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Is Toll Brothers a Good Turnaround Play?

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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.

Related Foolishness:

Fool contributor Stephen J. Marini doesn't own shares in any of the companies mentioned above. BioMarin Pharmaceutical is a Motley Fool Rule Breakers selection. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy

Read/Post Comments (3) | Recommend This Article (5)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 15, 2010, at 8:28 AM, mnoles wrote:

    I think you make good general points, but gloss over the specific case of TOL.

    Let's bring it to the top: future earnings come into play with MOST tax valuation reversals, but not THIS tax valuation reversal. You eventually reveal that this write off will go against "Historical" earnings. How does that change your earlier statements about general tax reversals in light of this revelation? Will Toll actually get a check from the government (since the taxes on prior profits have already been paid to Uncle Sam?) Do investors still need to worry about not being able to use this tax asset?

    The second issue is that Toll Brothers earnings trend is never discussed leaving the headline question un-answered. If you strip out the big tax write-offs what do you have? Is there a trend?

    "Is Toll Brothers a good turnaround play?"

    I don't know the answer, but I can see that It isn't discussed in this article.

    Just My Opinion. Fool on!

  • Report this Comment On December 15, 2010, at 12:45 PM, thenatural24 wrote:

    To answer your points:

    It wasn't really a case of eventually revealing a key fact. Not everyone has a good understanding of tax accounting, so a little background on how tax valuation allowances work was necessary before jumping into TOL. I could have ignored that it is typically a bullish signal / earnings optimism part given that it doesn't relate to TOL, but I wanted to include it because that is the overwhelming reason in most of cases of val allowance releases. While not relevant to TOL, I didn't want anyone to be under the impression that this is a negative occurance

    Regarding changing prior statements regarding general tax reversals- it really doesn't change anything that was said prior as that was more informational. The point was that this was not a future earnings issue, it was applied to historical earnings and therefore doesn't offer any optimism or type of bullish signal. I apologize if it's unclear.

    The fact that they released the val allowace indicates that they believe they will use the DTA. If they didn't think they would be able to use the tax asset, they would still have a val allowance on it. They also were able to convince their auditors that they would us it as well - and that threshold is generally high for a val allowance release such as this.

    Regarding earnings trend, the first paragraph talks about 11 straight quarters of losses before 2 quarters of profitability. The two quarters of profitability are almost exclusively the result of tax benefits (not write-offs) - and so if you strip them out, you have two more quarters of losses / breakeven. That was really the point, you don't have much of anything. I guess you could look at trends of the losses to see if they are approaching profitability, but that really wasn't the point. I was trying to highlight that the profitable quarters are not what they seem.

    In the end, whether it's a good turnaround play is up to the individual investor. However, I'm just pointing out that you can't just look at an earnings trend in a vacuum, see that they are now in the black for two straight quarters, and think that they've turn the corner. Maybe the title was misleading.

    I appreciate the feedback.


  • Report this Comment On December 16, 2010, at 8:41 AM, mnoles wrote:

    Thanks for the clarification, Steve.

    I understand your points now:

    1. Here is what a bullish trend looks like, and w/r to TOL, no bullish signal is there(w/r to the tax reversal.) I'm sure it doesn't hurt that Toll picked up a big pile of "free money," but I see your point.

    2. A loss is a loss, even when one time items make it appear as a profit. I guess the deeper question is: "When do you play a turnaround? Before, during, or after the change from losses to profits? " Unfortunately, reliable answers to "when" questions are usually best determined in hindsight!

    Thanks for your article and interaction.

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