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Morningstar | Toll Brothers' 1Q Results Easily Beat Wall Street's Expectations; 2019 Outlook Still Uncertain. See Updated Analyst Note from 27 Feb 2019

We've maintained our $48 per share fair value estimate for no-moat Toll Brothers following its fiscal first-quarter earnings release as our long-term outlook is unchanged. Despite the well-documented housing market slowdown, Toll Brothers' first-quarter financial performance topped consensus and management's expectations. Total revenue increased 16% year over year to $1.36 billion (versus $1.26 billion consensus), mainly due to an 8% increase in home deliveries and a 4% increase in the average selling price of deliveries. While Toll Brothers' GAAP EPS declined 8% year over year to $0.76 (versus $0.61 consensus), the prior-year quarter included a one-time tax reform-related tax benefit. Excluding this benefit, Toll Brothers' EPS increased 19% year over year. First-quarter home deliveries of 1,530 units was within management's guidance range, and adjusted gross margin; selling, general, and administrative expenses; and the effective tax rate all beat management's guidance.

The backlog Toll Brothers built throughout 2018 allowed the homebuilder to report strong first-quarter results. However, the firm was not immune to the slowing housing market; first-quarter new orders plunged 24% year over year and new order ASP declined 9%. Toll Brothers' California market was the hardest hit, with new orders declining 62%. However, to be fair, Toll Brothers was facing an extremely difficult comparison (new orders in California during the first quarter of 2018 were up 72% year over year). On the bright side, management noted that order activity improved throughout the first quarter, and customer deposits during the week ended Feb. 23, were higher than last year. Of course, we can't extrapolate one week's worth of sales activity, however, CEO Doug Yearley commented that last week is "historically one of the biggest sales weeks of the year." However, management's outlook is still uncertain enough that they didn't feel comfortable providing guidance beyond the second quarter.

With 30-year mortgage rates reaching one-year lows and improving housing-related data points (for example, pending home sales increased 5% in January and homebuilder confidence reached a four-month high in February), we think the all-important spring selling season could surprise to the upside. Still, with two consecutive quarters of declining year-over-year orders and a backlog value that is down 4% year over year to $5.4 billion, it's highly unlikely Toll Brothers will realize anywhere near as strong of growth in 2019 as it enjoyed over the previous few years. However, if the recent slowdown is in fact just a "pause" like we expect, Toll Brothers' growth can certainly rebound in the coming years. We're currently modeling Toll Brothers' home deliveries to grow about 1% in 2019 and then at about a 6% compound annual growth rate over the subsequent five years.

We were impressed with Toll Brothers' gross margin and SG&A expense leverage during the quarter. Adjusted gross margin, which excludes interest expense and inventory write-downs, improved 50 basis points year over year to 24.2%, and SG&A as a percentage of home sales improved 110 basis points to 12.3%. Management expects second-quarter adjusted gross margin of 23.1% (versus 22.5% last year) and SG&A as a percentage of sales to be 11.3% (versus 10.4% last year). Management's second-quarter SG&A guidance implies a 90-basis point unfavorable change in SG&A as a percentage of sales, which we think is mostly due to potentially lower home sales revenue as compared with the second quarter of 2018. The midpoint of management's second-quarter home delivery and ASP guidance implies home sales revenue of $1.5 billion (again at the midpoint of guidance) versus $1.6 billion last year.