Toll Brothers and Housing Market Dynamics

Erik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Whether we are looking at the residential spending part of the latest GDP report, new home sales, existing home sales, or the decline in foreclosure inventory, we see signs of a slightly improving real estate market.  The recent Toll Brothers (NYSE: TOL) earnings announcement suggests continuation of this trend.  But there are developments that raise flags and give investors reason to continue to approach this arena with trepidation.  While more-aggressive investors might find opportunities in recent stock-price weakness, more risk-averse investors might want to sit on the sidelines for a bit longer.  Here are some things to consider.

 Examining earnings

Toll Brothers announced its first-quarter earnings on February 20.  In the three months ended January 31, the company posted a per-share profit of $0.03, marking a significant improvement from the loss of $0.02 per share in the year-earlier period.  The EPS gain came amid a 32% increase in revenue (both in terms of volumes and dollars).  The results are solid, even if the company reportedly missed analyst estimates.  Further, conditions look relatively rosy going forward.  Douglas C. Yearley, Jr., Toll Brothers' CEO, is quoted in the earnings announcement stating: "Demand has increased. With our first quarter contracts up 49%, and contracts for the first three weeks of our second quarter up 40% versus comparable periods in FY 2012, it appears that momentum is building.” 

That’s the good news.  The part that concerns me about the overall housing market came in the next paragraph: “We are continuing to gain market share and see little competition from local private builders.”  That’s good for Toll Brothers, but this brings several questions to mind, and we will have to see how other developers’ earnings come in before we can answer them.  After all, Toll Brothers operates in 19 states, covering the southwest, south central, north central, and much of the east coast.  To get a better picture of other markets, we will need to wait to hear from other companies.  For example, builders KB Home (NYSE: KBH) and Hovnanian Enterprises report earnings in March.  KB Home is one of the oldest home-building companies.  It is well-positioned in ten states, primarily in the south, and the southern parts of both the east and west coast.  Toll Brothers also operates in nine of these states.  By comparison, Hovnanian is positioned in 16 states, all but four overlap with Toll Brothers.

As a general thought, I would like to know how much of Toll Brothers’ recent business comes from market share gains and how much comes from actual strengthening in the housing market.  Admittedly, Toll Brothers operates in the more affluent spectrum of the market, so its earnings report really doesn’t tell us too much about the rest of real estate.  I can’t help but be a bit concerned about the part that they aren’t seeing too much competition from private builders.  For that reason, it is a good idea to take a look at the economic statistics that cover more of the real estate market.

What the statistics tell us

The latest housing statistics continue to show that the real estate market is improving, but it isn’t great.  Still, there are signs to be somewhat hopeful down the road. 

According to the government, new single-family home sales in December 2012 were up 8.8% from the year-earlier period, but were down 7.3% from November.  (The government releases January’s statistics on February 26.)  Similarly, new housing starts in January were up considerably from the prior-year level (23.6%), but were down on a month-to-month basis (8.5%). 

The recent easing in some statistics does not necessarily indicate that housing is going to fall apart.  Single-family home starts climbed 20% year-over-year in January, and were slightly higher from December (0.8%).  And building permits in January were up 35.2% year-over-year and 1.8% since December.  It is important to remember that not every permit leads to a construction company actually breaking ground, and just because a company breaks ground doesn’t necessarily mean that the house is going to get sold or even built.  Therefore, we take a look at what else is going on in the housing market.

The National Association of Realtors reported that existing home sales, on a seasonally adjusted basis, climbed 0.4% in January.  That’s another nice sign that things are moving in the right general direction.  Yet, people still aren’t rushing to sell their homes.  The inventory of homes for sale fell 4.9% (the NAR reportedly did not adjust the inventory figures for seasonality).  This is the lowest inventory figure since December 1999, and that could suggest solid opportunities for home builders in the months ahead.

Not ready just yet

Recent weakness in home builders stocks could create an interesting buying opportunity for more-aggressive investors.  For example, shares of Toll Brothers sank roughly 7% over the last month, dropping its P/E ratio to about 11.7, which is a discount to the industry average. 

One cannot, however, dismiss the risks present.  Employment is a key factor to a healthy housing market.  Last year, the economy created, on average, 181,000 jobs each month.  More recently, the pace of employment growth has eased, hitting 157,000 in January.  Of course, there is also the potential contraction arising from the sequester, which could derail the improvements in the labor market and hurt the housing recovery.  Personally, I would really like to see a lot more people working, and the pipeline of foreclosed properties to be a bit smaller.  Investors looking for exposure to the real estate market, but perhaps not ready to stomach the home builders, might want to wait to see more signs of life before diving in.

edellith has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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