With Quiver Quantitative’s recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in Toll Brothers (NYSE: TOL). Firms such as Fidelity Investments, Greenhaven Associates, and Acadian Asset Management have all added to their TOL positions recently. Most notably, Greenhaven Associates increased shares held by 3.57% (as filed on 6/30), bringing their current TOL holdings to 5,537,947 shares worth around $443.6 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on Toll Brothers.
In May, Toll Brothers (NYSE: TOL) posted strong second quarter earnings results for fiscal year 2023. Toll Brothers reported net income of $320.2 million dollars and diluted earnings per share of $2.85, up 45.1% and 54% YoY, respectively, showing the increased operational efficiency of the business. Home sale revenues were $2.5 billion dollars, up 14% YoY, with home sale gross margins sitting at 26.4%, compared to 24.1% home sale gross margins in the second quarter of fiscal year 2022. Most notably, backlog value sat at a value of $8.4 billion dollars, down 28% compared to the second quarter of FY22, while homes in the backlog dropped 36% YoY to 7,574 homes. The disconnect between the drop in homes in the backlog and the total value of the backlog shows the increased demand for new homes, as the price of existing homes skyrocket as supply nears all-time lows. With homebuilders benefiting from industry tailwinds due to pent up demand for new home construction, Toll Brothers is a compelling investment opportunity at a very fair price.
Toll Brothers (NYSE: TOL) designs, builds, sells, and arranges financing for an array of luxury residential single-family homes, attached homes, master-planned communities, and low-, mid-, and high-rise urban communities. The development of these communities and homes are largely done on land that Toll Brothers’ owns and improves. Toll Brothers’, as a luxury home builder, largely targets a customer base of luxury first-time, move-up, empty-nester, active-adult, and second-home buyers in the United States. Through Toll Brothers City Living, Toll Brothers also designs, builds, markets, and sells high-density, high-rise urban luxury condominiums. As of October 31st, 2022, Toll Brothers had 981 communities in various stages of planning containing nearly 76,000 home sites that are owned or controlled through options. One large key performance indicator (KPI) for the business is the backlog, which consists of homes under contract that have not yet been delivered to customers. As of October 31st, 2022, the backlog had a value of $8.87 billion dollars, containing 8,098 homes worth an average price of over 1 million dollars (however, as of the second quarter of fiscal year 2023, this figure has dropped to $8.4 billion dollars, with homes in the backlog dropping 36%). Management expects to deliver 90% of these homes in FY 2023.
Toll Brothers is a highly acquisitive business, acquiring regional, privately-held home builders and their assets to expand the business’ geographic footprint and product offerings. In 2022, Toll Brothers acquired a privately-held homebuilder in San Antonio, Texas. Toll Brothers acquired assets from this acquisition that consisted of 16 communities with 450 home sites owned or controlled through land purchase agreements. In 2021, Toll Brothers acquired a privately-held homebuilder in the Las Vegas, Nevada market, acquiring assets that included inventory for future communities and 550 home sites owned or controlled through land purchase agreements. In 2020, Toll Brothers acquired the assets and operations of an urban infill builder with operations in the Nashville, Tennessee and Atlanta, Georgia markets, in addition to another acquisition where Toll Brothers acquired the assets and operations of a homebuilder with operations in Colorado Spring, Colorado. These acquisitions in 2020 included 1,100 home sites owned or controlled through land purchase options.
Toll Brothers operates with stringent land policies to assist in the evaluation of an acquisition. These land policies include comparative studies and analyses like soil tests, environmental studies, evaluation of zoning and other governmental entitlements, and extensive market research to evaluate which product offerings are appropriate for that specific market. These stringent land policies help reduce their risk in acquisitions and ensure that their acquisitions make sense for their customer base and geographic region that they are serving. Through option agreements, Toll Brothers is able to reduce the financial risk associated with land acquisitions and efficiently manage capital. These option agreements allow Toll Brothers to obtain necessary government approvals before acquiring the title to the land. They also allow Toll Brothers to acquire lots over a specified period of time at predetermined prices. While these option agreements may increase the overall cost basis of the land being acquired, it reduces risk and allows Toll Brothers to operate much more efficiently.
The home building industry is highly competitive and fractured, with Toll Brothers competing with numerous home builders of various size and geographic footprint. Sales of existing homes also provides competition at Toll Brothers as well, with the business primarily competing based on price, location, design, quality, service, and reputation. Management identifies that their financial stability in relation to other large national homebuilders gives them a favorable competitive factor in the space. Toll Brothers is also a seasonal business, with a significant portion of the business’ agreements of sale generally entered during the winter and spring months. Management acknowledges that weather-related events and inclement weather can delay housing starts and closings while increasing the costs of home construction. While Toll Brothers’ vast geographic footprint largely mitigates the risk of inclement weather affecting a large portion of the business’ operations, it is still a factor to keep in mind as an investor.
Management is solid and capital allocation priorities are shareholder friendly. Toll Brothers is a cannibal, decreasing shares outstanding by around 38% since 2013. Many of these share repurchases were made when the business was trading below tangible book value, allowing the business to efficiently reduce the size of its float. Due to a credit loan agreement and a term loan agreement, Toll Brothers must maintain a minimum tangible net worth, meaning that the business is limited in the amount of share repurchases that it can do. As of October of 2022, the business’ ability to repurchase its common stock was limited to $4.47 billion dollars, still a very sizable sum that would allow the business’ to repurchase around 55.3 million shares (approximately 50% of the free float) at current market prices. Toll Brothers also pays out a cash dividend alongside the share repurchases. In addition to share repurchases and dividends, Toll Brothers’ management is incentivized well, with the executive compensation plan designed to to motivate and retain skilled executive leaders, provide performance-based incentives, and align compensation with long-term creation of shareholder value. In 2022, CEO Douglas C. Yearley Jr. had around 62% of his total direct compensation in the form of performance-based rewards. These performance-based rewards are based on a few metrics. The annual incentive bonus is paid out based on the PTI Metric, a metric that captures the overall profitability of the business before taxes and includes the results of the business’ joint ventures and non-home building activities. This metric has a vesting period of one year. Additionally, the “Long Term Incentive Reward” includes metrics such as the Units Metric (measures the number of homes that are delivered to home buyers during the fiscal year), Margin Metric (measures the gross margin of the business’ home building operations and reflects the business’ ability profitably and efficiently execute on this core business), and ROE Metric (The ROE metric measures the business’ return on average equity over 3 consecutive years). These metrics within the long term incentive reward each have a weight of 1/3, and are vested over 4 years, 4 years, and 3 years, respectively. These incentives are solid, and they allow management to manage risk taking while improving the business’ performance, condition, and financial results over the short and long-term, aligning management compensation with shareholder interests.
Toll Brothers is an efficient business. The business operates at a LTM ROIC of 18.8% and a LTM ROE of 24.1%. With a WACC of 8.2%, the business operates at a ROIC to WACC ratio of around 2.3x. This ROIC to WACC ratio shows that the business is able to generate returns on capital reinvested back into the business at 2.3x the weighted average cost of capital. Evidently, the business is able to reinvest cash back into the business at favorable rates of return, rapidly compounding intrinsic value and handsomely rewarding shareholders.
Analyzing Toll Brothers’ income statements, we can see some stellar sustained growth in revenue, gross profits, and earnings over the past decade. Since 2013, Toll Brothers has grown its revenue at a CAGR of around 15%, with gross profit growing at a CAGR of 17.4% in that same time period. The excess increase in gross margin compared to revenue over the last decade can largely be attributed to incrementally expanding gross margins. In 2013, Toll Brothers operated at a gross margin of 20.4%, compared to today where the business operates at a LTM gross margin of 25.9%. In terms of earnings, Toll Brothers has grown EBITDA at a CAGR of 23% since 2013, with EPS growing at a CAGR of 28.75% in that same time frame. The growth in EPS can largely be attributed to share repurchases. Since 2013, shares outstanding have decreased around 38%, showing the cannibalistic nature of the business. With aggressive share repurchases like this, the business is able to return excess cash back to shareholders via share repurchases. With Toll Brothers currently trading at such low valuations, it makes sense that management is aggressively buying back shares and consequently rewarding shareholders.
Looking at Toll Brothers' balance sheet, we can see that the business operates in good financial health. The business has around $762 million dollars worth of cash on hand, compared to long-term debt of around $2.5 billion dollars. While we would like to see more cash on hand than debt, this cash to long-term debt ratio is very manageable. Additionally, the business operates with a Total Debt / Equity ratio of 46.3% and a Net Debt / EBITDA of 1.18x, showing the business’ strong financial health and manageable debt position in relation to the business’ earnings.
Looking at Toll Brothers’ cash flow statement, we can see stellar sustained growth in free cash flow and net income over the last decade. Since 2013, Toll Brothers has grown net income at a CAGR of around 24%. Since 2014, free cash flow has grown at a CAGR of around 15.5%. The gap between net income and free cash flow growth can largely be explained by the fluctuation of free cash flow. Toll Brothers’ free cash flow is always changing without pattern, along with free cash flow margins. Since 2014, Toll Brothers’ has operated with an average free cash flow margin of around 8.2%. Today, Toll Brothers’ operates with a free cash flow margin of 12.1%. Toll Brothers is a capital-intensive business, leading to unstable free cash flows.
After conducting a reverse discounted cash flow analysis, we can see that Toll Brothers is trading at share prices that imply a growth rate of -8.93% in free cash flow over the next 10 years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 10%. Toll Brothers is a very capital intensive business, leading to fluctuations in free cash flow. However, since 2014, Toll Brothers has still been able to grow its free cash flow at a CAGR of 15.% (despite the fluctuations in free cash flow), showing that this growth rate is very cheap. With such a capital intensive business, free cash flow can be hard to predict. Therefore, it is more intuitive, we believe, to value Toll Brothers by looking at its tangible book value per share, which shows the value of Toll Brothers physical assets per share. Toll Brothers is currently operating at a tangible book value of around $6.42 billion dollars or $58.67 dollars per share. With Toll Brothers currently trading at a share price of around $80 dollars, shares are trading at 1.36x tangible book value, a very light valuation. This means that the market is placing an excess value of around $2.3 billion dollars or around $21 dollars per share. This excess value represents the market’s perception of the business’ intangible assets, growth prospects, brand value, earnings potential, and other intangible factors. We believe that the excess value of the business placed by the market is low, primarily due to the fact that we believe that Toll Brothers will benefit from industry tailwinds as homebuilders ramp up construction to meet increasing housing demand as existing housing inventory prices skyrocket. According to the National Association of Home Builders (NAHB), existing housing inventory is at all-time lows, currently sitting at around 3.1 months supply. To put this figure into perspective, the figure usually hovers around 4.5 - 6.0 months of supply in a balanced market, however, lopsided demand has pushed down existing home inventories, causing prices to skyrocket. With heightened home prices and high demand for new housing causing tailwinds for the homebuilding industry, we believe that Toll Brothers will benefit with higher earnings, margins, and profit, causing positive price action as the market slowly realizes the discount that Toll Brothers is currently trading at.
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