Toll Brothers Inc. (NYSE: TOL) good schools and easy access to employment centers, major cities, cultural institutions, and top medical centers.
On September 21, Toll Brothers provided a mid-quarter update for 4Q20. The North region was up 83%; Mid-Atlantic was up 108%; the South region was up 170%; Mountain up 102%; Pacific up 165%. The City Living division, which sells luxury urban apartments, was down 57%.
We believe the surge in orders is being driven by record low interest rates, an undersupply of existing homes after a decade of underproduction, a limited number of existing homes for sale because owners don’t want people going through their rooms during the pandemic, growing interest from millennials, the company’s presence in high growth states, a migration from cities, a desire for new homes and a desire for customization. Buyers added even more amenities than usual in 3Q and we expect that to continue. Buyers want a home office, maybe two. They want a school and study room for kids learning remotely and they want space for young adults still living at home, aging parents. The latter trend is being driven by concern about the high infection and death rates at nursing homes.
Going forward, we would expect to see TOL raising prices rather than pushing very aggressive growth. This could help to offset high lumber prices which have recently been a concern for the builders. A few things have happened. Prices have eased, mills are reopening, the seasonal slowdown in homebuilding will give some of the lumber producers a chance to catch up and TOL has some long-term relationships with lumber mills that help it to manage some of the price changes.
EARNINGS & GROWTH ANALYSIS
Reflects a higher forecast for homebuilding revenue, as discussed above, reflecting better market conditions and more new orders than we had modeled at the end of August.
FINANCIAL STRENGTH & DIVIDEND
While TOL’s financial strength is solid, we don’t believe it is on par with companies such as Wal-Mart and Costco that have much higher credit ratings and less cyclical business models.
TOL’s long-term debt is rated Ba1 by Moody’s and BB+ by Standard & Poor’s. Wal-Mart is rated in the AAs, Costco is in the high single A’s and low AAs.
TOL ended fiscal 3Q20 with $559 million in cash and equivalents. Total debt was $4.7 billion.
There is a discussion of the covenants on the revolver on pages 15 and 16 of the 10-Q for 3Q.
TOL’s credit agreement includes a provision which could limit the dividend payout or the company’s ability to repurchase shares.
MANAGEMENT & RISKS
Douglas Yearley became the company’s CEO in 2010, succeeding Robert Toll, who remains as executive chairman. Mr. Yearley was formerly executive vice president. Marty Connor has served as CFO since 2008, and was previously the company’s outside auditor at Ernst & Young.
Toll generally caters to affluent consumers, who tend to have lower rates of unemployment than the national average, better credit quality, and the ability to get a large mortgage.
Despite the financial strength of the company’s core customers, it is important to remember that an upscale home is a luxury and that potential buyers may postpone their purchase. High-end buyers may be very sensitive to swings in the economy and especially the stock market because they could affect the value of their own business or their financial assets.
It is also possible that many semi-affluent buyers will be excluded from TOL’s markets because they don’t have the liberal borrowing options or stock market wealth they had before the COVID-19 pandemic.
Home builders must acquire appropriate amounts of new land, while protecting themselves from excess inventory if the market falters. TOL has a fairly robust portfolio of land. That’s important because the company’s core markets tend to be populous and obtaining the necessary building approvals can take years. It could also take time for the company to reposition.
The company’s mortgage subsidiary sells the mortgages that it initiates. A relapse or disruption in the mortgage market could make it more difficult for the company to offer financing to purchasers of the homes it builds.
Prior to 2006, TOL had pursued an aggressive program of lot acquisition, spending more each year to increase its land inventory than it took in as earnings. The difference was made up by an increase in debt and accounts payable. As the homebuilding sector cooled, the company reduced the number of lots under its control from 91,000 in 2006 to a low of 31,700 at the end of 1Q10. The tally was 47,167 at the end of FY14, with 36,224 owned and 10,943 controlled through options. At the end of FY15, TOL controlled 44,253 home sites, with 35,872 owned and 8,381 controlled with options. While we see the recent weakness as a pause in the housing recovery rather than the beginning of a pronounced decline, the company’s land could lose value in the event of a recession. Weak market conditions could raise the risk of asset impairments which could hurt earnings and financial metrics. TOL also has outsized geographic exposure in the northeast and mid-Atlantic regions and the 2014 acquisition of Shapell adds significant exposure to California. While this represents a risk, TOL is more diversified than many smaller builders and this may contribute to a relative edge in TOL’s access to capital. The company’s ability to deliver homes could be constrained by the availability or the price of labor in the markets where it operates. TOL also participates in joint ventures. If TOL’s partners have financial difficulties, TOL could face additional costs or suffer losses. The company does have off balance sheet arrangements with joint venture partners.
The company’s entry to the high-rise building market is an opportunity, but it adds complexity to the business model, including long cycle times and the potential for delays in obtaining permits and completing construction.
The company could be hurt by regional economic issues. It is also possible that shortages of workers or shortages of land in desirable locations could crimp future sales or reduce profitability.
TOL also operates a growing number of for-rent apartments. The company, which is based in Horsham, Pennsylvania, had fiscal FY19 sales of $7.08 billion, down from $7.14 billion in FY18 but above the prerecession peak of $6.1 billion in FY06.
We believe that the company’s unique position as the dominant builder of luxury homes, along with a normally strong operating margin, argues for a premium. An offset is that some investors prefer builders that serve entry-level buyers based on the belief that the market’s next wave of growth will be fueled by the low end of the market. We believe that TOL can continue to gain market share at the high end, offer more relatively affordable homes and ultimately outperform the S&P 500, helped by pent-up demand for homes. The company’s peers are trading at 1.4 to-2.5 times.