Toll Brothers (TOL 2.46%) reported earnings on February 25 that missed Wall Street expectations and sent the stock reeling over 16% (in what was admittedly a horrible week for stocks). This is the best homebuilding market since the Great Recession, yet Toll got clobbered. What is going on? It turns out that pivoting to the first-time homebuyer might be harder than it first appears.
Earnings
First-quarter net income fell from $0.76 a share in 2019 to $0.41 in 2020, which was below Street expectations of $0.44 a share. Revenue fell 2% to $1.3 billion, while gross margin decreased to 18.3% from 21% a year ago. Toll Brothers sold 1,611 units at an average price of $805,300, versus 1,530 in the same quarter last year at an average price of $862,300.
Guidance was below Street expectations as well. CFO Martin Connor attributed the earnings miss to a "combination of delayed deliveries, unfavorable mix, and additional closeout costs related to certain older communities." These issues will persist into the next quarter as well.
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Management mentioned a specific development in Northern California that was the main driver of the miss. Metro Crossings in Fremont is a development with about 600 units that has suffered delayed deliveries and cost overruns. Metro Crossings is a massive development, and has more in common with a dense urban project than the typical suburban condo development. Deliveries were delayed in other areas, primarily due to issues with permitting and subcontractors who are stretched at the moment.
While the COVID-19 coronavirus outbreak was mentioned as causing delays in California, it was minor, at about 11 units. In terms of supplies, it was felt in lighting, but the company believes it can work around those.
Affordable luxury is having growing pains
Toll Brothers focuses on the luxury segment of the market: Primarily large single-family residences and upscale urban apartments. Like many of its competitors, Toll is increasing its offerings to target the entry-level buyer, although Toll is focusing on "affordable luxury," not necessarily stripped-down starter homes.
The change is certainly evident in the 6.6% drop in average selling prices. Toll acknowledged the growing pains on the conference call and reintroduced the the concept of the "dumb tax." The dumb tax goes way back, and Chairman Emeritus Robert Toll historically referred to the dumb tax when entering a new geographic market, where lessons about which land to buy, which subcontractors to use were often learned the hard way. The dumb tax did apply to the Metro Crossings Development, and can be seen directly in the disappointing gross margins.
The dumb tax did apply in the affordable luxury segment particularly with subcontractors, where Toll still cannot acquire services at the same prices as other lower-priced builders. That lowered margins. In many ways, affordable luxury presents a similar learning curve to the "active adult" concept. Rolling out a new line is easier than entering a new geographic market, which is where that effect really takes a bite. However, there still is a learning curve, and elements of it did apply.
Valuation issues
Toll currently trades at 9.8 times 2020 expected earnings, which is below the sector average of about 10.1. Toll also sports the highest dividend yield of the sector, although builders aren't necessarily dividend plays.
The drop in revenue growth is a little concerning, but orders for 2019 were probably set in stone before the Fed began cutting interest rates. Toll also noted on the conference call that orders tend to lag changes in the market. It reported declines in orders for most of last year. We should see the results of the rate cuts play out in 2020.
Given that Toll is going to take time to work through its Metro Crossings issues (think late 2020 into 2021), it is probably fairly valued at this point. The luxury market on the West Coast will also be vulnerable to coronavirus issues. Entry-level is where the demand is most acute, and builders like LGI Homes and D.R. Horton have that segment covered, along with double-digit revenue growth.
