Last week, Toll Brothers Inc (TOL) chairman and CEO Bob Toll sold 791,000 shares from his vast portfolio of TOL stock.  He still owns nearly 16 million shares or close to 10% of the company’s stock, but he has a history of lightening up at the opportune time.  He has sold about $50 million worth of stock this year.  I can’t say that I blame him, as frequent readers of this blog are aware, at Ockham we believe that Toll Brothers is Overvalued.  Fundamentally speaking, there is not much to like about this stock as they continue to write-down the value of their assets and sales remain sluggish.  However, housing market bulls have bid up this stock in anticipation of a recovery.

The Wall Street Journal brought this story to our attention,

“Mr. Toll spoke encouragingly about the housing market Aug. 27 in presenting results for the company’s fiscal third quarter ended July 31. The company reported a loss of $472.3 million for the quarter, largely reflecting write downs of asset values, but Mr. Toll said: “We believe declining cancellations and more solid demand indicate that the housing market is stabilizing.”

In a conference call with investors, he said stronger housing demand in recent months “makes us feel a whole lot better.” In response to questions about the outlook for the economy and further waves of foreclosures, however, he said Toll hadn’t purchased much land recently. “So while we’re optimistic,” he said, “we’re also unwilling to make bets on the future being much different than the current market.”"

There is no doubt that Mr. Toll still has a lot of wealth tied to TOL stock, and it is his right to do with that stock as he pleases.  After all, he and his brother have built the company from the ground up since 1969.  The article quotes a spokesperson for the firm says that he is simply diversifying his personal holdings, which he said is “prudent”.  That is a fair statement to be sure, and like we said, we would probably do the same thing.

That being said, his actions are speaking louder than his conference call words.  Mr. Toll may be optimistic about what is ahead for TOL, but an argument could be made that $50 million in sales this year give the appearance that he believes the fundamentals do not support the price currently.  Earnings estimates are improving for TOL (though still negative through the next fiscal year), and the stabilization of housing is a welcome development.  However, we are reiterating our Overvalued stance on TOL stock, as we are for most other homebuilders.  There is still too much supply in the marketplace to make homebuilding a sector we would want to be investing in.

Residential real estate site Zillow.com released a discouraging report on the future of the housing market in the United States.  The web site compiles information regarding home prices, mortgage values, tax rates, and other important information and has become a leading authority on residential real estate.  Among the findings of Zillow’s analysis is that nearly one-quarter of all U.S. mortgage holders are now underwater on their mortgage loans.  Declining home values are of course the culprit and could continue to fall through at least the next year.  They estimate that by mid-2010 that number could continue to rise and reach about 30%.  This prediction is actually a great deal better than the opinion expressed just last week by analysts at Deutsche Bank (DB) , which claimed that as many as 48% of mortgage holders could be underwater as prices continue to fall through early 2011.

Homeowners are being hurt by price declines. The estimated median value for single-family houses slid to $186,500 in the period, a 12 percent drop from a year earlier and the 10th consecutive quarterly decrease, the Seattle-based real estate data service said in a report today.

“The negative-equity rate will rise and spin off more foreclosures,” Stan Humphries, Zillow’s chief economist, said in an interview. “I see a substantial downside risk to prices and don’t think we’ll see a bottom until the middle of next year.” — From an article by Dan Levy, Bloomberg.com

This analysis certainly puts a damper on many of the housing green shoots that have partially fueled the recent rally in equities.  The rate of declines in home prices does seem to be stabilizing, and that is not to be dismissed.  However, this report is further confirmation of our bearish stance on the residential construction industry.  The twenty stocks that we cover in this group have appreciated an average of 73% over the last six months.  However, the significant supply glut of unsold homes will continue to put pressure on these homebuilders.  At current sales rates, the supply of homes on the market right now would last about 9.4 months, which is more than twice the average supply level from 2000-2005.

Luxury homebuilder Toll Brothers (TOL) will report earnings Wednesday, and analysts are expecting to see a loss of $.32 per share ex-items.  We see no catalysts for a turnaround in TOL or its competitors, and we continue to rate most in the sector as Overvalued.

The National Association of Realtors pending home sales index increased by 6.7% to 90.3 in April.  This marks the largest increase in that measure in more than seven years and continues a streak of three straight months of strengthening data.  Pending home sales is regarded as a leading indicator because it tracks the number of contracts signed, however this does not always translate to a completed transaction.  Polling of industry analysts had yielded consensus expectations for a gain of only .5%.  Housing is comparatively more affordable now than any time in recent history as housing prices have fallen, mortgage rates hit historic lows, and the $8,000 tax credit for first time home buyers contained within the stimulus plan have all made buying a home more attractive.

Even though pending home sales have improved consistently over the past few months, as of yet existing home sales (recorded when the sale closes) have been much more volatile.  Existing home sales were lower in February, increased in March and only slightly increased in April by about 2.5%.  The disparity between the pending home sales and existing home sales suggests that mortgages are tougher to come buy as banks have tightened their lending standards.  This seems to correlate with recent data suggesting that lenders have not yet resumed lending at a historically normal pace.  Either potential home buyers are taking longer to approve or are not being approved at all.  However, as Brian S. Wesbury and Robert Stein of First Trust Advisors suggest bank lending is a lagging indicator, but their analysis focuses on commercial and industrial loans to businesses rather than mortgage loans.  It would make sense that banks would be more conservative in their mortgage lending practices as well, as capital preservation is still at a premium right now.

The important point in this data is that it shows demand is starting to be pulled back into the housing market.  It is on this news that homebuilders are getting a boost; as Hovnanian  (HOV) leads the pack up 10% while DR Horton (DHI), Toll Brothers (TOL), Pulte Homes (PHM) are all up as well.  However, as you can see from our chart of the Residential Construction sector, we are not at all positive on the stocks in this sector.  There has simply been to much of a degradation in earnings and too many balance sheet damaging write-downs that shares have not fallen enough to justify us getting more positive on them.

Furthermore, there is still a huge overhang of supply of housing in the market, and the combination of housing starts having declined very rapidly and this renewed demand is the only way to bring the market back into something of equilibrium and stop the destruction of housing prices.  In April, fueled by a record month for foreclosures housing inventory increased 8.8% to almost 4 million existing homes available for sale.  That represents more than 10 months of supply given current pace of sales, but the initial buyer’s interest is being drawn into the market which is at least an encouraging sign. 

It will be very interesting to see how the rise in mortgage rates will effect these developments going forward.  The average 30-year mortgage rate has increased to 5.32% from 4.94% just a month ago.  This data is an good sign, but it is still too early to tell if housing is turning a corner.  Either way, the earnings potential of homebuilders in an environment where supply is still hanging over the market, makes us want to steer clear of those stocks.

Toll Brothers (TOL) alluded to another painful quarter as the luxury homebuilder expects to take another bigger than expected write-down, this one in the neighborhood of $90 to $160 million.  The company issued its earnings outlook ahead of the official release two weeks from today, and Toll said that revenue has slipped 51% in the quarter.

“Luxury home builder Toll Brothers reports 2Q revenue of $398 million, that’s still 51% year-ago levels.” CNBC’s Squawk Box 5/20/2009

Closings were down 47% from a year ago, and the backlog of business fell 55%.  The bright spot in the release was the fact that the company has increased its stockpile of cash to about $2 billion, a stunning $12 per share.  This is a certainly a surprise as the company is projected to lose about $1.40 in fiscal 2009, and they are writing down the value of assets each quarter.  I have not heard of major asset sales, so the increased cash on hand must be reflective of the $400 million worth of notes they issued in April.  So, the cash hoard was not generated organically, and has added to Toll’s long term debt.

The stock has risen close to 3% in morning trading, which suggests the market is feeding off of Chairman and CEO Bob Toll’s remarks that suggest the worse is likely over in the housing market.

“With interest rates at an historic low, home price affordability at an historic high and consumer confidence starting to improve, we believe that more buyers are beginning to enter the housing market…Despite a weak economic and employment landscape, which was reflected in fiscal 2009’s second-quarter contracts, we have a few reasons for cautious optimism.  The most encouraging is our recent deposit activity.”–Bob Toll

Mr. Toll is correct to be cautious with his optimism, as just two days ago housing starts activity reported a record low for April.  In addition, April foreclosures were at a record pace as well.  There is still an oversupply of homes for sales it has just a shifted the supplier from home builders to banks holding foreclosed homes.  The worsening trend in foreclosures should give pause to anyone who thinks the housing market has certainly bottomed because foreclosures are bad for two reasons: they are destructive to demand as those foreclosed upon are very likely taken out of the buying pool and foreclosures increase supply at a time where there is already an imbalance.

At Ockham, we are confident to reaffirm our Overvalued rating on Toll Brothers because the price is still too high for the greatly eroded fundamentals.  Toll Brothers, whose stock one would think would be very effected by current market conditions, has been largely resilient thus far.  The stock is only down 27% from its 52-week highs, even as revenue and earnings are disappearing.  Furthermore, Toll is a luxury homebuilder which will be a tough place to be for some time, as home values have declined on existing homes making them even better competition.  So, even if the worst is over, which it may be, we think there are better stocks to take advantage of the recovery.

So let me get this straight. Yesterday morning, Toll Brothers (TOL) reported its worst fiscal year in twenty years as a public corporation and its shares rallied as much as 15% during the day. However, eventually the shares could not fight the negative direction of the broader market, finishing up nearly 7%. With most of the major market indices falling about three percent or more for the day, you might wonder what caused the rally in TOL shares?

It was not the luxury homebuilder’s performance during the quarter that propelled the stock. On the contrary, analysts had estimated Toll Brothers would lose $.47 per share for the quarter, but the company turned in a loss of $.49 per share. Some analysts optimistically called this “a narrowing of losses” considering that TOL lost $.52 per share in the fourth quarter of 2007. I would point out that the company lost more than $300 million dollars for the year, which is not exactly inspiring. Revenue for the fourth quarter was down 40% from last year to $698 million. On November 11^th Toll Brothers reported that its backlog of business has fallen 54% and that signed contracts are down 27%. To be fair, everyone knows that homebuilders–especially luxury homebuilders–are enduring one of the most dreadful operating environments in history.

So, can one attribute yesterday’s TOL rally to upbeat guidance for the year ahead? No–Toll Brothers did not offer financial guidance for 2009! I do not blame the company for its reticence given the substantial amount of uncertainty regarding the economic prospects for 2009. The company did say that it anticipates building between 2,000 and 3,000 homes in the next year with an average price of $600,000-$625,000. In comparison, the company sold 4,743 homes in the past year. Furthermore, the most recent National Association of Homebuilders’ survey showed the lowest confidence level regarding builder’s near-term prospects in the survey’s history. According to the AP, in the most recent quarter, median home prices fell 9% and 40% of all homes sold were sales on bank foreclosures.

Something must have sparked TOL’s rally and I have established that it was neither the company’s recent performance nor bright near-term prospects. So, I am left with to conclude that there must be some sort of external event causing newfound bullishness in the stock and these days that often means government is getting involved. Sure enough, word on Capitol Hill is that the government plans to artificially lower mortgage rates in order to entice new home buyers. It might be déjà-vu but I think we have seen this before and how did that work out?

The government’s imposition of a rate of 4.5% on 30-year mortgages will most definitely attract a new throng of buyers but is this really the answer to the housing crisis? The short answer is: no. As I have documented in previous posts about Toll Brothers (Home Builders: Not Finding Buyers Here and Toll Brothers CEO Warns of More Trouble Ahead), CEO Bob Toll has been asking for a government bailout for the homebuilders for about six months now. Back in June, few took Mr. Toll seriously and thought his plea was simply a diversion from his company’s woeful performance. Well mission accomplished; if this proposal is enacted, a bailout for homebuilders is exactly what we will have. All of this for a company whose stock is in positive territory thus far in 2008, meaning it has outperformed the market indices by more than 40%! That is pretty remarkable for a company that has just been through its worst fiscal year in its entire history as a public corporation. Does that sound like an industry that needs propping up? Once the government snowball starts rolling, look out below!

I suspect we will be dealing with a new housing bubble down the road, as prices always seek equilibrium and will not be buoyed by governmental intervention forever. As I wait for the other shoe to drop, Ockham Research rates TOL Overvalued because I see very little compelling reasons for optimism in its crumbling fundamentals. There are far better stocks to invest in right now that actually have improving fundamentals and have been unjustly beaten down in this bear market.

For a further bearish indicator, see Jim Cramer’s interview with Bob Toll on last night’s Mad Money (link). Cramer gleefully congratulated Toll on his company’s “beautiful balance sheet” as they discussed the future of housing. They skipped over the disappointing earnings as Cramer claimed that no one looks at those numbers anymore. Then they raved about the newfound affordability in housing after legislative action to artificially lower mortgage rates (to the direct benefit of Mr. Toll) yet failed to even consider the possibility that this could all backfire down the road. What really got to me was Mr. Toll not once, but twice calling on Congress and the Fed to start marketing this mortgage rate to the public. He really must believe that the government works for him, and unfortunately he may turn out to be right.