The Bell Tolls for Thee

By Chad Henage - August 30, 2012 | Tickers: DHI, KBH, LEN, PHM, TOL | 0 Comments

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One of the primary reasons that I keep track of Toll Brothers (NYSE: TOL) is because of Peter Lynch. He said in one of his books, as the housing market recovered one of the first thoughts he had was Toll Brothers would benefit. Granted this has been years ago, but the similarities between when he wrote his statement and today are striking. Many people still believe that the housing market is doing terribly, and expect this to continue for multiple years. However, looking at individual homebuilders, the results are very encouraging and surprisingly the average delivered house price is increasing. Investors looking for a play on the recovery of the housing market should place Toll Brothers at the top of their list.

Toll Brothers is in a somewhat unique position, in that they are one of the few remaining luxury housing builders. While they do face competition from many different companies, most of these companies operate at different price points leaving Toll Brothers to capture the high-end housing market. In addition, higher-end housing seems to carry a lower cancellation rate as the buyers are traditionally higher net worth and higher income individuals and families. These two positive factors are helping the company report tremendous results, and as the economy recovers further this trend looks to continue. Looking at the company's earnings release, Toll Brothers met or exceeded every possible measure that investors could ask for.

With total revenues up 41%, and total delivered units up 39%, it's clear that business is good. These higher revenues drove net income to increase 44% on a year-over-year basis. Even more impressive, the company's signed contracts jumped 66% in dollar terms and 57% in number of units. As proof that there is pent up demand in the housing market, the company's backlog increased by 59% in dollars and 44% in units. Take a look at the difference between Toll Brothers and their competition, and you'll see how well the industry is doing.

As you can see, not only does Toll Brothers have an impressive growth rate in both dollars and number of units, but the company also has a much lower cancellation rate than their competition. Only Lennar has a higher combination of increase in their backlog, but Lennar shows four times the cancellation rate. This means the company's net growth is likely to be much less than Toll Brothers. If I were an investor, the company in this group I would worry the most about would be KBHome. The company's backlog growth trails most of their competition, and their cancellation rate is the highest among the five builders. As I mentioned before, not only does Toll Brothers benefit from this increased business in the future, but the average price of their delivered homes has actually increased.

The average price per home delivered increased to $576,000 up from $569,000 last year. This increase in average selling price, combined with the increase in sales, helped gross margin to improve one full percentage point to 24.4%. In addition, the company managed costs well by decreasing their SG&A expenses to 13.5% of revenue versus 16.4% last year. Two extremely encouraging, and somewhat surprising statements were made in the earnings release that investors should take note of. The first was, “the pace of our contract growth has far exceeded the national housing data as we are gaining market share.” I think we can tell that this statement is true based on the backlog growth comparison above. What would probably surprise most people was a comment the CEO made saying, “with an industrywide shortage of inventory in many markets, we are enjoying some pricing power.” For all the naysayers that believe housing is struggling, this statement shows just the opposite. One of the advantages that Toll Brothers carries is, as a high-end homebuilder they face less competitive pressure from foreclosed homes.

Generally speaking, customers of Toll Brothers are higher net worth clients and if they are participating in the foreclosed housing market it's more likely as an investment rather than their primary dwelling. With this type of customer when it comes to their primary dwelling, they are not likely to wait around for a bank to tell them whether they can have the house that they want. Instead, they can go to Toll Brothers and build the house to their specifications knowing that they'll get what they want from a reputable homebuilder. While the stock has had a tremendous run over the last few months, it appears that we are at the beginning of a multi-year upturn in the new housing market. Considering the number of troubled years in this industry, it will take multiple years for this turnaround to be completed. Just like when Peter Lynch observed that the company would benefit from a turnaround in housing years ago, Toll Brothers' strong balance sheet and stellar reputation continues to serve them well. Investors who are afraid that they have missed the major move in the stock price, should realize that the company is likely to do well for at least the next several years until the pent up demand falls back to normal.

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