The Worst Stock for 2007: Toll Brothers

Here's the thing: I'm very intrigued by the homebuilding industry and looking hard at buying shares of a select few companies. That's because 2007 may offer investors one of those opportunities -- with regards to homebuilders -- to buy shares of great companies at dirt cheap prices.

These will be the companies that aren't forced to write down significant amounts of book value -- either because of their tight controls over inventory or because their land holds its value throughout the downturn.

First, the macroeconomic mumbo jumbo
We all know about the housing bubble.

Prices rose at unsustainable rates, demand was at record levels, and homebuilders rushed to keep pace and cash in. Then, all of a sudden, the economy started to slow. Demand slackened, prices dropped, and many homebuilders were left with cancellations and a glut of inventory.

Indeed, the SPDR Homebuilders (AMEX: XHB  ) ETF, which holds large stakes in Beazer Homes (NYSE: BZH  ) , Hovnanian (NYSE: HOV  ) , and Lennar (NYSE: LEN  ) , in addition to Toll, is down more than 20% since April.

Now experts are debating whether or not we've reached the bottom.

Here's my short, short answer
We're not at the bottom; we're near the bottom. That means that while now is the time to start looking at the industry, it's not the time to start snapping up shares willy nilly.

Toll Brothers (NYSE: TOL  ) , as you might have guessed, is a stock I would avoid.

The whys and wherefores
Put simply, Toll Brothers worries me.

First, Toll is a luxury builder. While it would seem intuitive that the first people to start purchasing again following this downturn would be wealthier Americans, I think much of Toll's growth in recent years was driven by Americans who overextended themselves to purchase, for lack of a better term, too much house. This segment of the population, reeling with debt, will actually be slowest to return to their free spending ways.

Second, Toll Brothers is a major player in hypercompetitive markets such as Washington, D.C. While the company benefits from this in the sense that demand won't drop off severely in D.C., the consequence is downward pressure on margins.

Currently, Toll stock trades for 1.4 times book value and 18 times forward earnings. To my eye, those are not cheap multiples. Rather, they indicate a company that is expected to sustain its book value and margins.

Indications are wrong
Unfortunately, I don't think we've seen the last of Toll's write-offs or reforecasts.

Toll is carrying more than $6 billion worth of inventory. This gives the company an inventory-to-equity ratio of 1.8, which lands it at the high end of the industry average.

Why does this matter?

If the housing market continues to slide, Toll may be forced to write off some of the carrying value of its land. The company wrote off some $152 million of value this year, and expects to take another $60 million worth of charges next year. To me, however, that $60 million looks low. And according to other analyst reports I've read, they're expecting $80 million or more -- particularly since the company has yet to take significant charges in the cooling Arizona and Florida markets.

Now, this wouldn't be a big deal if such charges were already priced into the company's stock. But I don't believe they are. Rather, as I said before, Toll trades for 1.4 times book and 18 times forward earnings -- multiples that imply a steady stalwart.

So, if book value is restated downward, then we'll see two downside consequences. First, the stock will start to look expensive, and the price will drop. Second, Toll may also see its multiple erode as its risk profile worsens. This will cause the drop in stock price to be somewhat more severe.

Finally, Director Bruce Toll sold nearly $15 million worth of stock in November for less than $30 per share even as management has expressed optimism in recent conference calls. While insider selling isn't necessarily a sign of trouble, this particular transaction could indicate that insiders actually think a recovery is a good ways off.

The Foolish bottom line
Despite the recent decline in stock price, Toll Brothers stock continues to have a lot of optimism priced into the shares. Because that optimism is not warranted, I believe Toll may be one of the worst stocks to own for 2007.

If you agree with my assessment of Toll Brothers, please let us know in our Motley Fool CAPS community stock database by rating TOL "underperform." If you disagree, and there is merit to that argument, rate the stock "outperform." Just click here to join CAPS, and we'll declare the worst stock for 2007 early next week.

Want to go back to the beginning of our Worst Stock for 2007 tournament? Right this way.

Tim Hanson does not own shares of any company mentioned. The Motley Fool has a disclosure policy.

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