Toll Brothers Taxes Homebuilders

By Dr. Duru written for One-Twenty

February 8, 2006

Just a few days ago I wrote an article suggesting that a trading bottom could be near in the stocks of homebuilders. Somehow, I forgot to point to the action in the stock of Toll Brothers (TOL). It also had a nice bounce in price on high volume in a weak stock market last Friday. But on Monday, the market took it all back, and on Tuesday the awful truth came out: TOL's business still stinks. This news likely caused much of the sharp declines in housing stocks across the sector on Tuesday.

I have written about TOL before. Last November, I "applauded" TOL for admitting that it was seeing a slowdown in business. Since then, the majority of TOL's competitors have reported good earnings numbers and have predicted more of the same for 2006 and even 2007. One big difference is that TOL focuses on the luxury market. This segment of the housing market is typically first to get hit by a slowdown in real estate because these high-priced products are essentially discretionary. When folks start to feel poorer, they will either postpone the purchase of that dream mansion, or they will get real and buy down to a more affordable home (or if they are lucky, they can get a seller to bring prices back down to earth). I have also read several analysts defend the homebuilders by stating that a slowdown in housing may not hurt results of the bigger players as they continue to take share from the smaller players. Regardless, I believe that TOL is "the canary in the coalmine," and we have all the proof we need that the housing boom has least for now.

So, what about Friday's tease? Is there or is there not a bottom looming in homebuilding stocks? Well, take a look at the fundamentals and the charts for yourself. When I looked at Meritage (MTH), I noted the important line of support that was getting tested. (For you technicians, I should emphasize that the daily pattern I pointed to was a bullish engulfing candlestick pattern. I printed "not" instead of "note" on the chart. Also, take a good look and you will see a dangerous head & shoulders top forming!). I also noted a big run in the stock over the past six years. If MTH is making a bottom, it is a shallow bottom compared to the long-term chart. All it would take is for MTH to declare a big miss in earnings forecasts for the market to send the stock cratering by 20% more. Such an event would justify the extremely low P/E ratio of the stock. But if MTH can continue to muddle along, eventually all the negativity surrounding it must burn off and dissipate. The same logic applies to most of the stocks of the homebuilders. However, TOL's problems tell me that MTH's troubles are not over, and the stakes have now been raised in this bottom-calling game.

Let's take a look at the key issues that TOL mentions in Tuesday's earnings warning. I see both trouble brewing and hooks for clining to hope. I encourage you to read the press release in its entirety for yourself especially for the specifics on the financials. Some of my notes come from listening to the actual conference call and the question and asnwer period with analysts (it was a loooooong call, and I can tell from the articles in other media outlets that no one endured the entire thing...if they bothered listening at all).
  1. Signed contracts declined by 21% year-over-year but this was down from record levels and represents the second highest total in company history.
  2. Demand is softening in many of TOL's markets, but the company expects demand to stabilize after speculators are finished exiting these same markets. Speculators have transitioned from buyers to sellers, and they are sending inventories up (and presumably pushing prices down).
  3. Job, income, and population growth look good in their markets (we are not given specifics though!)
  4. Delivery of homes slowed due to regulatory and logistic factors. While the company did not explain how or when these issues will be fixed, we can assume that when they are fixed, numbers should improve accordingly.
  5. The company continues to lose money on its own stock. Over the past two quarters, they have taken back about 2.61 million shares. Given that the stock has lost 25% in value in just the past month and is now sitting at 52-week lows, you can imagine the hit TOL is taking to its finances. But they remain unfazed and still have 15.1 million shares to go! (In Q&A, they said they will not buy back a "huge" amount but will buyback more stock than usual. They also claimed that the buyback is not impacting earnings).
  6. TOL is still raising prices in Phoenix, for example last week and the prior two weeks, albeit at a slower pace than the previous two years. Colorado has seen prices increase "a little bit." The West Coast of Florida was looking good until a few weeks ago and only one community of eight(?) has received price increases.
  7. No price increases in Northern California, Orlando, Massachusetts, Rhode Island, New Jersey (except Hoboken), Jacksonville, New York ex-urbs, or Connecticut.
  8. Michigan market is holding firm. Reno is slow. Las Vegas has slowed. Washington DC area is mixed.
  9. Analyst notes that the forecasted decline in deliveries is significant and surprised that TOL is not discounting prices more.
  10. Markets are not flooded with inventory from smaller builders, but larger builders are flooding markets with big promotional programs.
  11. Margins will "only" compress by a few percentage points from various price reductions.
  12. Cancellation rate was 8.1% for the quarter. Very high for TOL. Last year it was 4%. Some of it due to logistic problems in Las Vegas. However, TOL was able to resell the properties for higher prices than originally anticipated.
  13. Quite a bit of discounting in the Washington, DC market by competitors. TOL discounts "quietly." Just started discounting in one community in Northern California.
  14. Trying to maintain leverage and not over-buying land.
  15. Market appears to be already recovering, sooner than in past housing downturns. None of the homebuilders are "crying the blues." Certainly within three years, and probably much sooner, the market will see a return to an imblanace between supply and demographic growth. Noted that no recessions have gone as long as three years in recent history.
  16. Will soon see housing prices double (did not state the reference point), resulting in smaller living spaces for new homes.
  17. Northern New Jersey market will shrink quite a bit due to tough regulatory environment
  18. 43% of inventory is backlogged past 11 months.

TOL reports earnings on February 23, 2006. Even with this prior warning, we should expect more drama...and perhaps closer resolution on the question on whether homebuilder stocks are building bottoms or building false hopes.

Be careful out there!

Independent Thoughts:
The commercial mortgage loan is provided for big entrepreneurs in order to maintain businesses set up on a large scale. The mortgage lenders play a central role in convincing the customers to buy mortgages for getting financial assistance in case of foreclosures. There are extensive catalogues of different kinds of loan companies which offer free home mortgage leads. The bank home loan is offered for homeowners in order to cater to the needs of home building. The home owners are provided the opportunity to refinance to get the best remortgage rates by pledging on the same property.

DrDuru, 2006