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Everyone loves a comeback. So when Toll Brothers (NYSE: TOL ) reported fourth-quarter earnings earlier this month and showed its second straight quarter of profitability, I was intrigued. After 11 straight quarters of losses -- yes, you read that correctly -- I wondered whether this was a turnaround story in the making, a chance to get in on the cheap with a company that has weathered a major storm. So should you consider adding Toll Brothers to your portfolio? Let's take a closer look at the numbers.
Let's keep it simple and head straight for the income statement first to see if we can see any trends or underlying reasons for this recent success. While I could start discussing that gross margins are back in double digits for the past two quarters after being negative a year ago, a more significant factor quickly emerges.
Looking at the past two quarters, it's apparent that the profits recorded are almost entirely coming from tax benefits recognized in the quarter -- 118% and 97% for Q4 and Q3, respectively. So before we start popping the Champagne to celebrate this return to profitability, we should understand exactly what this means.
What is a tax benefit anyway?
Think of a tax benefit as the opposite of tax expense. When a company makes money, it has to pay Uncle Sam just like you and me, resulting in a tax expense. Likewise, if a company loses money, it can recognize a benefit on its income statement, provided that the company will be able to utilize it in the future.
However, the amount of expense or benefit recognized in a given year is often distorted by all sorts of timing issues and reconciling items. In the case of benefits, while the government is not going to cut you a check for the losses, it will allow you to deduct them against prior or future income. If you don't have any prior income to offset (the carryback is usually only two years), you can carry these net operating losses (NOLs) forward as an asset provided you will likely use them.
Here's the catch: If a company doesn't earn those planned profits, it has to record a valuation allowance against the asset, which reduces or even eliminates the asset.
Getting back to Toll Brothers
The benefit recorded by Toll Brothers in the quarter was because of the reversal of a valuation allowance. Typically, a reversal of a valuation allowance is a bullish sign for a company's future because it means that the company believes -- and has convinced its auditors -- that it will be able to use these tax benefits in the future to offset profits.
Recently, companies such as Harvard Bioscience (Nasdaq: HBIO ) , Telular (Nasdaq: WRLS ) , and BioMarin Pharmaceutical (Nasdaq: BMRN ) reversed valuation allowances because of expected sustained profitability in the future. Young companies like these record losses in their start-up years, but won't pay taxes during their first several years of profitability because they'll use these NOLs. Thus, the release of the valuation allowance indicates the expectation of future profitability for these companies, which is obviously a good sign.
In Toll Brothers' case, it not only lost money from operations before taxes, but it also reversed a valuation allowance because of a one-time legislative change that allowed it to apply losses against historical profits for the prior five years. So while this does have positive cash implications to Toll Brothers and the amount it will pay for taxes, it has nothing to do with its operating profitability and does not offer optimism like that of the companies mentioned above.
The Foolish bottom line
Don't get me wrong; the news is not all bad. While the company's income statement offers more questions than answers, it has generated cash from operations for the past three years. Additionally, its CEO is predicting strength in the housing market over the next few years, which is likely to drive future growth.
However, you have to look deep into the numbers and really understand what's going on in a business before jumping into a turnaround situation. When you do that with Toll Brothers, you'll see that the past two profitable quarters are not what they seem.