Order Concerns Take Toll Brothers

The builder's shares appear cheap, but worries remain about the prospects for the high-end market.
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At around $30,

Toll Brothers'

(TOL) - Get Report

battered-down shares appear tempting if you believe in the homebuilder's long-term prospects. But some observers fear that the company's focus on the fragile upper end of the housing market could mean further setbacks ahead.

During the last few years, nothing could stop Toll. The company nearly doubled its earnings in 2005 to $806 million, helped by rapid price increases at its luxury homes. Toll led the top 10 builders in net margins, with a healthy 13.8%.

But the stock has since fallen about 48% off its 52-week high of $58.67 last summer amid worries of a housing-bubble explosion. Now, some analysts expect earnings to be flat to down over the next few years.

The market will get the latest update when Toll releases new-home orders for its fiscal second quarter Friday, and the company could once again drag down the sector if the numbers look worse than expected. The stock fell below $30 in early February, when Toll posted a

29% drop in new orders for its first quarter.

Meanwhile, homebuilder investors are already jittery after grappling with a big earnings miss at

Centex

(CTX)

last week and a lowered guidance from

Hovnanian

(HOV) - Get Report

late Monday.

What separates Toll from the rest of the major builders is its heavy focus on the higher end of the housing market. The company primarily sells to move-up and second-home buyers. Its largest markets are the Northeast and Southwest, and the average selling price of its homes is just under $700,000, compared with the mid-$300,000-and-below range for most public builders.

Targeting this affluent segment has been an attractive niche for Toll in recent years, but there's worry now about how this strategy will pan out in a slowing housing market in which inventories are rising and discretionary housing sales might seriously slow. Toll pulled its fiscal 2007 earnings guidance in December and gave little comfort to investors in its

first-quarter earnings report in late February.

"One key thing hurting them is the inventory of existing homes for sale. That has surged," says Greg Gieber, an analyst with A.G. Edwards, who cut Toll to a sell rating Friday. "Anybody who is buying a Toll house most likely has a house that they are selling or will have to sell in order to close on the Toll house. It takes roughly 12 months for

CEO Bob Toll to deliver a house."

Last week the National Association of Realtors said the inventory of existing homes for sale jumped to 5.5 months of supply, the highest level since July 1998.

"Psychologically, people see buying a home for a year out as a lot more risky," Gieber says.

Gieber expects Toll to post flat net income in fiscal 2006 and a 23% drop in profits in 2007. He expects net orders this year to decline about 19%, which would negate the 19% increase in fiscal 2005. He expects gross margins in 2007 to return to 2003 levels.

Gieber fears that the inventory correction at the higher price points where Toll offers homes will be larger than he previously believed. "Once the inventory correction is complete, the degree of rebound in sales for higher-priced homes is apt to be less than we think the equity market anticipates," Gieber wrote in a note last week.

Bulls Still Roam

While there are always doomsayers on Toll, it's also not hard to find investors who feel the stock has corrected enough to warrant an investment. Seth Glickenhaus, chief investment officer of Glickenhaus & Co., says he is not of the camp that believes the run-up in the housing market now means a drastic correction is due. His firm took a position in Toll at the end of last year, buying 139,500 shares at an average price of $32.64 a share, right near where the stock is currently trading.

"I feel

prices and sales will settle back somewhat from their giddy peak, but that there will be a good demand for homes," Glickenhaus says.

It's also worth noting that highly regarded hedge fund manager Jeffrey Gendell of Tontine Partners also established a position in Toll late last year, purchasing 4.67 million shares at an average price right above $32 as well.

Gendell is known as an activist investor, and he used his 9% stake in

Beazer Homes

(BZH) - Get Report

to push that company to increase its share-buyback program. In a letter to Beazer management last fall, he wrote, "Based on current market conditions, the notion that it is cheaper to buy land on Wall Street than it is to buy land on Main Street has never been more clear."

Gendell's Toll stake amounts to 3% of the outstanding shares, making him the fifth-largest institutional shareholder. He declined to comment for this story. Right above Gendell on the totem pole is D.E. Shaw & Co., one of the world's largest hedge funds, which controls 3.1% of Toll's stock.

At $30, Toll trades at 6.4 times analysts' average estimate for fiscal 2007 earnings of $4.73 a share. Gieber, the A.G. Edwards analyst, cut his 2007 estimate to $4 last week. If more analysts cut their estimates in the next month, the stock could come under pressure -- with investors possibly facing a value trap

like the one emerging at Centex.

Toll's order numbers Friday will provide clues on just how much demand is left for the high end of the new-home market. The data will consist of sales from February through April, thus providing a key window into the beginning of the

all-important spring selling season for the builders.

If the report shows that Toll's business is deteriorating even worse than expected, investors can expect many questions on its order conference call about whether Bob Toll and the board of directors plan to increase its share-buyback program.

In February, Toll told investors on the call that his company would be buying back more shares than normal in coming months, but "we're not going to buy back so much that it will markedly impact earnings."

Such a philosophy in a slowing housing market will only sit well with activist hedge fund managers like Gendell for so long.