Toll Faces Growing Pains

The builder's orders drop amid a softer market, tough comparisons and construction delays.
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Updated from 11:59 a.m. EST

Toll Brothers

(TOL) - Get Report

is experiencing the pains of growing too fast.

The luxury-home builder, which doubled its earnings in fiscal 2005, said Tuesday that new home orders fell 29% in the fiscal first quarter amid difficult year-over-year comparisons and a tough sales market.

On a unit basis, Toll's orders fell 29% to 1,544 from 2,173 a year earlier. The value of those orders totaled $1.14 billion, 21% below the year-earlier period.

Even though the market had been expecting slower order growth, some analysts expected at least flat order trends or small bumps from Toll, not a huge drop. Deutsche Bank analyst Gregg Schoenleber, who rates the company a buy, had been expecting Toll's new orders to increase 9% to 2,407 in the quarter. Deutsche Bank seeks to do investment banking with Toll.

"Selling homes this first quarter was certainly more difficult than one year ago; we faced a particularly challenging comparison to last year, as signed contracts in FY 2005 rose 60% vs. FY 2004," said Chairman and Chief Executive Robert Toll in a statement. "We experienced softening demand, to varying degrees, in a number of markets and continue to be constrained by long delivery times at many of our communities."

Regionally, the value of orders declined 34% in the Mid-Atlantic, which accountsfor the bulk -- about 38% -- of Toll's total closings, Schoenleber wrote in a research note. The value of orders fell in every market, dropping 10% in the Southwest, 33% in the Northeast, 47% in the West, 19% in the Southeast, and 46% in the Midwest.

On a conference call, Robert Toll said the company's best markets of late have been Phoenix; the suburbs of Philadelphia; and Hoboken, N.J., outside of New York City. The affluent Southwest Florida city of Naples had been performing very well, but weakened recently, Toll said. Markets that remain weak include Chicago, Jacksonville and western New Jersey. Although demand in Detroit picked up recently, Toll expects the market to slacken because of the automobile industry's woes. Both Northern and Southern California remain good markets, Toll said.

Many of Toll's issues surround regulatory issues and other strictures unrelated to buyer interest. In explaining its delivery shortfall, the company cited delays in obtaining certificates of occupancy, construction inspections and utility hookups as the primary problems. Demand, on the other hand, firmed from its trough of last fall, the company said.

During the quarter, about 43% of Toll's communities had lag times of 11 months or more -- meaning if buyers ordered a home, they would have to wait almost a year for it to be constructed. "We believe when expectations of home price appreciation are strong, buyers are willing to wait a year or more for their homes; when their expectations are more modest, they are less willing to commit so far in the future," Toll said.

"If you told me it would be a year

to get a home, I think I'd back off a bit too," says Ron Muhlenkamp, portfolio manager of the

Muhlenkamp

fund (MUHLX), which owns about 1.87 million shares of Toll.

Robert Toll said on the call that the company continues to shy away from offering buyer incentives, except in weak markets. Typically, Toll's incentive might represent $10,000 to $15,000 in the form of special kitchen upgrades or more affordable mortgages. "We don't believe in advertising discounting. We'll give typically 20% of what the other majors will be discounting," Toll said.

But the company acknowledged that major price discounts from competitors may be hurting sales. Without naming names, Toll said, "Our markets are flooded currently by advertising by several large builders of giveaway programs. That can spoil the market for a week or two." Recently,

Centex

(CTX)

has been very aggressive in

offering discounts of as much as $100,000 in certain markets where Toll also has a presence.

Muhlenkamp says he is not concerned Toll's ability to grow. "Last year, the first quarter was a booming quarter. Everybody had been expecting this and hoping that this would level off," Muhlenkamp says.

One factor providing a cushion for Toll, Muhlenkamp says, is the company's backlog of homes sold but not yet delivered, which grew 22% year over year to $5.95 billion. That number represents roughly four quarters of revenue. Overall, Toll's first-quarter homebuilding revenue rose 35% from a year ago to $1.33 billion.

Because of the muted order numbers, Toll lowered its estimate for home deliveries for the year ending in October to 9,200 to 9,900 homes. The company's previous estimate called for 9,500 to 10,200 orders -- a forecast that was cut from a range of 10,200 to 10,600 on Nov. 8.

Even though Toll withdrew its 2007 earnings guidance in December, it did hint about how future growth would be achieved. The company at that time said it planned to open 143 new communities in fiscal 2006, one of the largest-ever expansions for the company.

Toll opened 17 new developments near the end of the first quarter. That means 90% of the planned 2006 communities still need to be opened, which will be a daunting task given the labor and supply problems facing builders all across the country.

Despite all the latest hangups, Toll remains optimistic about its future.

"Once this excess inventory clears the market, we expect that the fundamentals of constrained lot supplies and demographics-driven demand should return. Since the number of affluent households continues to increase and we control more than 86,000 home sites in many of the nation's most lot-constrained and affluent markets, we believe we are positioned for long-term prosperity," Toll said.

Toll shares fell 5.5%, or $1.73, Tuesday to $29.47, which represents about six times the fiscal 2006 Thomson First Call consensus earnings estimate of $5.14 a share. Toll shares are down 12% this year, off 11% from the start of 2005, but up 58% since the start of 2004.

At six times earnings, "we think we've got a good company cheap," says Muhlenkamp, the fund manager.

During the quarter, Toll bought back about 630,000 shares at an average price of $34.61. The company is authorized to purchase an additional 15.1 million shares, which represents 14% of the float.

Toll's management said on the call that the company may repurchase more shares than it has historically, but the buyback won't have a meaningful impact on earnings. Certain analysts and shareholders have been urging the company to slow land purchases and return cash to shareholders.