A whole generation of American investors avoids anything related to homebuilding as if it were the plague, and it is easy to see why. Vast numbers of people were burned badly by the Great Real Estate Meltdown of 2008.
More recently headlines about real estate bubbles, overpriced housing and mortgage shenanigans at institutions; such as Bank of Internet (NASDAQ: BOFI), have brought back many of the fears of 2007. So it is not surprising that Toll Brothers (NYSE: TOL) is a tough sell to today’s investors.
Yet Toll Brothers has been doing surprisingly well lately; revenues that have nearly doubled in the past three years, and it has a healthy profit margin. During the period between January 2013 and January 2016, Toll’s revenues increased by $2.255 billion. The builder reported revenues of $1.985 billion in first quarter 2013 that increased to $4.246 billion in first quarter 2016.
Has Housing Really Recovered?
To add icing to the cake Toll reported a profit margin of 7.88% and a net income of $355.02 million on January 31, 2016. That gave the company a healthy Earnings Per Share number of 1.927. Naturally these figures will make us wonder if housing has really recovered and if Toll Brothers is a value investment.
The answer to the first question is sort of, Toll Brothers’ revenues are up but it is not making that much money; it reported a negative free cash flow of -$24 million and just $70 million in cash from operations on January 31, 2016. The company also reported cash and short-term investments of just $336.24 for first quarter 2016.
These numbers also answer the second question; Toll Brothers is definitely not a value investment because it has no float and generates very little cash. In fact, it looks like a company that could collapse very quickly. The numbers also seem to justify the popular skepticism about American housing.
Does Housing Have a Future?
Toll Brothers is also heavily exposed to America’s current housing bubble; or rather the series of regional housing bubbles afflicting the nation. Its current projects seem to mirror the maps and lists of housing bubble cities that appear online.
Toll is building in Los Angeles, San Francisco, Fort Collins (Colorado), Denver, New York City, Boston, Seattle and Chicago. All of which have seen serious bubbles in recent years. It is also heavily exposed to some of the old bubble areas; including Orlando and Las Vegas.
The period of Toll’s revenue increase also matches the latest housing bubble. One has to wonder if its increased revenue is the result of artificially home prices generated by low mortgage interest rates; rather than a genuine housing recovery.
A major danger that Toll could face is that the Federal Reserve could raise interest rates to prevent a housing bubble. Such an action would burst the housing bubble and create a lot of pain for builders.
Investors should stay away from Toll Brothers, even though it is one of America’s most admired companies. There are better and safer ways to take advantage of this unstable real estate market. Some plays I like include the underpriced home-improvement store Lowe’s (NYSE: LOW), and mortgage-issuing banks like Wells Fargo (NYSE: WFC).
It will take a paradigm shift in the US economy to make homebuilders like Toll, a value investment. Until that happens, you should stay away from this sector, even the good companies are in very shaky condition.