Toll Brothers: Cautiously Optimistic After The Post-Earnings Drop

Summary

• Toll Brothers declined more than 14% after reporting slower than expected earnings.
• The company saw strong new orders growth and expects a stronger housing market going forward.
• While the market is currently very hostile, I expect the stock to bottom around current prices.

Toll Brothers (NYSE:TOL) is one of my favorite homebuilding stocks. Not because this is the best stock to be long (it is not), but because the company is focused on high-income customers and is selling houses at much higher prices compared to its competitors. This makes the stock a great tool to track homebuilding activities in that segment. Unfortunately, while I have been a homebuilding bull for some time, this stock has not been on my buy list as I discussed in my article published in December of 2019 as well. High-ticket housing is not the place to be, and Toll Brothers' long-term underperformance is only further supporting this case. Either way, the just-released first-quarter results show that earnings came in below expectations while new orders accelerated. The stock sold-off immediately in an already ugly environment thanks to the coronavirus. Nonetheless, I believe the sell-off has priced in a lot and considering that housing is recovering due to low rates, I think this stock is turning slowly into a buy.

Source: Toll Brothers

What Happened In Q4?

One of the reasons why Toll Brothers has underperformed its peers is its focus on more expensive homes. Only 21% of total deliveries have a price tag of less than $500,000. The company offers these homes in 23 states and 50 major housing markets. In 2019, the company added 7 new markets. Besides the company's large domestic exposure, it needs to be said that the company is servicing clients with a high FICO score. On a full-year 2019 basis, the average FICO score was 762. 22% of transactions were done with cash buyers.

With that said, let's look at the company's results. As you can see, the past three quarters all showed negative EPS growth. The just-released fourth-quarter earnings came in at $0.41. This is below consensus expectations of $0.46 and 46% lower compared to the prior-year quarter.

Source: Estimize

The earnings miss was mainly caused by lower than expected sales. Total sales also had their third consecutive quarterly decline. Int his case, sales totaled $1.33 billion. This is significantly below the expected number of $1.44 billion and 2% below the prior-year quarter. The reason for this miss has to do with the fact that some deliveries slipped into the second quarter according to Douglas C. Yearley Jr - Chairman and CEO of Toll Brothers.

Unfortunately, investors and traders pushed the sell-button as the stock declined more than 14% after earnings. This erased all 2020 gains (and more). While I am happy I did not become a Toll Brothers bull, I think the sell-off has priced in a lot of bad news.

Source: FINVIZ

I am saying this because there is much more to it than just bad sales and earnings. What I care about are new orders as these numbers say a lot about general homebuilding/housing strength in the US.

Toll Brothers reported net signed contracts for 1,806 units. This is an increase of 31% compared to the prior-year quarter. The contract value of these new orders was up 28% to $1.49 billion. The average price per unit was roughly 825,000, which once again emphasizes the company's target audience. Nonetheless, as new orders value underperformed new orders in units, we see that the ongoing pressure on prices is continuing. Another example is new orders growth in California where the company reported 32% higher orders (units). The dollar value of these orders was up 'only' 10%.

On top of that, the company expects adjusted gross margin in the second half of the FY2020 to improve by roughly 100 basis points compared to the first half as a result of an improved selling environment that started at the end of the 2019 fiscal year. Even pricing power is expected to accelerate. The total community count is expected to be up 10%.

Macro Is The Company's Biggest Tailwind

My favorite indicator to track future homebuilding sales and earnings is the year-on-year growth rate of nationwide building permits. As filing for a permit is one of the first things a future homeowner/homebuilder does, it tends to predict new orders of homebuilders very well. As you can see, in the second half of the 2019 calendar year, momentum started to shift to the upside resulting in building permits growth of more than 10%. The latest January data shows a surge to 18%. This is one of the highest growth rates since 2013.

As a result of this ongoing surge, I believe the company is right as both new orders and pricing are more than likely to recover and benefit sales and earnings in the second half of this year.

Takeaway

While I always liked the company's decision to stick to a high-income niche market, I have not used the stock as a trading vehicle. I liked companies that were able to catch lower-income/price demand as this market benefited more during the past period of falling housing prices.

Regardless, I think a lot of bad news has been priced in after the 14% post-earnings decline. The company is not reporting anything that could hint at prolonged troubles rising net income and I think the ongoing surge in new orders will continue to boost the company's bottom line.

After the recent stock price implosion, I think the current valuation of 9.4x earnings and 8.4x forward earnings is attractive. I am not buying but believe selling has gone too far. If you had this stock on your watchlist and are waiting for an entry, I think now could be a time to start buying a small number of shares. Keep in mind that the ongoing coronavirus uncertainties are doing a lot of damage to the market in general. Don't go overweight any cyclicals, but start buying small numbers of shares first. I look forward to seeing how Toll Brothers is doing in a much stronger market than 2019 and hope to see higher guidance in the next quarter.

Stay tuned!

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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