Why Cyclicality Is Less of an Issue for This Home Builder

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Toll Brothers (NYSE: TOL), the leading luxury home builder in the U.S. with an average home price exceeding half a million dollars, serves a wide variety of home buyers. It serves move-up, empty-nester and active-adult buyers; and has the financial strength to weather downturns.

Diversified product portfolio reduces dependence on any single customer segment

Toll Brothers is diversified across various customer segments, unlike most other home builders, which target first-time and move-up buyers of single-family homes as their primary customers. One example is the empty-nester market - where parents are staying alone after their children have grown up and left. Toll Brothers had specifically designed certain of its homes with master bedrooms on the ground floor and with recreational amenities targeting the aged.

In the past decade, Toll Brothers has transformed itself from a single-family focused home builder to one with exposure to varied customer segments. According to its most recent investor presentation, single-family homes have fallen from three-quarters of unit deliveries in 2002 to more than half of unit deliveries in 2012.

In particular, Toll Brothers has almost doubled its contribution from the age- qualified active-adult market over the past decade, with results rising from 6% of unit deliveries in 2002 to 11% in 2012. Based on a 2009 study by MetLife Mature Market Institute, an increasing number of home owners aged 55 and above are considering age- qualified active-adult communities based on a quality-cost trade off. Toll Brothers has indicated in its 10-K plans to open more age-qualified communities over the next few years.

Financial strength provides attractive access to capital markets

Toll Brothers boasts of a strong balance sheet with a net debt-to-capital ratio of 31.9% and a gross debt-to-equity ratio of 78.1%. Moreover, it is rated as investment grade by Fitch. As a result, Toll Brothers has access to relatively inexpensive debt, unlike some of its smaller private competitors and highly leveraged public peers. This is evidenced by its recent fund raising from public debt markets at attractive yields of around 4% in April and May.

Land bank is king

Toll Brothers currently controls 45,177 lots or home sites. It added approximately 6,100 and 4,827 home sites for full-year fiscal 2012 and the half-year ended fiscal 2013, respectively. Toll Brothers took advantage of attractive prices and early signs of demand recovery in certain markets to add significantly to its existing land bank, further enhancing its competitive advantage in a tight land-supply market.

Future outlook

Toll Brothers is actively making efforts to insulate itself from the cyclical effects of the industry. It started Gibraltar Capital in fiscal 2010 to invest in distressed real estate opportunities. Another initiative is its planned investment of between $100 million and $200 million in apartment and campus living programs in the North East and the Mid Atlantic, which will allow it to further diversify its customer base beyond traditional home buyers.

Toll Brothers delivered a good set of results for the second quarter of fiscal 2013, with revenue and net income up by 38% and 46% year-on-year, respectively. With its current backlog of $2.5 billion and 3,655 units, representing a 69% and 52% growth in dollar terms and units, respectively, I am optimistic of Toll Brothers’ future financial performance.

Peer comparison

Toll Brothers’ peers include PulteGroup (NYSE: PHM) and D.R. Horton (NYSE: DHI).

PulteGroup has a distinct multi-brand strategy to attract its three major customer groups: entry level buyers (Centex), move-up buyers (Pulte Homes) and active adults (Del Webb). It is particularly strong in the active-adult market, which accounts for about a quarter of its revenue. According to its most recent investor presentation, close to 40% of buyers in this segment pay for their homes, providing evidence of the financial strength and affluent status of the active adults.

On the back of a 35% year-on-year increase in revenue for the first quarter of fiscal 2013, it increased its authorized investment in land and development by $200 million each year to build up inventory for the future.

Despite this, I am negative on PulteGroup for two reasons. Firstly, it is more leveraged than Toll Brothers with a gearing of 114%. Secondly, inline with its focus on ROIC, it has been actively reducing its land bank since 2010 to generate more cash; unlike Toll Brothers, which has been increasing land bank over the past few years to prepare for the market recovery.

D.R. Horton adopts a cost leadership strategy and focuses on cost-cutting and sale of new single-family homes at below average prices. As a result of this strategy, it also has a relatively comfortable gearing of 87%. It registered strong revenue growth in the second quarter of fiscal 2013, increasing net sales orders by 34% in units and 52% in dollar terms to 7,879 homes and $2.0 billion, respectively. Its future outlook looks bright with backlog increasing 76% year-on-year to $2.4 billion.

However, I am concerned about D.R. Horton’s high cancellation rates historically. Its cancellation rates were above 25% from 2008 to 2011, but came down to 19% in the most recent quarter. Because of its low-price focus, it is possible that D.R. Horton attracts a significantly higher portion of fringe buyers who do not qualify for mortgages.

Conclusion

Toll Brothers’ product diversification and strong balance sheet help to reduce customer type concentration and bankruptcy risk, respectively. In addition, its recent investments in distressed real estate and campus living programs will make Toll Brothers less exposed to the cyclicality of the home-building industry. Moreover, Toll Brothers is cheap at 0.6 times PEG, indicating that the strong growth prospects of the company have not been factored into its stock price. This makes it an attractive investment candidate in my opinion.

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