out and buy houses. The truth of house prices is that the median never goes down (at least from the 1960's - as far back as I've looked). A curve of the median house price in any area (that I've checked) over time looks like a staircase. It shoots up for a few years, then plateaus for a few years, and then repeats. It does not drop. During the up phase, both low and high priced houses go up. During the plateau phase, low priced houses still go up toward the median, and high priced houses go down. So, the only place to fear the housing sector is at the top end in a stagnant market.

By 'top end', we mean prices greater than about twice the median price. The true mansions. From what we can tell from looking at the listed prices of homes offered by Toll Brothers in areas where we know something about prices, they offer homes for a good premium above the median, but not into the danger zone of crazy prices. And the homes they do offer are lavish for those dollars. So, the story as I see it, is that the trends are in Toll Brother's favor, and their products are top notch in the market but not extreme. They definitely have vulnerability, but the story is nevertheless, good.

As an aside, we would note that much of the housing market scare mongering has been propagated by the NYTimes, which we use as a contra-indicator. As another aside, most of the headline housing economic numbers get reported as seasonally adjusted, and those adjustments tend to be noisy. It's better to just look at the actual numbers, averaged over a few months or the last year.

Company: The big news is that the inventory of new homes is up, and Toll Brothers' signed contracts are down. That is off of record numbers, and may suffer from the seasonal adjustment issue. A thorough analysis would require looking at which geographic areas they derive their profits from in conjunction with the market supply overhang in those markets, discounting demographic and other economic trends in those areas that may soak up that extra supply. That analysis is more than we want to do, and it is likely to be fraught with errors. We'll just note that they are operating at near record levels. They report quarterly numbers today, but we think of them more as a multi-year play.

We think they are Solid, but we have not really made the case here.

Stock: This is the real reason to be interested in TOL. They are down about 50% (to ~$30) from their 2005 peak (~$60), up about 50% from their 2004 levels (~$20), and up about 200% from their 2001-2002 levels (~$10). Their long term trend is up. They definitely went through a speculative excess in late 2004 and 2005 as hedge funds piled on, and have now been dumping.

Also, from a chartist's technical standpoint they show a head-and-shoulders top, indicating a possible further drop. We view most charting techniques as unscientific pattern matching with no real criteria most of the time, but if enough people believe in it it can nevertheless become self-fulfilling. Thus there is definite further downside risk, but at a current P/E of about 6 (but housing stocks are always at low P/E's), we're thinking of dabbling, particularly if there is some froth regarding their earnings on Feb 23.

TOL 2-yr chart: