Friday, May 5, 2006

For Whom Toll Tolls

News Analysis
May 5, 2006

Business Week Online

For Whom Toll Tolls

Luxury homebuilder Toll Brothers' lower sales outlook might not signal a bursting bubble. But is the air leaking out gradually?

To housing bears, the latest news from Toll Brothers (TOL ) might have seemed like a dead canary in a coal mine. On May 5, the luxury homebuilder announced lower expectations for fiscal 2006 sales and a 29% decline in the value of orders for its fiscal second quarter, which ended Apr. 30.

On closer inspection, the housing market may not be in toxic territory, however. Toll Brothers' outlook probably isn't a sign of a housing crash, analysts say. Rather than pop like a bubble, the housing boom will more likely wind down slowly -- which could still have serious repercussions for the U.S. economy.

UPPER END.  Investors, for their part, were taking the Toll Brothers news in stride. Shares of the high-end homebuilder and its peers rose after a milder-than-expected jobs report. The data spurred speculation the Federal Reserve might soon stop hiking interest rates, which would keep a lid on mortgage rates Toll Brothers finished up about 4%, rising by $1.21, to $30.85. Other homebuilders, such as Centex (CTX ), D.R. Horton (DHI ), and Pulte Homes (PHM ), were up between 3% and 4% (see BW Online, 4/20/05, "Why Housing Looks Rickety").

For one thing, Toll's sales guidance didn't change all that much. The Horsham (Pa.) company projected it would deliver between 9,000 and 9,700 homes in fiscal 2006, a reduction of just 200 from its prior forecast. Taken from the upper end of the range, that's a change of only 2%. Toll Brothers also said the value of its second-quarter signed contracts dropped to roughly $1.56 billion, from $2.2 billion a year earlier.

Markets were already anticipating such declines, some analysts say. Standard & Poor's equity analyst William Mack says the announcement hasn't changed any of his 2006 estimates for the company. "It's pretty much a nonevent," Mack says. "We had expected the slowdown that we're now seeing play through." He maintains a four-star, or buy, rating on the stock.

SOFTER DEMAND.  In a conference call, Toll Brothers CEO Robert Toll sounded an upbeat note while acknowledging weaker demand, as the company enters its ninth straight month of slower sales. "We do not believe this slower market is the beginning of hard times," Toll said. "That is too inconsistent with our sales in several markets and with several new community openings."

The recent news is only the latest drip of weaker data trickling out from Toll Brothers since late last year. Indeed, if there was an unofficial end to the housing shares boom, it was on Nov. 8, 2005 (see BW Online, 11/9/06, "Housing: Red Alert, or a Wake-Up Call?"). That's when Toll Brothers warned of "some softening of demand in a number of markets." Shares tumbled 12%, closing at $33.91, and the fallout also beset stocks in related industries, from retailer Home Depot (HD ) to appliance maker Whirlpool (WHR ).

Bears had their day again earlier this year. On Feb. 7, Toll Brothers said its orders dropped 21% from a year earlier for its first fiscal quarter, which ended Jan. 31 (see BW Online, 2/7/06, "Is the Bell Tolling for Housing?").

OIL PRICES.  As a luxury builder, Toll Brothers may be situated differently from its competitors. On Apr. 10, JMP Securities downgraded the stock from market perform to market underperform, citing weak demand. "We are concerned that the demand for luxury homes is more discretionary," analyst Alex BarrĂ³n wrote.

Still, Toll Brothers isn't the only builder seeing business soften. On Apr. 11 the National Association of Realtors projected existing-home sales to fall 6% this year, to 6.65 million, from 7.08 million last year. New-home sales are expected to drop 10.9%, to 1.14 million, from 1.28 million in 2005. "We'll probably see sales ease a little bit further due to the increase in mortgage interest rates, but pretty well stabilizing," says Walter Moloney, a spokesman for the real-estate trade association, which is set to update its forecasts on May 9.

A decline in real-estate values could weaken the U.S. economy, where home equity has filled the gap between income and consumption, according to Morgan Stanley chief economist Stephen Roach. "The U.S. housing market has been pushed into bubble territory," Roach wrote on May 5. "In late 2005, fully 55 metropolitan areas were experiencing house price inflation of 20% or higher." He indicates that rising rates and surging oil prices could provide the pin that bursts the balloon.

TURNAROUND TIME?  Meanwhile, not all the figures are so gloomy. In April, real estate showed the fastest growth in new business activity among 14 service industries, according to the Institute for Supply Management's report on the non-manufacturing sector, issued on May 3.

Homebuilders may eventually be poised for a turnaround, some analysts say. "The rapidity of the decline in earnings and margins back to a more sustainable level of demand is likely setting the stage for the builders to experience a significant multiple expansion once the dust has settled," Citigroup (C ) analyst Stephen Kim wrote in a May 3 report. He has a buy rating on homebuilders, despite forecasting modest earnings declines through fiscal 2007.

Toll Brothers' lowered sales guidance might be the most recent indicator of a gradually slowing housing market. But that's not the same as a popped bubble -- or a dead canary.

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