I have generally observed that investing in a company catering to a niche segment can go either way; it can be pretty lucrative, or lead to disastrous consequences when that particular segment faces economic crisis. Toll Brothers (TOL) is one of those companies that has successfully created a niche market for itself over time. It is the nation’s leading luxury home maker with a market cap of approximately $6.22 billion. With the current housing market recovery phase, the company is on track to achieve magnificent growth.
Good in Many Ways
Well, there is no doubt about the fact that Toll Brothers has delivered excellent results, with a major point being pricing of the delivered homes. Winter is the best-selling season for homebuilders, and as such we saw big sales numbers for the company from January through April along with a reasonable increase in its backlog numbers. As a result of this increase in the backlog, the company has quite comfortably increased the prices without the fear of disturbing demand. Per its second-quarter earnings call, Toll Brothers raised approximately $26,000 per home in the quarter.
Another thing in the results to be happy about was an improvement in the gross margin as a percentage of revenues. Management has announced an improvement of 275 points in margins over the second quarter owing to the delivery of high-margin high-rise projects and price increases. It is definitely a worthwhile factor because it shows the efficiency of the company regarding expense control and working on big revenue projects.
The best part about Toll Brothers is that it caters to a niche segment of the industry, allowing it to dodge competition from other big players. In addition to that, the current scenario of low interest rates and easy lending has put more money in the hands of customers, enabling them to move into luxury homes segment.
If we take a broader perspective, however, then one of Toll Brother’s biggest competitors is Lennar Corp. (LEN), which has a market cap of a over $7 billion. Analysts have observed Lennar to be an overvalued stock, sighting concerns around increasing material and labor costs that are eating into its revenue and diminishing net earnings. I believe that Lennar has a good amount of business ahead in second half of 2014, and its first quarter results bear testimony to the fact that it has maintained adequate financial discipline.
Another player in this industry is KB Homes (KBH), which is smaller in size than Lennar with the uniqueness of selling its signature “built-to-order” homes. KB Homes is quite a small player in the industry, but has successfully created value for its shareholders via massive capital appreciation. The company has also declared a dividend of $0.025 per share in the second quarter as a result of increased operations and higher revenues. More recently, the company acquired 68 lots of land for a new community in the foothills of Jefferson Country alongside Red Rocks Country Club.
KB Home’s stock has appreciated over 52% last year, an impressive feat that raises confidence in the stock. The movement in its share price was being driven more by investor’s confidence than by pure statistics as the company is coming out of bad times and bad numbers.
The Bottom Line
All the points mentioned above, especially the housing recovery, definitely signal that Toll Brothers is a buy. However, there is one big concern around the housing recovery phase relating to the quantitative easing plan. Earlier this month, the Fed signaled its intention to slow down the pace of quantitative easing as employment rates were improving and inflation was also stabilizing to a reasonable level. When adopted, QE results in low interest rates, which brings about a recovery in housing prices due to easy lending and higher consumer spending.
Since the Fed has signaled a slowdown in QE’s pace, some skepticism has surfaced around the recovery phase that it would be largely hit with such action by Fed. Even though there is no actionable plan around it, investors should keep an eye on the Fed’s actions around QE, as it could send housing stocks down
However, as of now I would maintain a buy on Toll Brothers because there is no time frame attached to the Fed’s decisions around QE. Also, the company has got sizable business ahead of it that should bring in high revenues.