Housing's Woes Hit Toll Brothers

The luxury-home builder said earnings took a big hit last quarter as housing market troubles crept up the food chain

by Maya Roney

If anyone was still talking about a forthcoming bottom for home builders on the morning of May 9, chances are they were silenced by a discouraging announcement from the country's largest builder of top-dollar homes.

Though the official earnings report falls on May 24, Toll Brothers (TOL) said revenue for its fiscal second-quarter ending fell 19%, to $1.17 billion from $1.44 billion a year earlier, as new luxury homes lingered on the market and would-be buyers abandoned deposits. The Horsham (Pa.) builder also warned that profits would fall short of its original guidance, but assured investors that the quarter was still profitable.

"Twenty months into this housing downturn, we continue to face difficult conditions in most of our markets," admitted Chief Executive Robert Toll in a statement addressing the preliminary results. "We no longer expect to achieve the most recent quarterly and annual guidance we provided on Feb. 22."

Earlier this year, Toll Bros. said 2007 earnings per share would fall between $1.46 and $1.85. The company projected EPS of 43 to 57 cents for the fiscal second quarter; 33 to 45 cents for the third quarter; and 36 to 50 cents for the fourth quarter. Back in December, Toll reported signs of stabilization in some markets (see BusinessWeek.com, 12/6/06, "Toll Brothers: Scraping the Bottom").

New Outlook, No Surprise

How things have changed. The luxury-home builder now expects to take a second-quarter charge of $90 million to $130 million to account for falling home values across the country.

"You could generalize that earnings visibility is low for Toll Bros. for the next few quarters and for the homebuilder group also," says Standard & Poor's Equity analyst Tom Smith. "The write-down [$90 million to $130 million] was ahead of my estimates. But you never know what that amount is until the accountant comes back with it."

Smith lowered his price target on Toll Bros. to $33 from $36 after preliminary earnings were announced and maintained a "hold" rating on the stock. But it would be lying to say these results were unexpected. Toll Bros. shares were down barely 1% on Wednesday afternoon. "A lot of this bad news is built in [to the stock]," Smith says.

Coincidentally, the National Association of Realtors reported May 8 that home prices would decline nationwide in 2007. After stating in January that prices would edge up slightly over the year, the group now expects the national median home price to decline 1% in 2007 to $219,800, marking the first ever year-over-year decline in prices since they began tracking them in 1968.

Trouble at the Top

The NAR has blamed 2007's poorer-than-expected housing numbers on the new tighter lending standards put in place at companies like Washington Mutual (WM) and Merrill Lynch (MER), the consequence of a recent explosion in defaults on subprime loans (see BusinessWeek.com, 5/2/07, "No Spring Thaw for Housing"). Though it's not the whole problem, stricter lending reduces the pool of buyers and adds to already waning demand.

Fewer than 2% of Toll Bros. home buyers use subprime loans, but tighter loan standards can affect even those builders who cater to wealthier customers. If you're looking to upgrade from a starter home to one of Toll's fancier creations, selling your starter home is going to be a lot tougher without the subprime customers who may have considered it in the past. "This, in turn, can affect the entire 'housing food chain,' including some of our potential customers' ability to sell their existing homes," Toll said in Wednesday's statement.

In its fiscal second quarter (the three months ending Apr. 30), Toll Brothers signed 2,031 contracts, down 14% from the year-ago period. Subtract those contracts that were canceled during the quarter, and that total contact number is down 24% year-over-year to just 1,647. The value of the total contracts fell 25% from a year ago, to $1.17 billion.

Motivated Seller

The company's second-quarter cancellation rate fell to 19% from the prior quarter's 30%, but this number is still much higher than the 9% cancellation rate in 2006. And "it's not like they're comparing themselves to tough comps anymore," notes Morningstar analyst Eric Landry, who has a three-star rating (the equivalent of a "hold") on Toll shares. Roughly 70% of second-quarter cancellations came from contracts signed more than 30 months ago, Toll added.

"The initial take is that things are still ugly, and there's no sign of any turnaround anytime soon," says Landry, who doesn't expect to see an upturn for homebuilders until 2008 at the earliest. "There's just too much inventory out there." For now, homebuilders are still slashing prices to generate more volume, which, Landry says, is the right thing to do. "Volume is more critical than price at this point," he explains. "Many homebuilders have decided that we need to cut prices to get homes sold."

And for a million-dollar McMansion builder like Toll, that's really got to hurt.

Click here to see a roundup of the states with the highest foreclosure rates.

Roney is Real Estate writer for BusinessWeek.com.