Goldman Downgrades Toll Brothers, New Price Target Cut To $24 From $28
Earlier Goldman issued a new report on the homebuilders (found here). Not much in terms of overall macro perspective change, however notable was that Goldman downgraded TOL as the firm "believes that outperformance will be limited in the first half of 2010." However, before TOL management decides it will no longer pick up phone calls by Goldman's Joshua Pollard, GS hedges with: "That said, we still believe that there is significant value in Toll
shares for patient investors as Toll has one of the best franchises in
homebuilding." So sleep confident dear hedge funds managers - Goldman should still be able to arrange private one on ones with the CEO at your leisure. As for the true reason for the downgrade, whether this is due to most shorts having cleared out of the stock already, much in line with keeping with Goldman's strategy of upgrading stocks that have a substantial short interest (ref. MGM), is unclear.
From the report:
We downgrade Toll Brothers to Neutral from Buy as we believe that outperformance will be limited in the first half of 2010. That said, we still believe that there is significant value in Toll shares for patient investors as Toll has one of the best franchises in homebuilding.
Investors are wisely focused on the prospect for 2010 profitability in looking for investments in homebuilders. Unfortunately the 10-12 month build cycle for Toll Brother’s upscale homes is having multiple negative effects: First, the margin improvement that the rest of the group is exhibiting this quarter is likely a 2H10 event for Toll. Toll has often mentioned that they are lowering incentives on homes sold; however, those homes will not appear on the income statement until the third and fourth fiscal quarters of 2010. Hence, while the remainder of the group, which has 4-6 month build times, exhibits gross margin appreciation, we model Toll margins to move up only marginally over the next six months. Second, there is higher impairment risk at Toll than other builders. Toll’s long build times and older land portfolio aided the company in being profitable longer than the rest of the group and it’s October year end gives the company an additional 10 months to recoup cash tax refunds from the federal government. We have raised our writeoffs assumption by $150 mn to reflect the additional impairments the company may take as it sells land for cash.
We still believe that there is significant long term value at Toll Brothers; with shares trading near 1.2X trailing book value vs. the long term average of 2.2X, we think long term value exists. In our view, the premium multiple the stock has garnered historically (2.2X compared to peers at 1.6X) is the result of much higher returns on invested capital relative to the group, which we expect to return as (1) the company potentially sells undesirable lots in 2010, and (2) management’s land purchasing acumen and strong cash balance results in new land, with 25-30% embedded returns on capital. We note that Toll is only winning about 10% of its land bids, an encouraging sign for future returns.
Lastly, we believe there will be little builder competition for new luxury homes and master planned communities - the heart of Toll’s business. We expect Toll’s $1.6 bn cash balance (which we forecast to grow) and high-end expertise to be favorable as it has one of the few recognizable brand names in this business. Ultimately, while homebuilding has almost no barriers to entry, we believe Toll’s strategy will place them as one of the few and the most-healthy competitors in the highest barrier to entry subsegment of new home construction.
Factoring in higher write-offs, we lower our 2010 EPS to -$0.78 from $0.04. We also tweak our 2011 estimate to $0.64 (from $0.63). Our new $24 target price (from $28) still assumes 20% upside potential. Shares of TOL are down 41.3% and -11.0% since being added to the Buy list on 1/23/07 and over the last 12 months. This compares to the S&P 500 which is -19.6% and +36.3% over the same time periods. Despite its long term value, we believe shares of TOL underperformed given the reaction to homebuilding data which was thrown out of seasonal patterns.
Whether this downgrade will be the shot across the bow that sets off a barrage of homebuilder downgrades is unclear. What is clear, is that if the MBA is correct and mortgage originations are down 40% in 2010, then we will see quite a few Movie Gallery type situations in the coming year: refis (with Goldman as underwriter of course), that result in bankruptcies in under one coupon.