Even though the housing market continues to be incredibly tight, and the demand for new houses is relatively high, shares of Toll Brothers (NYSE: TOL) haven’t exactly had a great year thus far. Since the beginning of the year, shares are down more than 18%. This stock price performance seems to suggest that perhaps the company’s earnings are starting to plateau.
Based on Toll Brother’s most recent earnings results, it’s hard to say if this is the case or not. While the company continues to grow sales at an impressive clip, those sales aren’t necessarily translating to large net income gains. Let’s take a look at the company’s most recent earnings report to see if we can figure out why Toll Brothers’ stock has performed so poorly this past year, and whether this is a buying opportunity.
By the numbers
|Metric||Q2 2018||Q1 2018||Q2 2017|
|Revenue||$1.59 billion||$1.17 billion||$1.36 billion|
|Operating income||$134.3 million||$83.7 million||$139.2 million|
|Net income||$111.8 million||$132.1 million||$124.6 million|
In terms of growing the business, there isn’t much more you could ask for this past quarter. Revenue in the quarter was up 17% thanks to higher rates of new homes closed across all five of the company’s reporting regions and the average price per home sold up 1.5% to $812,900. On top of the closings, net new contracts were up 18% compared to this time last year, and Toll Brothers has a backlog of $6.36 billion, which was the highest it has ever been in the second quarter.
And yet, those fantastic operating numbers don’t quite seem to be showing up on the bottom line. Even though the company is benefiting from a much lower corporate tax rate than this time last year, and management has reduced total shares outstanding by 9.5% over the past year, earnings per share were down by a penny compared to this time last year.
Management noted that there were some one-time charges this past quarter such as a $13.8 million impairment related to the value of some properties, but even excluding those charges seems to come up with rather tepid growth. It would appear that the largest culprit for this past quarter was a contraction in gross margins, which slipped to 18.8%. Whether that is a sign of higher costs for land, labor, and materials, or it is simply a sign that Toll is ramping up its efforts to build new communities and expand its building capacity is yet to be seen. Management did say that it expects sales and gross margins to tick up in the third quarter, so we’ll have to wait and see if this is simply an aberration or a structural cost trend.
What management had to say
While conventional homes (if you want to call million-dollar homes conventional) are Toll Brother’s true bread and butter business, the company is also venturing out into several other business lines, including sales of urban apartments and even a rental business in high-demand urban and campus regions. While these are still a small part of the business overall, CFO Martin Connor made a point to highlight the efforts of this new venture in his prepared remarks:
We continue to focus on improving our Return on Equity (ROE) and driving value for shareholders, while maintaining our profit margins and balance sheet flexibility. In April, we increased our dividend 38% from $0.08 per quarter to $0.11 per quarter. We have also repurchased $291.5 million of stock to-date in FY 2018.
Our rental apartment business continues to grow. We now control a pipeline of approximately 16,000 units in projects completed, in construction, under development or in approvals. We are expanding this operation beyond our metro Boston to Washington, D.C. base and now have teams in San Francisco, Los Angeles, Atlanta, Dallas and Phoenix.
(You can check out the full conference call transcript here.)
Building developments for rentals is a very different business model than regular home building, but there are some benefits if management can pull it off. Rentals can provide more stable revenue and help smooth out the cyclicality of the home-building business. That may not seem like an issue now, with the housing market going absolutely bonkers, but it could be valuable in the future, when housing hits a bump in the road.
Stock looks cheap, but one uncertainty remains
There are certainly some things to like about Toll Brother’s stock right now. Operationally, it appears that there is still a lot of room for the company to grow, and even though we have seen interest rates tick up, there haven’t been any glaring red flags signaling that the housing market is slowing down yet. Management raised its dividend 38% in April, and the stock currently yields 1% and has a trailing-12-month P/E ratio of just 10. Those numbers suggest the market expects Toll Brothers’ earnings to deteriorate significantly from here.
The one thing that could take a serious bite out of Toll Brothers is if margins continue to deteriorate. Management did say that this was a bit of a one-time thing, but we will have to wait until the third quarter to be more certain that is the case.
10 stocks we like better than Toll Brothers
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has quadrupled the market.*
David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now… and Toll Brothers wasn’t one of them! That’s right — they think these 10 stocks are even better buys.
Click here to learn about these picks!
*Stock Advisor returns as of June 4, 2018