The housing crisis is where the financial meltdown started and some analysts speculate housing is where the recovery must begin. Implosion of the subprime and “Alt A” mortgage markets (loans made to lower-quality borrowers) began the painful decline in property values that continues as many regions of the country have a gross oversupply of housing inventory. Until this imbalance in the supply and demand equation is brought down to more reasonable levels, expect continued downward pressure on residential real estate values and continued pain for the overall economy.
The crisis that started in housing has rippled out into nearly every facet of our economy—and that of the world as a global recession appears underway. It should come as a surprise that while the S&P 500 is down 38% for the year and the Dow Jones Industrial Average has lost a third of its value, the stock of luxury homebuilder Toll Brothers (TOL) is down only 9% during the same time period. Seriously, just 9%! TOL has swung wildly over the last year but somehow has largely remained relatively unscathed. It’s not that business has been booming, far from it: Toll Brothers reported earnings today that show just how bad things are. Revenue dropped 41% from last year and the company declined to give any sort of earnings guidance going forward. With housing starts at multi-year lows, the company reported that its backlog of business fell 54% to $1.33 billion from $2.85 billion. Total contracts also fell 27% since last year. While everyone would like to see a bottom in the housing market, judging from TOL’s latest quarter, we are not going to see one anytime soon.
In a blog posted June 4th, we wrote about the CEO of Toll Brothers calling for government action to stem the misery in the residential real estate market. He is still waiting for a “bail out” and conditions continue to deteriorate. Today, Robert Toll called again for a government lifeline (take a number!!!) saying, “We believe the government’s attention should be focused on shoring up the housing market, which is the root of the current financial crisis.” We said it then and we will repeat it now, it is doubtful that the government is going to bail out homebuilders. The origins of this crisis are many but builders like Mr. Toll must take some of the blame as overbuilding created the overhand of inventory which is so problematic now. Thus, builders should have to endure some tough quarters and not encourage government action which will only delay the inevitable reckoning in the marketplace.
Frankly, it is a surprise to us that Toll Brother’s stock has not been hit harder considering its abysmal results and no guidance going forward. The stock didn’t even react negatively to today’s results and is actually up slightly versus the broader indices, which are negative. To be fair, the stock did take a nose dive from mid 2005 through the middle of 2006, but its performance has been virtually flat since then. Is it possible that the market accurately priced in a meltdown in the housing market almost two years ago? We think not, which is one of the factors which led us to downgrade TOL to an Overvalued rating in this week’s report.
We believe that the fundamentals simply do not justify this price, especially in this bear market. It is certainly uncommon in this market for a stock to be trading at levels that are above its historical valuation metrics. For example, over the last 10 years TOL has normally traded between .61-1.17 times revenue, but its current price-to-sales number is slightly higher at 1.18x. This overvalued condition is more pronounced when looking at price-to-cash flow. Historically speaking Toll Brothers has traded in the range of 13.47x to 25.7x for price-to-cash flow but the current level is 28.6x.
Generally, we are contrarian investors and believe that the market has overreacted negatively to many of the stocks we follow. However, we believe that in the case of Toll Brothers and other overvalued homebuilders (PHM, LEN, DHI) that the market has not dealt with them harshly enough for their severely crippled businesses with little near term hope of recovery.