I’ve been pounding the table to buy Toll Brothers Inc (NYSE:TOL) for a while now. I picked TOL in August 2011 to outperform the market on Fool.com CAPS, and the shares have more than doubled since that pick. While some might fear they have missed the opportunity to buy, it’s not too late. The same positives that I saw in 2011 are still present today. Even more important is, the recovery of the housing market will take years, and this over 100% gain in the last two years should just be the start for Toll Brothers Inc (NYSE:TOL) investors.
The Great Housing Revival
Just two years ago, it was hard to convince anyone that housing was beginning to rebound. It was common to read articles saying that housing was in the doldrums. However, if you looked at the backlog of most homebuilders, they were up across the board.
A homebuilder’s backlog is a gauge of potential future business. While it’s true that investors need to watch the homebuilder’s cancellation rate, if orders in the backlog aren’t cancelled, healthy growth should occur. A second metric to watch is the average price of delivered homes, and the average price of homes in the company’s backlog.
Contrary to the idea that house prices haven’t been strong, many homebuilders are reporting consecutive quarters of positive price momentum. Last but not least, investors need to watch homebuilder’s debt-to-equity ratios to make sure the companies aren’t taking on too much debt.
The Great Thing About Recessions
It might sound strange to suggest there is anything good about recessions, but investors get two huge benefits from these economic issues. First, companies are truly tested during a recession. It’s not unusual to find formerly strong companies reduced to conserving cash. Long-term investors get a chance to buy stocks at deep discounts to what they would otherwise trade for.
The second great thing that happens in recessions is weaker companies disappear. While this is certainly not good news for employees of these companies, it is ultimately a good thing for the companies that survive.
One of the simplest measures of a company’s staying power is the strength of their balance sheet. Using the debt-to-equity ratio, investors get a sense of a company’s relative strength or weakness. Peter Lynch used to say he preferred to see at least twice as much equity as debt, and the more equity and less debt the better.
By this measure, Toll Brothers Inc (NYSE:TOL) leads its peers by a comfortable margin. In the current quarter, Toll’s debt-to-equity ratio is 0.64. By comparison, Lennar Corporation (NYSE:LEN) and PulteGroup, Inc. (NYSE:PHM) reported debt-to-equity ratio of 1.29 and 1.21. Of Toll’s competition, KB Home (NYSE:KBH)appears to be in the weakest position with a debt-to-equity ratio of 4.15. Of course a big difference between Toll and their competition is, Toll doesn’t have a financing division whereas the other builders do.
I see this as a net positive, Toll is servicing a higher-end clientele that is likely to have established lending relationships elsewhere. The company essentially doesn’t need a financing division to get their deals done. In addition, while their competition may make some money from their financing divisions, the main source of income for all of these companies is homebuilding profits. Investors looking for a play on the continued turnaround in housing can buy Toll stock and not have to worry about the potential credit related issues and additional debt a financing subsidiary would entail.
It’s Great To Be The Last One Left
Technically Toll Brothers Inc (NYSE:TOL) competes with companies like Lennar Corporation (NYSE:LEN), PulteGroup, Inc. (NYSE:PHM), and KB Home (NYSE:KBH), but in reality Toll is pretty much by itself at the top of the homebuilding market. Toll markets to the high-end homebuyer, whereas the others compete for the more mainstream housing market. You can see this difference in that Lennar Corporation (NYSE:LEN), PulteGroup, and KB Home have average delivery prices around the $250,000 to $270,000 range. By comparison, Toll’s average delivered home price was $571,000 in the last three months. Even more impressive is Toll’s average price in their backlog.
It’s rare when investors get a tip that a company’s earnings should be significantly better in the future, that is also backed up with data. Potential investors in Toll, think about this number, in the current quarter the company’s average home price was $571,000, in their backlog the average price is $665,000. If the company delivers on this backlog, this indicates a 16.46% higher average price per home than in the current quarter.