Revisiting Toll’s Key Issues Ahead of Fiscal 2Q19 Results

Dan Oppenheim
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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Dan Oppenheim, CFA

(415) 889-5617

doppenheim@ssrllc.com

May 20th 2019

Revisiting Toll’s Key Issues Ahead of Fiscal 2Q19 Results

  • Stabilization and improving order trends are the key for TOL. The issues holding back TOL have been 1) the declining orders in California and the West, given the exposure to California (47% of fiscal 2018 homebuilding profit) and the West (20% of 2018 homebuilding profit), 2) overall weakness in orders, with declines in orders occurring in regions other than Mid-Atlantic. Stabilization of order trends – demonstrating a floor in order activity and demand – is necessary for upside in the stock. We expect to see a more modest decline in orders in fiscal 2Q than in fiscal 1Q, which should lead to a relief rally for the stock and allow for further upside in the stock in the coming months.
  • California to help margins in fiscal 2Q19, but then hurt in future quarters. Backlog conversion in California was at the lowest level (18%) for fiscal 1Q in several years, which leaves more backlog to close in fiscal 2Q19. That will be a benefit, as we expect 32% of 2Q19 revenue from California, with another 22% from the West region, with these two regions having substantially higher margins (26.2% and 23.4% ex-charge gross margins, respectively in fiscal 1Q19) than Toll’s other regions (15.7%-18.5% ex-charge gross margins in the Mid-Atlantic, North, and South), with California and the West likely representing a greater share of revenue in 2Q19 than in 1Q19 (54% vs 49%). However, we expect gross margins to fall in subsequent quarters based on the lower order activity from these high-margin regions, which will mean both a lower percentage of revenue in future quarters and also lower margins in these regions.
  • Is share repurchase driven by order trends, the balance sheet, or valuation? Toll management repurchased just $25 million of stock in fiscal 1Q19 and indicated that it expects a flat share count sequentially in 2Q19, pointing to limited repurchase activity in 2Q19. It appears that the slow order activity in fiscal 1Q19 influenced the repurchase activity, even though the average purchase price in 1Q19 was just below quarter-end 1Q19 book value. In addition, net debt to total capital ended fiscal 1Q19 at 33%, and likely with a positive outlook for cash flow based on the backlog and expected closings in fiscal 2Q19. We think the company could be more aggressive given the strength of the balance sheet and with the stock trading 15% above book value. (page 2)
  • Conversion of older backlog could help 2Q19 results. Toll’s backlog relative to the most recent quarter’s orders was 4.3, above the 3.4 ratio in the first quarter of each of the prior four years, reflecting the older backlog this year (due to the lower level of orders in 1Q19). This older backlog may lead to a higher level of backlog conversion and closings in fiscal 2Q19, potentially leading to closings biased toward the upper end of the 1650 to 1850 home closing guidance. (page 3)
  • Greatest opportunity in building products, homebuilders, home centers, and mortgage insurers. We continue to expect the favorable affordability to drive improving home sales, home improvement activity and home price appreciation. Among stocks, we see the greatest opportunity in DHI, LOW, MAS, and TOL.
Exhibit 1: SSR’s Preferences Among Housing-Related Sectors
Source: SSR analysis

Revisiting Toll’s Key Issues Ahead of Fiscal 2Q19 Results

Expectations for fiscal 2Q19 orders:

  • Overall, orders likely fell 12% in fiscal 2Q19, better than the 24% decline in 1Q19, and would expect orders to be relatively flat year/year in 2H19.
  • The key regions to watch for stabilization of orders are California and the West, given the 62% and 28% respective declines in 1Q19. We expect that California orders declined by 30-35%, but this is still substantially better than the 62% decline in 1Q19. We think that the West region may achieve flat orders on a year/year basis due to easier comps from 2Q18.

Outlook for gross margins in California:

  • Gross margins in California are likely to hold up through the remainder of 2019 based on the long construction and backlog cycle for Toll, with this prolonged in California. However, the weaker demand and order trends in California in early fiscal 2019 will likely translate into lower gross margins in California in fiscal 2020, as greater incentives and decreased pricing power on orders in 2019 will then translate into closings and revenue in 2020.

Share repurchase activity has become dependent on order activity:

Exhibit 2: Share repurchases have slowed with order trends, despite strong balance sheet
Source: Company reports and SSR analysis

Potential for higher backlog conversion due to older backlog than in recent years:

Exhibit 3: Toll’s “older” backlog could help backlog conversion in 2Q19
Source: Company reports and SSR analysis

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