Toll Brothers’ Key Issues for 2019
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Dan Oppenheim , CFA
February 10th 2019
- California exposure and margins, share repurchases and ROE, and land investment. We believe trends in the slowing California markets will be the key issue for Toll in 2019, but believe that the company’s efficient use of capital, seen in its share repurchase efforts and strategy to reduce its investment of owned land can help the offset the challenging conditions.
- Margin benefit from closings in California in 1H19, challenges later in year. We expect the slowing trends in California (51% of 2018 traditional homebuilding pre-tax income) to remain a concern, given the importance to Toll’s profitability (see p 2-3). However, we think Toll’s $1.9 billion backlog in California (34% of total backlog value, up from 30% at the end of 2017, despite the 32% year/year decline in order value in California in 4Q18) will aid margins and earnings in 1H19, but will then lead to year/year declines in margins and earnings in 2H19. Helping the 1Q19 results, backlog conversion in California was relatively low in 4Q18, likely leading to significant closings in 1Q19.
- Opportunity for continued share repurchase, given low leverage and focus on ROE. WeexpectToll to continue its share repurchase efforts (just over $500 million repurchased in fiscal 2018), given the flexible balance sheet and reduced investment in inventory. We estimate that Toll’s net debt to capital would fall slightly below 30% at year-end fiscal 2019, even if the company repurchases another $500 million of stock in 2019 (see p 3). However, the weakening order trends and recent increase in the share price may lead to more modest repurchase activity.
- Land investment to fall further, as Toll continues to shift to options on land. Toll has made significant progress on its effort to reduce its investment in land, cutting its investment in land for future communities by 62% since the Shapell acquisition in 2Q14, while now controlling 6% more lots and generating 50% more revenue. In addition, Toll now controls 39% of its lots via options at the end of fiscal 2018, up from 35% at the end of 2017 and 19% at the end of 2015. Our sense is that much of this investment in owned land is in California, given the region’s asset base relative to the backlog (with backlog reflecting work in progress), as compared with other regions. We see less need for land investment in the near-term, given that the land position lasts longer as order trends slow.
- 2019 Earnings guidance (if offered) likely to reflect caution on margins. Toll management only offered guidance for 1Q19 on its 4Q18 call, choosing to wait to provide full-year guidance. 1Q19 guidance for adjusted margins of 23.5% (down just 60 basis points sequentially) likely reflects a high level of closings from California, where 2018’s gross margins of 27.1% far exceeded the gross margins ex charges of 15.3-16.7% in the North, Mid-Atlantic, and South, and well above the 21.8% in the West. The remainder of the year will likely have a lower percentage of closings and revenue from California, which will likely lead to pressure on margins over the course of the year. We do not believe that the outlook is currently reflected in consensus estimates, but believe that downside is limited as the stock trades at approximately 1.1x estimated year-end 2019 book value. Nonetheless, we would remain cautious given the likely deterioration in order trends and risk to full-year expectations.
|Exhibit 1: SSR’s Preferences Among Housing-Related Sectors|
|Source: SSR analysis|
Toll Brothers’ Key Issues for 2019
California exposure and margins, share repurchases and ROE, and land investment. We believe investors should focus on three key areas for Toll: 1) its exposure to slowing California markets (51% of 2018 traditional homebuilding pre-tax income) and its margin trajectory, given that California will represent a lower portion of revenue as the year progresses, 2) significant potential to continue its share repurchase with its modest leverage (net debt to capital of 33% at the end of fiscal 2018), and 3) ability to further reduce its investment in land for future communities (down 62% since the Shapell acquisition in 2Q14, while controlling 6% more lots and with revenue 50% higher).
Toll’s presence in California to weigh on orders early in 2019, margins later in the year. California is of great importance to Toll, producing 51% of traditional homebuilding pre-tax income in 2018, despite having only 12% of Toll’s active communities at the end of 2018. However, these communities in California had more impact due to the higher average selling price ($1.67 million average closing price in California, more than twice Toll’s ex-California average of $710,700), higher gross margins (27.1% in California in 2018, far higher than the 18.5% ex-California gross margin), and higher absorption (communities in California averaged 3.4 orders per month, above the ex-California average of 2.1 orders per month). As a result, communities in California generated an average gross profit of $15.3 million, 4.5x the $3.4 million average gross profit generated from communities outside California.
|Exhibit 2: Communities in California brought greater profit due to the higher ASP, margins, and absorption|
|Source: Company reports and SSR analysis|
High backlog in California to help earnings in the first half of 2019. California comprised 34% of Toll’s year-end 2018 backlog, up from 30% at the end of 2017, with the value of the California backlog up 26% year/year. Toll ended 2018 with the strong backlog in California given a lower-than-normal backlog conversion rate in 4Q18, leaving more of the backlog to close in the first half of 2019. We think that these high-margin closings will help Toll’s overall margins in 1H19, but then would expect to see margin declines in the second half of the year, when California will represent a smaller portion of revenue.
SoCal communities concentrated in Orange and LA Counties, where sales have slowed. Toll’s Southern California communities are mostly in Orange County and LA County, with both areas having seen slowing sales and rising existing home inventory (approximately four months of supply, up from approximately two and a half months of supply one year ago). We believe that the greater supply of existing homes for sale will present competition and lead to a slower pace of sales for Toll. The Orange County communities are primarily in master planned communities (four communities in the Altair master planned community with Lennar in Irvine – Lennar is building at lower price points, while Toll is building at higher price points; three communities in the Pacific San Juan master planned community by Taylor Morrison in San Juan Capistrano, two in the Orchard Hills master planned community by The Irvine Company, and two communities in Yorba Linda). Master planned communities offer a source of land and often the ability to have structured options on the land (helping capital efficiency), but can then have limited flexibility on pricing decisions and also involve other new home competition in the same area. The LA County communities are largely north of Los Angeles (Porter Ranch, Santa Clarita, and Chatsworth), with one higher-priced community in Rolling Hills (south of the LA beach towns and west of Long Beach). The focus on the Porter Ranch/Santa Clarita area and proximity to oversupplied Ventura County may result in sluggish sales at Toll’s communities in the area.
NorCal communities face less competitive pressure, but still a slower sales environment. Toll’s NorCal communities should experience fewer challenges from existing home inventory, with inventory closer to two months of existing home supply, but sales volume has slowed meaningfully, down approximately 20% year/year. Toll’s communities are split between the East Bay (communities in Danville, Dublin, and San Ramon) and Silicon Valley (Fremont, Milpitas, and Santa Clara), along with one in Morgan Hill (south of San Jose) and Daly City (just south of San Francisco).
Non-California regions generating lower returns, unlikely to make up for slowing in California. Toll’s non-California regions will likely be unable to offset the slowing in California, where Toll generated an 18% pre-tax return on assets in 2018. Other regions have generated significantly lower returns, with the North, Mid-Atlantic, and South generating pre-tax return on assets of 6-9% in 2018, with better performance from the West and the smaller City Living division (pre-tax return on assets of 13% and 15%, respectively).
Balance sheet provides ability to continue with share repurchase program. Toll has focused on improving its ROE, with significant share repurchase activity over the past three years, with nearly $400 million repurchased in 2016, approximately $300 million in 2017, and just over $500 million in 2018. We believe that the expected cash flow generated by delivering the backlog will enable Toll to continue with its share repurchase program in 2019. We estimate that Toll could repurchase $500 million of stock and still end the year with net debt to cap below 30%. However, given that Toll only repurchased 783,000 shares from the end of fiscal 2018 (October 31st) until the filing of its 10-K in mid-December, we think the company may be proceeding more cautiously in light of the slowing market conditions.
Reduced investment in land leads to greater capital efficiency and less risk. Toll’s ROE focus also led to its reduced investment in land, especially investment in land owned for future communities. The capital in land for future communities peaked at $2.385 billion in 2Q14, immediately after the acquisition of Shapell, with Shapell significantly increasing Toll’s presence in California. The focus on reducing land owned for future communities and Toll’s sales efforts have enabled the company to work through much of the land inventory, with just $917 million invested in land for future communities as of the end of 2018. Reflecting this investment in operating communities (work in progress) represented 86% of Toll’s real estate investment at the end of 2018, up from 61% at the end of 2Q14. Facilitating the decreased investment in land, Toll has continued to work to control land via options, rather than direct ownership, with 39% of its lots controlled via options at the end of 2018, up from 35% at the end of 2017, and 19% at the end of 2015. In addition to the reduced capital invested, the options allow Toll to walk away from the option deposits as conditions deteriorate, reducing the risk in land. We anticipate that Toll will slow its efforts to control more land in 2019, as the deteriorating sales will mean that its current land pipeline will last longer.
2019 Guidance likely to be conservative given sales and margin pressure. We believe that Toll may take a cautious approach to 2019 guidance, either waiting further to provide full-year guidance, or by providing guidance that is below the current $4.71 per share consensus for 2019 EPS. We believe the key determinant of the guidance and estimates would be 1Q19 order trends, which will likely be weak, given the sluggish market trends during the quarter (November-January). Toll’s 4Q order value fell 15% year/year in 4Q18, and we would expect to see a slightly greater year/year decline in 1Q19, although we do not believe that this is reflected in consensus. However, we note that the larger homes and longer construction cycle, along with Toll’s strong backlog means that there is less uncertainty to Toll’s 2019 results than for other builders with shorter construction cycles.
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