Throw This Stock Away

The house rules are simple in this weekly column.

• I bash a stock that I think is heading lower.
• I offset the sting by recommending three stocks as portfolio replacements.

Who gets tossed out this week? Come on down, Toll Brothers (NYSE: TOL  ) .

For whom the bell Tolls
The market seemed to like yesterday's quarterly report out of the upscale homebuilder. Toll's shares climbed nearly 5%, and that's a welcome relief for shareholders, who had seen Toll hit a fresh 52-week low earlier in the week.

I'm not convinced.

Toll did manage to post improving bottom-line results -- even after adjusting for tax benefits and writedowns -- but where are the homebuyers?

Revenue fell by a sharper-than-expected 13% to $394.3 million, well short of the $406.3 million that analysts were targeting. There are signs of life given an improving rate of contract signings and a healthier net order backlog, but that ink doesn't dry as quickly as it used to. Toll's contract cancellation rate has climbed from 6.2% to 7.4% over the past year.

Toll is one of the better-positioned real estate developers on the market, but I'm sure there was a better-positioned buggy whip maker back in the day. If the market's appetite for new cookie-cutter communities in the suburbs doesn't improve, there isn't any domestic builder worth buying.

I realize that I am on the pessimistic end of the housing spectrum, but it needs to be said. Home prices are still too high, and rock-bottom mortgage rates aren't going to last forever.

It's not just me. TheStreet.com quoted Stifel Nicolaus analyst Michael Widner as saying that his firm sees national home prices falling by another 15%. If this is true, what do you think it will do to Toll's order cancellation rate? No one wants to close on a house that is suddenly worth less. If Toll has to adjust prices -- coming off its stiff average of $570,000 -- what will that do to margins?

Just because Toll has squeezed out five consecutive quarters of pre-tax and pre-writedown profitability doesn't mean that it will continue. There is still a glut of existing homes on the market. The urbanization movement that's sending the youth back into revitalized metropolitan markets is real.

Toll has the financial fortitude to be one of the last developers standing, but it doesn't mean that it will stand well.

Good news
As I do every week, I don't talk down a stock unless I have three alternatives that I believe will outperform the company getting the heave-ho. Let's go over the three fill-ins.

• Home Depot (NYSE: HD  ) : Crummy quarterly reports out of the country's leading alternative-wood decking and hardwood flooring specialists -- and even Home Depot rival Lowe's (NYSE: LOW  ) -- didn't bode well as the company behind the orange aprons prepared to deliver its latest quarterly financials last week. The fear wasn't warranted. Home Depot came through with improvement in sales, earnings, and even comparable-store sales. Homeowners may not be anxious to spend on big-ticket improvement projects such as a new patio or prefinished floor planks, but those hunkering down in their digs will still need to maintain their properties. Waiting for the broader recovery can also pay off nicely given Home Depot's healthy 3% yield.
• Gafisa (NYSE: GFA  ) : In bashing Toll's more problematic peer Hovnanian (NYSE: HOV  ) two months ago, I recommended overseas developers. Brazil's Gafisa and Mexico's Homex (NYSE: HXM  ) made the cut. I still think both are attractive alternatives to meandering stateside builders, though I have to give the Brazilian builder a nod this time. Gafisa is expected to grow its revenue at a healthier clip than Homex over the next two years, and it's also trading for a slightly lower earnings multiple. Gafisa now fetches a mere five times next year's projected earnings, while Homex trades at six times next year's income forecasts.
• Zillow (Nasdaq: Z  ) : Just because folks aren't interested in buying new homes doesn't mean that they're not curious about what their present digs are worth. Zillow operates a namesake real estate website that continues to grow in popularity on the heels of its free "Zestimate" home values. Zillow also provides more in-depth information on existing homes on the market than Realtor websites. Zillow completed its IPO at $20 last month, posting its first quarterly report as a public company last night. It was worth it. Revenue soared 116%, and Zillow came through with a modest profit.  

I hope I'm wrong about Toll, though I prefer to build on a stronger foundation.