Description

On March 10, 2003, I recommended the purchase of Toll Brothers’ shares.  The shares subsequently appreciated sharply with the stock rising about 6x over a little more than two years.

I am now strongly recommending Toll Brothers’ shares again because I believe there has been a positive sea change in the company’s business that will become apparent in coming months.

Toll Brothers is the only publicly traded homebuilder that focuses on luxury homes, heavily in the suburbs of cities. Between the financial crisis and March of 2020, the market for luxury suburban homes generally was weak. In the New York area, for example, many larger luxury homes in Greenwich, Connecticut and Westchester County had difficulty finding buyers, except at substantially marked down prices. In recent years, while D.R. Horton and other builders of lower priced homes prospered, Toll limped along with substandard profit margins due to the lack of pricing power. Because luxury homes take longer to build and are more land intensive than smaller less expensive homes, Toll’s business is more capital intensive and thus should earn higher margins than D.R. Horton and other homebuilders.  Indeed, in the early 2000s, Toll’s margins were higher. But this was not the case in recent years.

Currently, there is a marked migration of families from apartments located in urban areas to single-family houses located in suburbs. Some families are seeking the private space and relative safety of houses in the suburbs. Others are seeking better schooling for their children. And, evidently, many have decided that they will continue to work at least part time from a home office and are seeking a larger residence with a room that affords space and distance from distractions. As a result, the demand for suburban houses suddenly has turned very strong and the supply of luxury houses for sale has fallen sharply. From conversations with many families, this trend from luxury apartments to luxury suburban houses will continue, if not accelerate. It therefore is logical that Toll currently is experiencing a substantial increase in demand for its luxury homes and that the company has regained pricing power. In fact, orders, pricing, and the profit margin on ordered homes should have turned buoyant in June – and this buoyancy should continue for the foreseeable future.

The combination of increased demand and increased pricing should lead to a very sharp increase in EPS. Here are my estimates for Toll’s October 2022 fiscal year. I conservatively estimate that Toll will be selling homes from about 375 communities in that year and that annual closings per community will be at least 28 at an average price of about $825,000. I further conservatively estimate that Toll’s operating margins from homebuilding will be roughly 13% in 2022 (last year, the operating margins of Horton, Lennar, and Pulte averaged about 12%). Thus, I estimate that Toll’s operating earnings from the sales of luxury houses will be about $1,125 million. To calculate EPS, one must add about $115 million of other profits (mainly from rental apartments and JV income, mortgage and title operations, etc.), subtract taxes at a 26% effective rate, and then divide by a diluted share count of 130 million. The result is an estimated projected EPS power of about $7.00 per share. The shares currently are trading at about $32. The company’s tangible book value per share currently is about $36. The book value two years from now is projected to be about $45. We believe that the company’s management and quality are excellent. In Fortune Magazine’s list of most admired companies in the United States, Toll has been named the #1 most admired homebuilder for the past 6 years. And, management has been so confident of its future that, over the past year, the company has repurchased roughly 9% of its outstanding shares. In my opinion, the repurchases have slightly overleveraged the company’s balance sheet. But, the combination of strong earnings, shifting to an asset lighter strategy, joint venturing portions of their rental apartment business, and the sale of non-core land should result in very strong cash flows that should lead to a good balance sheet within the next twelve months.

The expected catalyst for the price of the shares is clear: the announcement of very strong orders and strong pricing power in the quarters than will end on July 31 and October 30.

DISCLAIMER: This is intended for information purposes only (not investment advice) and should not be relied upon solely as a basis for investment. The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Catalyst

families -- more than ever -- appreciate the comforts of home; migration of families from apartments located in urban areas to single-family houses located in suburbs