Toll Brothers, which swung to a fourth-quarter loss, and other homebuilder stocks rally on hopes the government's proposal will alleviate pain in the sector
While consumers, politicians and pundits debated the Bush administration's plan to help subprime borrowers that was unveiled on Dec. 6, investors piled into beaten-down homebuilder stocks. Shares of Toll Brothers (TOL), which reported fourth-quarter results before the market opened, jumped 13%, to $23.42, while Lennar (LEN) rose 15%, to $18.73; KB Home (KBH) surged 16%, to $24.25; and Centex (CTX) moved up nearly 13%, to $25.18.
Investors cheered the government's proposal to freeze interest rates for subprime buyers for five years and other measures designed to prevent a wave of subprime foreclosures that could cause the housing market to decline even further. Rising expectations for more interest rate cuts from the Federal Reserve might have also played a role in the rally, as lower rates would enable homeowners to refinance mortgages. The S&P Homebuilders index rose 12% on Dec. 6 as the group moved off its lowest levels of the year.
Indeed, this news overshadowed a dismal earnings report from luxury homebuilder Toll Brothers, whose shares have tumbled more than 30% this year. With an average selling price above $600,000, Toll Brothers caters to wealthy buyers who often have sterling credit. But Toll Brothers can still get hurt indirectly by problems for subprime buyers with riskier credit.
"The biggest hurdle for our clients right now is their concern about their ability to sell their old homes," Chairman and Chief Executive Robert Toll told analysts on Dec. 6. "An inability to obtain mortgages does not appear to be a problem for our buyers, but probably is a problem for our buyers' buyers."
In its fourth-quarter earnings report, Toll Brothers lost 52 cents per share, compared to earnings of $1.07 a year ago. Investors were expecting that loss, and were actually pleased to see Toll Brothers report $315 million in writedowns. A way of recording the declining value of Toll Brothers' land holdings and other damage from the weak housing market, these losses were actually less than some predicted.
But Toll Brothers executives, speaking on a conference call on Dec. 6, sounded genuinely puzzled as to which way the housing market goes from here. On the one hand, Toll said, there is "pent-up demand" for homes. "As soon as we remove the fear of dropping home prices, we may witness a faster and stronger recovery than anticipated," he added.
But some, like Bank of America (BAC) analyst Daniel Oppenheim, believe Toll Brothers is putting too much faith in a sharp recovery in the housing market. Unlike some other homebuilders, Toll Brothers hasn't aggressively cut prices to boost sales. "Falling home prices mean selling a home in future [will net] fewer proceeds than selling today," Oppenheim wrote.
But Morningstar (MORN) analyst Eric Landry says the strategy makes sense. Toll Brothers' luxury homes are typically built on scarce, valuable land close to the center of metro areas. That land is "hard to replace," so it makes more sense to hold onto it until the market recovers, he says.
And Toll Brothers doesn't need the money—at least not yet. Though it's recording big accounting losses, Toll Brothers is generating plenty of cash, Toll told analysts. The firm has about $2.1 billion in available liquidity, and its $1.5 billion in debt doesn't come due until 2011 at the earliest.
Thus, Toll Brothers believes it's prepared to survive even a very tough housing downturn. In fact, it plans to take advantage of falling land prices to prepare projects and increase market share in the next housing upturn. Much could depend on how far home prices fall and how long they stay low.
In the meantime, the Bush Administration's subprime proposal is an attempt to prevent a quick, deep drop in home values. Asked about the plan, Toll said he would prefer a broader effort, not one narrowly aimed at subprime borrowers. Many other homeowners will see interest rates reset next year; he proposed capping rates for all teaser mortgages at 8% or 8.5%.
Many experts note that even if the subprime problem is alleviated, housing prices could still fall. The idea that there is "pent-up demand" in the market is controversial. Years of overbuilding in many parts of the country may outweigh other factors like a strong labor market and increased immigration. Falling interest rates, government action or a return of buyer confidence may start to help homebuilders. But with a glut of new and old homes on the market, no one is predicting a strong rebound anytime soon.