In an alternate investment universe from that of drug pipelines and patent fights, Warren Buffett-type companies that just keep on doing their thing fulfilling basic wants and needs of people offer investors simpler opportunities for income and capital gains.
One of them, Toll Brothers (NYSE:TOL), the subject of this article, may be special enough to move from a depressed P/E to closer to a market multiple, and if earnings continue to grow, the upside could be large - and this process just might be underway now.
Just think: Per TOL's annual report that's lying on my desk, Fortune magazine's 2016 Survey of the World's Most Admired Companies ranked this company, in an unglamorous industry, #6 for Quality of Products and Services.
The top 1-5 were in order:
Yet at a stock price of $34, a price first reached at the end of 2004, and then in the post-Great Recession period it has exceeded every year except last year (when it peaked at $33.5), TOL may be a value play as well as a growth play.
In addition, it now has some catalysts that could help the stock levitate to what I would argue is closer to fair value.
Background - A top-down bullish thesis for the builders
Probably the most complex absolute necessity of modern life is a home. Food, water, most clothing can be produced simply, off-site, and brought to one's home. Constructing a home, such as a single-family house or townhouse, to US building code standards, is quite a different matter. While small, independent homebuilders simply have to deal (for the most part) with getting business and hiring subs to do the work, national builders such as TOL need additional skill sets that over time create large intangible values.
Since every then-public homebuilder I know of except NVR (NYSE:NVR) peaked in or around Q3 2005, these intangibles have not been needed to a great extent, as in most parts of the country, the pace of building new homes, as opposed to lower-quality rental apartments, has been historically slow. Not only has it been slow on an absolute basis, but adjusted for population growth it has also been at depression levels. So, margins have been far from boom levels; pricing has been tough for this industry.
So the basic top-down bull thesis on homebuilding and associated businesses such as mortgage lending is a simple reversion to the mean: that the flexible American economy will respond to the need of a record percentage of younger adults living in their parents' homes and to the record low fertility rate. An accelerating economy would help this process, but is not really needed to move this process along. A simple reallocation of spending would do the trick when dealing with most home buyers.
This basic idea of reversion to the mean is not guaranteed, of course. It also applies mostly to builders such as NVR, the blue chip of the industry; and to D.R. Horton (NYSE:DHI), which recently regained investment grade status and which has had strong earnings trends recently.
To some degree, this thesis applies to TOL. In the next sections, I'll give a bullish argument for TOL to trade up to $40 this year and sooner rather than later to $50-60.
TOL is becoming more like NVR, but better
NVR, like TOL originally a northeastern/mid-central states builder that has grown internally and by acquisition, has had far superior stock market returns. Over the past 10 years, NVR has almost tripled, whereas TOL is up about 25%; neither has paid dividends. Over the past 20 years, NVR has risen from $13 to $1900, an incredible 28% CAGR. TOL, in contrast, has risen from about $4.80 to $34, a little over a 10% CAGR.
As a stable, profitable, intrinsically slow-growing company, NVR has given shareholders massive excess returns.
It has done this by focusing on capital efficiency. TOL is emulating NVR's focus on optioning land rather than buying it outright where possible. NVR has also done what has turned out to be a brilliant strategy. Year after year, until recently, NVR's stock sold at single-digit P/Es. It thus bought back its stock, then bought more back. In 1997, Value Line data shows NVR with 11.1 MM shares outstanding. Its projection for this year: 3.50 MM.
The Value Line data for NVR's annual revenues go back to 2001, when they were $2.56 B. Consensus estimates for 2017 are around $6.6 B, and with lower profit margins than in 2001. Yet the stock is up hugely since 2001, and the reason has to be capital efficiency.
One of the reasons I began looking at TOL again, and wrote about it last November when it was around $30, was that I noticed that it had begun emulating NVR last year by engaging in some buybacks. Diluted shares outstanding yoy from the end of fiscal Q1, which is Jan. 31, 2017, vs. 2016 dropped from 182 MM to 170 MM. These were done in the $28/share range.
Whatever strategy NVR can do going forward with about 10% operating profit margins (Value Line estimate), TOL can do better with 13% margins. Plus TOL has a wealthier clientele, which is always a positive.
To summarize, TOL indicated in the conference call that running the business rather than managing the stock remains its #1 priority, but it will run the business in a less capital-intensive manner. It will then prioritize at least a small dividend, which is beginning at 8 cents per share (almost 1% at the current share price), and then shrinking the float.
While share buybacks may be better longer term than dividends if TOL is growing, and with the stock near book value, for now, the dividend can do at least two good things for shareholders beyond the cash benefit. These include bringing institutions and other shareholders into the stock who cannot or will not buy a stock that lacks a dividend, and inducing people to hold the stock for a longer period of time. The latter point was specifically made by the company during the conference call.
TOL is enhancing capital efficiency in other ways while preparing to improve earnings predictability and operational robustness
As I read through the Seeking Alpha transcript of the conference call, I was alternately thinking that this company is now focused on managing the stock price as well as the business. For example, TOL has gotten into the business of partnering to build high-end rentals. These were said on the call to be condo quality rather than typical mid- or low-range apartments. TOL was asked how much of an ownership interest it would retain, and while on the one hand it wants to redeploy capital efficiently, my take is that on the other hand, it wants to have the ability to take (expected) profits as needed and desired either to manage the business and/or to help meet earnings expectations.
TOL has diversified. Besides condo-quality rental apartments, it has its City Living division centered in the NYC region, which involves building and selling apartments. It is an opportunistic investor in NYC, and is waiting for better land values before expanding operations there. It has a growing Active Adult division and a campus division.
To deal with economic strains in Houston due to Oil Patch issues, it has introduced a budget version of TOL homes that it calls Toll Select. These are less customized homes that do not offer access to TOL's local design centers. This will be rolled out to areas that need lower price points.
My impression is that TOL is showing good flexibility in meeting the needs of its pool of affluent buyers.
This includes buying Coleman Homes, based in Idaho, where for the first time in many years, TOL is selling homes below the $400,000 price point.
To the extent that it does JVs and the like where it contributes its know-how, reputation, some capital, and the like, the more it moves toward a superior licensing-type business model.
Operations are satisfactory
Understanding these are not boom times in the industry, TOL is reporting strong growth well into the double-digit range. Last fiscal year's (ends Oct. 31) results were depressed by a charge to do remedial stucco work in the Philly area; TOL reports this problem affected other builders.
Based on updated guidance, I'm in agreement with the analysts where consensus for this fiscal year is for $3.06 EPS and for $3.32 next year. This year's results are probably reasonably predictable; next year's more of a guess.
TOL reports minor problems with availability of skilled labor, but these problems are slowing delivery of its homes by a couple of weeks.
An encouraging straw in the wind for future business trends is that in Q1, yoy order trends accelerated each month. Management's views that things are getter better in several ways, and can improve further toward the boom years, came through in this exchange with an analyst:
Nishu Sood - Deutsche Bank Securities, Inc.
Thank you. Also wanted to touch on the really strong demand trends through the quarter. Thinking about the reaction to the rates and the change in economic environment, was wondering if you could shed some light maybe on the improvement in demand. Is it a greater conversion of traffic flow that's already been happening through your communities? Are you seeing a higher level of traffic flow driving it? And obviously, just trying to look for any potential clues on the consumer reaction to the macro environment.
Douglas C. Yearley - Toll Brothers, Inc.
Nishu, good question. Traffic is up a little bit. And the conversion is up a little bit which means the quality of the traffic has improved, and it's reflective of the better results. Nothing dramatic. Traffic numbers are still lower than they were a decade ago. I'm convinced that's because of the Internet and the ability to do most of your buying or screening online before you spend the time to visit the model. But we're encouraged by traffic trends. We're encouraged by conversion ratios. Remember, rates went up a half a point back in November and then they stabilized in the beginning of this year.
And so we're very encouraged by the year-over-year acceleration that I just mention on the first question for Mike because January had the most acceleration of this quarter in orders. And that was after rates had pretty much flattened. So that pull forward of demand because people fear a rate increase, you really would have thought would have occurred in November into December. But when you look at the trends we had throughout the course of the quarter, once the rates had settled in, very encouraging.
TOL has a good mix of sensitivity to rates. It estimates that about 56% of the total monies spent to buy its homes are financed with a mortgage; the rest either from all-cash purchasers or from down payments that average 30%.
So my "lower for longer" projection for interest rates can work well with TOL. If I'm right, it has good sensitivity toward lower mortgage rates; if I'm wrong and rates surge, at least TOL is less sensitive to this adverse trend than its peers.
A major point about the builders is that historically one year's EPS is almost meaningless.
TOL's value historically is bounded by book value
The old dictum was that builders were worth at least book value, which traditionally was land plus homes under construction, plus net cash or minus net debt, etc. So if an investor was interested in this small part of the investing universe, one would look to buy them typically during or after recessions, when times were cyclically tough and prices of the stocks were low, and sell them near 2X book. In the bubble, a new paradigm was promoted, and in that bubble, TOL reached above 3X fiscal year-end book.
Using Value Line data going back to the late '90s, TOL has typically reached at least 40% above book value during the calendar year in which the Oct. 31 fiscal year ends. In a number of non-bubble years, it has traded at double book at the peak, and sometimes the range has been between book and twice book: a large range.
Given the dividend and effects on calculation of book related to repurchasing stock, I am estimating year-end book this fiscal year for TOL of $29+ and $32+ for 2018.
Using what historically is a hair-shirt top trading range for the year of 40% above book, that gives me upside targets of $40+ for this year and $45-50 for calendar 2018.
Downside trading ranges have typically been bounded by book value. At around $34, there certainly is downside risk to the stock based on that, and that risk could extend to next year.
So indeed I am looking upward; I do that in part because that's how the average stock is trading.
TOL can speak for itself in its 10-K and other regulatory filings, and other disclosures such as in the latest earnings report.
The biggest risk for a builder is that with billions of dollars invested in land, though little spec building underway, another serious recession could force another round of liquidation of land inventory at significant losses. But there are plenty of other risks that fall short of the 2007-8 era catastrophe for TOL's industry.
Concluding thoughts - why TOL might come into favor
There are only so many themes that Wall Street can glom on to. It can pump up break-even or money-losing "glamour" stocks, including the one on the 10 most admired list mentioned in the introduction to the article, but eventually either the companies will deliver the goods or get acquired, or the Street will want to move on.
With TOL, my guess - and it's just a guess as a long-time industry-watcher and occasional real estate investor - is that reasonable economic times means that its book value is solid and could be undervalued. After all, land suitable for residential development tends to appreciate gradually over time.
But, on top of that, as was mentioned above, TOL has been in business 50 years and has developed its niche as the nation's leading large-scale luxury and near-luxury home builder. In doing so, it has gained all the knowledge than NVR and DHI have about how to deal with different parts of the country in beginning with raw land and ending with a community of finished homes. But it also has a more differentiated practical knowledge base of how to perform large-scale semi-custom home building, and before that, how to sell the sizzle so that homebuyers are upsold to the most expensive (most profitable) add-ons in addition to getting maximally hungry for a premium price house. These and related skills TOL has that few if any other public builders have. They have to be worth a substantial amount.
That begs the question of whether Warren Buffett or another industry consolidator might find TOL to be an undervalued juicy morsel.
Looking at the stock market from a top-down perspective, the latest S&P data put the "500" (NYSEARCA:SPY) above 24X TTM EPS using GAAP, and my guess is that would translate to about 21-22X current year EPS. Whereas TOL is at about 11X current-year EPS estimates, and it's growing revenues at double-digit rates yoy.
If the market is reasonably right that these are times to be optimistic about the economy, corporate profits, and the persistence of above-average valuations, then at some point, TOL and other builders can easily see their valuations move up in line with the anticipated generally positive economic times.
Now that TOL is finally showing real interest in its stock price, perhaps the trajectory of TOL could move more like NVR and begin to attain a higher valuation.
So the bet on TOL involves some combination of:
- Reversion toward the mean for family formation and housing production,
- more shareholder-friendly actions by the company,
- reasonable economy, and
- recognition of TOL's intangible as well as tangible assets.
The homebuilding industry has probably been the laggard amongst all major industries since peaking in 2005 and only partially recovering. With a major builder ETF (NYSEARCA:ITB) hitting multi-year highs, and note it also includes home-related retailers such as Home Depot (NYSE:HD), I'm long TOL on the premise that it could well rebound back at least to its 2015 high around $40-42, possibly this year. If that does not happen, there's always next year.
Thanks for reading and sharing any comments you may have.
Disclosure: I am/we are long TOL, DHI, HD, AAPL, AMZN.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Not investment advice. I am not an investment adviser.