Stephanie Link: This Could Be the Season for Toll Brothers
By: Stephanie Link
| 04/08/14 - 05:50 PM EDT
NEW YORK (TheStreet
) -- Since my investment bias is a GARP style, I always look for groups and stocks that have lagged the broader averages. One group that has lagged for a while has been the home builder stocks - and that's piqued my interest. The headwinds are sort of obvious - that when rates rise, demand slows and earnings are at risk for this sector. I am of the mindset that rates will continue to increase and the yield curve will steepen as the U.S. economy continues to improve - although so far this year the surprise has been just the opposite where the 10-year bond yield remains stubbornly below the recent 3% peak level seen at the end of 2013.
I think the risk is to the upside in GDP and that we could see a 4% growth handle some time next year - as the data points continue to show upside acceleration in PMIs, ISMs, new orders, factory orders, durable goods, auto sales, retail sales and better job growth. We're also beginning to see stronger corporate CAPEX spending which is slated to grow 7% this year - something we've not seen in the last several years. So why would I even look at the home builders when I think rates will continue to go higher? Simply put, I don't think rates are going to run away from us - but rather I see it more a gradual move higher and at the same time, if jobs get better, if the participation rate for the unemployed improves, and home prices continue to rise - consumer confidence should also improve. And demand will not decelerate - especially those companies that have exposure to the higher end consumer - and are somewhat protected from higher rates. So if you have patience and can weather the daily volatility from interest rates, I think the home builders are attractively priced here. My favorite is Toll Brothers
TOL focuses on the luxury suburban and urban markets with 50% of its sales in the Northeast/Mid-Atlantic regions. It has the exposure to the high income demographic which has shown more resilience during uneven economic times and charges a higher end price point. Since 1995 the number of households earning over $100,000 annually has increased 277% (an 8% CAGR) versus all households combined income at 23% growth in the same time period. To some extent higher rates are less impactful to the higher end consumer as it generally doesn't change their buying intentions. And in addition 25% to 30% of TOL's customer base pays in cash. Its vertical scale has given the company a leg up on the competition and has resulted in above average margins versus its peers. I like that over the last few years Toll Brothers has expanded beyond the Northeast/Mid Atlantic towards higher growing regions like Texas, California, and Seattle and that it has diversified its product mix towards high rise and active adult communities so that it is less reliant on the single family home market. The active adult community is particularly interesting to me given the U.S. aging population demographics and higher pricing potential. Getting exposure to the active adult community was behind its recent acquisition of Shapell
and the integration and mix shift should lead to gross margin expansion north of 200 bps in 2014 and 2015.
I think the company could see total deliveries grow 25% this year vs. its peers 15%, which helps margins (adult home gross margins are 35% to 40%). In addition to region and product initiatives, the company continues to streamline non-core assets and over time it will use the proceeds to improve its balance sheet - with stated goals of getting its debt/cap ratio down to 40% from the current 47% level. Expense management is very important to the company and after eliminating 5,000 jobs during the downturn, it remains a lean organization. Project startup costs have been elevated but should ease throughout the year so that the company can get to its stated goals of SG&A as a percentage of revenues at 9% to 10% vs. the current 12% to 13%. The wild card is the weather - January and February were softer than usual but March likely saw an improvement. Normalizing weather in the spring should see a pick up and recent permits data has showed better trends (December was 986,000, January 937,000, February 1.018 million) while housing starts have also remained strong (December was 999,000, January at 880,000 and February at 907,000).
So with steady demand, a higher end customer, acquisition synergies and margin expansion there is strong visibility to earnings. The stock trades at 2x TBV which is below its historical average of 2.2-2.3x and is below the group average at 2.2x TBV. Historically TOL has traded at a premium to the group. Over time I see the multiple disparity narrowing as the company delivers improved margins (pricing, mix, scale) and better operating leverage.
--Written by Stephanie Link in New York.