Toll: Favor the chocolate chips, not the stock

Aaron Pressman

Luxury homebuilder Toll Brothers (TOL) is having an awful year in the stock market as the designated punching bag for real estate bubble watchers. After tripling in price from late 2004 to July 2005 and peaking at almost $59, the shares have tumbled below $30 lately. Unfortunate for shareholders but less so for the CEO, Robert Toll, who sold 2 million shares last summer around $50. As he tells Barron’s, "The reason I sold it is that we hit an all-time high and we were trading at a 40% to 50% premium to our peers." That’s a refreshing burst of honesty from an overpaid CEO – at least he didn’t pin the blame on estate planning needs. And to be fair, he still owned 18.8 million shares as of a December 21 securities filing. But is the current price a great buying opportunity, as Barron’s suggests?

Count me as a big skeptic. Despite its low p/e ratio, Toll’s holding 36,000 home sites and $2 billion in debt on its balance sheet as real estate prices in its top markets look increasingly ready to plunge. People say there won’t be a housing bubble nationwide, only in select overheated markets? Toll is heavily exposed to the northeast and Mid-Atlantic with a big dollop of Arizona and California thrown in. My colleague Peter Coy argued Toll’s not a bellwether due to its high-end focus. It sells homes with an average price closing in on $700,000 and top-end McMansions that go for over $2 million. So it’s selling some of the most expensive homes in some of the fastest-appreciating markets.

Not that my opinion should carry too much weight. I was very bearish – and mistakenly so – on Toll and its brethren in 2004. Back in October 2004, Pulte Homes (PHM) announced a huge bust in the Las Vegas market due to a surge in cancellations. But it was a mark of bad management, not of a sector going south, and provided a good buying opportunity for those who saw the truth. Two top fund managers, Legg Mason’s Bill Miller and Fidelity’s Will Danoff, certainly did. I’ll stay more focused here and not venture an opinion on the sector.

But Toll is raising the same question as Pulte. Two weeks ago, Toll pre-announced its fiscal first quarter results (for the three months ended January 31) by revealing that it had experienced what Bob Toll called “softening demand,” cough, cough, nudge, nudge. While total revenue of $1.3 billion and its $6 billion backlog (of homes sold but not yet delivered) were both at record levels, the value of new signed contracts declined 21% from a year earlier to $1.14 billion. Unlike Pulte’s solo experience in 2004, Toll’s announcement has so far been followed by similar revelations from KB Homes (KBH).

Be especially watchful when Toll reports its official quarterly results on Thursday. The pre-announcement included a 3% reduction in the number of homes Toll expected to deliver this year but didn’t offer a revision of projected earnings per share. That comes with the official announcement. A greater than 3% reduction could signal that the price slowdown is biting into results as well as the sales slowdown.

Ironical addendum: Pulte Homes today announced a higher than expected 2007 profit projection helping send Toll and the rest of the group higher.

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