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Morningstar | Toll Brothers Reported Good 2Q Results, but 2019 Performance Will Likely Fall Short of Last Year. See Updated Analyst Note from 22 May 2019

Toll Brothers’ stock traded lower on May 22 following the no-moat-rated homebuilder’s fiscal second-quarter earnings release. While Toll Brothers beat its guidance and consensus sales and EPS expectations, management’s outlook for the rest of 2019 was disappointing.

Starting with the good news. Toll Brothers delivered 1,911 homes during the quarter, which topped management’s guidance of 1,650 to 1,850 homes. Homebuilding revenue increased 7% year over year to $1.7 billion due to a 1% increase in delivery volume and a 6% increase in the average selling price of delivered homes. Total sales beat the consensus estimate by 11%. EPS of $0.87 grew 21% year over year, beating the $0.75 consensus estimate. Strong operating income growth, driven by 7% sales growth and a 90-basis-point improvement in gross margin, was the primary driver of the firm’s strong earnings growth.

Now for the bad news. New orders, which is a leading indicator of future sales, slumped 9% on an absolute basis and 17% on a per community basis. California was the primary driver of this decline with orders in the region down 46% year over year. After two quarters of weak order activity (down 15% year to date), Toll Brothers began its fiscal second half with a backlog value 11% lower than last year ($5.7 billion). Management’s best-case scenario sees a 2% decline in total deliveries in 2019, and the worst-case scenario assumes a 7% decline.

We’ve reduced our fair value estimate about 6% to $45 per share to account for a 2019 that will likely fall short of our previous expectations as well as our moderated near-term assumptions for homebuilding market share gains and profitability. We remain constructive on the long-run prospects for residential construction, and we think Toll Brothers can at least keep pace with the overall market. That said, homebuilders focused on entry-level housing, like D.R. Horton, will almost certainly grow faster than Toll Brothers over the next decade, in our view.

The 46% decrease in California orders seems extreme, but it’s worth noting that Toll Brothers was facing a very difficult prior-year comparison (California orders were up 45% during the second quarter of 2018). Management also blamed lower inventory relative to the year-ago quarter and inclement weather as drivers of reduced demand in the region. However, housing data from the west has been particularly weak so far this year. For example, existing home sales are down 9% year to date, and total housing starts are down 20% year to date in the west. As such, we think lower demand was to blame to as well, which could’ve been exacerbated by Toll Brothers’ lower inventory and bad weather.

On a positive note, management said that order activity accelerated throughout the quarter. Compared with the prior year, total orders were down 22% in February, down 19% in March, but increased 11% in April. However, this dynamic wasn't unique to Toll Brothers. In fact, all 17 homebuilders that hold conference calls (NVR doesn’t) reported a similar sales pace trend throughout the quarter.

Management spent some time on the earnings call discussing the firm’s opportunity in for-rent apartments and single-family homes--two side businesses that investors may not be giving the firm enough credit for. According to the National Multifamily Housing Council, Toll Brothers is the 14th-largest multifamily developer in the U.S. and the fastest growing in 2018. Toll Brothers enters joint venture partnerships to reduce its risk exposure to apartment projects. Management also said it entered a joint venture with BB Living and a “large financial partner” to build and operate single-family rental communities. Toll Brothers committed $60 million to the venture. While management firmly said that these ventures are “strictly ancillary,” we can’t help but think it’s a defensive play as well, to help guard against potential future lost share to the rental market.

Management also made it clear that the firm is not afraid to build at lower price points, commenting that one third of Toll Brothers’ for-sale communities offer some homes with base prices below $500,000. While not a new strategy nor the first time the company has made this point, we think it’s smart for management to continue to hammer this point home with investors. The fact is, Toll Brothers does build homes that more affluent millennials can afford, so the firm is not precluded from benefiting from the “millennials coming of age” narrative. That said, production homebuilders that are more focused on lower-priced housing (for example, 35% of D.R. Horton’s fiscal second-quarter home deliveries were Express Homes with an ASP of $242,000) should enjoy stronger growth from millennial buyers than Toll Brothers.

Toll Brothers entered the Atlanta market through it acquisiton of Sharp Residential, which sells a variety of price points in Atlanta’s northern suburbs. The acquisition added 125 homes worth $65 million to Toll Brothers’ backlog and 10 communities to its community count. We view this small-scale acquisition as an extension of Toll Brothers’ land acquisition strategy.