Toll Brothers Inc. Stock Report

Toll Brothers, Inc.

 

The graph shows how the bottom fell out of the earnings during the housing price crash in the U.S. at the time of the financial crisis. There has been a continuous very sharp recovery since 2011.

This company is somewhat unique in that revenues and earnings lag by nine months to one year the time when the sale of a new home is contracted for. Revenues and adjusted earnings per share continue to recover but are still lower than the pre-crash peak of 2005 and 2006.

Toll Brothers Inc. (TOL, New York)
RESEARCH SUMMARY
Report Author(s): InvestorsFriend Inc. Analyst(s)
Author(s)’ disclosure of share ownership:  The Author(s) holds shares
Based on financials from: Oct ’17 Y.E. +Q2 ’18
Last updated: 23-May-18
Share Price At Date of Last Update:  $                             39.58
Currency: $ U.S.
Generic Rating (This rating does not consider the circumstances of any individual investor and is therefore not specific advice for any individual): (lower) Strong Buy rated at $39.58
SUMMARY AND RATING:  (See below for more details on the comments in the summary). The economics of the business have been good over the long term and have recovered after the housing market crash and are improving. The graph of revenues per share (red line) shows strong growth since 2011. The earnings per share line shows that profits crashed all the way to large losses during the financial crisis years but since then have been increasing rapidly but are still below former peak levels of 2005 and 2006. Book value per share (the green line) also declined in the financial crisis but was relatively more stable and has increased only relatively modestly due to the impact of large stock buybacks. The Value ratios, in isolation, would justify a (higher) Buy rating. Management quality appears strong. The insider trading signal is neutral. Recent adjusted earnings per share  growth has been very strong although with slower growth in the latest quarter. The profit outlook is for earnings growth in the next year in the range of about 27% based on contracts signed in the past year and based on a reduced share count but this assumes that costs will increase no faster than revenues (which was not the case in the latest quarter where costs increased faster than revenues). There is a lag of almost one year before signed contracts become sales. Toll Brothers may have some competitive advantages in terms of its inventory of approved building lots,  know-how and access to debt at lower rates and also has strong brand equity. We originally chose this investment in mid- 2011 as a way to participate in the recovery in U.S. housing prices and sales. The earnings have risen strongly but with periods of flatness but the stock has been quite volatile. Overall this is a company with reasonably good economics that can be expected to continue to grow and that is well managed and that currently appeared to be attractively priced.  Overall, with a focus on the revenue earnings growth expected in the next year, we rate this as a  (lower) Strong Buy. Canadian investors, of course, face currency risk if they wish to measure the value of this investment in Canadian dollars.
LON TERM VALUE CREATION: Over its 50 year life, the company has taken in $717 million in equity capital. Much of that would have been in the past decade since the figure was about $230 million ten years ago. It has total accumulated earnings of about $5,000 million and has returned to investors $925 million in share buy-backs and about $65 million in dividends. The current book value is $4,481 million and the market values this equity at $6,140 million. Therefore it might be said that the company has turned $717 million into $6,140 million in addition to paying out about $990 million in share buybacks and dividends. The paid in capital may be largely in the form of the value of stock options received and the accounting for this is complex.
DESCRIPTION OF BUSINESS: (updated March 2018) Toll Brothers is primarily a large builder of executive and luxury homes. Its average home price is about $700,000 in most of its regions based on recently signed contracts. In California its average home price is much higher at $1.7 million.  It is vertically integrated in that it also has large land holdings and acts as the developer of its own communities and also is active in providing mortgages to its home buyers although it then appears to sell the mortgages to other financial institutions.  In interpreting its financial results it is important to understand that there is a lag of roughly 9 to 12 months between signing a sales contract and when that shows up as revenue and earnings. It is currently active in about 295 “selling communities” (sub-divisions). It operates in 19 States in four different regions of the United States. The biggest operations are on the east coast with some operations in other parts of the country. Recently California has become a larger share of its operations. It has about 4000 full-time employees. It also has other businesses of increasing importance including selling building lots to other builders, building luxury high rise condos in large cities and building and renting apartment units in selected large cities. Also some mortgage operations. It was founded in 1967 by two brothers, one of whom is the executive chairman. It appears to make heavy use of contractors in the actual building of homes and the development of land. In 2017 it contracted to build 8,175 homes up 22% from the prior year and but still down from the 10,372 homes it contracted for in 2005 which was the peak year.
ECONOMICS OF THE BUSINESS: The company basically “manufactures” building lots by buying raw land and developing it into finished lots and then it manufactures higher-end housing. The economics seem reasonably good since there is some brand equity and some ability to differentiate the product due to location and quality. The company does face risks on land values. The (adjusted) profit on sales was recently 8.5%. And the financial leverage (assets as a multiple of equity) was 2.20 times. But the annual sales over assets were only 64% resulting in an ROE (return on ending equity) of 12.0%.  Management expects  the ROE to increase to about 15% range in the next year based on higher sales and the lower income tax rate as well as lower equity due to share buy-backs. With some brand value and given the ROE, the economics of the business appear to be reasonably good but not exceptional but are improving.
RISKS: The primary risk would appear to be that house and land prices do not continue to recover sufficiently. It may possibly have substantial land that was purchased at higher prices than today’s market price although this seems less likely as time passes and home prices rise. And some of land values from the 2006 peak era has already been written off. Recently there was a large charge related to warranty work on stucco homes in the North East and so warranty costs are a risk.
INSIDER TRADING / INSIDER HOLDING: (Based on Yahoo Finance as of May 23, 2018)  In the past year there has been some selling by insiders at prices from $36 to $52.  Some of the sales are automatic without regard to price. However, no trades are shown after January 25 which was when the shares dipped below $50. Considering the current price of just under $40 and the lack of very recent trading the insider trading signal is neutral. The company itself has aggressively bought back shares at prices up to at least $47.40 which was the average in Q1 fiscal 2018. The average paid in Q2 was $45.44.
WARREN BUFFETT’s CRITERIA: Buffett indicates that all investments must pass four key tests: the business is  simple to understand (pass), has favorable long-term economics due to cost advantages or superior brand power (pass due to brand and probable barriers to entry), apparently able and trustworthy management (pass due to surviving the circa 2008 housing crash and the long-term track record), a sensible price – below its intrinsic value (pass based on the value ratios), Other criteria that have been attributed to Buffett include: a low  debt ratio (pass), good recent profit history (pass) little chance of permanent loss of the investors capital (pass – given that it has survived very well the extreme downturn) a low level of maintenance type capital spending required to maintain existing operations excluding growth (pass – it spends extensively on land inventory but not on its operating assets)
MOST RECENT EARNINGS AND SALES TREND:  Adjusted earnings per share in the past four quarters starting with the most recent (Q2 2018) rose 17%, 56%, 9%, and 14% (Revenues are driven by sales contracts signed about 9 to 12 months prior to each quarter). Revenues per share in the latest four quarters, starting with the most recent rose 29%, 37%, 14%, and 20% (again note there is a about a 9 to 12 month lag from signing contracts to booking revenue).  In fiscal 2017 adjusted earnings per share rose 11% and revenues per share rose 17%.  In fiscal 2016 adjusted earnings per share rose 30% and revenues per share rose 30%. In fiscal 2015 adjusted earnings per share rose 8% and revenues per share rose 7%. In fiscal 2014 adjusted earnings per share rose 99% and revenues per share rose 40%. These figures are affected by a lag as revenues lag signed contracts by almost one year. Overall, the recent trend has been very strong.
INDUSTRY SPECIFIC STATISTICS: Signed contracts in units in the past four quarters beginning with the most recent (Q2, 2018) rose 6%, rose 20%, 15%,  and 24%. Signed contracts in dollars in the past four quarters, starting with the most recent, rose 18%,  rose 36%, 20%,and 25%.  The recent trend in the units contracted for and in dollars of signed contracts is very strong except that the unit growth in the latest quarter has slowed considerably.
Earnings Growth Scenario and Justifiable P/E:  Only relatively modest growth is required to justify the current P/E of 12.
VALUE RATIOS: Analysed at a stock price of $39.58. The price to book value ratio of 1.37 seems at least somewhat attractive. The company is likely worth more than book value considering there is  little or no goodwill on the books and considering the “hard” nature of the assets and considering that company would have  going concern value beyond its asset value and also considering that some higher cost land was written down in value during the financial crisis. The dividend yield is modest at 1.1% as the company retains the great majority (about 87%) of earnings for growth and only recently instituted a dividend. Adjusted earnings in the trailing year are lower than GAAP earnings as certain income tax benefits were deducted. The Price to Earnings Ratio based on adjusted earnings is, in isolation,  attractive at 11.9, particularly considering that earnings could rise 27% in the next year based on contracts signed in the past year and the resulting 27% increase in the backlog versus Q2 2017. The ROE is reasonably good at 12.1% based on adjusted earnings and management appears to be projecting about 15% for 2018. In terms of an intrinsic value calculation, we calculate $43 if earnings grow for five years at just 6% and the P/E rises slightly tot 13 and $63 if earnings grow at 10% and the P/E rises to 16. This growth may be quite conservative considering the potential 27% growth in the next year based on the backlog but this is a cyclic industry. The value ratios, in isolation would justify a (higher) Buy rating.
SUPPORTING RESEARCH AND ANALYSIS
Symbol and Exchange: TOL, New York
Currency: $ U.S.
Contact: fcooper@tollbrothersinc.com
Web-site: www.tollbrothers.com
INCOME AND PRICE / EARNINGS RATIO ANALYSIS
Latest four quarters annual sales $ millions: $6,305.5
Latest four quarters annual earnings $ millions: $584.4
P/E ratio based on latest four quarters earnings: 11.0
Latest four quarters annual earnings, adjusted, $ millions: $538.8
BASIS OR SOURCE OF ADJUSTED EARNINGS: We use figures provided by management which deduct certain income tax refunds and add back certain asset write-offs. We used adjusted pre-tax earnings less an assumed 35% income tax rate for 2009 to 2013 because the income tax amounts were then highly volatile.
Quality of Earnings Measurement and Persistence:  The adjusted earnings appeared to us to be reasonably measured. However earnings are cyclical in this industry.
P/E ratio based on latest four quarters earnings, adjusted 11.9
Latest fiscal year annual earnings: $536.9
P/E ratio based on latest fiscal year earnings: 12.0
Fiscal earnings adjusted: $497.5
P/E ratio for fiscal earnings adjusted: 12.9
Latest four quarters profit as percent of sales 8.5%
Dividend Yield: 1.1%
Price / Sales Ratio 1.02
BALANCE SHEET ITEMS
Price to (diluted) book value ratio:                                         1.37
Balance Sheet: (Q1 2018) Assets are comprised as follows: 80% is “inventory” (primarily land and land under development and houses under construction and would include some capitalised interest) 5% is cash, 5% investments in unconsolidated entities, 6% receivables, prepaid and other, 1% customer deposit funds held, 1% mortgage loans receivable, 2% is property construction and office equipment. Note that there is no goodwill on the balance sheet. These assets are financed as follows: 46% common equity, 37% debt, 10% accrued expenses  (includes previously expensed allowances for warranties and self insurance and some wages to be paid in future and some future capitalized land development costs) , 4% accounts payable and 3% customer deposits. Retained earnings constitute 87% of the common equity which indicates a history of profitability. However with no dividend, until very recently, this may be no great accomplishment 50 years of operation. Overall this balance sheet has solid and hard physical assets and is well financed with a debt level that is not excessive.
Quality of Net Assets (Book Equity Value) Measurement: Assets consist mostly of land, both developed and raw. Goodwill has been written off and significant land values have been written off. Land values have likely increased materially in recent years.  It seems reasonable to assume that the net asset or net book value is now quite conservatively stated. The shares now trade at a 37% premium to book value and so this high quality of the assets is at least partially reflected in the share price.
Number of Diluted common shares in millions:                                 155.1
Controlling Shareholder: There does not appear to be a controlling shareholder. Co-founder and Executive chair Robert Toll owned 7.5% as of February 2018 and the other cofounder would own several percent in addition but there are large institutional owners who could collectively out-vote.  Black Rock owns (or controls) 11.2% and the Vanguard Group 7.4. The nature of the institutional ownership is not entirely clear to me and clients may have most of the votes. The two Toll Brothers likely effectively control the company. The CEO owns about 0.8%.
Market Equity Capitalization (Value) $ millions: $6,140.0
Percentage of assets supported by common equity: (remainder is debt or other liabilities) 45.5%
Interest-bearing debt as a percentage of common equity 81%
Current assets / current liabilities: not disclosed
Liquidity and capital structure: Appears to have a strong balance sheet. Credit rating is low investment grade at BBB minus at Fitch though below investment grade at BB+ from Standard and Poors.
RETURN ON EQUITY AND ON MARKET VALUE
Latest four quarters adjusted (if applicable) net income return on average equity: 12.1%
Latest fiscal year adjusted (if applicable) net income return on average equity: 11.4%
Adjusted (if applicable) latest four quarters return on market capitalization: 8.8%
GROWTH RATIOS, OUTLOOK and CALCULATED INTRINSIC VALUE PER SHARE
5 years compounded growth in sales/share 25.4%
Volatility of sales growth per share:  Highly Cyclical long term
5 Years compounded growth in earnings/share 2.0%
5 years compounded growth in adjusted earnings per share 43.7%
Volatility of earnings growth:  Extremely Cyclical long term
Projected current year earnings $millions: not available
Management projected price to earnings ratio: not available
Over the last ten years, has this been a truly excellent company exhibiting strong and steady growth in revenues per share and in earnings per share? No
Expected growth in EPS based on adjusted fiscal Return on equity times percent of earnings retained: 9.9%
More conservative estimate of compounded growth in earnings per share over the forecast period: 6.0%
More optimistic estimate of compounded growth in earnings per share over the forecast period: 10.0%
OUTLOOK FOR BUSINESS:   Based on existing signed contracts we would expect growth in revenues of about 27% or more in  the next year as the backlog is up 218. Earnings growth is harder to predict as costs will rise along with revenue but could be more than 27% given economies of scale. And due to a lower share count associated with the redemption of convertible debt there should be an additional 3% growth in EPS. This company is unusual in that the 9 to 12 month lag between contracting to build a house and delivering that house means that the revenues are quite predictable in the year ahead. However, note that in Q2 cost increases led to slower adjusted earnings per share growth and its not clear if similar factors will affect the next few quarters. See our comments on recent earnings where we provide the figures for growth in recent sales contracts. Contracted sales could also continue to increase based on the economy and on an increased number of active selling communities in the  next two quarters.
LONG TERM PREDICTABILITY: Home building is a cyclic industry. But over the long run a strong company like Toll Brothers should continue to grow. Earnings can be expected to be volatile.
Estimated present value per share: We calculate  $43 if adjusted earnings per share grow for 5 years at the more conservative rate of 6% and the shares can then be sold at a P/E of 13 and $63 if adjusted earnings per share grow at the more optimistic  rate of 10% for 5 years and the shares can then be sold at an increased P/E of 16. Note that it may grow revenues 27% in the next year alone based on its backlog. Both estimates use a 7.0% required rate of return. This is a cyclic industry and the earnings growth is particularly hard to predict.
ADDITIONAL COMMENTS
INDUSTRY ATTRACTIVENESS: (These comments reflect the industry and the company’s particular incumbent position within that industry segment.) Michael Porter of Harvard argues that an attractive industry is one where firms are somewhat protected from competition based on the following four tests. No barriers to entry (marginal pass, the ability to invest large amounts of capital to hold and develop land and to finance house construction may be a barrier to entry especially for companies wanting to grow to a large size. No issues with powerful suppliers (pass). No issues with dependence on powerful customers (pass), No potential for substitute products (pass) No tendency to compete ruinously on price (marginal pass, normally builders would not sell at large discounts although some would in distress situations such as the 2008 U.S. housing bust). Overall this industry appears to be moderately attractive.
COMPETITIVE ADVANTAGE: Toll Brothers has advantages in terms of its brand reputation. In early 2018 it was named most admired home building company in a Fortune magazine survey for the fourth year in a row. Also has advantages in its know-how. Also its scale. At this time its strong balance sheet may be an advantage although in most times borrowing to finance house construction and land development is probably relatively easy but management indicates that smaller builders have limited access to capital at this time and that Toll Brothers has lower borrowing costs. Management believes that the company’s large inventory of approved building lots in desirable locations is an advantage because it is becoming harder to obtain land and to obtain approvals.
COMPETITIVE POSITION: We have not studied its market share but we understand it has an attractive market share in this highly fragmented industry. It is the 6th largest U.S. home builder. The company indicates that it dominates its target market.
RECENT EVENTS: In September 2017 they redeemed convertible debt which has lowered the diluted share count by 3.4% and this has provided a one-time (but permanent) increase to diluted EPS of about 3%.  The company has continued to buy back shares aggressively and astutely on dips.
ACCOUNTING AND DISCLOSURE ISSUES: The disclosure appears to us to be candid and is concisely stated in the earnings press releases. We saw no major issues with the accounting. However, in Q4 2016 the disclosure of an income tax benefit was absent in the release and only mentioned on the conference call. Subsequently in 2017 we note a lack of consistency in reporting and high lighting various unusual items – such a   gain on sale mentioned in Q2 but not mentioned in the annual press release. And, it would be helpful to see a more detailed breakout of the cost of goods sold. The income statement has very few line items. It is disappointing that there is not more focus on, and a summary table of, adjusted earnings per share figures in the disclosure. We are disappointed that the earnings press releases do not include a cash flow statement although this omission is common for U.S. companies. By nature, the revenues and earnings are based on contracts to build houses that are signed on average some 9 to 12 months prior.
COMMON SHARE STRUCTURE USED: Normal, one vote per share.
MANAGEMENT QUALITY: Our impression is that management is of high quality. We take it as a positive indicator that the company still has a co-founder in place as an active executive chairman. We are impressed that the company was able to come through the horrific 2008 crash in the housing market and to emerge with a reasonably strong balance sheet. They wisely sold off land as the housing crisis evolved and then bought back land more recently. This allowed it to actually build cash, and reduce debt despite suffering losses and huge declines in sales. In the 2013 annual report at page 17 they speak of being careful stewards of shareholder capital over their 27 years as a public company. The balance sheet is proof of this as it shows that retained earnings are large compared to the amount invested by shareholders. Since 2015 they have moved aggressively to buy back shares during dips and that is a sign of a rational management.
Capital Allocation Skills: We think these skills have been strong for the same reasons as mentioned under management quality.
EXECUTIVE COMPENSATION: Updated Spring 2018. Executive compensation appears to be generous. The co-founder and executive chairman was compensated at $6 to $8 million in each of the last three years.  The CEO  was compensated $10 to $12 million in each of the past three years.  For  context, the 2017 adjusted net profit of the company was $498 million, so this compensation reduced net income but not by a very large percentage. Director compensation is relatively high at about $200,000 and could be high enough to affect the likelihood of directors to act independently in cases where such independence might put their directorship at risk.
BOARD OF DIRECTORS: (Updated May 2018) 10 members all but two of long-standing. One member is a founder and major owner which we view as positive. The others appear well qualified but there are perhaps too many who have been in the Board too long. Director compensation is about $200k which could be high enough to limit the independence of the Board members although their high ownership helps in that regards. Overall, this appears to be a somewhat weaker Board that would be unlikely to ever challenge the founder.
Basis and Limitations of Analysis: The following applies to all the companies rated. Conclusions are based largely on achieved earnings, balance sheet strength, achieved earnings per share growth trend and industry attractiveness. We undertake a relatively detailed  analysis of the published financial statements including growth per share trends and our general view of the industry attractiveness and the company’s growth prospects. Despite this diligence our analysis is subject to limitations including the following examples. We have not met with management or discussed the long term earnings growth prospects with management. We have not reviewed all press releases. We typically have no special expertise or knowledge of the industry.
DISCLAIMER: All stock ratings presented are “generic” in nature and do not take into account the unique circumstances and risk tolerance and risk capacity of any individual. The information presented is not a recommendation for any individual to buy or sell any security. The authors are not registered investment advisors and the information presented is not to be considered investment advice to any individual. The reader should consult a registered investment advisor or registered dealer prior to making any investment decision. For ease of writing style the newsletter and articles are often written in the first person. But, legally speaking, all information and opinions are provided by InvestorsFriend Inc. and not by the authors as individuals. The author(s) of this report may have a position, as disclosed in each report. The authors’ positions may subsequently change without notice.
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