With Housing Improving, Buy This Stock Today

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

Some stocks scream buy so loudly that only a fool (small f) would ignore the opportunity. However, many times the stocks that are screaming buys also belong to an industry that seemingly everyone is betting against. This is exactly what has been happening at Toll Brothers ). Even after a nice run in the stock, Toll is still too good of a value to ignore.

If you want to gauge the health of the housing market, read the comments in homebuilder's earnings reports. Nearly every company is saying the same thing, they see strength in the housing market. In fact, Toll has been making comments about the strength of the housing market in successive quarterly reports for the last year. Their competitors Lennar (NYSE: LEN), KB Home ), and PulteGroup ) have been making similar comments as well. As proof that some things never change, this reminds me of the negative perception of the group when Peter Lynch found opportunity years ago.

Lynch noticed more than 20 years ago that the homebuilding segment was out of favor. However, the “quiet facts” suggested a housing turnaround. A similar situation is happening today. Everyone knows that the housing market has been terrible, mortgage rates are still at multi-decade lows, and the difference between renting and buying is extremely favorable for people looking to buy. Despite all of this, what most people hear from the mainstream media is that housing is in a funk. The question for investors is, who's right?

If one homebuilder were showing positive results, but others were reporting problems I would be inclined to avoid the industry. However, when multiple companies are showing positive results, I tend to believe the industry as a whole is rebounding. If you look at Toll's last quarterly results, it seems clear the housing market is improving.

Toll reported significant revenue and EPS growth in their last quarterly report, and this was no flash in the pan. The company's 48% revenue growth and 81.71% adjusted EPS growth were just the most recent examples of this company's huge growth in the last year. The fact that Toll has beaten analyst expectations by an average of 312% per quarter in the last four quarters just shows that even analysts have been caught off guard. What was even more impressive were Toll's numbers beyond the headlines.

If you heard a company reported 75% growth in new orders, and their backlog of orders grew 70%, most investors would immediately launch an investigation into buying the shares. This is exactly what Toll reported, yet many still doubt the company. While Toll's growth is impressive, one challenge for homebuilders in the last few years has been cancellations. This is another area where Toll leads the way with a relatively miniscule 4.6% cancellation rate. When you consider that Lennar at last count had a cancellation rate of 16%, PulteGroup showed a cancellation rate of 14%, and KB Home just reported a rate of 35%, you can see how impressive Toll's results are. Part of the reason for Toll's low cancellation rate is their concentration on the high-end housing market.

While companies like Lennar, KB Home, and PulteGroup have average selling prices between $230,000 and $300,000, Toll's average selling price was $582,000. In fact, the increase in average selling prices is just another way that investors have proof of the strength in housing. Toll reported that their average selling price increased 3.01% versus last year, and the average price has increased sequentially over the last three quarters. For those who might worry about Toll's ability to sustain this type of growth, let me reassure you, Toll is just getting started.

According to management, “from 1987 to 2006 average annual sales per community was 28.6.” Considering that in 2012, “contracts were 18.2 per community” you can see there is still room for tremendous improvement. In addition, Toll has an impressive gross margin at 24.6%, and this was actually up from 24.2% last year. Lennar comes the closest to Toll with a gross margin of 23.5%, and PulteGroup and KB Home fall a good bit behind at 18.21% and 17.88% respectively. With high margins, investors should be excited about Toll's projected growth.

Analysts expect Toll to report nearly 25% EPS growth over the next few years. By comparison, Lennar, KB Home, and PulteGroup are expected to grow earnings by 4% - 6% during this same timeframe. While it's true that Toll's forward P/E ratio stands at about 38, homebuilders cyclical stocks. Peter Lynch once said you have to think of P/E ratios in cyclicals differently than traditional stocks. In a cyclical stock, a high P/E may be a good thing, as the company is going through an earnings trough. However, as the recovery picks up, and the industry stabilizes, earnings will pick up and the P/E ratio will compress.

Considering Toll's earnings crushing numbers this last year, I would suggest this has already begun. The failure of other high-end homebuilders during the Great Recession was bad news for those companies, but great news for Toll. As one of the only players left in this segment, if the economy continues to improve, Toll is left to capture a bigger slice of this extremely profitable market. It happened 20 or so years ago, and it's happening again today. I've recommended Toll before, and not much has changed, this company can still ring up impressive profits for investors going forward.

MHenage 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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